Zero Hedge

There was a time on Wall Street when insider trading was rampant, when sellside analysts would pump stocks under the guidance of their superiors only to have their corporate finance colleagues do an equity offer shortly after, when the amount of money a bank's corporate clients paid would determine its rating, and when analysts said in internal emails a company is worthless, only to issue reports claiming the company was the next sliced bread. Then things changed for the better briefly, when Spitzer came on the stage. However, with his thunderous fall from grace in an act of utter hypocrisy, the behavior he fought so hard to curb started gradually coming back.

Yesterday, Wall Street's shadiness came back with a vengeance.

As Zero Hedge disclosed yesterday, mall REIT Kimco decided to dilute its equityholders by issuing over $700 million (including the green shoe) in new shares which would be used to buy back the company's debt, as KIM has $735 million in debt maturities over the next 3 years, and a $707 million currently drawn on its secured credit facility. One look at the company's equity prospectus reveals that the lead underwriter is non other than "scandal-central" investment bank Merrill Lynch.

There is, of course, nothing wrong with being a member of an underwriting syndicate - in fact, absent generating profits from AIG structured finance liquidations forever, banks like ML (better known these days as Bank of America's slam dunk acquisition if one listens to Ken Lewis) will need it if they want to generate revenues. However, what Zero Hedge has a major problem with, is what ML equity research analyst Craig Schmidt did hours if not minutes after the offering was announced. In a research note update, Schmidt, who now gets his paycheck from Bank Of America (this will be relevant in a second), raised KIM's rating from Underperform to Buy.

This is where visions of Jack Grubman should resurface. While Zero Hedge will not speculate over the efficiency of the Chinese Wall at Merrill Lynch, aka Bank Of America, something in this transaction stinks to high heaven.

Let's walk through the sequence of events:

1) First Merrill Lynch/BofA gets clients to subscribe to a massively diluting equity offering (105 million new shares out of 271 million pre-offering shares, or 39% dilution). The offering prices at $7.10/share, a 6% discount to the previous day closing price of $7.49. In the process Merrill pockets an underwriting fee likely equal to 3% of the offering or around $20 million.

2) Minutes after the offering Merrill REIT analyst Schmidt comes out with a report, changing the recommendation on the stock from a Sell to a Buy, thereby getting the vanilla money which makes critical fiduciary decisions merely based on what some sell-side analyst will recommend. As a result Kimco stock rises throughout the day and closes at $9.40, a 25% premium to the closing price, and a 30% premium to offering price of $7.10, which closed that very same day.

3) Notable here is that Schmidt had come out with a Sell (aka Underperform) report on the company less than two months ago, on February 5, titled "Write-downs drove the miss." Among Schmidt's concerns were the following very salient points:

Write downs, not Q4 operating metrics, are the issue

KIM’s Q4 operating metrics took a back seat to write downs in the quarter as the company reported a sharp drop in FFO as it booked $111.8mn in non-cash impairment charges. These write-downs included $83.1mn for securities investments, $22.2mn for the equity investment in JVs with Prudential and $6.5mn for development projects in addition to $4mn of severance charges due to a reduction in headcount. While Kimco’s shopping center operations held up reasonably well in Q4 (rent spreads remained positive and same-store NOI was +1.4%), the company expects far weaker results in 2009 which is common theme running through the REIT industry.

Transaction income non-existent; lowering estimates

With the extensive write-downs, KIM’s reported 4Q08 FFO of $0.04 was $0.21 below our estimate. Looking to ’09, we expect NOI to decline 3% which includes a 300bp decline in vacancy by YE09. Given the impact of deteriorating operating metrics combined with a sharp reduction in transaction activity, we are reducing our ’09 FFO estimate from $2.15 to $1.74 while our ’10 estimate drops from $2.14 to $1.60.

Lowering PO to $12.50

Due to lower projected NOI growth for ‘09, we reduced our forward NAV for KIM from $17.04 to $14.13 and as a result our PO falls from $15.50 to $12.50 which is roughly a 10% discount to forward NAV. Given the weakness in retail spending and cautious leasing environment combined with a sharp erosion in Kimco’s noncore business segments we are maintaining our Underperform rating until we gain better visibility on the retail landscape.

4) Even assuming Merrill's Chinese Wall is fully operational, it would be curious to see how the company managed to "sell" to its clients a stock offering in which its very own analyst had a Sell rating: the cynics among us would presume these very clients would have no problem buying into the offering if they knew or anticipated a change in recommendation (especially one from a Sell to a Buy), and knew they could flip the stock they bought through the offering for a 30% gain in one day!

5) And now for the piece de resistance. The company said in its prospectus it would use the offering proceeds to pay down its revolver. "We intend to use the net proceeds from this offering for debt repayment and for general corporate purposes. Our U.S. revolving credit facility is scheduled to mature in October 2011 and accrues interest at LIBOR plus 0.425% per annum. Affiliates of certain of the underwriters are lenders under our U.S. revolving credit facility and will receive their pro rata share of repayments thereunder from the net proceeds of this offering." That last bit is critical. The company's $1.5 billion credit facility, on which it had $707 million outstanding as of December 31, will be the direct beneficiary of the offering as the entire $707 million amount would be paid down with the proceeds. And what entity benefits from this paydown: none other than Bank Of America, otherwise known as Merrill Lynch!

Ah, good old circular conflicts of interest. To summarize: i) Merrill, which is probably not too happy with having lent out Kimco $707 million on its credit facility, underwrites a $720 (including a 15% overallotment) stock offering for which it gets $20 million, ii) Merrill's analyst changes the stock from a Sell to a Buy, causing it to pop 30% in one day, and allegedly allowing participants in the offering to sell their shares at a 30% gain in a day, a mindblowing annualized return, iii) Kimco uses to proceeds to repay Merrill's credit facility, cleaning out any credit risk exposure Merrill might have with respect to Kimco's underperforming properties and operations.

At least Schmidt can sleep with a clean conscience after putting the following disclaimer in his report: "I, Craig Schmidt, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report."

Another point: on March 25, another REIT, AMB properties, on which ML also previously had a Sell rating, raised over $500 million in stock - ML was not a lead arranger on the credit facility, which would end up being repaid with the offering proceeds, but was a lead underwriter on the equity offering. Another ML analyst, Steve Sakwa raised the stock from a Sell to a Neutral (5 day after the event mind you), not a Buy, on the offering. If the deleveraging thesis was indeed the critical issue here, does it not stand to reason that both stocks would have gotten the same rating (either Neutral or Buy) based on the same catalyst?

Zero Hedge, for one, hopes that Cuomo is reading Zero Hedge, as this kind of conflicted circularity would never have been allowed in the Spitzer days. Additionally, on a recent trip, this author stumbled upon a mall in a major metropolitan area where a Michael's store (another LBO special) had recently vacated thousands of square feet of retail space: the beneficiary of this lack of future cash flow: Kimco Realty Corporation.

In conclusion - to those that managed to get in on the stock offering: congratulations. The 30% return in one day is nothing to sneeze at. To all those other retail and institutional accounts, who piggybacked, and all day were buying the shares sold by the follow-on participants (likely using Merrill's brokerage desk as an intermediary, thereby generating even more profits for the company), hopefully you see something about the dreary mall REIT space that Zero Hedge is missing. Then again, as these purchasers are likely the very same people who are convinced that all the bad news in this market are lagging indicators, with all the seasonally adjusted "good" news are leading, the fair price of KIM to them is likely much, much higher. We hope they are right: in the meantime it never hurts to look at a cash flow or FFO model, and determine just how much cash a 38% equity-diluted KIM will be generating in the future as the bulk of its mall tenants either go bankrupt or decide they simply can not afford the rising rents that retail REIT operators hope to charge.

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