Accounting Irregularities Knock Down ARCP: Buying Opportunity or Enron Part 2?

It’s never a good sign when a company’s CFO and top accountant abruptly resign at the same time “accounting irregularities” are announced, but that’s exactly what happened at American Realty Capital Properties (ARCP) this morning.

An audit committee said, in a nutshell, that every quarterly report put out this year should be discarded and that the number from last year’s annual report shouldn’t be relied upon.

This is the sort of thing that makes investors dump a stock first and ask questions later.  At time of writing, ARCP was down about 30% on the day  after being down significantly more.

Given the extent of Wednesday’s stock implosion, I would consider this a buying opportunity in ARCP—albeit a risky one.  In the interests of full disclosure, I added to my existing position in ARCP at prices ranging from $8.22 to $8.48, and we’re a little above those levels now.  But I believe that ARCP could easily deliver total returns including dividends of 50% or more in the next six months if the accounting irregularities end up being anything short of catastrophic.

Let’s take a look at the numbers.  Based on the preliminary reports, the 2014 Q1 adjusted funds from operations (“AFFO”) of $0.26 would be cut to $0.23, and the Q2 AFFO of $0.24 would be cut to $0.22. The audit committee believes that the 2013 numbers are probably accurate, though they are still investigating.

The worst aspect is that there are allegations that management—or at least the CFO—knew about the irregularities and knowingly abetted them.

Still, let’s keep this in perspective.  We’re talking about a difference of 5 cents over two calendar quarters.  Still, this doesn’t cover the 8.3-cent monthly dividend—which could mean that a dividend cut is a real possibility.

I’m not too worried about a dividend cut in the immediate future, though anything is possible.  ARCP should have plenty of access to cash to sustain that dividend, though it probably won’t be growing it much.  Furthermore, even before today’s meltdown, ARCP was modestly cheap.  Shares traded at book value, meaning the market was valuing ARCP’s management expertise at zero.  After today’s move, ARCP trades for about 75 cents on the dollar.  Stripping out goodwill and intangible assets,  ARCP still trades at slightly below tangible book value. Sure, some of ARCP’s properties–such as the Red Lobster purchase–might be hard to liquidate.  But buying a REIT for less than the value of its property gives us a decent margin of safety.

The biggest reason I am inclined to give ARCP the benefit of the doubt, however, is that company insiders have been steadily accumulating the shares throughout 2014. Ten different insiders—including the company’s general counsel—have purchased a combined $3 million since January of this year.

Insider	Position	Date	Buy/Sell	Shares	Trade Price	Cost
Stanley William G	Director	7/11/2014	Buy	10,000	$12.66	$126,600
Stanley William G	Director	6/25/2014	Buy	18,000	$12.39	$223,000
Silfen Richard A	EVP and General Council	6/25/2014	Buy	4,850	$12.34	$59,800
Silfen Richard A	EVP and General Council	6/11/2014	Buy	7,500	$11.80	$88,500
Stanley William G	Director	5/23/2014	Buy	24,000	$12.35	$296,400
Bowman Scott J.	Director	5/21/2014	Buy	10,000	$12.27	$122,700
Bowman Scott J.	Director	5/16/2014	Buy	10,000	$13.08	$130,800
Weil Edward M Jr.	Director	4/21/2014	Buy	7,500	$13.28	$99,600
Beeson Lisa	COO	3/28/2014	Buy	3,500	$13.88	$48,600
Weil Edward M Jr.	Director	3/28/2014	Buy	10,000	$13.80	$138,000
Schorsch Nicholas S	Chairman of the BoD and CEO	3/27/2014	Buy	50,000	$13.78	$689,000
Block Brian S	EVP, Treas, Secy and CFO	3/27/2014	Buy	20,000	$13.8	$276,000
Kahane William M	Director	3/27/2014	Buy	25,000	$13.78	$344,500
Kay David S	President	3/27/2014	Buy	15,000	$13.78	$206,700
Michelson Leslie D	Director	1/28/2014	Buy	700	$13.94	$9,800
Michelson Leslie D	Director	1/17/2014	Buy	6,900	$13.53	$93,400

Is it possible that they’ve all been bamboozled by a crooked CFO who had been cooking the books?  Sure.  Stranger things have happened, and it’s a legitimate risk.  But it’s a risk I consider worth taking for now given ARCP’s pricing after the rout.

The most likely scenario here is that, due to incompetence and not mal intent, ARCP’s now departed CFO and Chief Accounting Officer botched their reporting by a few cents.  That’s bad—really bad.  But not quite bad enough to justify lopping off a third of the company’s market cap.

My advice: Use this selloff as an opportunity. I should reiterate that this is a risky investment.  The auditors could come back and find that the accounting irregularities go deeper than originally reported, in which case ARCP would potentially see a lot more downside.  But given the extent of the selloff and the steady insider buying, it’s a risk I’m comfortable taking.  And of course, the usual caveats apply here: be smart, use sensible position sizing, and have an exit plan.

Disclosures: Long ARCP

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.