In the world of preferred stock investing, there is no objective fair value for a particular preferred stock. The spread between the 30-year treasury yield and preferred stock yields can vary greatly depending on investor psychology, current economic strength and the perception of credit risk. When investors/traders exam a preferred stock for investment, all they can do is see how it compares relatively to other comparable preferred stocks. This is primarily what I do in making my fixed income investment/trading choices. I plan to publish a series of articles on relatively mispriced (underpriced) preferred stocks, and I will start in this article with a relatively simple analysis of QTS-PA, a preferred stock recently issued by QTS Realty Trust.

QTS is a data center REIT. It recently IPO'd its first preferred stock, QTS-PA, which has a par (call) price of $25. There is another data center REIT, Digital Realty (symbol DLR), which has issued 5 preferred stocks with call prices of $25 which gives us an opportunity to do a comparison to see if we can find a preferred stock bargain among these preferred stocks. The data in this chart is as of March 24th, 2018.

Stock Symbol       3/24/2018 Price      Dividend      Current Yield        Yield to Call         Call Date

QTS-PA                            25.25                    $1.781              7.05%                    7.1%               3/15/2023

DLR-PC                             26.95                    $1.656              6.12%                    4.0%               5/15/2021

DLR-PG                            24.94                    $1.469               5.90%                Not Useful        4/09/2018

DLR-PH                            26.23                    $1.844              7.04%                    2.38%             3/26/2019

DLR-PI                              26.47                    $1.587              5.97%                    3.78%             8/24/2020

DLR-PJ                              23.90                    $1.312              5.50%                Not Useful         8/07/2022

I think it is obvious from the above chart that, with all things being equal, QTS-PA is far and away the superior preferred stock. It has the highest current yield, the highest yield to call, and the best call protection with a call date which is further out than any DLR preferred stock. DLR-PH comes close on current yield but the yield to call is only 2.28% versus 7.1% for QTS-PA. DLR-PH will almost certainly be called in one year unless preferred stock yields go up dramatically. As a rule, a company will call a preferred stock if they can issue a new preferred stock with a dividend of $0.20 lower than the one that is callable.  If you examine DLR-PG, it would seem that DLR can issue new preferred stock with a dividend of $1.47. That is $0.37 lower than DLR-PH and makes DLR-PH almost a certainty to be called in one year.

All of the DLR preferred stocks which sell over par have a significantly lower yield to call than QTS-PA and DLR-PG, which is slightly under par, is callable in a couple of weeks so the price upside is limited.

QTS-PA has significant upside in price given that it has call protection for 5 years. DLR-PC, with a lower dividend than QTS-PA and a much lower yield to call, has a significantly higher price than QTS-PA making it a poor relative choice when compared to QTS-PA.

The best comparison to make is QTS-PA versus DLR-PJ. Both have price upside with call dates that are relatively similar. If QTS-PA were to trade at the same 5.5% current yield as DLR-PJ, it would trade at over $32 per share. Because of the possibility of an eventual call in 5 years, QTS-PA will never trade that high, but what this tells you is there is huge downside price protection in owning QTS-PA versus DLR-PJ. The key to doing well in investing is not to lose on a trade/investment, and this is first and foremost in my investing philosophy. Trading stocks with little downside price risk allows me to use a lot of leverage (margin) to greatly juice up my returns.

So What Is Fair Value for QTS-A?

Of course, what we have not yet addressed is the credit risk of QTS versus DLR.  Even though they are in the same industry, are we comparing apples to oranges in terms of credit risk? Is DLR extremely safe and QTS at risk, which one might surmise from the large yield difference in their respective preferred stocks? In my examination of credit safety, I do find that DLR clearly has the edge, but not nearly so much as to explain the large difference in yield between DLR-PJ and QTS-PA. Using the balance sheet as a safety metric, DLR has a ratio of 54% liabilities (including preferred stock) to assets versus 59% for QTS, according to their respective 10K filings. In terms of liabilities to enterprise value, the difference is larger with DLR at a ratio of around 36% of liabilities to enterprise value versus 56% for QTS, although this ratio is related to the current stock prices of each company and these ratios were closer to each other before the hard fall QTS common stock has taken since the company announced a “restructuring” in February.

I believe that QTS’ use of the term “restructuring” has caused concern as many think of “restructuring” as something that companies do when they are nearing bankruptcy or having financing issues. But the “restructuring” in the QTS announcement, as I read it, is primarily announcing a change in the focus of the company meant to simplify and streamline the company’s operations for higher future growth (at least according to management). The plan to cut costs and increase EBITDA should provide for greater coverage of the preferred stock dividend. I don’t claim to be an expert on data center REITs, but this announcement does not seem very consequential in terms of the safety of the preferred dividend payments, but the fall in the common stock price likely spooked the underwriters into requiring a high yield on the new issuance of preferred stock to be sure they would be able to sell it at a profit. Underwriters are very cautious, they hate any uncertainty (such as this restructuring, apparently) and want no chance that the preferred stock will be difficult to sell to the public at prices above what they are paying for it. Therefore, I view this as an opportunity to buy an underpriced preferred stock, and it appears that the underwriters are making a nice profit on the issuance of QTS-PA.

Both DLR and QTS have little credit risk, so what should be the difference in yield between the preferred stocks of the 2 companies with DLR being a better credit? Determining this mainly comes from years of experience and researching many companies and is not a pure science. One could use “preferred dividend coverage”, and QTS actually has slightly better coverage than DLR. Funds from operations (FFO) of QTS is 17 times their preferred dividend payments while DLR has FFO that is 15 times their preferred dividend payments. Both have super coverage of their preferred dividends and are both very safe, however, let’s use the balance sheet metric which favors DLR. PSA preferred stocks are a good bell-weather as they are by far the best credit among equity REIT preferred stocks. PSA has a ratio of liabilities to an enterprise value of only 17% and the vast majority of that is the preferred stock itself with almost no debt. Using the balance sheet metric, I would say that the difference in credit risk between PSA and DLR is similar to the difference between DLR and QTS. PSA-PD, for example, trades at a similar price to DLR-PJ and yields 5.25%, only a .25% difference from DLR-PJ's 5.5% yield. Therefore QTS-PA should probably trade at around a 5.75% yield given this relationship but I will put a 6.25% yield as fair value for QTS-PA for safety sake and because I believe that DLR-PJ is overpriced relative to PSA preferred stocks.

Summary

For QTS-PA to yield 6.25%, it would trade at $28.50 versus the current $25.25. I would not expect it to reach that price but I believe that $27.25 is a fair target price. A $2.00 per share upside for a reasonably safe preferred stock is actually quite large in the preferred stock world. In my mind, QTS-PA is far superior to any of the preferred stocks offered by DLR and very competitive with the best values in the equity REIT preferred stock space. In fact, I wouldn’t touch DLR-PJ except from the short side in this environment.  Should treasury interest rates continue to rise, it is likely that the lower yielding safer issues (most similar to treasuries) will fall harder than the higher yielders which trade more on credit risk than on interest rates. Therefore, I believe that DLR-PJ has more downside price risk than QTS-PA despite the edge in credit quality.

Often stocks that IPO are held down in price because the underwriters want to sell all of the shares they own to lock in their profit. Generally, underwriters purchase preferred stock at $24.25 per share from the issuing company (QTS in this case) and make money by selling it to the public at a price higher than $24.25. As I wrote earlier, underwriters are very conservative and put selling pressure on a new IPO for some period following the IPO as they unload their inventory of stock. Once this selling is finished, preferred stock IPOs can move much higher in price. I believe we are now at that point for QTS-PA, but even if it simply stays at its current price it provides a very nice dividend stream for investors. Obviously, should we see much higher long-term rates in the future, all preferred stocks will be hit, but I expect that QTS-PA will be one of the least affected.

As a risk-averse investor, I would recommend that those interested in QTS-A take an initial position now as the common stock price of QTS seems to have stabilized and add to the position later if the common stock remains stable or moves higher. As a trader, one could buy QTS-PA at $25.25 with a stop 30 cents lower with the idea you have an upside that is at least 5 times the downside. I like those odds.

If you are a holder of DLR-PJ, I would definitely swap those for QTS-PA.