Why is SRG Preferred falling?

Is a disturbing conspiracy theory true?

So another quick update on my SRG position, which so far looks like a mistake, or at least I didn’t catch the bottom. My basis on the preferred is now $22.64, which is hella cheap based on last years trading ranges, but terrible based on today’s trades in mid $19 range (as I post this we are back over $20). The common isn’t doing well either, it’s dropped below $6 today, so a small loss on my mid $6 basis. And worse, after another week of research, I’ve now lowered my estimate to $7 to $12/share.

But this price action is strange, why would the preferred be down more as a percentage than common? It’s the more secure instrument, one would expect the preferred price fluctuations to be significantly lower than common.

The reason may be a conspiracy theory circulating around, that might not be far fetched. SRG has said they are open to a sale, and so the theory is this creates a significant tail risk for the preferred. The redemption rights of the preferred in a change of control are limited to conversion to common at a ratio of IIRC roughly 1.28 common shares for each preferred share. So even a company sale at a price as high as $12/share would only net preferred shareholders $15 in a conversion.

But preferred doesn’t have to convert, and one can hang on to preferred shares until redeemed at the $25 face value getting paid $1.75/year in dividends while waiting. Here’s where the conspiracy theory arrives. Why would the acquirer redeem the preferred at all, when 7% interest makes them very cheap financing in today’s rate environment? Even more, why wouldn’t the acquirer just suspend the dividends to improve their own cash flow? Dividends would still accrue, but it may be years before any are paid. And there is no interest owed on accrued dividends, reducing returns even further.

I am not going to deny this is a legit risk. But so far I don’t think it’s very likely. First, I think shareholders will want to sell SRG only near the top of liquidation range. Any offer should give shareholders confidence that liquidation proceeds will be significantly higher than the offer, or why is the buyer trying to buy it?

So to make an offer near top of range the aquirer needs to have some special insight/information or be able to monetize something current management can’t in order to have confidence they can generate substantially more than present day market values. The cheap $70M in preferred saving them a few million a year in interest should not be a sufficient incentive to pay near full price for a $600M+ acquisition.

Instead its been proposed that SRG’s $200M in NOLs would provide that incentive. My understanding is the acquirer could use a limited amount of the NOLs if they purchase SRG in a stock purchase. At current interest rates my calculation is that they could use up to $30M/year worth. The alternative would be a reverse merger, where SRG buys the acquirer and the remaining company could use all of the NOLs without limitation. But with the collapse of the SPAC market, I don’t think that’s remotely likely to happen. So does that roughly $10M/year in tax savings (for 6 years) + a few million in annual interest savings from the cheap preferred provide enough incentive to pay $600M+ for SRG? I don’t know.

If it happens my losses on the preferred will be partially offset by gains on my common. So I do have a minor hedge, and can add to it by purchasing more common. I have not done that yet, as I’m not a big fan of hedging. Instead I would prefer to sell my preferred if I think the risk is too great, but so far I’m not going to do that. At $20 the risk of being forced to convert into $12ish of common vs. getting the full $25 + interest would mean I think sale is more than 33% likely, and so far I don’t. But there is no way for me to discount the idea that a transaction is already underway and this price action is being caused by information leakage.