Hence, there are a large number of avenues by which the court might decide that at least $15 million of the settlement account is due and payable immediately.  Since Power REIT has only 1.62 million shares outstanding, that amount to a payment of over $9 a share.  As I write, Power REIT’s stock last traded at $8.10.

In any case, the court may decide that the balance is subject (as Power REIT argues) to interest at the Applicable Federal Rate (AFR).  I was only able to find AFR data back to 1990, but the long term AFR appears to be about 1% less than the 10 year Treasury rate for those years, so I used this approximation for 1967 to 1989.  If we assume that the settlement balance has accrued in straight-line fashion over the 45 years since the beginning of the lease, we get a total (with compounded interest) of around $70.7 million.

While the legal argument that a debt should accrue interest seems sound to me, I have trouble believing that the court would award $70 million to a company with a $13 million market cap.  On the other hand, much stranger things have been known to happen.

Payment of Legal Costs

The lease seems quite clear that the lessee should pay all P&WV’s tax payments and legal costs that are not strictly for the benefit of shareholders.

The legal costs are disclosed in Power REIT’s 10Q, and amount to $366,000, or $0.23 a share.    Although these legal costs are recoverable under the lease, GAAP accounting rules require them to be booked as an expense, and this has been depressing earnings over the last few quarters.  There was also a smaller amount spent in 2011.

Power REIT management believes that the lessees will have to reimburse these legal fees.  This confidence makes this tiny company willing to take on a behemoth like NSC in a legal battle.  The expense might be hurting the stock now, but the cost is much easier to bear when it’s likely your opponent will be paying your expenses.  This also means the lessees have an incentive to wrap the case up quickly.

When the case is over, the worst case scenario is that the court decides NSC will not have to reimburse any of these expenditures or taxes.  In that case, the bleeding will stop, and PW’s earnings per share will return to their former level of about $0.44 a year based on the rent from the lease.  Otherwise, we will see a one-time earnings boost of $0.23 a share or more, some of which might have to be returned to shareholders as a special dividend in order for Power REIT to retain its REIT status.

Implications for Power REIT

This litigation has so far prevented Power REIT from progressing with its plans to diversify its business into Renewable Energy Real Estate.  I have also spoken to multiple investors who are unwilling to invest in the company until the dispute is resolved.  I think such investors are being overly cautious.

Potential moneys that the lessees might be ordered to pay are

  • $0.23 per share or more in legal fees.  I think this is very likely.
  • $15,882,651 or $9.80 a share for the value of the settlement account.  I think there is a decent chance that the court will order NSC to pay this one way or another, although it might not come as a lump sum.
  • Interest on the above amount.   If the court does award interest, it would come to about $55 million ($34 per PW share) of compound interest on top of the $15.5 million principal if they use the long term AFR.
  • Increased rent under a renegotiated lease, which could be many times the current lease payment.  The current lease pays $915,000, or $0.56 per PW share per year.

The downside for Power REIT would simply be that the court orders that the status quo be maintained (in which case they could still order the lessees to reimburse Power REIT’s legal fees.)  In this case, the legal spending will stop, investors will have greater certainty and still own a REIT yielding over 5% which has plans to expand its asset base into renewable energy real estate.  As I have previously written, that expansion is likely to allow PW to increase its per share dividend.

In addition, Power REIT could write off the noncollectable settlement account against future income.  This has been carried on Power REIT’s tax returns as a receivable. 

While no cash would change hands, writing off the $15,882,651 against future income would allow Power REIT to return $9.58 per share to shareholders as a tax-exempt return of capital, rather than as unqualified dividends.  At the current quarterly dividend rate of $0.10 per share, that would mean that all Power REIT’s dividends would be exempt from tax for the next almost 24.5 years.

With the stock price at $8.10, PW’s annual yield is 4.9%.  While the write-off would make no difference to a tax-exempt investor, a taxable investor in the 30% tax bracket would get an after-tax income stream comparable to another REIT yielding  7%, a substantial difference which I do not believe is yet priced into the stock.

Normally, I would suggest that any investor with the option should purchase a REIT in a tax-advantaged account, such as an IRA.  In this case, if you think the chances of Power REIT being able to collect on the indebtedness are low, a taxable account would be most appropriate.

Heads: Win Big, Tails: Win Small

PW is a $8.1 stock carrying no debt whose price can be justified on the basis of current assets and dividend alone.  On top of that, it has a decent (in my opinion) chance of a legal victory in 2013 that could result in payments significantly in excess of the company’s entire market capitalization.  If they lose, they can still write off the noncollectable $15,517,325 settlement account, allowing the company to characterize distributions to shareholders as non-taxable capital gains for many years to come.

That’s an investment even a large investor would love… if only they did not have too much money to buy it.

Disclosure: Long PW.

This article is derived from two articles published on the author's Forbes.com blog, Green Stocks on November 27th and 29th.

DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results.  This article contains the current opinions of the author and such opinions are subject to change without notice.  This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.