May 11, 2010 - 2:52pm EST by
2010 2011
Price: 23.00 EPS $1.90 $2.05
Shares Out. (in M): 25 P/E 12.1x 11.2x
Market Cap (in $M): 575 P/FCF 0.0x 0.0x
Net Debt (in $M): 170 EBIT 0 0
TEV ($): 745 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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Shares: 25mm
Share Px: $23
Market Cap: $575mm
BV: $210mm
Undepreciated BV:$350mm
Debt: $170mm
EV: $745mm
Dividend Yield: 8%

Getty Realty ("GTY") is a REIT created by the separation of Getty Oil's Northeastern gas station real estate (land and premises) from their associated gasoline marketing. In 1997, the marketing was spun-off into its own public company ("Marketing"), and later taken private by Lukoil. Around the beginning of 2001, GTY elected to become a REIT and signed a unitary triple net master lease ("the Master Lease") with Marketing that expires in December of 2015. At that time, all of GTY's stations were leased to Marketing. Since that time, GTY has made several acquisitions to diversify, but Marketing still leases over 75% of their properties and pays 70% of revenues.

We believe GTY is an excellent short because Marketing is in financial distress, has negative cash flow on its Master Lease properties, and is likely to either go bankrupt or negotiate substantial rent concessions from GTY.

Rough CF Model

$87mm rent ($60mm from Marketing)
-11mm property expenses
-8mm environmental (lumpy and unpredictable)
-7mm G&A
-6mm interest

$1.90 annual dividend on 25mm shares, $47mm in required cash flow

Marketing and the Master Lease

Marketing's lease is a unitary lease for 832 stations with 2% annual rent escalations. Marketing is responsible for environmental damage incurred over the term of the lease, a $13-20mm obligation that would revert back to GTY if Marketing filed. Business conditions for Marketing have deteriorated over the last several years. Since at least 2007, Marketing has claimed to be cash flow negative and reliant on funds from parent Lukoil.

In November 2009, Marketing announced a restructuring that could be seen as a precursor to bankruptcy. It sold all of it's non-GTY assets to Lukoil affiliates, and used the cash proceeds from the sale to retire all Lukoil-guaranteed debt. Marketing is now a shell that has the Master Lease and a small amount of cash. Marketing has exited the gasoline marketing business, has sub-leased a portion of their stations at undisclosed rates. 150 stations have had their underground gas tanks removed and GTY believes each to be vacant or cash flow negative.

Two press releases provide context for the relationship between Marketing and GTY:
-- 14 April 2008: Getty Realty Corp. Announces Appointment of Lead Independent Director and Addresses Recent Communications with Getty Petroleum Marketing, Inc.
-- 16 Nov 2009: Getty Petroleum Marketing Inc Announces Restructuring

Why is Marketing so unprofitable?

The economics of gas stations have been tough over the past few years. High gas prices and the recession have slowed the pace of demand growth and led to margin compression-- margins tend to be a fixed number of cents per gallon. Margin compression has been made worse by credit card companies refusing to yield on fixed percentage of sale charges. While gross profits have failed to grow in proportion to gas prices, required working capital has not.

In addition to industry problems, Marketing suffers from high fixed rents and an old store base that lacks modern convenience stores. Their consistently poor results are indicative of other problems (bad management, trading losses, etc.), but, because GTY keeps Marketing's financials confidential, we have limited visibility. Most important is that Marketing has announced its exit from the gas marketing business, has sub-leased and vacated its stations, and no longer stands to substantially benefit from an improvement in industry conditions.


Best case: Marketing pays their full rent until the 2015 lease expiration. In the meantime, GTY continues to make modestly accretive acquisitions. Shareholders earn cash returns of 8-10% per year until 2015, after which they may see a dividend step down as GTY attempts to release the Marketing portfolio.

Base case: Marketing renegotiates its lease with GTY, giving back some vacant properties and receiving rent reductions for others. The effect rent reduction is 33%. Cash flow falls to $30mm per share. The dividend is reduced to $1.20 per share. The market holds the yield at 8%, leading to a $15 share price.

Worst case: Marketing files bankruptcy. GTY net worth falls below $180mm, creating a covenant violation under their credit facility. After a few months of missed rent, the Master Lease is rejected in bankruptcy. GTY becomes the largest creditor in the bankruptcy, and must determine a way to maximize the portfolio value without violating the REIT rules forbidding business operations. The entire Marketing environmental liability reverts to GTY. GTY suspends its dividend to preserve liquidity. Shares go low.

Base case supporting by GTY's own numerous statements in latest Q (please read the Q for full context)

Based on discussions with representatives of Marketing, our decision to attempt to negotiate with Marketing for a modification of the Marketing Leases, and our belief that the Marketing Leases will be modified prior to the expiration of the current lease term, we believe that it is probable that we will not collect all of the rent due related to properties we identified as being the most likely to be removed from the Marketing Leases.

In connection with its restructuring, Marketing eliminated all of the debt which had been guaranteed by Lukoil with proceeds from the sale of assets to Lukoil affiliates and with financial support from Lukoil, which we believe increased Marketing's liquidity and improved its balance sheet. However, we cannot accurately predict whether the restructuring announced by Marketing will stem Marketing's recent history of significant annual operating losses, and whether Marketing will continue to be dependent on financial support from Lukoil to meet its obligations as they become due through the terms of the Marketing Leases. We continue to believe that to the extent Marketing requires continued financial support from Lukoil, it is probable that Lukoil will continue to provide such support. Lukoil is not, however, a guarantor of the Marketing Leases. Even though Marketing is a wholly-owned subsidiary of Lukoil, and Lukoil has provided capital to Marketing in the past, there can be no assurance that Lukoil will provide financial support or additional capital to Marketing in the future.

If Marketing should fail to meet its financial obligations to us, including payment of rent, such default could lead to a protracted and expensive process for retaking control of our properties. In addition to the risk of disruption in rent receipts, we are subject to the risk of incurring real estate taxes, maintenance, environmental and other expenses at properties subject to the Marketing Leases.

GTY's Plan

Getty's plan seems to be to raise equity and debt capital and diversify as fast as possible, such that the risk of Marketing failing is spread over a wider capital base. We do not believe they have much additional debt capacity without raising equity. Their equity cost of capital is currently low enough to support such a strategy. Just yesterday (11 May), GTY announced that they were offering to sell 4.5mm equity shares through an underwritten follow-on offering (JPM and BofA are somehow willing to bank these guys). As the stock averages less than 100k shares traded per day, 4.5mm shares is quite an offering, particularly since there is no specific use of proceeds. We view the raise as GTY's desperate attempt to bail themselves out of the Marketing mess before the market fairly penalizes them for it.



-- Marketing renegotiates its lease or goes bankrupt. 
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