Friday, April 21, 2017

Innocoll Holdings: PE Buyout, Big CVR Attached

Innocoll Holdings (INNL) recently agreed to be acquired by Gurnet Point LP, a healthcare investment fund headed by Sanofi's former CEO Christopher Viehbacker and backed by billionaire Ernesto Bertarelli's family office, for $1.75 per share plus up to $4.90 per share in contingent value right ("CVR") payments.  The CVR has several milestones based on the approval and commercial success of Innocoll's drug/device Xaracoll which is a biodegradable implant that delivers bupivacaine to provide non-opioid acute pain relief for several days post surgery.  During surgery, Xaracoll is implanted near the incision to provide an initial burst of bupivacaine followed by a slower sustained release that delivers pain relief over 72 hours, and since its biodegradable, it doesn't need to be removed and instead dissolves in the body.

Prior to the buyout offer, Innocoll was troubled and near insolvent.  In 2016, the company pulled the plug on their previously touted Cogenzia (for treatment of diabetic foot infections) after studies failed to show it was effective.  Then late in the year Innocoll experienced another set back when Innocoll received a Refusal-to-File letter from the FDA for Xaracoll causing the stock price to drop roughly 60% in a day.  According to the company, the Refusal-to-File was mostly clerical as the FDA considers Xaracoll a drug/device, not just a drug, thus requires additional information/studies to be performed before the FDA could take it under full consideration for approval.  However, Innocoll didn't have the cash to fund additional studies and was forced to either raise capital or find a buyer, Innocoll found a buyer.

The specifics of the CVR Payment Events:
  • First CVR Payment Event: Gurnet Bidco will pay $0.70 in cash per CVR if on or before December 31, 2018, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following open abdominal Hernia repair
The first payment event seems like a low hurdle, they ran a successful phase 3 trial for postsurgical pain following open abdominal Hernia repair, it seems reasonable that once the paperwork is in order, the FDA will approve it.  Innocoll's only other potential pipeline product is CollaGuard which prevents post-operative adhesions, CollaGuard's potential commercialization is farther out and the addressable market appears smaller than Xaracoll (there are over 1MM Hernia repair surgeries annually in the US).  Often the drug or asset contemplated in the CVR is a secondary asset that the seller believes in more than the buyer, but here the CVR is referencing the primary remaining asset of Innocoll and the deal structure appears to be more of a risk mitigating scheme for Gurnet Point than a typical CVR.  If Xaracoll fails completely, the remaining assets are likely worth less than the $1.75 per share cash offer making Gurnet Point incentivized to at least meet this first initial milestone.
  • Second CVR Payment Event: Gurnet Bidco will pay an additional $1.33 in cash per CVR if, on or before December 31, 2018, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Soft Tissue repair (and not limited to hernia repair).
  • Third CVR Payment Event: If the milestone is met, Gurnet Bidco will either pay: $1.00 in cash per CVR if, on or before December 31, 2019, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Hard Tissue repairs; or, if not $0.60 in cash per CVR if, after December 31, 2019 but on or before June 30, 2020, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Hard Tissue repair.
The second and third CVR payment events require new clinical trials that Gurnet Point will need to fund.  The phase 3 trial for Hernia repair ran for 8 months, so the timelines given for these events seem reasonable.  However, since Gurnet Point will need to fund these trials, there's a risk that they'll time the trials *just so* to miss the CVR payment date.  That's the primary risk with CVRs, the seller is essentially putting the final purchase price in the hands of the buyer, the incentives are misaligned.
  • Fourth CVR Payment Event: If the milestone is met, Gurnet Bidco will either pay: $1.87 in cash per CVR if global net sales of Xaracoll exceed $60 million in any four consecutive Calendar Quarters ending on or prior to December 31, 2019; or, if not, $1.00 in cash per CVR if global net sales of Xaracoll exceed $60 million in any four consecutive Calendar Quarters ending on or prior to March 31, 2020.
I don't feel comfortable handicapping the potential sales of Xaracoll so its hard to have an opinion on the fourth CVR.  There is a competitor in Exparel that combines bupivacaine with a foam in a similar manner and has annual sales above $200MM.  However, opioid painkillers are cheap and they're great at treating acute short term pain, the real opioid epidemic problem revolves around their use for treating long term pain, so its hard to determine if the benefits of Xaracoll would be worth the additional cost?  Maybe for addicts or those at risk to be?

Most likely for today's $2.05 stock price, you get $1.75 cash in the next few months and $0.70 for 1st CVR milestone in ~12 months, plus the optionality of the long dated payment events.  Seems like a reasonable speculation to me, I bought a small amount.

Disclosure: I own shares of INNL

Tuesday, April 11, 2017

Safety, Income & Growth Inc: iStar's Ground Net Lease REIT

This is a pretty ridiculous name/logo right?  It's pretty clear the target market is yield hungry dividend investors who are looking "to sleep well at night".
Despite the awful name, I think iStar (STAR) has a chance to make this work (for iStar) as its a good sales pitch and would be a unique REIT in the market, plus they're selling 12 of their assets for $340MM or a ~5% cap rate.

This week, iStar filed the registration statement for a new REIT, Safety, Income & Growth Inc (SFTY), they've been kicking around quietly since last August.  According to the filing, it would be the first REIT targeted at ground net leases, a structure where the company would own the land, but not the building/improvements, and enter into very long term leases (30-99 years) with the building owner.  The safety part comes from the ground net lease structure, in the event of a default, despite only owning the land, the lessor can foreclose on both the land and the structure built on it.  The leasee and the mortgage lender (if there is one) on the property have every incentive to make the lease payment.  In effective, there's a significant overcollateralization built into the lease, the value of the lease is worth 30-45% of the combined value of the land/buildings, so often times in a foreclosure scenario a ground net lessor can make more than a full recovery.

At first I thought this was a public listing of the net lease JV iStar has setup with a sovereign wealth fund (GIC), however it appears to be a separate portfolio, but with investors in that fund participating in the SFTY IPO.  Safety, Income & Growth Inc will start out life with 12 assets from iStar's net lease portfolio, all 12 are either ground leases or at least look/function similarly if you squint.  The two primary assets will be One Ally Center which is the largest office building in Michigan, leased out to Ally Financial and PwC, and a portfolio of 5 Hilton branded hotels leased to the recent spinoff, Park Hotels & Resorts.
A good strategy in recent years has been buying net lease REITs that are discounted because of concentrated tenant exposure (GPT, FCPT, CSAL)  before they make deals to diversify their rent roll.  iStar says they're looking at a pipeline of over $500MM ground net lease deals, so expect them to diversify fairly quickly after listing.  They're starting with $227MM in debt at a rate of 3.773%, after the deal is done they'll enter into a new $300MM credit facility giving them additional room to add ground leases.

iStar will be the external manager of SFTY, it'll have one of the more unique external management agreements I've seen: 1) waiving their fee altogether for the first year, 2) no incentive fee or termination fee, 3) base management fee of 1% on equity up to $2.5B and 0.75% above, 4) the management fee will be paid in stock.  Granted, there's little work in managing a lease that expires in 2114 (doesn't even look like a valid year), but it's another reason this entity should be an easy to sell to the masses.

Safety, Income & Growth is paying about a 5% cap rate for iStar's assets (combination of cash and stock), the company argues that ground net leases should trade even lower than that:
This seems somewhat reasonable given the overcollateralization built into the structure, if it trades anywhere near a 4.5% cap rate, iStar should be able to source a lot of deals that make sense, especially early on when they can do small individual deals that still move the needle.

We're still waiting on an IPO date, but again, I think this has potential to do well and gather a decent amount of assets.

What does this all mean for iStar?
At year end, they had a $1.5B net lease portfolio (includes accumulated depreciation added back) that generated an NOI yield of 9.1%, in my initial post last summer I argued the net lease portfolio should be valued at 6.5% cap rate, which adds about $600MM mark-to-market above the carrying value on iStar's balance sheet.  It's probably incorrect to assign a 5% cap rate to the entire portfolio, but that would produce a $1.2B mark-to-market gain, quite significant for a company with a market cap of $1B.  But now iStar monetizes some assets at an attractive valuation by putting them in a simpler vehicle the market will be able to digest and assign a higher multiple to -- all while earning a (small) carry on their remaining investment going forward.  It's hard to argue iStar is anything but very cheap, hopefully they use some of the proceeds to buyback stock.

Thanks to the commenter in the original iStar post for bringing this deal to my attention.

Disclosure: I own shares of STAR

Friday, March 17, 2017

New York REIT: Winthrop Team Liquidating Another REIT

New York REIT (NYRT), as the name implies, owns office, retail, and hospitality real estate exclusively in New York City.  It began as a public non-traded REIT, then known as American Realty Capital New York Recovery REIT, and was brought public in April 2014 and externally managed by American Realty Capital (run by Nick Schorsch).  So it had two strikes against it: 1) former non-traded REITs tend to have disparate portfolios since they turn into indiscriminate buyers of anything that's for sale as their commission incentivized sales force pushes client assets into the REIT; 2) externally managed vehicles are often filled with conflicts, especially in regard to adding assets to boost the external manager's fees.

Not surprisingly, after going public the shares consistently traded below net asset value, making additional capital raises difficult for the already highly levered New York REIT.  They couldn't issues shares without serious dilution, they couldn't raise additional debt, they were stuck as a sub-scale REIT that would have difficultly growing and justifying itself as a standalone entity.

Facing investor pressure, the company put itself up for sale in late 2015, which eventually led to a confusing transaction with Washington DC developer JBG Companies that was effectively structured as a back door IPO for JBG, and would have created a confusing mismatch of stabilized NYC assets and a large, mostly multi-family, development pipeline in Washington DC.  Michael Ashner of Winthrop Realty Trust (FUR) launched a campaign against the deal, arguing instead that management should pursue a liquidation of the company, similar to the stance he took at Winthrop (which is now a liquidating trust and no longer traded).  The deal was terminated, and JBG recently found a new dance partner with Vornado (VNR), Vornado will be spinning off their Washington DC assets in an effort to become a NYC centric REIT as well, and will immediately merge the spunoff assets with JBG to create JBG Smith (JBGS).  JBG's management will run the new entity, I'm skeptical of their intentions, but it's one to watch as REIT investors may undervalue the development pipeline value "hidden" within the typical FFO/AFFO valuation metrics.

Back to New York REIT and fast forward a few months, the board and shareholders have approved the liquidation plan and appointed Winthrop as the new external manager and tasked them with selling all their assets and returning the proceeds to shareholders.

Winthrop REIT Advisors
A little background on the new manager (or "Service Provider" as they're listed in the management agreement), they previously managed, and still kind of do, an opportunistic REIT in FUR that invested across the capital structure, asset classes within real estate, both stabilized and development opportunities, and the market never properly valued the company as a result of its complexity.  Michael Ashner, who ran FUR, made the relatively odd decision to wind down the company and temporarily put himself out of a job, clearly a shareholder friendly move that paid off considerably as the total anticipated proceeds will be well in excess of the original estimates.  To get more background on how Michael Ashner thinks, Winthrop Realty Trust still has the old shareholder letters up on their investor relations page which may come down at some point now that the liquidation is almost wrapped up.

Michael Ashner's lieutenant, Wendy Silverstein, is officially in charge of New York REIT as the newly appointed CEO.  She has a long history, so does Ashner, in the New York real estate scene.  Winthrop has now set themselves up as a professional liquidator and its interesting to see how they've structured their incentive fee with New York REIT:
(b)          Incentive Fee.

(i)  In connection with the payment of (x) Distributions during the term of this Agreement and (y) any other amounts paid to the Stockholders on account of their Common Shares in connection with a merger or other Change in Control transaction pursuant to an agreement with the Company entered into after the Transition Date (such Distributions and payments, the “Hurdle Payments”), in excess of $11.00 per share (the “Hurdle Amount”), when taken together with all other Hurdle Payments, the Company shall pay an Incentive Fee to Service Provider as compensation for Services rendered by Service Provider and its Affiliates in an amount equal to 10.0% of such excess; providedhowever, that the Hurdle Amount shall be increased on an annualized basis by an amount equal to the product of (a) the Treasury Rate plus 200 basis points and (b) the Hurdle Amount minus all previous Hurdle Payments.

(ii)  The Incentive Fee shall be payable within two (2) business days of any applicable Hurdle Payment.
They've done their homework and clearly think its worth more than $11.00 per share when today it trades at about $9.70 per share.  In their initial activist presentation, Winthrop laid out their own NAV calculation based on management estimates that's a good  valuation road map for how to think of the ultimate liquidation proceeds.
It's a bit hard to read, but they came up with $11.39 - $12.31 assuming exit cap rates of 4.0 to 4.5%, which still seems about the right range based on industry numbers I've seen.

New York REIT Valuation
A quick snapshot of New York REIT that I recreated from their recent supplemental:
Winthrop's net asset value estimate came from an earlier version of this slide the company published in August:
The majority of New York REIT's value is in 5-6 properties, the two highlighted above, Viceroy Hotel and 1440 Broadway, require the most asset management/re-positioning.  The Viceroy Hotel opened in the fall of 2013, it's a 5-star hotel located two blocks from Central Park, the company paid $148.5MM for it but took a $27.9MM impairment charge recently as the hotel has failed to live up to expectations.  1440 Broadway is only 75% leased and had a few lease expirations that weren't renewed in 2016.

Others might not want to give credit to these two stabilizations occurring, but how I think this plays out is both Viceroy and 1440 Broadway will be some of the last assets sold and only once they've been stabilized, that's been Winthrop's playbook previously.  I think it makes sense to stretch out the liquidation time-frame, rather than discount the NOI for these two assets.  While there is a "clock" on the incentive fee Winthrop earns, their incentive is skewed towards price over speed.

The most significant asset New York REIT owns is a 48.9% equity interest in One Worldwide Plaza, a large predominately office building that takes up an entire city block.  It was purchased in October 2013, included in the sale was an option to purchase the remaining 51.1% at a fixed price of $678 per square foot, valuing the entire building at $1.375 billion.  New York REIT has leased up the building to 100% occupancy, the two largest tenants are Nomura Holdings and Cravath, Swaine & Moore that that both represent more than 10% of the company's overall rent roll.

The Real Deal recently published an article saying the building is being shopped for $1,000 per square foot.  NYRT investor, Rambleside Holdings, came up with a similar number of $1,100 per square foot in a letter sent to management in 2015:
To back into a $1,000 per square foot price, in the 10-K, New York REIT disclosed Worldwide Plaza's cash rent per square foot at $67.75 for the office space and $42.30 for the retail space.
Assuming a 4% cap rate, 60% NOI margins, and using last year's rent roll (conservative since you'd assume some increases), you could just about back into that $1000 per square foot price justification.

Using management's $144MM NOI run rate, the initial $115MM liquidation expense estimate, $1.51B in net debt, and nothing for ongoing NOI, we can come up with a simple table varying the exit cap rates and price per square foot for One Worldwide Plaza outlining the possible outcomes.
I'm hopeful the total liquidation distribution total is somewhere in the $11.33 - $12.44 per share range, with upside if they find someone to overpay significantly for One Worldwide Plaza, 1440 Broadway, or the Viceroy Hotel.  At $9.70 per share today, that's somewhere between ~17% and ~28% upside, with the wild card being timing of the liquidation distributions.  The liquidation plan outlines a 6-12 month time period to realize most of the asset sales, this feels quick?  But unlike Winthrop Realty Trust (FUR), New York REIT doesn't have any assets under development and most of the asset base is stabilized in a fairly liquid market.

Other risks include general softness in New York real estate, it currently appears mostly centered on the high end condo and multi-family market, but could clearly leak into office and particularly retail as that industry continues to be under pressure.  Rising cap rates is also a concern as interest rates continue to pick up, but that tends to not be a perfect correlation and given the near term nature of the asset sales, we'd need to see a significant shift in how the market views the pace of interest rates increasing to have a large impact on pricing.

Disclosure: I own shares of NYRT

Saturday, February 25, 2017

Tropicana Entertainment: Buyback Plan Ramping, Tender Coming?

Tropicana Entertainment (TPCA) is the Icahn Enterprises (IEP) controlled regional gaming operator with 8 casinos and related hotels, bars, restaurants, and entertainment venues.  I've covered it a few times on the blog and have owned the stock since early 2013, to summarize the story:
  • Carl Icahn (through IEP) owns 72.5% of the shares and has a solid track record of investing in gaming throughout the cycle.
  • Given Icahn's ownership, Tropicana's free float available to the public is small and the shares trade rather infrequently on the pink sheets which limits the number and size of potential investors despite TPCA being an $810MM market cap company.
  • Tropicana's balance sheet is unlevered with minimal net debt, fairly unique in the regional casino industry where most peers are heavily levered and its not uncommon to see leverage over 5-6x (especially when including operating leases).
  • Tropicana's flagship casino is located in Atlantic City, a market that has seen a precipitous decline since the recession (which pushed Tropicana into bankruptcy) as competition has destroyed Atlantic City's once gambling monopoly on the east coast.  Since 2014, the number of casinos in Atlantic City has dropped from 12 to 7 with the latest casualty being Icahn (but not TPCA) owned Trump Taj Mahal which closed in October.  Tropicana has been able to capture increased market share in Atlantic City as a result of the closures and Caesars underinvesting there due to their prolonged bankruptcy.
  • The shares trade at a significant discount to peers.
The 10-K was posted today, Tropicana doesn't host conference calls or issue press releases targeted at investors, so the SEC filings are really the only place to gain insight on the company.  Business results continue to steadily move along -- Tropicana primarily targets drive-in markets and focuses on slots as they have more consistent results and require less staffing, with the goal being more predictable results -- nothing in there was too worthy of an update until I got to the share repurchase section.

Share Repurchase Plan
Tropicana initiated a $50MM buyback program in July 2015, but given the limited free float and low trading volume it was a bit head scratcher to determine how the company would execute on that plan without significantly impacting the share price.  Over the following 15 months the company only purchased ~$6MM of shares, but then something happened during November and December of 2016, Tropicana bought over $37MM worth of shares at an average price of $27.62.  What changed?  The election?  Hard to tell, but given the undervaluation and how long the shares had been languishing around $15-18/share, it appears the company decided it should be its own catalyst.
Additionally, if you look at the fine print, on 2/22/17, the board authorized an additional $50MM buyback authorization for a total of $100MM, with about $57MM left remaining.

As of 12/31/16, there were 24,634,512 shares outstanding, of which Icahn Enterprises owns 17,862,706, so while the market cap is about $810MM, the free float is only $222MM, the remaining share repurchase authorization is then over 25% of the non-Icahn shares outstanding.  The company has $240MM in cash, more than the free float, the company could continue to buyback shares and effectively take itself private while bringing their capital structure more inline with peers as they go.

Icahn Enterprises each quarter puts out an indicative NAV, questionably they don't use the market value of their TPCA holding, but instead put a private market value on it given its low trading volume.
IEP marks their ownership in Tropicana at $877MM or $49/share which is 8.5x EBITDA as of 9/30, shares closed today at $32.90.  If Icahn believes in this valuation, continued share repurchases make a lot of sense and would be accretive to IEP's NAV.

While the stock price has about doubled over the past 12 months (now we know why) without a significant change in the business, given the company's appetite for their own shares, Tropicana Entertainment continues to be a very compelling opportunity.  At some point, I wouldn't be surprised to see Icahn Enterprises conduct a tender offer for the remaining shares like it recently did with Federal-Mogul.

Disclosure: I own shares of TPCA

Actelion: J&J Deal Offers a Free R&D Spinoff

Catching up a bit here after a busy few weeks, so not breaking any news here, but again I like putting my positions in writing.  I don't understand biotech, but I've been looking for ways to get a free look or a small merger security in a biotech that could be used as a tracker position, enough to keep me interested in following their development pipeline.

On 1/26/17, Johnson & Johnson (JNJ) won the bidding war against Sanofi for Actelion (ALIOY), a Switzerland based biotechnology company led by Jean-Paul Clozel whose main drug is Tracleer which treats aterial pulmonary hypertension.  Johnson & Johnson is paying $30B or $280 per share ($70 equivalent for the ADR), but the interesting aspect is immediately before the deal is completed, Actelion will spinoff their R&D pipeline of 14 products, most of which are years away from potential commercialization.

Often in biotech or pharmaceutical mergers the bid-ask spread is wide because the target believes in their R&D pipeline far more than the acquirer is willing to pay for it.  This problem is often solved with a contigent value right (CVR) that pays off if a drug in development meets certain targets, the CVR bridges the valuation gap.  The spinoff (or demerger as they're called outside the U.S.) contemplated by the Johnson & Johnson/Actelion deal functions very similar to the a CVR, Jean-Paul Clozel believes in his product pipeline far more than Johnson & Johnson was willing to pay for it.  Per the offer prospectus that was released last week, the spinoff was essentially a condition of sale for Actelion:
On October 18, 2016, Mr. Gorsky sent a second letter to Mr. Garnier in which J&J proposed to acquire all Actelion Shares at a revised price per share. On October 25, 2016 the Board of Directors, together with representatives of Niederer Kraft & Frey, Wachtell, Lipton, Rosen & Katz (“Wachtell Lipton”) and Slaughter and May, met to discuss the revised proposal and, after thorough consideration of the revised proposal, determined that the revised offer price did not reflect Actelion’s intrinsic value. In particular, the Board of Directors believed that the revised proposal continued to undervalue Actelion’s preclinical discovery and clinical pipeline business, and that, while Actelion would be willing to engage in discussions concerning a transaction with J&J, Actelion would require a higher indicative offer price before engaging further. Following the meeting, Mr. Garnier conveyed this decision to Mr. Gorsky. 
Mr. Garnier and Mr. Gorsky remained in contact in late October and the first half of November 2016. Mr. Garnier continued to express to Mr. Gorsky the Board of Directors’ concern that J&J’s prior proposals failed to provide adequate value for Actelion’s preclinical discovery and clinical pipeline business. In order to bridge the valuation gap, Mr. Garnier proposed the Demerger as part of an alternative transaction structure, in which Actelion would spin off its preclinical discovery and clinical pipeline business prior to Actelion’s acquisition by J&J. The representatives of J&J expressed their willingness to consider the Demerger structure, but indicated that the complexity of the Demerger, as compared to straight-forward acquisition, would require additional time to negotiate.
The spinoff, currently dubbed "R&D NewCo", will be capitalized with CHF 420MM in cash from Actelion prior to the spinoff and Johnson & Johnson will contribute another CHF 580MM in the form of a convertible loan, part of which will convert immediately to a 16% ownership in R&D NewCo with the other 84% owned by prior Actelion shareholders.  The remaining loan will be convertible to another 16% of R&D NewCo by Johnson & Johnson at any time for 10 years.  So while R&D NewCo will be independent, they'll have a built in partner in Johnson & Johnson to advance their pipeline to commercialization.

I don't know much about R&D NewCo's pipeline, but I'd encourage anyone interested to watch Actelion's CEO Jean-Paul Clozel's remarks in the deal announcement press conference:

He owns 3.6% of Actelion, Johnson & Johnson is paying $30B for the company, he's set to get paid over $1B in cash for his shares, yet he's going to R&D NewCo and sounds excited to get back to early stage research and be relieved of the sales and marketing overhead of running a commercial pharmaceutical company.

Deal Risk
There was report in the days following the merger announcement that Actelion's Uptravi drug was linked to 5 deaths in France, but those concerns have seemed to be pushed aside as it came out that Johnson & Johnson knew of the issue ahead of time and the European Medicines Agency (EMA) recommend on 2/10/17 that the drug could continue to be used despite the probe into the deaths.

The Material Adverse Effect clauses seem fairly standard to my novice eye:
A Material Adverse Effect means a reduction of:
(i) the annual consolidated earnings before interest and taxes (EBIT) of CHF 98.3 million – which is an amount equal to 15% of the consolidated EBIT of the Company and its Subsidiaries in the financial year 2015 as per the Company’s annual report 2015 – or more;
(ii) the annual consolidated sales of CHF 204.5 million – which is an amount equal to 10% of the consolidated sales of the Company and its Subsidiaries in the financial year 2015 as per the Company's annual report 2015 – or more.
When determining whether a Material Adverse Effect has occurred with respect to the Company and its Subsidiaries, taken as a whole, the following changes in circumstances, events, facts or occurrences shall not be taken into account, individually or together:
(i) any circumstance, event, fact or occurrence in the industries in which the Company and its Subsidiaries operate or in the economy generally, except to the extent (and only to the extent) that such circumstance, event, fact or occurrence disproportionately affects the Company or any of its Subsidiaries relative to other participants in the industry in which the Company and its Subsidiaries operate; or
(ii) any circumstance, event, fact or occurrence that arises from or relates to R&D NewCo, the R&D Business or any of the Transferring Business Assets or Assumed Liabilities, in each case as defined in the Demerger Agreement, except to the extent (and only to the extent) such circumstance, event, fact or occurrence affects any other aspect of the Company or its Subsidiaries; or
(iii) any circumstance, event, fact or occurrence that arises from or relates to the commencement of sales of a generic form of Bosentan (marketed by the Company as Tracleer) in the United States. 
Johnson & Johnson has a lot of cash overseas, this deal helps solve some of that problem as we all wait for the new administration to change repatriation tax laws.  This deal seems fully vetted by both sides and fairly safe to close, the offer prospectus puts the earliest close date at 5/5/17, but seems likely that might get pushed back to June based on the initial guidance.

The ADRs which represent 1/4th a share currently trade for $67, representing a 4.4% absolute return to the $70 offer price, the spinoff is worth something, let's call it $1B for another $2.30 per ADR or ~$9 per Actelion share traded on SIX in Switzerland.  Add in the spinoff, and the current spread represents an 8% return by the end of June.  I could also see R&D NewCo being sold off indiscriminately after the deal closes as it's rather tiny compared to the overall deal and traditional arbritrages don't want to hold a development stage biotech longer than needed.  So this could be a two staged investment, capture the deal spread, and then reinvest some of the proceeds into R&D NewCo.

Disclosure: I own shares of ALIOY

Wednesday, January 11, 2017

Vistra Energy: Energy Future Holdings Reorg, Discount to Peers, Uplisting

Another company that recently emerged from bankruptcy is Vistra Energy (VSTE), the unregulated businesses that made up the old TXU/Energy Future Holdings, the largest leveraged buyout at one point.  Energy Future Holdings filed for bankruptcy in 2014 after years of low natural gas prices squeezed their margins, making their coal power plants less competitive and as result they were unable to service their large debt load.  As part of the reorganization, Energy Future Holdings was effectively split into two, NextEra Energy (NEE) bought Oncor, the regulated traditional utility transmission lines and sub-station business that acts as a natural monopoly, and Vistra Energy which contains the competitive power generation and electricity retailer businesses was spunoff to senior creditors.  Vistra Energy now trades over-the-counter but in late December filed a registration statement with the SEC and should uplist to NYSE/Nasdaq in the spring.  The combination of Vistra's low valuation and the uplist could create an interesting short term opportunity as shares rerate closer to peers and more institutional investors get comfortable with the new company.

Company Overview
Texas was an early adopter of introducing competition into the electric utility industry.  Most people think of utilities as stodgy widows and orphans stocks, that perception is still correct for the regulated parts of the business, but the unregulated parts of the business can be very competitive and cyclical.  Vistra is in this second bucket, but their business model which pairs both generation and retail together helps mute some of the cyclicality of each business.

Vistra Energy is an independent power producer (IPP), through its Luminant subsidiary it is the largest power generator in Texas with 15 plants capable of generating 17,000 MW of capacity.  Electricity demand varies greatly during the day and the time of the year, and electricity can't be efficiently stored, so power generators need to vary their output throughout the day which creates some operational challenges.  Luminant's baseload plants are nuclear and coal based power plants, these run at near capacity at all times of the day/year, their intermediate and peaking plants that go to work during high volume times are primarily fueled with natural gas.  

The predecessor company ran into trouble after the leveraged buyout because they're effectively long natural gas prices in relation to coal (which they are vertically integrated by owning/mining their own supply) since their baseload plants are coal and other independent providers are more skewed towards natural gas.  As natural gas prices dropped, marginal natural gas power plants became competitive with Luminant's baseload coal plants which squeezed margins.  I'll let others speculate on the day-to-day or month-to-month movements of natural gas, but overall the glut in supply has started to recede as high-cost E&P companies have gone under and as exports begin to ramp, I think we see a little more rational actors in the industry, but never know.

The TXU Energy side of the business is the retail arm that interacts with residential and commercial consumers, they'll source the electricity from the power generators, transmit the power over the regulated transmission assets to the eventual end consumer where they'll earn a small clip to bill, collect payments, and handle most customer service issues, etc.  TXU is the incumbent brand that was in place before deregulation and thus still has a strong competitive position as the largest retail provider in Texas.  However, this is a competitive business with new entrants driving down margins and pricing; its fairly easy to setup a retail electric provider business, at least in comparison to the upfront investment required to build/buy transmission or power generation assets.

The company believes the combination of the two businesses reduces the cyclicality of either business, when margins are up in the retail business they're likely down in the power generation business and vice versa.
December Lender Presentation
In early December, Vistra added some additional leverage and paid out a special dividend of $2.32 per share as a step towards right sizing their capital structure slightly.  However, they're still fairly unlevered on traditional metrics compared to peers, which makes sense for a company emerging from bankruptcy and trying to repair its reputation with the investor community.

Vistra Energy is significantly less levered than its independent power producer peers (NRG, Calpine, and Dynergy) and arguably has a more durable business model and competitive position than all three, yet trades at a significant discount to the peer group.
NRG Energy is the closest peer as it also pairs power generation with retail (thanks to its purchase of Reliant in 2009/2010), it trades for 8.5x EBITDA, at the same multiple, Vistra would be worth ~$21 per share versus just under $16 today.

Tax Receivables Agreement
One nagging concern I have with Vistra Energy is the presence of a Tax Receivables Agreement (TRA) that essentially creates two sets of shareholders.  A TRA is an agreement between the company and its former owners to share in the tax savings that were created through the formation of the new company (usually a step up basis on their assets, but sometimes an NOL) that wouldn't have been present without the former owners savvy structuring (or that's the pitch given).  In a typical arrangement, and in Vistra's case, 85% of the tax savings are sent to the former owners and 15% are kept by the company as an incentive to create the tax savings through generating taxable income in the first place.

This arrangement gives the former holders, the senior creditors turned controlling shareholders, a preferred economic return over anyone buying the shares now.  Vistra's TRA shows up on the balance sheet as a $938MM estimated liability, not an insignificant sum, that will stretch out over a decade and can't be prepaid like other debt unless there's a change of control event, which the presence of the TRA would also likely discourage.  But in effect, Vistra is a little better off than a full tax payer as they will get to keep that 15% tax savings, but the company is more leveraged in reality than it looks or screens.  If Trump gets his way and corporate taxes come down, so will the TRA, which could be another potential benefit of lower rates.

Why separate out the tax attribute assets from the rest of the company?  There could be some valid reasons like the market wouldn't value them correctly (likely true) but I don't conceptually like the idea of not being on an equal economic standing in the overall business as other shareholders.

Other Considerations
  • Apollo, Brookfield Asset Management and Oaktree own 39% of the company.
  • As alternative energy technology continues to improve and makes wind/solar more competitive with fossil fuels that will put pressure on Vistra Energy's baseload coal power plants.
  • Operates solely in Texas (ERCOT), particularly concentrated in Dallas/Fort Worth one of the fastest growing MSAs.
  • No clearly articulated capital allocation strategy, likely acquisitions over dividends or buybacks.
Disclosure: I own shares of VSTE

Friday, December 30, 2016

Year End 2016 Portfolio Review

Time to wrap up 2016.  Thank you to all my readers, especially those who have reached out via email or commented on posts, the comment sections are often better than the posts themselves.  My portfolio returned 22.47% for the year, which by coincidence is near my 22.63% IRR since inception and comfortably ahead of the S&P 500's 11.95% gain for 2016, which is admittedly not a great benchmark to compare my strategy but a close enough proxy for a passive U.S. based investor.  The Russell 2000 (small cap index) did 19.48% in 2016, so less of an out-performance, but I'm still pleased with the absolute result.
The big winners this year were Leidos Holdings, Tropicana Entertainment, MMA Capital, Nexpoint Residential Trust, Green Brick Partners and the big losers were Verso, Par Pacific Holdings, and LiLAC Group, breakdown of the attribution is below:
Closed Positions:
  • I sold Crossroads Capital (XRDC) in October at $1.62 to book an early "tax loss" or so I told myself, more likely just me being impatient, which was before news was released that they had hired an investment bank to shop their assets and eventually ended up selling a couple positions.  Today it trades for $2.13 and NAV is over $3, I'd guess the liquidation takes another year or so but it remains an interesting idea.
  • Hawaii's Public Utility Commission blocked the merger between NextEra Energy and Hawaiian Electric (HE) which then cancelled the pending spinoff of their bank subsidiary, ASB Hawaii, which is the main reason I was interested in the first place (still want that bank!).  There could be another buyer out there, but I moved on at a small loss.
  • KCAP Financial (KCAP) was a small position I bought in the early spring as people were panicking, especially with risky credits in particular, but performance of bank loans that KCAP (and other BDCS) held were still chugging along just fine.  The market was pricing in a crisis that never occurred, pair that with the news that KCAP was shopping their CLO manager, and it seemed like a good way to play the bounce when the market returned to normal.  Markets returned to normal, the CLO manager sale didn't materialize (they actually just issued a new CLO), and with dividends I booked a nice gain.  KCAP still looks cheap at 73% of NAV and bank loan marks have only gone up since 9/30 as people pile into floating rate debt.
  • The Lockheed Martin exchange offer for Leidos Holdings (LDOS) turned out to be one for the ages.  I don't normally post about exchange or tender offers, but I liked this one because I'm familiar enough with the government services sector and thought Leidos was cheap with or without the exchange offer discount.  After the exchange offer ratio was finalized, LDOS stock price shot up, either because of a squeeze or possibly because it screened cheap after the deal due to extra leverage caused by the special dividend needed to qualify as a RMT.  After I received my shares, I ended up booking the quick profit but I still like the government services sector in a era where infrastructure and fiscal spending will be in vogue.
  • As hinted at in my mid-year post, I did end up selling the remainder of my Nexpoint Residential Trust (NXRT) holding around ~$20, still like the Class B apartment asset class but just don't trust management and it was close to fair value.
  • I'm not entirely convinced that Verso (VRS) won't end up working out reasonably well, but I didn't have the initial patience, basically got caught being a little bored and impulsive, without having conviction to hold or add to it as the former senior creditors sold out of the stock.  The other lesson here is to be more skeptical of management projections in disclosure statements, and of course most fairness opinions can be thrown out the window, investment banks just back into whatever valuation their clients want to hear.
  • The Zais Financial Corp (ZFC) tender offer worked out pretty much as planned, I ended up selling the Sutherland Asset Management (SLD) stub shortly after the deal closed to book a high single digit return in a little more than a month.  Sutherland is now back on my watchlist, they've announced a dividend, trade well below book value, and as former private REIT shareholders sell their shares it has created an opportunity.
Current Portfolio:
No cash was added or withdrawn in 2016.

My favorite ideas for 2017 are iStar Inc (STAR) and Resource Capital Corp (RSO), both are REITs that either don't pay a dividend, iStar, or pay an abnormally low dividend, Resource Capital, and have mixed portfolios that don't lend themselves to being valued properly by the public markets.  As both continue to recycle their capital and make their portfolios easier to understand, the market should reward them with higher valuations.  Two "buy complexity, sell simplicity" type ideas.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.