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.

Valuation
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.

Friday, November 25, 2016

Hilton Worldwide: Management Co, Hotel REIT, Timeshare Business

I mention from time-to-time that I co-host a monthly Special Situation Research Forum discussion group sponsored by CFA Society Chicago where we pick a specific company each month and have a deep dive discussion on it.  This month we picked Hilton Worldwide (HLT) which is splitting into three companies at the end of the year by spinning off its owned real estate into a REIT, Park Hotels & Resorts (PK), and its timeshare business, Hilton Grand Vacations (HGV), leaving an asset-light management company as the remaining parent.  The choice was made before the election and ensuing stock market run up, so while the situation is a little less compelling as one company today, as we've seen with RR Donnelley's (RRD) three way split, a lot of market distortions can happen in these scenarios which makes Hilton worth investigating ahead of time.

Background
Founded in 1919 by Conrad Hilton, Hilton Worldwide is the second largest hospitality company with over 4,800 hotels flying one of their brand's banners across 104 different countries.  Hilton was one of the largest leveraged buyouts before the financial crisis with Blackstone taking it private for $26B in 2007 and then subsequently taking it public again in 2013.  Blackstone made out surprisingly well in the deal, and since reappearing on the public markets Hilton has been following the trend towards an asset-light management company model.  To that end, earlier this year Hilton announced intentions to break up into three companies, which should happen by year end.

Current corporate structure:
Post-spinoff corporate structure:
Why do the spinoffs?
  • Typical spinoff rationale of varying capital structures, aligning incentives, investor choice, etc.
  • REIT valuation arbitrage, as a pass through entity that pay high dividends REITs are valued more richly than the same real estate would be within a larger Hilton.
  • Financial engineering of turning Park Hotels management fees and Hilton Grand Vacations licensing fees from an expense that's eliminated in consolidation to a revenue stream at the parent Hilton where they'll likely earn a higher valuation than either spinoff.
  • The parent will be a vast majority of the value, by simplifying the business towards the management contracts, the parent should earn a higher multiple.  The market values simplicity, all three entities will be easier to understand separate than together.
Additionally, Hilton's larger rival Marriott (who recently merged with Starwood) has done similar spinoffs in the past of Host Hotels & Resorts in the 1990s (highlighted in Greenblatt's book) and Marriott Vacations Worldwide in 2011.  There's a clear precedent for this split-up and both Marriott spinoffs have been successful.  Hilton's current CEO, Christopher Nassetta, previously headed up Host Hotels and knows the playbook to make this a successful split-up.

Park Hotels & Resorts (PK)
The larger of the two spinoffs will be one of the last REIT spinoffs, Hilton secured an IRS private letter ruling before the crackdown in late 2015.  The new rule prevents spinoffs from converting to a REIT for ten years after the spin date, effectively eliminating the loophole.  Park Hotels & Resorts will be the second largest lodging REIT behind the old Marriott real estate spin, Host Hotels & Resorts (HST), and significantly bigger than the third largest in the sector.  Now that REITs are their own sector of the S&P 500, some active managers will be forced to add REITs where they were previously underinvested, as a sizable lodging REIT, Park Hotels might be a beneficiary of that index change.

Park Hotels will start off life with 36,000 rooms across 69 hotels, heavily tilted to their largest ten convention and resort style hotels below.  Due to their locations, these hotels are more difficult to replicate and thus face less competition than midscale and economy tier hotels in suburban locations.
Park will only have exposure to Hilton brands initially, but I don't see that as big of a problem as other single exposure REIT spinoffs as its an easier task to rebrand a hotel than say an Ameristar casino or an Olive Garden restaurant.  Park does intend to diversify away from Hilton's brands via acquisition, there are 22 public lodging REITs, some consolidation of this sector seems likely with another big player in the mix.  REITs are one of the few areas where M&A makes a lot of sense as operations are easier to integrate and G&A can more easily be cut at the target thereby spreading the parent's corporate expenses over a larger asset base.  Besides straight M&A deals, REITs can also take advantage of private/public valuation arbitrage, the public markets often times take shortcuts in valuing REITs (me included) and don't make cap rate adjustments for different local markets.  Assets in prime locations that would fetch very low cap rates are grouped in with the rest of a portfolio.  For example, last year Hilton sold the Waldorf Astoria hotel on Park Avenue to a Chinese buyer for 32x EBITDA, an amazingly high multiple, and invested the proceeds in Orlando and Key West hotels via a 1031 exchange at 13x EBITDA (still not cheap) as a way of recycling capital and showing higher EBITDA/FFO irregardless if the underlying real estate value didn't change.

Lodging REITs are on the riskier side of the REIT industry as their leases are the shortest, one night at a time, versus apartment REITs with 1 year leases, or office and industrial REITs that can have average lease terms of 10+ years.  It's not a great business, if it weren't for the REIT tax-free pass through status and investors desire for yield, Park Hotels would be the classic capital intensive bad business that the parent company is trying to shed via a spinoff.  Park puts up all the capital and has to pay Hilton 3% of gross hotel revenues, an incentive fee of 6% of hotel earnings and reimbursement of staffing and operating costs.  Lodging REITs are better than other franchisee businesses because of the tax-free pass through status, but otherwise it's very similar.  Although with corporate level taxes potentially coming down, REITs may lose some of their appeal.

Back to Park Hotels, a few of the particulars:
  • Tom Baltimore will become the CEO, he was previously the CEO of RLJ Lodging Trust and recently left that post specifically to become the CEO of Park Hotels & Resorts after the spinoff.  He's previously worked for Hilton, Marriott and Host Marriott at different times so he likely understands the benefits of the spinoff.  Part of his incentive compensation will be based on Park Hotel's total stockholder return compared to the FTSE NAREIT Lodging/Resorts Index over a 3 year period.
  • 90% of Park's hotel exposure is in the U.S., 10% is abroad, Hilton had to be careful to minimize the international exposure in order to meet REIT requirements.  I'd expect Hilton to continue to divest the owned international real estate in smaller one off transactions.
  • 85% of their hotels are upper upscale and luxury brands, basically this means the flagship Hilton brand level and higher.  90% of their rooms are either urban, resort, or airport hotels, versus only 10% in suburban locations with less barriers to entry.
  • There will be a special purging dividend of roughly $200MM sometime after the spinoff, 80% of the special dividend will be in stock (but still taxable) and 20% in cash.
  • Target leverage of 3-5x EBITDA, generally Lodging REITs are less levered than other REITs due to their cyclical nature.
  • Included in Park are 4 operated hotels and a laundry service business, likely these are the active trade businesses ("lemonade stands") that are required for a tax free spinoff.
Host Hotels is the best and clear comp, however Park Hotels probably deserves a little discount to Host because it's not diversified among hospitality management companies and doesn't have the long track record.  Host trades for 11.1x EBITDA, Park should trade for at least 10x EBITDA, especially given their hotels in New York, San Francisco and Hawaii, plus remember they bought their Orlando and Key West hotels at 13x EBITDA.  Park will have $3B in debt and has proforma 2016 EBITDA of $775MM, at 10x, Park's equity value should be $4.75B or $4.80 per share of HLT.

Hilton Grand Vacations (HGV)
Timeshare spinoffs have been officially a thing for a few years now, Marriott spun off Marriott Vacations Worldwide (VAC) in 2011 and Starwood completed a spinoff via a reverse morris trust of their Vistana Signature Experiences timeshare unit with ILG (f/k/a Interval Leisure Group, ILG) earlier in 2016.

The latest timeshare spin, Hilton Grand Vacations will have more than 265,000 timeshare owners, 46 resorts, and over 7,500 units.  Since being acquired by Blackstone, Hilton has made over its timeshare business to be predominately an capital-light model where instead of developing and funding the construction of the resort themselves, Hilton Grand Vacations partners with third-party developers (PE real estate funds) who then contract out the timeshare share sales and resort management to HGV for a fee.  More than 75% of their timeshare sales now comes from this fee-for-service or a just-in-time inventory method versus 0% in 2009, this has greatly increased ROIC.
Timeshare companies typically make money in four different ways:
  1. Selling timeshare units, this is a cyclical, expensive (tours, free vacations, etc), yet profitable business that's still significantly below pre-financial crisis levels.
  2. Financing the timeshare sales, this is a great business, typically these are 10 year fully amortizing loans that carry interest rates of 10-18% depending on downpayments and FICO scores (HGV's typical buyer has $100+k income and a 745 FICO score).  These loans then get securitized and sold with the timeshare company receiving servicing fees and an equity strip.  Timeshare securitizations have performed surprisingly well throughout the market cycle.
  3. Management contracts on the timeshare resorts, this is another great business, timeshare companies typically charge ownership associations a fee in a cost-plus arrangement (cost + 10% in HGV's case) for managing the resort and up-keeping the property, rooms, etc.  While the hotel management companies typically take a clip off of revenue, here the timeshare companies are taking one off of expenses, the result is a lower upside but a lower risk recurring revenue stream.  The management contracts are sticky, HGV hasn't had a contract terminated since the unit was created in 1992.
  4. Rental income from unsold inventory, units that haven't been sold to a timeshare purchaser can be rented out like any other hotel room, this is less than ideal but is a way of reducing inventory drag as timeshare units are sold.
Another interesting dynamic of the industry is the lack of a secondary market for timeshares.  Once you purchase a timeshare, it's difficult to sell them because the industry makes it difficult by offering perks only to members that buy directly from them that secondary purchasers aren't eligible for.  Another big factor is that there's a lack of financing options for secondary market timeshares, no one will lend to them because there's essentially no collateral.  The timeshare companies themselves are willing lenders because if a loan defaults, that timeshare unit can be foreclosed on and put back into their inventory to be sold to another buyer rather easily.  That mechanism isn't really available to anyone else.

Back to HGV, Mark Wang leads the division now and will be the CEO once the spinoff commences.  He's been in charge of Hilton's timeshare operations for many years and as led the company through the current transition to an capital light business model.  Unlike Park, HGV doesn't plan to diversify away from the Hilton Brand and has signed a 100 year licensing deal to use the Hilton brand name in exchange for 5% of timeshare sales.  Mark Wang has done an admirable job at HGV, they've grown timeshare sales every year through the recessioin, with a CAGR of 7.9% from 2007 to 2015, outperforming the industry, which experience a decline of 2.6% over the same time.

Marriott Vacations Worldwide (VAC) is a pretty good comp, their business segments are nearly identical with Hilton Grand Vacations being a little farther along in their move to a capital light model.  VAC trades for about 8x EBITDA (excluding securitization debt), HGV's proforma 2016 EBITDA is expected to be $380MM and it will have $500MM of non-recourse debt, at 8x EBITDA the equity value of HGV should be $2.54B or $2.56 per share of HLT.

At a $2.5B market cap, Hilton Grand Vacations has the potential to be sold by large cap indexes and unlike Park Hotels & Resorts, HGV won't pay a dividend and doesn't have the REIT investor backstop, in my mind it has the most potential to be mispriced following the spinoffs.

Hilton Worldwide (HLT)
Following the spinoffs of PK and HGV, the parent Hilton Worldwide will generate over 90% of its EBITDA from fee based capital light sources, the remaining 10% from owned hotels which should go down over time in smaller owned hotel sales and as the fee based business continues to grow organically.  Hotel management is a great business as others put up the capital to develop and construct the hotels and then contract out to the likes of Hilton to manage the hotel and be included in their rewards program (HiltonHonors) which brings immediate patronage that being an independent hotel otherwise wouldn't.

Hilton is able to grow very quickly with minimal additional invested capital, since year end 2007, as shown below, Hilton has invested $184MM in the fee businesses which has created an additional $726MM in run rate EBITDA.
Hilton's pipeline is equally impressive, they currently have 789,000 rooms in the system or 4.8% of the global supply, but have over 21% (288,000 rooms) of the new development pipeline (again at minimal additional investment), which should drive growth for years to come.  Next year they expect to add 50,000 - 55,000, or a growth rate of about 6%  from current levels, much of this growth is in overseas markets.
What will Hilton do with their cash flow?  Management's plan is to maintain a low investment grade credit profile, dividend out 30-40% of recurring cash to shareholders, with the remaining cash flow available for share repurchases in a new program to be initiated after the spinoffs occur.  So with Hilton, you have a business that needs very little capital to grow and will return the vast majority of cash to investors via dividends and share repurchase, the best of both worlds.  Marriott paid 14x EBITDA for Starwood earlier this year, backing out a takeover premium and valuing Hilton at 13x EBITDA seems reasonable to me.  At 13x, with $1.76B in 2016 EBITDA and $6.1B in debt would make the equity worth $16.8B or $16.97 per share of HLT.

Adding up the three pieces and I come up with $24.33 per share, a slight discount to the current share price of $25.31 and the $26.25 that HNA Group recently paid for a 25% stake from Blackstone (BX).  This is more of a growth situation than value, and much of the valuation rests on Hilton Worldwide's EBITDA growth trajectory, which since it's not the spinoff, we have little insight into how they've calculated the proforma 2016 EBITDA.  They've disclosed approximately $200MM in transaction expenses, which seems extreme to me, and there's roughly $180MM in management and licensing fees coming from the two new spinoffs into the parent.  If those aren't included in the proforma number or somehow netted against the transaction costs, that would be an additional $2.36 per share in value, plus the additional organic growth coming online in 2017.  I've seen 2018 EBITDA estimates above $2B for proforma Hilton.  The company is hosting an investor day on 12/8, maybe we get some more clarity on the parent at that time.

For now I've just purchased a placeholder position via just in the money January 2018 calls.  If the growth strategy works out, so will my LEAPs, if not, I've limited my downside.  Once the spinoffs occur maybe one of the three will be more interesting as the investor bases turnover.

Disclosure: I own HLT LEAPs

Wednesday, November 16, 2016

Resource Capital Corp: Dividend Cut, New Management Simplifying Portfolio

C-III Capital Partners, led by Andrew Farkas, in September closed on the purchase of Resource America (REXI) which was the external manager of Resource Capital Corp (RSO), a troubled commercial mortgage REIT that has struggled since the financial crisis.  Prior to the financial crisis, as was popular, Resource Capital financed most of their commercial real estate loans through the CDO market, unlike the other mortgage REITs of that era, the company has pretty much stuck to that strategy creating a confusing portfolio with a eclectic mix of assets financed through securitization structures.  These assets include syndicated bank loans, middle market bank loans, life settlements, etc., more fit for a BDC but all squeezed into the 25% taxable REIT subsidiary carve out along with another side pocket of residential mortgages and mortgage servicing rights.  To be cynical, it appears that prior management would see an opportunity to earn a fee managing a new pool of assets, and simply used Resource Capital as a seed investor whenever needed, how else do you end up with that mix of assets in a commercial mortgage REIT?

The company reported third quarter earnings on Monday, first under C-III, and new management basically hit the reset button on the balance sheet, strategy, and the dividend policy all in one swoop.  Book value went from $17.63 to $14.71 per share as they took several impairment charges, and the dividend was cut from $0.42 to $0.05 per quarter.  The result was as you'd expect with many yield investors selling sending the stock down ~30% as they reacted to the dividend cut irrespective of the underlying value.  While certainly tough for previous RSO shareholders, the changes C-III Capital is making should result in the company trading closer to book value over time compared to a 40% discount today.

Capital Structure: $275MM market cap ($450MM book value), $270MM in preferred stock (3 tranches), and $1.4B in debt (both recourse and non-recourse).  Resource Capital reports leverage just under 2x which includes the preferred stock in denominator, putting the preferred in numerator would result in the common shares being levered 3.7x equity.

New Business Plan
The old plan in the 10-K.  It's odd that they use "commercial finance assets" for bank loans and CLOs, never heard that before but maybe because it sounds closer to "commercial real estate"?
C-III Capital's plan:
"Our plan, candidly, is simplify the Company and make it more understandable for investors and improve the transparency of RSO's performance.  We're going to do this by disposing of underperforming assets, divesting non-core businesses, and investing solely in CRE assets that produce consistent recurring cash flows and pay dividends out of earnings and not just out of cash that's on the balance sheet." - Bob Lieber, RSO CEO
The fact that this is a new plan says a lot about previous management.  I've talked about how public investors, especially in REITs like clean and simple portfolios, and that investors could get ahead of this when management is prepared to execute on that plan.  We saw that with Gramercy Property Trust (GPT) twice, first when they were transitioning from a mREIT not unlike Resource Capital to a triple net REIT and second when they absorbed the mix and match portfolio that Chambers Street Properties had created as a private REIT.  A good example of that today would be iStar (STAR) as they clean up their foreclosed operating and land assets, eventually returning to a hybrid mortgage and net lease REIT.  I think Resource Capital could do something similar as Gramercy and iStar, but in a quicker 12-15 month timeline.

The good news is that roughly 70% of Resource's portfolio is already CRE whole loans with a subset of that being legacy pre-2007 loans.  But most of these are senior mortgages on stabilized properties, 80% LTV, 3-5 year maturities and financed with cheap non-recourse (to RSO) funding via securitization structures.  They're currently passing all their OC/IC tests in these structures, if these were to fail cash flow would be diverted to pay down the senior notes.  This portfolio can earn mid-teen ROEs before expenses.
Outside of the CMBS piece, the rest of the assets (C-III's pegs it at 22% of the portfolio) are now considered non-core and will either be sold or allowed to runoff (much of it in the next year).  Included in ABS and other is more syndicated and middle market bank loans that are held via CLOs, these can either be sold into the secondary market or possibly Resource could utilize call features as the equity holder and liquidate the CLOs as pricing on bank loans has bounced back significantly from earlier in the year.  To quote the CEO again:
"To summarize, our strategy is to prudently divest non-core and underperforming assets, which account for nearly $0.5 billion, or 22% of our book value and as we realize the proceeds from the maturities and sales, we will deploy incremental capital into our CRE lending business and CMBS acquisition business" - Bob Lieber, RSO CEO
In setting the stage for the updated business plan, new management took the opportunity to take $55.3MM worth of impairment charges and reset book value lower.  Much of the impairments were related to their middle market and syndicated bank loan operation that they're exiting, along with write-downs of pre-financial crisis CRE loans in legacy securitizations.  While each of these were likely prudent, it has the effect of lowering the bar for future incentive fees RSO will be paying to C-III Capital if the new plan materializes as expected.

Management Agreement
Andrew Farkas, the new Chairman of Resource Capital, is a veteran real estate investor who founded Insignia Financial Group in 1990, took it public in 1991 and eventually sold the business to CBRE in 2003.  More recently he started C-III in 2010, and has since acquired special servicers, real estate brokers, and asset management groups to create a diversified real estate company.  Farkas is savy and RSO is their new fund to extract management fees, important to never really forget that management and shareholders aren't on the same side.

The external management agreement is typical-to-bad:
  • 1.5% of equity base management fee (better than if it was of assets, but REXI called this 70% margin revenue in their own presentation materials)
  • 25% incentive fee over 8% return (25% of which is taken in shares, 75% cash)
  • Expense reimbursement for CFO's salary and partial reimbursement on investor relations team (not covered in the base management fee apparently)
  • Termination fee equal to 4x the average base management fee and the average incentive compensation earned by the manager during the two 12-month periods prior (this would be at least 20% of the market cap, and that's low because no incentive has been earned in recent years)
C-III Capital is inheriting 714,000 shares of RSO from Resource America, or 2.3% of the company, rather insignificant compared to the fees they'll be earning annually.  But from C-III's perspective, their goal is to get RSO in a place where they could raise capital and grow the platform, that will only happen at a share price closer to book value and by playing nice in the sandbox with investors going forward.

Valuation
The larger, best of breed, commercial mortgage REITs like Starwood Property Trust (STWD) trade well above book value, other smaller externally managed ones like Ares Commercial Real Estate (ACRE) trade for about 95% of book value.  At even 85% of current book value, Resource Capital's upside is 35+% and over time as the new plan is executed even that discount should close to peers.  New management has guided that 2017 will be a transition year, and that dividends will likely stay in the $0.05 a quarter range, once the dividend policy is updated about this time next year, I'd expect RSO to be trading at least 85% of a simpler to understand book value.

New management plans to have an investor day soon where they will disclose more details on their future plans which could be an additional catalyst for the shares.

Risks
  • External Management - There's always going to be inheritent conflicts of interest with external management agreements.  With C-III Capital and RSO it seems to be initially surfacing with the buyback, the old management repurchased 8-9% of the shares at prices above $12 over the last year.  C-III plans to shelve the plan and instead deploy capital in CRE whole loans, with the stock trading at a 40% discount, there's no CRE investment I'm aware of that would equate to the same return as buying back shares.  But buying back shares would reduce equity and thus reduce management fees.
  • Leverage - Mortgage REITs are leveraged bets on the underlying portfolio.  CRE whole loans are typically floating rate so the portfolio shouldn't have much interest rate sensitivity but will be concavely exposed to any defaults.  I don't believe we're on the edge of another blowup in CRE/CMBS, but that's certainly always a risk.  
  • More Non-Core Impairments - C-III Capital took $55MM worth of impairments in their Q-3 earnings, about half of that was on the non-core, non-CRE assets and business lines that they're looking to sell.  Logic would say that they'd take the opportunity to get those marks correct, but they could need to come down more as they market these assets and determine what they're really worth.  The good news is CLO/bank loan market is open for business, but as we saw in the first quarter of 2016, these markets can close very quickly.
Summary
I bought some shares on Tuesday for $8.70, and expect the share price to be a little volatile over the next few weeks.  I'm not a long term holder of externally managed companies as eventually the conflicts of interest usually settle with management being the beneficiary.  But my plan is to hold RSO until it finishes management's capital recycling plan and the dividend normalizes which should bring back in the typical yield investors and push the price back up near book value.

Disclosure: I own shares of RSO