Tuesday, November 30, 2021

Altisource Asset Management: Preferred Overhang, Cash Shell w/ Optionality

Many readers will know this situation, Altisource Asset Management (AAMC) is a cash shell with approximately $80MM in the bank after their only asset management client, Front Yard Residential (RESI), terminated their external management agreement with AAMC resulting in RESI being internalized (AAMC was a 2012 spin, was trendy at the time to spin the management company).  Front Yard later sold itself to private equity (Ares and Pretium) which likely will turn out to be a great deal (even after they hiked the offer) for the buyers given how single family rentals have traded since.  Friend of the blog, Andrew Walker did an excellent podcast (and even answered one of my questions on it) with Thomas Braziel and Jeff Moore pitching AAMC.  They go into some of the background, particularly on the controversial Bill Erbey, who was formerly an executive (back in the early-to-mid 2010s, Erbey ran Ocwen and a few satellite entities like AAMC), but now is *just* a 39% shareholder in AAMC after legal trouble forced him out of the day-to-day operations.

Long story short, Altisource has a large preferred overhang (originally $250MM, currently $150MM after two exchanges), the stock previously traded north of $1000/share (now for $17.90) and issued a zero coupon convertible preferred stock with a strike price of $1250.  The cash from the convertible preferred was used to buyback shares, presumably to boost the shares above the strike price making everyone happy, but instead the stock collapsed.  Now that piece of paper is hopelessly out of the money, it is basically a zero coupon bond with a mandatory redemption date of 3/15/44.  However starting in March 2020, every five years the preferred holders can request a full redemption:

(b)    Each holder, at its option, shall have the right, in its sole discretion, to require the Corporation to redeem all of its outstanding Series A Preferred Shares by providing written notice to the Corporation within fifteen (15) Business Days (but not more than thirty (30) Business Days) prior to a Redemption Date of its intent to cause the Corporation to redeem such holder’s Series A Preferred Shares on such Redemption Date (each, a “Holder Redemption Notice”) which will specify (i) the name of the holder delivering such Holder Redemption Notice and (ii) that such holder is exercising its option, pursuant to this Section 5, to require the Corporation to redeem shares of Series A Preferred Shares held by such holder. The Corporation shall, within fifteen (15) Business Days of receipt of such Holder Redemption Notice, deliver to the holder exercising its rights to require redemption of the Series A Preferred Shares a notice specifying the date set for such redemption, which date shall be no more than thirty (30) Business Days after the Holder Redemption Notice (the "Holder Redemption Date"). The Corporation shall redeem for cash on the Holder Redemption Date, out of funds legally available therefor, all, but not less than all, of the outstanding Series A Preferred Shares held by such holder at an amount equal to the Redemption Price.

The larger holders did indeed request redemption last year.  But the trick is AAMC has to redeem the entire class at once, and obviously they can't redeem the $150MM outstanding with only $80MM in net cash.  The preferred stock is closely held, two holders (Putnam and Wellington) have settled with AAMC and exchanged for either a combination of cash and stock in the case of Putnam or just cash in the case of Wellington.  Both worked out to approximately 11-12 cents on the dollar.   The remaining significant holdout is Luxor Capital which is pursuing litigation against AAMC.

I have never subscribed to the "preferred stock has no teeth" thesis, here is where my views differ (again, I'm often totally wrong):

  • Luxor is not anchored in any way to the previous two settlements, they're the largest holder (basically the only remaining holder) of the preferred stock and still have leverage.  I'm a structured finance guy, they're almost the "controlling class" in this situation, without them the overhang isn't resolved.  Additionally, Putnam included a "most favored nation" clause in their settlement which effectively hitches their settlement to Luxor, it gets Putnam out of the lawsuit but also allows them to retain the optionality of a better deal.
  • Altisource won't risk consummating a new business combination/merger before the preferred stock overhang is resolved.  If the deal is successful, then AAMC could potentially be on the hook for the full $150MM down the road or at a minimum increases the recovery rate for Luxor.  I don't see anything happening until Luxor settles, maybe there's a settlement and merger simultaneously but it feels highly unlikely that the preferred can just sit out there until 2044 (for either side).  So this is a game of chicken until then, and those situations can last longer than people want to believe (I would have thought RHE would have settled by now).
But the price has fallen considerably in the last several weeks to $17.90 today, at this price the thesis seems more interesting (basically back to where it was before Wellington settled) and allows some margin of safety in the circumstance that Luxor strikes a significantly better deal than either Putnam or Wellington did.

Here's the current situation, obviously the capital structure is upside down at full face for the preferred, I'm discounting the net cash for two quarters of cash burn, dealers choice there.


How I'm thinking about a post-settlement proforma: I'm assuming that the Putnam settlement is the best case.  Putnam held $81.8MM of the preferred stock and received 288,283 shares of stock and $2.863MM in cash (split in two payments), if we applied that ratio to the remaining $150MM outstanding, I get about a $25 NAV.

But if Luxor was going to settle for the Putnam deal, they would have already, so applying a multiple to that, let's say they negotiate a 25% or 50% better deal than Putnam, I get an NAV of $23.28 and $21.50 respectively.  Against a $17.90 stock, that seems like a reasonable discount, if you did a goal seek on the multiplier to get to the current price, Luxor would need to strike a deal more than 100% better than Putnam (also includes the incremental benefit to Putnam for MFN clause) to get to the current share price.

I'm not going to speculate on a deal target, the podcast interview I referenced does a bit of that if you're interested, but AAMC included in the below in their Q3 earnings release:
Mr. Thomas K. McCarthy, Interim Chief Executive Officer, stated, “The Company’s attention and focus continues to be the evaluation and pursuit of certain business opportunities and acquisition targets in which to focus the Company’s resources and enhance shareholder value. The Company has liquidated its equity holdings and is now in an all-cash position in preparation of an acquisition event.

During the third quarter, the Company also engaged the services of both an investment bank, Cowen and Company, LLC, and the law firm, Norton Rose Fulbright, LLP, to assist us in identifying and reviewing potential acquisition and merger opportunities. While no final decision has been made, the Company is in discussions with several potential acquisition or merger targets including cryptocurrency and brokerage related businesses”.

The company is probably mid-process, I'm guessing that a settlement with Luxor is announced at the same time (if they take shares, they could participate in the upside, removing the litigation overhang will likely cause the stock to bounce significantly), plus there are some "meme able" buzzwords in there and a relatively low float, I agree that something crazy could happen with this one and at today's price you're not paying much, if anything, for that optionality.  But there are hundreds of SPACs also competing for similar buzzy deals, so who knows, could be challenging to get a deal done and there could be a frustratingly long stretch with no news.

Disclosure: I own shares of AAMC 

Wednesday, November 24, 2021

Sonida Senior Living: Out of Court Restructuring, fka Capital Senior Living

Sonida Senior Living (SNDA, fka Capital Senior Living under the old symbol CSU) recently completed an out of court restructuring led by Conversant Capital, the same investor that has been instrumental in institutionalizing and providing growth capital to INDUS Realty Trust (INDT).  While clearly different, the industrial/logistics asset class has covid tailwinds versus senior housing having covid headwinds, the results could rhyme with each other longer term as this micro cap "grows up" (to steal a tweet from "Sterling Capital" @jay_21_, also h/t for the idea). Sonida is now positioned to use their reset balance sheet to take advantage of a fragmented senior housing market with plenty of distress (looking over at our friend RHE), but also with long anticipated demographic tailwinds finally being realized with an increasingly large population aging into senior housing.

Below is the standard investor relations overview slide.  Unlike some others in senior housing, SNDA is not a REIT (more similar to BKD), but owns and operates the vast majority of their facilities as they exited locations the company formerly leased from others (VTR, WELL, PEAK etc) in recent years.  There's embedded real estate value at SNDA as a result, which may someday lend itself to some kind of REIT transaction.  They also have a small management business that resembles Five Star's (FVE) business model (got there in a similar way too when SNDA restructured their leased properties) that helps offsets some G&A in the meantime.


The restructuring agreement took a few twists and turns, including heavy opposition from 12+% shareholder Ortelius Advisors, but was eventually approved by shareholders in October and closed earlier in November.

A total of $154.8MM (net $140.8MM) was raised through a combination of:
  • $41.25MM in convertible preferred stock (11%, conversion price of $40) to Conversant plus an additional $25MM accordion to the convertible preferred stock if needed for growth capital 
  • $41.25MM in common stock at $25/share to Conversant, plus warrants to purchased an additional 1 million shares at $40/share
  • $72.3MM through a rights offering at $30/share to all company shareholders
  • Conversant previously provided a $16MM rescue bridge loan to the company, it was repaid in full upon closing of the transaction on 11/3/21.
Most of the capital is going to be used to stabilize the company's balance sheet and take care of some deferred maintenance capex the company likely punted on the last two years.  The capital basically allows the company to recover and get back to some kind of normalized operating environment.  Senior housing has had the unfortunate position of getting hit by covid from both the revenue and expense side.  It's not fun to mention but obviously covid caused a lot of deaths in this age group and likely prevented a lot of move ins as family members stayed home and turned into caregivers to avoid subjecting love ones to senior housing during a pandemic.  On the expense side, first they had PPE expense and now a tight labor market which is squeezing their margins.

But attempting to look through to what their results could look like in a year or two as the world normalizes, the key numbers to run a scenario analysis are the occupancy and NOI margin (I'm going back to YE 2017, no good reason just seemed "normal", for their owned properties they did 88% and 38% respectively):
To be clear, they're a ways away from normal, as of their last earnings report, occupancy was 82.3% and NOI margin was 21%.

For the cap rate, it's a bit tricky too, senior living is similar to hotels where if you're the owner operator it's less of a real estate business and more of a service business.  But Ventas (VTR) recently purchased Fortress controlled New Senior Investment Group (SNR) for $2.3B:
"The transaction valuation is expected to represent approximately a 6% capitalization rate on expected New Senior Net Operating Income ("NOI").. the acquisition price implies a 20% to 30% discount to estimated replacement cost on a per unit basis.. the transaction price represents a multiple of <12 times estimated 2022 New Senior normalized FFO per share including full synergies."  
It's not an apples-to-apples comparable, New Senior didn't operate their properties, just leased them out which is arguably less risky (although a lot of senior housing REITs have had to take back properties) but at least allowed them to be a REIT and lower their cost of capital.

The proforma debt and share count is a little messy, I've probably made some errors here, so those who know better, please feel free to correct me.
That compares favorably to today's share price of ~$32 per share, but that's an asset/takeout value (doesn't include corporate overhead, etc.) and assumes a full recovery.  But also doesn't include any additional growth or deal making which will likely come in the future, based on who they've brought in, the re-branding, it all signals that this is going to be more of a growth platform (similar to the GRIF to INDT rebrand).  
On sort of a going concern basis, using normalized numbers, including the convert but excluding the effects of the warrants, I have it trading at 12.5x normalized EBITDA (below where other senior housing companies trade, but to be fair, they'd trade lower on a normalized number too).  Not screaming cheap on an absolute standalone basis, they probably need additional scale to create some operating leverage on the G&A and corporate expenses.

Other thoughts:

  • I don't have the stats to back it up at my finger tips, but the dynamics in senior housing appear to be similar to those in single family residential.  There was significant overbuilding of senior housing in the middle of the last decade, then it dropped off a cliff, now we're finally seeing the long promised demographic wave moving into the 80+ cohort which could cause supply to tighten and rent/occupancy to rise.
  • I like the new board of directors.  The new Chairman is Dave Johnson, he was previously the President of Wyndham Hotels (WH) and is a board member of Hilton Grand Vacations (HGV), two companies I've followed/respected for several years.  Then to repeat the tie in with INDT, Conversant is bringing in Ben Harris as a board member, formerly the president of Gramercy Properties Trust (fka GPT) which was a blog favorite, most of the other key members of that team are at INDT now.
  • While not as great of an inflation hedge as multi-family due to the greater percentage of variable/labor costs in senior housing, inflation should be able to be mostly passed onto to the residents.  SNDA disclosed in a recent call that they were increasing rents by 5+% next year, VTR is targeting 8% in their owned properties, etc.
  • Sonida has a fairly high concentration in Texas, Wisconsin, Indiana and Ohio.  Their facilities tend to be smallish and on the older side, about an average age of 23+ years.
  • The company recently announced they'd be managing an additional 3 properties for Ventas starting 12/1, while not material yet, perhaps the managed segment could be a growth business for Sonida.  It's a fee business, not exposed to lease expense or capex of an operator, etc.
  • The company is going to restart giving guidance for 2022, presumably with Q1 earnings, which could give some needed visibility to investors as I fully admit my back of the envelope math is mostly a guess at this point.

Disclosure: I own shares of SNDA (plus INDT and RHE-A still too)

HMG/Courtland Properties: Microcap REIT Liquidation

*Disclaimer: Please note that is this a $18MM market cap that is closely held and illiquid*

HMG/Courtland Properties (HMG) is a tiny REIT that recently announced intentions to hold a vote early next year to approve a plan of dissolution and liquidate.  HMG was founded in 1974 by Maurice Wiener, he is 80 and is still the CEO of the company (technically this is an externally managed REIT, but there is no incentive fee), he controls 56% of the shares through various entities leaving little doubt the liquidation proposal will be adopted.  

The company's assets are a bit of mess (this liquidation will probably take several years), but the largest asset is a 25% equity ownership in a newly constructed Class A multi-family apartment building ("Murano at Three Oaks") in Fort Myers, FL.  Construction began in 2019, the building was completed in March and is already 97% leased as of the recently released 9/30 10-Q.  With inflation running hot and migration to the sun belt, cap rates on multi-family assets like this one are being quoted below 4%.  This is a hidden play on the craziness in multi-family M&A.  


Disclosure on the property is limited.  But checking the building's listing on apartments.com, it appears the going rate for their units is around $25 annually per square foot, there are 318 units and 312,000 square feet of rentable space.  Let's round down a bit for some vacancy to $7.5MM top line revenue, again back of the envelope, let's use 40% of gross rent goes to some combination of property management, operating expenses and taxes (I spot checked a few multi-family REITs for this, could be off!), that gets you an NOI of $4.5MM on the property.  

I'm sure I'll get the comment that this asset would go for less than a 4 cap but let's use that for now too, since it just started leasing this year, guessing there's not a lot of rents that need be reset to market as leases rollover like other properties.  There's a $39.5MM construction loan on the property, so the net value to the equity under my math is ~$73MM with HMG's share of that being $18.25MM, or roughly the market cap of the company.  Their equity investment in the apartment joint venture is held on the balance sheet at $3.3MM (HMG put in $3.6MM into the project, but due to equity method of accounting, HMG recognizes the proportional losses of the project has experienced since it has been in lease up mode).  Again, sounds a bit crazy, the asset was built for $54.1MM and now seemingly worth double that or more.  Given the debt here is a construction loan and the asset is freshly stabilized, even if the equity group doesn't sell it outright, they'll likely refinance and pull a decent amount of cash out that could be used for an initial liquidation dividend.

The rest of the REIT sort of looks like someone's personal portfolio/family office, in this case the CEO's:

  • The external advisor's "Executive Offices" at 1870 South Bayshore Dr in Coconut Grove, FL.  This appears to be a single-family home (unclear if the CEO uses it as his primary residence) that has a Zestimate of $2.5MM, it has a tax assessment of $1.5MM and a book value of $590k (it was purchased in the 90s).  There's no debt on the property, let's call it $2MM net to HMG or roughly another $2/share in value.
  • 28% interest in a 260 River Street in Montpelier, VT, carrying value of $870k.  Tricky to tell what this really is but they had some environmental abatement issues that are seemingly behind them, a new tenant took possession of the property in March.
  • About $4MM in net cash (after subtracting out ~$800k of current liabilities)
  • $2.8MM of marketable securities, much of which is equities and preferred stock in undisclosed large cap REITs
Then it gets a little strange (if it hasn't already), there's $4.85MM (as of 9/30) in carrying value in 46 individual private investments, it appears like most of these are real estate related (including some multi-family which could have embedded gains) but also includes non-real estate related stuff like technology and there's an energy investment hidden in here somewhere too.  Below is the breakout from the last 10-K, the carrying values have moved around a bit but gives you a sense of the asset classes.  

These investments are carried the lower of cost or fair value, there could be some diamonds in the rough, a few excerpts from recent monetization events: 
"During the nine months ended September 30, 2021, we received cash distributions from other investments of approximately $1.03 million. This included distributions of approximately $584,000 from our investment in a multi-family residential property located in Orlando, Florida which was sold during this quarter. We recognized a gain of $315,000 from this investment." 

And this one: 

In August 2021, one of our other investments in a private bank located in Palm Beach, Florida merged with a publicly traded bank, and we exchanged our original shares for shares in the publicly traded bank. Accordingly, we have reclassified this investment as marketable securities, and as of September 30, 2021 this investment with historical cost basis of $35,000 has an unrealized gain of approximately $128,000.
But also this one:
The other OTTI adjustment in 2020 was for $175,000 for an investment in a $2 billion global fund which invests in oil exploration and production which we committed $500,000 (plus recallable distributions) in September 2015. To date we have funded $658,000 and have received $206,000 in distributions from this investment. The write down was based on net asset value reported by the sponsor and takes into consideration the current disruptions in the oil markets because of the economic fall out of the pandemic.
Even stranger there are some ~$1.5MM in loans they've made, apparently mostly all to the same person.

On the minus side of the ledger, there's about a $1MM in annual expenses between the management fee and G&A, we should probably capitalize that for at least 4 years given it's going to take time to unwind all the mess here and I get approximately ~$30/share in value and it trades for about ~$17.25/share today.  

The key with any liquidation is the timing of the cash flows.  Here it could be a reasonably attractive IRR since the largest asset just stabilized and it would make sense to either sell or refinance cash out of it in the near term.  Once most of your basis is out of the stock, it's easier to be patient on later monetization events.

Disclosure: I own shares of HMG

Sunday, November 7, 2021

Advanced Emissions Solutions: Another Informal Liquidation

We're at the end of earnings season for small caps, this could be stale in under a week (ADES reports 11/10), Advanced Emissions Solutions (ADES) is a $130MM market cap with no debt and by year-end should have ~$90MM in net cash as one of their two business segments is running off due to the expiration of a tax credit.  The company announced strategic alternatives in May, likely intending to sell the remaining business segment and effectively liquidate the company.  Similar to other informal liquidation ideas lately (LAUR, PFSW, RVI, JCS, BSIG, etc), the downside is protected by the cash generated from monetizing one business segment that could be returned to shareholders either by a tender offer or a special dividend, with upside coming from an M&A event for the remaining segment.

This is an unoriginal idea, it appeared in the comment section of my Laureate Education post (might have appeared earlier but I can't find it) and other investors have shared their views with me given the similarity to others I've written up, there is also an excellent VIC long thesis on the situation.  If you've read it, you can probably stop here.

In 2011, the U.S. government implemented a 10-year tax incentive program (IRS Section 45 Tax Credit) to motivate electric utilities to use cleaner burning coal and reduce emissions.  That tax credit is expiring at the end of 2021.  Within ADES's refined coal segment, they own a 42.5% interest in Tinuum Group, which is basically a royalty business on the tax credits power plants receive utilizing their services.  In their Q2 press release, ADES is projecting $30-$40MM after-tax to be distributed to ADES from this runoff segment by year end.  Add that to the $57.3MM of cash on the balance sheet as of 6/30, and the cash balance should be roughly $90MM.  There are 18.85 million shares outstanding, that's $4.75/share in net cash on a ~$7.00 stock.

The remaining segment is an activated carbon business, Advanced Purification Technologies ("APT").  Out of their Red River Plant in Louisiana, APT produces chemical products primarily used to purify coal fired power plants (reduces mercury emissions) but they've also made efforts to diversify into other end markets like industrials and water treatment plants that aren't in secular decline.  APT was acquired by ADES in late 2018 for $75MM from Energy Capital Partners who had originally built the Red River plant for $380+MM (*correction, ADES originally built it, see first comment*).  Coal usage has declined faster than was underwritten a decade ago when the plant was built; the original greenfield investment wasn't money well spent.  Although, with natural gas prices moving up significantly this year, maybe the coal-to-gas fired plant conversion theme will slow?  As part of the acquisition, ADES also acquired the on-site lignite coal mine (Five Forks) that is used as an input to produce activated carbon, interestingly the mine operations are subcontracted out to old friend of the blog NACCO Industries (NC).

The APT business continued to struggle after ADES acquired it, covid didn't help either, but back in September 2020, ADES entered into a 15 year supply agreement with competitor Cabot (CBT) to supply activated carbon in North America that results in two important things: 1) diversifies the APT business away from coal into other end markets (also provides some revenue certainty to a buyer); 2) rationalized the competitive market by facilitating Cabot's exit from the industry.  Earlier this year, they entered into a second supply agreement with Cabot to supply international markets for 5 years.  On the negative side, Cabot had ADES take ownership of their Marshall Mine (on-site lignite mine of Cabot's plant) and immediately shutter it, reclamations efforts have begun (again, being performed by NACCO), but importantly for Cabot, the asset retirement obligation moved from its balance sheet to ADES.  The remaining ARO is about $12MM to ADES (there is a cost sharing agreement between ADES and CBT), 70% of the work/cost is to be completed in the first two years, but it could have a long tail and make a sale of APT more challenging.

Currently the APT segment is roughly breakeven, but appears to be inflecting, per the press release describing the Cabot supply agreement inked in Q4 2020:

We expect our production to ramp up incrementally during a 4-5 quarter transition period, which when complete is expected to yield the following net impacts to our current operations:
Incremental annual revenue growth of 30% - 40%;
Incremental annual EBITDA growth of $10 million to $15 million; and
Diversified end markets will reduce our power generation exposure to less than 50% of product portfolio.

Presumably ADES should start to see some improvements in Q3 results given that 4-5 quarter timing (the backdrop for their remaining coal exposure seems positive as well) and hopefully hear some hints the Red River plant's utilization rate is ramping, this is a high fixed cost business so the operating leverage can be pretty huge.  ADES bought the business for 4.2x EBITDA back in 2018, implying $17-18MM in EBITDA, it doesn't seem unreasonable that the post-covid run rate (including the CBT supply agreement) is above that number.  Conservatively assuming that the APT segment is worth what ADES paid in 2018, $75MM, netting out the $12MM in ARO, gives a $63MM "remainco" valuation or $3.35/share.  Add that to the net cash and its at least an $8.10/share stock, that's probably conservative on both sides, coal is surprisingly hot (meaning the remaining royalty could be closer to $40MM) and APT should be worth more than $75MM post CBT deal.  But I'm not an engineer, only have a loose idea of what activated carbon is based on YouTube, this is clearly more a situation I like (rhymes with others that have done well with recently) more than the business itself.

Other thoughts/notes:

  • ADES has $93.8MM of federal NOLs, in order to protect against a change of ownership that would eliminate the NOL, the company put in a plan in place effectively prohibiting anyone from acquiring more than 4.99% stake in the company.  Given the small market cap, the plan limits the potential pool of investors.  Also leads itself to a liquidation mindset as the NOL should provide a tax shield.
  • In March, ADES felt confident enough in the trajectory of the business to institute a price increase.
  • The Red River plant is a low-cost (reportedly the lowest-cost AC producer), underutilized asset, that thesis alone could appeal to PE buyers.

Disclosure: I own shares of ADES

Friday, October 29, 2021

Orion Office REIT: Form 10 Notes

Similar to my last post on Loyalty Ventures (LYLT), this is a half baked idea, it hasn't started trading yet but it might help others if I put my thoughts on paper and help me if anyone else has spent some time on it and would be willing enough to share thoughts, especially if you have a different view.

I love a good merger-spinoff combo, the latest one is a result of the merger of two large net lease REITs, Realty Income (O) (which is the bluest of blue chip in net lease land) and VEREIT (VER), the merger closes 11/1, the two are combining their office properties and spinning them off as Orion Office REIT (ONL, presumably for "Office Net Lease") mid-November.  About 2/3rds of the portfolio is coming from VEREIT and 1/3rd from Realty Income, VEREIT has spent the last few years selling down their office exposure to look closer to Realty Income and other high quality peers, so there is some risk these are their lower quality office assets.  Office properties usually aren't a great fit for a net lease REIT, they're less mission critical to the operations of the tenant as a restaurant location would be or a casino or an auto body shop.  Caesars Entertainment is not going to leave Caesars Palace (net-lease owned by VICI), but they can change a corporate office building without impacting the business.  Add covid into the mix where people are generally living their lives as normal other than returning to the office and it makes sense that Realty Income would use this opportunity to spinoff their office exposure.  This could be viewed as a BadCo or garbage barge spin, here's the Form 10.

The Realty Income management team is going to stay in place, while much of the VEREIT team is moving to the spinoff.  Orion is positioning itself as a single-tenant, long-term leased (resemble a triple-net if not explicitly one), suburban office REIT with the thesis that in a post-covid world, suburban office is going to make a comeback as millennials move to the suburbs and white collar employees generally want shorter commutes.  Orion wants to be a growth vehicle, taking advantage of any covid induced dislocations and a lack of competition, targeting properties in fast growing sun-belt metro arears.

Anecdotally, my friends that pre-covid worked in the suburbs are back in the office at least part time, others that worked downtown are still fully virtual.  I think it will be difficult to get people, especially those with families, to return to the old normal routine of an hour plus on a commuter train when the labor market is this tight.  Try taking a dog treat away, the dog won't be happy, everyone has adjusted and proved many formerly cube farm jobs can be done in pajamas from the comforts of home.  But maybe suburban office makes a comeback, suburban office would generally feature shorter/more flexible commutes as employees drive-to the office versus take public transportation on set schedules.  Again anecdotally, in my typical office job, we're trying to get people back to the office, it's difficult to train new people in fully virtually environment and we're generally having trouble keeping the previous corporate culture together almost two years removed from the beginning of covid.  Many people have never met face to face (even with their manager), there's resulting infighting, clients hate us, etc.  I have an uninformed view that how big corporates handle their return to office/remote strategy might be more important for long term success than their go-to-market strategy with clients in the next 1-3 years.  Office space will likely have a place in the future, but clearly a smaller footprint, more communal layouts and possibly different locations than pre-covid.  Maybe Orion gets sold off on the perception that it is a garbage barge spin but is instead well timed at the inflection points of both a return to office theme and suburbs over central business districts themes?  I'm not fully there on that thesis, but I'm intrigued by the idea.

The biggest problem is while it might be Orion's go-forward strategy, the starting portfolio doesn't resemble a long-term leased sun-belt suburban office portfolio.  The weighted average lease life is less than 3.5 years and many of their 92 properties are large headquarter like campuses in the northeast and midwest.  For example, they will own the old Merrill Lynch Princeton, NJ campus now occupied by Bank of America and the Walgreen's corporate campus down the street from me in the northern suburbs of Chicago.  The headline portfolio metrics seem good, it's 94.4% occupied (I assume this means leased, would be interesting to see the percentage where the tenants have returned), 72% investment grade tenants and 99% rent collection through covid.


Below is the lease expiration schedule, many of their leases are expiring in the next 3.5 years, depending on your view of the pace of return-to-office, this could be a challenging time to re-lease these properties at or near the same levels of base rent or square footage.
I'm going to compare Orion to Office Properties Income Trust (OPI) which also focuses on long-term single tenant office buildings, it differs from Orion positively as its weighted average lease term is 6 years (plus has more central business districts properties) and on the negative side, it is externally managed by RMR Group (RMR) which comes with conflicts that deserves a discount and has less net leases leading to more capex and lower FFO to AFFO conversion.  OPI is one of the cheapest office REITs and might be a good bogey for where Orion will trade initially.

Part of OPI's strategy is to sell assets with upcoming lease expirations that are not net leased and thus require the owner to upkeep the property and pay for capital expenditures.  I found their recent commentary on the Q3 earnings call surprising:

Ronald Kamden

And then just on the disposition side, can you just maybe comment on who are the buyers, what the market - like who sort of looking at these properties and any comments on pricing would also be helpful, whether it's cap rates or you're seeing increased interest would be helpful. Thanks.

Chris Bilotto

Yes. So I think from who the buyers are, I mean these - given kind of the size of these assets, a lot of these properties are kind of more local, local, regional groups, not necessarily institutional investors. And so it really is a mix, just kind of given the fact that these properties, it's not necessarily a portfolio, but they're individual dispositions. And so I think from kind of looking at the financial aspect, I would say that from kind of a cap rate for these assets and at least what we've sold, we're seeing kind of collective cap rates in between 7% and 8% and that can kind of vary on one side or the other depending on the circumstances.

And I think it's just kind of important to note that these are buildings we're selling as part of our capital recycling strategy because they're buildings that we feel like where we would rather maximized value. These are buildings that are older in age, capital intensive and in some cases kind of have short-term fault and so by way of example from what we've sold to-date, as I noted, the weighted average lease term was 1.2 years.

Again, those are surprising cap rates for a property type that many, include me, believe to be potentially obsolete. If these properties are trading for a 7%-8% cap rate, ONL should probably trade somewhere in there, maybe closer to the 7% range since the governance structure will be better and these are true net lease properties.

FFO is a fairly standardized number, while it's not GAAP, most REITs follow the same industry methodolgy, adjusted AFFO can vary, it is supposed to further adjust FFO (which is primarily just net income + depreciation, then adjusted for acquisitions/dispositions) by removing recurring capital expenditures to maintain the properties, a closer true cashflow/earnings number.  In a net lease REIT, FFO and AFFO should be very similar since the tenant is responsible for maintaining the property.  

That is what we see with ONL:

For the Realty Income office assets (FFO is proforma for the new capital structure, it does include the anticipate debt, overhead, etc.):

For the VEREIT office assets:

FFO and AFFO match up pretty well, call it ~$150MM in combined AFFO for the pro forma ONL.  There will be 54.2 million shares outstanding at the time of the spin (1 share of ONL for every 10 of O), or ~$2.75/share of LTM AFFO for Orion.  OPI trades for 8x AFFO, if ONL traded similarly it would go for ~$22/share.

That might be a bit harsh, the broader net lease REIT group trades for a high-teens AFFO on average, but I don't think this will trade like the others.  Based on the Form 10, I come up with about $170MM in NOI for the ONL portfolio, they're going get spun with $616MM in debt, if we put a 7% cap rate on that it should trade for ~$33.50/share and at an 8% cap rate it should trade for ~$27.80/share (the range where OPI is selling assets).  I could have a few mistakes in here, so please do your own work, but if ONL trades well below this range I'd be interested.  In post-covid/pre-merger calls, VEREIT was looking to sell office assets in the 6-6.75% range, possibly I'm being conservative again like CCSI.  

Other thoughts/notes:

  • This is another lightly talked about spinoff, in this instance I couldn't even find an investor deck or any materials on either Realty Income or VEREIT's websites.  Realty Income in particular has a highly retail oriented shareholder base as it has marketed itself as "The Monthly Dividend Company", with low rates, many retail investors have migrated towards the net lease REITs as bond proxies and Realty Income is the king of retail net lease.  I expect most retail investors to sell ONL and treat it like a dividend since it will only be 3-4% of the total value of O if my estimates are in the right ballpark.
  • All REIT spinoffs are taxable, another reason why O/VER shareholders are likely to sell because it is effectively a dividend anyway.  It also means that an acquirer doesn't need to wait the two year safe harbor period to avoid becoming taxable like regular spinoffs.  I don't have it in front of me, but back in 2016, two office REITs merged, Parkway and Cousins (CUZ), with the two entities doing a similar spin at the time of the merger.  Back then they spun off their Houston properties (this was shortly after the oil crash) in a "new Parkway" entity that was public only for a short while before it went private.  Something similar could happen here if the valuation precludes them from embarking on their growth plans.
  • Orion does plan to pursue a growth strategy, they're going to have $616MM of debt at the time of the spin which seems fairly modest here and in relation to most spinoffs.  So I think that strategy seems reasonable, suburban office likely doesn't have a lot of buyers right now, they should at least have a chance to begin executing on that strategy immediately given their capital structure.

Disclosure: No position, but interested depending where ONL begins trading

Tuesday, October 26, 2021

Loyalty Ventures: Form 10 Notes

Alliance Data Systems (ADS), after a few years of speculation, is spinning off their LoyaltyOne segment as Loyalty Ventures (LYLT) in an attempt to become a more pure-play private label credit card company.  The spinoff's primary business (~80% of  EBITDA) is the Canadian loyalty program "AIR MILES" where consumers ("collectors" in LYLT speak) shop at participating retailers ("sponsors") and earn points that can be redeemed for travel, cash/gift cards or other rewards.  AIR MILES collects a fee from sponsors at the time of purchase but only recognizes revenue fully when the collector redeems the reward, creating an attractive negative net working capital business.

AIR MILES is similar to the old Blue Chip Stamps business that was a Warren Buffett favorite from a generation ago. AIR MILES is an independent rewards program, it is not formally connected to an airline or hotel chain which is common in the U.S., instead they partner with retailers offering rewards on everyday recurring consumer purchases like groceries and gas. The other business under the Loyalty Ventures corporate umbrella is "BrandLoyalty", it is more of a targeted short-term promotional business that primarily caters to grocery store chains globally. I haven't seen their promotions at any grocery stores I frequent, but the campaigns BrandLoyalty runs seem analogous to the Monopoly game promotion McDonalds occasionally does to generate a short-term bump in sales.  It doesn't appear to have the same float dynamics and its results are rather lumpy.

The spinoff setup reminds me a bit of the recent one from J2 Global, Consensus Cloud Solutions (CCSI), an historically underinvested yet steady cash flowing business the parent had harvested cash from to pursue M&A in other segments.  While I continue to have my doubts about Consensus (the market clearly doesn't share my view) not being a melting ice cube, Loyalty Ventures should be a low-single digit revenue grower inline with GDP.  It is not an exciting growth story but it will produce plenty of cash that now instead of sending up to ADS corporate, can be used to deleverage (starting off with ~3x net debt), invest in the business or return to LYLT's own shareholders (no plans for a dividend).

This is a business with some baggage and requires a little leap of faith to assume it will get back to its normalized earnings.  Back in 2016, the AIR MILES segment made a pretty terrible public relations blunder (here's a local news story on it), they had previously quietly added a 5 year expiration date in 2011 to their reward miles, all historically issued miles would then at year-end 2016 unless they were redeemed.  Due to the revenue recognition dynamics, this created a windfall in 2016 as collectors rushed to redeem their miles or have them expire, either outcome is generally good for the company's financials.  But people don't like the rules changed mid-game and AIR MILES faced significant backlash (they also reportedly didn't have enough rewards/merchandise to meet demand), eventually it became a legislative issue and the company caved to pressure a month before the deadline, removing the expiration feature from the program.  The miles once again never expire, but many long time collectors redeemed their miles for unwanted rewards just to risk not losing them and they weren't allowed to return their rewards after the expiration policy was reversed.  Naturally if you had been saving miles for a dream vacation for a decade and instead had to redeem for a fancy vacuum, you'd be upset.  Management in charge during this time have since moved on, it is not the same team that will be in charge of the spin.

The AIR MILES segment was just about back to normal when covid hit which reduced the appeal of a travel awards program and due to travel restrictions, mile redemptions (and thus revenue/earnings) dropped significantly in 2020 and 2021.  In Q2 2021 business is potentially inflecting, miles created is up (+8%) and redemptions (+32%) are following, albeit against an easy comparable Q2 2020.  The company is anticipating $187MM in adjusted EBITDA in 2021, but a normalized number is probably something closer to $200-210MM, this is something of a leisure travel recovery story.

There is not a great public peer for Loyalty Ventures currently public, Aimia previously owned Aeroplan (spun from Air Canada and repurchased by the airline a couple years back for $370+MM) and AeroMexico's loyalty plan that was sold for 9x EBITDA.  The U.S. airline carriers used their loyalty programs as collateral to raise financing for themselves last year, for example United raised financing with a 12x EBITDA multiple valuation on their rewards program.  Probably not apples-to-apples.  I have no clue where LYLT will trade, but I'm going to throw a 9x multiple on it as a guess.
When issued trading was supposed to start today under the symbol LYLTV but I didn't see any trades, regular way trading is set for 11/8.  As always, I'm very open to hearing from those more knowledgeable about the situation, especially those more comfortable with the accounting and piecing out the true cash flow of this business.

Other thoughts/notes:
  • This spin seems a bit off the radar, ADS has been kind of quiet about it too, the investor deck is about as sparse on details as the Trump/DWAC one, there hasn't been an investor call made public (guessing there's one for the debt or will be one).  Most pitches for ADS (previously was a bit of a hedge fund hotel, some potential investor fatigue here) have always been focused on the card business and the loyalty segment has been a throw away afterthought.
  • The company likes to tout that 2/3rds of Canadian households have an AIR MILES account, but many collectors are probably only loosely active in the program, the top 15% of collectors make up 70% of new miles created.  This is both good and bad, collecting miles seems like a habitual exercise, it gamifies shopping, you need the power users but you also need to keep them active and happy.
  • BMO is their largest sponsor with 15% of revenue, I believe this is their primary credit card partner, their contract comes up again in 2023.
  • ADS is retaining a 19% stake in LYLT, like other recent spins, they'll divest the retained amount over the next year or so to reduce debt.  ADS calls out that 27% of their shareholders are index funds that might be forced to sell LYLT, so there could be a bit of an overhang.  The distribution ratio is 1 share of LYLT for every 2.5 shares of ADS, if LYLT is worth $50 then its about $20 of ADS's $100 stock price.
  • I don't know the full history, but LYLT pays a 1% royalty fee to Diversified Royalty Corp (DIV in Canada) for the use of the AIR MILES brand name, rather insignificant but also kind of odd.
  • LYLT invests the "float" rather conservatively, mostly cash equivalents and some corporate bonds (most miles are redeemed after 2-3 years, so the portfolio probably matches the duration).  While their miles never expire if an account is active, miles do expire if an account is abandoned and not used for two years, so there is some breakage still despite the 5-year policy being reversed.
  • It wouldn't surprise me if we see a goodwill write-down on the BrandLoyalty business, it accounts for $542MM of goodwill and is expected to generate $52MM of EBITDA, so that would value the segment at 10x EBITDA.  They acknowledge the risk in the Form 10 noting that the fair value is less than 10% above the goodwill carrying value.  Or one could spin it that if BrandLoyalty's intrinsic value is 10x, the overall company should be at least that as the AIR MILES segment is a more valuable business model.
Disclosure: I have a tiny position in ADS $100 Jan 2022 calls, basically just a FOMO trade in case LYLT takes off out of the gate similarly to CCSI (seems like one of those situations where both parent and spin will trade up), look to add LYLT directly once it starts trading.

Tuesday, October 12, 2021

Bluerock Residential Growth REIT: Messy Balance Sheet, Possibly Pursuing a Sale

Multi-family REITs have been one of the stronger real estate beneficiaries of covid, particularly those with properties located in the sun belt.  The WSJ recently reported that national asking rent rose 10.3% in August, with asking rents rising more than 20% year over year in sunbelt cities like Phoenix, Las Vegas (HHC!) and Tampa.  With the tailwinds of migration trends, increased inflation driving rent growth and plenty of liquidity looking for safe returns, all of these factors have driven down cap rates significantly to the 4.0-4.5% range.  

One bit of semi-surprising M&A news/rumors, in mid-September, Bloomberg reported that Bluerock Residential Growth REIT (BRG) was exploring a potential sale, the company hasn't commented on the report or confirmed they're exploring strategic alternatives.  Bluerock is a complicated story, one filled with related party transactions and a mess on both sides of the balance sheet, but if the reporting is accurate, Bluerock's common stock could be significantly undervalued.  BRG was formerly an externally managed REIT, however in 2017 the structure was technically internalized, but only kind of, management maintains several related interests in other Bluerock entities that earn fees off of BRG making the market skeptical of a sale.

Starting with the left side of the balance sheet, Bluerock has interests in 60 multi-family properties, mostly in the low class-A, high class-B range, think $1300-$1400/month garden and midrise style apartments in the first rung of the suburbs in sun belt cities like Phoenix, Austin, Atlanta, Raleigh, etc.  

Of those 60, 35 are consolidated properties where BRG owns the vast majority and operates the property like a normal multi-family REIT and the remaining 25 are more credit style investments where they have a preferred equity, mezz loan or ground lease interest in the multi-family property (some of these are new developments).  

This second credit investment bucket can cause issues when trying to screen BRG as you need to back out these investments to determine an implied cap rate for the operating portfolio when coming up with a sum-of-the-parts valuation.  The credit investments bucket also has the potential to make a sale trickier, the operating portfolio should have plenty of buyers, but if they insist on including the miscellaneous other credit stuff it would shrink the buyer pool.  The credit investments are also often tied to related party developments that management has an outside interest in (obvious question would be if these are truly market/arm's length terms), in a sale, management might have to take this pool and buy it into one of their other vehicles or sell it to a commercial mREIT like entity.

On the right side of the balance sheet, Bluerock has a heavy slug of preferred stock in their capital structure essentially making the common stock an equity stub.  There are currently four separate series of preferred stock outstanding, the series C and D preferred are pretty traditional in that they have a $25 liquidation preference and are exchange traded.  The series B (still outstanding, but discontinued) and T are non-traded and placed through RIA channels with investors (similar to a non-traded REIT) via an affiliate of management, Bluerock Capital Markets LLC, where management receives a 10% commission/fee (broken up into a 7% and 3% component) of the total money raised.  The B/T also have a strange feature where after 2 years, the company can redeem the preferred shares for common stock, so naturally management pitches this as an attractive capital raising method where they can continuously issue the preferred and then convert the preferred to common at opportune times.  There's some validity to that, but clearly some conflicts of interest too.  The problem is the stock has continued to trade at discount to peers and a theoretical NAV, they've converted some preferred over to equity this year, but where private assets are being valued after this recent spike in rent growth, it's probably value destructive to continue to convert the preferred stock.  

The the bull case is why management might actually be looking for an exit, they do own a lot of the stock (technically units in the operating partnership) thanks to their incentive plan and the 2017 internalization transaction, the capital structure is stuffed full of preferred stock, how much more can they realistically issue?  From the Q2 conference call (tikr.com):
We have a buyback in the market that provide support for the stock. So I wouldn't be surprised if you saw us redeem part of the B cash. I wouldn't be surprised if we take a break from redeeming the B, to a lot of stock -- the common to absorb and recover. We have -- as you know, we own north of 30% of the equity -- common equity here as management. So we're very sensitive to the stock price, making sure that we deliver value for the shareholders.  
Since the capital structure is so levered to the common, the upside if someone is willing to pay top dollar could be pretty huge.  On the bear side, management could keep issuing preferred stock, earn their 10% levy, continuously convert those shares after two years in perpetuity and drain a lot of value from minority shareholders.  Again, this is technically internalized structure but still feels externally managed.  Here is BRG mapped out in my typical back-of-envelope style, this is for a sale scenario so doesn't include overhead or some of the other accounting noise in BRG's financial statements, and there could be errors:
Then a super basic scenario analysis based on potential transaction cap rates and assuming the credit investments are valued at book value:
The combination of high upside in a sale scenario with the uncertainty that management would actually sell even if a great deal presents itself pushes me to like call options in this case.  I can participate in the upside if a deal happens and limit my downside if it ends up being an unfounded rumor or something management planted to get the stock price up so they could convert the preferred at more advantageous terms.

Other thoughts:
  • REIT M&A activity is above or near all-term highs as a result of a combination of low rates, PE money sloshing around the system, plus it seems like private values for real estate didn't fluctuate nearly as much as publicly traded REITs did during the pandemic. Some of that mispricing is being fixed through take private transactions.  One example, Condor Hospitality's (CDOR) proxy statement came out, as expected there were plenty of buyers and they all coalesced around the same value (I'm also anxiously waiting for a similar result at CorePoint Lodging (CPLG)).  If BRG is indeed running a similar process, I'd expect similar results, plenty of buyers and offers coming in at or below a 4.5% cap rate.
  • BRG has a value-add component to their portfolio, similar to the Nexpoint Residential Trust (NXRT) thesis, they can earn 20% IRRs on their capital by doing some surface upgrades to things like kitchens and bathrooms or adding smart-locks to their doors.  About 4,300 of their 11,500 operating units are still unrenovated, providing some additional growth levers, or it could be part of the thesis of a new buyer that makes paying a low 4s cap rate palatable.
  • Another odd related party transaction that is probably nothing, but BRG does have an Administrative Services contract with other Bluerock entities where BRG pays another entity the expenses to the run the REIT, it is done at cost, but just another strange arrangement for a supposedly internally managed REIT.
  • In 2018/2019, Harbert Special Opportunity Fund offered $12.25/share (below where it is trading today) but got the cold shoulder from management, likely another reason the market seems to be discounting the Bloomberg sale report.
  • Management consistently talks about getting into the MSCI US REIT Index (RMZ in ETF form), they're currently outside the index, one of management's stated reasons they've converted the Series B preferred stock to common is to increase the float/market cap to meet index inclusion parameters.  I do sympathize with this thesis, I believe (don't have any real data) that REITs are over owned/represented in ETF/indices because retail investors like REITs and their yields.  It's another possibly reason other than the clear conflicts why BRG is undervalued, its also part of my NexPoint Strategic Opportunities (NHF) thesis, which should be officially converting soon to a REIT and shortly after will be eligible for the index.
Disclosure: I own call options on BRG (along with shares in CDOR, CPLG and NHF)