Tuesday, May 19, 2015

Gannett: Familiar Publishing Spin Playbook

Continuing on a familiar trend in the legacy broadcast/publishing media space, Gannett announced in August 2014 the spinoff of their publishing business to separate the headwinds facing business from the growth broadcast and digital businesses.  The transaction structure isn't as interesting and doesn't appear to create the same inefficiencies as the SSP/JRN merger spinoff, but I think the upside opportunity is roughly the same.  Plus with Gannett, Carl Icahn owns a 6.57% stake and he will likely generate some media headlines as the spinoff nears in the next couple of months.

The publishing business will be the spinoff and retain the Gannett (and GCI ticker) name with the parent being awkwardly renamed TEGNA and trading under the TGNA ticker.  TEGNA will be the #1 NBC, #1 CBS, and #4 ABC independent affiliate with a total of 46 broadcast stations across 36 markets, including a big slug of Texas exposure thanks to the 2014 acquisition of 6 London Broadcasting Company stations.  The company will cover roughly 30% of U.S. households, comfortably below the 39% FCC limit allowing continued station acquisitions.

Broadcast television stations are a fairly straight forward business to analyze with many near pure play public comparables thanks to the previous deals done in the space.  The current plan is to make the publishing spinoff virtually debt free, so for the sake of a simple SOTP analysis all of the debt is going on the broadcast TV business.  Similar to the Scripps thesis, I'm going to take an average of the expected EBITDA of 2015 and 2016 to capture the election cycle revenue which can really skew off-year results.
Interestingly Scripps still looks pretty cheap and under-levered compared to peers (I sold the day or two after the transaction, continue to hold JMG).  TEGNA's broadcast business should be worth at least 9x a blended EBITDA given the attractive market profile and size which should get them leverage in upcoming retransmission and affiliate negotiations.

Along with the broadcast business, TEGNA will also include the two main Gannett digital assets in Cars.com and CareerBuilder.  Both were formed as joint ventures in the late 1990s by a consortium of newspaper publishers in an attempt to combat the rise of the internet in classified advertising, so it's odd that they'd be included with the parent over the spinoff.  Gannett purchased the 73% of Cars.com it didn't own last year for $1.7B implying a $2.5B valuation for the entire asset (or less if you want to subtract the control premium).  CareerBuilder is a little trickier to value, in the 2014 10-K, Gannett had $68MM in net income attributable to non-controlling interests, presumably the vast majority of this is the 47.1% of CareerBuilder that Gannett doesn't own.  Putting a 15x multiple on CareerBuilder net income values the company at $2.1B ($144MM NI), making Gannett's 52.9% ownership worth $1.1B.  As a double check, McClatchy owns 15% of CareerBuilder and using the equity method values the company at $1.5B.  Splitting the difference and Gannett's position in CareerBuilder is worth about $950MM.

Adding the broadcast and digital groups together I get an enterprise value of $11.77B or an equity value of $7.4B after backing out the debt (assuming virtually all of it stays with the parent).

Gannett Co (Spinoff)
The publishing company's main asset is the USA Today which is the top newspaper in the U.S. by circulation, possibly because its a staple of Holiday Inn breakfast bars all around the country.  Additionally, Gannett has over 100 local dailies in both the U.S. and U.K. which include a mix of larger papers like the Arizona Republic, Indianapolis Star, Detroit Free Press, along with other smaller community papers which are generally stickier.  Their circulation number declines have slowed, however they're still feeling declining advertising revenues as social media gains are typically at the expense of legacy media companies.  

Their current strategy is to leverage the USA Today brand/content by selling it into local newspapers and beefing up their sports coverage.  USA Today has a strong brand - everyone recognizes their red/sports, green/money, and purple/life sections - with over 70MM unique monthly readers to either their print or digital content.  I'm not sure how I missed it late last year, but Horizon Kinetics has an interesting discussion on spinoffs and specifically the recent publishing spinoffs that's worth reading.  Gannett isn't specifically touched on, but many the same parallels apply, the spinoff's challenge will be turning the low-to-negative margin business of print publishing into a higher margin digital content company that has a broader geographic reach than print.  Gannett seems to have a good mix of small community papers that can turn into local databases and the USA Today which could increase its readership through continued digital build out.

Below is the same basic list of comparables used for Journal Media Group (which could be a natural acquisition target for the new Gannett), and again all the debt is on the broadcast company for the purpose of the SOTP:
The publishing companies are valued more widely than the broadcasters, but Gannett will be clearly the largest in the space and should garner at least a 6x EBITDA multiple, or a $2.7B valuation.

Total pre-spin valuation: $7.4B (net of debt) for TEGNA and $2.7B for the new Gannett, for a total of $10.1B or roughly $44.50 per share, it's currently trading at ~$36 for a potential 23% upside.  Thanks to Carl Icahn's influence the corporate governance at both companies should be shareholder friendly, there's no controlling family like other media companies, but I see both more as acquirers in their space.  I purchased some in the money calls a few weeks ago and will be interested to see where both end up trading after the mid-2015 transaction date.

Disclosure: I'm long GCI calls

Friday, April 3, 2015

Journal Media Group: Quick Update

About a month and a half ago I discussed my position in the Scripps/Journal transaction that ended up closing on Wednesday (4/1/15), as a Scripps shareholder I was about 90% exposed to the eventual TV/radio broadcasting company (keeping the Scripps name and SSP ticker) and 10% exposed to the new newspaper publishing company Journal Media Group (JMG).  From the SSP side pre-transaction, I ended up about ~34% but that was heavily weighted towards SSP; I sold the new SSP position post-closing as it's trading for roughly fair value at 8.5-9.0x a blended '15/'16 EBITDA.

In contrast and classic small spinoff fashion, Journal Media Group was sold off indiscriminately yesterday - down over 10% on the day despite trading extremely cheaply based on EV/EBITDA and free cash flow metrics.  To recap, Journal Media Group is a combination of the Milwaukee Journal Sentinel (formerly with Journal Communications) and Scripps' dozen or so smaller regional/community papers.

Unlike other publishing spinoffs (TPUB & TIME), Scripps was kind enough to leave JMG with no debt, no pension liability and roughly $10MM in cash.  Only AH Belo is in a similar position among the remaining pure play newspaper companies:
In the Journal roadshow presentation, they updated their proforma financials (downward from the proxy statement) below:
Given its balance sheet and proforma financials, JMG is trading too cheaply, even for a newspaper publisher when compared to peers at under 4x EBITDA:
I know many don't like the EBITDA metric, so on a free cash flow basis JMG should generate roughly $1.40/share unlevered in free cash or ~18% FCF yield (check my math on that).  New Media's valuation is a clear outlier, the market seems to be paying up for the Fortress sponsorship and capital allocation acumen.  Given JMG's lack of debt, and former Scripps CFO in the CEO spot, I could see JMG pursuing a similar community paper acquisition strategy that would tuck in nicely with the ex-Scripps newspaper assets.  It's just too cheap after the post-transaction dump to sell.

[Another similar deal to take a close look at is Gannett's upcoming broadcast & digital/publishing split]

Disclosure: I own shares of JMG

NexPoint Residential Trust: New Class B Apartment REIT

A few weeks ago a reader brought to my attention a unique spinoff where a closed end fund, NexPoint Credit Strategies Fund (NHF), was spinning off an apartment REIT they had been building inside NHF, essentially they created a non-traded REIT and then floated it via a spinoff.  On Wednesday (4/1/15), the spinoff was completed and NexPoint Residential Trust (NXRT) began trading - a small cap, externally managed apartment REIT focusing on Class B & C properties primarily in Texas and the southeast.  The REIT is managed by an affiliate of Highland Capital Management, a Dallas based alternative investment manager co-founded by Mark Okada who frequently appears on financial television and actually provides intelligent, sane commentary.

NexPoint Residential's current portfolio includes 38 multi-family properties containing 11,816 apartment units, with concentration in strong growing markets like Atlanta and Dallas.  The initial plan is to target class B & C properties and add value through rehab/redevelopment of the properties.  Larger REITs typically focus on big class A trophy type assets as its more economical, moves the needle, makes for better investor presentation materials, and immediately adds to AFFO and other metrics that REIT investors direct their focus.
Being small also has another advantage, NexPoint Residential will be able to build their asset base in small increments (not unlike GPT) and fish in ponds where the largest apartment REITs and other institutional investors are precluded from playing due to their size.  They also point out that very few mid and lower priced apartments are being built in the current environment, anecdotally I can attest to that as shiny new apartment buildings are going up all around Chicago's near north and near west sides reminiscent of the mid-2000s.  The feverish pace of class A building leaves that market susceptible to supply shocks in the next recession, whereas the limited new supply in the mid to lower markets should provide a little protection to NexPoint Residential.

I found the below slide interesting from NexPoint Residential's investor presentation, obviously these kind of comparisons are cherry picked a bit, but two things stood out to me that you don't typically see in externally managed REITs: insider ownership, and a willingness to be taken over.
Highland Capital (technically an affiliate) will earn a management fee/expense reimbursement amount capped at 1.5% annual of the assets, not the equity, so there's naturally a lean towards levering up the portfolio.  The interesting part is there is no incentive payment and there's only a two year initial contract period that can be cancelled anytime after with 60 days notice, unlike others where the external entity is essentially tied permanently to their manager.  That doesn't appear to be the case here and opens up the possibility of a takeover down the road which would likely be very accretive to the acquirer given NXRT's higher cap rates and ability to strip out the 1.5% management fees.  

Additionally, management has acquired 11.5% ownership of NexPoint Residential and indicated in their presentation they "will continue to be a natural buyer" and "management does not intend to sell shares or reduce its ownership stake", not typical statements you'd see in an externally managed vehicle that was just there to generate fat fees.

So what's it potentially worth?  Management is initially guiding to FFO of $1.12/share, at yesterday's closing price of $13.70, that's a 12.2x forward multiple, well below peers:
NexPoint Residential is clearly smaller, more leveraged, focused on lower quality assets, and doesn't have the track record of its peers, but over the next year as the platform grows out and establishes itself in the market I'd expect the valuation gap to close.  The bottom few like MAA, HME, PPS, and AEC are probably the best comparables for NXRT, at a 15x FFO multiple it's worth $16.80/share or 23% higher than yesterday's close.  Not super exciting, especially in a potentially rising interest rate environment where cap rates could widen, but that also doesn't take into account asset and FFO growth which NXRT should be able to do in the next 12 months.

NexPoint Credit Strategies Fund (NHF)
A smaller opportunity might exist in NHF, the CEF parent to NXRT, after the spinoff NHF committed to maintaining its previous dividend, essentially hiking the dividend 38% given the smaller NAV base.  NHF's strategy is to provide a credit hedge fund like offering with monthly dividend payments and liquidity, their performance despite the almost 2% management fee has been strong, yet it's hovered at a 10-12% discount to NAV for a few years (one reason they did the spinoff).  Now that the yield is higher, and the spinoff has lifted some of the funds more illiquid assets from the portfolio, the discount to NAV should decline slightly.  As of yesterday's close, its trading at a 12% discount to NAV with a 9.5% yield.

Disclosure: I own shares of NXRT, NHF (likely selling NHF in the next 1-2 weeks)

Thursday, March 26, 2015

Rentech: New Management, Strategic Alternatives, and Potential MLP IPO

For years Rentech has wasted shareholder capital by chasing the alternative energy dream, the company has never turned a profit in 30+ years of existence.  In 2014, Rentech's board finally threw in the towel, fired the CEO, hired an MLP veteran, sold the last of the alternative energy business, and shifted focus to their agricultural commodity/fertilizer business Rentech Nitrogen Partners (RNF) which they own 60% of the MLP's units, and their wood fibre business which produces wood chips and pellets for both industrial and energy market use.

I'll be the first to admit that I know little about the nitrogen fertilizer or wood fibre businesses, but the sentiment is severely depressed around Rentech, despite most of the capital spend being completed in the wood fibre business and a new CEO with a wide range of experiences centered around the MLP space in Keith Forman.  Using current market prices for RNF, the market is assigning very little value to the wood fibre businesses which have been marred by delays and cost overruns, but are still on target to produce significant cash flow by year end with the ultimate goal to float the business as it's own MLP.  Additionally on 2/17/15, Rentech announced they were pursuing strategic alternatives of their primary asset RNF, all options are on the table, either in whole or one of the two fertilizer facilities in East Dubuque, IL and Pasadena, TX, both of which struggled in 2014 with site specific issues and industry headwinds.

Wood Fibre Business
In 2013, following the decision to exit the alternative energy space, Rentech started converting and acquiring wood chipping and pellets plants to sell into the packaging/paper industry and power/heating markets.  They divide their business into three segments based on products and historical acquisitions:
  • Fulghum Fibres: Rentech entered the wood fibre market in 2013 with the purchase of Fulghum Fibres which produces wood chips for the pulp, paper, and packaging industry.  Fulghum operates 31 mills each typically under long term contracts with a major market participant, with the customer being responsible for supplying the wood product and Fulghum is paid a processing fee for running the mill.  Fulghum has a strong 70% market position in the United States (also has operations in South America) but struggled in 2014 due to a fire at one of their mills and some resulting costs.  It's projected to do $17MM in EBITDA in 2015, down from the originally guided $20MM annually at the time of the acquisition.
  • New England Wood Pellet (NEWP):  Rentech acquired NEWP on 5/1/14, NEWP operates four wood pellet processing facilities in the northeast for commercial and residential heating applications (so it's a pretty seasonal business).  They primarily sell through big box retailers like Home Depot and Lowe's but also will sell directly to entities like governments, schools, etc.  NEWP has been performing above expectations (perhaps the only RTK unit that can say that) and is expected to earn $9MM in EBITDA in 2015.
  • Wood Pellets - Industrial: Rentech's expensive boondoggle has been the repurposing of two plants in Ontario, Canada that when operational will produce and sell wood pellets for use by two large Canadian power utilities (Drax and OPG).  The Wawa plant (the larger of the two) was a former strand board mill and the Atikokan plant a former partical board processing mill, both are significantly behind schedule and over budget (although Atikokan is essentially completed and in the commissioning phase).  These two projects are where much of the negative investor sentiment lies, as incremental progress is made and revised timelines are met, Rentech has the opportunity to regain the market's trust.  The segment isn't expected to be cash flow or EBITDA positive in 2015, but in 2016 new management is sticking to the $15MM EBITDA estimate.
All of these business segments are qualified assets for an MLP which remains the primary goal of management and would force the market to revalue the stub via the MLP tax arbitrage game.  There doesn't appear to be a good comparable in the MLP market (please alert me if you know of one), so below I just took a swag at determining a multiple for each piece of the stub that's hopefully reasonable and conservative.
Assuming the market is valuing RNF correctly (although you can play with various upside scenarios a strategic buyer would pay for those assets, plus there appears to be some traction in their turnaround plan for the Pasadena plant), I come up with the below valuation for the Rentech stub:
Given Rentech's failure in the past several decades to generate taxable income, they also have $177MM in NOLs to help shield any windfall in selling RNF, but expect some tax leakage.  The real key is new management, Keith Forman is a relative outsider to Rentech (he was previously a board member), he brings a fresh perspective without emotional attachment to any legacy business or asset.  Plus he has wide ranging experience throughout the MLP value chain; as a lender to many early MLPs, senior management roles, and leading a trade association group.  With him leading Rentech it's more likely than not the wood fibre businesses gets IPO'd within the next 12-18 months and the market will start to recognize that event sometime sooner.  Risks include continued poor execution in the wood fibre businesses, RNF not being sold (although it's trading below where it was when strategic alternatives were announced, and well below 2012-2013 levels), and GSO/Blackstone (debt, convertible preferred holder) taking a bigger bite out of the upside.  I started a small position this week.

Disclosure: I own shares of RTK

Friday, March 6, 2015

Gramercy: European Business, AM Fees, Likely Spin

Gramercy Property Trust (GPT, f/k/a Gramercy Capital) is a well known company to many value investors, it was a busted commercial mortgage REIT that was essentially in runoff mode and traded near cash ex-non recourse debt that was obscuring the value.  In came former W.P. Carey CEO Gordon DuGan and his lieutenants in the middle of 2012 to reshape the company as an office and industrial triple net lease equity REIT.  I covered it often in 2012-2013, since then it's continued on its path of raising capital, deploying it primarily into class B net lease properties, and creating additional value by utilizing the inherent operating leverage of spreading their expenses over a larger asset base.  It's morphed into your typical equity REIT now with a $2.3B enterprise value, why am I still holding it?  First, I have great respect for management and they're 2/3rds of the way through their incentive agreement that will pay the top 3 guys $20MM if they can hit $7 in 2015 (already there) and $9 in 2016.  Second, they've made a recent move into asset management (an area of interest for me in 2015) through the creation of Gramercy Europe which should effectively create additional leverage from external management and incentive fees.

Gramercy Europe
In past investor presentations the company has teased the idea of expanding into Europe as Gordon DuGan has had previous experience with that market through W.P. Carey (started up the business in 1998 for WPC).  The question from analysts had always been why?  Gramercy is a relatively small REIT, there should be plenty of runway here in the United States for the company to grow.  In December, the company announced the formation of Gramercy Europe Property Fund, a €350MM joint venture, through the purchase of ThreadGreen Europe (renamed Gramercy Europe Asset Management) which is also run by some former W.P. Carey executives and currently manages €146MM worth of net lease industrial and office properties.
Gramercy expects to list the company within 18 months as a separately traded entity that will be externally managed by Gramercy (think North Star's recent announcement of a European spinoff).  The European market looks attractive, many corporations still hold operating real estate on their balance sheets, there's less competition, and cheap interest rates.  Other players like North Star, Blackrock, and Colony Financial have been making opportunistic pushes into Europe as well.  Gramercy is going to keep its focus on class B assets in Europe as they do in the U.S., a pretty overlooked and boring market, but one with the capability of generating predictable solid returns.

They haven't publicly disclosed what the management fees will be, but Gordon DuGan slightly slipped up on the conference call this morning mentioning a 1% base fee before retracting and stating market rates.  While unlikely to be a meaningful driver in 2015, the combination of ROI on their €50MM investment plus the added bonus of management and incentive fees should help Gramercy reach that $9 management incentive payout target by middle 2016 (25-30% return in 18 months).

Gramercy is a pretty simple business to value currently, management has projected a $0.45-$0.50 FFO for the year, putting a 15 multiple on that gets you a $6.75-7.50 range of reasonable value, right where its trading at currently.  Using that same math, Gramercy needs a $0.60 FFO run rate to get to $9 share price, let's say $0.05 of the needed $0.10 comes from continuing to play the private/public market arbitrage game and adding to their U.S. net lease portfolio.  If the European fund can do $9.5MM in asset management fees annually it can add another $0.05 to FFO without issuing additional shares.  Assuming some incentive fees and some expansion to the €350MM initial target, the fund probably needs to double before it lists, the $9 target shouldn't be too much a stretch. 

My only disappointment, and its minor at that, is the CDOs.  Gramercy still holds the equity and some junior pieces in their three legacy CRE CDO transactions they sponsored as GKK from 2005-2007.  As they continue to issue additional equity, the optionality of those legacy CDO positions gets smaller and smaller to the point now they're just a drop in the bucket on a per share basis.  It would have been interesting to have seen them spinoff the CDOs or have created some kind of CVR when they switched strategies and isolated the CDO value.

Gramercy likely doesn't hold much appeal to readers anymore, but it should, watch out for the Gramercy Europe business, it might make things more interesting this time next year especially if they decide to spinoff the overall asset management business too.

[Note: There's a 1-for-4 reverse stock split coming soon, all amounts are pre-split if you're reading this after the split happens]

Disclosure: I own shares of GPT

Tuesday, February 17, 2015

E.W. Scripps & Journal Media Group: Double Spin, Double Merger

Another interesting yet complicated transaction that was announced in 2014 and closing soon is the "double spin, double merger" of The E.W. Scripps Company (SSP, "Scripps") and Journal Communications (JRN) that will create one pure play broadcasting company and one pure play newspaper company from two mixed local media companies.

Scripps is the larger of the two and owns 21 local television stations as well as mid-size and community newspapers in 13 markets.  Journal Communications owns 14 television stations and 35 radio stations in 11 states, along with the Milwaukee Journal Sentinel and several community newspapers in Wisconsin.  Following the completion of the transaction, both companies will have strong balance sheets compared to peers and will be in a position to continue consolidating their respective industries.  The new Scripps (the broadcast company) will be the fifth largest independent TV broadcasting company and will have dual tailwinds of increasing retransmission fees and 2016 political ad revenue in key swing states.  The new Journal Media Group (the newspaper company) will have a net cash position, strong free cash flow, and will be in a position to make accretive acquisitions.

Neither industry is incredibly exciting, I hate the local TV news, but there's a demo that still watches it regularly and it's the best medium for politicians to sling attack ads at each other.  Warren Buffett has made investments in both industries in recent years and with the increased deal and spinoff activity, it's a natural place to look for ideas.

Transaction Details
On the closing date (early Q2), Scripps will spinoff their newspapers into the Scripps SpinCo entity, and Journal will spinoff its newspaper business into Journal SpinCo.  Following the consummation of the spinoffs, the two newspaper spinoffs will merge to form Journal Media Group (JMG).  All on the same day, Scripps will pay a $60MM special dividend to their shareholders and then merge the remaining Scripps and Journal broadcasting businesses to form the new Scripps as a standalone television and radio broadcasting company.  Both companies will be free of cross-media ownership rules and could therefore pursue acquisitions in markets they were restricted from as combined broadcast and print companies.

E.W. Scripps (new)
The new E.W. Scripps Company will own 34 television stations reaching 18% of households (well below the 39% FCC maximum), 34 radio stations, a few digital properties, and the Scripps National Spelling Bee.  The Scripps family will maintain control over the new Scripps with 93% of the vote via the Class B shares.  Scripps has shown prudent capital allocation in the past, they sold their cable business, spun-off the wildly successful Scripps Networks Interactive and bought back shares following the great recession.  Controlling families aren't ideal, but part of the media landscape, there are worse families to be attached to than the Scripps.

The local news seems to exist just to run political ads, Scripps GAAP profit alternates between windfall and breakeven every other year based on the election cycle.  With no incumbent president and both parties moving more and more to the extremes, expect another big spending year in 2016.  The new Scripps will have a strong political footprint with television stations in important swing states Florida, Ohio, Michigan, Wisconsin, and Colorado.
Scripps will also have the tailwind of the controversial increasing retransmission fees, currently their fees are well below industry averages and will step up drastically in 2015 to $165MM.  Cable companies, broadcast companies, and content companies are all in a race to consolidate in order to increase their leverage at the bargaining table.  At some point the consumer is going to push back on rising cable bills, over-the-top options like Netflix and HBO-Go are already disrupting the industry to a certain extent.  All things to keep in mind when considering retransmission revenue trends.

Another advantage Scripps will have is a strong balance sheet with just 2x EBITDA in debt, whereas others in the space (Sinclair or Nexstar) are in the 3.5-5x EBITDA range.  The company highlights their 18% market share and how it's well below the FCC maximum of 39%, I wouldn't be surprised to see Scripps add stations to its portfolio.

Below is a table of comparables for the new Scripps, both television and radio broadcasting companies:
For the new Scripps revenue is highly cyclical based on the election cycle, so it makes sense to take a blend of expected 2015 and 2016 EBITDA, I'm coming up with $263MM based on the joint proxy statement.  Using a 8.5x multiple (average of the above comparables is 9.2) and ~$365MM in net debt, I come up with an expected market cap of $1.87B for the new Scripps.

Journal Media Group
JMG will be a fairly simple business to analyze, it will have the flagship Milwaukee Journal Sentinel, roughly a dozen other smaller newspapers, no debt or pension shortfalls, and it will own its facilities and real estate.  Basically the exactly opposite start that was granted a similar spinoff in Tribune Publishing (TPUB).  It will be led by Timothy Stautberg, currently the head of the newspaper business at Scripps but who has a background in finance and was formerly the Scripps CFO.  With the trend of newspaper consolidations and spinoffs (will likely lead to another round of mergers) it's a benefit to have a finance guy in the CEO role.  JMG will be in a position to implement a similar strategy to New Media who have been successful at rolling up smaller weaker players at 2-4x EBITDA and having the market re-rate them higher.

Below is a table of comparables for the new Journal Media Group:
New Media likely gets a higher multiple due to the dividend retail crowd, I would anticipate JMG initially trading more inline with Lee Enterprises and McClatchy, but for conservatisms sake let's put a 5.5x EBITDA multiple on the company.  Using 2015 projected EBITDA from the joint prospectus of $57MM, and a net cash position of $10MM, the projected market cap would be $326MM.

Valuation Pieced Out Between SSP & JRN
Current Scripps shareholders will receive 69% of the new broadcast company and 59% of the newspaper company, plus a $60MM special dividend at closing.  Using the valuations above, both JRN and SSP are modestly undervalued at this point.  While there's not a ton of upside, there doesn't seem to be a lot of downside either considering both companies will be in a strong financial position compared to peers.  I picked up some shares of SSP recently, I'm mostly indifferent between the two but it might be initially safer to hold proportionally more of the new SSP versus JMG which could be sold off after the transaction (possible opportunity) as newspapers continue to be out of favor.

Disclosure: I own shares of SSP

Wednesday, February 4, 2015

American Capital: Complicated Structure, NOLs, Pending AM Spinoff

Expanding on the externalizing management theme, American Capital (ACAS) is a business development company ("BDC") that was an epic disaster during the financial crisis, it has somewhat recovered, but due to their NOLs the company has elected to not resume their dividend payments making it out of favor with the traditional BDC investor (muppet retail, dividend focused).  On 11/4/2014, the company announced a long awaited plan to separate their asset management division (American Capital Asset Management, or "ACAM") from their traditional BDC assets by creating and spinning off two new BDCs with the remaining parent company, ACAM, becoming a pure play permanent capital asset management company.  The two BDCs will then turn on the dividends making them more attractive to retail investors and ACAM will enter into highly valuable asset management agreements with the spinoffs.  American Capital's shares trade for $14.50, a significant discount to their self-reported NAV of $20.50 (as of 9/30), which doesn't include the incremental value of the two new BDC asset management agreements to ACAM.

The idea is well known among special situation investors and the separation of the asset management company from the BDCs has been well telegraphed, so why is it still trading at such a significant discount to it's NAV?  I believe the many blowups in popular event-driven names in 2014 has caused managers to reduce exposure and the spinoff of two new BDCs is extremely complicated and has required more patience than many short term focused traders have been willing to give American Capital.

For this situation to work out two questions need to be answered positively: 1) What will be the normalized run rate EBITDA for ACAM including fees received from the two new BDCs? and 2) Will the BDC spinoffs trade near NAV?  And of course, this situation needs time to play out before another recession takes a bite out of American Capital's risky assets.

American Capital was founded in 1996 and went public in 1997, ACAS is based out of the DC area and like other BDCs traditionally invests primarily in debt and equity of small and middle market companies who can't access capital through traditional bank loans or the corporate debt markets.

BDCs like REITs are pass-through structures for tax purposes, if the BDC passes along 90% of its taxable income to shareholders its exempt from paying corporate income tax and instead the earnings are only taxed at the individual level (although at ordinary rates).  Since BDCs have limited retained earnings, they need access to the capital markets in order to grow their asset base and increase fees to the management company.  The ability to arbitrage their cost of capital against that of the assets they're purchasing can add value as the BDC turns illiquid risky assets into a liquid asset that appeals to retail investors reaching for yield.  This arbitrage only works if the company's shares trade for above net asset value (NAV), otherwise equity issuances will dilute current shareholders and destroy value.

Back to American Capital, from their 1997 IPO until the second quarter of 2008 the company's shares traded above NAV allowing the company to continually issue shares and grow their asset base.  The great recession brought American Capital to the brink as their risky loans to mediocre businesses took significant losses (creating its net operating loss carry-forwards).  The company turned off the dividends and sealed their fate with dividend focused retail investors as a toxic dump (that's still somewhat fair).  American Capital's management knew they could no longer issue shares to grow and now had a valuable tax asset to monetize, so in 2011 they changed corporate structures switching from a regulated investment company (RIC) to a traditional c-corp allowing the company to retain its earnings.  Retaining their earnings allowed them to repurchase shares in the years since the crisis at significant discounts to NAV and utilize their NOL position.

American Capital Asset Management
Back to the current situation, after the proposed spinoff ACAS (ACAM) will become a valuable permanent capital asset manager with external management agreements with 5 publicly traded BDCs or mortgage-REITs, 3 private equity funds, and 5 collateralized loan obligations (CLOs).  The management agreements with the 5 publicly traded vehicles are particularly valuable as they represent the holy grail of permanent capital, unlike open end funds investors can't withdraw their funds directly from the manager, they must sell their shares to another holder.

In a previous post on another permanent capital asset manager, Ashford Inc, I was likely too conservative by backing into a 10x EBITDA valuation, this multiple is more accurate for a traditional open-end manager but the new breed of permanent capital managers are trading at higher multiples, closer to 14-16x as their fees are nearly annuities.  Additionally, managers typically have a wide ability to push their expenses directly onto their captive vehicles and get fully reimbursed at full cost. Questionable?  Yes, but in this low rate environment, many retail investors continue to pile into dividend focused vehicles as a bond substitute allowing managers to get away with exorbitant fees.

So what is ACAM worth?  Below are their externally managed vehicles with the earning assets under management of each:
A couple of assumptions here, there are some moving parts with the two new BDCs and what the ultimate fee agreements will be, but I'm assuming a 1.5% fee on assets and ACAM only adding a little bit of leverage (when they'll probably add a lot more).  Additionally, most of their vehicles have incentive fees, so you can layer that on top as well, and then I'm using a 15x EBITDA multiple, which one can argue is high but the permanent nature of their AUM deserves a premium over the typical fund manager.  ACAM also has shown the ability to raise capital in different credit segments and aren't as concentrated to the shaky middle market as recent BDC manager IPOs have been.

Additional Assets: ACAM will also be structured as a c-corp and will keep the $620MM in NOLs that were created by the poor investments within the BDC portfolio but will now be applied to the earnings stream of the asset management company, a nice bit of financial engineering and tax avoidance.  In the investor presentation, ACAS guided to $1B in equity being available to the company, this appears to include the European Capital business ($680MM at NAV) which could be an additional spinoff in the future and also allows ACAM to seed new strategies before placing them in new public vehicles like they've done with American Capital Senior Floating (ACSF) in early 2014.

Value of ACAM = $2.5B (including European Capital, but giving you the NOLs for free)

American Capital Growth & Income and American Capital Income - BDC Spinoffs
The other key to this situation is determining what the new BDCs will trade at once the dividends are turned on and Seeking Alpha articles start getting circulated.  BDCs are pretty terrible investments, they charge high fees and mask those fees with risky loans and high leverage, most retail BDC investors would be better off investing in a low cost stock/bond mix and peeling off their own "dividend" by selling shares.  There is a noticeable bifurcation in valuation between internally and externally managed BDCs with the internal ones selling a sizable premium to NAV where the external BDCs are lucky to trade at NAV.
I don't have a lot to add specifically regarding the new BDCs.  American Capital Growth & Income will include the operating companies (thus able to be a tax-free spinoff) paired with the syndicated bank loan/CLO equity portfolio where they'll use all their available leverage and pile on debt.  Bank loans generally held up during the great recession and belong in a permanent capital vehicle instead of a traditional open end fund or ETF.   I could see this larger BDC transforming into something like their ACSF vehicle, syndicated bank loans are more transparent and easier for ACAM has a manager to service.  American Capital Income will have their third party middle market type loans, nothing particularly interesting about it, but the key is both of these BDCs will start paying "market rate" dividends.  In a record low interest rate environment, retail investors will continue to flock to BDCs as a fixed income replacement, once American Capital's BDCs start paying dividends they should trade near NAV or just below.

Value of the BDCs = $3.6B ($4B with a 10% haircut)

Adding up ACAM and the BDCs, I come up with a total valuation of $6.1B, or $23 per share, above the $20.50 estimated NAV because of the two new asset management contracts and a higher permanent capital manager multiple assigned to ACAM.  It should be noted that ACAS has over 54 million in options outstanding at an average exercise price above $9 per share,  ACAS will probably cover some of this dilution with share repurchases, but that will knock the $23 estimate down a notch or two.
  • Breaking apart the tangled corporate web is complicated and could take longer than anticipated, American Capital hasn't guided to a specific transaction date yet which is likely holding back some event-driven investors
  • If American Capital's publicly traded vehicles don't trade above NAV, AUM growth will be stunted and it will be more difficult to "cover up" bad assets with new assets potentially spiraling the discount to NAV problem
  • In 2014, a few BDC managers went public (ARES, FSAM, MDLY) and haven't fared well, mostly due to BDC market specific concerns and in FSAM's case, questionable corporate governance and management
  • If you think a recession is around the corner, this is not the situation for you, BDC assets are typically made to shaky middle market companies that can't get financing through traditional channels.  The syndicated loan book and CLO equity should be okay in a recession (relatively minimal losses there in 2008-2009), but I'd be more concerned with the middle market loans and operating companies that will be in the BDCs
  • Management pays themselves lavishly, at ACAS and in the BDC industry in general, eventually if BDC managers don't add value for their clients the industry is going to suffer and some of that sentiment is already in BDC market values
American Capital is a combination of a few themes that I like right now: (1) it has a complicated structure and balance sheet that doesn't screen well and requires some work to dig through; (2) the remaining asset management company will be a c-corp (versus a partnership, no K-1s, widens the investor base) with a significant NOL tax asset; (3) it's a company that currently doesn't pay a dividend in a dividend focused sector, essentially getting punished for displaying rational capital allocation; (4) and of course it's about to embark on a break-up/spinoff which will force the market to value it on a sum of the parts basis (and create AM agreements with two new BDC vehicles).

I'm more interested in the asset management company for obvious reasons, but one might need to hold onto the BDCs for a quarter or two after the spinoffs to give time for the market to re-rate them inline with peers.  I bought a mid-sized position this week around $14.40, will look to potentially supplement my shares with LEAPs as well. 

Disclosure: I own shares of ACAS