Wednesday, January 11, 2017

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

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

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

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

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

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

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

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

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

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

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

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

Friday, December 30, 2016

Year End 2016 Portfolio Review

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

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

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

Friday, November 25, 2016

Hilton Worldwide: Management Co, Hotel REIT, Timeshare Business

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: I own HLT LEAPs

Wednesday, November 16, 2016

Resource Capital Corp: Dividend Cut, New Management Simplifying Portfolio

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

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

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

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

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

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

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

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

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

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

Disclosure: I own shares of RSO

Monday, October 3, 2016

Donnelley Financial Solutions: New RRD Spin, Asset-Light, Recurring Revenue

Donnelley Financial Solutions (DFIN) is one of two fresh spinoffs of RR Donnelley & Sons (RRD) that provides services to help create, manage and deliver financial communications to investors and regulators.  This means the unwanted paper annual reports and prospectuses you receive for equities, mutual funds and insurance products, much of that is printed by Donnelley Financial.  This is a slowly dying business that represents about 42% of DFIN's revenue, its declining low single digits annually, and being mostly held up by regulations that require funds to physically mail annual and semi-annual reports to investors.  The other half of Donnelley Financial's revenue is generated by software and cloud like solutions that assist companies in putting together filings and data rooms that are used as depositories for M&A and IPO transactions.  This is the growth side of the business and one where RRD had been actively acquiring technology and software companies to compete in an increasingly paperless world.

The company breaks out their lines of business into three segments, mostly by customer type:
  • Global Capital Markets: Clients consist of primarily publicly traded companies that are subject to the Securities Act of 1933 and the Securities Exchange Act of 1934 who need to make periodic regulatory and investor filings along with transactional filings when M&A, IPOs, bankruptcies or other large corporate actions happen.  About half of the revenue from this segment is recurring in nature, the other half is transactional and depends heavily on deal making activity in the financial markets.  Donnelley Financial did business with 422 S&P 500 firms in 2015 via this segment.
  • Global Investment Markets: Clients consist of mutual funds, hedge funds, insurance companies that use Donnelley Financial's products to create reports, prospectuses, fact sheets and other marketing materials.  Almost all of this segment is recurring in nature, although it may face broader secular headwinds as active management strategies continue to face challenges outperforming and the resulting outflows.
  • Language Solutions: DFIN's smallest segment provides translation services that adapt business content into different languages for specific countries.  This segment could be where future acquisitions are made as the market is highly fragmented.
Overall DFIN believes 62% of their revenue is derived from recurring sources and 38% from transactional deal related activity.  Some products that those in finance might recognize: EDGAR Online, EDGAR Pro, Venue, FundSuite Arc, Proxy Design, ActiveDisclosure.

RR Donnelley didn't run what is now DFIN as a separate business vertical prior to the spinoff making it difficult to see historical numbers or business trends.  Besides reading the Form 10-12, it might be helpful to go back and review Bowne & Co (BNE) which RR Donnelley bought back in 2010 for ~$460MM, significantly beefing up their financial communications business.  For cyclicality context, Bowne's revenue dropped about 20% from 2007's peak to 2009's trough.

Why do the spinoffs?
RR Donnelley split up into three companies which itself could create some market uncertainty (seems to have today at least) as investors digest the prospects for each separate business.  Donnelley Financial appears to be the best business of the three, but to complicate matters RRD CEO Thomas Quinlan jumped to what looks like the 'garbage barge' retail printing business (LSC Communications) and the remaining RRD will be maintaining a 19.25% interest in both spin-offs for up to a year which could result in exchange offers for fans of those transactions.
But overall, the spinoffs seem to be designed to separate the headwind facing business, LSC Communications, from the parent that has moved to a more value add business model.  Secondarily highlighting the high margin, low capital intensive financial communications business (DFIN) from the parent, which should lead to DFIN trading at a higher valuation.  Most of the legacy pensions, PP&E, and other old-economy like cash drags will be either going to LSC Communications or staying with RR Donnelley.

Daniel Leib, the old CFO of RRD, is now the CEO of DFIN.  He's been the CFO of RRD for many years and before that was their internal M&A and strategy lead.  I generally like when CFO's take over the head job, especially of a company like DFIN that is expected to generate a lot of free cash which management will need to allocate and DFIN's entire business model is based around financial statements and regulatory disclosures, Daniel Leib as a former CFO should be intimately aware of these challenges from a client prospective.  The board will be led by Chairman Richard Crandell, 77, he like the rest of the board don't appear to have much of a printing industry background, more technology and software, lending more credit to the strategy of shifting the company to software products.

Donnelley Financial will be substantially asset-light, they outsource much of the physical printing during peak times around proxy season, and have minimal capital expenditures ($20-30MM) as they shift their business to more software and cloud offerings.

New IPOs and deal making activity was a little muted during the first half of the year, particularly the first quarter, pushing down DFIN's numbers year over year.  I'm going to use a rough $200MM EBITDA number, below the current run rate to account for both some peak market activity risk and the inherent carve out risk of using proforma Form 10-12 numbers.  DFIN has approximately $600MM in net debt and 32.4 million shares outstanding (which includes the stake retained by RRD), at $24.50 per share, DFIN is trading at 7x EBITDA for a mostly recurring revenue stream, with strong margins and minimal cap ex requirements.  Seems too cheap to me.

Disclosure: I own shares of DFIN

Wednesday, September 14, 2016

ZAIS Financial: Merger w/ Private REIT, Tender Offer, ZAIS Group

ZAIS Financial Corp (ZFC) is a $125MM market cap residential mortgage REIT that failed to gain size and operating leverage, ZFC's external manager ZAIS Group (ZAIS) is reeling from some poor performance at its main credit hedge fund and decided to refocus efforts away from the sub-size mortgage REIT.  In April 2016, ZAIS Financial announced it was merging with Sutherland Asset Management, a private commercial mortgage REIT, ZAIS Group's management agreement will be cancelled and Waterfall Asset Management, Sutherland's external manager, will take over the combined company with a typical base/incentive fee structure.

The merged company will take the Sutherland Asset Management name and trade under the symbol SLD.  Sutherland's strategy is to acquire and originate small commercial loans and SBA loans, they classify small commercial loans as those ranging from $500k to $10MM that often have a personal guarantee attached back to the business owner.  This is a bit of a niche non-bank lender sector made possible by the retreat in community and regional banks from making riskier loans that come with greater capital requirements.  Sutherland both originates their own loans and acquires portfolios of performing and non-performing loans from larger banks and the securitization market.  There might be an opportunity for alpha in this niche as these loans are too small for larger institutional investors but too risky for small banks, but it's not without risk as these are loans to franchisees and small time commercial real estate investors, basically borrowers without any scale or significant enough collateral for traditional lenders to touch.

Additionally, Sutherland is one of a few non-banks with an SBA license, borrowers that take out SBA loans are even shakier than their core small commercial loan business but with SBA loans the government guarantees a (senior) portion of the loan.  The guaranteed portion is then sold and securitized into the secondary market, there's usually a nice premium for the lender in the sale as these loans have a wide spread compared to traditional treasuries or other government sponsored enterprises.  The lender of an SBA loan keeps the servicing relationship whether they choose to keep the guaranteed portion on balance sheet or not, if the guaranteed portion is sold as the servicing relationship is kept, that effectively increases the interest and fees earned on the remaining portion held by the lender.  Originating SBA loans is a good business.

So that's Sutherland's business, lending to riskier small commercial lenders, it should do well during good times and not so good during bad times.  It's effectively a commercial mortgage REIT with elements of a residential mortgage REIT.

Why merge with ZAIS Financial?  
Sutherland attempted an IPO in January 2015 and ended up pulling the offering when it couldn't raise capital within the desired range.  Sutherland is about 3 times the size of ZAIS Financial, so merging with ZFC can effectively be thought of as a reverse merger and a way to backdoor list Sutherland.  Further to that point, ZAIS Financial has sold most of their liquid assets leaving their mortgage servicing operation, a business unit that a fund managed by Sutherland sold to ZAIS Financial a couple years earlier.

Why is this deal interesting?  
If shareholders approve the issuance of shares to complete the merger on 9/27, then ZAIS Financial is going to commence a tender offering for approximately 47% of their shares outstanding (cash from selling down their liquid RMBS assets) at $15.36 per share, the shares trade for a $14.07 per share, or a 9.2% premium that should happen fairly quickly.  Additionally, ZFC is paying a $0.40 dividend to shareholders on 10/17 with a record date of 9/30, for another 2.8% return.
Per the merger agreement, both sides adjusted their book values down to account for intangible assets, litigation costs, transaction fees, and ZAIS Group's termination payment.  If you follow the math, assuming everyone tenders their shares (the math gets better the fewer people tender), an investor can create shares in the new Sutherland (SLD) at 73% of tangible book value.  The deal should close in the 4th quarter assuming both sides approve the deal on 9/27.

I expect SLD shares to trade poorly after the deal happens as previously locked up (and mostly retail) shareholders now have liquidity and can sell their shares.  But most mortgage REITs trade somewhere between 0.9-1.1x BV, residential mortgage REITs on the low side, commercial mortgage REITs on the high side, Sutherland should trade somewhere in between the two sectors overtime as it has elements of both, but either way above 73% of book value.

Sizing a situation like this is important, you'll get about half your money back quickly and don't want to worry about the remaining stub if the new SLD gets sold off once the deal closes.

ZAIS Group
ZFC's soon to be former external manager, ZAIS Group (ZAIS), might be a situation worth digging into further.  After losing ZFC's management contract, ZAIS will have a little more than $3B in AUM primarily across two hedge funds that have good long term records but poor short term (far from their high water marks) and 4 CLOs, one of which they closed this year which is a feat for a small manager like ZAIS.  As a result of losing their incentive fees, their operating expenses are greater than their run rate management fees putting them in a tight spot.  The stock is down 80+% in the past year.  There are some corporate governance issues, its a former SPAC, and one of those structures where the public company owns 2/3rds of the operating LLC and insiders own the rest.  But at a $28MM market cap, its trading below book value (mostly cash) and other CLO managers have been sold recently at nice premiums (see CIFC), ZAIS could be another.

Disclosure: I own shares of ZFC, no position is ZAIS

Friday, September 2, 2016

Dell Technologies Class V: New VMWare Tracking Stock

I'm posting this on Friday afternoon before a long holiday weekend for a reason, smarter people than I have written on this topic so not much of the below is new but I wanted to memorialize some thoughts as part of my process.

Last October, Dell and Silver Lake (their PE backers) announced the acquisition of EMC in a cash and stock deal worth $67B.  Dell is a private company and wants to stay that way, so the stock part of the merger consideration is a bit tricky.  EMC owns 81% of VMWare, a software company that sells virtualization technology that helps large enterprise servers share resources and become more efficient, the remaining 19% stake is publicly traded under the VMW symbol.  But Dell is a recent leveraged buyout, and they didn't have the available financing to buy both EMC and their stake in VMWare simultaneously, so instead of paying cash for all of EMC and their 81% stake in VMWare, Dell is issuing a tracking stock that represents 65% of EMC's 81% interest in VMWare to former EMC shareholders to bridge the funding gap, but still get to control VMWare.

In Dell's own words (Denali is Dell's parent company):
Q:           Why is a tracking stock being used to finance the acquisition of EMC?
A:           The Class V Common Stock will afford EMC shareholders the opportunity to benefit from any value creation that may result from any revenue synergies of the Class V Group with Dell. Collectively, EMC shareholders indirectly own approximately 81% of VMware as of the date of this proxy statement/prospectus. Upon the completion of the merger, EMC shareholders will receive shares of Class V Common Stock that will be publicly traded and that are intended to track, in the aggregate, an approximately 53% economic interest in the VMware business (assuming no change to the percentage economic interest of EMC in the VMware business prior to the completion of the merger and that EMC shareholders either are not entitled to or do not properly exercise appraisal rights).
Owning EMC’s interest in the VMware business is a fundamental part of Denali’s strategic rationale for this transaction. VMware’s success is important to the business strategy of a merger combining Dell and EMC, and Denali believes it will be in the best interests of its common stockholders after the merger to retain a large economic interest in the VMware business. Additionally, given constraints on the amount of cash financing available for the transaction, the issuance of the Class V Common Stock enables Denali to pay a higher purchase price for EMC than it could in a transaction consisting entirely of 100% cash consideration.
Shares of the tracking stock, Dell Technologies Class V, started trading recently in the when-issued market under the symbol DVMTV and will start trading regular way as DVMT after the deal closes on 9/7/2016.  Each share of DVMT represents the same economic equivalent of each share of VMW, there will be 223MM shares of DVMT outstanding compared to just 80MM of the regular VMW common shares, meaning the tracker should be more liquid than the real thing, an odd situation.

While neither DVMT or VMW have any material voting rights, the two stocks are significantly different in that DVMT is exposed to Dell's highly leveraged balance sheet as DVMT is a share class of Dell Technologies (the merged Dell and EMC) not VMWare.  After the deal closes, Dell will be levered about 6 times and their debt is rated below investment grade, Dell's stated plan is to deleverage (as they did following their 2013 buyout) over the next 18-24 months in order to re-achieve an investment grade rating.  Their debt facilities do allow for some share repurchases but I would expect those to come second to the initial de-leveraging.

The big question is what discount should be applied to the DVMT tracker for taking on the additional balance sheet risk?  I think most scenarios where Dell ends up in serious financial trouble so does VMWare.  Several have speculated that Dell is really interested in VMWare over the rest of EMC, VMWare's software will be a key differentiating factor in Dell's enterprise business going forward.  If one falters the other will, Dell is in complete control of both.  The circumstance where Dell's balance sheet could be an issue for DVMT is a near term slowdown in their business that puts a wrench in the de-leveraging plan.  What discount is that risk worth?  I'd vote a 15-20% discount is fair for DVMT, it's currently trading at $43.90 and VMW at $72.88, or a 40% discount.  I don't have a strong opinion on VMW's valuation but its trading for a forward P/E of ~17x or fairly close to the market as a whole for a company that's generating mid-single digits topline growth.

How does this structure get fixed long term?  Dell has the option to swap VMW shares for the tracker, but likely won't do so for both tax reasons and they don't want to give up control.  The more likely scenario is after paying down debt from the EMC transaction, Dell might come back for the tracker and VMW shares in another deal.  Dell's initial management buyout was scrutinized for being unfair to minority shareholders, so the prospect of Dell doing it again to VMWare is another possible reason for a high discount rate.  Either way, 40% seems too high and is worthy of a small position.

Disclosure: I own shares of DVMT