Friday, June 8, 2018

Perspecta: DXC Government Services Spin, CSRA 2.0

On 6/1, DXC Technology (DXC) completed the spinoff of its U.S. government services business and merged it with Vencore and KeyPoint, two PE owned government services businesses, to form Perspecta (PRSP).  There's been a lot of M&A in this industry, DXC was formed in 2017 via the combination of Computer Services (CSC) and Hewlett Packard Enterprise's (HPE) services business, prior to that merger, CSC had spun off its government services business as CSRA in November 2015 only to re-enter the business via the HPE deal.  Then in February, General Dynamics (GD) came in bought CSRA at a rich 12x EBITDA or 18x earnings multiple. Now once again DXC/CSC is returning to the same playbook and spun off its government services business.

Several years ago I profiled and owned several of the government spins (EGL, XLS, VEC, CSRA, LDOS), large defense contractors were dealing with the draw down of troops in the Middle East and sequestration started pinching Federal budgets by spinning off their lower growth and lower margin services businesses.  Now that the Federal budget is in growth mode again, projected at 1.5-2.0% annually through 2022, government services multiples are on the rise and you're seeing the opposite M&A trend taking place with GD buying CSRA.

If anyone in the industry reads this they'll likely cringe, but from an investment standpoint, most of these government services are very similar with nearly indistinguishable strategies making them fairly straight forward to value.  This kind of M&A in any industry would likely be disruptive to clients, but here deal teams work on individual government contracts and have more of an identity with the contract than the cute name currently on their business card.  It's a very competitive business where valuation multiples should converge over time as its nearly impossible for a firm to have a clear competitive advantage.  The nature of the business also makes these firms a bit of black box, many of their contracts are classified and its hard for the average investor to shift through the contract re-compete pipeline.

Perspecta is pitching their margin profile as their differentiating factor due to their heavy weight towards firm-fixed price contracts compared to peers.  This is partially the nature of the IT services business, CSRA featured similar EBITDA margins.
Fixed contracts are where the government and the contracting firm agree upfront on a price/value of a given engagement and its up to the contracting firm to make it profitable.  These types of contracts are potentially more lucrative if a management team can squeeze costs out as those savings don't have to be shared with the government (at least until the next re-compete).  But this can cut both ways, if Perspecta were to run into issues with cost overruns and or just flat out misprice a fixed-price contract in a competitive bid (animal spirits can get the best of anyone) then they could be stuck in a negative margin position unable to get out for several years.  Whereas the cost-plus contracts are safer, but with lower more predictable margins, as the contracting firm and the government agree on a specified margin upfront and the total value fluctuates with expenses (think timeshare resort management or Nacco's coal mining operating agreements).

As mentioned, all these independent government service providers trade in a pretty tight range, Perspecta has moved up a bit this week, but still remains at the bottom of the table on both an EV/EBITDA and P/E basis.
Perspecta has one large contract with the U.S. Navy servicing their intranet and related communication needs ("NGEN") that is coming up for re-compete, its a $3.5B 5-year contract, or roughly 17% of Perspecta's pro-forma $4.1B annual revenue base.  They're the incumbent on the contract through predecessor firms (was DXC, before that HPE, before that EDS) since the program was established in 2000.  The Navy is splitting the contract into two, one will be the services and the other the equipment side of the contract, Perspecta is likely to give up some of this revenue either by adding additional subcontractors to the team, or losing one side or the other, and then just general competitive pressures will decrease the profitability of NGEN through the re-compete process.  They're projecting flat revenue growth over the next year, given the healthy budget backdrop, I'm guessing its less the integration/new public company focus they've stated, and more an acknowledgment that NGEN will be rolled back for them this time around.  In the Form 10, the old DXC government services business ("USPS") had a 90% historical re-compete win rate and Vencore has a 97% historical re-compete win rate.  It's unlikely that the Navy would move completely away from Perspecta, incumbents are hard to beat, but that headline risk is out there and is potentially a reason why the stock is cheap.  I don't think the market is intentionally doing this but if you were to back out the NGEN contract entirely, Perspecta is trading for roughly the same multiple as its peers.

Perspecta has 165.6 million shares (old DXC shareholders own 86% of the company) and net debt of $2.7B, if it were to trade at a peer multiple of 12x EBITDA, the shares are worth $33/share versus the $24.25/share they trade at today.

Other thoughts:
  • DXC is a S&P 500 constituent, I haven't seen an announcement kicking PRSP out, presumably because there's nothing to announce if PRSP is just simply not added to the S&P, but we've likely seen some forced selling by index funds since the 6/1 spinoff.
  • Mike Lawrie is the CEO and Chairman at DXC, he'll be the Chairman at PRSP, since taking over CSC a few years ago he's done a tremendous job for shareholders in both creative M&A and operating performance.  Good manager that is worth following.
  • One thing about NGEN that feels a bit wrong to me, it's barely mentioned in the Form 10, and not in the risk section for concentration risk, despite being a material 17% of revenue.  Could be an intentional oversight because the risk of losing the contract is minimal, or a bit deceptive, I'm not entirely sure which?
  • Perspecta's leverage will be a little higher than peers to begin with which is pretty typical for spinoffs, the company is projecting $1.5B in operating cash flow over the next three years and have slated 35% of that to pay down debt which would get them to the lower end of their target range of 3 to 3.5x EBITDA.
  • Vencore filed an S-1 last year before pulling the IPO, the S-1 is worth reading, Vencore is more of a mission services business versus the IT services at DXC's old USPS business.  KeyPoint, the smallest of the three being merged together, is the leader in background checks and security clearance, good little niche.  Perspecta believes they can go after contracts they previously weren't qualified for now that they've merged the three entities (combining mission and IT services), that's possible, but doubt it moves the needle much.
Disclosure: I own shares of PRSP

Monday, April 16, 2018

Tropicana Entertainment: Deal with GLPI & ERI, Merger Arb

This won't be actionable for some readers, but Tropicana Entertainment (TPCA, 84% owned by IEP) announced a deal today where Gaming & Leisure Properties (GLPI) will purchase the real estate and Eldorado Resorts (ERI) the gaming operations for a combined total of ~$1.85B, subject to adjustments.  One of those adjustments relates to Tropicana's Aruba property which needs to be sold or spun-off prior to the closing.

So here you have a controlled company, with an illiquid stock, entering into a complicated deal with two parties and an uncertain final cash amount all leading to a potentially attractive merger arbitrage spread.  If the headline number is correct, using the current share count of 23.8 million shares, gets you to $77.61 per share versus under $70 today.  Unpacking that number is a little more complicated, from the 8-K today:

(a)                                 $640 million, which reflects the consideration paid by Parent in respect of the Merger;

(b)                                 plus $1.21 billion, which reflects the Real Estate Purchase Price received by the Company;

(c)                                  plus the amount of net proceeds received by the Company in connection with the distribution, transfer or disposition of its Aruba Operations;

(d)                                 minus the Real Estate Purchase Tax Amount (as defined in the Merger Agreement); 

(e)                                  minus 50% of the Estimated State Income Tax Amount (as defined in the Merger Agreement), which Estimated State Tax Amount is limited to a maximum of $38 million;

(f)                                   minus the excess, if any, of the Estimated State Income Tax Amount over $38 million;

(g)                                  divided by 23,834,512, which reflects the aggregate number of shares of Common Stock that are issued and outstanding.

Without taking into consideration any net proceeds associated with the distribution, transfer or disposition of the Aruba Operations which is reflected in clause (c) above, the Company has estimated that the aggregate merger consideration, as adjusted to take into account the amounts set forth in clauses (d)(e) and (f) above, will be approximately $1.77 billion.

Couple things here, ERI is paying $640 in (a) and GLPI is paying $1.21B in (b) totaling up to $1.85B and from there we adjust down for taxes (there are NOLs at TPCA) but those are almost entirely offset by the expected sales price of the Aruba resort.  The footnote at the bottom, even if Aruba is valued at $0 then the total consideration is estimated at $1.77B or $74.26 per share, still a decent spread from today's price.

Tropicana Aruba is a fairly small operation, its a short walk from the beach (read: not beachfront) on 14 acres with 360 hotel rooms they've been renovating and converting into timeshare units over the past several years, there's also a 4000 sq ft casino property that mirrors what you see at a many Caribbean resorts.  In the financials, Aruba gets lumped in with their Baton Rouge and Greenville casinos making it difficult to determine what the property is worth, but at the $1.85B headline number its being valued at $80MM.  That feels high, but maybe I'm anchoring to the original thinking that Aruba was simply an option to build a larger property.

The deal is expected to close by the end of 2018, if we call the range of potential (positive) outcomes $74.26 - $77.61 on today's close of $69.75 that's a 6.5% - 11.2% absolute return in less than 9 months.  Unfortunately I sold last year into the tender, but given my comfort with the company and the attractive deal spread, I repurchased a position today.

From the buyers perspective, both are out touting the benefits of the transaction, GLPI is receiving $110MM annually in rent for their $1.21B investment for a 9.1% cap rate or 11x EV/EBITDA, and Eldorado is quoting a 6.6x pre-synergies (BYD is paying 6.25x for certain PNK/PENN casinos) and 5.0x post-synergies multiple on the operations that includes some net cash and cash build until close.  At 9.75x 2017 EBITDA of $190MM, Tropicana received a great deal (TPCA was trading at 4-4.5x EBITDA in 2013) that really touts the benefits of utilizing the REIT structure and its lower cost of capital to consolidate the industry.  But as someone invested in the gaming sector, is Icahn marking the top here?  He timed the cycle well pre-financial crisis, let's hope his timing isn't quite as perfect this time around and he has other motivations as it appears he's piling up cash throughout IEP.

Disclosure: I own shares of TPCA

Wednesday, April 4, 2018

CorePoint Lodging: Form 10 Notes

Today I'm doing another update, this time on La Quinta's upcoming REIT spinoff, CorePoint Lodging (CPLG), based on the long awaited update (at least on my part) to their Form 10 and the merger agreement between La Quinta (LQ) and Wyndham Worldwide (WYN).  Quick recap, La Quinta announced last year their intention to separate the hotel management business from the real estate, initially that was a straight forward spinoff of the real estate into a REIT, but Wyndham came along and offered to buy the management company for $1.95B in cash.  Later in Q2, La Quinta shareholders will receive $8.40 per share from Wyndham for the management company and shares in the REIT spinoff, CPLG.

The setup for CPLG checks off a lot of boxes, it's likely to sold/trade cheaply as a taxable spinoff, plus it will have the dual benefits of EBITDA growth and a multiple that needs to come up.  When I've gotten in trouble with spinoffs or just special situations in general, its usually because the spinoff is a dressed up melting ice cube, I believe the opposite is true in CorePoint's case.

CorePoint will have 317 hotels with over 41,000 rooms across the United States (all of LQ's international hotels are franchised or managed) and is positioning itself as the "only public REIT focused on the midscale and upper midscale self-service lodging segment."  That's more happenstance than design, but self-service hotels feature more consistent and wider margins than their equivalent segment full-service competitors (fewer employees, 99% of revenues from room rentals).  On the negative side select-service hotels are viewed as easier to build, CorePoint pointed to the fact that midscale hotels are the fastest new build segment (its pitched as a positive), that's good for Wyndham has a management company but likely bad for operators like CorePoint as more suppy comes onto the market.  The majority of their hotels are located near suburban office parks, airports and along interstates, mostly avoiding urban and resort locations that could be more impacted by AirBnB and HomeAway like room sharing services (but again, easier to build new supply in suburban locations).  As a REIT, CorePoint technically can't operate the hotels under the typical franchise arrangement Wyndham uses and instead the hotels will be managed by Wyndham for a 5% of revenue fee (plus your typical royalty, reservation, and marketing fees you'd see in a franchise arrangement).

Quick screen shots from the Form 10, listing the locations and chain scale, much of the economy bucket is exterior corridor hotels that they've been selling off in recent years, but as you can see, a reasonably diversified hotel base for a one brand REIT.
At the time of my brief post on the idea in January, we didn't know the proforma capital structure at CorePoint and it muddied up the valuation a bit.  CorePoint is taking out $1.035B of CMBS financing that is secured by their hotel properties and then paying a dividend to LQ/WYN of $983.95MM subject to the adjustments listed below from the Separation and Distribution Agreement:
Section 3.6. Cash Payment. Upon the completion of the Financing Transactions and immediately prior to the Effective Time, CPLG shall transfer to LQ Parent or the applicable member of the LQ Parent Group, as directed by LQ Parent, an amount equal to $983,950,000, as such amount may be adjusted pursuant to this Section 3.6, such amount of which will, substantially concurrently with the Distribution and the Merger, be used by LQ Parent to satisfy a portion of the Liabilities outstanding under the Existing Debt Agreements; provided that:
(a) in the event the Closing Existing Net Indebtedness exceeds the Estimated Existing Net Indebtedness, the Cash Payment shall be increased on a dollar-for-dollar basis by the amount of such difference;
(b) in the event the Estimated Existing Net Indebtedness exceeds the Closing Existing Net Indebtedness, the Cash Payment shall be decreased on a dollar-for-dollar basis by the amount of such difference;
(c) in the event the amount of accrued but unpaid Transaction Expenses as of the Distribution Date exceeds the Estimated Transaction Expenses, the Cash Payment shall be increased on a dollar-for-dollar basis by the amount of such difference; and
(d) in the event the Estimated Transaction Expenses exceed the amount of accrued but unpaid Transaction Expenses as of the Distribution Date, the Cash Payment shall be decreased on a dollar-for-dollar basis by the amount of such difference.
The Estimated Existing Net Indebtness is listed as $1.665B in the agreement, as of 12/31/2017, LQ had net debt of $1.53B, reducing CPLG dividend payment down to ~$850MM.  The cash position at the time of the spinoff will then be something in neighborhood of ~$185MM ($1.035B - $850MM).  Proforma CorePoint earned $208MM in (adjusted) EBITDA for 2017, using my previous 12x multiple, gets me to about $14/share for CPLG.
$14 + $8.40 from WYN when the deal closes, gets you to $22.40 per share, or put another way, the market is currently valuing CPLG at a little under 10x EBITDA (no internally managed lodging REIT trades that cheap) at today's $18.84 share price.

Sources of Upside:
  • The cash balance will likely be higher than $185MM, we should assume some additional cash build from the beginning of the year until the deal closes (although maybe not due to rebuilding efforts after the hurricanes).  Plus as part of the Tax Matters Agreement, CPLG will receive any excess between the actual tax due and the $240MM amount Wyndham agreed to escrow as part of the management company deal.  I can't quite figure out what the cost basis is for LQ itself (I saw an analyst note that pegged it at $1.7B but can't source it for myself) so if you know what the amount is, please let me know.  Let's say that $1.7B is correct and my EV on the first day is correct at $2.5B, the Tax Matters Agreement assumes the tax rate at 24.65%, which would be about ~$200MM of the gain, meaning $40MM could come back to CPLG and potentially more if really trades down day 1 (most likely as I doubt it'll trade at 12x EBITDA to start).
  • This will also be taxable for shareholders, your taxable gain will be $8.40 + CPLG's first day price over your own tax basis, so all current LQ shareholders (including 30% owner Blackstone) should be cheering for the shares to get dumped the first day and then hopefully recover once the proforma numbers are clearer.
  • The spinoff is maybe ~2 months out and we don't have a CorePoint specific shareholder presentation, I haven't seen a lender presentation (which makes sense since they went the CMBS route) or heard about a road show, maybe there has been one but its certainly under the radar, it seems pretty clear to me that management isn't going to try and pump the stock up ahead of time.
  • This is quite the interesting dynamic where the lower the price, the better for everyone involved, management appears to know this and hasn't put out any forward guidance for the spinoff leaving the market to anchor to 2017's numbers.  2017's numbers could be deceptively low for three reasons: 
    1. The 2017 hurricanes significantly impacted La Quinta's owned hotels in Florida and Texas, in Florida more than 3000 rooms were out of service for the last four months of the year, and as of 2/28, 5% of CPLG's rooms remain out of service as they undergo repairs.  They disclosed a $36.7MM revenue impact due to Hurricane Irma closures in 2017, and on the Q4 call translated this into an annualized estimated EBITDA loss of $28-35MM (to be recouped through insurance proceeds which should add to the cash balance as well).  This could be a short term risk to the stock price depending on how quickly their Florida hotels get back online, but eventually the insurance proceeds will come in and the hotels will reopen.
    2. LQ initiated a big capex program in late 2016, they identified 50 hotels to renovate with the hope to move them from midscale to upper-midscale and capture greater room rates.  With this renovation project, many hotel rooms were out service and are just now re-opening, the renovation project cost $180MM and is expected to be largely complete by the time of the spinoff, what return will that investment make going forward?  On the Q4 conference call, managemend stated that remodeled hotels had on average a 13% increase in RevPAR upon reopening.
    3. La Quinta has always been a standalone brand without a larger rewards group.  La Quinta Rewards has 15 million members, by joining Wyndham Rewards and their 55 million members, WYN will funnel more travelers to CorePoint's properties.  They'll also potentially see some margin benefits from shifting a few percentage points away from OTA's to their direct reservation sites being part of Wyndham.  Additionally, there could be some opportunity to rebrand some of CorePoint's La Quinta hotels that are upscale or on the high end of the upper mid-scale segment to one of Wyndham's upscale brands.
  • Let's pretend forward EBITDA is closer to $235MM for 2019 (hurricane recovery, renovated hotels coming back online at higher rates and WYN synergies) CorePoint could be worth over $16 per share, or over 50% upside from today's implied price.
Other Thoughts:
  • I've received some pushback on this idea due to the "one brand" risk, however with a hotel REIT, I think some of that risk is overblown.  CPLG as a hotel REIT is not taking the credit risk of LQ/WYN unlike some of the triple-net lease REITs that were spun off with one master lease tenant.  Hotels change the logo on the outside of the building not infrequently; brand diversification makes for a nice investor relations slide but how important is it really?  Quick service restaurant franchisees usually specialize in one brand, although Papa Johns franchisees maybe wished they also own Dominos stores, I think of the hotel REIT business similarly, more about locations, markets and value/price over single brand risk.
  • CorePoint will have geographic market concentration risk, 23% of their hotel rooms are in Texas which caused the stock to drop significantly during the oil downturn in 2014-2015, and more recently their concentration in Florida resulted in significant disruption after Hurricane Irma.  Mr. Brightside, both markets are recovering and should provide a tailwind to CorePoint's results post spinoff.
  • There will be a 1 for 2 reverse split ahead of the transaction, keep that in mind when it actually starts trading, my $14 estimate becomes $28.  In the Form 10, a purging dividend is mentioned but its expected to be minimal.
  • CorePoint mentions they intend to be an acquirer, initially that seemed strange, but given the potential cash position at the spinoff, it might make sense to play consolidator for a minute in the fragmented midscale segment (another source of growth).  Either way, with the spinoff being taxable and the presence of a 30% private equity owner, I'd expect CorePoint to be acquired in relatively short order (6-24 months) after the spinoff.
It might be better to wait for the spinoff to occur and get some more color around the Florida hotel recovery speed before diving in but I have a position now and expect to add to CPLG when it begins trading.

Disclosure: I own shares of LQ and WYN (plus WYN calls)

Monday, March 19, 2018

Wyndham Hotels & Resorts: Form 10 Notes

Once again, apologies for being somewhat repetitive, but the Wyndham Hotels & Resorts Form 10-12 came out today and I wanted to update my numbers for a few changes and add some additional thoughts around the spinoff.  The biggest change from my post last week is it appears Wyndham Worldwide (WYN) already incorporates the timeshare-to-hotel group royalty fee in their segment results, which mutes some of the multiple arbitrage upside of creating an expense from the lower valuation company into a revenue of the higher valuation company.
Removing the double counting of Hotel EBITDA brings down the overall valuation a few dollars.
*Edited from original, proforma net debt was incorrect
It was also disclosed in the Form 10 that Wyndham Hotels & Resorts will have $1.888B in net debt at the time of the spinoff, essentially all the purchase price of La Quinta's management and franchise business will be placed on the spinoff which makes sense.  By incorporating the net debt number, we can infer what the target price of each side will be after the spinoff (using my multiples above) which might be useful as there's often significant volatility around the when issued and spinoff dates.
*Edited from original, proforma net debt was incorrect
Other thoughts/notes from the Form 10:
  • After the closing of La Quinta's management business, Wyndham Hotels & Resorts will have over 9300 hotels in their system, making them the largest franchiser in the world by the number of hotels and #3 in hotel rooms (economy hotels tend to be smaller in size).
  • The typical franchisee is a first time hotelier and single property owner, Wyndham has 5700 franchisees for their 9300 hotels, this is a small business in a box type service.  This is likely good and bad, good in that they're not exposed to any one large franchisee and bad in that the net worth of their franchisees is likely minimal outside of their hotel, leaving them more susceptible to distress.  Their value proposition is the single property owner can work with Wyndham and receive the marketing, reservation and technology system of an upscale hotel but for the economy and midscale segments.
  • Royalty fees are typically 4-5%, plus marketing fees of 2% and another 2% of gross revenues for rooms book through their reservation system.  Here's a good place to point out that the economy segment is less pressured by the Online Travel Agencies (OTA's) as the upscale and luxury segments, many of Wyndham's guests are drive-up, meaning they book their room the night of based on which hotels in a particular destination have vacancies.
  • Their two main strategic priorities going forward will be to grow in the midscale segment (to a lesser extent the upscale segment as well) and grow internationally.  Growing outside the economy segment helps strengthen Wyndham Rewards, their loyalty program, by keeping more people within the system, they don't want loyal guests being forced out of the Wyndham system because they don't have a mid or upscale hotel in a desired location.  International growth is an obvious given, about 70% of U.S. hotels are branded, while only 46% internationally, creating a growth runway for the entire industry.  Wyndham could also receive a tailwind from the growing middle class in developing markets, the middle class leisure traveler is the primary target demographic of economy chains.  Their recent purchase of La Quinta's management and franchise business hits both the moving upscale and international boxes.
  • This is the dream asset-lite "compounder" type business model.  Capital allocation will be split between a dividend, share buybacks (starting out of the gate with a repurchase plan in place) and M&A.  They've been an active acquirer over the past few decades:
  • Completing a spinoff isn't cheap, one-time costs add up to $330MM here with $280MM on the parent and $50MM on the spinoff.
Disclosure: I own shares and calls on WYN

Wednesday, March 14, 2018

Wyndham Worldwide: Hotel Spin from Timeshare Business

This idea is another addition to my unintentional ongoing series circling around the timeshare and hotel management industries.  Wyndham Worldwide (WYN) is the largest of the U.S. based timeshare companies and they will be spinning off their hotel franchise management division in the second quarter of 2018.  Timeshare multiples have run up significantly in the past several years, while this situation might not be as juicy as the past timeshare spinoffs, the pre-spin Wyndham trades at a discount to the parent's closest peer after the spinoff in ILG, while hotel management companies all trade significantly higher.  One also could argue that as the timeshare companies begin to generate increasingly more of their revenue from sticky resort management contracts, their multiples should continue to converge with the hotel management companies.

Wyndham is currently divided into three business lines:
  1. Wyndham Hotel Group:  Almost entirely a low capital requirement franchise business, Wyndham has over 8400 hotels in its stable which primarily skew to economy and midscale brands.  Their brands include the namesake Wyndham, along with brands well known to those that travel US interstates like Super 8, Days Inn, Ramada, Howard Johnson, Baymont and Travelodge.  Franchise fees are usually structured with an initial on-boarding fee, plus a percentage of revenues royalty irrespective of the underlying profitability of the hotel making the business less cyclical than the hotel operator REITs.  The essential components of the hotel management business are the number of rooms in your system and the revenue per available room (RevPar), both of which have been growing for Wyndham's hotel group.  To illustrate where Wyndham's brands are on the hotel segment landscape, the RevPAR for the entire in U.S. lodging industry was $83.57 in 2017, Wyndham's RevPAR was $37.63 for the same period.  Management guidance has this segment projected to do $445-$455MM of EBITDA in 2018.
  2. Wyndham Destination Network:  Wyndham operates the largest timeshare exchange network, RCI, which allows members (for an annual fee plus transaction fees) to trade their weeks or points in their own timeshare for another.  This is another low capital requirements business, but faces headwinds as consolidation across the timeshare industry has lessened the need for exchange networks.  Smaller or one off timeshare developers would typically give away an RCI membership in order to entice a sale, sell that the owner on having the option to be apart of a greater exchange network.  As larger brands entered the space, they've created their own exchange network ecosystems putting pricing pressure on RCI and their main competitor, Interval Internation (ILG's exchange network).  Management guidance has this segment projected to do $265-$275MM of EBITDA in 2018.
  3. Wyndham Vacation Ownership:  Wyndham is the largest timeshare business globally, they have 221 resorts under management representing 25,000 units and 878,000 owners.  Their model is almost entirely points based giving timeshare owners flexibility in how they book their vacation, plus more importantly to Wyndham it makes it easier for a current timeshare owner to upgrade/buy additional points than it would be to sell the same owner additional weeks under the old model.  Like everyone else in the industry, Wyndham has moved to a less capital intensive model where 80% of the units sold in 2017 were not developed by the company, instead buy a developer or via a just-in-time purchase of inventory.  Additionally, Wyndham provides financing to timeshare owners and then securitizes these loans in the ABS market.  Management guidance has this segement projected to do $735-$750MM of EBITDA in 2018.
Wyndham Hotel Group is going to be the spinoff, leaving the Destination Network and Vacation Ownership segments behind to become a purer play timeshare business.  In recent months, Wyndham has announced two large M&A transactions: (1) they sold their European vacation rentals business that was within their Destination Network segment for $1.3B in cash and (2) purchased La Quinta's hotel management business for $1.95B in cash ahead of its own spinoff.  Additionally, as part of these hotel/timeshare spinoffs, there has typically been a royalty fee going from the timeshare business to the hotel management company.  In all of the other timeshare spinoffs, the hotel management company has been the larger/parent in the transaction, where the opposite is true with Wyndham.  Even so, I'm going to assume management is smart and will put in place a 5% of VOI sales royalty agreement in place going from the timeshare parent to the hotel spin.

In order to come up with the post-spin picture, I took management's guidance and added the impacts of the European vacation rental business being sold (but it's already excluded from EBITDA guidance), the purchase of LQ's management business (and varying synergies levels), a potential 5% timeshare royalty to the spinoff, and then added some additional overhead to account for running two separate public companies.
Taking a look at peers of each, the parent will look most similarly to ILG with a combination of a large VOI sales business and an exchange.  ILG has had a epic run since the RMT with Starwood's Visitana (I sold unfortunately in the low-to-mid $20) and trades for a forward EBITDA multiple of just under 13x.  The hotel group spinoff will most resemble Choice Hotels (CHH), both compete primarily in the economy to midscale segments with brands like Comfort Inn, Quality and Econo Lodge.  The hotel management group all has significant growth baked into some of these EBITDA projections, the backwards numbers are several turns higher, but Choice Hotels trades for a 16x multiple on analyst 2018 estimates.
If we assume the timeshare business parent trades for 11.5x and the hotel group spinoff trades for 15x EBITDA, I come up with the below SOTP based on my mid-point forecasts:
The primary risks here is valuation, we're presumably late in the cycle, hospitality companies are historically very cyclical (timeshare and hotel operators more than hotel management) and we could be looking at both peak revenue/earnings and peak multiples.  This spinoff transaction would have looked a lot more attractive one or two years back, but I think it still will work and I've established a position with the hopes that there's something more to do after the spinoff if one or the other trade well outside my valuation targets.

If you're interested in WYN and in the Chicago area, we're covering WYN on 3/19 at the CFA Chicago meeting I co-host every month, details here: https://specialsituationsresearchforum.wordpress.com/meeting-registration/

Disclosure: I own shares of WYN

Tuesday, March 6, 2018

Spirit MTA REIT: Form 10 Notes

Some of this will be a rehash of my other post on Spirit Realty Capital (SRC) from January, but today SRC released the Form 10-12 for their spinoff, Spirit MTA REIT (SMTA), its a fun structure that deserves a little more fleshing out as it could result in an interesting investment opportunity once it starts trading in the second quarter.

As a refresh, SRC is a triple net lease REIT primarily focused on single tenant retailers that needs to rid itself of its largest and most troubled tenant, Shopko, in order to increase its valuation to the point where it can raise capital again (a must for any REIT).  SRC is hoping to accomplish this by spinning off its Shopko properties (and other workout assets) into SMTA but this would only work if SRC could receive proceeds in return -- here's where their securitization vehicle, Master Trust 2014, comes into play.  Master Trust 2014 is an SPV that houses many of SRC's small-to-middle market tenants that are unrated (but not Shopko or the other workout assets), and uses the SPV to obtained financing secured by the leases pledged to the SPV.  By putting the leases in the SPV, Spirit is able to obtain favorable financing terms such as being able to leverage the SPV up to 75% loan-to-value.  As the Master Trust has amortized over the last few years, the SPV had become overcollateralized, by putting the Master Trust with the spinoff, Spirit was able to put additional debt on SMTA and return it to SRC, in essence they're able to effectively "sell" the Shopko/workout assets by spinning it off with a cash out refinancing of the Master Trust SPV.  Of course they could have done the cash out refinancing of Master Trust 2014 anyway, but that would have increased SRC's leverage ratio and likely wouldn't have made their equity valuation any higher with Shopko stuck at the top of their rent roll.  But by positioning the spinoff as a highly levered REIT, they're able to rid themselves of Shopko and receive precious dry powder in return.

SMTA's mission statement per the Form 10:
The basic strategy will be to sell off or redevelop the Shopko assets and put the cash/collateral into Master Trust 2014, issue notes against it at 75% LTV and run a very leveraged REIT that looks more like a mREIT or CDO structure of yesteryear.  Coming out of the spinoff, SMTA will be leveraged 9.2x, but if all goes as planned, the leverage will climb significantly as Shopko makes up 20% of contractual rent and all of those properties are unencumbered.  As these assets are sold, the leverage will increase substantially to something like 12x EBITDA at the end state, or about double any traditional net lease REIT.
SRC mentioned on their recent earnings call that SMTA would have a very high payout ratio, I take this to mean it'll likely be at or above FFO, here's a little back of the envelope calculation of where cash available for distribution could be before any non-cash charges like impairments or loan loss reserves.
Please alert me if there are errors, likely I've made a few, but I think it's directionally right, and then below is the potential accretion if SMTA sells their Shopko/workout portfolio at various levels of their stated "Real Estate Investment Value" of $646MM per the Form 10.
*Revised from the original, I only had the debt proceeds and not the cash sale proceeds being reinvested originally.
A couple other points worth highlighting:

  • Some feedback I heard on my comparison of SRC to STOR was "well, STORE Capital's secret sauce is they get unit level financials and run their own internal ratings to monitor their tenants", the tenants in Master Trust 2014 are the same, 98% provide unit level financials and SRC utilizes Moody's to provide shadow ratings on all their borrowers.  I contend this is a commoditized industry and there is very little secret sauce or competitive advantage, other than the "shares are really your product" marketing to equity investors concept and lowering their cost of capital.
  • Fraudulent conveyance was also brought up, but in this structure the secured lenders in the Master Trust and one CMBS asset aren't being impacted by the spinoff directly, their notes are secured by the pools of leases in each SPV.  Even if Shopko went bust immediately after the spinoff, the debt holders of both SPVs wouldn't be impacted.  Which isn't to say the equity of SMTA being worth zero isn't a risk, clearly a recession or continued weakness in traditional retail (40% of SMTA's rent, 50% of that 40% is Shopko) will eat away at the equity strip of the SPVs and the value of the workout assets.
  • SRC will be the external manager, they're charging a flat $20MM plus a promote in the out years, $20MM works out to be about 2% of the equity NAV they laid out in their Path Forward III presentation slide below.  Not fantastic, but it is fixed, so as SMTA moves along in its recycling program the base management fee will remain the same providing some operational leverage (of course could go the other way too).
  • SRC and SMTA will have overlapping investment strategies, high level SRC wants to pursue the more investment grade rated tenants and SMTA will focus on the smaller non-rated tenants, but I'm sure there will be times when SRC has to decide which portfolio a prospective investment should go and it likely won't often be advantageous to SMTA.
  • SRC's recent $35MM term loan to Shopko will be "contributed" to the spinoff, it's included in their workout portfolio numbers, the coupon is 12% and is very likely to end up in some kind of restructuring before it matures in 2020.
Here's the old sum-of-the parts slide, I think the only changes are in the workout portfolio bucket, SRC must have contributed additional properties as the value moved to $646MM in the Form 10 versus $477MM below.
Using the new workout number, the NAV should be $3.05/share, it won't trade there but I think it's an important reference point.  If my CAD number is correct, and SMTA trades like one of the ugly Class B/C mall REITs with a 15+% dividend yield, then the shares could be worth $1.50 per share of SRC.  $1.50 is also about the value of the equity strip in the Master Trust SPV, as part of the refinancing, the collateral was reappraised and presumably the debt holders and rating agencies signed off on the new market value.  Certainly not something to be given too much faith, but another reference point.  I expect SMTA to be incredibly volatile those first few days of trading as many of SRC's traditional retail shareholders are likely to dump the stock, keep it on your watchlist!

Disclosure: I own shares and call options on SRC

Tuesday, January 23, 2018

Spirit Realty: Leveraged Shopko Spinoff Uncovering Value

Spirit Realty Capital (SRC) is a triple net lease REIT focused on single tenant commercial real estate, SRC effectively makes middle market loans secured by real estate collateral.  The REIT is very similar to STORE Capital (STOR) which did a private placement with Berkshire Hathaway last year, the difference being Spirit has a high concentration to one troubled retailer, Shopko, that is creating an unwarranted discount in the shares.  REITs generally need their shares to trade at a premium to NAV in order to play the private/public valuation arbitrage game and grow, when a REIT trades a significant discount like Spirit does, it gets stuck and is forced to come up with a strategy to continue on a growth path.  Spirit was a net seller of assets in 2017, but it has come up with an interesting solution to fix their discount, in the second quarter they will be spinning off their Shopko assets along with the assets and debt related to one of their asset backed securitization vehicles called Master Trust 2014.  The spinoff will be named Spirit MTA REIT (SMTA) and is generally viewed as a garbage barge spinoff that's worthless, while it's likely to trade ugly initially, there's call option like value in the spin while more importantly allowing the parent company to shed its riskiest asset.  After the spinoff, Spirit should trade more inline with its net lease peers.

Here's how the combined SRC compares to its net lease peers:
Most REITs are going to look cheap compared to Realty Income Corp, but after the spinoff new SRC should look a lot like STORE Capital and that large discount between the two should close over time.

Spirit MTA REIT (SMTA)
The "bad bank" REIT will primarily contain two sets of assets (today they tossed in some more workout assets similar to Shopko that will be sold with the proceeds going into the Master Trust):
  • Shopko is a mostly rural (midwest and western US) discount store that's facing similar pressures to many retailers, its under-invested in its stores and sells ubiquitous products that you can buy almost anywhere.  It's target market is similar to Sears, its sort of an unfocused general store.  Spirit currently leases 101 properties to Shopko, representing 7.8% of its lease roll (prior to the spinoff), it recently became a secured lender of Shopko as well, advancing $35MM in the form of a term loan at a 12% interest rate.  The term loan will provide SRC/SMTA with quarterly financial statements and more direct insight into how the business is performing and also gives them optionality to separate the Shopko assets further if necessary.  SRC has been selling down Shopko assets in recent quarters/years, and will continue to do so at SMTA with the goal to completely dispose of the assets within 24 months of the spinoff.  With the proceeds from the dispositions, SMTA will contribute those proceeds to the Master Trust and lever it up.  The Shopko portfolio is debt free today, so in the event of a bankruptcy/liquidation at Shopko, the remaining assets at SMTA within the Master Trust shouldn't be impacted.
  • Master Trust 2014 (also seen it referred to as Master Trust A): Here's the interesting portfolio, the Master Trust portfolio is setup as an SPV, its bankruptcy remote from the rest of SMTA, and has a A+ rating by S&P with a 75% LTV.  The asset base is very similar to that of the rest of SRC, single tenant triple net leases, albeit a higher concentration of smaller tenants.  The effective leverage SMTA will be able to get inside the SPV is about 12x EBITDA.  I was able to locate the trustee report and the distributions to SRC have been pretty consistent over the past few years and they haven't stuffed the SPV with bad assets since announcing the spin.  Through the Master Trust and a new CMBS issue, SRC was able to raise an additional $698MM in debt at SMTA that will be used to reinvest in STOR/O/NNN like assets at SRC.
SMTA will be externally managed by SRC for an annual fixed fee of $20 million plus a $6 million property management fee.  There's additionally a one time incentive fee that triggers in the event of a change of control or the management agreement is terminated without cause after 3.5 years.  I think that shows you where management's head is at, if things work out, this entity will be merged away or some other transaction will take place within plus/minus 3.5 years.

Valuation
I had a simple model put together late last week to break out new-SRC vs SMTA, but today the company released an updated presentation that does all the heavy lifting for us:
New-SRC is the critical piece to the overall SOTP, after the spinoff it will be under leveraged compared to peers with a largely similar tenant roster, if it can re-rate to STOR's multiple (not suggesting it happens over night) it's a $9.75 stock ($0.65 * 15) versus an $8.50 price today, and that's a conservative approach since we already know they're going to have a lot of dry powder ($698MM from SMTA that they'll lever 2-1) to start the acquisition engine again, growing AFFO.

SMTA won't have any close peers that I'm aware of (please correct me if there is one) and will probably trade terribly initially as the investor base for SMTA will be much different than SRC.  SRC provided an NAV build in the presentation today, the $1.61 value in the Master Trust is likely pretty solid (as of January 2018) as its just refinanced and had a third party assess the value of the collateral as part of that process.
The Shopko and workout assets are a little trickier, SRC has been able to dispose of some Shopko properties at similar cap rates to what they're showing here, but its unlikely the public REIT market will assign a 9% cap rate to the Shopko leases.  Quick and dirty, I'd probably assign a 50% discount to the $2.34 NAV presented here for today's purposes although I like the spinoff for its call option like return potential if their reinvestment plan works given the leverage at the Master Trust.

$9.75 for new SRC + $1.17 for SMTA = $10.92 versus a share price of $8.50 today, or ~30% upside without accounting for any new investments either side makes with their growth capital.

Why is this so undervalued?  I think it mostly relates to the typical net lease investor base, REIT investors like simple and safe stories, this spinoff transaction while creative is far from simple and the headline concentration risk to Shopko has scared away many investors.  This spinoff should remove the tenant concentration risk, simplifies the story, and then through the reinvestment of the capital raise from SMTA, allows SRC to return to the market and show a growing AFFO/dividend stream which should also help raise the valuation.

Biggest risks here: 1) interest rates moving higher than expected, the majority of their leases do have escalators built in but they're long dated and the investor base is also interest rate sensitive as net lease REITs are viewed as a bond alternative; 2) general recessionary risks, particularly with retail, although SRC is trying to move more towards services based tenants, these are risky borrowers that often can't get traditional financing elsewhere so they turn to a sale-leaseback transaction.

Disclosure: I own shares of SRC