Tuesday, July 25, 2017

STORE Capital: Berkshire Deal, High Risk Lender?

STORE Capital (STOR) is an internally managed triple-net lease REIT, I don't own it (and usually don't like to write about companies I don't own), but Berkshire Hathaway (BRK) recently made a direct investment of $377MM for a 9.8% stake that deserves a closer look.  STORE is acronym for Single Tenant Operational Real Estate, basically it means they lend money primarily to middle market retail and service businesses using a sale-leaseback structure where the single tenant box is the collateral.  While STORE Capital is a REIT, it's closer to a BDC type lender than it is to an office, multifamily or even a mall REIT.  The tenants come to them because they need financing and can't get financing through more traditional bank lending.  The tenants then still control the property, pay the taxes, capex, and insurance, plus these are very long term leases, usually 15+ years.
STORE currently has 1750 properties, they're focusing on service sectors (restaurants, movie theaters, health clubs) as a way to mitigate the threat of online shopping, their largest tenants include Art Van Furniture, AMC Entertainment, Gander Mountain, Applebee's, Popeye's and Ashley Furniture.  Often the tenant is really a local franchisee of Applebee's or Ashley Furniture, and not the parent company.

There are plenty of triple-net lease REITs out there, it's a fairly common structure and a commodity business, if STORE does have a "secret sauce" its their focus on unit level profitability.  From their 10-K (click to expand):
To summarize, they strive to have each location be profitable to the tenant, not just the overall tenant themselves, that way if the tenant does get into financial trouble they'll want to hang onto those profitable locations through restructuring and not hand back the keys to STORE.  Again, think of STORE as a lender and not a landlord, they're not in the business of re-positioning a failed retail box into a higher and best use, just like a bank is not in a great position to manage the sale of a foreclosed home.  To facilitate this level of underwriting, STORE receives unit level financials on 97% of their locations, surely a useful data point that helps manage the growing portfolio.

Where the story gets a little promotional for me, STORE rates the credit quality of each tenant with an internal metric dubbed "The STORE Score".  Their tenants are almost entirely non-rated entities, last year they average an 8% cap rate on new investments, and again, these are entities that typically don't qualify for traditional bank financing.  Yet, based on SCORE's internal metric, 75% of their tenants would be investment grade if rated, or at least default at rates similar to a Baa2 rating.
Here's where I question the validity of the score, if I look at bank loans rated Baa2, I see the average coupon being something like LIBOR + 200 bps, no where near the equivalent to an 8% cap rate that STORE is receiving, what's the explanation?  The management team here is well thought of here, STORE was originally created by Oaktree in 2011 before going public in 2014, they're focused on doing smaller one off deals for the time being (likely will become more difficult as they grow), so maybe its just better management and the ability to do bespoke deals?  Possible, to me it seems questionable that they're tenants are really investment grade but at least STORE is doing their own underwriting work.

But promotion is part of the REIT game, STORE's real product is their own shares, in order for them to continually grow they need to raise more capital by issuing shares.  It's not entirely different than an asset management company marketing their funds and selling the product.  Berkshire Hathaway bought at $20.25, today the shares trade for $23.25, so accepting BRK's stamp of approval lowered their cost of a capital, probably a smart capital raise on STORE's part.  Depending on your assumptions for the fresh BRK capital, STOR trades for about a 6.0-6.5% cap rate today and if they're continually able to invest at 7.5-8.0% cap rates they'd be smart to continue to issue equity.

I'd peg STORE Capital at about fair value today and think it's reasonable to assume a ~10% annual return from here going forward.  Management lays out the math a bit in their presentation, but if you're buying in at a 6.5% cap rate today, levering it, reinvesting some of the cash flows, raising rents 1.8% per year, issuing equity to buy at 8%, dock something for defaults/recovery and the returns lay themselves out pretty well.
This is a better mouse trap than many other alternative investment products out there or a BDC/CEF, at least here you have the real estate as collateral, it should perform close to the overall market with lower volatility.  Given Berkshire's cash hoard, can't blame them for taking that proposition.
-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
I co-chair a monthly investment research group where we discuss special situations and just general value investing ideas, yesterday the topic was STORE Capital, if you're in Chicago and free on the 4th Monday of every month come join us.
https://specialsituationsresearchforum.wordpress.com/

Disclosure: No Position

Friday, June 30, 2017

Mid Year 2017 Portfolio Review

My portfolio is up 15.75% for the first six months of 2017, pulling up my since inception IRR to 23.74%, and comfortably ahead of the S&P 500's 9.34% gain so far this year.  Significant winners have been Tropicana Entertainment, MMA Capital, Pinnacle Entertainment and Resource Capital, the only significant loser has been New York REIT.
Closed Positions:
  • ILG Inc (ILG): In hindsight, this was one of my favorite special situations of the past several years.  ILG (f/k/a Interval Leisure Group) had entered into a reverse morris trust transaction with Starwood prior to the announcement of Starwood's merger with Marriott, thus those that wanted to play the merger arb on the Starwood/Marriott transaction had to short out both Marriott and ILG against Starwood creating an uneconomic selling pressure on ILG's shares.  Since the deal has closed, ILG has run up well over 100%, I unfortunately sold a little too soon in the low $20s as ILG is now being bid up under speculation of a merger with Marriott Vacations Worldwide (VAC).  I'll be looking closely for ideas like this in the future, something similar was the Dell buyout of EMC/VMWare which created a coiled spring in VMWare stock that's caused the DVMT tracker to do very well too.
  • Actelion (ALIOY):  The Actelion/J&J deal closed and the development stage biotech company that was created out of the merger, Idorsia, has done very well too.  I bought the unsponsored ADR, there was a short week or two there when the shares dropped and people started speculating on why and if withholding taxes were going to be an issue, I got scared out of my position, ended up making a small amount of money but left some on the table.
  • CSRA (CSRA):  CSRA is the government services spinoff of CSC, with CSC I had the right idea at the time of the spinoff, CSC was setup to be sold and it was earlier this year when it merged with a division of HP Enterprises in a reverse morris trust to create DXC Technology (DXC).  I haven't spent much time on DXC, but CSC turned out to be the better side of the CSC/CSRA split.   I ended up selling CSRA earlier this spring in a slight fit as I didn't realize pension income was being included in their "adjusted" EBITDA figure they were presenting.  It caused the shares to look artificially cheap compared to peers and I just missed it, lesson learned.
  • WMIH Corp (WMIH):  The white whale of NOL shells, with over $6B in NOLs and apparently no dance partner in sight, it appears like the company's sponsor KKR is unable to find a deal that makes sense, they can walk in January, and will likely use that as leverage to strike an even more advantageous deal with WMIH.  If a deal does happen in the meantime, there still could be money to be made after but I don't see a reason to wait around any longer.
Previously Unmentioned New Positions:
  • Miramar Labs (MRLB):  Miramar Labs is another CVR opportunity, and even smaller than the others mentioned on the blog, but they make a medical device that's used to reduce underarm sweat and hair.  It's more of a elective beauty and/or lifestyle product that is sold to plastic surgeons, spas, etc, and its treatments are paid in cash and not processed through insurance companies.  Sientra (SIEN) is buying Miramar for $0.3149 per share upfront and $0.7058 per share in contingent payments for a total just over $1.02 per share.  The contingent payments are a little unique, where the milestone is a cumulative net sales number with no deadline.  Unlike the other CVRs that rely on an FDA approval, here Miramar already has an approved and commercialized product, so unless the sales flop going forward, the payout should occur, its just a matter of when.  The big payout is for $80MM in sales, Mirmar did $20MM in sales last year, but they're seeing some growth, I'm modeling out a 3-3.5 year timeframe to hit the milestone payment which at current prices of around $0.55 per share generates a pretty nice IRR.  Thanks to @yolocapital on Twitter for pointing it out to me.
  • Sound Banking Company (SNBN):  Sound Bank is a tiny North Carolina based community bank that is being acquired by another small bank but with high growth ambitions, West Town Bancorp (WTWB).  There are many small bank mergers happening, if I was less capital constrained, or had a lower risk mandate I'd probably be diving head first into more of these as the spreads are fairly wide for what should be low risk deals.  West Town Bancorp is offering $12.75 in cash or 0.6 shares of WTWB for each share of SNBN.  With SNBN currently trading at $13.40, you could create shares of WTWB for $22.33 when they currently trade for $24.45.  There is a cap on the cash/stock consideration, so proration is likely with the stock trading over the $12.75 cash payout, but it still seems/seemed like a good bet, the merger is expected to close in the third quarter.
  • Interoil Corp (IOC) Contingent Resource Payment:  I got bored and ended up trying this CRP/CVR the day or two before the merger with Exxon Mobil was completed, no view on how much natural gas is actually in PNG, so its a pure speculation that should be decided in the next quarter.
Current Holdings:
I added a little money earlier this year, the performance figures take that properly into account.

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, June 9, 2017

Merrimack Pharmaceuticals: Broken Biotech with CVR-like Optionality

Over the last couple months I've been developing a basket of small broken biotechnology companies that all peaked around the sector's euphoric days in 2015 only to be forced to sell themselves more recently to larger companies as their funding has dried up.  Merrimack Pharmaceuticals (MACK) is one such company, they're focused on developing therapeutics for the treatment of cancer, in 2015 their first commercial product was approved by the FDA, Onivyde, a second-line treatment for those with pancreatic cancer.  Merrimack has struggled to market Onivyde effectively, its current addressable market is rather small as its not approved yet for front-line treatment, and its a difficult proposition to scale a sales force from nothing quickly and efficiently.  Add in the expensive nature of conducting clinical trials for the remaining cancer drugs in their pipeline, and it became clear that Merrimack needed to raise cash quickly.

So Merrimack sold their commercial business in Onivyde (along with a generic version of Doxil) to Ipsen (IPSEY) for $575MM in cash at closing, $33MM in near term milestone payments related to Onivyde sales through their licensing agreement with Shire (originally Baxalta), and up to $450MM in contingency payments based on additional regulatory approvals for Onivyde.  Following the sale, the company's plan was return cash to shareholders via a special dividend, pay off most of their debt, and refocus the company as a development stage biotech again.  The deal closed in early April, a $140MM special dividend was paid and their senior notes have been redeemed.  Today the company's market cap is roughly $200MM, or about the same as net cash following the closing of the Onivyde sale and resulting special dividend.

Merrimack 2.0
The company will now have a few different shots on goal, to be clear, this is all very speculative at this point and I know very little about the chances of any of these milestones being reached or the drugs in their pipeline ever being approved and commercialized.

Merrimack's board of directors has committed to passing through to shareholders any payments received net of taxes related to the Ispen deal in the form of special dividends.  In essence, these will function like contingent value right payments, but they're stapled together with the common shares and the company could go back on their word and find other uses for the cash in the future.

The three milestone payments are as follows:
  1. $225MM for FDA approval in first-line pancreatic cancer
  2. $150MM for FDA approval in small cell lung cancer
  3. $75MM for FDA approval in any third indication
There doesn't appear to be a deadline on any of these, at least one that's worrisome, that's good as it prevents Ipsen from delaying the approvals until just after the milestone date expires.
Milestone 1 is in a phase 2 trial, milestone is just beginning a phase 3 trial, and milestone 3 has a couple in phase 1 or beginning stages of phase 1 trials, translation, all are probably years away from potentially materializing.  Merrimack's financial advisers in the transaction estimated the probability weighted NPV of Ispen's offer at $685MM, with $575MM upfront and the Shire milestone payments of $33MM likely to hit this year, the bankers put the NPV of the contingency payments at roughly $77MM.  Seems fairly reasonable assuming a low-to-mid probability on either 1 or 2 being met in 3-4 year time and then discounting that back pretty heavily.

As part of Merrimack's restructuring, they've narrowed their pipeline to the three most promising anti-cancer products which they plan to focus their attention now as a new development stage company:
These three are also pretty distant catalysts, MM-121 has failed three phase 2 trials in non-small cell lung cancer, ovarian cancer, and breast cancer, so they're running out of options for that drug.  I'm curious to hear others thoughts on these three programs and their prospects as the company even after the restructuring is only funded through the end of 2019 - developing oncology drugs is extremely expensive.

Merrimack also has convertible debt outstanding, as part of the Ipsen deal the company eliminated their senior notes but conveniently left out any mention of their convertible debt, the convertible holders were understandably unhappy with the company.  Merrimack sold off their one commercial drug, bypassed them and distributed cash to shareholders, reducing the collateral backing the convertible notes which significantly increases the probability of default.  Bondholders are suing the company and as a result, Merrimack escrowed $60MM -- or about the amount it would take to redeem the upset bondholders.  The convertible bonds might be an interesting special situation in their own right, they trade in the upper 60s, way out of the money with a strike price of $6.25, have a 4.5% coupon, and if the lawsuit is successful they could be redeemed at par by year end.  If Merrimack is successful however, then the $60MM (or $0.45/share) will be distributed to shareholders as an additional special dividend.

Prior to the special dividend that's already been paid, MACK was trading between $3.30-$3.70 per share, after the $1.06 dividend it sold off down to $1.44 as of today, so roughly $0.80-$1.20 has come off the stock price for no other reason than the asset sale was completed and the dividend was paid.  There are a lot of upset retail shareholders and other day trader types in the stock, but it looks to be cheap and some forced selling happening after the restructuring has taken place as holders reassessed whether they wanted a pre-revenue stage biotech -- its almost like old spinoff selling dynamics taking place after the dividend was paid.

But at net cash, with new management taking over who were just issued a new options package, and the possibility of future contingent payments related to Onivyde, Merrimack seems like an another interesting speculation to add to my broken biotech bucket.  It'll be about 3 years before we know how this bucket turns out and that's likely a big part of the discount, but I think/hope I have the patience and ability to wait it out.

Disclosure: I own shares of MACK

Friday, May 26, 2017

Caesars Entertainment: Finally Emerging in Q3, OpCo-PropCo Split

Caesars Entertainment (CZR) is the largest gaming company in the United States which traces its roots back to the 1998 Hilton spinoff Park Place Entertainment.  Park Place later purchased Caesars from Starwood in 2000, eventually changing its name to Caesars Entertainment before being bought by Harrah's Entertainment in 2005.  A few years later in 2008, Harrah's was taken private in one of the largest private equity deals at the time for $30B by Apollo, TPG, and Blackstone.  While under private equity ownership, it switched the name back again to Caesars Entertainment.  In the near decade since the LBO, Caesars has struggled under a heavy debt load, unable to adequately invest in their properties or effectively compete for development opportunities in new jurisdictions.  It briefly appeared back on public markets before filing for bankruptcy in January 2015.  After a long and contentious reorganization process, Caesars will finally emerge from bankruptcy sometime in the third quarter.  Recently management has been out in front of the press and analysts telling their story as they drum up interest for the post-bankruptcy shares.

I'm buying the story and think reorganized Caesars presents an interesting opportunity for a few reasons:
  • Low hanging capex project wins: Caesars has under-invested in their properties since the LBO and financial crisis, anyone who has been to one of their properties in 2010-2014 would agree, but in the last 12-18 months Caesars has begun an extensive room renovation program that will have them hit 50% of rooms renovated by the end of 2017 and 90% of Las Vegas inventory renovated by 2020.  Its a similar theme to Nexpoint Residential Trust (NXRT) renovating their Class B apartment units that's played out so well, Caesars renovating their "Class B" hotel rooms on the strip provides an attractive return on investment as they're able to raise room rates 10-20% after renovation.  Additionally, Caesars owns some land behind (they use the term "adjacent", but it's really behind if you're standing on the strip) the LINQ hotel that they're going to build a mid-sized convention center on to serve their hotels on that side of the strip (Flamingo, LINQ, The Cromwell, Bally's, Planet Hollywood, and Paris).  They won't be competing for the large trade show business (the expansion of the Las Vegas Convention Center is another tailwind though) but adding some convention space should help attract more business oriented customers that typically spend more than leisure customers.
  • OpCo/PropCo Split and Management Co growth opportunities: As part of the reorganization, former creditors (not current/old CZR shareholders) will be receiving equity in VICI Properties, the new REIT that will own the property of CEOC (more on the org structure below) which includes Caesars Palace and most of the regional casinos, but not the other Las Vegas casinos which will continue to be owned by wholly owned subsidiaries of Caesars Entertainment.  It's effectively turning the old debt it something that looks like debt, but isn't quite in the form of the triple net lease structure.  We're still fairly early in the OpCo/PropCo structure for casinos, but long term its an effective way to leverage the company and take advantage of REITs lower cost of capital.  Also intriguing to me is the possibility of Caesars using the hotel management model and utilizing truly third party capital to build/operate the casinos while Caesars manages the resort for a fee.  They do this today mostly on Native American reservations, but curious why this hasn't been the structure all along?  Ideally the gaming REITs would look like hotel REITs and not triple net lease REITs, maybe someday.
  • International expansion opportunities:  The United States is pretty saturated with casinos, most markets have casinos within driving distance.  Especially on the east coast, where states are geographically smaller creating more jurisdictional competition, as each state fights for its fair share of gambling tax revenue, the pie doesn't appear expand much but rather the slices are getting smaller and smaller.  Caesars missed out on Macau and Singapore, but is actively pursuing opportunities and partnerships in South Korea, Japan, Canada and Brazil.
  • Leverage:  This could also could be a bad thing, but after emerging from bankruptcy CZR will be just under 6x leveraged if you include the capitalized lease obligation to VICI Properties - which I give credit to management here, they don't over-emphasize their non-GAAP versus GAAP debt structure like Penn and Pinnacle Entertainment do.  But if you believe in the short term theme in the first bullet or the longer term international expansion theme, then any incremental increase in EBITDA or earnings could substantially increase the equity.  For example, after Pinnacle Entertainment (PNK) did the OpCo spinoff, its share price has increased about 70% in the past year while its EV/EBITDA multiple is only up half a turn and EBITDA has grown mid-single digits.  Of course the opposite can happen just as easily too.
Caesars Entertainment Corporate Structure
I won't pretend to know all the history or legal reasons for the division of the subsidiaries, other than to assume their private equity owners were doing everything they could to protect certain assets from creditors once it became obvious (which was soon after the buyout) that a restructuring would be coming.
I pulled this off of a Caesars Entertainment Resort Properties ("CERP") lender presentation, so the emphasis on that subsidiary isn't intentional.  It's worth noting that the new Caesars will continue to own the real estate of Caesars Growth Partners ("CGP") and CERP which are primarily the Las Vegas properties other than Caesars Palace.  Also, CEOC is only entity in bankruptcy and as a result is deconsolidated on CZR's financial statements, which only adds to the confusion around the situation as there aren't clean SEC financials.

Caesars PropCo REIT, to be called VICI Properties, will include the 18 casino/resorts that were owned by CEOC but not CERP or CGP, plus a few golf course to be placed in the taxable REIT subsidiary likely for tax reasons (the "lemonade stand").  VICI Properties will additionally have the option to buy Harrah's Atlantic City, Harrah's New Orleans, Harrah's Laughlin and has the right of first refusal to the real estate of any U.S. (but outside of Vegas) property that Caesars might acquire or develop.  This REIT will look a lot like Gaming & Leisure Property Trust (GLPI), while casino resorts aren't easily convertible to another use in the case of obsolescence or default, the master lease structure with operating company tenants protects the REIT pretty well.  As long as the majority of the properties are stable and functional, and the operating company healthy, they'll receive their master lease payment plus a 2% step up annually.  I'm curious what the future holds for the REITs, including MGM's, it'll be interesting to see how they handle M&A going forward, thoughts here are welcome.

CZR/CACQ Merger
Another fun complication to the story is the merger of Caesars Entertainment (CZR) and Caesars Acquisition Company (CACQ), CACQ owns a stake in Caesars Growth Partners and previously Caesars Interactive which was sold in a separate transaction to a Chinese buyer.  The merger will happen in conjunction with CEOC emerging from bankruptcy to recombine the company, and give 100% ownership in CGP to CZR.  Lots of Caesars acronyms.
CACQ shareholders will be receiving 1.625 shares of CZR for each share of CACQ, as of today there is a slightly spread (less than 2%) at the moment between the two, probably for liquidity reasons as there's little chance at this point that deal won't be completed.  As part of the reorganization then, current CZR shareholders will receive 8.7% of new CZR, CACQ shareholders will receive 32.9%, and the former creditors will receive 58.4%.

Valuation
The new Caesars Entertainment will look like a combination of MGM without the Asian operations and PENN/PNK but with significant Las Vegas exposure.  Caesars is also more diversified by revenue sources as Las Vegas transforms itself with less emphasis on gaming revenues and more emphasis on entertainment, nightlife, restaurants, shopping and experiences.

The recent analyst day provided a lot of good information in an Excel supplement, I used the below and just plugged in today's stock price with a discount via CACQ.
Comparing the new CZR's to peers:
MGM deserves a premium to CZR, but the question is how much?  I'd probably just guess 1-1.5 turns compared to CZR.  Given the leverage and valuation, even putting a 10x multiple on CZR would generate a low 20% gain from here without any benefit from the hotel renovation project, convention center, general economic tailwinds regional casinos have been seeing, or just Las Vegas momentum in general with the Raiders & NHL, housing market coming back there, etc.

Disclosure: I own shares of CACQ (PNK and TPCA also)

Tuesday, May 2, 2017

GenVec: Intrexon Buyout, Novartis Partnership CVR

GenVec (GNVC) is another semi-failed biotech (and pretty tiny - only a $14MM market cap), GenVec is being purchased by Intrexon (XON) in a deal that should close by the end of the second quarter.  GNVC shareholders will receive 0.297 shares of XON + contingent payment right equal to 50% of any milestone or royalty payments received within 36 months after closing from GenVec's collaboration agreement with Novartis (NVS).  Assuming the deal closes as expected, the CVR is currently being valued at approximately zero.

Back in 2010, GenVec struck a partnership agreement with Novartis to discover and develop treatments for hearing loss and balance disorders.  The partnership centers around CGF166, currently in phase 1/2 trials, the goal of CGF166 is to regenerate sensory hair cells in the inner ear using gene therapy to restore hearing.  Hearing loss is a big addressable market and many of those suffering don't utilize hearing aids and the like due to social stigmas.  GenVec licensed the rights to this program to Novartis, in return, GenVec received a $5MM upfront payment, Novartis purchased $2MM of GNVC common stock, and GenVec was eligible to receive up to an additional $206.6MM in milestone payments.  To date, GenVec has only received $5.6MM in milestone payments, and none in the past two years.
Sorry if that's too small, but there's $201MM in potential milestone payments out there, plus royalties on any sales, the CVR will split any potential payments 50/50 with Intrexon.

Without knowing much about the probability of milestones being met (let's just go with a very low probability), the interesting thing about this CVR is its success or failure is in the hands of Novartis, a third party not involved in the merger.  The 36 month clock on the CVR doesn't directly relate to anything I can see in the Novartis partnership, so Novartis has less incentive to game the milestone dates, the 50/50 split with Intrexon puts the CVR on equal footing.  Within 36 months, we should know if there's something to CGF166 or not.

There's likely not much value in the CVR, but with a tiny market cap and a long dated non-tradeable CVR, I could come up with some behavioral arguments on why its being completely discounted.  Intrexon feels a bit scuzzy to me, they're highly promotional and did a weird faux spinoff earlier this year, so I'd recommend shorting out the 0.297 shares of XON for every share of GNVC to just synthetically own the CVR.

Thanks to the reader who sent me this idea after my INNL post.

Disclosure: I own shares of GNVC

Friday, April 21, 2017

Innocoll Holdings: PE Buyout, Big CVR Attached

Innocoll Holdings (INNL) recently agreed to be acquired by Gurnet Point LP, a healthcare investment fund headed by Sanofi's former CEO Christopher Viehbacker and backed by billionaire Ernesto Bertarelli's family office, for $1.75 per share plus up to $4.90 per share in contingent value right ("CVR") payments.  The CVR has several milestones based on the approval and commercial success of Innocoll's drug/device Xaracoll which is a biodegradable implant that delivers bupivacaine to provide non-opioid acute pain relief for several days post surgery.  During surgery, Xaracoll is implanted near the incision to provide an initial burst of bupivacaine followed by a slower sustained release that delivers pain relief over 72 hours, and since its biodegradable, it doesn't need to be removed and instead dissolves in the body.

Prior to the buyout offer, Innocoll was troubled and near insolvent.  In 2016, the company pulled the plug on their previously touted Cogenzia (for treatment of diabetic foot infections) after studies failed to show it was effective.  Then late in the year Innocoll experienced another set back when Innocoll received a Refusal-to-File letter from the FDA for Xaracoll causing the stock price to drop roughly 60% in a day.  According to the company, the Refusal-to-File was mostly clerical as the FDA considers Xaracoll a drug/device, not just a drug, thus requires additional information/studies to be performed before the FDA could take it under full consideration for approval.  However, Innocoll didn't have the cash to fund additional studies and was forced to either raise capital or find a buyer, Innocoll found a buyer.

The specifics of the CVR Payment Events:
  • First CVR Payment Event: Gurnet Bidco will pay $0.70 in cash per CVR if on or before December 31, 2018, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following open abdominal Hernia repair
The first payment event seems like a low hurdle, they ran a successful phase 3 trial for postsurgical pain following open abdominal Hernia repair, it seems reasonable that once the paperwork is in order, the FDA will approve it.  Innocoll's only other potential pipeline product is CollaGuard which prevents post-operative adhesions, CollaGuard's potential commercialization is farther out and the addressable market appears smaller than Xaracoll (there are over 1MM Hernia repair surgeries annually in the US).  Often the drug or asset contemplated in the CVR is a secondary asset that the seller believes in more than the buyer, but here the CVR is referencing the primary remaining asset of Innocoll and the deal structure appears to be more of a risk mitigating scheme for Gurnet Point than a typical CVR.  If Xaracoll fails completely, the remaining assets are likely worth less than the $1.75 per share cash offer making Gurnet Point incentivized to at least meet this first initial milestone.
  • Second CVR Payment Event: Gurnet Bidco will pay an additional $1.33 in cash per CVR if, on or before December 31, 2018, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Soft Tissue repair (and not limited to hernia repair).
  • Third CVR Payment Event: If the milestone is met, Gurnet Bidco will either pay: $1.00 in cash per CVR if, on or before December 31, 2019, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Hard Tissue repairs; or, if not $0.60 in cash per CVR if, after December 31, 2019 but on or before June 30, 2020, Xaracoll is approved by the FDA with a label covering indications for the treatment of postsurgical pain immediately following Hard Tissue repair.
The second and third CVR payment events require new clinical trials that Gurnet Point will need to fund.  The phase 3 trial for Hernia repair ran for 8 months, so the timelines given for these events seem reasonable.  However, since Gurnet Point will need to fund these trials, there's a risk that they'll time the trials *just so* to miss the CVR payment date.  That's the primary risk with CVRs, the seller is essentially putting the final purchase price in the hands of the buyer, the incentives are misaligned.
  • Fourth CVR Payment Event: If the milestone is met, Gurnet Bidco will either pay: $1.87 in cash per CVR if global net sales of Xaracoll exceed $60 million in any four consecutive Calendar Quarters ending on or prior to December 31, 2019; or, if not, $1.00 in cash per CVR if global net sales of Xaracoll exceed $60 million in any four consecutive Calendar Quarters ending on or prior to March 31, 2020.
I don't feel comfortable handicapping the potential sales of Xaracoll so its hard to have an opinion on the fourth CVR.  There is a competitor in Exparel that combines bupivacaine with a foam in a similar manner and has annual sales above $200MM.  However, opioid painkillers are cheap and they're great at treating acute short term pain, the real opioid epidemic problem revolves around their use for treating long term pain, so its hard to determine if the benefits of Xaracoll would be worth the additional cost?  Maybe for addicts or those at risk to be?

Most likely for today's $2.05 stock price, you get $1.75 cash in the next few months and $0.70 for 1st CVR milestone in ~12 months, plus the optionality of the long dated payment events.  Seems like a reasonable speculation to me, I bought a small amount.

Disclosure: I own shares of INNL

Tuesday, April 11, 2017

Safety, Income & Growth Inc: iStar's Ground Net Lease REIT

This is a pretty ridiculous name/logo right?  It's pretty clear the target market is yield hungry dividend investors who are looking "to sleep well at night".
Despite the awful name, I think iStar (STAR) has a chance to make this work (for iStar) as its a good sales pitch and would be a unique REIT in the market, plus they're selling 12 of their assets for $340MM or a ~5% cap rate.

This week, iStar filed the registration statement for a new REIT, Safety, Income & Growth Inc (SFTY), they've been kicking around quietly since last August.  According to the filing, it would be the first REIT targeted at ground net leases, a structure where the company would own the land, but not the building/improvements, and enter into very long term leases (30-99 years) with the building owner.  The safety part comes from the ground net lease structure, in the event of a default, despite only owning the land, the lessor can foreclose on both the land and the structure built on it.  The leasee and the mortgage lender (if there is one) on the property have every incentive to make the lease payment.  In effective, there's a significant overcollateralization built into the lease, the value of the lease is worth 30-45% of the combined value of the land/buildings, so often times in a foreclosure scenario a ground net lessor can make more than a full recovery.

At first I thought this was a public listing of the net lease JV iStar has setup with a sovereign wealth fund (GIC), however it appears to be a separate portfolio, but with investors in that fund participating in the SFTY IPO.  Safety, Income & Growth Inc will start out life with 12 assets from iStar's net lease portfolio, all 12 are either ground leases or at least look/function similarly if you squint.  The two primary assets will be One Ally Center which is the largest office building in Michigan, leased out to Ally Financial and PwC, and a portfolio of 5 Hilton branded hotels leased to the recent spinoff, Park Hotels & Resorts.
A good strategy in recent years has been buying net lease REITs that are discounted because of concentrated tenant exposure (GPT, FCPT, CSAL)  before they make deals to diversify their rent roll.  iStar says they're looking at a pipeline of over $500MM ground net lease deals, so expect them to diversify fairly quickly after listing.  They're starting with $227MM in debt at a rate of 3.773%, after the deal is done they'll enter into a new $300MM credit facility giving them additional room to add ground leases.

iStar will be the external manager of SFTY, it'll have one of the more unique external management agreements I've seen: 1) waiving their fee altogether for the first year, 2) no incentive fee or termination fee, 3) base management fee of 1% on equity up to $2.5B and 0.75% above, 4) the management fee will be paid in stock.  Granted, there's little work in managing a lease that expires in 2114 (doesn't even look like a valid year), but it's another reason this entity should be an easy to sell to the masses.

Safety, Income & Growth is paying about a 5% cap rate for iStar's assets (combination of cash and stock), the company argues that ground net leases should trade even lower than that:
This seems somewhat reasonable given the overcollateralization built into the structure, if it trades anywhere near a 4.5% cap rate, iStar should be able to source a lot of deals that make sense, especially early on when they can do small individual deals that still move the needle.

We're still waiting on an IPO date, but again, I think this has potential to do well and gather a decent amount of assets.

What does this all mean for iStar?
At year end, they had a $1.5B net lease portfolio (includes accumulated depreciation added back) that generated an NOI yield of 9.1%, in my initial post last summer I argued the net lease portfolio should be valued at 6.5% cap rate, which adds about $600MM mark-to-market above the carrying value on iStar's balance sheet.  It's probably incorrect to assign a 5% cap rate to the entire portfolio, but that would produce a $1.2B mark-to-market gain, quite significant for a company with a market cap of $1B.  But now iStar monetizes some assets at an attractive valuation by putting them in a simpler vehicle the market will be able to digest and assign a higher multiple to -- all while earning a (small) carry on their remaining investment going forward.  It's hard to argue iStar is anything but very cheap, hopefully they use some of the proceeds to buyback stock.

Thanks to the commenter in the original iStar post for bringing this deal to my attention.

Disclosure: I own shares of STAR

Friday, March 17, 2017

New York REIT: Winthrop Team Liquidating Another REIT

New York REIT (NYRT), as the name implies, owns office, retail, and hospitality real estate exclusively in New York City.  It began as a public non-traded REIT, then known as American Realty Capital New York Recovery REIT, and was brought public in April 2014 and externally managed by American Realty Capital (run by Nick Schorsch).  So it had two strikes against it: 1) former non-traded REITs tend to have disparate portfolios since they turn into indiscriminate buyers of anything that's for sale as their commission incentivized sales force pushes client assets into the REIT; 2) externally managed vehicles are often filled with conflicts, especially in regard to adding assets to boost the external manager's fees.

Not surprisingly, after going public the shares consistently traded below net asset value, making additional capital raises difficult for the already highly levered New York REIT.  They couldn't issues shares without serious dilution, they couldn't raise additional debt, they were stuck as a sub-scale REIT that would have difficultly growing and justifying itself as a standalone entity.

Facing investor pressure, the company put itself up for sale in late 2015, which eventually led to a confusing transaction with Washington DC developer JBG Companies that was effectively structured as a back door IPO for JBG, and would have created a confusing mismatch of stabilized NYC assets and a large, mostly multi-family, development pipeline in Washington DC.  Michael Ashner of Winthrop Realty Trust (FUR) launched a campaign against the deal, arguing instead that management should pursue a liquidation of the company, similar to the stance he took at Winthrop (which is now a liquidating trust and no longer traded).  The deal was terminated, and JBG recently found a new dance partner with Vornado (VNR), Vornado will be spinning off their Washington DC assets in an effort to become a NYC centric REIT as well, and will immediately merge the spunoff assets with JBG to create JBG Smith (JBGS).  JBG's management will run the new entity, I'm skeptical of their intentions, but it's one to watch as REIT investors may undervalue the development pipeline value "hidden" within the typical FFO/AFFO valuation metrics.

Back to New York REIT and fast forward a few months, the board and shareholders have approved the liquidation plan and appointed Winthrop as the new external manager and tasked them with selling all their assets and returning the proceeds to shareholders.

Winthrop REIT Advisors
A little background on the new manager (or "Service Provider" as they're listed in the management agreement), they previously managed, and still kind of do, an opportunistic REIT in FUR that invested across the capital structure, asset classes within real estate, both stabilized and development opportunities, and the market never properly valued the company as a result of its complexity.  Michael Ashner, who ran FUR, made the relatively odd decision to wind down the company and temporarily put himself out of a job, clearly a shareholder friendly move that paid off considerably as the total anticipated proceeds will be well in excess of the original estimates.  To get more background on how Michael Ashner thinks, Winthrop Realty Trust still has the old shareholder letters up on their investor relations page which may come down at some point now that the liquidation is almost wrapped up.

Michael Ashner's lieutenant, Wendy Silverstein, is officially in charge of New York REIT as the newly appointed CEO.  She has a long history, so does Ashner, in the New York real estate scene.  Winthrop has now set themselves up as a professional liquidator and its interesting to see how they've structured their incentive fee with New York REIT:
(b)          Incentive Fee.

(i)  In connection with the payment of (x) Distributions during the term of this Agreement and (y) any other amounts paid to the Stockholders on account of their Common Shares in connection with a merger or other Change in Control transaction pursuant to an agreement with the Company entered into after the Transition Date (such Distributions and payments, the “Hurdle Payments”), in excess of $11.00 per share (the “Hurdle Amount”), when taken together with all other Hurdle Payments, the Company shall pay an Incentive Fee to Service Provider as compensation for Services rendered by Service Provider and its Affiliates in an amount equal to 10.0% of such excess; providedhowever, that the Hurdle Amount shall be increased on an annualized basis by an amount equal to the product of (a) the Treasury Rate plus 200 basis points and (b) the Hurdle Amount minus all previous Hurdle Payments.

(ii)  The Incentive Fee shall be payable within two (2) business days of any applicable Hurdle Payment.
They've done their homework and clearly think its worth more than $11.00 per share when today it trades at about $9.70 per share.  In their initial activist presentation, Winthrop laid out their own NAV calculation based on management estimates that's a good  valuation road map for how to think of the ultimate liquidation proceeds.
It's a bit hard to read, but they came up with $11.39 - $12.31 assuming exit cap rates of 4.0 to 4.5%, which still seems about the right range based on industry numbers I've seen.

New York REIT Valuation
A quick snapshot of New York REIT that I recreated from their recent supplemental:
Winthrop's net asset value estimate came from an earlier version of this slide the company published in August:
The majority of New York REIT's value is in 5-6 properties, the two highlighted above, Viceroy Hotel and 1440 Broadway, require the most asset management/re-positioning.  The Viceroy Hotel opened in the fall of 2013, it's a 5-star hotel located two blocks from Central Park, the company paid $148.5MM for it but took a $27.9MM impairment charge recently as the hotel has failed to live up to expectations.  1440 Broadway is only 75% leased and had a few lease expirations that weren't renewed in 2016.

Others might not want to give credit to these two stabilizations occurring, but how I think this plays out is both Viceroy and 1440 Broadway will be some of the last assets sold and only once they've been stabilized, that's been Winthrop's playbook previously.  I think it makes sense to stretch out the liquidation time-frame, rather than discount the NOI for these two assets.  While there is a "clock" on the incentive fee Winthrop earns, their incentive is skewed towards price over speed.

The most significant asset New York REIT owns is a 48.9% equity interest in One Worldwide Plaza, a large predominately office building that takes up an entire city block.  It was purchased in October 2013, included in the sale was an option to purchase the remaining 51.1% at a fixed price of $678 per square foot, valuing the entire building at $1.375 billion.  New York REIT has leased up the building to 100% occupancy, the two largest tenants are Nomura Holdings and Cravath, Swaine & Moore that that both represent more than 10% of the company's overall rent roll.

The Real Deal recently published an article saying the building is being shopped for $1,000 per square foot.  NYRT investor, Rambleside Holdings, came up with a similar number of $1,100 per square foot in a letter sent to management in 2015:
To back into a $1,000 per square foot price, in the 10-K, New York REIT disclosed Worldwide Plaza's cash rent per square foot at $67.75 for the office space and $42.30 for the retail space.
Assuming a 4% cap rate, 60% NOI margins, and using last year's rent roll (conservative since you'd assume some increases), you could just about back into that $1000 per square foot price justification.

Using management's $144MM NOI run rate, the initial $115MM liquidation expense estimate, $1.51B in net debt, and nothing for ongoing NOI, we can come up with a simple table varying the exit cap rates and price per square foot for One Worldwide Plaza outlining the possible outcomes.
I'm hopeful the total liquidation distribution total is somewhere in the $11.33 - $12.44 per share range, with upside if they find someone to overpay significantly for One Worldwide Plaza, 1440 Broadway, or the Viceroy Hotel.  At $9.70 per share today, that's somewhere between ~17% and ~28% upside, with the wild card being timing of the liquidation distributions.  The liquidation plan outlines a 6-12 month time period to realize most of the asset sales, this feels quick?  But unlike Winthrop Realty Trust (FUR), New York REIT doesn't have any assets under development and most of the asset base is stabilized in a fairly liquid market.

Other risks include general softness in New York real estate, it currently appears mostly centered on the high end condo and multi-family market, but could clearly leak into office and particularly retail as that industry continues to be under pressure.  Rising cap rates is also a concern as interest rates continue to pick up, but that tends to not be a perfect correlation and given the near term nature of the asset sales, we'd need to see a significant shift in how the market views the pace of interest rates increasing to have a large impact on pricing.

Disclosure: I own shares of NYRT

Saturday, February 25, 2017

Tropicana Entertainment: Buyback Plan Ramping, Tender Coming?

Tropicana Entertainment (TPCA) is the Icahn Enterprises (IEP) controlled regional gaming operator with 8 casinos and related hotels, bars, restaurants, and entertainment venues.  I've covered it a few times on the blog and have owned the stock since early 2013, to summarize the story:
  • Carl Icahn (through IEP) owns 72.5% of the shares and has a solid track record of investing in gaming throughout the cycle.
  • Given Icahn's ownership, Tropicana's free float available to the public is small and the shares trade rather infrequently on the pink sheets which limits the number and size of potential investors despite TPCA being an $810MM market cap company.
  • Tropicana's balance sheet is unlevered with minimal net debt, fairly unique in the regional casino industry where most peers are heavily levered and its not uncommon to see leverage over 5-6x (especially when including operating leases).
  • Tropicana's flagship casino is located in Atlantic City, a market that has seen a precipitous decline since the recession (which pushed Tropicana into bankruptcy) as competition has destroyed Atlantic City's once gambling monopoly on the east coast.  Since 2014, the number of casinos in Atlantic City has dropped from 12 to 7 with the latest casualty being Icahn (but not TPCA) owned Trump Taj Mahal which closed in October.  Tropicana has been able to capture increased market share in Atlantic City as a result of the closures and Caesars underinvesting there due to their prolonged bankruptcy.
  • The shares trade at a significant discount to peers.
The 10-K was posted today, Tropicana doesn't host conference calls or issue press releases targeted at investors, so the SEC filings are really the only place to gain insight on the company.  Business results continue to steadily move along -- Tropicana primarily targets drive-in markets and focuses on slots as they have more consistent results and require less staffing, with the goal being more predictable results -- nothing in there was too worthy of an update until I got to the share repurchase section.

Share Repurchase Plan
Tropicana initiated a $50MM buyback program in July 2015, but given the limited free float and low trading volume it was a bit head scratcher to determine how the company would execute on that plan without significantly impacting the share price.  Over the following 15 months the company only purchased ~$6MM of shares, but then something happened during November and December of 2016, Tropicana bought over $37MM worth of shares at an average price of $27.62.  What changed?  The election?  Hard to tell, but given the undervaluation and how long the shares had been languishing around $15-18/share, it appears the company decided it should be its own catalyst.
Additionally, if you look at the fine print, on 2/22/17, the board authorized an additional $50MM buyback authorization for a total of $100MM, with about $57MM left remaining.

As of 12/31/16, there were 24,634,512 shares outstanding, of which Icahn Enterprises owns 17,862,706, so while the market cap is about $810MM, the free float is only $222MM, the remaining share repurchase authorization is then over 25% of the non-Icahn shares outstanding.  The company has $240MM in cash, more than the free float, the company could continue to buyback shares and effectively take itself private while bringing their capital structure more inline with peers as they go.

Icahn Enterprises each quarter puts out an indicative NAV, questionably they don't use the market value of their TPCA holding, but instead put a private market value on it given its low trading volume.
IEP marks their ownership in Tropicana at $877MM or $49/share which is 8.5x EBITDA as of 9/30, shares closed today at $32.90.  If Icahn believes in this valuation, continued share repurchases make a lot of sense and would be accretive to IEP's NAV.

While the stock price has about doubled over the past 12 months (now we know why) without a significant change in the business, given the company's appetite for their own shares, Tropicana Entertainment continues to be a very compelling opportunity.  At some point, I wouldn't be surprised to see Icahn Enterprises conduct a tender offer for the remaining shares like it recently did with Federal-Mogul.

Disclosure: I own shares of TPCA

Actelion: J&J Deal Offers a Free R&D Spinoff

Catching up a bit here after a busy few weeks, so not breaking any news here, but again I like putting my positions in writing.  I don't understand biotech, but I've been looking for ways to get a free look or a small merger security in a biotech that could be used as a tracker position, enough to keep me interested in following their development pipeline.

On 1/26/17, Johnson & Johnson (JNJ) won the bidding war against Sanofi for Actelion (ALIOY), a Switzerland based biotechnology company led by Jean-Paul Clozel whose main drug is Tracleer which treats aterial pulmonary hypertension.  Johnson & Johnson is paying $30B or $280 per share ($70 equivalent for the ADR), but the interesting aspect is immediately before the deal is completed, Actelion will spinoff their R&D pipeline of 14 products, most of which are years away from potential commercialization.

Often in biotech or pharmaceutical mergers the bid-ask spread is wide because the target believes in their R&D pipeline far more than the acquirer is willing to pay for it.  This problem is often solved with a contigent value right (CVR) that pays off if a drug in development meets certain targets, the CVR bridges the valuation gap.  The spinoff (or demerger as they're called outside the U.S.) contemplated by the Johnson & Johnson/Actelion deal functions very similar to the a CVR, Jean-Paul Clozel believes in his product pipeline far more than Johnson & Johnson was willing to pay for it.  Per the offer prospectus that was released last week, the spinoff was essentially a condition of sale for Actelion:
On October 18, 2016, Mr. Gorsky sent a second letter to Mr. Garnier in which J&J proposed to acquire all Actelion Shares at a revised price per share. On October 25, 2016 the Board of Directors, together with representatives of Niederer Kraft & Frey, Wachtell, Lipton, Rosen & Katz (“Wachtell Lipton”) and Slaughter and May, met to discuss the revised proposal and, after thorough consideration of the revised proposal, determined that the revised offer price did not reflect Actelion’s intrinsic value. In particular, the Board of Directors believed that the revised proposal continued to undervalue Actelion’s preclinical discovery and clinical pipeline business, and that, while Actelion would be willing to engage in discussions concerning a transaction with J&J, Actelion would require a higher indicative offer price before engaging further. Following the meeting, Mr. Garnier conveyed this decision to Mr. Gorsky. 
Mr. Garnier and Mr. Gorsky remained in contact in late October and the first half of November 2016. Mr. Garnier continued to express to Mr. Gorsky the Board of Directors’ concern that J&J’s prior proposals failed to provide adequate value for Actelion’s preclinical discovery and clinical pipeline business. In order to bridge the valuation gap, Mr. Garnier proposed the Demerger as part of an alternative transaction structure, in which Actelion would spin off its preclinical discovery and clinical pipeline business prior to Actelion’s acquisition by J&J. The representatives of J&J expressed their willingness to consider the Demerger structure, but indicated that the complexity of the Demerger, as compared to straight-forward acquisition, would require additional time to negotiate.
The spinoff, currently dubbed "R&D NewCo", will be capitalized with CHF 420MM in cash from Actelion prior to the spinoff and Johnson & Johnson will contribute another CHF 580MM in the form of a convertible loan, part of which will convert immediately to a 16% ownership in R&D NewCo with the other 84% owned by prior Actelion shareholders.  The remaining loan will be convertible to another 16% of R&D NewCo by Johnson & Johnson at any time for 10 years.  So while R&D NewCo will be independent, they'll have a built in partner in Johnson & Johnson to advance their pipeline to commercialization.

I don't know much about R&D NewCo's pipeline, but I'd encourage anyone interested to watch Actelion's CEO Jean-Paul Clozel's remarks in the deal announcement press conference:


He owns 3.6% of Actelion, Johnson & Johnson is paying $30B for the company, he's set to get paid over $1B in cash for his shares, yet he's going to R&D NewCo and sounds excited to get back to early stage research and be relieved of the sales and marketing overhead of running a commercial pharmaceutical company.

Deal Risk
There was report in the days following the merger announcement that Actelion's Uptravi drug was linked to 5 deaths in France, but those concerns have seemed to be pushed aside as it came out that Johnson & Johnson knew of the issue ahead of time and the European Medicines Agency (EMA) recommend on 2/10/17 that the drug could continue to be used despite the probe into the deaths.

The Material Adverse Effect clauses seem fairly standard to my novice eye:
A Material Adverse Effect means a reduction of:
(i) the annual consolidated earnings before interest and taxes (EBIT) of CHF 98.3 million – which is an amount equal to 15% of the consolidated EBIT of the Company and its Subsidiaries in the financial year 2015 as per the Company’s annual report 2015 – or more;
(ii) the annual consolidated sales of CHF 204.5 million – which is an amount equal to 10% of the consolidated sales of the Company and its Subsidiaries in the financial year 2015 as per the Company's annual report 2015 – or more.
When determining whether a Material Adverse Effect has occurred with respect to the Company and its Subsidiaries, taken as a whole, the following changes in circumstances, events, facts or occurrences shall not be taken into account, individually or together:
(i) any circumstance, event, fact or occurrence in the industries in which the Company and its Subsidiaries operate or in the economy generally, except to the extent (and only to the extent) that such circumstance, event, fact or occurrence disproportionately affects the Company or any of its Subsidiaries relative to other participants in the industry in which the Company and its Subsidiaries operate; or
(ii) any circumstance, event, fact or occurrence that arises from or relates to R&D NewCo, the R&D Business or any of the Transferring Business Assets or Assumed Liabilities, in each case as defined in the Demerger Agreement, except to the extent (and only to the extent) such circumstance, event, fact or occurrence affects any other aspect of the Company or its Subsidiaries; or
(iii) any circumstance, event, fact or occurrence that arises from or relates to the commencement of sales of a generic form of Bosentan (marketed by the Company as Tracleer) in the United States. 
Johnson & Johnson has a lot of cash overseas, this deal helps solve some of that problem as we all wait for the new administration to change repatriation tax laws.  This deal seems fully vetted by both sides and fairly safe to close, the offer prospectus puts the earliest close date at 5/5/17, but seems likely that might get pushed back to June based on the initial guidance.

The ADRs which represent 1/4th a share currently trade for $67, representing a 4.4% absolute return to the $70 offer price, the spinoff is worth something, let's call it $1B for another $2.30 per ADR or ~$9 per Actelion share traded on SIX in Switzerland.  Add in the spinoff, and the current spread represents an 8% return by the end of June.  I could also see R&D NewCo being sold off indiscriminately after the deal closes as it's rather tiny compared to the overall deal and traditional arbritrages don't want to hold a development stage biotech longer than needed.  So this could be a two staged investment, capture the deal spread, and then reinvest some of the proceeds into R&D NewCo.

Disclosure: I own shares of ALIOY

Wednesday, January 11, 2017

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

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

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

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

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

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

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

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

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

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

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

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