Friday, November 15, 2019

Hilton Grand Vacations: In Play, Speculating on a Deal

Another idea I'm returning to after it has received some takeover speculation is Hilton Grand Vacations (HGV), as a quick recap, HGV is Hilton Worldwide's (HLT) timeshare business that was spun (alongside Park Hotels & Resorts) from Hilton at the end of 2016.  I won't go through the timeshare business (I've done that a few times previously) but of the other two larger timeshare rivals (VAC and WYND), HGV is a pure play on one brand without an exchange or rental business, making it a simpler candidate for consolidation.

HGV ran into some accounting noise and operational/timing issues with their inventory strategy that caused a selloff in their shares opening the door for an activist or an unsolicited bid.  In August, the NY Post reported that private equity behemoth Apollo Global (APO) was interested in making a bid for HGV.  Apollo previously took unbranded (and somewhat controversial) timeshare operator Diamond Resorts International (DRII) private in 2016, and tried to re-list shortly after in 2018 but pulled the IPO.  Apollo clearly got feedback that the public markets weren't interested in an as-is Diamond Resorts (they've recently dropped the "International" from their name) at an acceptable valuation to Apollo, so they need a plan B.  It appears plan B could be to take HGV private and merge it with Diamond, re-brand the HoldCo and bring it back public without the same Diamond brand stench.  Some point to the risk that Hilton needs to consent to a merger, this is true, but it seems contemplated that HGV would be acquired or operate non-Hilton branded timeshare properties with the caveat that it would be operated separately from Hilton branded properties and without access to the loyalty program, from the 10-K:
We are able to operate vacation ownership properties under other brands (with no royalty due to Hilton) if we do so without using any Hilton IP or Hilton Data and they are otherwise separate operations from the Licensed Business.
And they would likely lose the Hilton Grand Vacations name per the licensing agreement since Diamond has more units than HGV, again from the 10-K:
Under the license agreement, our right to use the Hilton Marks as a trade, corporate, d/b/a or similar name will automatically terminate if (i) the aggregate number of units of accommodation in our Licensed Business falls below two-thirds of the total number of units of accommodation in our entire vacation ownership business; (ii) we merge with or acquire control of the assets of Marriott International, Inc., Marriott Vacations Worldwide Corporation, Hyatt Hotels Corporation, Wyndham Destinations and Interval Leisure Group, Inc.  or their respective affiliates and we or they use their brands in any business after such acquisition; or (iii) we become an affiliate of another Hilton competitor.
It wouldn't be the first time potentially competing (is Diamond technically a Hilton competitor?) hotel brand flags were housed under the same corporate timeshare entity, ILG had the Hyatt brand and first merged with Vistana which housed Starwood's timeshare business before being brought back into the Marriott/Starwood fold when it was purchased by Marriott Vacations Worldwide (VAC).  But the Hyatt timeshare properties remain at VAC, although they represent a much smaller percentage than Diamond's properties would be under a proposed HGV/Diamond merger.  Why might Hilton consent?  HGV pays a 5% royalty on all timeshare sales, this amounted to $100MM in 2018 (and essentially falls straight to HLT's bottom line), a well capitalized and scaled HGV is to their advantage, I'm sure the team at Apollo can come with a few slides showing how this revenue stream could grow in the coming years with Diamond cash flow being used to fund HGV inventory and growth.

The other buyer being mentioned is Blackstone (BX), they took Hilton private in 2008 but no longer have a significant investment in HGV having divested their stake in 2017.  They're familiar with the business, but they'd be strictly a financial buyer and seem less likely to be the winner.  Worth noting that Blackstone's president, Jonathan Gray, is also the chairman of Hilton, unclear if that matters but seems noteworthy.  Additionally, I wouldn't count out Wyndham Destinations (WYND) being involved in the bidding process either (although their stock trades well below that of HGV), there are lot of potential synergies and HGV is part of the WYND's RCI exchange network, plus it could move WYND slightly up market and bring down Wyndham's persistently high loan loss reserve averages.

HGV's management at least acknowledges the benefits of industry consolidation, essentially confirming the rumors, from the most recent earnings call:
Stephen Grambling: Great, and I appreciate you can't comment on the reports out there on M&A, takeover stuff specifically, but how do you generically think about the positive and negatives of consolidation in the space, and perhaps tying in anything that’s specific to HGV?
Mark Wang: Yes, Stephen, it's Mark. I think we recognize the value proposition of consolidation in our industry and other industries. I think, from our perspective, some of the key reasons for consolidation is you want to improve your asset base, you want to strengthen your brand, and in this industry's case, you want to have the access to a pipeline of incremental new customers. So, I'd say, look, we've got a great set of assets and we have this great brand and relationship with Hilton, and we've talked about the tour pipeline that they provide us, and we've had a long and strong history of execution and growth. So, look, I think consolidation has been positive in the industry and we understand the rationale behind it.
Clearly he's speaking from HGV's attractiveness as an asset and not how an acquirer might help HGV, but I think his comments could apply to either Apollo/Diamond or Wyndham quite nicely, primarily access to Hilton's growing hotel and customer base needed to source additional timeshare owners.

In the latest round of bidding, Bloomberg reported Apollo's bid is $40 and the stock currently trades for $35+ showing some skeptism that the deal will be consumated.  From a valuation perspective, HGV sits essentially in-line with VAC on 2020 estimates:
In 2018, VAC purchased ILG for a total enterprise value of approximately $4.7B on $365MM of EBITDA plus $75MM of synergies, for a fully synergized multiple of ~10.5x EBITDA.  ILG had an exchange business that while low/no growth is a free cash flow machine and likely pushed the overall multiple up some.  But let's say the number needed to finalize an HGV deal is $42, with no synergies that would be 10x multiple and using a $50MM synergy number gets it back down to just under 9x, quite attractive for control over a timeshare business with a quickly growing hotel chain like Hilton.

Other Thoughts:
  • Elliott Management was rumored to be involved in HGV, but it doesn't show up in their recent 13F, probably doesn't mean anything - maybe they never owned it, but worth closing that loop.
  • HGV offers a fixed/week interval product while Diamond Resorts uses a points based product, maybe a little additional culture clash to be concerned about, or Apollo could see an opportunity to modernize HGV's product into a points based system (one benefit of the points based system for the timeshare operator is its easier to sell upgrades to existing owners)
In summary, we have several buyers, both strategic and financial, circling HGV, I'm surprised that shares are trading well below the $40 reported first bid even if HLT needs to provide its approval.

Disclosure: I own HGV calls (also remain long WYND)

Franchise Group: fka Liberty Tax, Franchise Rollup

Franchise Group (FRG) is the result of the odd conglomeration of: 1) Liberty Tax (old TAXA); 2) Buddy's, a franchised chain of rent-to-own electronics and furniture stores; 3) Sears Outlet business; and soon to be 4) Vitamin Shoppe (VSI); that is being orchestrated by Vintage Capital's Brian Kahn who was recently named the CEO of the newly launched platform company.  Andrew Walker posted two excellent write-ups (here and here) on the situation a couple months ago, I won't do it the same justice, but I'll run through my thoughts anyway as I took a position in it.

Liberty Tax is the third largest tax preparer, well behind both H&R Block and Jackson Hewitt, the tax preparer market is a highly fragmented business with a lot of mom and pops.  It is the type of franchise business where you effectively own your job and you outsource the marketing and back-office infrastructure to the franchiser.  Liberty's business model is mostly targeted at lower income taxpayers who are unlikely to purchase TurboTax or do-it-yourself type software, they want someone else to do it quickly for them and assist in getting their refund as fast as possible, it's a decent business that should be relatively stable.  However, in 2018 Liberty Tax's founder and CEO was forced out after a sex scandal was uncovered and his shares where sold to Vintage Capital that July.  The company understandably struggled through this upheaval and EBITDA dropped 17% from 2017 levels to $35MM (9/30 fiscal year end).  Then in November 2018, TAXA received an acquisition proposal for $13 per share from a private equity buyer that ended up going no where.

Concurrently with all that, Vintage Capital was wrapped up in a bizarre failed merger with Rent-a-Center (RCII) which competes in the same rent-to-own market as Vintage's Buddy's chain with Vintage forgetting to execute a routine extension to the merger agreement that allowed Rent-a-Center to break the deal and force Vintage to pay a substantial break up fee.  Presumably Vintage was going to merge Buddy's with Rent-a-Center and continue to pursue a franchise model.  With that deal off, Vintage moved to Liberty Tax where they already had a substantial holding and offered to recapitalize the company and give existing shareholders an option to tender their shares at $12, a substantial premium to where the shares had fallen after the $13 buyer had backed away.  As part of the transaction, Liberty Tax bought Vintage's Buddy's chain of stores and created "Franchise Group" to pursue a rollup strategy of franchised or "franchisable" businesses.

Since the creation of Franchise Group, Vintage isn't wasting time buying additional struggling businesses, since the merger with Buddy's, they've entered into two transactions but while both Liberty Tax and Buddy's are primarily franchised, the next two fall into the franchisable category.  The first announced was with Vitamin Shoppe (VSI), a struggling vitamin and nutrition retailer that is being disrupted by internet shopping.  The second transaction announced, which just recently closed, is with Sears Hometown and Outlet for the Sears Outlet business and the 8 Buddy's stores that SHOS operated.  My guess is overtime these Sears Outlet stores more or less end up looking like or being re-branded to Buddy's stores as they sell similar household durable type items to the lower income segment.

There's a lot going on here, its a complex situation that I'd guess very few people are looking closely at, volume has been minimal and it just today uplisted back to the NASDAQ under the FRG symbol.  I'm sure there are quite a few mistakes with the below, so do your own homework as well, but I tried to come up with a proforma look at what the combined company might look like once the dust settles.
Most of these numbers are pulled from the recently completed tender offer and the VSI proxy statement.  Alongside the closing of the Sears Outlet transaction, they went ahead and franchised 5 stores to "A-Team" for $15MM (they have 120 more stores).  The tender offer closed this week with just under 4 million shares participating at $12.  Throwing it all together on an admittedly back of the envelope fashion, I come up with the proforma company trading at roughly 5x EBITDA.  Franchise businesses trade all over the map, but generally well above 5x -- a rent-to-own comp like RCII for example trades over 7x EBITDA and they are still mostly company operated stores.  It's hard to put an exact value on FRG, but I'm guessing there are a lot of value levers to pull here and if it works out (and the economy doesn't rollover) could be a multi-bagger.

Disclosure: I own shares of FRG

Ben Franklin Financial: Tiny Bank Merger and Liquidation

Ben Franklin Financial (BFFI) is a tiny (sub $10MM market cap) two branch community bank located in the northwest Chicago suburb of Arlington Heights that completed its second step mutual-to-stock conversion in 2015.  Ben Franklin Financial is a pretty straight forward community bank, it takes in deposits from a small local radius and primarily turns around and makes a mix of residential mortgages and commercial loans.  At just under $100 million in assets, Ben Franklin Financial is sub-scale, poorly managed and as a result loss making bank (to pile on, BFFI was also operating under an OCC consent order until this past February) that caught the attention of community bank activist Joseph Stilwell who encouraged the company to pursue shareholder friendly actions like repurchasing shares or pursuing a sale.  In July, the company announced a unique sale transaction with Illinois based Corporate America Family Credit Union ("CAFCU") for between $10.33 and $10.70 for shareholders, the stock bounces between $9.60 and $9.80 today.  Why sell to a credit union?  Since a credit union is technically non-profit, they might be willing to pay more for a struggling operation like BFFI since they just need to cover their operating costs.  The credit union buying a bank thing is a recent trend but this is a first of its kind transaction where the credit union is purchasing a bank that converted from a mutual holding company.  The catch being there is some uncertainty as to how depositors who did not participate in the mutual conversion process will be treated in the liquidation and other uncertainties like terminating employee benefit plans.  Not only is the amount uncertain, but the timing is as well, the transaction with CAFCU is expected to close in early 2020 with the distribution to shareholders occurring "within several months", thus this is more of a two step process, an asset sale and then a liquidation rather than a clean merger.

Assuming a 5/15/2020 payment date (call it 4 months after an early 2020 transaction settlement) and I get an IRR of between 12% and 20% off of the last trade at $9.75 or gross returns between 6% and 10%.
Maybe I'm underestimating the possibility of the deal breaking but I think you're getting paid for the illiquidity of a nano cap and the uncertainty of both the ultimate payout and timing, both risks that a small personal account like mine is well suited to take.

Disclosure: I own shares of BFFI

Asta Funding: Going Private Offer

Asta Funding (ASFI) is an old familiar name in the value investing community (I owned it for a stretch), it was once primarily a buyer of defaulted consumer debt for pennies on the dollar that would then go out and sue debtors in order to garnish their wages and recoup their investment, fun stuff.  Following the financial crisis, Asta took a writedown of most of the value in one of their large consumer receivables portfolios but it ended up still cash flowing and looked cheap with this potentially large zero basis asset.  They used those cash flows to diversify into similarly unsavory financial services businesses without much logic such as social security disability advocacy, personal injury claims and structured settlements.  This is a family controlled business and they have treated it that way in the past, they had a dust-up with Mangrove Partners which Asta ultimately ended up paying what looked like greenmail with a large tender offer, followed by a special dividend for most of the market capitalization pushing it further into microcap terriority, then had to restate years of financials, all of which led the shares to be completely ignored by the market.  For a while there it was trading below cash, a clear error of omission on my part not jumping on it then as I've always kept ASFI on my watchlist.

But on November 1, Gary Stern, Asta's Chairman and CEO offered to purchase the remaining outstanding public float (the Stern family owns ~60% of the company) for $10.75 per share conditioned upon acceptance by a special committee of independent directors and a majority of the minority shareholders vote for its approval.  Given the premium to where shares had been trading, I would expect both to be relatively easy to obtain.  Book value is about $13.50 with more than half that being cash, maybe there's a tiny chance of a bump.  But the board is only 5 members, one of which is Gary Stern, two of them have been on the board since the mid-2000s and have let this situation play out to-date, the other two are relatively new but likely friendly with the Stern family given the controlled status.  Even without a bump, financing should be a breeze considering the Sterns can dividend out the cash to themselves when in full control making this a low risk idea.

It's about a 6% gross spread, not fantastic, but I'm familiar with the company and its management, I see this as their opportunity to return to a family company and operating in the dark without pesky minority shareholders or exchange listing requirements (about half their press releases in recent years are NASDAQ de-listing notices).  Plus I have some dry powder and have been stashing cash in more small special situations like this until I find more mainstream ideas.

Disclosure: I own shares of ASFI

Thursday, September 12, 2019

Syncora Holdings: Operating Business Sold, Cash and NOL Stub

Syncora Holdings (SYCRF), through its subsidiary Syncora Guarantee ("SGI"), is a provider of bond insurance that ran into a whole bunch of trouble following the financial crisis.  Like the other bond insurers, Syncora branched out beyond municipal insurance (to be fair, they did also suffer with Detroit and Puerto Rico) to subprime RMBS, CDOs and other toxic securitizations of the pre-crisis era.  During and following the recession, many of the supposedly AAA structured securities were impaired and Syncora was called upon to make good on their guarantee which forced the insurer to the brink of insolvency.

In the decade since, Syncora has been in constant litigation (they scored several huge settlements with banks that issued subprime RMBS) and restructuring mode.  Previously a bit of a black box, Syncora last month sold SGI to an affiliate of credit manager Golden Tree Asset Management for $392.5MM with a go-shop period through September 13th.  It then re-struct the sale price higher with Golden Tree this past week to $429MM plus the assumption of some preferred share pass-thru securities that wasn't originally included in the deal after receiving an unnamed unsolicited offer (the go-shop was also cancelled).  Once the transaction with Golden Tree closes in Q4/Q1, Syncora plans to distribute the sale proceeds to shareholders, all that will remain is $30+MM of cash and miscellaneous assets (valued at $45-60MM total including the cash) plus around $300MM of net operating losses.

Syncora has 87 million shares outstanding, assuming about $20MM in leakage and other deal related expenses, the company will likely distribute cash back to shareholders roughly equaling today's $4.70 share price.
Assumes no value attributed to the NOL
What is the company going to do with the stub after the SGI deal closes?  Anyone's guess, it will be a tiny shell with a few random assets (waterfront raw land in Detroit, 80% of Swap Financial), management claims to be in active conversations with their advisers on a transaction, but the NOL monetization dream is elusive for many if not nearly all similar NOL shell stories.  So maybe the 30% discount to NAV needs to be a touch higher, at a 50% discount I come up with a 16% IRR, still an attractive situation.

Disclosure: I own shares of SYCRF

Wednesday, August 21, 2019

Avenue Therapeutics: Two-Step Merger with Cipla, CVR

Avenue Therapeutics (ATXI) is a one product development stage biotech with a binary investment outcome (let's be honest, most small biotechs are binary, this one just more explicitly so) related to their Stock Purchase and Merger Agreement with a subsidiary of Cipla, an India based global generic pharmaceutical company.  On 11/12/18 (closed in February), Cipla (via their U.S. subsidiary InvaGen) announced the purchase of 33.3% of Avenue for $35MM or $6/share (where it trades today) and agreed to purchase the remaining shares for $180MM or $13.94/share conditional on the FDA approval of IV Tramadol as a Schedule IV drug for post-surgery pain relief.

Tramadol is a fairly common pain reliever (~40th most prescribed medication in the U.S.), it has been around for decades internationally and was first approved in pill form in the U.S. in 1995.  Tramadol is an opiod, but it's considered a weak or a non-conventional opiod, most of the conventional opiods are classified as Schedule II controlled substances by the DEA, which essentially means they're highly susceptible to misuse and abuse, Tramadol contrastingly is Schedule IV (DEA's schedule is a I-V ranking, I being the most dangerous/no medical use).  Given the growing awareness of the opiod epidemic in this country, there's an opportunity for a painkiller that sits somewhere between Schedule II opiods like morphine or Vicodin and over-the-counter drugs like Tylenol and Advil.

Tramadol is currently only approved in oral/pill form in the U.S., Avenue (via their controlling shareholder Fortress Biotech - FBIO) owns the exclusive license to develop and commercialize an intravenous ("IV") version of Tramadol, IV Tramadol is widely approved and used (~10% of IV painkiller market share in Europe) internationally but hasn't been approved for use in the United States.  Avenue has already completed two Phase 3 studies of IV Tramadol with positive results, for moderate to moderately severe pain IV Tramadol has generally performed as well as morphine (don't need something as strong as morphine if you're only in moderate pain, something weaker does the job just as well).  Currently the company is putting together their new drug application ("NDA") to submit to the FDA for approval.

The conditions of the merger specify:
  1. Final FDA approval of the Product on or before December 1, 2020, if as of such date there are no pending queries from the FDA with respect to such Product approval, but if there are such pending queries from the FDA as of such date, then such FDA approval shall have been obtained on or before April 30, 2021;
  2. Labelling for the Product containing an indication as moderate to moderately severe (post-operative) pain, not restricted to any specific type of surgery; and
  3. Classification of the Product by the U.S. Drug Enforcement Agency (“DEA”) as a Schedule IV Drug under applicable Legal Requirements; 
The timeline for FDA approval is typically about a year, 2 months of a preliminary review that justifies a full 10 month review of an NDA.  If Avenue is able (the company says they're on track) to complete and submit the NDA by the end of November, the 12/1/2020 deadline shouldn't be an issue.  By doing two Phase 3 studies (one for tummy tucks and one for bunion surgery) Avenue is going for the broad label and given IV Tramadol's widespread use, should have a good case for it.  The wildcard might be the Schedule IV classification, we are entering into an election season and opiod litigation is heavily in the news, if the DEA changes Tramadol to a Schedule II drug alongside the conventional opiods, that could blow a hole in the merger agreement.

If the merger is completed following FDA approval, Avenue shareholders will get an additional kicker in the form of a CVR tied to the sales of IV Tramadol with a $325MM annual revenue threshold with a favorable graduated tier scale above that.  One similar example to look at is IV acetaminophen (Tylenol), it is both a success story we can point to where it was approved in oral form for many years and then was only recently (well, 9 years ago) approved in IV form, but a quick Google and there's a lot of dispute whether the IV form is any different from than oral, especially hard to justify given that Mallinckrodt has done a series of price increases.  In 2017, IV acetaminophen did $300MM in sales, still below the CVR threshold for Tramadol many years after IV acetaminophen was commercialized.  But again, Tramadol might have a better chance of filling that pain gap than acetaminophen considering it's a weak opiod, either way, the CVR's value is likely many years off and not worth underwriting.

Avenue is an interesting binary outcome, the market is pricing in a less than 50% of chance of the merger with Cipla being completed, despite what appears to be a mostly straight forward FDA approval process (at least to this clueless retail investor) considering the drug is already approved in a different form in the U.S. and in the same form in many other developed markets.  Why is it mispriced?  Management answered this question by pointing to the lack of investor relations and promotion, they don't need additional financing after the deal with Cipla to complete the FDA approval process, so no need to promote the stock.  Makes some sense to me along with the relatively low float given the large stakes owned by FBIO and Cipla.  Additionally, I think people don't like such explicitly binary outcomes and general loss aversion keeps people away despite the seemingly favorable odds.  Thanks to "Ben's Jamin" who mentioned Avenue in a comment section a while back.

Disclosure: I own shares of ATXI

Industrial Services of America: Tiny Liquidation, Assets Sold to Nucor Sub

Another small personal account type idea:

Industrial Services of America (IDSA) is a nanocap ($9MM market cap but trades on the NASDAQ) metal recycling and auto salvage business headquartered in Louisville, KY doing business as ISA Recycling.  On August 19, the company announced the sale of substantially all of their assets to River Metals Recycling, a subsidiary of the large steel producer Nucor Corporation (NUE), for $23.3MM and following the sale, the dissolution of the company with proceeds being distributed to shareholders.  IDSA's balance sheet is a bit of a mess and the company was facing de-listing, but following the liquidation, IDSA expects to distribute $1.15-$1.35 per share, with the stock trading at ~$1.10 that's an attractive 13.5% spread to the mid-point.

The sale is expected to close late 4th quarter or early 1st quarter 2020, IDSA will likely need to reserve some cash following the sale to handle any final wind down expenses and other contingencies but I would expect the bulk of the distribution to happen alongside the asset sale with River Metals.  River Metals is a subsidiary of The David J Joseph Company which is Nucor's scrap metal recycling business, they're in the same business as IDSA so this deal makes plenty of strategic sense, clean tuck-in transaction.  IDSA is heavily owned by insiders including over 20% of the shares owned by the former CEO's family trust, perhaps the family was disinterested and wanted to cash out?  IDSA shareholders will need to approve, but again, it is a fairly tightly controlled company.  It's worth mentioning there is also a closing contingency around a storm-water drain, hard to handicap that.  Anyway, seems like an attractive situation, any thoughts welcome.

Disclosure: I own shares of IDSA

Wednesday, August 7, 2019

Extended Stay America: Rejects Split-Up, Underlying Value Here

Extended Stay America (STAY) is the last remaining public company of size that is an integrated hotel operator and owner of their real estate in the United States (other than Hyatt which is family controlled).  As their name suggests, they compete and are the largest player within the extended stay lodging segment where the average guest stays anywhere from a week to several months.  Demand for the extended stay segment is typically not leisure driven, but rather temporary business assignments, training, relocation bridge housing, medical, or other needs that could span a few weeks.  Extended Stay America has a unique corporate structure where the publicly traded STAY is a "paired" stock, underlying STAY is a hotel management company ("Extended Stay America Inc") and a REIT ("ESH Hospitality Inc"), this structure provides most of the tax benefits of a REIT without the conflicts that can arise between OpCo and PropCo.  ESH Hospitality is 43% owned directly by shareholders via the paired stock structure and 57% owned by Extended Stay America Inc which pays corporate taxes on the dividends received from the REIT.  In the summer of 2018, the company announced it was exploring strategic alternatives with most assuming either a true spinoff or a sale of the management company to one of the hotel brand aggregators with a simultaneous spin of ESH Hospitality (similar to LQ/CPLG/WH last year).  Today, along with earnings, the company announced that it had concluded its strategic review and was going to maintain the status quo, the stock fell 5-10% on the news.

It had been over a year now since that strategic alternatives announcement, the first quarter conference call got a little chippy and some fatigue had built up in the investor base.  Given the relative size of the franchising business and where multiples in the sector are today (especially on the REIT side), I think the company made the right move and event driven sellers (along with the general slide in the market) are providing an opportunity to pick up shares of STAY at a discounted price.

Most of the value is in the real estate and not the management company (unfortunately), as of 6/30, the REIT owned 554 hotels with 61,500 rooms, the management company managed an additional 73 hotels for third parties with 55 more in various stages in the pipeline.  By maintaining the status quo, it allows the franchise side of the business to build up with new construction or conversions, plus ESH plans more asset sales to third parties.   But eventually, the company will succumb to pressure and split the company somehow.  How might that look?

Just to give an idea how STAY is valued today, it essentially trades at the bottom end of the limited service lodging REITs group despite not having to pay a third party management company for its owned properties and having a small franchising business.  Sure there is some tax leakage with the pair structure compared with a pure REIT, but the optionality (it's going to happen someday) on the sale of the management business should make it more valuable than REIT peers, not less.
The extended stay business model is fairly high margin (no frills, rooms cleaned once a week) and STAY generates a decent amount of free cash, roughly $325MM on their current asset base using a maintenance capex of 7% of revenues.  At today's prices, that's a 12% free cash flow yield to the equity.  Looking at it another way, using $80MM of maintenance capex on $564 in EBITDA, STAY is trading at 10x UFCF when they've been selling hotels at ~17x that metric over the past few years.  Management did caution today not to assume that 17x multiple on future asset sales, the next round will be their lower performing hotels, but it's still a useful read through to the disconnect between private and public multiples in real estate today.

Back to what a split might look like: ESH Hospitality would be another economy-midscale REIT similar to CorePoint Lodging (CPLG), it would have the most keys of any lodging REIT but a relatively small market valuation.  If we assume that STAY puts a similarly egregious management and franchise contract on ESH Hospitality as Wyndham/LQ did to CorePoint (I don't think this will be the case since most of the value is in the REIT) with a 5% management fee and a 5% franchise fee, I come up with the following back-of-the-envelope breakout between the two:
Sticking with the LQ/WYN comparisons, if we value the management company similarly to Wyndham Hotels (WH) at 12x and the REIT at 9x similarly to CorePoint Lodging (CPLG), STAY would equate to a combined value of $17+/share versus $14.50 today.  Again, I think this is the worst case split scenario as hopefully management has learned a lesson from CPLG and wouldn't put that management contract on the larger piece of the business.  If the market slowdown passes without a recession we could additionally see multiple expansion back to where lodging REITs traded in 2017-2018.  If the management company were sold versus split off, there would be additional upside as the G&A would essentially be wiped out, perhaps $20+ per share in total under that scenario using today's multiples.  To be clear, this split isn't happening in the near term, but it shows the underlying value in their operations and I believe it's only a matter of time before the market really forces management's hands.

Other thoughts:
  • Just one example of the benefit to STAY's management company being part of a larger brand, as a one-brand entity, Extended Stay's loyalty program is small (under 3 million members), plugging the brand into a larger rewards program could prove valuable to people who are on a temporary work assignment and can use their points on a resort vacation versus another sterile Extended Stay property off the side of the interstate.
  • Labor costs are really squeezing hotel operators at this point in the cycle, unemployment rates are so low that they're having a hard time recruiting labor and are mostly unable to pass that additional cost onto customers.
  • STAY increased their buyback authorization, they have $263MM remaining which is roughly 10% of share outstanding, on the conference call they made it clear they intend exhaust the authorization this year.  Alongside a ~6% dividend yield and that's a compelling total "shareholder yield".
  • Their numbers can look a little messy on a year-over-year basis as they've been selling hotels to third parties, to normalize the 2019 EBITDA vs 2018, you would need to add $21MM for the sold hotels.
  • Management also talked about what a recession might do to their results, anywhere from a $50MM hit to EBITDA in a mild downturn to $100MM hit in a more severe recession, taking those haircuts off of current EBITDA means it would be trading at 9.5-10.5x, certainly not a high valuation considering lodging REITs were trading for 11-12x not too long ago.
Disclosure: I own shares of STAY (continue to own CPLG and WH too)

Empire Resorts: Going Private Offer, Possible Bump?

Empire Resorts (NYNY) is a one property newly built casino resort ("Resorts World Catskills") located about 90 miles from Manhattan in the Catskills region of New York.  The Resorts World branded casino cost ~$1B to build and opened in 2018, it has struggled to ramp up in the year or so that it's been open.  Empire Resorts is 86% owned and controlled by Malaysian billionaire KT Lim, chairman of the Genting Group, via a family trust ("Kien Huat").  On August 5th, Kien Huat made an offer of $9.74 in cash per share for the remaining 14% it doesn't already own, shares are trading for ~$9.25 today (shares are pretty illiquid).  While that's not a tremendous return -- a 5.3% spread (but still good enough) -- this has the possibility of following the path of similar controlled buyouts I've written about in TRK and VLTC where to placate the independent directors (and perhaps save them from shareholder lawsuits) the controlling shareholder bumped up the bid once or twice before entering into a definitive agreement.  From a 10,000 foot view, this feels a bit opportunistic, the resort just opened, casinos often take a little time to season and develop a loyal clientele, sports betting is being rolled out in New York state, and the corporate structure is a little strange as it probably makes sense for this property to be wholly controlled under the Genting umbrella.  Just all feels a bit opportunistic and maybe leads to a small bump.

Disclosure: I own shares of NYNY

Thursday, July 25, 2019

Gannett: Rumored Deal with New Media

Gannett (GCI) is the publisher of the USA Today and about one hundred other midsized and smaller daily publications, newspapers are clearly in secular decline and have been for some time.  Newspaper publishing is an industry that went through a period several years back when there was a trend of spinning off the newspaper business from TV broadcasting or other media businesses (current GCI was a spinoff of the original Gannett that was renamed TEGNA).  I participated in several of those breakups and was lucky to make a little bit of money despite the backdrop of the industry, so why not give it another try with two companies I've written about previously potentially merging.

Last week, the Wall Street Journal reported that New Media Investment Corp (NEWM) was in talks to purchase Gannett in a cash-and-stock deal.  New Media is similar to Gannett, just without the USA Today, they own a bunch of small town newspapers and a couple midsized ones.  New Media is externally managed by Fortress Investment Group (now owned by Softbank), NEWM is one of the few operating businesses (non-REIT/BDCs) I know of that is externally managed, it was a spinoff of Newcastle (now Drive Shack) originating as the result of Fortress buying the debt of local newspaper publisher GateHouse Media (the entity WSJ references as the buyer) within Newcastle and later taking control of the post-reorg GateHouse.  Fortress has since used New Media as a vehicle to roll-up the distressed local newspaper industry at low single digit EBITDA multiples and then pay an out sized dividend to attract retail investors (standard externally managed playbook type stuff).

This deal has a hint of HPT buying SMTA's master trust to it, Fortress gets paid a management fee of 1.5% off of New Media's equity, Gannett is a low-quality asset but represents a way for Fortress to roughly double their management fee with one of the last large willing sellers (the other publishers are mostly controlled/family owned) at a price that both could claim victory with given the synergies at stake.  As an asset gatherer, New Media will be aggressive in pursuing Gannett and will likely get a deal done.

As a little recent background on Gannett, earlier this year they fended off a hostile takeover and later a proxy fight from PE owned MNG Enterprises (dba "Digital First Media"), the owner of the Denver Post and the San Jose Mercury News among other publications.  MNG Enterprises offered $12 per share for GCI (currently trades at ~$9.60) but the hostile bid and lack of committed financing led Gannett management to dig in their heels and resist the effort.  While this was happening, Gannett's CEO stepped down in May and the company has been without a named successor since.

How could this be a win for all three parties (Fortress, New Media, Gannett)?  The Wall Street Journal references $200MM of potential synergies being discussed in the deal, which sounds like a lot compared to Gannett's $290MM EBITDA guidance for 2019, and it is, but there is a lot of overlap between the two's footprint and $200MM is roughly 25% of Gannett's run rate G&A expenses, I think there is some reasonableness to the synergy number that a PE manager could extract from the operations.  New Media's stated acquisition criteria is to buy publishing assets at 3.5x-4.5x EBITDA, GCI trades for 5.6x standalone EBITDA of $290MM (mid-point of 2019 management guidance).
New Media can buy Gannett for "4x EBITDA" using a post-synergy number of $490MM and all three parties can claim victory: 
  1. Fortress gets to roughly double their management fee; 
  2. New Media gets a large acquisition within their stated price target to bleed for continued dividend yield, and given NEWM trades at a premium to the industry (due to the high dividend yield) it would be accretive to shareholders; 
  3. Gannett gets a higher price with credible financing than what they turned down earlier this year justifying their actions
Speaking of financing, New Media's debt is primarily a term loan that is owned by CLOs.  The leveraged loan industry is under a microscope at the moment, primary issuance is down considerably year-over-year as investors prepare for lower interest rates (loans are floating rate products) and loan mutual funds have seen 30+ months of outflows.  However the demand for CLOs has kept a strong bid under loans and have essentially created forced buying of risky debt.  New Media is already a familiar name and present in dozens of CLOs, they could presumably finance a bid for Gannett through this channel.  Fortress is a strong PE sponsor and an active CLO manager in their own right.

So how might a cash-and-stock deal look like?  New Media has conventional debt of $450MM against a $180MM LTM EBITDA, or 2.5x levered, if they added the $490MM (let's save EBITDA addback math for another time) and kept leverage roughly the same they could raise enough financing to pay $6-7/share in cash and then issue the rest in NEWM stock.  I'm also including Gannett's pension shortfall in EV, NEWM likes to exclude their capital leases and pension liability from their leverage numbers so maybe they could justify paying on the higher side of my back-of-the-envelope estimates.  Anyway, I think this deal crosses the finish line as Gannett is floundering and doesn't have a controlling shareholder, New Media wants to gather additional assets for its external manager, it's a win-win for a dying industry.

Disclosure: I own shares GCI (and a few calls as well)

Friday, June 28, 2019

Mid Year 2019 Portfolio Review

The calendar can sometimes play tricks on the way returns look, now in hindsight 12/31/18 was a tough determination date skewing my 2018 results to the downside and now is skewing my 2019 results to the upside.  Through the end of the second quarter my blog portfolio is up 58.3% versus 17.9% for the S&P 500, the big first half has pulled up my lifetime-to-date IRR to 22.5%.  Outsized winners this period included KAR and SMTA due to sizable call option positions and then to a slightly lesser extent big wins in CZR, HHC and MMAC.
Often when I post an idea it's sort of an initial indication of interest, usually starting with a 3-5% position for me, and then in the comments section I get more bullish or bearish on an idea.  KAR Auction Services (KAR) was one of these, I liked the idea and the spinoff of IAA in January, posted on it, received some feedback so when the company conducted an odd conference call in February and the stock subsequently sold off, I was ready to act.  Ended up buying a large (for me at least) position in call options that paid off handsomely, although I sold too soon (last week) given the price movements today on the first day of regular way trading.  IAA looks fully priced to me.  KAR looks potentially cheap depending on how you value TradeRev and RemainCo's closest public peer, BCA Marketplace in the UK, was sold this week to private equity for 12x EBITDA.

Other Closed Positions:
  • Caesars Entertainment (CZR):  Eldorado Resorts (ERI) and Caesars inked their cash and stock deal earlier this week with a headline price of $12.75 per share, with much of the cash coming from VICI Properties (VICI) via the sale leaseback of three casinos.  The deal price isn't too far off of what I paid in 2017 for my initial position in CZR through CACQ, but it is a big move from the 4Q lows when the world was potentially falling apart, what a difference 6 months can make in the markets.  Now seems like a good time to back away from the gaming sector, I'm interested to see how the industry does through the next recession, especially with the PropCo/OpCo model that's all but rolled out across the entire group.  I suspect we'll see some opportunities and dislocations there in the future, but for now I'm going to wait on the sidelines. 
  • Spirit Realty Capital (SRC): When the news broke that SMTA had sold the assets in their master trust to HPT, I took the opportunity to exit SRC and roll some of that into SMTA.  SRC will be a vanilla net-lease REIT by the end of the year and it'll probably trade up a bit higher from here as the multiple plays catch-up, but an acquisition by one of the larger net-lease names is likely off the table.  There are enough net-lease properties in private hands that there's no reason for someone like Realty Income (O) to buy SRC, they could issue their expensive shares in a secondary and buy cheap assets directly without the headache and expense of a merger.
  • Mitek Systems (MITK): Mitek Systems ended up dropping their strategic process, they have new management that presumably wants to create value independently (and not lose their jobs), the company has a strong niche, but investing in a small software growth stock wasn't my initial thesis so I sold it for a small gain.
  • Hamilton Beach Brands (HBB):  I was still holding onto a stub position in HBB as a result of its 2017 spinoff from NACCO Industries (NC), ended up selling it as I just didn't have conviction enough in the company meeting its long term revenue goals in the face of increasing pressure from Amazon.  Amazon's advertising model to get into the top of the search results is going to pressure margins going forward.
  • OncoMed Pharma (OMED):  Mereo Biopharma has been a disaster since the reverse merger with OncoMed, it's notably tied up in the Woodford Patient Capital Trust mess and likely has an overhang as a result.  Celgene also decided not to exercise their option on a drug that was 2 of the 3 CVRs in this transaction, chalk this one up as a loss.
  • Voltari Corp (VLTC):  This tiny NOL shell ended up being a home run for those small enough to get into it, the final price was $0.86/share versus the initial $0.58/share offer Icahn made to start things off.
Portfolio as of 6/30/2019:
CVRs: GNVC, INNL, MRLB, OMED
Disclosure: Table above is my blog/hobby portfolio, I don't manage outside money, it's a taxable account and a only portion of my overall assets.  The use of margin debt, options, concentration doesn't fully represent my risk tolerance.

Speedway Motorsports: Going Private Offer, Bump Coming?

Speedway Motorsports (TRK) is the owner of 8 racetracks around the United States, they primarily host NASCAR events and other smaller motorsports promotion races.  The company is 71% owned by founder Bruton Smith and his family, earlier this year a entity controlled by the Smith family (Sonic Financial) offered to buyout the minority shareholders for $18 per share.  This follows a similar path as TRK's larger peer, International Speedway (ISCA) which has agreed to be taken private by the controlling France family (who also own NASCAR).

Similar to other sports, TV broadcasting rights are a major source of revenue for NASCAR, they entered into a 10 year deal with Fox and NBC that runs through 2024.  NASCAR's structure is a little different than others, the governing body is privately owned and receives approximately 10% of the TV revenue, the racetracks themselves are owned by three publicly trades companies (ISCA, TRK, and smaller DVD) which receive approximately 65% of the TV revenue, with the remaining 25% going to the drivers and their teams.  The France family will be merging NASCAR and International Speedway once the deal closes.

NASCAR has struggled since peaking in the early 2000s, television ratings and attendance have fallen through the floor, with many people point to changing the car to make it safer (but leads to dull racing) or to the general decline in interest in cars.  But it still garners media attention, like all sports programming it is something that needs to be watched live and has a niche loyal following that would complain if it was suddenly dropped from cable television packages.  Interestingly, the most recent television contracts were struck in 2012 and 2013 with a 30% increase from the previous deals despite clear evidence that NASCAR was already in decline.  Maybe the Smith family has an inside track on what the next deal might look like?  If so, now is an opportunistic time to take it private, retool the sport and industry structure outside of public shareholder view, with the 5 years left on the current TV contract providing much of the cash to fund the take-private deal.

I can't find any historical news on it, but Chuck Akre mentions in the podcast Invest Like the Best a history with Bruton Smith (well not by name) indicating that several decades ago when Smith took Charlotte Motor Speedway (predecessor to TRK) private and that he had his hand in public shareholders pockets, Akre vowed never to invest with him again.  But since returning to public markets, it appears TRK has acted reasonably with minority shareholders, the Smith family have maintained their ~70% ownership throughout the current iteration's history.  But there is some history here of minority shareholder abuse.

This situation likely follows that of International Speedway ($42 bid in November, followed by a $45 accepted offer in May) and there's a 5-10% bump from the $18 offer price, the market is certainly anticipating one with the stock trading around $18.50 per share.

Disclosure: I own shares of TRK

Friday, June 21, 2019

Command Center: Reverse Merger with Hire Quest, Tender Offer

Command Center (CCNI) is an illiquid micro-cap staffing company providing temporary semi-skilled and unskilled labor to light-industrial, hospitality, transportation and retail customers.  Through a network of 67 branches in 22 states they deployed over 32,000 employees to 3600 customers last year, a sizable operation given their $25MM market cap.  The company has historically struggled with mediocre management, exposure to oil and gas markets and a lack of scale, all of which led to activist investors pressuring the company to explore strategic alternatives in 2018.

On 4/7/19, the company announced a merger with privately held Hire Quest Holdings, effectively structured as a reverse merger where Hire Quest management will run the combined company and Hire Quest shareholders will own 68% (76% after the tender) of the proforma company's stock.  Temporary staffing is a fragmented industry with several large players and then many "mom and pop" type operators. Hire Quest's business is structured as a franchiser, they provide the back office support and negotiating scale on workers compensation insurance (a significant expense for this industry) to its franchisees under the brand names Trojan Labor and Acrux Staffing.  After the merger with Command Center is complete, the company plans on franchising the 67 Command Center branches to mirror the Hire Quest business model.  Interestingly, Command Center previously operated under the franchise model but bought out their franchisees in 2006.

In tandem with the reverse merger, the combined company will be conducting a tender offer of up to 1,500,000 shares at a price of $6 (versus a price of $5.45 today), in the proforma financials provided in the proxy, it shows the current cash on CCNI's balance sheet of $7.5MM being withheld for the tender offer.  They're a little short of the $9MM necessary for the tender, but given the cash build since the Q1 financials came out, I'm going to assume the company is essentially both cash and debt free.  Additionally, since the company will be franchising the current 67 Command Center locations, they should see some cash inflow from those sales.  The 2006 acquisition of 69 franchised stores which formed Command Center was done for 13.2 million shares which traded at roughly $1 at the time of the announcement (data is a bit hit and miss, this was an even tinier OTC stock at the time so my figures could be off), or we'll call it $180k per location which sounds reasonable as the buyers are going to be the store manager or someone looking to own their own job.  If correct, that's another $12MM in additional cash that could be used for buybacks/tender offer or expansion.

In the press release announcing the reverse merger, management provided the following pro-forma commentary:
"If Hire Quest revenue were determined on a similar revenue for the year ended December 31, 2018 would have been approximately $189 million.  Based on our current projections, after some period of integration and normalization, we believe the combined entities will produce annual EBITDA in excess of $15 million, exclusive of growth opportunities."
Following the tender offer, the company will have 12,968,678 shares on a diluted basis, at today's share price of $5.45 (and the assumption of zero net cash/debt, no value to the franchising), the enterprise value for the proforma company is approximately ~$70.5MM.  Against a post deal (could be messy the first year or so) estimated EBITDA of $15MM, the new Hire Quest is trading for roughly 4.7x EBITDA, well below the large publicly traded staffing companies.
Clearly some of these companies have higher quality businesses than that of a sub-scale CCNI, but with a new owner-operator management team in place, a differentiated franchise business model, post deal closing Hire Quest could have a more attractive story to tell investors narrowing some of that valuation gap.  At 7.0x EBITDA, still a discount to the group, shares would be worth $8.10 per share, or nearly 50% higher than today's trading price.  If we want to get a little crazy and use my $12MM cash number from the sale of franchises, that's just under another $1 per share, call it $9 per share total. Originally the deal was targeted to close in the second quarter, but that time frame has slipped a bit, the company is holding the shareholder vote alongside their annual meeting on 7/10/19 with the merger likely to close sometime shortly after it's approved.

Disclosure: I own shares of CCNI

Craft Brew Alliance: Speculating on ABI Qualified Offer

Craft Brew Alliance (BREW) is a collection of craft beer brands formed with the merger of Redhook Ale and Widmer Brothers in 2008, but it is best known for its fast growing Kona Brewing brand of beer.  Originally a Hawaiian craft beer, Kona is now positioned as a beach inspired mass marketed lifestyle beer.  If you're unfamiliar with Kona, they recently did a big media buy during the 2019 NCAA basketball tournament, here a link to one of their commercials espousing the island lifestyle.  CBA is ~31% owned by brewing giant AB InBev ("ABI"), in August 2016 ABI entered into a distribution agreement with CBA that laid out a path for ABI to purchase the remaining ~69% they don't already own.  The agreement has a graduated payout schedule based on the date of an announced acquisition, the first two dates have passed and the last deadline for ABI to make a "qualified offer" for CBA is 8/23/2019, the qualified offer has a minimum of $24.50 per share.

Craft Brew Alliance is an unfortunate name, it's now widely agreed the craft beer segment is over-saturated with thousands of breweries, it's difficult for the mid-sized independent brewers to survive as most craft drinkers have migrated to the ultra-local inside your own zip code breweries.  It's much more fun to show up to a party with a growler of IPA from down the street than a 6 pack from a super-regional brand you can get at any Walgreens.  The original version 1.0 craft brands like CBA's stale Redhook or Widmer brands are in free fall and pioneering brands like Boston Beer (SAM) have pivoted to so called "alcopop" and spiked seltzers.  Similarly, Kona has morphed into a mass-marketed lifestyle brand, their two flagship beers (Blue Wave and Longboard) are relatively easy drinking and light.  A small anecdote reflecting that shift, my old college bar now has "$3 Big Wave Thursdays" as the weekly special, it's no longer "craft brew" if 19 year olds are playing beer pong with it.

AB InBev is viewed as over-leveraged after the acquisition of SABMiller, they also cut the dividend in half last October sending their shares to multi-year lows as they deal with declining beer volumes, but since the dividend cut shares have recovered nicely this year.   Acquiring CBA would be a relatively small check (~$325MM) for ABI to write and would fill a hole in their U.S. portfolio where they don't have the rights to the similarly positioned Corona brand.  Additionally, if ABI passes on making a qualified offer, they would owe CBA a $20MM fee and potentially open themselves up to another brewer making an attempt to purchase CBA, how would ABI feel about a competitor (Constellation Brands?) getting a free ride on their distribution system for the next several years?

But the market clearly doesn't believe it will happen, today shares trade for $13.60, the minimum qualified offer price of $24.50 would represent an 80% premium.  The downside is probably in the $8-9 range if there's no offer, so by triangulating the implied odds the market is telling you there's about a 4-1 or 3-1 chance of the deal being completed.  Let's just assume that's right, an interesting way to speculate on the deal getting done is through August $20 call options which are trading for ~$0.20 per contract.  If the deals consummates, it's likely to be all cash and at the minimum price, so we know the timing and we know the price, assuming a small spread, the calls would move up to ~$4.00 or so on a deal announcement, or a 20-1 payout structure.  I'd love to be able to invest in 30 similar trades to spread out the dispersion, but even on its own its a compelling proposition and I have made it about a 1% cost basis position in the calls.

Disclosure: I own BREW August $20 calls

Monday, June 3, 2019

Spirit MTA REIT: Sells MTA Assets to HPT, Remains Compelling

[Apologies for another SMTA update, I'm still active, but I haven't really bought much new lately.]

Spirit MTA (SMTA) this morning announced the sale of the assets contained within the Master Trust to Hospitality Properties Trust (HPT) for ~$2.4B, after redeeming the Trust's debt and other transaction expenses will net SMTA approximately $450MM (I was hoping for more like $500MM, but this is a reasonable outcome).  HPT shareholders (bagholders?) might be asking why a hotel REIT is buying net leased retail assets, but it is good news for SMTA shareholders as the transaction is for cash that has committed financing from an investment grade borrower and doesn't require an HPT shareholder vote.  HPT is externally managed -- abused -- by RMR Group (RMR), they're interested in increasing AUM and resulting management fees, closing is targeted for the end of Q3.

Updating my NAV for the $450MM sale:
With no value to the remaining NAV pieces that are in question, the value to SMTA shareholders is approximately $7.90, so at today's price of $8.30 (and assuming the deal closes), you can buy the remaining assets for $0.40 with upside of potentially up to ~$2.50-3.00 of value on the workout and other assets.

Old news to those deep in the comment section of my earlier SMTA post this year, but here are additional thoughts on the remaining NAV components/risks:

As part of the spinoff, SRC via SMTA loaned Shopko $35MM via a term loan to receive access to ShopKo's periodic financials.  When Shopko filed for bankruptcy in January, SMTA wrote off the term loan and as a result, it doesn't appear in their NAV table, however, per the liquidation waterfall in the almost wrapped up Shopko bankruptcy, the term loan should be paid in full.
The low end estimate also shows essentially a full recovery, that's approximately $0.75/share, already well ahead on the $0.40 investment in the other assets above the MTA and cash.

The Academy Sports + Outdoors distribution center in Katy, TX is another big component to the other asset category, it is Academy's largest warehouse and home to their headquarters.  Like many other retailers, the company is struggling, it's owned by KKR and has significant debt that trades at a discount.  But if they were to restructure, I'm guessing they'd keep this warehouse as again, it's their headquarters, and it serves their largest/original market in Texas.  Katy, TX is outside of Houston, home to many large warehouses including Amazon.  Industrial real estate is hot right now, just this weekend Blackstone announced another deal (they've done several including GPT and FRPH).  As part of the CMBS financing transaction, the property was appraised at $144MM in 2018, and Academy's distress was very apparent at the time of this appraisal, below is the chart of the Academy term loan going back to issuance.  It trades for 75 today, down from early 2018 levels, but was still in distressed territory back then, it's not a new story.
In my NAV, I'm putting a 8.5% cap rate on the $9.5MM NOI, call it a 20-25% haircut from the appraised value done before the spinoff.

On the workout portfolio, many want to write these off completely, much of these are actively leased, just don't fit the portfolio profile of a publicly traded REIT but still of institutional type asset quality.  From the Q1 recorded conference call:
"Starting with portfolio activity, we continued to actively manage the portfolio during the first quarter, selling three properties for $5.4 million in gross proceeds. We also executed a lease with 7-Eleven on a former non-core vacant asset which we will look to dispose of at a far improved price above its previous start value.
In addition, the leases for two non-core assets formerly leased to Neighbors Health System have recently been assumed by new operators. We plan on contributing those two assets into the Master Trust, which allows us to deploy restrictive release account cash before that cash is swept to repay ABS notes with corresponding make whole penalties. In turn, these contributions will enhance our unrestricted cash position outside of the Master Trust."
The new tenant is Diagnostic Health and according to the servicer report, entered the trust with a collateral value of $8.41MM at a cap rate of 13.6%, assuming the same cap rate across the rest of the workout portfolio plus the book value of the vacant properties nets out a $57MM value.  This number likely has the widest range of outcomes, much of the value is a multi-tenant office building leased to PwC in Columbia, SC, hard to get a read on how much that asset is worth, open to others thoughts.

Another risk people site is the Shopko CMBS lender coming back to SMTA, but it appears the CMBS lender has moved on, as mentioned in the SITE Centers (SITC) Q1 call:
"First, we signed a management agreement with Credit Suisse, providing them advisory and operational services for 83 assets leased to Shopko on which they have recently foreclosed. Importantly, the agreement came with rights of first refusal for 10 assets in the portfolio and allowed us to leverage our existing operating platform to generate nearly 100% margin on any fees we received. Credit Suisse's needs were ultimately short-lived, but we nonetheless earned the $1 million in the process which was a contributor to our strong quarterly results."
Later in the Q&A, they clarified it was a short lived asset management agreement because their client sold the portfolio quickly.

Putting it all together, I think it's pretty reasonable to come up with $10.70 NAV with some range of outcomes around that value primarily dependent on the Academy distribution center and other workout assets being sold for reasonable valuations.  The main risk from here is the timing, HPT didn't buy the SMTA holding company, so there will likely need to be a small holdback amount to address any clean up and other shut down expenses.  Maybe its $10 by the end of Q3 with the remainder sometime down the road after that?  The other concern might be the HPT deal requires a shareholder vote at SMTA, SRC is waiving their promote/incentive fee surprisingly, maybe to get in the good graces of a couple activist shareholders in Indaba and Mangrove, but surprising nonetheless for Jackson Hsieh to leave money on the table.  I find the valuation compelling today and added more, it's my largest position by a decent margin at this point.

Disclosure: I own shares of SMTA and Oct $7.17 Calls

Friday, March 29, 2019

Howard Hughes: Updated Thoughts 2019 Version

It's been about three years since my last post on Howard Hughes Corporation (HHC) and I wanted to updated my mini-model and walk through some updated thoughts on their progress.

Howard Hughes is a real estate development company that was originally spunout of GGP during its restructuring to hold the master planned communities and non-core assets of GGP.  Since the spin, close to 9 years ago now, HHC has focused its efforts on five key markets: Houston, Las Vegas, Honolulu, Columbia MD, and the Seaport District in New York City.  Their story is pretty well known by now in the investment community but HHC shares still provide a compelling long term value for a few primary reasons:
  1. Howard Hughes is a real estate company that is not a REIT and does not pay a dividend, also because of its mixed portfolio, doesn't screen well or fit into any easy to value bucket.  Additionally, much of its value is in land and large assets that aren't currently producing any cash flow (for example, the Seaport).  A counter to this, many REIT funds are including non-REIT real estate companies, for example, Vanguard's switched its mandate from a REIT fund to a real estate fund and included HHC in the process.
  2. Much has been written about the lack of new home construction since the financial crisis, one day this will normalize and HHC will be well positioned, their master planned community ("MPC") assets are highly sought after, providing the raw material homebuilders need and because of their maturity (hundreds of millions have been spent previously on infrastructure), feature high cash margins.  HHC uses these cash flows to self fund commercial construction (office, multi-family, retail) in these MPCs that HHC holds for investment.
  3. NOI (and thus NAV) should continue to grow at a fast clip without needing to raise any equity capital, additionally the company has further growth levers it can pull via several under appreciated assets outside of their core markets that could have significant value.
The easiest way to value the company is to run an net present value calculation on the land sales in the MPCs and the condo sales in Honolulu and add it to a NAV of the current operating properties and strategic developments minus any remaining construction costs and debt.

Master Planned Communities
The company publishes an undiscounted and unappreciated value of their land holdings in their 10-K, this is simply the average recent selling price of their land multiplied by the remaining acres, it doesn't account for the time value of money or any future appreciation in pricing as the remaining acreage should get more valuable over time as Howard Hughes builds out the amenities.  I took those numbers and simple ran an NPV using a 10% discount rate assuming a straight line selling pace until the sell out date with no price appreciation built into it.  Note: I just used book value for The Summit, which is an ultra-luxury community in Summerlin that's being developed with a JV partner, it's been a big success and likely worth more than book.
In 2018, the MPC assets generated EBIT of ~$200MM, this roughly equates to a 10-11x EBIT multiple for the land business if you value it at $2.3B, which seems reasonable to me.  Using roughly the same framework for the condo development business in Honolulu, ~$1300 square foot average selling price and costs of $1100/square foot and running an NPV using a 10% discount rate until the 2028 sell out date equates to about $833MM in remaining value.  This doesn't account for the retail transformation that will happen over that time, just the condos, which the company has mentioned they'll be increasing their pace of tower construction as they have found a niche in smaller pre-furnished units in Oahu's highly supply constrained market.

The company also provides a lot of detailed disclosure on their operating property and strategic developments segments making an NAV calculation fairly straight forward.  Below, sorry its small, but I've taken each property, assigned a cap rate and deducted any property level mortgages or remaining construction costs on the unstabilized properties.

Office Properties
HHC's office portfolio was heavily weighted towards Houston 2-3 years ago, they clearly made a mistake in overbuilding ahead of the oil rout in 2015 and several of the office assets in Houston remain unstabilized years later.  However, since then they've been focusing office construction on Columbia, MD and in Las Vegas, most of these properties are new in the last three years.  Another asset that didn't get much attention until recently is 110 N Wacker, it was a four or five story building that covered an entire city block along the Chicago river, it was previously the headquarters of GGP and was recently demolished.  HHC along with JV partners (HHC owns 33% now, mostly just contributing their land) have commenced construction with a projected finish date in the back half of 2020.
110 N Wacker - 3/29/19
Bank of America will be the anchor tenant, leasing activity was brisk enough that two additional stories were added to the building to meet demand.  It's a prime location on the river and near transportation, despite the building boom in the Loop, I can't imagine them having difficulty fully leasing the building upon completion.  At that point, I'd expect them to sell their stake as it is non-core in that they don't control any properties or land around it, but anyway it's an asset that was an after thought in NAV models until recently, HHC has a couple others that could be even more significant that I'll touch on later.

Retail Properties
The biggest piece to the retail portfolio is the Seaport District located on the East River in Lower Manhattan, it was a tired yet popular tourist attraction until Superstorm Sandy destroyed it in 2012.  Since then, Howard Hughes has been working on redeveloping the area, it has taken longer than originally expected and gone through a few strategic changes (notably switched from a "regular mall" to more of an experiential shopping experience).  I don't like commenting too much on the Seaport's value as I'm not a New Yorker like many in the investment community who might have stronger opinions on the asset, but I mentioned in my year end post that a similar property in Chelsea Market was sold for over $2.4B.  Chelsea Market is roughly twice the square footage as the Seaport, giving rough credit to the $1.25B value I'm putting on the Seaport before the remaining construction costs.  HHC also bought a parking lot for $180MM near the Seaport that it plans to redevelop, likely into multi-family, as the Seaport stabilizes and increases demand around the neighborhood.

Multi-Family, Hotel, Other
They've heavily invested in multi-family properties in recent years, mostly successfully, less successfully on the hotel properties which are located in the Woodlands and were built right before the oil rout, similar to their office portfolio there, these properties have taken longer than anticipated to stabilize.
These are the random other assets that Howard Hughes owns including the new AAA ballpark they built in Summerlin, a ground lease beneath the Vegas Golden Knights practice facility and the marina in Honolulu.

Two of these other assets that I think are interesting and carried at little value on the balance sheet but could be significant drivers of NAV growth over the next 2-5 years are the Fashion Show air rights and Monarch City.
Fashion Show Mall - Las Vegas
HHC owns 80% of the air rights above the Fashion Show mall on the Las Vegas strip across the street from the Wynn and adjacent to Trump Tower on one side and TI on the other side.  Back in 2017, there were rumors that the company was reaching out to design and construction firms for a potential casino resort development, but nothing more has really come of it and Las Vegas is in a mini-slowdown right now.  The mall was owned by GGP, but Brookfield bought GGP last year and likely makes a more natural development partner for the project as Brookfield's stated strategy is to redevelop many of the acquired malls into mixed use properties. It may be another few years before anything happens here, but it's another potential driver of NAV that isn't included in my model or any that I've seen put out by analysts.

Promotional Deck for Monarch City
Another under followed asset that HHC owns is 280 acres of land in Allen, TX on the corner of two highways that was recently renamed Monarch City and has plans for over 9 million square feet of mixed use development.  To put that scale in perspective, HHC has 14 million square feet of entitlements (only a small fraction of which are currently built) in Downtown Columbia, but Monarch City is still large enough be a significant asset and potentially a 6th core market for HHC.  Allen is an attractive market, it is a suburb north of Dallas and right in the heart of a big housing development corridor, fellow long time holding of mine Green Brick Partners (GRBK) is active in the area with several ongoing communities being built within a short drive of Monarch City.  The Dallas metro area is very popular with corporate relocations given its low taxes, Howard Hughes is likely waiting for a big relocation opportunity to anchor the development before breaking ground or publicizing the asset further, if they're able to sign one, Monarch City is large enough to be a nice call option that's not currently factored into the stock price.

Adding it all up, I get a reasonably conservative "today" price of HHC around $140 per share.
Other Thoughts:
  • HHC likes to point to their control of the markets they operate in and the reinvestment opportunities available to them within those tightly controlled locales.  It potentially limits the risk of oversupplying a market (although they did that to themselves in Houston), plus it gives them an advantage when non-HHC owned assets come up for sale.  They've recently purchased underperforming properties in The Woodlands and Columbia that they didn't previously own and have added them to their redevelopment pipeline, creates some synergies and continunity.
  • Three years ago I got some feedback that Ward Village was unsustainable because of Chinese buyers, similar to the impacts Vancouver has seen, but HHC discloses the types of buyers in Ward Village and Chinese make up a low single digit percent, essentially a non-factor, most of the buyers are locals, Japanese and mainland second homes as you'd expect for that market.
  • Mentioned this previously, but one thing I do like about Bill Ackman recruited senior management is he insists on skin in the game, with HHC, CEO David Weinreb put up $50MM out of his own pocket (one could argue he's rolling his previous warrant payday over, but I think the message is still the same) to buy a warrant package with a strike price at $124.64 expiring on 6/15/22.  There's still plenty of time, but the stock price hasn't moved much despite all the activity over the last five years, I think management will do whatever they can to close the gap between the share price and their perceived NAV (which is much higher than mine) over the next 4 years.  The CFO and COO are under similar incentive packages, but they put up significantly less money, $2MM and $1MM respectively.
  • HHC has started publishing an AFFO metric, it was $5.41 for 2018, for approximately a 20x multiple which given the NOI growth path over the next 5-10 years seems cheap compared to many popular REITs.
  • A similar company that I follow (but don't own) is Five Point Holdings (FPH), it's a developer of three master planned communities in California.  It was created out of a partnership with Lennar (LEN) and is much earlier in its life cycle than HHC, but it has a similar plan to develop/sell lots to homebuilders and then build commercial development for investment once demand occurs.  FPH is a broken IPO, trading about half its IPO price from a year or two ago, if anyone has thoughts on them I'd be grateful and interested to hear.
Disclosure: I own shares of HHC

OncoMed Pharmaceuticals: Merger Arb + CVRs

OncoMed Pharmaceuticals (OMED) is the latest entry in my occasional series on busted biotechs, as the name suggests OncoMed is a development stage company focused on cancer related therapies, it hit a series of setbacks in 2018.  It's now a micro-cap, just $40MM in market cap with $57.3MM in cash as of 12/31 (minus a significant burn rate) and few apparent prospects.  In December, OncoMed announced a merger with U.K. based Mereo BioPharam Group (MPH), the deal is effectively structured as a reverse merger/cash infusion for Mereo resulting in the new combined company being dual listed in the U.S. and U.K thus opening up more channels for inevitable future capital raises.  Mereo is focused on rare diseases, it has an interesting history of acquiring the "dogs and cats" of larger pharmaceutical companies that have received significant previous investment but for some reason or another are no longer strategic priorities.  Mereo is technically public and trades on the smaller AIM exchange, but liquidity is extremely limited with just a few trades occurring over the past couple months.

Mereo is going to create 23.7 million new MPH shares and through a depositary create Mereo ADRs that will trade in the U.S. to issue to OncoMed shareholders.  The exchange ratio is subject to adjustment based on an expected OncoMed cash balance of $38MM at the time of the closing (guided to Q2), it can be adjusted both ways if the cash comes in above or below that line.  At year end, cash was $57.3MM versus $70.9MM at 9/30, indicating about a $13.5MM quarterly burn rate putting that $38MM cash goal in jeopardy unless serious cost cutting as happened since the deal was announced.  But using the 23.7 million shares number, current market prices (again, MPH barely trades, but is quoted at 160 pence) and current GBP:USD exchange rates equates to ~$50MM in stock consideration versus a market cap of $40MM for OncoMed.

OncoMed has two therapeutic candidates currently in their pipeline, each is getting its own non-transferable CVR in the transaction:
Celgene is OncoMed's historical development partner, however, they have declined to exercise several license agreements on OncoMed assets in the last 18 months, TIGIT is the last of those options and based on recent events seems unlikely to get exercised.  NAVI doesn't have a commercialization partner (Celgene already turned it down), finding a new partner is step one before the CVR payment can be contemplated, in even the most optimistic scenario, receiving any payments is a long ways off.

Additionally, earlier this month, OncoMed added a 3rd(!) CVR which seems a bit silly for a tiny micro-cap merger.  However, it might signal that OncoMed is more optimistic that Celgene will opt-in to the TIGIT program than the market believes (okay, I'm probably stretching there), this new CVR will cover any additional payments received (other than the $35MM opt-in payment which would still be paid in MPH shares) from Celgene, so it only becomes a live bet after the opt-in occurs sometime in 2019 and diverts cash from NewCo to OMED shareholders.  This CVR wasn't contemplated at the time of the merger, its likely a result of shareholder feedback and an effort to gain additional support for the merger.

In summary, you have a potential ~25% upside from the arb spread closing (again, using stale/illiquid MPH market cap, I'm not underwriting to that number as it could drop significantly once there is liquidity but I've also had success from these reverse mergers going up after the deal closes) and the possibility of Celgene exercising their option on TIGIT which would add another ~90% return from the CVR before year end.  This is obviously very speculative,  I've sized my position small accordingly.

Disclosure: I own shares of OMED

Friday, January 18, 2019

KAR Auction Services: Insurance Auto Auctions Spin

KAR Auction Services (KAR) will soon be spinning off their salvage car auctions business, Insurance Auto Auctions (IAA), leaving the wholesale used car auction business and their floorplan financing unit at KAR.  It's not entirely clear to me why this spin needs to happen, but the market is valuing the sum of the parts at a significant enough discount to each's standalone peer to make it an interesting spinoff to follow and see where the two pieces end up trading.

KAR Auction Services (RemainCo)
ADESA ("Automotive Dealer Exchange Services of America") is the second largest provider of used car auctions in North America, with about 28%-30% of the market, behind industry leader Manheim, a subsidiary of privately held Cox Enterprises, that commands 42% market share.  ADESA's auction sites link large volume car sellers (off-lease, rentals, repossessions, excess dealer inventory) with used car dealerships utilizing a consignment model where the company doesn't take ownership of the vehicles, but charges buyer/seller fees, transportation fees, and other fees that help prepare a car for sale (paint, small dent repair, detailing, etc.).  Each car sold through ADESA represents about $600 in revenue.  This is a reasonably good business, there are significant barriers to entry (for one it would be difficult to replicate their auction site footprint), low capital expenditures and limited working capital requirements, but it does feature some cyclicality to it via the supply and price of used cars.

There are two big sources of used vehicles for ADESA: 1) cars going off-lease, as leasing has become a more popular option in recent years (although leveling off now) it provides ADESA with a strong tailwind as lessees turn their cars into the lessor, who then sells through an auction provider to used car dealers; 2) repossessions, on one call management described themselves as "Repo Kings" since KAR has an active repo business inside of ADESA, auto lenders are not natural sellers of cars on their own, so they sell to used car dealers through an auction provider.  More people financing cars at greater and greater loan balances translates into more cars falling into default and repossession.
AFC ("Automotive Finance Corporation") is the second piece of RemainCo, AFC provides "floorplan financing" to independent used car dealers to help facilitate sales at ADESA.  Floorplan financing is a short term loan secured by the car that's paid back once the car is sold by the dealer.  Because the loans are short term (65 days on average), 50% of the revenue ends up fee based generating mid-teens ROE and adding to the attractiveness of the business.  Additionally, there are tens of thousands of independent dealers making this a difficult business to replicate at a nationwide scale and AFC's securitization financing provides a cheap competitive funding source.

In 2017, KAR purchased the remaining 50% in TradeRev that it didn't already own, TradeRev is a dealer-to-dealer mobile app that facilitates real time auctions between dealers versus a traditional auction platform where the dealers are typically only on the buyer side.  With the spin dividend cash from IAA, KAR will continue to invest heavily in TradeRev as they're in the midst of a nationwide dealer by dealer roll-out of the platform.  Additionally, KAR has international ambitions and recently bought an online auction platform that serves much of Europe with stated desires to continue to pursue international acquisitions.

Insurance Auto Auctions ("IAA Spinco" in the Form 10 or just "IAA")
IAA will be a standalone salvage auction business, when a car is totaled in an accident or has aged out of useability (think car donation charities) the car will be sold at a salvage auction for parts or scrap.  Salvage auctions are similar to whole used car auctions in its transaction based ($500/car revenue, slightly lower due to fewer add-on services) where IAA doesn't take ownership of the car, however it's a more predictable business as cars will always need to be salvaged regardless of the economic cycle.
IAA in their Form 10 forecast the salvage vehicle auction industry will grow at 5%-to-7% annually for the foreseeable future driven by 3 main tailwinds:
  1. Growing automotive car parc -- Industry speak for the total number of cars on the road, now just under 300 million, the average age of vehicles continues to rise, older cars getting into an accident are more likely to be a total loss.
  2. Increasing vehicle complexity leading to higher total loss frequency -- there are more electronic components and repair labor costs are rising making car repair more expensive, if the repair costs are more than the car is worth, it of course results in a total loss.
  3. Increasing accident frequency --  here they cite more cars on the road and more distracted driving (texting and driving, etc.).
The stated reason to spinoff IAA is to create a standalone company that compares directly with their competitor Copart (CPRT).  Copart maintains a similar ~40% salvage market share but has superior margins partially due to owning the real estate beneath their auction sites (IAA leases their sites), the rest of the margin difference is hard to parse out and might be an opportunity for improvement post-spin.  IAA has been managed separately from KAR (different auctions sites, different customer bases, separate headquarters) and the soon to be CEO, John Kett, has been running IAA since 2014, eliminating some of the risk of IAA stumbling out of the gate that we often see with spinoffs.

Valuation
New KAR Auction Services doesn't have a direct North American public competitor since Manheim is privately owned by Cox Enterprises, but it does have a peer in the leading wholesale auction provider in the UK, BCA Marketplace PLC (BCA.LN).  The combined KAR has $2.74B worth of debt and $345MM of cash, KAR is going to raise $1.3B of debt (not finalized) at IAA, sending $1.25B back to new KAR after gifting IAA with $50MM in cash, leaving new KAR with $1.145B in net debt.

Copart (CPRT) trades for 15.5x EBITDA, but its better run and has minimal debt so it should trade at a significant premium to IAA.  For the sum-of-the-parts, I'm going to use 10.5x for new KAR (1x discount to BCA) and 12x for IAA (2.5x turn discount to CPRT):
Adding to the two pieces together, I get a price of $60, not a ton higher than today's $52 share price.  Despite that I added a smallish position going into the spinoff, IAA in particular interests me as an interesting long-term spinoff:
  1. IAA doesn't have to make a significant change to its business model to succeed, instead there is both a discounted valuation and a margin gap, if both of these close it could be a home run; 
  2. Deleveraging, as mentioned, since IAA doesn't have to do anything transformational or reinvent the business, and its growing at a healthy clip, they'll have plenty of FCF to deleverage and/or return cash to shareholders via buybacks or dividends; 
  3. Management has been running this company as a separate unit, we should see some animal spirits unlocked now that their comp will be directly tied to the success or failure of IAA and the operating performance gap between IAA and CPRT will be on full display.
I'm not worried about autonomous cars eliminating all accidents and thus total losses, or Americans giving up their cars entirely for ride sharing services, both of these risks seem far off into the future and may only capture a small niche in the end.  I do worry that this thesis is too easy, KAR provides extensive and transparent segment reporting, investors should be able to see through the sum of the parts here?  And I prefer when spinoffs have different shareholder bases, that's not the case here, but the business model interests me and given that the combined company trades below where both pure play peers trade, I think there's some margin of safety going into the spin, its worth keeping on your watch-list.

Disclosure: I own shares of KAR