Wednesday, December 19, 2012

Betting on a Natural Gas Rebound

I'll start off by saying I'm not an oil & gas industry expert, probably just the opposite, so the majority of this post will be qualitative in nature, but I think any investor with a long term outlook could agree that natural gas prices must come up over time.  New fracking and horizontal drilling technologies have made previously unattainable resources accessable creating a booming supply of domestic natural gas in the United States.  The 2011-2012 mild winter didn't help the situation, it was the 4th warmest on record.  Since one of the primary uses for natural gas is heating homes in the winter, supplies remained elevated and prices dropped to below $2 per bcfe as the winter ended. 

Natural gas prices have rebounded to $3.34 per bcfe, but very few natural gas producers can turn a profit at these prices, and those that can are limiting their new investments in additional resources.  The old saying is the cure for low prices, is low prices, it causes producers to stop or slow production, and it encourages new sources of demand.  Low natural gas has increased demand in three main ways:
  • Electricity utilities are switching from aging coal plants to gas as its become cheaper, cleaner, more politically agreeable
  • Encouraging discussion and investment in exporting liquified natural gas to exploit the large spread between natural gas prices in the US and elsewhere in the world 
  • Spurring on the natural gas as a transportation fuel trend, especially for commercial vehicles
On the supply side, producers have reduced the rig count by 50% compared to last year, it's a bit of a leading indicator so it's yet to show up in natural gas supplies.

These are two good data points to keep bookmarked to keep updated on the supply side:
Last winter/spring (in hindsight too early) I started searching for a way to go long natural gas, I passed on the poorly put together yet surprisingly popular natural gas ETF UNG and stumbled on Ultra Petroleum based out of Texas.  Despite the name, Ultra is almost exclusively a producer of natural gas, and pretty much the lowest cost producer.  They operate in two main areas, the Pinedale and Jonah fields in Wyoming and then in the Marcellus Shale region of Pennsylvania (through JV partners in the Marcellus).  Below are two slides that Ultra provides on a regular basis showing their cost structure compared to peers and their breakeven points for net income and cashflow, clearly they have structured their operations in such as way where they can survive in a low price environment and thrive in a more normalized one.


The major concern with any smaller independent explorer is the balance sheet and their ability to meet the high capital expenditure costs.  Ultra has been proactive about improving the liquidity position as evidenced by their recent sale of mid-stream assets for $225 million.  In 2012, Ultra will spend a net $600 million on capex compared to $1.5 billion in 2011, while only modestly increasing debt.  Its clear if you listen to recent conference calls that management is not willing to spend more money than necessary in this environment and is more focused on long term profitability over short term growth in assets, just the type of management I like.

In summary, Ultra Petroleum is a great way to invest in the eventual rise in natural gas prices.  It does experience a lot of daily volatility, so have a strong stomach before jumping in and be prepared to hold it through the cycle, although it seems reasonable to assume we've seen the low in natural gas prices.

Thursday, December 13, 2012

Asta Funding

As Bruce Berkowitz of Fairholme Funds puts it, "investing is all about what you give versus what you get."  One way to go about looking for value is determining when GAAP accounting rules often result in a company's assets being carried at values far less than their intrinsic value. 

Asta Funding is such a company, their main business is as debt collector on defaulted loans, not exactly a popular or sexy business model.  Asta acquires portfolios of consumer receivables for pennies on the dollar and then it goes about the collection process to recover as much of the original loan as possible.  The collection of these receivables has typically been attempted by the originator and potentially several others, these are really aged and bad debts. 

Asta Funding is a family run business by the Stern family, who control 30% of the shares outstanding.  The company's founder is Arthur Stern, who at 90 is still a company director and "Chairman Emeritus".  His son, Gary Stern, is now the President and CEO and has been in the post for close to two decades.

Asta has $106,347,000 of cash and marketable securities as of 9/30/12, with virtually zero recourse debt, versus a market capitalization of $121 million.  A little history, in March 2007, Asta made a mistake in buying an incredibly large receivables portfolio at the top of the market, called the Great Seneca portfolio, a $6.9 billion portfolio for $300 million, by far the largest acquisition they had ever done.  They paid for the portfolio with $225 million in non-recourse loans and $75 million from their credit line.  The portfolio has been significantly written down and currently sits on the books for $65.4 million versus $61.5 million in non-recourse debt.  The company's business plan is in a bit uncertain going forward as they are not making any large receivable purchases since they believe the price is too high, a market condition also mentioned by other publicly traded competitors.

The potential value in Asta comes from how they account for their consumer receivables portfolios.  When the company can no longer determine the timing of cash flows from one of their portfolios, they switch from the interest method to the cost recovery method of accounting.  Under the cost recovery method, all cash flows from the portfolio go immediately towards a reduction in the principal amount of the portfolio.  Compare this to the interest method, where a portion of the cash flows is recorded as revenue and a portion as principal reductions.  Eventually, the entire portfolio is written off under the cost recovery method even if there are still cash flowing assets remaining in the portfolio.

The cost recovery method understates the true value of the consumer receivables as it reduces revenues in the near term as the company recognizes basically no revenue until the entire portfolio has been recovered, defers taxes as a result, and then eventually creates a "zero basis" asset that has no book value but produces cash flows.

Asta experiences considerable revenue from these zero basis portfolios, $36.4 million for the fiscal year ended 9/30/2012.  The revenue received on the zero basis portfolios is surprisingly consistent, clearly showing these assets have considerable value that is not being portrayed on the company's balance sheet.  Calculating the value of the zero basis portfolios is difficult, as the company does not provide much information in any of their filings.  In order to ballpark the amount, I took an quarterly average of the revenue for the last two years, ran that revenue off at 5% per quarter for 3 years (0 revenue after 3 years), took out 40.3% for taxes, and then discounted those cash flows back at a 16% discount rate to be extra conservative.  That comes out to an NPV of $37.4 million that is being carried at zero.

Since the Great Seneca portfolio's debt is non-recourse, let's just assume that the portfolio eventually ends up being put back to BMO, the lender.  Shedding this portfolio on both the asset and liability sides would result in an overall $3,937,000 write-down.  The net effect of these two adjustments (adding the zero basis assets and removing Great Seneca) adds additional $33.4 million to the assets making Asta's current market price look even cheaper when compared to book value.

What is the company doing to close the gap between the market value and instrinist value?  Asta has been repurchasing shares, $16 million worth in the last year most of which came in one block trade with Peters MacGregor Capital Management ($9.4 million, 1 million shares).  Expect Asta to pursue similar private market transactions as the limited trading volume of their stock limits their ability to repurchase shares in the open market legally.  They also announced a fairly insignificant special dividend of $0.08 today, speeding up the 2013 dividend ahead of what is anticipated to be higher taxes on dividends next year.

Additionally, Asta has also started investing in two related businesses, personal injury settlement financing and divorce funding financing:
Management is potentially reaching outside of their circle of competence in these recent new businesses, however both have joint venture partners who are doing the day-to-day managing and high hurdle rates before those partners receive additional returns, the incentives should be aligned for both to be profitable.  Currently they're only a small piece of Asta, accounting for $18.6 million (listed as other investments), or 8% of assets, but these could be potential growth areas if the traditional consumer receivable portfolio business continues to be uneconomic.

Asta Funding isn't an outstanding operator or a franchise company, but it's clearly cheap and the cash position provides a large margin of safety.

Disclosure: I own shares of ASFI

Tuesday, December 11, 2012

Eagle - Unforced Error

I committed the dreaded "unforced error" with the Eagle Hospitality preferreds as the company announced this morning that it had failed in its attempt to sell the 13 hotel properties and had handed over the keys to the Blackstone.

Eagle Hospitality's Secured Lender Takes Ownership of 13 Hotels
Blackstone Adds to Hotel Haul with Eagle Foreclosure

In the press release Eagle states that they will use the remaining funds to wind down the operations and no distributions will be made to the preferred share holders.  Luckily this was only a small and speculative position for me, and with shares trading down 99% this morning I will likely hold my position (may need to sell for tax reasons) to see if any of the large shareholders make a stink about the outcome or there's more disclosure around what assets the company has remaining.  Lesson learned.

Thursday, December 6, 2012

Quick Gramercy Update

Gramercy recently announced the closing of their two previously discussed transactions, one the Indianapolis industrial properties last week and the much larger Bank of America portfolio transaction today.

Gramercy Capital Corp. Announces the Acquisition of a $27.125 Million Industrial Portfolio

Gramercy Capital Corp. Closes the Previously Announced Acquisition of a $485 Million Portfolio in a Joint Venture with Garrison Investment Group

Both transactions closed at nearly the same terms as previously described, which speaks well for management transparency and their ability to meet expectations.  The industrial properties were purchased for cash, but management has discussed the advantage of being able to close with cash quickly and then refinancing once the dust settles, so expect to see a mortgage put on the properties shortly.

However, the closing of these properties doesn't change my valuation of the common shares as Gramercy still needs to increase assets, and thus the equity, to spread their overhead costs across a larger base.  One news item I'm looking forward to is the sale of the CDO equity and management business (hopefully before year end), if the sale brings in a material amount it would improve the outlook by freeing up additional cash for investment without issuing shares and clear most of the complexity in the balance sheet.

Wednesday, November 28, 2012

PICO Holdings

I generally don't invest in capital allocation type holding companies (or closed end funds) as you give portfolio management duties to another party, resulting in exposure to certain asset classes you like, but certain asset classes or business models you'd rather avoid.  From the manager's perspective, these vehicles have the advantage of a permanent capital base allowing the manager to avoid short term market fluctuations and focus on the long term returns.  This lesson was learned by many hedge fund and hedge fund investors during the credit crisis where managers were forced to sell assets, particularly illiquid ones, at almost any price in order to meet investor redemption requests.

While I don't normally invest in these structures, I do find them interesting to track in order to gain manager insights and see what markets others with similar styles see as attractive.  One such company I follow is PICO Holdings (, headed by John Hart since 1996, their strategy is to buy significantly undervalued or "unique" assets and generate superior long-term growth in book value per share.  Since 2007, PICO hasn't met its goal of growth in book-value (see the below screenshot, in thousands), decreasing book value by 32.2% per share.  However, many of the investments the company made recently could be on the cusp of realizing significant profits if the economy continues to recover.

Operating Businesses
PICO Holdings currently has three main operating businesses: water resource and water storage operations (Vidler Water Company), real estate operations (UCP), agribusiness operations (Northstar), and then a sprinkling of other assets including a start-up company and two legacy insurance companies (in discontinued operations below) that were recently sold to White Mountains Insurance Group.

Two of PICO's three operating businesses are heavily levered to a rebound in housing prices, especially to the hard hit states of California, Arizona, and Nevada.  After 6 long years, there are signs of a housing bottom and a sustainable national recovery, as the Case-Shiller index is showing year over year gains and there has been a noticeable reduction in mortgage delinquencies.

Home Prices Rise for the Sixth Straight Month According to the S&P/Case-Shiller Home Price Indices
October Month-End Data Shows Decline in Delinquencies and Foreclosures

Vidler Water Company (Water Resource and Water Storage Operations)
PICO's water resource and storage business, Vidler Water Company, makes up 46% of the company's book value or $220 million.  The company primarily operates in the southwest where population growth rates have exceeded the national averages and water resources are scarcer due to the desert climates.  Vidler generates its revenue by selling water resources for both residential and industrial use, and through water storage.  The development of water assets is a long term process, lasting many years between the acquisition of the asset and the sale.  Since the timing of the water resource asset sales is discretionary, Vidler's revenue is volatile and infrequent.

The demand for water resources are correlated with housing and real estate demand; as new developments are built, developers need to secure adequate water sources to sustain the development.  Vidler has many of their water assets in Arizona and Nevada, two of the hardest his states by the mid-2000s housing bubble.  As a result, new housing developments have been few and far between and the demand for Vidler's water assets shrunk causing write-downs.

Arizona's housing market and economy have clearly been impacted by the housing bubble, but green shoots of recovery are appearing.  Arizona still ranks #7 nationally in population growth, and with 10,000 baby boomers turning 65 each day, the desert climate still remains an appealing retirement destination.

Reno, Nevada is another region where Vidler has large assets, it's housing market also appears to have bottomed out and is showing an improvement of 5.5% year-over-year according to Zillow's local index.  Reno is also particularly attractive to retirees as Nevada does not have state income taxes, which puts it at an advantage over neighbor Lake Tahoe in California.  To the north of Reno, one of Vidler's major assets is a 51% interest in the Fish Springs Ranch project that includes 13,000 acre-feet of permitted water use and a 35 mile pipeline to deliver 8,000 acre-feet annually.  In the aftermath of the housing bubble, PICO took heavy impairment charges against this asset, it's now carried at $84.9 million.  It appears the prospects for this asset have improved since the write-down, John Hart commented in the 2011 annual letter that the carrying value of Fish Springs Ranch is now about 1/3rd of current comparable market transactions.

So while its hard to put a price on the value of the water assets, it appears management has been conservative in taking impairments and several other of Vidler's water assets have been on the books at cost since the late 1990s.  As the southwestern U.S. real estate market continues to improve, so should the value of Vidler's water assets.

UCP (Real Estate Operations)
Their real estate operation, UCP, is possibly the crown-jewel of PICO.  UCP was formed following the housing bubble bursting in 2008, to take advantage of the distressed housing markets in California and Washington.  UCP currently owns 5,268 residential lots in various stages of development, and has also been constructing homes or remodeling existing homes where it sees the opportunity to add additional value.  PICO has invested $134 million dollars in UCP to acquire these lots and has really just begun efforts to monetize this investment as the housing market strengthens.  In the first nine months of 2012, PICO has sold 17 homes for $4.3 million ($254,000 per home) and 224 residential lots for $23.9 million ($107,000 per lot) while achieving a 27% margin on both.

As referenced earlier, the Case-Shiller index is showing signs of a modest national housing recovery.  Additional indicators of a housing recovery include declining inventory levels (especially for entry - level homes), reduced foreclosures (in California, for instance, new foreclosures have fallen to their lowest level since 2007), record low mortgage rates, affordable home prices, and increasing rent costs.  An illiquid investment like thousands of residential lots in the hardest hit housing markets is a perfect investment for a holding company to make as it can afford to wait and be opportunistic in realizing profits.  There are several funds pursuing similar strategies, but none that I know of are currently available to the public, and likely won't be until a housing recovery is more established, and more expensive. 

UCP groups their residential lot holdings into four different geographical regions, each of which is showing signs of improvement in year over year values according to Zillow:

Santa Clara County:
Puget Sound:
Monterey, California (East Garrison):

The East Garrison ( lots are a little different animal as its a master planned community that UCP gained control of in 2009 when it purchased a delinquent note for $22.6 million, and subsequently foreclosed on after the original developer fell into bankruptcy.  As part of the first phase of development, UCP is currently constructing a 66-unit affordable housing project expected to be finished and ready for occupancy by May 2013.  Affordable housing is typically a drag on real estate values in the surrounding areas, but UCP has plans to build another 441 homes as part of phase 1 and 959 more homes as part of phases 2 and 3 with all lots to be sold by 2016 and homes completed by 2021.

With the improved outlook for housing, UCP is stepping up their construction and sale activities.  They currently have 56 completed or under construction homes in California, and it is their intention to start construction on additional 140 homes in California in the next twelve months.  If the housing market continues to show strength, presumably UCP would pick up sales activity to take full advantage.  

A quick valuation exercise, if UCP can continue to average a 27% margin, and sells all of its lots for the 2012 average of $107,000, that's an additional profit of $152 million over time.  As the housing market continues to improve and UCP can add value in the construction of homes (UCP maintains the 27% on finished homes for additional $40,000 per sale), this number could be much higher, but there is the risk of a double dip in housing prices and it will take some time to realize the profits so an appropriate discount rate should be applied.  But it's safe to say that UCP's assets, even conservatively valued, are significantly higher than their carrying value on the balance sheet.

Northstar (Argibusiness Operations)
In 2010, PICO purchased an 88% ownership interest in a new operation, Northstar, which built and now operates a canola seed processing plan strategically located near Hallock, Minnesota (about 150 miles north of Fargo), with approximately one million acres of canola currently planted within a 100 mile radius of the plant.  PICO believes this strategic location will result in cost efficiencies.  Another appealing factor to PICO is the trend toward healthy eating, canola oil contains the least amount of saturated fat of any cooking oil.

Northstar just began operations and has had a troublesome start, resulting in an initial operating loss due to margins that were tighter than projected.  As a result, Northstar has already breached its debt covenants due to ongoing operating losses that the company insists are due to temporary conditions and less than full capacity initial start-up operations.  To solve the covenant failure, PICO will convert their preferred capital position of $10.5 million to equity, and if necessary add additional equity to Northstar.  Either way the lender syndicate hasn't exercised their option to declare a default and PICO believes the failure will be resolved before year end.  Northstar has also taken other actions to mitigate their current struggles, (1) they have entered into fixed margin pricing swap agreements from October 2012 to March 2013 for 67% of the capacity or 19,500 tons per month with ING, and (2) Northstar is reducing their capacity sufficiently to only match their forward sales obligations.

The agricultural industry is not an area where I have much insight or expertise, so I'm open to other's points of view on the canola plant outlook, but in the case of most commodities, it's hard to earn an economic profit over the long term.  But PICO sees more opportunity as they have secured a second processing plant in Enid, Oklahoma, with ground breaking on the plant in the fall of 2013 and completion in 2015 (Northstar Agri Industries Announces Oklahoma Expansion Plan).  The combination of a debt covenant failure and a new plant opening is an odd one, and potentially a major cause for the recent sell off in the stock.

PICO anticipates EBITDA of between $35 and $58 million annually from the Minnesota plant, put a 5 multiple on the low end projection and you come out a value close to the book value.  So the business is pretty conservatively valued and has the potential to be beneficial to shareholders if business operations improve as PICO's management suggests.

Other Investments
In 2008, PICO made a $6 million venture capital investment in internet start up Spigit (after subsequent capital raises, PICO's stake is currently at 28% of the start-up).  Spigit's software platform helps customers with idea generation and social collaboration, it's designed to tap into the collective intelligence of an organization and transform it into actionable, predictive information, crowd sourcing within one's organization essentially.  PICO uses the equity method of accounting for their stake in Spigit as they believe they have significant influence over the operations.  Due to the consistent losses that Spigit has experienced, PICO's balance sheet value of Spigit has been written down to zero.  But how much is Spigit really worth?  In March 2012, Warburg Pincus (with $30 billion under management) led a syndicate of investors in another capital raise (Spigit Closes Series E Financing Led By Warburg Pincus).  As a result of Warburg's $15.2 million additional investment, PICO's stake was reduced from 30% to 28%, which implies a value back in March of $212 million for Spigit (PICO's 28% would be worth $59.5).  This capital raise occured pre-Facebook IPO and following aftermath of other failed social media IPOs, so this could have been a lofty valuation at the time, but any value realization event could be a windfall to PICO's balance sheet.

PICO doesn't break out their holdings in common stocks ($41.6 million) and corporate bonds ($11.4 million), but they describe their holdings as small-capalization value stocks, which is consistent with their overall strategy of buying overlooked and sometimes illiquid investments ($18.8 million of the equities are in OTC stocks). 

PICO also recently freed up some additional cash by selling their two insurance subsidiaries that have been in run-off mode (not writing new insurance contracts) for some time.  Selling the insurance operations frees up $44 million in cash, $28.9 of which was paid to the company in the form of a pre-close dividend.  On November 21, the company announced the closing of the transaction which resulted in the remaining $15.5 being distributed to the holding company.

Insider Ownership
My major concern with PICO is a lack of management ownership, John Hart has a curiously small bi-weekly purchase plan of about 900 shares a pop, and he currently owns 29,954 shares (~$530,000).  A small amount for someone who has been in charge since 1996 and receives a base salary of $2 million per year (plus cost of living adjustments).  If he was a larger shareholder, his incentives would be greater aligned to take actions to push the stock price closer to fair value.

PICO is currently trading at $17.66, about 15% below book value and below it's historical price-to-book ratio.  At current prices it gives an investor the opportunity to purchase assets at a discount that are heavily levered to the ongoing housing recovery. The stock price's recent dip is the result of the poor performance in the Northstar business and the subsequent announcement of a second plant, while it was a disappointment (although maybe a timing issue that will reverse), the real estate assets of PICO and the potential value of Spigit are appealing enough to balance out the underperforming canola business. 

Disclosure: No position in PICO, but may add in the future.

Saturday, November 24, 2012

Be Cautious of BDCs

Everyone should read Jason Zweig's The Intelligent Investor column in the Wall Street Journal, he provides rational and concise investment commentary, this week's article (Should You Bottle Up Your Money in 'Baby Bonds'?) reminded me of my distaste for business development companies, or BDCs, as investment vehicles and how yield chasing investors may not fully understand the risk they're incurring in pursuit of yield.

Most BDCs invest in small and middle market commercial loans, and in some cases equity, to businesses that have trouble raising cash from traditional banks or other lenders.  Similar to REITs, BDCs must pay out 90% of their taxable income to investors and have become popular with retail investors seeking income.

Since BDCs invest in small and up and coming businesses, many people describe BDCs as "private equity" funds for the individual investor.  And like private equity funds, the management company selecting the securities in the portfolio charges an average fee of 2% annually on the assets and then 20% of capital gains above a certain return threshold.  In order to pay out an average yield of 9-11% after expenses, managers have to take additional risks and leverage in order to achieve it, no free lunches.  As an example of how fees eat into potential investor returns, one of the most prominent BDCs, Apollo Investment Corporation has paid the manager an incredible 28% of the revenues in the first 9 months of 2012.  In this low interest rate and yield chasing environment, how are BDCs able to pay the high dividend on top of the high management expenses?

One way is leverage, business development companies have a legal limit to their leverage, they're only allowed to be 2:1 assets to equity.  Leverage was an issue during the credit crisis as many BDCs were hit especially hard, following the recovery many BDCs lowered their leverage significantly, however its been creeping up in the past several quarters signaling that managers are having to increase risk in order to meet investor dividend expectations.  The "Baby Bonds" described in Jason Zweig's article is an example of how some BDCs are getting more creative in their financing and pushing more levers.

Sample list of BDCs as of 11/24
The other way to pay the yield is increasing credit risk.  Due to their similar dividend yield, BDCs get a lot of comparisons to mortgage REITs.  However, a BDC's assets are far riskier than that of the typical mREIT.  An mREIT is essentially a spread game, purchasing long term government guaranteed agency mortgage bonds (zero credit risk) and financing those purchases with the issuance of lower interest rate short term debt (thank you to the Fed's ZIRP), with investors collecting the difference.  BDCs invest in small businesses that are below investment grade and can't get financing through more conventional means, these are highly speculative loans made to shaky companies at credit card like interest rates.  Valuing these securities is also tricky as there's not an active secondary market, for accounting purposes these loans are often considered Level 3 meaning there are unobservable inputs for the asset or liability in the public markets, these assets aren't "marked to market".  Level 3 assets allow management a lot of room in determining the carrying value of an asset, and increasing the risk of fraud (see David Einhorn's book "Fooling Some of the People All of the Time").

Lastly and more for amusement purposes, the chase for yield and the proliferation of new ever more thinly sliced ETFs has brought a 2x leveraged BDC ETN, BDCL, the ETRACS 2x Leveraged Long Wells Fargo Business Develop Company Index distributed by UBS (since it's an ETN, you'd be exposed additionally to the credit risk of UBS).  The advertised leveraged yield is 18.71%, the 2x leverage is on top of the already leveraged underlying BDCs, and the annual ETN tracking fee is an additional 0.85% on top of the high fees of the underlying BDCs, creating an incredible amount of risk and leverage to pay out the sky high yield.

Investors should simply stay away from BDCs, and especially the BDCL.

Tuesday, November 20, 2012

Eagle Hospitality Liquidation

Background Information
Eagle Hospitality Properties Trust ( is a bubble era private equity buyout of a real estate investment trust (REIT) that owns 13 branded hotels (2 Marriott, 1 Hyatt, 8 Embassy Suites, and 2 Hilton) with 3,538 rooms spread throughout the United States and Puerto Rico. Back in 2007, a joint venture of Apollo Real Estate Investment Fund V L.P., Aimbridge Hospitality, L.P., and JF Capital Advisors, LLC purchased Eagle Hospitality for $13.35 per share, or roughly $700 million. At the time, Eagle Hospitality’s preferred shares were not callable and remained outstanding following the closing of the transaction while the common shares were delisted after going private. The timing couldn’t have been worse for transaction as it was done at the top of the cycle shortly before the bursting of the real estate bubble. As a result, starting in December 2008, Eagle Hospitality decided not to pay the preferred dividend due to economic conditions and the resulting impact on the hotel industry.

The joint venture financed the deal with loans provided by Bear Stearns. After Bear Stearns teetered on the brink in the spring of 2008 and was saved by J.P. Morgan, with aid provided by the Federal Reserve, the loans ended up in the Fed’s Maiden Lane I vehicle of assets deemed too toxic by J.P. Morgan.

Current Situation
In March the company approached the Federal Reserve to renegotiate the debt load, but was unsuccessful. As a result this past May, as part of the Federal Reserve's plan to unwind the Maiden Lane transactions, it put the loans issued up for sale. 

The loans, maturing on September 9, included the mortgages on the hotel properties for $348,716,241 and five tranches of mezzanine debt that totaled $253,527, 132 for a grand total of $602,243,373. Blackstone ended up winning the auction, acquiring the debt for $468 million (a 23% discount) utilizing a $350 million loan from J.P. Morgan.

As September 9th passed, Eagle Hospitality was able to convince Blackstone to allow the company to sell its 13 hotels and repay the secured debt at a discount. Brian Kim, a managing director of real estate at Blackstone, said in the below linked article that, "Our view is that the assets did not cover the debt balances... What we decided to do is to give them a (chance to) basically market all of the properties for sale at a minimum price that we would be able to get paid out for a slight discounted par... We basically gave them a price that we were indifferent about between the two outcomes.. If we got taken out at that price, we'd make a very attractive return... Alternatively, we could basically take the assets and do what we do, which is fix problems." That assessment doesn't sound very promising for any of Eagle Hospitality's other stakeholders, however, is it accurate?

Eagle to sell portfolio to pay off Blackstone

Blackstone is likely willing to allow Eagle Hospitality the chance to sell the portfolio because it would still represent an fantastic quick return for their fund and requires less effort on their part not having to operate, or bear the costs involved in selling the assets. If Blackstone accepted a 10% discount to the ~$600 million face (the balances has amortized since the May sale), it would still receive $540 million, subtracting out the $350 million J.P. Morgan loan, and that leaves Blackstone with an approximate $65 million profit (after paying interest expense) on its $114 million equity investment in less than a year with minimal time and effort. 

Eagle Hospitality’s hotels are performing well and have remained current on their mortgage debt, experienced EBITDA growth of 15.9%, growth of revenue per available room (RevPAR) of 7.1%, an average occupancy rate of 75.4%, an average daily rate of $126, and expected 2012 NOI of $45 million. The hotels remain in good condition, as the company hasn't slacked off on capital expenditures, spending $77 million since 2008, or $20k per room. According to the Mid-Year 2012 USRC Hotel Investment Survey, full-service capitalization rates were at 7.9%, down from 8.1% six months ago, but flat to 7.9% twelve months ago, using the 7.9% cap rate and applying it to $45 million NOI would value the portfolio at $570 million ($161k per room). It's hard to get a handle on good comparable transactions, but RLJ Lodging Trust recently purchased an Embassy Suites 20 minutes outside of downtown Boston for $235k per room and a 7.9% cap rate, so discounting the per room value for Eagle's more midwest centric properties makes the valuation seems reasonable.

RLJ Lodging Trust acquires Embassy Suites Boston/Waltham

As a result of the going private transaction, the financials for Eagle Hospitality are not publicly available, however since it has been able to cash flow its debt payments and make significant additional capital expenditures, there's potential for a material amount of cash on the balance sheet available for either recapitalization or distribution after the hotel portfolio is sold and the Blackstone debt is repaid. It's a complete shot in the dark, but I'm going to assume there's at least $25 million in net cash on the balance for valuation purposes.

Very rough liquidation waterfall, but assuming the $570 million portfolio sale price, 10% discount on the Blackstone debt, and the projected NOI and net cash available, I come up with $41.5 million available for the preferred shareholders, or $10.38 per share. I would stress that this is a very rough number and highly sensitive to the assumed sales price which could be too high or too low, even a small change would result in a significant change in the recovery value.


The preferred shareholders do have representation on the Board of Directors by two members of an activist investor, Esopus Creek, which should provide some comfort that interests are aligned and the distribution of proceeds is equitable. But there are lot of unknowns which makes the preferred shares highly speculative and potentially worthless in the event that Eagle is unable to sell the properties for the agreed upon amount and within the time frame stipulated by Blackstone. However, in the event that Eagle Hospitality is forced to turnover the keys there could be enough cash on available for a small recovery for the preferred shares, but without the financials its very difficult to put a floor on the value.

I have a small position in EHPTP, small enough where a total loss would have a minimal impact on my portfolio. In taking a closer look at Eagle, I may have initially underestimated the risks involved, but I'm going to hold my position until a final resolution is reached.

Monday, November 19, 2012

Gramercy 2.0

Summary/Background Information:
Gramercy Capital ( is a commercial mortgage REIT that is undergoing a transformation to become a net lease equity REIT focused on office and industrial properties.  Formed in 2004, Gramercy previously originated and acquired commercial real estate whole loans, mezzanine loans, and commercial mortgage backed securities by utilizing financing through collateralized debt obligations (CDO).  Gramercy issued three CDOs, one each in 2005, 2006, and 2007. Gramercy managed and retained the equity interest in the CDO, thus exposing themselves to the first loss in the collateral pool.  CDOs have an overcollateralization ratio test which measures the assets owned divided by the liabilities issued by the CDO, if the test is breached, excess interest cash flows are diverted from the equity and junior notes to pay down the most senior notes in the structure until the test is cured.  As of 9/30/12, all three of Gramercy’s CDOs are failing their overcollateralization tests and the cash flows are now limited to the senior management fee.

Outside of the CDO management business, Gramercy also has a property management division, named Gramercy Realty, which oversees its small and low-quality owned portfolio of 21 bank branches and 13 office buildings with an occupancy rate of 40.9% as of 9/30/12.  Additionally, Gramercy Realty manages $1.9 billion in real estate assets for KBS Real Estate Investment, Inc. (KBS), as part of a collateral transfer and settlement agreement executed in September 2011 where Gramercy Realty’s prior assets were transferred to KBS for the forgiveness of debt.  The portfolio includes 514 bank branches, 273 office buildings and one land parcel, totaling approximately 20.1 million rentable square feet.  After the settlement agreement, Gramercy Realty was retained to manage the portfolio for a fee of $12 million annually with some additional incentive bonuses.  Going forward, Gramercy is going to use the Realty platform as a launching pad for the net lease business model.

The company's past as a commercial mortgage REIT has been well documented, so I’d like to focus on what the company could be worth going forward with the new net lease equity REIT business model.

Balance Sheet
Gramercy has a strong liquidity position, which is being masked by the GAAP accounting treatment of the equity ownership in the CDOs.  Accounting rules require Gramercy to consolidate the CDOs assets and liabilities on its balance sheet, creating a negative book value due to the assets in the CDOs being marked at less than the CDO debt outstanding.   It also creates the illusion of a highly leveraged company; however all the CDO liabilities are non-recourse to Gramercy, meaning any losses beyond Gramercy’s initial equity investment in the CDOs will be borne by CDO debt holders.  If you remove the CDO consolidation the balance sheet would breakout as below:

Gramercy’s capital structure also includes 3,525,822 Class A preferred shares with a redemption value of $25.00 per share, which earn $0.50781 in dividends quarterly (8.125% annually).  Beginning in the 4th quarter of 2008, Gramercy elected to suspend the preferred dividend payment to maintain liquidity in order to survive the financial crisis, as of the end of Q3 12, the amount due to preferred holders totaled $28.65 million.  Due to the non-payment of preferred dividends for six consecutive quarters, the preferred stockholders exercised their right to elect a board member, William Lenehan, and will continue to have representation on the board until the accrued dividends are current.

New Management & Strategy:
After considering strategic alternatives, including an outright sale of the company, Gramercy decided to stay an independent company and in July 2012, the Board of Directors hired a new management team to transform the existing public entity into a net lease equity REIT. In a triple-net lease, the tenant is typically responsible for all improvements and is contractually obligated to pay all property operating expenses, such as real estate taxes, insurance premiums and repair and maintenance costs.  Gordon DuGan was brought in as CEO, he spent over 20 years at real estate firm W.P. Carey & Co (NYSE: WPC) where as CEO he oversaw the growth of the company’s assets from $2.5 to $10 billion.  One concern is how he abruptly resigned from W.P. Carey in 2010 because of a disagreement with the founder and chairman (  But on the plus side, under his leadership Gramercy is resuming quarterly conference calls which were absent the last couple of years.

Gramercy’s new stated strategy is to focus on industrial and office properties in top 50 markets with an average lease term of more than 10 years.  Gramercy plans to use leverage of approximately 50%, utilizing primarily fixed-rate non-recourse debt with an expected borrowing rate between 3.0% and 4.75%.  By targeting cap rates of 7.5% to 9.0% and 1:1 leverage, Gramercy expects to earn an ROE in the 12%-15% range.

Insider Purchases
As a show of commitment to the new business strategy, Mr. DuGan purchased 1,000,000 shares of common stock at $2.52 per share directly from the company (not in the secondary market) before taking his post as CEO.  He’s not the only insider showing confidence with their wallet, new president Benjamin Harris also made an open market purchase of 40,000 shares at $2.64 a share on 8/27 and preferred share director William Lenehan purchased 20,000 common shares at $2.62 a share on 8/24.  With his interests aligned with the preferred shareholders it’s interesting to see Mr. Lenehan purchasing the common shares, it makes the investment case even stronger that the accrued preferred dividend will be paid before too long.

MG&A Costs
One of the new management’s goals is to reduce the cost structure of Gramercy; the net-leased business by nature should be a low overhead operating model.  A lot of the cost baked into Gramercy lies in the CDO management business, Gramercy Finance, which employs 25 people and experiences a lot of the professional fees associated with managing distressed assets.  Gramercy communicated in their September investor call that the goal SG&A run rate is below $20 million, which still seems high in comparison to their size.  Hopefully as the asset base grows, the expenses come more in line with peers.

Bank of America Portfolio Transaction
Management has gotten off to a quick start in deploying Gramercy’s free cash into the new investment strategy.  They started off on 8/21 by entering into a joint venture with Garrison Investment Group to purchase a portfolio of office buildings and bank branches which had previously been apart of Gramercy Realty and are currently in the KBS Portfolio that Gramercy already manages.  The portfolio consists of 5.6 million square feet of which approximately 81% is leased to Bank of America, N.A. for a term ending in June 2023.  The projected 2012 net operating income for the portfolio is approximately $41.5 million.  Gramercy will also manage the portfolio and earn a management fee of about $1 million from the joint venture, although that’s less than the agreed decrease in the management fee of the KBS portfolio from $12 million annually to $9 million on the remaining KBS portfolio.

At the deal closing, the joint venture will sell two large office buildings in Chicago and Charlotte for $135 million, bringing down the total purchase price to $350 million.  Additionally, management has a plan to sell 45 non-core and primarily multi-tenant properties to “more active investors” in the next twelve months for an estimated $350 million, leaving the joint venture with a portfolio of core properties primarily leased to Bank of America, N.A.

To fund the purchase, Gramercy will use $60 million of its cash position and issue $15 million worth of common stock to KBS (6 million shares at $2.50 per share, no transaction fees).  The common stock issuance is a little puzzling as management is issuing cheap shares (expensive funding) when it has plenty of available cash on the balance sheet.  Potentially KBS knows the Bank of America Portfolio is an attractive asset and negotiated receiving equity in exchange for slightly more favorable terms.  Garrison will also kick in $75 million in equity, and then the joint venture has secured a $200 million loan from a major bank.

Industrial Property Acquisitions
Gramercy also recently announced it has entered into a contract to purchase two Class A industrial buildings in Indianapolis leased to three tenants for an average weighted lease term of 10+ years.  Details provided so far have been light but management provided the below in a recent investor presentation:

Another transaction that appears more preliminary was announced in the third quarter results press release.  Gramercy entered into a letter of intent to buy an industrial building portfolio totaling 1 million square feet with a cap rate in excess of 8.5%.

After the closing of the three transactions, Gramercy provided the below data for what the asset composition will look like at year end:

After the closing of the three transactions, based on the approve purchase price and leverage, Gramercy will be left with available free cash of $73.95MM.  The company also has additional assets that are up for sale or can be sold and used to buy additional net lease portfolios.

CDO Management Sale
Gramercy has hired Wells Fargo as an advisor to sell the CDO management business and the CDO equity.  All three CDOs are failing their overcollateralization tests and it is likely that they will for the foreseeable future.  However, that doesn’t mean the equity pieces are worthless, with a long-term horizon and an active management approach a manager could eventually end up extracting value from the CDOs.  On the 3rd quarter conference call, Gordon DeGan commented, “Our hope is the transaction will be completed this year and I think that the investors will be pleased with the results of that transaction.”  While the CDO/CLO market is making a surprising comeback, it's still advisable to temper expectations and assume the sale will bring in a non-material amount.

The non-accounting reporting benefits to selling the CDO business includes reducing overhead costs and freeing up cash advances made to the CDOs.  The current servicing advances to the CDOs total $10.2 million as of the end of the 3rd quarter, which should be freed as a result of the CDO business sale and become available for investment in the new strategy.

KBS Mezzanine Loan
As part of the KBS/Bank of America Portfolio transaction, Gramercy invested $19 million in the origination of a mezzanine loan to KBS which KBS will pay off with the proceeds of the Bank of America Portfolio closing.  The loan included a 1% origination fee and accrues interest at 10% annually, creating a quick but compelling IRR profit if the Bank of America Portfolio closes as expected in the 4th quarter.  The repayment of the loan will also increase the available cash proceeds for investment.

CDO Senior Bonds
Gramercy holds some senior bonds that were previously issued by their CDOs but were repurchased by the company, these bonds are consolidated and cancelled on the balance sheet, but they have a face value of $45.4 million with a fair market value of $36.2 million.  Gramercy previously had purchased junior notes at a discount in order to cancel them to prevent the overcollateralization tests from failing and to keep the equity payment turned on.  However the CDO bonds currently held are high in the capital structure of each CDO (Class A-1, A-2, and B) and wouldn’t have a material impact on the overcollateralization tests if cancelled as you get more bang for your buck lower in the capital structure. 

Due to GAAP accounting rules, these holdings are consolidated on the balance sheet and are essentially cancelled out.  Once management has invested the available cash, they have indicated they would look to sell the CDO bonds in order to continue investing in net leased properties until fully ramped.

Available Liquidity
If you conservatively assume that Gramercy will get the $10.2 million in servicing advances out of the CDOs, receives full payment of the $19 million KBS loan, and is able to sell the CDO bonds for $36.2 million, that frees up an additional $65.2 million in cash for a total of $139.35 million in available funds to purchase more net-leased assets, with upside pending the CDO business sale.

At current prices the market is valuing the common shares at about investable cash (including the additional liquidity items mentioned above) subtracting out the preferred shares, almost like a blank check IPO.  Equity REITs typically are valued on a multiple of funds from operations (FFO), which is calculated by adding depreciation and amortization expenses to earnings, instead of earnings.  Management has declined to provide any FFO guidance, so in order to attempt to put a value on the new Gramercy model; I’ve attempted to project what the normalized FFO could be given the money available for investment.

Using the numbers provided by management of what the portfolio will look like on 12/31/12, and then assuming the remaining $139.35 million (including the CDO servicing advances, CDO bonds, and KBS loan) is invested in similar fashion I come up with the below via a back of the envelope income statement:

This doesn’t include the value of any of the legacy owned properties or any cash that comes out of the sale of the company’s CDOs and CDO management business.

Comparable NNN REITS

Realty Income (O) and National Retail Properties (NNN) are not great comparables since they are primarily focused on the retail market and trade at high valuations due to their long track record of dividends, dividend increases, perceived quality, and the rush into yield in the zero rate investment environment.  In terms of assets and quality, CapLease (LSE) and Lexington Realty Trust (LXP) are better comparables for Gramercy, averaging the two Price/FFO ratios equals an 8 multiple, leading to a value of ~$3.20 for Gramercy’s common shares, with the potential upside in time to trade closer to a 13.2 multiple of the average net lease REIT.  It should be noted that each of these comparables is much larger than the projected Gramercy and can spread their costs over a much larger asset base, so as Gramercy adds assets using equity issuances the increased scale should be accretive to future FFO.

Most net lease REITs are highly diversified across tenants and industries, Gramercy will start out with its largest pool of properties highly primarily leased to Bank of America, N.A.  Bank of America is still in the midst of their own turnaround and reorganization strategy to sell non-core assets, shrink the business, and cut costs in the aftermath of the financial crisis.  While Gramercy management stresses that these properties are critical to Bank of America’s operations, it’s still worth noting and monitoring.  As management deploys more cash into net lease assets, it will be important to increase the number of tenants in order to reduce credit risk to any one entity.

Management’s decision to issue shares as part of the Bank of America Portfolio purchase when it has plenty of available cash is concerning, one of the new goals is also to “expand the equity base” of the company which foreshadows additional equity raises in the near future.  Gramercy should wait until its shares are trading more in line with net-leased peers to avoid issuing additional undervalued shares.  However, even fully invested, Gramercy would be one of the smallest publicly traded net leased REIT and it will be necessary to issue additional equity in order to gain scale and spread the management costs over a wider asset basis.

Old Gramercy didn’t have a natural long-term buyer; it’s a non-dividend paying mortgage REIT with a negative book value.  So yield investors aren’t interested, and with a shareholder deficit it doesn’t show up on many screens utilized by value investors.  By reshaping the company as a net-leased REIT, Gramercy will have two main catalysts to unlock value: (1) the sale of the CDO business to allow for the balance sheet to be easier to understand and (2) the payment of a dividend after the investment of the free cash in income producing net leased assets.

Management has hinted that the CDO business could be sold as early as the end of the year.  Mr. DuGan said on the recent conference call that the fourth quarter would be a “watershed quarter in terms of transition” for Gramercy, presumably he means shedding this legacy business in order to fully focus efforts on the net-lease space.   If the CDOs and CDO management business bring in a material amount in the sale, that could provide more upside to the share price.

The timing of the dividend is a little more uncertain, while management has expressed that they intend to pay a dividend and remain a REIT, its difficult to project exactly when that will happen.   Management has stated their philosophy is to pay dividends out of “recurring cash flows”, so only once the available cash is invested in the new strategy and those investments start to cash flow the dividend payments will be turned back on to investors.  The preferred shares have accrued $28.6 million up to this point (still accruing $1.8 million per quarter), and based on my projections of FFO, it could still be another 18 months until the preferred dividend is paid in full.

The preferred shares still offer a compelling investment opportunity; currently trading at $30.00 the preferred shares offer a 10.8% discount to the fully accrued dividend and $25 redemption value ($33.63 as of the most recent missed dividend date).   The preferred shares are well covered by the assets and cash on the balance sheet, and management has signaled repeatedly that they intend to pay the dividend once the new strategy is up and running, it continues to accrue 6.8% in yield off of the current market price, creating an attractive risk/reward opportunity in a low return environment.

At current prices, the common shares sell for near cash, creating a margin of safety.  Once the business is simplified and the dividends are turned back on, the shares should trade up more inline with the net lease peers in time, but it will test the patience of current shareholders who have already been waiting quite some time for the turnaround to materialize.

Disclosure: I own both GKK and GKK-A.