Thursday, January 31, 2013

Gramercy Sells CDO Management Business

Gramercy Capital has been on quite a run lately (22% YTD) as it continues its transformation into a net-lease equity REIT.  After the close today, Gramercy announced they sold the CDO management business to CWCapital for $9.9 million plus freeing capital that was tied up in the CDOs:

Gramercy will continue to hold the equity tranche of each CDO, which are probably worthless but potentially have some optionality value if the commercial real estate continues to improve.  While retaining the equity tranches is likely the right thing to do long term (free option), it means the CDOs will still be consolidated on the balance sheet creating negative shareholder's equity.  I'd probably trade the CDO equity for a clean balance sheet that more investors are able to understand.

Even with an additional $56 million in liquidity, Gramercy will still need to raise additional equity to fully becoming a performing REIT again and reinstate the dividend, but at least with the recent runup, they won't be issuing equity quite as cheap.

Disclosure: I own shares of GKK and GKK-A

UPDATE (2/6/13): I heard back from Investor Relations that "at settlement, we expect to deconsolidate."  Great news, Gramercy will have a clean balance sheet making the company easier to understand for investors and get to retain the potential upside of the CDO equity, however small that might be.

Saturday, January 26, 2013


After years of being shunned, suddenly stocks are a hot asset class again with the Wilshire 5000 index (broad total market index) hitting a new all time on January 24, 2013.  Will retail investors finally return to the market?  What companies may profit from a broad shift from bonds back into stocks?

One such company is FRMO Corp, an "intellectual capital" firm headed by Steven Bregman and Murray Stahl of Horizon Kinetics fame.  FRMO can be thought of has having two sleeves, one sleeve includes various investment product revenue streams and a 0.87% interest in Horizon Kinetics, which is an investment boutique formed in 2011 through a combination of Horizon Asset Management and Kinetics Asset Management.  The second sleeve is cash and securities managed by Bregman and Stahl, including investments in several of the hedge funds managed by Horizon Kinetics.  FRMO's book value per share has grown at an incredible pace, starting at just under $50k in 2001 and as of 11/30/12 it stands at $58.3 million.

2011 Shareholder Letter
Horizon Kinetics
Back in February 2002, FRMO acquired a 8.4% interest in Kinetics Advisers for 315 shares of FRMO stock, then valued at $204.75, clearly an incredible investment for FRMO.  Today, Horizon Kinetics is a private investment company that manages roughly $7 billion in a variety of separately managed accounts, mutual funds, and alternative investments.  It manages primarily equity based portfolios that have faced constant redemption pressure across the entire industry for the past several years as investors have fled equities (and in particular active managers) for bonds and alternative investments.  While its nearly impossible to know when the bond "bubble" will end, at some point interest rates will rise causing bond prices to fall.  Pension funds who have return targets are unlikely to meet their objectives given the low return potential of bonds, while bonds prices might not crash, they won't earn what they have in the recent past likely pushing investors into riskier asset classes.

Several of the "Bond Kings" have recognized the potential shift into equities broadly and have begun opening up equity strategies: U.S. Bond Stars Bet Big on Equities Revival.  One change Kinetics Funds (Horizon Kinetics' mutual fund arm) recently made was to adjust the strategy of their Water Infrastructure Portfolio into an alternative fund strategy that tries to create bond like returns and volatility with stocks and stock options, the new fund is called Alternative Income Fund.  Horizon Kinetics hopes the fund will become popular with current bond investors as they realize past returns are no longer achievable in the current bond market.

Below is a breakdown of the firm's current AUM.  However, not all AUM is created equal, for instance alternative investments while a small piece of AUM contribute a disproportionate amount of the revenue in Horizon Kinetics compared to rather vanilla separately managed accounts that charge lower fees.

FRMO Q1 '13 Earnings Transcript

Many of FRMO's intellectual capital consultancy and revenue sharing agreements are based on the assets under management.  Below is what FRMO provided in their Q1 '13 earnings call transcript to provide a little more color on the portfolios:
FRMO Q1 '13 Earnings Transcript
For example, one of FRMO's revenue streams is a 20% interest in all the management and performance fees of Horizon Multi-Disciplinary Fund.  The Multi-Disciplinary Fund's strategy involves selling six month at-the-money put options on equities that they would otherwise be comfortable holding.  It only takes a little success and investor recognition for assets to multiple rapidly off of a small base generating revenue for FRMO.

Another one of their revenue streams could be on the verge of improving.  As mentioned on the latest conference call,  the Horizon Global Advisers Multi-Strategy Fund which founded in 2007, right before the credit crisis and at one point dropped 70% from peak to trough.  However instead of closing the fund, the managers stuck with it despite needing to return 400% in order to earn performance management fees above the high water mark.  Well as of this past weekend, the Multi-Strategy Fund finally crossed that high water mark and FRMO could potentially start earning a incentive performance management fee going forward in addition to the percent of assets management fee.  FRMO also has $5.2 million invested in the Multi-Strategy Fund, so they continue to benefit from the turnaround from an investor perspective too.  Management also noted similar circumstance at Polestar where it has recently cross the high water mark and will start earning performance fees.

Unique Business Structure
The beauty of FRMO's structure is the revenue streams are like royalties in there are no associated operating costs.  By nature, the intellectual capital business doesn't have operational costs as the costs are borne by the entity that FRMO is advising.  The level of business activity can thus be increased without the creation of expenses.  Bregman and Stahl have been successful in purchasing these interests before they are proven successful, and thus are generally inexpensive to the point where failures should not meaningfully harm the company.  Should such an investment prove successful, as the initial Kinetics Advisors interest was, the returns could be many multiples of the original investment.

FRMO also has no paid employees (the entry on the income statement is non-cash for audit reasons) and from the sounds of it, they don't intend to as long as they maintain the current structure, pretty shareholder friendly considering how much value management has created.

FRMO has $21.7 million in cash and below are their disclosed investments in limited partnerships, and their bond and equity securities.  It's difficult to find information on the hedge fund strategies, but both Bergman and Stahl are related to the two main holdings, Horizon Multi-Strategy Fund and Polestar Fund.  I tend to be skeptical of hedge funds and their ability to generate alpha due to high costs, but since FRMO is entitled to a portion of the management fees, the costs of FRMO's investments are essentially slightly subsidized as a result.
FRMO Q2 '13 10-Q

Shareholders equity is at an all time high of $58.3 million as of November 30, 2012 and virtually no real debt, the liabilities on the balance sheet mostly represent deferred taxes due to their investment holdings and their portfolio of securities they've sold short.  

The question of valuation for FRMO comes down to how you value the intellectual capital side of the business.  Backing out the book value of the cash, securities, and other investments, the market is valuing the intellectual capital side at $23.87 million.  Seems reasonable, but hard to really judge with the limited information and reporting that FRMO currently provides.

Potential Catalysts
FRMO has recently made efforts to increase its visibility with investors by holding very candid quarterly investor calls where they specifically make an effort not just to read the quarterly earnings report.  FRMO will also soon be eligible to start filing with the SEC again following two years after their reverse-forward split and the switch to the cost method of accounting of Horizon Kinetics after the merger.  Filing with the SEC will allow FRMO to leave the OTC Markets and once again list on a national exchange, opening FRMO up to a new investor base.

Additionally, FRMO is also exploring transactions that would add an operating business within the context of FRMO to provide cash flow for investments.  Management has stated that they are actively exploring such transactions, so something could be on the horizon in the near future.

FRMO is a unique company that is difficult to peg an intrinsic value, but you can't argue with the record of Bregman and Stahl as capital allocators.  I believe we could be on the cusp of a big shift into equities, and FRMO is well positioned to capture that trend.  I'm in the midst of selling a few legacy positions as their stories are playing out, so I'll likely allocate some of that raised cash to FRMO shortly.

Disclosure: No Position

Monday, January 21, 2013

Silver Bay Realty Trust

The Great Recession created many interesting investment opportunities in the financial and real estate sectors.  One market that's been off limits to public REIT investors until recently has been the single family home rental sector.  Historically this market has been limited to local landlords as its questionable if economies of scale exist or are translatable to a national REIT.

Silver Bay Realty Trust is a REIT recently formed to acquire, renovate and lease out single family homes with an eye towards dividends first and capital appreciation second.  It was formed in December 2012 as a partial spin-off of single family homes from Two Harbors Investment Corp (TWO), a mortgage REIT managed by Pine River, and a portfolio of single family homes from Provident, a private equity real estate fund.  The new portfolio will be managed by PRCM Real Estate Advisors, a joint venture between the two management companies.  Below is the new corporate structure:

The company at the time of formation has 2,548 single family homes (1,660 contributed by Two Harbors and 880 by Provident) located in the target markets of Phoenix, Tampa, Atlanta, Las Vegas, Tucson, Orlando, Northern and Southern California, Charlotte, and Dallas.  Each of these markets has a positive long-term trend of being located in desirable and growing locations away from the midwest and rust belt.  The company's portfolio is pretty new, with only 881 (or 34.5%) of their homes being owned for over 6 months, their general timetable to renovate and stabilize a rental asset.  Of the homes that have been owned for more than 6 months, 91% of them are occupied for an average rent of $1,126.  Costs at this point are pretty difficult to forecast, but the company estimates all property related expenses (vacancy, bad debt, property taxes, insurance, HOA, repairs and maintenance, and capital expenditures) will average 40-50% of rental revenues.  Silver Bay also has plenty of liquidity as it has $229.1 million in cash and no debt (all the homes are owned free and clear).

Its clear based on the current cost structure and pro-forma income statement laid out in the prospectus that Silver Bay will need to ramp up pretty quickly due to overhead costs at the corporate level.  The company is doing just that by completing most of their asset purchases through bank foreclosure auctions, many of these properties are likely very distressed and require a lot of work before becoming a performing rental, the company is current pegging those renovation costs at 10-15% of the acquisition costs.

From SBY's S-11
But the opportunity to acquire foreclosures is probably worth the renovation costs as these are exactly the kind of distressed properties that have the chance to achieve capital appreciation as the housing market continues to recover, housing inventories normalize, and family formations return to normal.

As for the potential rental revenues and potential dividend estimates, here's my extremely rough back of the envelope calculation:
  • 2, 548 homes at $1,126 per month with 91% occupancy = $31.3 million
  • $231 million in excess cash could purchase an additional 1,900 homes (at the current average of $121k per home), assuming rents remain constant, rental income = $23.4 million, for a total of $54.7 million
  • Estimated property expenses are 40-50% of rents, so at 50%, rental income = $27.35 million, or $0.74 per share (37MM shares), that doesn't include the management fee or any first year extraordinary costs.
Assuming a normalized distribution of about $0.60 per share, and an 5% required yield, that would put the price at $12.00 per share, well below the current market price of $21.22.  This is a rough number and doesn't account for any added leverage Silver Bay might apply or any secondary offerings they might do to spread the costs over a larger asset base, but I think it's clear that shares aren't cheap at the current price.

I have a few other concerns besides the valuation, the one clear negative is the management cost structure, PRCM is due 1.5% annually of the total market capitalization.  Basing the fee off of market capitalization will encourage the firm to engage in secondary offerings, and as the stock price increases the profitability will decrease, an odd combination.  Also, if I were purchasing distressed properties for my own portfolio, part of my strategy would be to renovate and rent out the home until prices recovered, then harvest the gains and sell.  However, as part of the management and compensation structure, it appears Silver Bay would likely hold on to the rentals for the long term and realize those gains through rent increases.  I would prefer to see it structured more as a liquidating trust, over time working the portfolio down to zero, but that structure is more suited for a private fund.  I also have a bias against IPOs, the company is still too new and untested, the asset class seems like a difficult one to achieve national economies of scale, especially if operating the properties over the long-term.

While I don't think I'll get the opportunity to invest in Silver Bay at what I believe to be a reasonable price, its still an interesting company to monitor in case they have a temporary slip-up and the market overreacts.  I do believe there are substantial opportunities in single family homes, but its probably better suited to a different structure.

Disclosure:  No position

Friday, January 18, 2013

AIG: "Bring on Tomorrow"

I was initially attracted to AIG because of the presence of a forced seller, the U.S. Treasury.  However, now most of AIG’s short-term catalysts have come to fruition in the last month and a half, including selling 80% of their airplane leasing business (ILFC) to a Chinese consortium, the Treasury selling their remaining equity stake for $7.6 billion, and selling the remaining stake in AIA for $6.45 billion.  They’ve also rebranded their Life Insurance & Retirement and Property & Casualty Insurance businesses back to AIG (from SunAmerica and Chartis respectively) and launched a prolific advertising campaign thanking America for the bailout.  Going forward AIG represents more of a post-reorganization that needs to execute the new business model for a period of time before investors will trust it again and revalue it alongside peers.

So the investment thesis for AIG is fairly simple, it trades at roughly half of book value and expects to earn 10% ROE by 2015.  If AIG is able to grow book value at 10% over the next 5 years and the valuation gap between market value and book value converges during that time, it implies a ~26% annualized return (or over 3 times the current price).  AIG has been accelerating the book value growth through buybacks recently, however these are likely to slow in the near term as the company is switching its focus to improving the company’s interest coverage ratio, by repurchasing or retiring outstanding debt.  A simpler capital structure should reduce interest expense, improve credit ratings, and reduce the overall cost of capital, all positives.  AIG has also mentioned its intention of paying a dividend in 2013, opening it to more income based managers.

There are two large risks in my mind, the first is the overheated bond market which is the primary asset class owned by AIG.  Interest rates are low, and insurance companies are leveraged due to their float, rising interest rates could be a double edged sword.  Rising interest rates will increase earnings on the float in the long term, but also put pressure on bond prices in the short term, so AIG will have to manage its duration and continue to diversify into other assets.

Secondly there is the regulatory overhang.  AIG is expected to receive designation as a non-bank systemically important financial institution (SIFI) in 2013.  If AIG is designated as a SIFI, it will be required to carry additional capital above other insurers, hampering their profitability and balance sheet flexibility to return cash to shareholders.

Robert Benmosche, CEO of AIG, should be congratulated for the job management’s done restructuring the company since the bailout.  As the business plan is executed and AIG repairs its image with the public, the shares should overtime move closer to book value resulting in a tremendous opportunity for the patient long term investor.

Disclosure: I own shares in AIG, another way to play this story is through the warrants

Saturday, January 12, 2013

Subcontinent Consumer with a Margin of Safety

I recently attended a McKinsey & Company presentation on the "Five Global Forces of Innovation" that will drive the global economy for the next several decades.  One of the five forces is what they call "the great rebalancing", essentially how the emerging economies will catch up to developed economies, especially with respect to the creation of a consumer driven middle class.  This isn't a new or groundbreaking concept, as it's been forecasted for many years, however it's a great long-term trend to keep in mind when searching for investing opportunities.

With that backdrop in mind, Retail Holdings NV ("ReHo") presents a compelling emerging market investment opportunity with a reasonable margin of safety and a potential liquidation catalyst.  Retail Holdings NV is a holding company incorporated in Curacao with no operating activities and three main assets:
  1. 56.13% equity interest in Singer Asia Limited
  2. Seller notes, arising from the sale of the Singer worldwide sewing business and trademark in 2004
  3. Cash and cash equivalents at the holding company level with no external debt outstanding
Below is an excerpt from the 2011 Annual Report which outlines how the management thinks of the value of Retail Holdings:
"The Company's net asset value at December 21, 2011, attributable to ReHo Shareholders, was $87.6 million, equivalent to $16.51 per Share outstanding.  This essentially reflects the book value of the Company's investment in Singer Asia, the notional amount of the SVP Notes and the cash at the ReHo holding companies.  Using the $157.1 million Market Valuation for Singer Asia attributable to the ReHo shareholders, the $26.8 million notional value amount of the SVP Notes, and the $2.9 million in cash at the ReHo holding companies, the corresponding figure would be approximately $186.8 million, equivalent to $35.20 per Share.  There can be no assurance that the Company's shareholders will ever realize either the $16.51 per Share or the $35.20 per Share amounts given the substantial contingencies and uncertainties"
With that valuation framework, I'll dive a little deeper into Singer Asia and the SVP Notes.

Singer Asia Limited
Retail Holdings' main asset is a 56.13% equity stake in Singer Asia Limited.  Singer Asia Limited has ownership stakes in 5 separate publicly traded consumer durable product companies located in Bangladesh, India, Pakistan, Sri Lanka, and Thailand.  The Singer brand name is most highly associated with sewing machines, and in 2004 Retail Holdings sold the trademark and sewing machine business to SVP (fka KSIN Holdings), more on this transaction later.  Singer Asia, through its subsidiaries, now is a premier seller of consumer products (think washing machines, refrigerators, televisions) for the home, and as the emerging middle class continues to desire home conveniences of developed market consumers, Singer should be positioned capture a good amount of this long-term growth trend.  

Singer Asia's major subsidiaries are all publicly traded in their respective countries, providing easy assistance in valuing each:

The value to Singer Asia comes out to $240.55 million, with Retail Holding's 56.13% ownership of Singer Asia coming out to $135.02 million (or more than 20% above the current market capitalization alone).  In a sense the value of these underlying publicly traded companies is hidden like a Russian nested doll, with the 5 publicly traded companies partially nested within Singer Asia, and then Singer Asia partially nested with Retail Holdings. 

SVP Notes
In September 2004, Retail Holdings sold the Singer sewing business and trademark to SVP Holdings ("SVP", fka KSIN Holdings) for $65.1 million in cash, and $22.5 million of unsecured notes ("SVP Notes") which it still holds.  The question is how much are the SVP Notes currently worth?

During the 2008 bear market, SVP's operations were negatively impacted by the economic downturn resulting in an Event of Default in October 2009.  SVP cured the Event of Default in May 2010, and is now current on the notes.  As a result of the default, the interest rate on the notes increased from 10.0% to 12.0%, with minimum cash interest payments of 7% with the remaining being capitalized.  SVP has elected to pay these minimum cash interest payments since the Event of Default, and has capitalized the remainder.  These notes are clearly still distressed and unlikely to be equal to par.

In the June 30th semi-annual report, Retail Holdings disclosed they had made the following transaction with SVP:
"In June 2012, as part of an increase and extension of the financing facilities at SVP, ReHo agreed to extend the maturity of the SVP Notes from February 2014 to September 2018.  The interest rate on the SVP Notes remains at 12% with a minimum cash interest payment of 7% of the outstanding principal.  Concurrent with the refinancing, SVP made a cash payment to ReHo of USD 5,000 thousand in consideration of a reduction in the principal amount of the SVP Notes by USD 5,882 thousand, representing a 15% discount to notional value."
This transaction reduced the principal value of the remaining SVP notes to $21.598 million.  While extending the maturity hopefully gives SVP enough runway to eventually make good on the entire amount, the 15% discount is a reasonable benchmark of the current value of the SVP notes.  

Adding together Retail Holdings three primary assets:
  1. Singer Asia Limited = $135.02 million
  2. SVP Notes (discounted 15%) = $18.36 million
  3. Cash at the holding company level = $9.8 million (per the June 30, 2012 report)
Totaling three up yields an NAV of $163.18 million (or $30.74 per share), representing a 31% discount to the current market capitalization of $112.38 million.  

Medium-Term Liquidation 
If the discount to NAV and long term trend of the emerging middle class aren't enough, there's also the potential hard catalyst of the liquidation of the company.
"ReHo's strategy is to maximize and monetize the value of its assets, with the medium-term objective of liquidating the Company and distributing the resulting funds and any remaining assets to its shareholders."
Besides owning roughly 25% of the shares outstanding, CEO Stephan Goodman also has a special bonus in place to liquidate the company:
"ReHo has put in place a special bonus program for the Company's Chief Executive Officer which provides a cash award following the liquidation, dilution, wind-up, merger or sale of the Company, in the event that aggregate dividends and distributions to shareholders, including any final dividend or distribution, exceed a certain threshold amount."
Retail Holdings has economic trends at its back, a significant discount to NAV, and a potential value realization catalyst of a liquidation.  What's not to like?

Disclosure:  No current position, but will likely add shortly.

Thursday, January 10, 2013

Howard Marks' Latest Memo

I admire Howard Marks' ability to articulate and rationally take the market's temperature; it's always important to know about where in the cycle we are and whether investor sentiment is getting ahead of itself.  Most of his latest memo (a great read as always) is focused on the cycle in relation to the credit markets, where it's clear that we're far closer to a top than a bottom, so caution is definitely warranted for anyone adding to a fixed-income position (especially high-yield, or long term bonds).

The other aspect of Marks' memo I found incredibly insightful was his discussion on investment risk (starting on page 3, his emphasis):

Much (perhaps most) of the risk in investing comes not from the companies, institutions or securities involved.  It comes from the behavior of investors.  Back in the dark ages of investing, people connected investment safety with high-quality assets and risk with low-quality assets.  Bonds were assumed to be safer than stocks.  Stocks of leading companies were considered safer than stocks of lesser companies.  Gilt-edge or investment grade bonds were considered safe and speculative grade bonds were considered risky.  I'll never forget Moody's definition of a B-rated bond: "fails to possess the characteristics of a desirable investment."
All of these propositions were accepted at face value.  But they often failed to hold up.
  • When I joined First National City Bank in the late 1960s, the bank built its investment approach around the "Nifty Fifty."  These were considered to be the fifty best and fastest growing companies in America.  Most of them turned out to be great companies... just not great investments.  In the early 1970s their p/e ratios went from 80 or 90 to 8 or 9, and investors in these top-quality companies lost roughly 90% of their money.
  • Then, in 1978, I was asked to start a fund to invest in high yield bonds.  They were commonly called "junk bonds," but a few investors invested nevertheless, lured by their high interest rates.  Anyone who put $1 into the high yield index at the end of 1979 would have more than $23 today, and they were never in the red.
Let's think about that.  You can invest in the best companies in America and have a bad experience, or you can invest in the worst companies in America and have a good experience.  So the lesson is clear: it's not asset quality that determines investment risk.
The precariousness of the Nifty Fifty in 1969 - and the safety of high yield bonds in 1978 - stemmed from how they were priced.  A too-high price can make something risky, whereas a too-low price can make it safe.  Price isn't the only factor in play, of course.  Deterioration of an asset can cause a loss, as can its failure to produce profits as expected.  But, all other things being equal, the price of an asset is the principal determinant of its riskiness.
The bottom line on this simple.  No asset is so good that it can't be bid up to the point where it's overpriced and thus dangerous.  And few assets are so bad that they can't become underpriced and thus safe (not to mention potentially lucrative).
Perfectly stated, this is an important concept as an investor needs to determine when the price of a security is materially out of line with the intrinsic value of the company, many times this is due to irrational investor sentiment.