Thursday, February 28, 2013

REITs are Overvalued

It seems like the Federal Reserve's zero interest rate policy (ZIRP) is having its intended effects all across the market with investors being forced to replace traditional income producing assets, such as treasuries and investment grade bonds, with riskier substitutes like REITs, BDCs, and junk bonds.  Risk averse investors sure have short memories as all three asset classes were hit particularly hard during the 2008-2009 credit crisis, however, as Howard Marks has been saying recently, they may not have any other alternative and are becoming essentially forced buyers.  Whereas forced sellers tend to create the best buying opportunities (see AIG), forced buyers are just the opposite, they distort the market and end up overpaying for certain assets, REITs in particular being one.

REITs (real estate investment trusts) are corporations that specialize in real estate based activities, and by electing to be a REIT, can avoid federal income tax as long as they pay out 90% of their taxable income to investors.  REITs are a popular way for retail investors to gain exposure to commercial real estate investments they would otherwise be restricted from due to vast funds needed to build a diversified portfolio of assets.  Publicly traded REITs also give the added benefit of liquidity that owning a strip mall outright wouldn't allow the average investor.

REITs definitely have positive qualities, but there's been many articles written recently on sites like Seeking Alpha that essentially ignore the price investors are currently paying.  Brad Thomas is a particularly ever present voice pushing REITs as a safe investment for those seeking income, focusing primarily on the dividend yields and the fact that some have never been cut (how'd the workout for GE?) or comparing REITs dividend yield to other income producing assets (aka reaching for yield). 

Total return should be the focus of every investor (capital gains and dividends), and at a price-to-adjusted funds from operations (P/AFFO - the REIT equivalent of P/E), investors are paying an over 21 times multiple, quite rich.  A 21 P/E might be appropriate for a growth stock that requires little in the way of capital investment, but REITs inheritantly require a lot of upkeep and generally have to fund growth through stock issuance and not retained earnings.

The inverse of the P/AAFO ratio is the AFFO yield, which can be thought of as the capitalization rate that the market is assigning to each REITs underlying assets.  Institutional buyers should be able to compare the cap rates they're getting the in private market with those available in the publicly traded sector and act accordingly.  If they're getting a better deal in the private market, simply purchase a portfolio of office buildings, malls, or apartment buildings outright.  At this time, it appears individual investors are acting irrationally and bidding up the prices of REITs compared to the underlying value of their assets.

Below are the 20 largest holdings of the Vanguard REIT Index Fund, one of the largest REIT focused mutual funds or ETFs.  The 2013 AFFO estimates are the average analyst estimates per Bloomberg.

During "normal times" cap rates are usually in the 7-10% range in the commercial real estate market in the private market, for instance, our friend Gramercy Capital  is targeting acquisitions in this range.  At today's prices, investors are willing to pay for publicly traded REITs at 4.6% cap rates, almost double, something is off here

As an investor in Gramercy Capital, this inefficiency is great, management can pick up real estate using cash on hand at 7.5%-9.0% cap rates and then have the public markets eventually value those same assets much higher (assuming of course Gramercy gets out of the penalty box and starts paying a dividend).  Other REITs are of course doing the same thing in order to maintain their AFFO growth and raise the dividend, however the available inventory and disconnect will eventually come to an end (possibly with the rise in interest rates). 

For the typical investor, I would be very careful adding additional REIT exposure at this time.  Many investors already have the market weight in REITs through a total stock market type index fund, so there's no reason at this point to overweight with an additional REIT sector fund.  I do feel for investors requiring income right now, but I don't think REITs are the magic answer, drawing a balance of capital gains (principal) and interest/dividends from a well balanced portfolio is a better solution than simply stretching for yield so you "don't touch the principal".

Disclosure: I own shares in GKK, recently sold GKK-A

Tuesday, February 19, 2013

My Take on Ultra Petroleum's 4th Quarter

To be a successful value investor sometimes you need to endure short term pain while "Mr. Market" goes through one of his mood swings.  While the broad stock market has been continually making new highs over the past two months, one industry that continues to be shunned is natural gas producers.

I run a fairly concentrated portfolio, natural gas producer Ultra Petroleum is one of my larger positions, and so far has been a disappointment.  After reporting 4th quarter results last week, Ultra hit fresh 52 week lows as gas prices remain stubbornly low and Ultra was forced to take another reserve write-down per SEC guidelines.

What is Ultra doing in response to the current environment?

Ultra is aggressively withdrawing capital as it doesn't make sense to monetize their assets at current natural gas prices if they can help it.  Despite cutting capital expenditures from $1.5 billion in 2011 to $835 million ($607 net after the LGS midstream asset sale), Ultra Petroleum still had record natural gas and oil production in 2013 of 257 Bcfe, illustrating the lag between cutting expenditures and the eventual decrease in production.  Ultra will be cutting capital expenditures even further in 2013 to $415 million and as a result will show their first reduction in year over year production, projecting 228 to 238 Bcfe for 2013.  Other natural gas producers are following suit in cutting production, including their joint venture partners in the Marcellus, Shell and Anadarko.

Natural gas supplies are sticky and still slightly elevated at 16% above the five year average, but if you compare that to where we were last spring/summer, supplies have closed the gap considerably and should continue to do so.

Despite low natural gas prices Ultra's margins continue to remain healthy, 64% operating cash flow margin and a 29% net income margin (after backing out the non-cash impairment charge).  Going forward Ultra is targeting $100 million free cash flow annually as they peg capital expenditures to operating cash flow for the next several years.  Management also stressed on the conference call that they are not in danger of breaching debt covenants, so the balance sheet looks safe with the debt having an average maturity over 7 years.

Ultra also provided the below reserve sensitivity, management has repeatedly targeted the $5 price to start deploying additional capital again, so what might their reserves look like at the $5 price?
UPL Reserve Fact Sheet
At the current market capitalization of $2.51billion in equity, and $1.8 billion in debt, that brings a total enterprise value of $4.35 billion.  Taking the $5 sensitivity with all the PUDs, its about a $7.182 billion valuation, subtracting out the $1.837 billion in debt, and you get an equity valuation of $5.345 billion, or over double the current valuation (~$35 per share).

I still believe that as natural gas producers reduce supply and new sources of demand come online, natural prices will eventual rise to where there's a reasonable balance.  That balance sounds like its in the $5-6 range over the next year or two which would still be half what it is in Europe or Asia.  I've taken advantage of this dip in Ultra's shares and continue to add to my position.

Disclosure: I own shares in UPL

Monday, February 11, 2013

Checking in on Asta Funding

Asta Funding announced their fiscal first quarter earnings today.  No big surprises as the company continues to accumulate cash, repurchase shares, receive cash flow from their zero-basis portfolio, and invest in their personal injury financing business over their traditional credit card receivable business.

The most interesting part of the conference call was the surprisingly robust Q&A session, a few takeaways:
  • The divorce business (BP Case Management) is slow, Asta has put very little money into it, doesn't sound like they're committed to the business or just can't find the necessary scale to move the needle
  • Asta still hasn't made a lot of progress on their share repurchase plan outside of the one off-market block trade with Peters MacGregor Capital Management
  • The zero-basis portfolios total over $1 billion in face value which represents a large asset portfolio that is not on the balance sheet, Asta collected $8.1 million last quarter, and $35.9 million over the trailing twelve months
  • The Great Seneca portfolio's loan matures in April 2014, Gary Stern anticipates an extension, but has had no direct discussions yet with BMO
  • Asta is working on lowering overhead costs, but couldn't provide any further details
  • One caller asked about Asta's purchasing criteria and how other publicly traded debt collectors have been actively purchasing credit card receivables, why hasn't Asta been able to?  But Asta is holding firm on not changing their purchasing criteria standards, they would like to purchase additional credit card paper, just haven't seen attractive pricing, specifically, earning 2.7x purchase amount over 84 months would not clear Asta's required return hurdle
Asta is still just treading water, waiting out the current pricing cycle, and that doesn't bother me as I don't want to see them stretch for a large portfolio again.  Where I would like to see more progress is on the share repurchasing front, any additional repurchases would be highly accretive to current shareholders, especially if management doesn't see credit card paper pricing improve in the near term (why earn 1% in CDs when you can buy the stock back?).  Even so, I peg the adjusted book value of the company at $15.25 after deducting the carrying values of the Great Seneca portfolio's assets and non-recourse debt, then adding back an estimate of the zero-basis portfolio's NPV.  Based on the current quote of $9.47, a nice wide margin of safety here.

Disclosure: I own shares of ASFI