Thursday, August 25, 2016

iStar: Non-Dividend Paying REIT with Significant Development Assets

iStar (STAR), f/k/a iStar Financial, is an internally managed former commercial mortgage REIT that ended up foreclosing on a variety of land, development projects, and operating assets (office, hotel, condo projects) across the country following the financial crisis.  Over the last several years iStar has poured money into these foreclosed assets to reposition them for an eventual exit, much of that investment should start showing up in asset sales over the next 1-3 years.  Cash from the sales could then be recycled into their core commercial mortgage and net lease business making the company easier to understand and value.

iStar is an odd REIT that doesn't pay a dividend, REITs are generally under-invested in by institutional investors (although that may change now that REITs have recently been carved out of financials into their own S&P sector) but are generally favored by retail investors because of their high dividends.  iStar misses both investor bases.  iStar is a unique pass-through entity that has NOLs from the financial crisis (similar to ACAS in the BDC industry) and are using their tax asset to shield taxable income (bypassing the 90% distribution rule) in order to reinvest in their business and repurchase shares.  They're not getting credit for this strategy as it doesn't immediately result in higher dividends or in a clearly articulated higher NAV value.  Instead, iStar uses a gross book value metric in their press releases which adds back depreciation on their real estate but does not give any credit to the increase in real estate values since they acquired the development assets via foreclosure or the additional value created above cost as they've deployed capital into those properties.

iStar breaks out their business into four main buckets: 1) Real Estate Finance, 2) Net Lease, 3) Operating Properties, and 4) Land and Development.  Real Estate Finance and Net Lease are complementary businesses as a triple net lease property is essentially a financing transaction.  The Operating Properties and Land and Development segments are the assets iStar acquired through foreclosure, over time these segments should shrink from 36% of assets to become a smaller part of the pie.
2015 10-K
Their asset base is pretty well diversified across geography and real estate subsectors, although the public market likes clean pure-play REITs, diversification still reduces risk, especially in the land and development asset class.  If one area of the country is seeing a slowdown, they can pull back their development plans and focus on other opportunities (seeing this with HHC shifting capital away from their Houston assets).
Q2 16 10-Q
There's a lot of noise in their Operating Properties and Land and Development businesses as earnings are lumpy based on when assets are sold.  iStar breaks out their commercial Operating Properties between stabilized, those that are leased up at prevailing market rents, and transitional, those that have low occupancy and need to be re-positioned.  I think it makes the most sense to value iStar's core Real Estate Finance, Net Lease business lines and the stabilized Operating Properties as if it were a typical straightforward REIT that pays a dividend.  The below is a bit of a crude back of the envelope valuation, but it shows that the market is giving little credit to the value in iStar's transitional operating properties and in their land and development holdings.

On an FFO basis:
iStar has quite a bit of leverage, so a pure FFO multiple probably isn't appropriate but still shows the value embedded in iStar's complicated structure as the shares currently trade for $11.00, less than 14x FFO of just the core Real Estate Finance and Net Lease portfolios.

On an NAV basis:
The above analysis assumes a 6.5% cap rate for the net lease and stabilized operating property assets and values the rest of iStar's assets at book value despite many of the land and development assets being valued at 2010-2012 cost basis on the balance sheet.  One way to look at iStar's valuation, the market is hair-cutting the foreclosed assets by 70% despite significant progress made in recent years to entitle and further develop these assets.  It's likely that these assets could be worth 1.5-2.0x what they're carried at as value is realized over the next 1-3 years.

Land and Development Assets
iStar's Land and Development assets are quite extensive but there's not a lot of disclosure around the specifics of each asset in the 10-K, maybe something for the new CFO to implement?  In total they control land that will eventually contain over 30,000 residential units, not an insignificant number.  Management expects the back half of 2016 and into 2017 to be big realization years, with $500MM in exits targeted from the Land and Development and Operating Properties segments.  Below are a few projects that are currently in production or under development:
  • 1000 South Clark: 29 story, 469 unit luxury apartment complex located in Chicago's South Loop.  iStar partnered with a local builder in a JV, its both an equity investor and a lender in the deal, it will likely be sold after stabilization early next year.
  • Asbury Park Waterfront: iStar recently opened an "adult playground" hotel, The Asbury, in Asbury Park, NJ (Jersey Shore), the hotel/entertainment venue is meant to spur additional development in the surrounding 35 acres of land iStar owns that will eventually support over 2,700 residential units.  iStar is currently finishing up a small condo project, called Monroe, which is 40% sold and has plans to revive an uncompleted high rise construction project called Esperanza that was abandoned after the financial crisis.
  • Ford Amphitheater at Coney Island: iStar just recently completed construction on a 5,000 seat amphitheater along the boardwalk in Coney Island, the amphitheater was built to spur additional development around it, which iStar has 5.5 acres and plans for 565 residential units.
  • Grand Vista: 5,500 acres of mostly raw land on the outskirts of Phoenix that has plans for 15,000 residential units, this was a large failed project before the financial crisis and it may take a while before Phoenix builds out to this site.
  • Highpark: Formerly known as Ponte Vista, Highpark is a 62 acre former naval shipyard in San Pedro, California which will house 700 new residences.
  • Magnolia Green: A classic master planned communities outside of Richmond, VA with a golf course and room for 3,500 residential units.  It has an estimated sellout date of 2026 and another 2.400 units remaining to be sold.  Richmond is becoming a hot market, the city itself is pretty vibrant and it's in a good geographic weather location, it should attract both millenials and retiring baby boomers.
  • Marina Palms:  Two luxury towers along with a marina in North Miami Beach, the second tower is currently under construction and slated to be finished in December 2016.  The company partnered with a local builder and contributed the land for a 47.5% interest in the JV.
  • Spring Mountain Ranch Place: 785-acre master planned community located in the Inland Empire.  For the first phase of the development, iStar partnered with KB Homes and retained a 75.6% interest in the JV, the first phase calls for 435 homes, 200 of which had been sold as of 12/31/15.  Additional phases of the MPC will bring a total of 1,400 home sites.
iStar has $856MM of net operating loss carry-forwards at the REIT level that can be used to offset taxable income and don't expire until 2034.  The NOL allows iStar to utilize retained earnings to grow rather than tap the capital markets constantly like traditional REITs.  This is a plus for iStar as they trade for a significant discount to my estimate of NAV, if forced to pay out market rate dividends they might not be able to access enough capital to fully realize the value of their development assets.  Additionally, they have more available free cash flow to buyback shares which should ultimately be a better use of cash at these prices than paying out a dividend.

Share Repurchases
The company is a large net seller of real estate, they will be selling down their portfolio as time goes on using the proceeds to pay down debt and repurchase more shares.  In the past twelve months iStar has repurchased 19% of their shares outstanding, after the second quarter they approved another $50MM increase to their repurchase program.  The combination of selling their non-core assets above book value and buying back shares below NAV is powerful and could lead to some substantial returns.

  • Jay Sugarman is the CEO of iStar, he's been in that position since the late 1990s and thus led iStar into the financial crisis, he has a lot of the trappings of a NYC real estate guy (owns a sports team, Philadephia Union of the MLS, and a massive home in the Hamptons).  But like Michael Falcone at MMAC, sometimes you need the guy who led you into the abyss to lead you out because they know each asset intimately and where the bodies are buried.
  • Does iStar go back to the "boring" business of real estate finance and net lease after diving into the glamorous development world?  Their website and headshots don't look like your typical REIT or credit shop, I worry the management team has fallen in love with real estate development and the portfolio won't ever resemble a clean REIT until iStar exhausts its NOLs.
  • Timing of asset sales, a few of iStar's land and development assets have long tails (10+ years), if they intend to do the development themselves versus selling to a local builder it could push out the value realization time frame.
  • Leverage, convertible bonds/preferreds, development assets all make iStar more vulnerable to a recession and a downturn in real estate prices.  They have some near term debt maturities and are generally dependent on the capital markets on an ongoing basis for both debt refinancing and asset sales.
iStar reminds me of a combination of HHC (hard to value development assets, atypical for a public vehicle), MMAC (real estate acquired through foreclosure that's difficult to piece out, cannibal of its own shares), and ACAS (pass through entity that doesn't pay a dividend due to its NOL assets).  Over time I think can generate similar gains as those previous ideas.  Thanks to the reader who pointed it out in a previous comment section.

Disclosure: I own shares of STAR

Monday, August 1, 2016

Verso Corp: Bankruptcy Reorg, Cheap Valuation

Verso Corporation (VRS) is a paper producer, primarily of coated papers used in magazines, catalogs, direct mailings, and other commercial applications.  They operate 8 paper mills, most of which are in the upper midwest.  This is a business in secular decline, shrinking mid-single digits annually the past five years as all media shifts to digital formats.  Verso was created by Apollo Global in a $1.4B 2006 leveraged buyout of International Paper's coated paper business, shortly afterwards the industry began to decline and Verso was sub-scale and had too much debt to compete.

In January 2014, Verso announced they would attempt to fix the scale problem and agreed to purchase competitor NewPage for another $1.4B.  The deal was heavily scrutinized by the Department of Justice fearing a monopoly in the coated paper market, all while both businesses were struggling and needed the combination to cut an estimated $175MM in costs.  Eventually the combined company agreed to sell 2 paper mills to appease regulators for $74MM and the deal was completed, but not in time to save Verso which filed for bankruptcy this past January with $2.8B in debt.  In July, Verso emerged from bankruptcy eliminating $2.4B in debt leaving it with $371MM split between an asset-back line and a term loan.  The former Verso and NewPage creditors became the equity shareholders and the company resumed trading under the symbol VRS.

After a company emerges from bankruptcy, the new equity is often in the hands of disinterested owners, the former debt holders, and similar to a spinoff there's no IPO road show to get investors excited.  The dream scenario is when a good business over-leverages themselves and a temporary setback in their business pushes them into bankruptcy while the underlying business is solid with long term growth prospects.  That's not the case here with Verso, the paper business is a declining commodity industry with high fixed costs and a variable priced end product that also has to compete against foreign producers benefiting from the strong dollar and lower labor costs.  But a cheap price can overcome a lot of flaws and Verso's equity is priced very cheaply.

Verso's management provided financial projections out to 2020 as part of the bankruptcy process, here's a link to the entire docket but I found the disclosure statement filed 5/10/16 to be the most helpful.
Verso expects to earn $145MM in 2017, it's current market cap is $404MM, so it's trading at a forward multiple of under 3 times earnings.  But P/E is probably not the best measure for Verso, they have a significant pension liability at $565MM that needs to be funded.
Verso expects to generate approximately $70MM annually in free cash flow after making pension plan contributions which works out to a 17% free cash flow yield.

PJT Partners, a 2015 Blackrock spinoff, was Verso's financial advisor through the process and provided their own valuation analysis.
A $700MM market cap would equal $20.35 per share (75% higher than today's $11.50) and value Verso at ~5x earnings, 10% free cash flow yield, and about ~4.4x EBITDA before pension contributions.  Sounds like valuations for other declining industries like newspapers and terrestrial radio stations.  Cheap and very reasonable even for a terrible business like coated paper.

The company is currently searching for a new CEO who would presumably have freshly struck options at today's depressed prices and a mandate for change, they wouldn't be tied to any of the decisions of previous management and could accelerate a shift to more profitable and less commodity specialty papers.  The ill-fated NewPage acquisition had strategic merit, the industry needs to consolidate and take capacity out of the system, Verso just had the wrong balance sheet and not enough time to experience the cost synergies of the merger.  By eliminating $200+MM of interest payments and realizing $175MM in cost synergies, new Verso should be more agile and able to adjust their business to the industry's realities.

Verso isn't a business you want to hold long term, I view this as a Graham cigar butt trade, get one last puff to the upside and move on to another one.

  • High fixed costs, variable input/outpost costs - Verso's input costs (timber, pulp, energy) are all highly variable and it's a price taker in their end coated paper markets, pair those dynamics with a high fixed cost expense base (expensive to maintain mills, unionized labor force) and a lot could go wrong.  A $25 change in pricing per ton would wipe out their entire annual EBITDA.
  • Paper industry is in secular decline - Demand for paper decline 10% from 2012 to 2015, expected to decline another 4% in 2016, and likely will continue to decline at a similar pace for the foreseeable future.
  • Verso hasn't been profitable since 2009 - I'm somewhat relying on management's financial projections and assuming they'll be able to come close to meeting those expectations which would be a significant turnaround from their results prior to bankruptcy.
  • Continued strong US dollar - many of Verso's competitors are foreign, a strong dollar makes Verso's paper less competitive both domestically and in overseas markets.
Disclosure: I own shares of VRS