Year End 2016 Portfolio Review

Time to wrap up 2016.  Thank you to all my readers, especially those who have reached out via email or commented on posts, the comment sections are often better than the posts themselves.  My portfolio returned 22.47% for the year, which by coincidence is near my 22.63% IRR since inception and comfortably ahead of the S&P 500's 11.95% gain for 2016, which is admittedly not a great benchmark to compare my strategy but a close enough proxy for a passive U.S. based investor.  The Russell 2000 (small cap index) did 19.48% in 2016, so less of an out-performance, but I'm still pleased with the absolute result.

The big winners this year were Leidos Holdings, Tropicana Entertainment, MMA Capital, Nexpoint Residential Trust, Green Brick Partners and the big losers were Verso, Par Pacific Holdings, and LiLAC Group, breakdown of the attribution is below:

Closed Positions:

• I sold Crossroads Capital (XRDC) in October at $1.62 to book an early "tax loss" or so I told myself, more likely just me being impatient, which was before news was released that they had hired an investment bank to shop their assets and eventually ended up selling a couple positions.  Today it trades for $2.13 and NAV is over $3, I'd guess the liquidation takes another year or so but it remains an interesting idea.
• Hawaii's Public Utility Commission blocked the merger between NextEra Energy and Hawaiian Electric (HE) which then cancelled the pending spinoff of their bank subsidiary, ASB Hawaii, which is the main reason I was interested in the first place (still want that bank!).  There could be another buyer out there, but I moved on at a small loss.
• KCAP Financial (KCAP) was a small position I bought in the early spring as people were panicking, especially with risky credits in particular, but performance of bank loans that KCAP (and other BDCS) held were still chugging along just fine.  The market was pricing in a crisis that never occurred, pair that with the news that KCAP was shopping their CLO manager, and it seemed like a good way to play the bounce when the market returned to normal.  Markets returned to normal, the CLO manager sale didn't materialize (they actually just issued a new CLO), and with dividends I booked a nice gain.  KCAP still looks cheap at 73% of NAV and bank loan marks have only gone up since 9/30 as people pile into floating rate debt.
• The Lockheed Martin exchange offer for Leidos Holdings (LDOS) turned out to be one for the ages.  I don't normally post about exchange or tender offers, but I liked this one because I'm familiar enough with the government services sector and thought Leidos was cheap with or without the exchange offer discount.  After the exchange offer ratio was finalized, LDOS stock price shot up, either because of a squeeze or possibly because it screened cheap after the deal due to extra leverage caused by the special dividend needed to qualify as a RMT.  After I received my shares, I ended up booking the quick profit but I still like the government services sector in a era where infrastructure and fiscal spending will be in vogue.
• As hinted at in my mid-year post, I did end up selling the remainder of my Nexpoint Residential Trust (NXRT) holding around ~$20, still like the Class B apartment asset class but just don't trust management and it was close to fair value.
• I'm not entirely convinced that Verso (VRS) won't end up working out reasonably well, but I didn't have the initial patience, basically got caught being a little bored and impulsive, without having conviction to hold or add to it as the former senior creditors sold out of the stock.  The other lesson here is to be more skeptical of management projections in disclosure statements, and of course most fairness opinions can be thrown out the window, investment banks just back into whatever valuation their clients want to hear.
• The Zais Financial Corp (ZFC) tender offer worked out pretty much as planned, I ended up selling the Sutherland Asset Management (SLD) stub shortly after the deal closed to book a high single digit return in a little more than a month.  Sutherland is now back on my watchlist, they've announced a dividend, trade well below book value, and as former private REIT shareholders sell their shares it has created an opportunity.

Current Portfolio:

No cash was added or withdrawn in 2016.

My favorite ideas for 2017 are iStar Inc (STAR) and Resource Capital Corp (RSO), both are REITs that either don't pay a dividend, iStar, or pay an abnormally low dividend, Resource Capital, and have mixed portfolios that don't lend themselves to being valued properly by the public markets.  As both continue to recycle their capital and make their portfolios easier to understand, the market should reward them with higher valuations.  Two "buy complexity, sell simplicity" type ideas.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Hilton Worldwide: Management Co, Hotel REIT, Timeshare Business

I mention from time-to-time that I co-host a monthly Special Situation Research Forum discussion group sponsored by CFA Society Chicago where we pick a specific company each month and have a deep dive discussion on it.  This month we picked Hilton Worldwide (HLT) which is splitting into three companies at the end of the year by spinning off its owned real estate into a REIT, Park Hotels & Resorts (PK), and its timeshare business, Hilton Grand Vacations (HGV), leaving an asset-light management company as the remaining parent.  The choice was made before the election and ensuing stock market run up, so while the situation is a little less compelling as one company today, as we've seen with RR Donnelley's (RRD) three way split, a lot of market distortions can happen in these scenarios which makes Hilton worth investigating ahead of time.

Background
Founded in 1919 by Conrad Hilton, Hilton Worldwide is the second largest hospitality company with over 4,800 hotels flying one of their brand's banners across 104 different countries.  Hilton was one of the largest leveraged buyouts before the financial crisis with Blackstone taking it private for $26B in 2007 and then subsequently taking it public again in 2013.  Blackstone made out surprisingly well in the deal, and since reappearing on the public markets Hilton has been following the trend towards an asset-light management company model.  To that end, earlier this year Hilton announced intentions to break up into three companies, which should happen by year end.

Current corporate structure:

Post-spinoff corporate structure:

Why do the spinoffs?

• Typical spinoff rationale of varying capital structures, aligning incentives, investor choice, etc.
• REIT valuation arbitrage, as a pass through entity that pay high dividends REITs are valued more richly than the same real estate would be within a larger Hilton.
• Financial engineering of turning Park Hotels management fees and Hilton Grand Vacations licensing fees from an expense that's eliminated in consolidation to a revenue stream at the parent Hilton where they'll likely earn a higher valuation than either spinoff.
• The parent will be a vast majority of the value, by simplifying the business towards the management contracts, the parent should earn a higher multiple.  The market values simplicity, all three entities will be easier to understand separate than together.

Additionally, Hilton's larger rival Marriott (who recently merged with Starwood) has done similar spinoffs in the past of Host Hotels & Resorts in the 1990s (highlighted in Greenblatt's book) and Marriott Vacations Worldwide in 2011.  There's a clear precedent for this split-up and both Marriott spinoffs have been successful.  Hilton's current CEO, Christopher Nassetta, previously headed up Host Hotels and knows the playbook to make this a successful split-up.

Park Hotels & Resorts (PK)
The larger of the two spinoffs will be one of the last REIT spinoffs, Hilton secured an IRS private letter ruling before the crackdown in late 2015.  The new rule prevents spinoffs from converting to a REIT for ten years after the spin date, effectively eliminating the loophole.  Park Hotels & Resorts will be the second largest lodging REIT behind the old Marriott real estate spin, Host Hotels & Resorts (HST), and significantly bigger than the third largest in the sector.  Now that REITs are their own sector of the S&P 500, some active managers will be forced to add REITs where they were previously underinvested, as a sizable lodging REIT, Park Hotels might be a beneficiary of that index change.

Park Hotels will start off life with 36,000 rooms across 69 hotels, heavily tilted to their largest ten convention and resort style hotels below.  Due to their locations, these hotels are more difficult to replicate and thus face less competition than midscale and economy tier hotels in suburban locations.

Park will only have exposure to Hilton brands initially, but I don't see that as big of a problem as other single exposure REIT spinoffs as its an easier task to rebrand a hotel than say an Ameristar casino or an Olive Garden restaurant.  Park does intend to diversify away from Hilton's brands via acquisition, there are 22 public lodging REITs, some consolidation of this sector seems likely with another big player in the mix.  REITs are one of the few areas where M&A makes a lot of sense as operations are easier to integrate and G&A can more easily be cut at the target thereby spreading the parent's corporate expenses over a larger asset base.  Besides straight M&A deals, REITs can also take advantage of private/public valuation arbitrage, the public markets often times take shortcuts in valuing REITs (me included) and don't make cap rate adjustments for different local markets.  Assets in prime locations that would fetch very low cap rates are grouped in with the rest of a portfolio.  For example, last year Hilton sold the Waldorf Astoria hotel on Park Avenue to a Chinese buyer for 32x EBITDA, an amazingly high multiple, and invested the proceeds in Orlando and Key West hotels via a 1031 exchange at 13x EBITDA (still not cheap) as a way of recycling capital and showing higher EBITDA/FFO irregardless if the underlying real estate value didn't change.

Lodging REITs are on the riskier side of the REIT industry as their leases are the shortest, one night at a time, versus apartment REITs with 1 year leases, or office and industrial REITs that can have average lease terms of 10+ years.  It's not a great business, if it weren't for the REIT tax-free pass through status and investors desire for yield, Park Hotels would be the classic capital intensive bad business that the parent company is trying to shed via a spinoff.  Park puts up all the capital and has to pay Hilton 3% of gross hotel revenues, an incentive fee of 6% of hotel earnings and reimbursement of staffing and operating costs.  Lodging REITs are better than other franchisee businesses because of the tax-free pass through status, but otherwise it's very similar.  Although with corporate level taxes potentially coming down, REITs may lose some of their appeal.

Back to Park Hotels, a few of the particulars:

• Tom Baltimore will become the CEO, he was previously the CEO of RLJ Lodging Trust and recently left that post specifically to become the CEO of Park Hotels & Resorts after the spinoff.  He's previously worked for Hilton, Marriott and Host Marriott at different times so he likely understands the benefits of the spinoff.  Part of his incentive compensation will be based on Park Hotel's total stockholder return compared to the FTSE NAREIT Lodging/Resorts Index over a 3 year period.
• 90% of Park's hotel exposure is in the U.S., 10% is abroad, Hilton had to be careful to minimize the international exposure in order to meet REIT requirements.  I'd expect Hilton to continue to divest the owned international real estate in smaller one off transactions.
• 85% of their hotels are upper upscale and luxury brands, basically this means the flagship Hilton brand level and higher.  90% of their rooms are either urban, resort, or airport hotels, versus only 10% in suburban locations with less barriers to entry.
• There will be a special purging dividend of roughly $200MM sometime after the spinoff, 80% of the special dividend will be in stock (but still taxable) and 20% in cash.
• Target leverage of 3-5x EBITDA, generally Lodging REITs are less levered than other REITs due to their cyclical nature.
• Included in Park are 4 operated hotels and a laundry service business, likely these are the active trade businesses ("lemonade stands") that are required for a tax free spinoff.

Host Hotels is the best and clear comp, however Park Hotels probably deserves a little discount to Host because it's not diversified among hospitality management companies and doesn't have the long track record.  Host trades for 11.1x EBITDA, Park should trade for at least 10x EBITDA, especially given their hotels in New York, San Francisco and Hawaii, plus remember they bought their Orlando and Key West hotels at 13x EBITDA.  Park will have $3B in debt and has proforma 2016 EBITDA of $775MM, at 10x, Park's equity value should be $4.75B or $4.80 per share of HLT.

Hilton Grand Vacations (HGV)
Timeshare spinoffs have been officially a thing for a few years now, Marriott spun off Marriott Vacations Worldwide (VAC) in 2011 and Starwood completed a spinoff via a reverse morris trust of their Vistana Signature Experiences timeshare unit with ILG (f/k/a Interval Leisure Group, ILG) earlier in 2016.

The latest timeshare spin, Hilton Grand Vacations will have more than 265,000 timeshare owners, 46 resorts, and over 7,500 units.  Since being acquired by Blackstone, Hilton has made over its timeshare business to be predominately an capital-light model where instead of developing and funding the construction of the resort themselves, Hilton Grand Vacations partners with third-party developers (PE real estate funds) who then contract out the timeshare share sales and resort management to HGV for a fee.  More than 75% of their timeshare sales now comes from this fee-for-service or a just-in-time inventory method versus 0% in 2009, this has greatly increased ROIC.

Timeshare companies typically make money in four different ways:

1. Selling timeshare units, this is a cyclical, expensive (tours, free vacations, etc), yet profitable business that's still significantly below pre-financial crisis levels.
2. Financing the timeshare sales, this is a great business, typically these are 10 year fully amortizing loans that carry interest rates of 10-18% depending on downpayments and FICO scores (HGV's typical buyer has $100+k income and a 745 FICO score).  These loans then get securitized and sold with the timeshare company receiving servicing fees and an equity strip.  Timeshare securitizations have performed surprisingly well throughout the market cycle.
3. Management contracts on the timeshare resorts, this is another great business, timeshare companies typically charge ownership associations a fee in a cost-plus arrangement (cost + 10% in HGV's case) for managing the resort and up-keeping the property, rooms, etc.  While the hotel management companies typically take a clip off of revenue, here the timeshare companies are taking one off of expenses, the result is a lower upside but a lower risk recurring revenue stream.  The management contracts are sticky, HGV hasn't had a contract terminated since the unit was created in 1992.
4. Rental income from unsold inventory, units that haven't been sold to a timeshare purchaser can be rented out like any other hotel room, this is less than ideal but is a way of reducing inventory drag as timeshare units are sold.

Another interesting dynamic of the industry is the lack of a secondary market for timeshares.  Once you purchase a timeshare, it's difficult to sell them because the industry makes it difficult by offering perks only to members that buy directly from them that secondary purchasers aren't eligible for.  Another big factor is that there's a lack of financing options for secondary market timeshares, no one will lend to them because there's essentially no collateral.  The timeshare companies themselves are willing lenders because if a loan defaults, that timeshare unit can be foreclosed on and put back into their inventory to be sold to another buyer rather easily.  That mechanism isn't really available to anyone else.

Back to HGV, Mark Wang leads the division now and will be the CEO once the spinoff commences.  He's been in charge of Hilton's timeshare operations for many years and as led the company through the current transition to an capital light business model.  Unlike Park, HGV doesn't plan to diversify away from the Hilton Brand and has signed a 100 year licensing deal to use the Hilton brand name in exchange for 5% of timeshare sales.  Mark Wang has done an admirable job at HGV, they've grown timeshare sales every year through the recessioin, with a CAGR of 7.9% from 2007 to 2015, outperforming the industry, which experience a decline of 2.6% over the same time.

Marriott Vacations Worldwide (VAC) is a pretty good comp, their business segments are nearly identical with Hilton Grand Vacations being a little farther along in their move to a capital light model.  VAC trades for about 8x EBITDA (excluding securitization debt), HGV's proforma 2016 EBITDA is expected to be $380MM and it will have $500MM of non-recourse debt, at 8x EBITDA the equity value of HGV should be $2.54B or $2.56 per share of HLT.

At a $2.5B market cap, Hilton Grand Vacations has the potential to be sold by large cap indexes and unlike Park Hotels & Resorts, HGV won't pay a dividend and doesn't have the REIT investor backstop, in my mind it has the most potential to be mispriced following the spinoffs.

Hilton Worldwide (HLT)

Following the spinoffs of PK and HGV, the parent Hilton Worldwide will generate over 90% of its EBITDA from fee based capital light sources, the remaining 10% from owned hotels which should go down over time in smaller owned hotel sales and as the fee based business continues to grow organically.  Hotel management is a great business as others put up the capital to develop and construct the hotels and then contract out to the likes of Hilton to manage the hotel and be included in their rewards program (HiltonHonors) which brings immediate patronage that being an independent hotel otherwise wouldn't.

Hilton is able to grow very quickly with minimal additional invested capital, since year end 2007, as shown below, Hilton has invested $184MM in the fee businesses which has created an additional $726MM in run rate EBITDA.

Hilton's pipeline is equally impressive, they currently have 789,000 rooms in the system or 4.8% of the global supply, but have over 21% (288,000 rooms) of the new development pipeline (again at minimal additional investment), which should drive growth for years to come.  Next year they expect to add 50,000 - 55,000, or a growth rate of about 6%  from current levels, much of this growth is in overseas markets.

What will Hilton do with their cash flow?  Management's plan is to maintain a low investment grade credit profile, dividend out 30-40% of recurring cash to shareholders, with the remaining cash flow available for share repurchases in a new program to be initiated after the spinoffs occur.  So with Hilton, you have a business that needs very little capital to grow and will return the vast majority of cash to investors via dividends and share repurchase, the best of both worlds.  Marriott paid 14x EBITDA for Starwood earlier this year, backing out a takeover premium and valuing Hilton at 13x EBITDA seems reasonable to me.  At 13x, with $1.76B in 2016 EBITDA and $6.1B in debt would make the equity worth $16.8B or $16.97 per share of HLT.

Adding up the three pieces and I come up with $24.33 per share, a slight discount to the current share price of $25.31 and the $26.25 that HNA Group recently paid for a 25% stake from Blackstone (BX).  This is more of a growth situation than value, and much of the valuation rests on Hilton Worldwide's EBITDA growth trajectory, which since it's not the spinoff, we have little insight into how they've calculated the proforma 2016 EBITDA.  They've disclosed approximately $200MM in transaction expenses, which seems extreme to me, and there's roughly $180MM in management and licensing fees coming from the two new spinoffs into the parent.  If those aren't included in the proforma number or somehow netted against the transaction costs, that would be an additional $2.36 per share in value, plus the additional organic growth coming online in 2017.  I've seen 2018 EBITDA estimates above $2B for proforma Hilton.  The company is hosting an investor day on 12/8, maybe we get some more clarity on the parent at that time.

For now I've just purchased a placeholder position via just in the money January 2018 calls.  If the growth strategy works out, so will my LEAPs, if not, I've limited my downside.  Once the spinoffs occur maybe one of the three will be more interesting as the investor bases turnover.

Disclosure: I own HLT LEAPs

Resource Capital Corp: Dividend Cut, New Management Simplifying Portfolio

C-III Capital Partners, led by Andrew Farkas, in September closed on the purchase of Resource America (REXI) which was the external manager of Resource Capital Corp (RSO), a troubled commercial mortgage REIT that has struggled since the financial crisis.  Prior to the financial crisis, as was popular, Resource Capital financed most of their commercial real estate loans through the CDO market, unlike the other mortgage REITs of that era, the company has pretty much stuck to that strategy creating a confusing portfolio with a eclectic mix of assets financed through securitization structures.  These assets include syndicated bank loans, middle market bank loans, life settlements, etc., more fit for a BDC but all squeezed into the 25% taxable REIT subsidiary carve out along with another side pocket of residential mortgages and mortgage servicing rights.  To be cynical, it appears that prior management would see an opportunity to earn a fee managing a new pool of assets, and simply used Resource Capital as a seed investor whenever needed, how else do you end up with that mix of assets in a commercial mortgage REIT?

The company reported third quarter earnings on Monday, first under C-III, and new management basically hit the reset button on the balance sheet, strategy, and the dividend policy all in one swoop.  Book value went from $17.63 to $14.71 per share as they took several impairment charges, and the dividend was cut from $0.42 to $0.05 per quarter.  The result was as you'd expect with many yield investors selling sending the stock down ~30% as they reacted to the dividend cut irrespective of the underlying value.  While certainly tough for previous RSO shareholders, the changes C-III Capital is making should result in the company trading closer to book value over time compared to a 40% discount today.

Capital Structure: $275MM market cap ($450MM book value), $270MM in preferred stock (3 tranches), and $1.4B in debt (both recourse and non-recourse).  Resource Capital reports leverage just under 2x which includes the preferred stock in denominator, putting the preferred in numerator would result in the common shares being levered 3.7x equity.

New Business Plan
The old plan in the 10-K.  It's odd that they use "commercial finance assets" for bank loans and CLOs, never heard that before but maybe because it sounds closer to "commercial real estate"?

C-III Capital's plan:

"Our plan, candidly, is simplify the Company and make it more understandable for investors and improve the transparency of RSO's performance.  We're going to do this by disposing of underperforming assets, divesting non-core businesses, and investing solely in CRE assets that produce consistent recurring cash flows and pay dividends out of earnings and not just out of cash that's on the balance sheet." - Bob Lieber, RSO CEO

The fact that this is a new plan says a lot about previous management.  I've talked about how public investors, especially in REITs like clean and simple portfolios, and that investors could get ahead of this when management is prepared to execute on that plan.  We saw that with Gramercy Property Trust (GPT) twice, first when they were transitioning from a mREIT not unlike Resource Capital to a triple net REIT and second when they absorbed the mix and match portfolio that Chambers Street Properties had created as a private REIT.  A good example of that today would be iStar (STAR) as they clean up their foreclosed operating and land assets, eventually returning to a hybrid mortgage and net lease REIT.  I think Resource Capital could do something similar as Gramercy and iStar, but in a quicker 12-15 month timeline.

The good news is that roughly 70% of Resource's portfolio is already CRE whole loans with a subset of that being legacy pre-2007 loans.  But most of these are senior mortgages on stabilized properties, 80% LTV, 3-5 year maturities and financed with cheap non-recourse (to RSO) funding via securitization structures.  They're currently passing all their OC/IC tests in these structures, if these were to fail cash flow would be diverted to pay down the senior notes.  This portfolio can earn mid-teen ROEs before expenses.

Outside of the CMBS piece, the rest of the assets (C-III's pegs it at 22% of the portfolio) are now considered non-core and will either be sold or allowed to runoff (much of it in the next year).  Included in ABS and other is more syndicated and middle market bank loans that are held via CLOs, these can either be sold into the secondary market or possibly Resource could utilize call features as the equity holder and liquidate the CLOs as pricing on bank loans has bounced back significantly from earlier in the year.  To quote the CEO again:

"To summarize, our strategy is to prudently divest non-core and underperforming assets, which account for nearly $0.5 billion, or 22% of our book value and as we realize the proceeds from the maturities and sales, we will deploy incremental capital into our CRE lending business and CMBS acquisition business" - Bob Lieber, RSO CEO

In setting the stage for the updated business plan, new management took the opportunity to take $55.3MM worth of impairment charges and reset book value lower.  Much of the impairments were related to their middle market and syndicated bank loan operation that they're exiting, along with write-downs of pre-financial crisis CRE loans in legacy securitizations.  While each of these were likely prudent, it has the effect of lowering the bar for future incentive fees RSO will be paying to C-III Capital if the new plan materializes as expected.

Management Agreement

Andrew Farkas, the new Chairman of Resource Capital, is a veteran real estate investor who founded Insignia Financial Group in 1990, took it public in 1991 and eventually sold the business to CBRE in 2003.  More recently he started C-III in 2010, and has since acquired special servicers, real estate brokers, and asset management groups to create a diversified real estate company.  Farkas is savy and RSO is their new fund to extract management fees, important to never really forget that management and shareholders aren't on the same side.

The external management agreement is typical-to-bad:

• 1.5% of equity base management fee (better than if it was of assets, but REXI called this 70% margin revenue in their own presentation materials)
• 25% incentive fee over 8% return (25% of which is taken in shares, 75% cash)
• Expense reimbursement for CFO's salary and partial reimbursement on investor relations team (not covered in the base management fee apparently)
• Termination fee equal to 4x the average base management fee and the average incentive compensation earned by the manager during the two 12-month periods prior (this would be at least 20% of the market cap, and that's low because no incentive has been earned in recent years)

C-III Capital is inheriting 714,000 shares of RSO from Resource America, or 2.3% of the company, rather insignificant compared to the fees they'll be earning annually.  But from C-III's perspective, their goal is to get RSO in a place where they could raise capital and grow the platform, that will only happen at a share price closer to book value and by playing nice in the sandbox with investors going forward.

Valuation

The larger, best of breed, commercial mortgage REITs like Starwood Property Trust (STWD) trade well above book value, other smaller externally managed ones like Ares Commercial Real Estate (ACRE) trade for about 95% of book value.  At even 85% of current book value, Resource Capital's upside is 35+% and over time as the new plan is executed even that discount should close to peers.  New management has guided that 2017 will be a transition year, and that dividends will likely stay in the $0.05 a quarter range, once the dividend policy is updated about this time next year, I'd expect RSO to be trading at least 85% of a simpler to understand book value.

New management plans to have an investor day soon where they will disclose more details on their future plans which could be an additional catalyst for the shares.

Risks

• External Management - There's always going to be inheritent conflicts of interest with external management agreements.  With C-III Capital and RSO it seems to be initially surfacing with the buyback, the old management repurchased 8-9% of the shares at prices above $12 over the last year.  C-III plans to shelve the plan and instead deploy capital in CRE whole loans, with the stock trading at a 40% discount, there's no CRE investment I'm aware of that would equate to the same return as buying back shares.  But buying back shares would reduce equity and thus reduce management fees.
• Leverage - Mortgage REITs are leveraged bets on the underlying portfolio.  CRE whole loans are typically floating rate so the portfolio shouldn't have much interest rate sensitivity but will be concavely exposed to any defaults.  I don't believe we're on the edge of another blowup in CRE/CMBS, but that's certainly always a risk.  
• More Non-Core Impairments - C-III Capital took $55MM worth of impairments in their Q-3 earnings, about half of that was on the non-core, non-CRE assets and business lines that they're looking to sell.  Logic would say that they'd take the opportunity to get those marks correct, but they could need to come down more as they market these assets and determine what they're really worth.  The good news is CLO/bank loan market is open for business, but as we saw in the first quarter of 2016, these markets can close very quickly.

Summary

I bought some shares on Tuesday for $8.70, and expect the share price to be a little volatile over the next few weeks.  I'm not a long term holder of externally managed companies as eventually the conflicts of interest usually settle with management being the beneficiary.  But my plan is to hold RSO until it finishes management's capital recycling plan and the dividend normalizes which should bring back in the typical yield investors and push the price back up near book value.

Disclosure: I own shares of RSO

Donnelley Financial Solutions: New RRD Spin, Asset-Light, Recurring Revenue

Donnelley Financial Solutions (DFIN) is one of two fresh spinoffs of RR Donnelley & Sons (RRD) that provides services to help create, manage and deliver financial communications to investors and regulators.  This means the unwanted paper annual reports and prospectuses you receive for equities, mutual funds and insurance products, much of that is printed by Donnelley Financial.  This is a slowly dying business that represents about 42% of DFIN's revenue, its declining low single digits annually, and being mostly held up by regulations that require funds to physically mail annual and semi-annual reports to investors.  The other half of Donnelley Financial's revenue is generated by software and cloud like solutions that assist companies in putting together filings and data rooms that are used as depositories for M&A and IPO transactions.  This is the growth side of the business and one where RRD had been actively acquiring technology and software companies to compete in an increasingly paperless world.

The company breaks out their lines of business into three segments, mostly by customer type:

• Global Capital Markets: Clients consist of primarily publicly traded companies that are subject to the Securities Act of 1933 and the Securities Exchange Act of 1934 who need to make periodic regulatory and investor filings along with transactional filings when M&A, IPOs, bankruptcies or other large corporate actions happen.  About half of the revenue from this segment is recurring in nature, the other half is transactional and depends heavily on deal making activity in the financial markets.  Donnelley Financial did business with 422 S&P 500 firms in 2015 via this segment.
• Global Investment Markets: Clients consist of mutual funds, hedge funds, insurance companies that use Donnelley Financial's products to create reports, prospectuses, fact sheets and other marketing materials.  Almost all of this segment is recurring in nature, although it may face broader secular headwinds as active management strategies continue to face challenges outperforming and the resulting outflows.
• Language Solutions: DFIN's smallest segment provides translation services that adapt business content into different languages for specific countries.  This segment could be where future acquisitions are made as the market is highly fragmented.

Overall DFIN believes 62% of their revenue is derived from recurring sources and 38% from transactional deal related activity.  Some products that those in finance might recognize: EDGAR Online, EDGAR Pro, Venue, FundSuite Arc, Proxy Design, ActiveDisclosure.

RR Donnelley didn't run what is now DFIN as a separate business vertical prior to the spinoff making it difficult to see historical numbers or business trends.  Besides reading the Form 10-12, it might be helpful to go back and review Bowne & Co (BNE) which RR Donnelley bought back in 2010 for ~$460MM, significantly beefing up their financial communications business.  For cyclicality context, Bowne's revenue dropped about 20% from 2007's peak to 2009's trough.

Why do the spinoffs?
RR Donnelley split up into three companies which itself could create some market uncertainty (seems to have today at least) as investors digest the prospects for each separate business.  Donnelley Financial appears to be the best business of the three, but to complicate matters RRD CEO Thomas Quinlan jumped to what looks like the 'garbage barge' retail printing business (LSC Communications) and the remaining RRD will be maintaining a 19.25% interest in both spin-offs for up to a year which could result in exchange offers for fans of those transactions.
But overall, the spinoffs seem to be designed to separate the headwind facing business, LSC Communications, from the parent that has moved to a more value add business model.  Secondarily highlighting the high margin, low capital intensive financial communications business (DFIN) from the parent, which should lead to DFIN trading at a higher valuation.  Most of the legacy pensions, PP&E, and other old-economy like cash drags will be either going to LSC Communications or staying with RR Donnelley.

Management
Daniel Leib, the old CFO of RRD, is now the CEO of DFIN.  He's been the CFO of RRD for many years and before that was their internal M&A and strategy lead.  I generally like when CFO's take over the head job, especially of a company like DFIN that is expected to generate a lot of free cash which management will need to allocate and DFIN's entire business model is based around financial statements and regulatory disclosures, Daniel Leib as a former CFO should be intimately aware of these challenges from a client prospective.  The board will be led by Chairman Richard Crandell, 77, he like the rest of the board don't appear to have much of a printing industry background, more technology and software, lending more credit to the strategy of shifting the company to software products.

Valuation
Donnelley Financial will be substantially asset-light, they outsource much of the physical printing during peak times around proxy season, and have minimal capital expenditures ($20-30MM) as they shift their business to more software and cloud offerings.

New IPOs and deal making activity was a little muted during the first half of the year, particularly the first quarter, pushing down DFIN's numbers year over year.  I'm going to use a rough $200MM EBITDA number, below the current run rate to account for both some peak market activity risk and the inherent carve out risk of using proforma Form 10-12 numbers.  DFIN has approximately $600MM in net debt and 32.4 million shares outstanding (which includes the stake retained by RRD), at $24.50 per share, DFIN is trading at 7x EBITDA for a mostly recurring revenue stream, with strong margins and minimal cap ex requirements.  Seems too cheap to me.

Disclosure: I own shares of DFIN

ZAIS Financial: Merger w/ Private REIT, Tender Offer, ZAIS Group

ZAIS Financial Corp (ZFC) is a $125MM market cap residential mortgage REIT that failed to gain size and operating leverage, ZFC's external manager ZAIS Group (ZAIS) is reeling from some poor performance at its main credit hedge fund and decided to refocus efforts away from the sub-size mortgage REIT.  In April 2016, ZAIS Financial announced it was merging with Sutherland Asset Management, a private commercial mortgage REIT, ZAIS Group's management agreement will be cancelled and Waterfall Asset Management, Sutherland's external manager, will take over the combined company with a typical base/incentive fee structure.

The merged company will take the Sutherland Asset Management name and trade under the symbol SLD.  Sutherland's strategy is to acquire and originate small commercial loans and SBA loans, they classify small commercial loans as those ranging from $500k to $10MM that often have a personal guarantee attached back to the business owner.  This is a bit of a niche non-bank lender sector made possible by the retreat in community and regional banks from making riskier loans that come with greater capital requirements.  Sutherland both originates their own loans and acquires portfolios of performing and non-performing loans from larger banks and the securitization market.  There might be an opportunity for alpha in this niche as these loans are too small for larger institutional investors but too risky for small banks, but it's not without risk as these are loans to franchisees and small time commercial real estate investors, basically borrowers without any scale or significant enough collateral for traditional lenders to touch.

Additionally, Sutherland is one of a few non-banks with an SBA license, borrowers that take out SBA loans are even shakier than their core small commercial loan business but with SBA loans the government guarantees a (senior) portion of the loan.  The guaranteed portion is then sold and securitized into the secondary market, there's usually a nice premium for the lender in the sale as these loans have a wide spread compared to traditional treasuries or other government sponsored enterprises.  The lender of an SBA loan keeps the servicing relationship whether they choose to keep the guaranteed portion on balance sheet or not, if the guaranteed portion is sold as the servicing relationship is kept, that effectively increases the interest and fees earned on the remaining portion held by the lender.  Originating SBA loans is a good business.

So that's Sutherland's business, lending to riskier small commercial lenders, it should do well during good times and not so good during bad times.  It's effectively a commercial mortgage REIT with elements of a residential mortgage REIT.

Why merge with ZAIS Financial?  
Sutherland attempted an IPO in January 2015 and ended up pulling the offering when it couldn't raise capital within the desired range.  Sutherland is about 3 times the size of ZAIS Financial, so merging with ZFC can effectively be thought of as a reverse merger and a way to backdoor list Sutherland.  Further to that point, ZAIS Financial has sold most of their liquid assets leaving their mortgage servicing operation, a business unit that a fund managed by Sutherland sold to ZAIS Financial a couple years earlier.

Why is this deal interesting?  
If shareholders approve the issuance of shares to complete the merger on 9/27, then ZAIS Financial is going to commence a tender offering for approximately 47% of their shares outstanding (cash from selling down their liquid RMBS assets) at $15.36 per share, the shares trade for a $14.07 per share, or a 9.2% premium that should happen fairly quickly.  Additionally, ZFC is paying a $0.40 dividend to shareholders on 10/17 with a record date of 9/30, for another 2.8% return.

Per the merger agreement, both sides adjusted their book values down to account for intangible assets, litigation costs, transaction fees, and ZAIS Group's termination payment.  If you follow the math, assuming everyone tenders their shares (the math gets better the fewer people tender), an investor can create shares in the new Sutherland (SLD) at 73% of tangible book value.  The deal should close in the 4th quarter assuming both sides approve the deal on 9/27.

I expect SLD shares to trade poorly after the deal happens as previously locked up (and mostly retail) shareholders now have liquidity and can sell their shares.  But most mortgage REITs trade somewhere between 0.9-1.1x BV, residential mortgage REITs on the low side, commercial mortgage REITs on the high side, Sutherland should trade somewhere in between the two sectors overtime as it has elements of both, but either way above 73% of book value.

Sizing a situation like this is important, you'll get about half your money back quickly and don't want to worry about the remaining stub if the new SLD gets sold off once the deal closes.

ZAIS Group
ZFC's soon to be former external manager, ZAIS Group (ZAIS), might be a situation worth digging into further.  After losing ZFC's management contract, ZAIS will have a little more than $3B in AUM primarily across two hedge funds that have good long term records but poor short term (far from their high water marks) and 4 CLOs, one of which they closed this year which is a feat for a small manager like ZAIS.  As a result of losing their incentive fees, their operating expenses are greater than their run rate management fees putting them in a tight spot.  The stock is down 80+% in the past year.  There are some corporate governance issues, its a former SPAC, and one of those structures where the public company owns 2/3rds of the operating LLC and insiders own the rest.  But at a $28MM market cap, its trading below book value (mostly cash) and other CLO managers have been sold recently at nice premiums (see CIFC), ZAIS could be another.

Disclosure: I own shares of ZFC, no position is ZAIS

Dell Technologies Class V: New VMWare Tracking Stock

I'm posting this on Friday afternoon before a long holiday weekend for a reason, smarter people than I have written on this topic so not much of the below is new but I wanted to memorialize some thoughts as part of my process.

Last October, Dell and Silver Lake (their PE backers) announced the acquisition of EMC in a cash and stock deal worth $67B.  Dell is a private company and wants to stay that way, so the stock part of the merger consideration is a bit tricky.  EMC owns 81% of VMWare, a software company that sells virtualization technology that helps large enterprise servers share resources and become more efficient, the remaining 19% stake is publicly traded under the VMW symbol.  But Dell is a recent leveraged buyout, and they didn't have the available financing to buy both EMC and their stake in VMWare simultaneously, so instead of paying cash for all of EMC and their 81% stake in VMWare, Dell is issuing a tracking stock that represents 65% of EMC's 81% interest in VMWare to former EMC shareholders to bridge the funding gap, but still get to control VMWare.

In Dell's own words (Denali is Dell's parent company):

Q:           Why is a tracking stock being used to finance the acquisition of EMC?

A:           The Class V Common Stock will afford EMC shareholders the opportunity to benefit from any value creation that may result from any revenue synergies of the Class V Group with Dell. Collectively, EMC shareholders indirectly own approximately 81% of VMware as of the date of this proxy statement/prospectus. Upon the completion of the merger, EMC shareholders will receive shares of Class V Common Stock that will be publicly traded and that are intended to track, in the aggregate, an approximately 53% economic interest in the VMware business (assuming no change to the percentage economic interest of EMC in the VMware business prior to the completion of the merger and that EMC shareholders either are not entitled to or do not properly exercise appraisal rights).

Owning EMC’s interest in the VMware business is a fundamental part of Denali’s strategic rationale for this transaction. VMware’s success is important to the business strategy of a merger combining Dell and EMC, and Denali believes it will be in the best interests of its common stockholders after the merger to retain a large economic interest in the VMware business. Additionally, given constraints on the amount of cash financing available for the transaction, the issuance of the Class V Common Stock enables Denali to pay a higher purchase price for EMC than it could in a transaction consisting entirely of 100% cash consideration.

Shares of the tracking stock, Dell Technologies Class V, started trading recently in the when-issued market under the symbol DVMTV and will start trading regular way as DVMT after the deal closes on 9/7/2016.  Each share of DVMT represents the same economic equivalent of each share of VMW, there will be 223MM shares of DVMT outstanding compared to just 80MM of the regular VMW common shares, meaning the tracker should be more liquid than the real thing, an odd situation.

While neither DVMT or VMW have any material voting rights, the two stocks are significantly different in that DVMT is exposed to Dell's highly leveraged balance sheet as DVMT is a share class of Dell Technologies (the merged Dell and EMC) not VMWare.  After the deal closes, Dell will be levered about 6 times and their debt is rated below investment grade, Dell's stated plan is to deleverage (as they did following their 2013 buyout) over the next 18-24 months in order to re-achieve an investment grade rating.  Their debt facilities do allow for some share repurchases but I would expect those to come second to the initial de-leveraging.

The big question is what discount should be applied to the DVMT tracker for taking on the additional balance sheet risk?  I think most scenarios where Dell ends up in serious financial trouble so does VMWare.  Several have speculated that Dell is really interested in VMWare over the rest of EMC, VMWare's software will be a key differentiating factor in Dell's enterprise business going forward.  If one falters the other will, Dell is in complete control of both.  The circumstance where Dell's balance sheet could be an issue for DVMT is a near term slowdown in their business that puts a wrench in the de-leveraging plan.  What discount is that risk worth?  I'd vote a 15-20% discount is fair for DVMT, it's currently trading at $43.90 and VMW at $72.88, or a 40% discount.  I don't have a strong opinion on VMW's valuation but its trading for a forward P/E of ~17x or fairly close to the market as a whole for a company that's generating mid-single digits topline growth.

How does this structure get fixed long term?  Dell has the option to swap VMW shares for the tracker, but likely won't do so for both tax reasons and they don't want to give up control.  The more likely scenario is after paying down debt from the EMC transaction, Dell might come back for the tracker and VMW shares in another deal.  Dell's initial management buyout was scrutinized for being unfair to minority shareholders, so the prospect of Dell doing it again to VMWare is another possible reason for a high discount rate.  Either way, 40% seems too high and is worthy of a small position.

Disclosure: I own shares of DVMT

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.

NOLs
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.

Risks

• 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

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.

Risks:

• 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

Leidos Holdings: Reverse Morris Trust with Lockheed Martin

Following the draw-down of U.S. troops in Iraq/Afghanistan and the 2013 budget sequestration we've seen many defense and consulting firms spinoff their headwinds facing government services businesses (EGL, VEC, CSRA to name a few) as a way to continue to show growth.  In 2013, Science Applications International Corporation or "SAIC" spunoff it's slower growth technical services and IT divisions, the parent company changed it's name to Leidos Holdings (LDOS) and the slower growth government services division kept the name SAIC.  The reason for that spinoff wasn't entirely clear to me at the time, and still isn't, especially now that Leidos Holdings is acquiring the Information Systems & Global Solutions business of Lockheed Martin (LMT) in a Reverse Morris Trust transaction that will close in mid-August.

However after the transaction closes, Leidos will be the largest pure-play IT and government services contractor in the U.S., about twice as big as CSC's government services business CSRA.  They will be broadly diversified across government agencies, and internationally, in fact they'll be one of the few businesses to touch all seven continents as Lockheed's contract to run the U.S. research base in Antarctica will move to Leidos.  This is an industry where scale matters, in today's budget environment more and more contracts are being put out to bid as "Lowest Price Technically Acceptable".  Prior to sequestration, agencies used the "Best Value" method for determining a winning bid, allowing agencies to balance the trade-off between quality and cost, greater value for a higher cost was still okay.  Now the award goes to the lowest price as long as the bid meets all the technical requirements of the contract, there's less judgment on the contracting agency's part.  By being able to spread your corporate overhead over a larger contracting base, those with significant scale will be in a better position to compete on price.

Once a contract is won, it's often difficult to unseat the incumbent in future re-competes as the incumbent has the advantage of not needing to shoulder start-up and implementation costs, putting them in an advantage on price.  If a contract is lost, many of the employees working on the contract end up with the new contractor, the cost model for these firms is more variable than other industries allowing them to experience revenue declines but maintain acceptable margins.

Reverse Morris Trust Transaction
Below is an Leidos investor relations' slide outlining the transaction.  Lockheed Martin's IS&GS business generates about $500MM in EBITDA, at the $5B headline price, LDOS paid 10x EBITDA.

Leidos will be making a special dividend prior to the transaction closing to effectively true up the ownership bases of the two firms, in order for it to qualify as a Reverse Morris Trust and be tax free, Lockheed Martin shareholders need to own more than 50% of the combined company.  RMTs have been interesting to me recently because they pair the effects of a spinoff, but with immediate/improved scale and an in-place management team.

Valuation
There will be approximately 151 million diluted shares outstanding after the transaction is complete, the Leidos special dividend will be $13.64 adjusting the pro-forma stock price down to $34.95 for a $5.3B market cap company.  Per the prospectus, the combined pro-forma EBITDA is $1.05B without any cost synergies which are expected to equal $120MM by 2018.

I have pro-forma Leidos trading for 8.2x EBITDA, 1-3 turns below most of their peers despite the company's new scale which should make them more competitive and lead to an increased win rate.  While 8x EBITDA might not be absolutely cheap for a business like Leidos, consider the U.S. Federal government has a budget for the first time in years with all sectors of government including the Department of Defense seeing increased appropriations.  The economy is still sluggish and treasury rates are near record lows, fiscal spending is likely to increase in an attempt to spur growth as deficit concerns and the risk of sequestration lessen.

Exchange Offer
There's a cheaper way to buy LDOS shares being offered right now.  Instead of spinning off LDOS shares directly to shareholders, Lockheed Martin is conducting an exchange offer where LMT shareholders can select to exchange their LMT shares for LDOS shares at a 10% discount rate (subject to an upper limit).  Even without the exchange offer this is an attractive deal and LDOS should be worth ~$44 per share (adjusted for the $13.64 special dividend) or 9.5x EBITDA.

Disclosure: I own shares of LMT (will be exchanging for LDOS) and CSRA

Hawaiian Electric: Public Utility Commission Denies NextEra Merger

Late last Friday, Hawaii's Public Utility Commission voted against NextEra Energy's (NEE) 19 month old deal to purchase Hawaiian Electric (HE) which provides electricity to 95% of the state.  I held out brief hope that the initial rejection would be a political move as the merger is deeply unpopular in Hawaii (they don't like outsiders) and both sides would come back to the table, make some concessions and the deal would get done.  No luck.  NextEra threw in the towel on Monday and terminated the merger transaction, Hawaiian Electric will receive about $95 million in a termination fee and deal expenses.  As part of that transaction, Hawaiian Electric was going to spinoff their bank subsidiary, American Savings Bank (ASBH), to HE shareholders but now that has also been shelved.

The shares sold off about 7% (to be fair they sold off about the same two weeks ago in anticipation of a no vote) as merger arbitrage investors exited the trade, when a deal breaks it often creates opportunities, time will tell if this is one with HE.  So what now?  Who would go through the pain of dealing with Hawaiian regulators to buy HE?  It's fairly clear that the utility can't go it alone and make the state's desired clean energy mandate by 2045.  Reports show that Berkshire Hathaway's energy subsidiary recently registered a business in Hawaii.  Berkshire has the brand recognition, deep pockets and commitment to moving towards clean energy that could appeal to the Hawaiian populace; Warren Buffett again playing the "friendly" acquirer role.

I continue to hold for the time being, if they were to find another buyer or just spinoff ASBH outright it could be a very attractive transaction.  To summarize the spin's appeal:

1. Regulatory spinoff - 1) Anyone besides HE isn't allowed to own ASBH per Federal banking regulations, it's a strong bank that's capital allocation is being driven by the needs of a weakly positioned utility; 2) As part of HE, ASBH's debit card exchange fees are capped as part of the Durbin Amendment due to the overall size of HE.  If ASBH was independent it would fall under the threshold and regain $6MM in net income annually from debit card exchange fees (about a 11% increase).
2. Differing investor bases, potential forced selling - 1) HE is primarily a utility and owned by many utility focused funds and ETFs, post deal these funds would be forced to sell ASBH; 2) HE is owned by many retail dividend focused investors who will likely sell ASBH as it only makes up a relatively small portion of HE's enterprise value.
3. Strong local market - The Hawaiian banking market is strong, loans are growing at 8+% and deposits are growing at 5%, the two other publicily traded Hawaiian banks trade for 1.7x BV and 2.75x BV, choosing the lower of the two would put ASBH at about $8-9 per HE share.

Disclosure: I own shares of HE

Mid Year 2016 Portfolio Review

Brexit free discussion ahead, it was a fairly crazy first half of the year even before the last week, at one point in February my blog portfolio was down almost 20% before climbing back to gain of ~6% at the halfway point of the year.  The significant winners have been MMA Capital, NexPoint Residential, American Capital and Gramercy Property Trust - the significant losers have been CSRA, Liberty Global's LiLAC Group and Par Pacific Holdings.

Current Position Updates:

• Crossroads Capital (XRDC) is soliciting a shareholder vote to convert to a liquidating trust, cash makes up about $1.40 of the $2.05 current share price, it may take a few years to fully liquidate but I assume much of the cash will be distributed to shareholders (technically unit holders) shortly after the liquidating trust conversion reducing the basis and pulling some of the potential return forward.  I added a little more since I first discussed the idea, there might be some indiscriminate selling from those who don't want the illiquidity of a non-tradeable security ahead of the conversion.
• Another current position I recently added to is CSRA (CSRA) which is the U.S. government services spinoff of Computer Sciences Corp (CSC).  I had the original idea right that CSRA should be sold after the spin and CSC held as it was the buyout candidate of the two (HPE is doing an Reverse Morris Trust with CSC) but ended up calling a poor audible and holding CSRA instead for tax reasons.  CSRA is down 25-30% for little reason since then.  The U.S. government has a budget for the first time in years and most government agencies (including the Department of Defense) have seen funding increases.  Leidos (LDOS) is buying the services business of Lockheed Martin (LMT) later this year in a Reverse Morris Trust transaction (could be an interesting split off special situation) for 10x EBITDA, no reason that CSRA should trade for a couple turns below that.
• NexPoint Residential Trust (NXRT) has had a nice run recently on minimal news and is basically at my estimation of fair value in its current external management form.  I want to continue to hold as I like the strategy and their target markets in the Southeast and Southwest but it's hard to fully commit to an external management structure (despite significant insider ownership) as the principal-agent problem is strong and management's best interests are often at conflict with shareholders.  I've sold a little bit and will likely continue to do so, just being slow about it to hedge against Highland selling the company outright in the $20-22 range.

Closed Positions:

• The spread has come in on the American Capital (ACAS) deal with Ares Capital Corp (ARCC), but in the wrong way with ARCC falling since the deal was announced.  After letting the deal settle in my head, I decided merger arbitrage isn't my strong suit so I sold around $16 and moved on.
• I ended up selling Gramercy Property Trust (GPT) this month around $9 after owning it for nearly five years, at that time it was a busted commercial mortgage REIT that held the junior debt and equity in three CRE CDOs that were in various levels of distress.  The old board brought in Gordon DuGan and team in the summer of 2012 to transform the company into a net lease REIT focused on industrial and office properties.  New management grew the company quickly through several large acquisitions and corresponding capital raises which was topped by the merger with Chambers Street late last year.  The market didn't initially respond well to that deal, likely because of Chambers Street's previous private REIT status and corresponding messy asset base and unsophisticated retail investors.  REIT mergers are great because of the scalability of the business, once a management team is in place, there's significant operating leverage.  Gramercy was able to eliminate most of the Chambers Street expense structure and recycle the random assortment of office and industrial properties into a more streamlined portfolio that public REIT investors would assign a premium valuation.  That process is far enough along and investors are once again giving Gramercy credit, I have the shares trading for about a ~6.5% cap rate, and given it's new larger size and wider coverage, just don't see a lot of additional alpha remaining.
• Sycamore Networks (SCMR) drew me in with it's large NOL asset and two activist investors who were looking to stop the ongoing liquidation and preserve the tax asset.  However, the company is set on a liquidation and made an additional distribution during the first half of the year, making it even more unlikely that the tax asset can be monetized (and as we see with Par Pacific and others, even with management focused on the tax asset, not always easy to actually make a dent in it quickly).  It was already a small speculative position for me and after the liquidation distribution it was even smaller, wasn't worth mental effort any longer and I sold for a small loss.

Current Portfolio:

My watchlist is a bit short on new ideas other than a few nano-caps, if any readers have their eye on anything interesting that I should be looking at, please reach out.  Otherwise, have a great holiday weekend for those in the United States and thanks for reading.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation (most of which is restricted) which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Pinnacle Entertainment: Tax Attributes, Remaining Real Estate, Insider Buying

This post is mostly a promo for this month's Special Situations Research Forum meeting hosted by the CFA Society Chicago, I'll be leading the discussion on Pinnacle Entertainment (PNK) and the recent sale of its real estate to GLPI.  We usually get anywhere from 6-12 people, it will be held in the loop on 6/27 at 5:30pm, if you're in the area and would like to attend, sign up here or shoot me an email.  Here's the original post from last month, and then below are some additional thoughts around assets that add to PNK's undervaluation to complete the picture.

Tax Attributes
At the time of the GLPI transaction, old Pinnacle had significant NOLs along with the standard D&A tax shield that made it an insignificant federal income tax payer.  The NOLs were exhausted through the taxable spin of the OpCo and even though the D&A of the real estate will still flow through the GAAP financial statements, they can only depreciate the assets they own for income tax purposes.  But due to the structure of the spinoff, Pinnacle Entertainment will continue to be a minimal income tax payer, below are explanations from both PNK and GLPI executives:

"However, we did receive a step-up basis in our assets.  That step up just to give some shorthand for it.  You look at the enterprise value of the company as a whole.  We had a tax basis on what was spun of roughly about $1 billion and the difference between those two will be amortized over a 15 year period evenly.  That will create a deduction going forward, main point being, that our effective tax rate will be materially lower than the statutory one by virtue of the deduction" - Anthony Sanfilippo, Pinnacle Entertainment CEO

"..and the reason we did it this way [spin the OpCo and merge the PropCo with GLPI], was obviously to help solve for some tax problems.  It also, some people expressed some concern that the Pinnacle NOLs would be going away but the reality is, on the spin they will be getting a stepped-up basis of the NOLs as well as to the extent that we pay gain above and beyond the NOLs, their assets will get stepped up actually higher than their NOLs.  So in the end they should be, from a tax perspective, in very good shape going forward with a higher asset level basis for depreciation." - William Clifford, GLPI CFO

Back to the EBITDA to free cash flow bridge slide:

Pinnacle is projecting only $4MM in cash taxes annually on the current business (including the Meadows acquisition), gaming companies typically aren't significant tax payers due to their considerable fixed assets, but even with the sale of their real estate to GLPI, Pinnacle via the stepped up basis of their assets/goodwill that they'll be able to amortized over 15 years have maintained similar same tax efficiency.  I'd be curious to hear anyone's thoughts on how much their tax attributes could be worth?

Real Estate Remaining at Pinnacle Entertainment (OpCo)
GLPI is a net lease REIT and thus uninterested in development assets, their investors want predictable cash flows and not excess land sitting around generating insufficient revenue for dividends.  As part of GLPI's sweetened offer to buy Pinnacle's real estate they sent a letter to Pinnacle's shareholders outlining the increased value of the second offer, and specifically called out the property assets to be left behind at the operating company.

Belterra Park

In 2013, old Pinnacle began the redevelopment of the River Downs racetrack outside of Cincinnati to be refashioned as Belterra Park (to create an association with the Belterra Casino Resort across state lines in Indiana) a "racino" with video lottery machines and six full service restaurants.  The all-in redevelopment price was approximately $300MM, it opened in the spring of 2014 and almost immediately began to under-perform expectations.  By the time GLPI came knocking with an offer to buy Pinnacle's real estate on an earnings basis the Belterra Park property was generating almost nothing - making it a hard fit for a REIT - it would have to be valued at almost zero for it to make sense to GLPI shareholders who demand a current yield on their assets.

William Clifford, CFO of GLPI said on a call discussing the deal:

"The primary reason why we left off Belterra with the operating company is because on a historical basis it has fairly low levels of EBITDA which meant that we weren't really paying very much for it.  And what we were able to do by leaving it behind, was to take the tax basis of the property and transfer that to OpCo which will eventually save us taxes on the gain relative to spend.  That represented probably somewhere north of $50 million worth of tax savings.  So even on a multiple basis, it seemed to make sense and quite candidly, we think it adds value for OpCo and will depreciate by the Pinnacle team."

The decision to leave Belterra Park with the OpCo was made almost a year ago, since then the property has begun to turnaround its performance.  Ohio built 4 casinos between 2012 and 2013, plus granted licenses to many similar racinos, all that development at once hurt the entire market in the state and is just now beginning to recover, Beltera Park included.  Net win at the racino is up 31% year over year through April of this year.

GLPI valued it at $75MM in its letter, typically I would discount this valuation as GLPI was attempting to convince Pinnacle shareholders the deal was in their best interest.  But if anything, $75MM seems low compared to the initial development costs even considering the properties initial struggles - but improving - and additionally new Pinnacle will benefit from the depreciation tax shield in addition to the step up basis on the sold assets discussed earlier.  It's also clear that Pinnacle's management is willing to sell real estate and may look to do a sale-leaseback of Belterra Park once it fully stabilizes.

Excess Undeveloped Land - Lake Charles & Baton Rouge
Staying with Pinnacle Entertainment is roughly 500 acres of undeveloped land, about 50 of those acres are adjacent to their flagship L'Auberge Lake Charles resort which is positioned as a regional destination with non-gaming amenities (concerts, restaurants, golf course) and has an equally positioned Golden Nugget resort next door (which was supposed to be an Ameristar Casino, but Pinnacle had to divest it at the time of the Ameristar-Pinnacle merger).  This land could potentially be valuable as an additional redevelopment asset for this growing market and could benefit from the Golden Nugget casino as well building up the overall market and land value around the two casinos.

The other 450 acres around the L'Auberge Baton Rouge resort looks a bit more uncertain given its size and isolated location (at least according to Google Maps).  GLPI valued the excess land near both properties at $30MM or roughly $60,000 per acre which seems within reason.

Insider Buying
While the new Pinnacle Entertainment isn't your normal spinoff since all the employees came with the spinoff, it's still encouraging to see management has been buying shares in recent weeks (maybe with proceeds from GLPI shares?) giving more validity to their own thesis that the shares are undervalued.

In addition to the insider buying, the company also announced a $50MM share repurchase plan signaling both confidence in their free cash flow and again that their shares are undervalued.

Summary
Profroma for the Meadows acquisition that should be completed this fall, Pinnacle Entertainment trades for 6.5x EBITDA whereas its near identical peer in Penn National Gaming trades for 7.5x EBITDA.  Yes, the structure is leveraged unconventionally and has some risk, but for a $700MM market cap company with almost no tax liability going forward and ~$105MM in real estate provides additional margin of safety at this valuation.  Additionally, management and the company itself are significant buyers of the company's shares.

Disclosure: I own shares of PNK