Tuesday, January 23, 2018

Spirit Realty: Leveraged Shopko Spinoff Uncovering Value

Spirit Realty Capital (SRC) is a triple net lease REIT focused on single tenant commercial real estate, SRC effectively makes middle market loans secured by real estate collateral.  The REIT is very similar to STORE Capital (STOR) which did a private placement with Berkshire Hathaway last year, the difference being Spirit has a high concentration to one troubled retailer, Shopko, that is creating an unwarranted discount in the shares.  REITs generally need their shares to trade at a premium to NAV in order to play the private/public valuation arbitrage game and grow, when a REIT trades a significant discount like Spirit does, it gets stuck and is forced to come up with a strategy to continue on a growth path.  Spirit was a net seller of assets in 2017, but it has come up with an interesting solution to fix their discount, in the second quarter they will be spinning off their Shopko assets along with the assets and debt related to one of their asset backed securitization vehicles called Master Trust 2014.  The spinoff will be named Spirit MTA REIT (SMTA) and is generally viewed as a garbage barge spinoff that's worthless, while it's likely to trade ugly initially, there's call option like value in the spin while more importantly allowing the parent company to shed its riskiest asset.  After the spinoff, Spirit should trade more inline with its net lease peers.

Here's how the combined SRC compares to its net lease peers:
Most REITs are going to look cheap compared to Realty Income Corp, but after the spinoff new SRC should look a lot like STORE Capital and that large discount between the two should close over time.

The "bad bank" REIT will primarily contain two sets of assets (today they tossed in some more workout assets similar to Shopko that will be sold with the proceeds going into the Master Trust):
  • Shopko is a mostly rural (midwest and western US) discount store that's facing similar pressures to many retailers, its under-invested in its stores and sells ubiquitous products that you can buy almost anywhere.  It's target market is similar to Sears, its sort of an unfocused general store.  Spirit currently leases 101 properties to Shopko, representing 7.8% of its lease roll (prior to the spinoff), it recently became a secured lender of Shopko as well, advancing $35MM in the form of a term loan at a 12% interest rate.  The term loan will provide SRC/SMTA with quarterly financial statements and more direct insight into how the business is performing and also gives them optionality to separate the Shopko assets further if necessary.  SRC has been selling down Shopko assets in recent quarters/years, and will continue to do so at SMTA with the goal to completely dispose of the assets within 24 months of the spinoff.  With the proceeds from the dispositions, SMTA will contribute those proceeds to the Master Trust and lever it up.  The Shopko portfolio is debt free today, so in the event of a bankruptcy/liquidation at Shopko, the remaining assets at SMTA within the Master Trust shouldn't be impacted.
  • Master Trust 2014 (also seen it referred to as Master Trust A): Here's the interesting portfolio, the Master Trust portfolio is setup as an SPV, its bankruptcy remote from the rest of SMTA, and has a A+ rating by S&P with a 75% LTV.  The asset base is very similar to that of the rest of SRC, single tenant triple net leases, albeit a higher concentration of smaller tenants.  The effective leverage SMTA will be able to get inside the SPV is about 12x EBITDA.  I was able to locate the trustee report and the distributions to SRC have been pretty consistent over the past few years and they haven't stuffed the SPV with bad assets since announcing the spin.  Through the Master Trust and a new CMBS issue, SRC was able to raise an additional $698MM in debt at SMTA that will be used to reinvest in STOR/O/NNN like assets at SRC.
SMTA will be externally managed by SRC for an annual fixed fee of $20 million plus a $6 million property management fee.  There's additionally a one time incentive fee that triggers in the event of a change of control or the management agreement is terminated without cause after 3.5 years.  I think that shows you where management's head is at, if things work out, this entity will be merged away or some other transaction will take place within plus/minus 3.5 years.

I had a simple model put together late last week to break out new-SRC vs SMTA, but today the company released an updated presentation that does all the heavy lifting for us:
New-SRC is the critical piece to the overall SOTP, after the spinoff it will be under leveraged compared to peers with a largely similar tenant roster, if it can re-rate to STOR's multiple (not suggesting it happens over night) it's a $9.75 stock ($0.65 * 15) versus an $8.50 price today, and that's a conservative approach since we already know they're going to have a lot of dry powder ($698MM from SMTA that they'll lever 2-1) to start the acquisition engine again, growing AFFO.

SMTA won't have any close peers that I'm aware of (please correct me if there is one) and will probably trade terribly initially as the investor base for SMTA will be much different than SRC.  SRC provided an NAV build in the presentation today, the $1.61 value in the Master Trust is likely pretty solid (as of January 2018) as its just refinanced and had a third party assess the value of the collateral as part of that process.
The Shopko and workout assets are a little trickier, SRC has been able to dispose of some Shopko properties at similar cap rates to what they're showing here, but its unlikely the public REIT market will assign a 9% cap rate to the Shopko leases.  Quick and dirty, I'd probably assign a 50% discount to the $2.34 NAV presented here for today's purposes although I like the spinoff for its call option like return potential if their reinvestment plan works given the leverage at the Master Trust.

$9.75 for new SRC + $1.17 for SMTA = $10.92 versus a share price of $8.50 today, or ~30% upside without accounting for any new investments either side makes with their growth capital.

Why is this so undervalued?  I think it mostly relates to the typical net lease investor base, REIT investors like simple and safe stories, this spinoff transaction while creative is far from simple and the headline concentration risk to Shopko has scared away many investors.  This spinoff should remove the tenant concentration risk, simplifies the story, and then through the reinvestment of the capital raise from SMTA, allows SRC to return to the market and show a growing AFFO/dividend stream which should also help raise the valuation.

Biggest risks here: 1) interest rates moving higher than expected, the majority of their leases do have escalators built in but they're long dated and the investor base is also interest rate sensitive as net lease REITs are viewed as a bond alternative; 2) general recessionary risks, particularly with retail, although SRC is trying to move more towards services based tenants, these are risky borrowers that often can't get traditional financing elsewhere so they turn to a sale-leaseback transaction.

Disclosure: I own shares of SRC

La Quinta Holdings: WYN Buying OpCo, PropCo Undervalued

In a recent post I mentioned there are some interesting spins on the horizon, one of those is La Quinta Holdings (LQ) doing an OpCo/PropCo split sometime in Q2 2018.  Their plans changed a little last week with the announcement that Wyndham Worldwide (WYN) - also doing an interesting spin - is buying La Quinta's asset-lite management company business for $1.71B in cash (after backing out $240MM Wyndham is reserving for potential taxes La Quinta will owe in the spinoff) or roughly 15.1x EBITDA.

Since Wyndham is paying cash, it's fairly easy to back into what value the market is assigning to La Quinta's PropCo spinoff, to be named CorePoint Lodging (CPLG).  Today, La Quinta's enterprise value is roughly $3.83B and combined company has an estimated $331MM in EBITDA for 2017.  Wyndham is paying $1.71B for the management company that will do $113MM in EBITDA, leaving an EV of $2.12B and $218MM in EBITDA behind in the REIT spinoff, for a 9.7x EBITDA multiple.
CorePoint is a hotel REIT, I've discussed the disadvantages of those in previous posts, but in summary they're more an operating company/franchisees than true REIT models, they're taking the majority of the business risk rather than acting as a landlord charging rent.  La Quinta's model is a mid-market select service hotel, historically they've been concentrated in the south (particularly Texas) but have expanded and diversified in recent years after being hit hard in the oil downturn.  Their hotels typically tend to be situated in suburban, airport and interstate locations that might be less susceptible to AirBnB but more at risk for overbuilding/supply risk.

There are a lot of hotel REITs, here's a small sample of internally managed ones I pulled, they might not all be perfect comparable companies but as you can see, none of them trade below 10x EBITDA:
If CorePoint is worth 12x EBITDA, my math gets me to about a $14/share price for the spinoff (might move around a little depending on the eventual net debt on the spin) + $8.40/share from Wyndham for the management business for a total of $22.40 versus a $19.60 stock price today, or about 14% upside.  No one is going to get rich on this idea, if you could isolate the spinoff directly it'd be a better deal, but I like the risk/reward.  Two other points to consider: 1) the $240MM WYN is reserving for taxes approximates a $2.85B EV valuation or 13x EBITDA for CorePoint (21% on the difference between the first day of trading and the book value of the assets); 2) since CorePoint is a taxable spinoff (REIT spins are no longer allowed to be tax free) it will be immediately be available to get acquired, and I expect it won't be a standalone company for very long.

Disclosure: I own shares of LQ

Wednesday, January 10, 2018

MMA Capital: Externalizing Management, Transforming into BDC-Like Vehicle

Woke up to some fun news Tuesday, MMA Capital (MMAC) is selling its asset management business and some other assets to Hunt Investment Management for $57 million resulting in Hunt becoming the external manager of MMA Capital.  Once the dust settles, if you squint hard enough, MMA Capital will look like a BDC or yieldco but maybe without the high dividend to attract in retail investors.  Even though my thesis is almost played out (original idea: this was a pile of assets that was hidden by GAAP accounting choices, maybe one day becomes an operating company), the current price may offer a short term opportunity as the series of transactions with Hunt are completed.

Here's the deal deck (try not to cringe, MMAC clearly didn't pay high priced advisers): https://mmacapitalmanagement.com/wp-content/uploads/docs/MMAC-Shareholder-Presentation.pdf

Who is Hunt Investment Management?
Hunt is a privately held asset manager that focuses on real estate and infrastructure sectors, they specifically mention they manage $12B in real estate related assets and have some expertise in public-partnerships, military housing, and other sectors that might have some parallels with MMA Capital's affordable housing and solar energy verticals.  All of MMAC's employees will move over to Hunt and keep their same employment contracts which still do call for much of management's bonuses to be invested in MMAC's stock in open market purchases.

The new management fee agreement is the biggest concern I see in the deal, it's 2% annually (0.5% quarterly is how its presented, hate that optics game) of shareholder equity up to $500MM and tiered down to 1% annually after that.  We're a long way from $500MM, so its effectively 2% for the foreseeable future.  Plus Hunt will get a 20% carry on shareholder returns above 7%, so this is a fairly standard (bad) external management agreement like you'd typically see in the BDC industry. There is a carve out for this year that adjusts the equity value up to the proforma book value of ~$33.50 shown in the presentation when calculating 2018 fees and will be adjusted to exclude the effects of the companies NOLs in the event the valuation allowance is removed and a deferred tax asset is recognized.  There's also a termination payment of 3 years fees, so yes, while this is standard and I assume Hunt required this to protect their $57 investment, its far from a shareholder friendly deal.

What's Left?
This transaction removes the main remaining 'hidden asset' the company had, the asset management platform it had built in affordable housing, South Africa multifamily, and solar energy.  What's remaining is the bonds themselves, their investment in one of the South African funds, and two real estate projects.  Additionally they have ~$400MM in NOLs that are worth less under the new tax code.  If they ever are realized it'll be because MMAC was able to raise capital, scale up, and generate some taxable income (their plan), but that also means a higher share count and the value of those NOLs will be significantly diluted to current shareholders by the time their realized.

In their own words:
The new strategy sounds very much like a specialized BDC (maybe the altruistic mandate will appeal to some people) attempting to earn a ~10% ROE, general rule of thumb is a 10% ROE financial should trade for roughly book value.  Today it trades for $28.60, leaving 17% upside to the proforma book value, maybe that discount is deserved for reasons discussed below, but I'll continue to hold for now and wait for the dust to settle.

Other thoughts:
  • The company is doing a capital raise with Hunt, where Hunt will be purchasing $8.375MM worth of MMAC stock at $33.50, afterward Hunt will own a little more than 4% of the company.  This is in addition to the $57MM headline number, mostly for PR to show alignment of incentives with the public shareholders.  While not an arms length transaction, still shows someone is willing to pay book value.
  • MMAC is providing seller financing to Hunt for the full $57MM amount, 7 year term at a 5% coupon.  Hunt will be receiving about a $4MM annual base management fee off of the proforma equity base of ~$200MM.  When coming up with a new NAV, might be reasonable to discount it, not necessarily for credit reasons (the base management fee easily covers the annual interest payments) but because MMAC's capital is now tied up in an asset that wouldn't meet its targeted return requirements even if levered up.  They'll have a little drag in the portfolio until its redeemed.
  • CEO Michael Falcone owns over 182k shares (~3.15% of the company) and his lieutenant Gary Mentesana owns over 167k shares (~2.87%), they've been surprisingly transparent on conference calls, structured their compensation to align with shareholders, bought back as much stock as they legally could; they're mostly aligned with shareholders in this deal despite now being employees of Hunt.  I don't see this as a typical dirty BDC-like management stealing the company type move.
  • They didn't specifically touch on it, but the company will likely need to pay a dividend in order to raise capital in the future, that's at odds with most NOL companies mantra to retain all earnings in order to grow and pull the NOL forward as much as possible.  I think a dividend would be the right move once the transactions are finalized, as mentioned earlier, the NOL is going to get diluted anyway, might as well get the valuation uplift from yield based investors.
I started this post with the idea that shares were unfairly undervalued after the deal, but maybe the price is approximately right given the deal closing risks, interest rate risk in the current environment, and the discount applied to externally managed companies.  Most of all, the deal is probably management signaling the heavy lifting is all but complete in bringing MMAC back from the brink after the financial crisis.  So this is more of an update and an interesting twist in this deep value micro cap story, would love to hear from other MMAC shareholders too.

Disclosure: I own shares of MMAC