Thursday, December 31, 2020

Year End 2020 Portfolio Review

What a traumatic and unpredictable year, certainly it has been tragic for those directly impacted by the virus or who have suffered the death of a loved one.  From a pure financial standpoint, I am in a lucky position where I'm able to work from home and didn't need to tap into savings or my brokerage account to make it through the year.  Being in that fortunate position, and also not managing outside capital, allowed me to hold through difficult times and not capitulate.  However, especially after November and December there are now signs of excess everywhere and I'm having a hard time squaring overheated speculation in certain areas with the never ending list of bargains I'm finding.  Confusing times in the market.
I finished the year up 24.34%, which is well shy of some others investors performance this year but still above the S&P's 18.40% -- fully acknowledging that the large cap index is not a good benchmark for my portfolio, on the surface I take more risk, but it's more of an opportunity cost bogey and widely quoted.  My lifetime-to-date IRR of this portfolio is 24.52%.  Positive attribution winners this year included Green Brick Partners (GBRK), Colony Capital (CLNY), Five Star Senior Living (FVE) and Franchise Group (FRG); negative attribution losers were MMA Capital Holdings (MMAC), Liberty Latin America (LILA/K) and some undisclosed special situations (MCK/CHNG splitoff, MGM tender) that went haywire in the spring meltdown.

Thoughts on a few Current Positions
  • While not a high conviction idea, I still do like Accel Entertainment (ACEL), the largest distributed gaming provider in Illinois.  The thought here is that slot players are going to go hyper local post-covid, why drive an hour or two to a depressing rundown regional casino when you can drive five minutes to a depressing rundown strip mall?  These VGT locations are essentially mini-casinos first and a bar or restaurant second, the bar/restaurant piece is often regulatory arbitrage to allow for the VGTs and not the other way around.  Regional casinos make the vast majority of their money from slot machines, ACEL is the slot machine revenue without the capex and overhead of actually running a casino.  Currently there are no VGTs in the city of Chicago, but with covid destroying the budget even further, wide spread tax increases seemingly difficult to push through in the current economy, legalizing VGTs within the city limits could be on the table providing an easy growth opportunity for ACEL.
  • Despite a good run in 2020, Five Star Senior Living (FVE) is still a cheap stock, with an enterprise value of just $150MM ($96MM of cash, $7MM of debt, and I'm capitalizing an RMR termination payment of 2.875x annual fees) and another $96MM of owned real estate on the balance sheet, against $30-35MM of EBITDA, trading under 4.5x EBITDA for a company that is now mostly an asset-lite management company.  Tucked away inside of FVE is a high growth rehabilitation concept, Ageility, that is growing quickly and only requires $20-30k of upfront start up costs per new location, it could be quick to scale.  What happens to all the cash?  Management clearly has their hands full operating the business this year, but once covid passes, what will be the capital allocation plan?  It hasn't been well articulated at this point.
  • My obligatory bullish comments on Howard Hughes Corporation (HHC) -- Their diversified model should help them versus pure play REITs, in the coming years I picture HHC being more focused on residential land development than on office/multi-family new construction they were pre-covid, their big land banks are in Las Vegas and Houston, maybe not as hot as Austin and Miami but they're both low cost-of-living and no state income tax markets that should have the wind at their backs.  While not in the same markets, Green Brick Partners (GBRK) should continue to benefit from similar migration trends to Texas as well as their shift in focus to entry level homes which are benefiting from incredibly low mortgage rates.  Rounding out a real estate discussion, "new" BBX Capital (BBXIA) should still have some upside despite the obvious problems, their assets are primarily cash, a note to a timeshare operator (good reopening/stimulus trade) and Florida real estate which should have continued tailwinds.  It's trading at just 35% of book value, even if the right number is 50% of book value, that represents an additional 42% upside.
  • MMA Capital Holdings (MMAC) has been a frustrating hold since they went to an external structure, I won't pretend that I've spent more than a few minutes on Hannon Armstrong Sustainable Infrastructure Capital (HASI), it appears to be a better and more diversified business, but it trades at over 4.75x book value and MMAC trades at 0.65x.  Just reading through the HASI 10-K and investor presentations you get all the good ESG vibes that MMAC should be putting out, but still aren't, maybe with the recent CEO we'll see a change, with all the money flowing into ESG products, MMAC has to take full advantage.  Even from a skeptical external manager point of view, you'd assume Hunt wants a piece of what could be a decade long theme.
  • Colony Capital (CLNY) was a significant winner for me this year, thank you to those that encouraged me to take a closer look at the common after my post on the preferred stock near the bottom of the crisis.  I doubt I'll have much to add on CLNY going forward, the business is a bit above my head, but willing to give Ganzi some room and will continue to hold.  I found this write-up well done and helpful in modeling the path forward from here.  Even if you're not sold on CLNY, I think it is worth of monitoring because of the number of transactions that revolve around it (hopefully CLNC), there will opportunities that arise in the next few years.
Previously Unmentioned Positions
  • Back in the spring, I puked out of my position in Perspecta (PRSP), a 2018 spinoff of DXC that provides IT services to the government, but since then activist fund JANA Partners has taken a liking to it after PRSP passed its 2 year safe harbor post-spin making it able to be acquired without jeopardizing the tax free spinoff.  In November, Bloomberg reported that PRSP had hired advisors to pursue a sale.  The original thesis was that PRSP could be a replay of CRSA (also a DXC government services spinoff) which was sold for 12x EBITDA to General Dynamics, that thesis might still hold, 12x PRSP's ~$600MM EBITDA would be approximately $30 per share. 
  • ECA Marcellus Trust I (ECTM) is a 2010 vintage oil and gas trust that were a popular structure a decade ago, an E&P company would sell producing wells to the trust and the trust in turn sold shares to retail investors promising high dividend payments.  Unsurprisingly, these didn't go quite as promised, ECTM is now a tiny nano-cap that is pushing closer to tripping a clause in its trust indenture that would force a liquidation of the trust, returning any proceeds to unit holders.  ECTM shut off the dividend and if the royalty payments fall below $1.5MM for the trailing twelve months the trust will liquidate, royalty payments were $1.12MM through 9/30 putting it very close to tripping for the year.  Greylock (successor to the original sponsor ECA) projects the royalty to exceed the threshold this upcoming quarter (however that was before natural gas prices started to fall on fears of a warm winter), even if it does, it appears this trust will trip it sometime next year forcing the liquidation.  The trust has 17,605,000 units outstanding, trading at a price of $0.17, for a total market cap of just ~$3MM against a book value of $17MM.  Most of that book value is the estimated fair value of the royalty interests which can be pretty squishy, Greylock has the right of first refusal buying the royalty interests back and there's a bit of uncertainty around if ECTM is entitled to get 100% of that payment or 50% (I read it as the 50% clause applies only on the formal trust termination date of 3/31/30 but I could be wrong).  Either way, pretty attractive upside that should be non-correlated with much of the market, but again, only a small PA type trade.
  • I did jump into the SPAC arb trade with Pershing Square Tontine Holdings (PSTH) thanks to a great post by Andrew Walker.  Instead of selling puts, I did a buy-write trade, just fits my eye a little better.  I see the downside as pretty minimal, Bill Ackman is an incredible marketer (I'm generally a fan of him despite his flaws) and if a deal is announced in the next few months that would close before 6/18/21, I have a hard time imaging it would trade significantly below the trust value after it de-SPACs.  Ackman will get on TV, etc., and he'll also be investing a significant sum alongside PSTH in a pre-committed PIPE at $20 further providing support to the transaction value.  Selling pre-deal SPAC call options might be a theme for me next year.
Closed Positions
  • On 10/19, Front Yard Residential (RESI) announced that it would be acquired by a consortium of private equity (Ares and Pretium) for $13.50 per share, I sold that day, and then several weeks later on 11/23, the offer was bumped up to $16.25 after a better offer came to light.  This could be the start of similar deals where post-covid the entity will be too subscale (MCC and CLNC are two potential examples) and there is plenty of private equity money out there willing to buy cheap real assets.
  • I've mostly reduced my exposure to hospitality plays, Extended Stay America (STAY) has weathered the storm nicely as their rooms feature kitchens (limiting interaction between guests) and acts as temporary residences rather than true leisure travel.  It also drummed up some rumors of PE interest, I sold to put money to work in other places, but it could be worth monitoring as it still is the only remaining major hotel chain that is both the brand manager and the owner of its hotels (plus the weird paired share structure), eventually that will change.  Similar idea with Hilton Grand Vacations (HGV), it probably still gets sold at some point to Apollo (who will pair it with DRII before coming back to the public markets), but I sold to put money to work elsewhere, HGV might be interesting as a re-opening trade.  I could see stimulus checks going towards downpayments on timeshares, people will want to "live a little", prioritize vacations again, plus timeshares are similar to extended stay, often feature a kitchen and more space that might be desireable in a post-covid environment.  Lastly, I have been selling calls over and over on Wyndham Hotels & Resorts (WH), the implied volatility (not that I really know what that means) seems to be too high to me and so I've been rolling covered calls until the day when the shares get called away from me.  WH is almost a pure franchising play on economy and midscale hotels, which have held up better than the upscale business or destination focused hotels, but its trading at a fairly full 12x 2019 EBITDA and who knows when it'll get back to 2019 EBITDA levels?  I like the business, but feels like its been bid up as a reopening play alongside MAR/HLT when it shouldn't necessarily as its business model is significantly different enough.  These three all skew away from the traditional business traveler which will likely be the last to return in full, so all three could be attractive depending on your view of the reopening trade.
  • Another one where there is probably a little more upside but I've needed cash for other ideas is Gaming & Leisure Properties (GLPI), their primary tenant is Penn National Gaming (PENN), PENN's stock as 20x since the bottom and presumably has unlimited access to capital right now thanks to Barstool Sports and the online sports gambling theme.  PENN starts to pay cash rent again here next month which should allow GLPI to reinstate a cash dividend (dividends have been a combination of cash and stock this year) and should fully recover to the mid-to-high $40s. 
  • I finally let go of Liberty Latin America (LILA/K) this month (at least temporarily), I did fully participate in the recent rights offering and the stock responded well after that, but had a sizeable tax loss that just became too valuable for me this year.
  • I sold about 2/3rds of my Avenue Therapeutics (ATXI) position after getting long term capital gains treatment, unfortunately, I should have sold it all as I ended up taking a loss on the remaining 1/3rd when ATXI failed to secured FDA approval for IV tramadol.  Their merger partner has moved to terminate the deal while ATXI is trying to fix their FDA submission, I'm far out of my comfort zone in trying to handicap the situation but could be an interesting idea for others more inclined.
  • The Marchex (MCHX) tender offer was bumped up and I exited, haven't followed it much since then but did have several people reach out to me saying their call analytics software is best-in-class so there might be something there to those interested in small cap software businesses.
  • Maybe it was a bit of "quarantine brain", but I did a lot of small merger arb or other quirky special situations throughout the year that I didn't get to writing about or didn't have anything more to add to the discussion -- more than I normally would -- these included CETV, SKYS, BREW, DLMV, SPAC warrant exchange offers for BIOX and ATCX.  One positive to the SPAC mania this year is its likely to result in a lot of interesting special situation opportunities in the coming years.  Screw ups included the MCK/CHNG exchange offer where I was unhedged and loss a fair amount of money and to a lesser extent miscues with the MGM and AMCX tender offers.
  • Two old CVRs came up empty, INNL and GNVC, BMYRT appears to be the same way, I still want to like these but it is important to be selective, think through the structure of each CVR and the counterparty.  On the positive side I did receive interim distributions from IDSA and MRLB -- although curiously MRLB hasn't paid its final milestone payment despite the sales threshold being met several months ago, if you know the story there, please reach out.
Performance Attribution

Current Portfolio
My leverage is a bit higher than I'm comfortable with right now, but given personal circumstances, didn't want to realize gains in 2020 versus 2021, so I might be trimming early in 2021 (anecdotally I'm not the only one) some winners to make room for new ideas.  As always, thank you for reading and especially to those that I've interacted with either via the comment section or via email/DM, I'm not always quick to respond but I do appreciate the networking and the sharing of ideas has made me a better investor.  Happy New Year and stay safe, there's light at the end of the tunnel.

Disclosure: Table above is my blog/hobby portfolio, I don't manage outside money, its a taxable account and only a portion of my overall assets.  The use of margin debt, options, concentration doesn't fully represent my risk tolerance.

Sunday, December 13, 2020

Colony Credit Real Estate: CLNY Moving Quickly, CLNC Sale Next?

Colony Credit Real Estate (CLNC) is a commercial mortgage REIT that is trading at 52% of undepreciated book value (their owned real estate is triple-net), Colony Capital (CLNY) owns 37% of the shares and is the external manager of CLNC.  CLNY is in the midst of a transition to a PE manager focused on digital infrastructures assets (they've hinted that they'll likely convert to a c-corp next year) and is quickly selling off their legacy traditional REIT assets, in recent months announcing the sale of their hospitality portfolio (a bit of a surprise versus handing over the keys) and more recently their remaining industrial assets.  CLNY CEO Marc Ganzi is everywhere, blitzing the virtual conference circuit, multiple TV appearances and selling assets left and right, the CLNY stock price has responded by roughly doubling in the last 5-6 months.  

CLNY has two large assets remaining (lots of smaller ones too), their healthcare real estate portfolio and CLNC, prior to covid they announced intentions to pursue an internalization transaction with CLNC where CLNY would presumably have gotten additional shares in CLNC as compensation for their management contract.  Post-covid, that internalization concept no longer makes sense as the bid-ask spread is too wide since CLNC trades at such a significant discount of book value, it makes it difficult for both sides to come to an agreement, CLNY would have to take a discount or CLNC shareholders would face dilution for an internalization transaction to work at current prices.

What do I think might happen?  Somewhat similar theme to MCC, most commercial REITs are externally managed and thus incentivized to grow/acquire --  I think we could see Ganzi push a sale of CLNC and CLNY's external management agreement to another commercial mREIT.  This would create a win-win for all sides, CLNY would get full immediate value for their external management contract, the buyer would acquire CLNC at a discount which benefits both its shareholders and adds AUM to the buyer's external manager, and CLNC shareholders would get a premium to current price and relieve the overhang of what might happen to CLNY's non-strategic 37% ownership position.  There is some transaction on the horizon, just a matter of the structure, here is Ganzi on the Q3 CLNY earnings call (courtesy of

Jade Rahmani (KBW)

Okay. Well, I applaud the swift actions the management team had taken. Definitely refreshing and very good to see the progress. I wanted to ask you about a particular -- as Tom Barrack might call it a Rubik's Cube, which is CLNC. There's an overhang in the mortgage REIT space because people are looking at commercial real estate as a long cycle to recover and potential impairments, loan losses on the credit front. So that's one thing that they have to address. Secondly, there's the liquidity that go into managing that. And finally, there is some access investment capacity. But when you look at stocks like CLNC and there's many others TRTX, LADR, to name a couple trading at 40% to 50% of book value. It means that investors are also potentially assuming an eventual dilutive capital raise.

So CLNY owns 37% of CLNC. And to me, that bodes for an opportunity, you can have CLNC buyback some of those shares at a premium to where it's trading, yet it still would be wildly accretive to its book value, wildly accretive to its earnings. It would reduce the overhang of CLNY's 37% stake because people do wonder when those shares will be liquidated, and yet it would provide CLNY with fresh capital to accelerate the digital transformation. How do you think about that as a potential option for both CLNY and CLNC to explore?

Marc Ganzi

Well, Jade, it's almost like you bugged our investment committee. So look, seriously, first and foremost, I want to applaud Mike Mazzei, Andy Witt, David Palamé. For those of you that had the chance to hear that earnings presentation, it's also another great story of transformation and execution.

When we brought Mike Mazzei on board to run that business unit, we couldn't have been more clear about what the objectives were: first and foremost, to make sure that we shored up our loans that had any issues with them, hit repo lines on 2 loans, gravitating to liquidity, and Mike's done an amazing job stabilizing that portfolio, returning cash to the balance sheet. And now that business is poised, as you heard yesterday, to play offense and be selective. And they'll play offense inside of their sandbox. And I don't get too involved in what Mike and his team does. I think they're doing a great job of executing and as one of their largest shareholders, we couldn't be happier with the progress that's happening at CLNC.

When you look at its peer group, CLNC got ahead of its issues quickly. Mike addressed those issues. He stabilized the story, he rotated the cash and now we have an enviable position where we can play offense, and we'll continue to recover book value.

You saw the shares perform well after market last night. They performed well today. We have a lot of confidence around that management team's capability. And in the meantime, we keep our options open, Jade. No option is off the table for CLNC. We've made that clear 2 quarters ago. We made it clear a quarter ago. I'll make it clear today. As we rotate to digital, if there's a good opportunity to harvest, the hard work that's been done at CLNC, we have an open ear, and we'll listen to whatever proposal comes across the table.

Seems pretty clear to me that a transaction will happen soon, given the pace of divestitures at CLNY, I would bet on Ganzi surfacing value here.  I doubt that CLNC would buy back CLNY's shares as suggested by the analyst question as it doesn't divest the external management contract, an outright sale of both CLNC and the management contract seems more likely, swift and bold, more in the Ganzi deal mold.

But let's take a look a CLNC a bit closer, I think its reasonably attractive as a standalone entity.  CLNC was created out of the threeway merger of old CLNY/NSAM/NRF, it was previously a non-traded product that was brought public in early 2018 and has since had a rough existence.  As expected with a non-traded REIT, their portfolio resembled an asset gatherer mentality without much of a cohesive strategy.  Here's what the portfolio looks like today, predictably they have a legacy segment ("LNS" = legacy non-strategic) where they house all the iffy stuff like their retail exposure.

The portfolio is a little bit of a grab bag, but back in March, Colony brought Michael Mazzei in to be the CEO of CLNC, Mazzei is an alumni of Ladder Capital (LDR, disclosure: long) where he served as the president until June 2017.  Ladder has a reputation has being a conservative credit shop, I personally like their style, so when Mazzei joined CLNC it was worth monitoring.

I've been surprised along with others, but commercial real estate loans have generally held up better than expected during the pandemic, whether the reason is modifications, interest reserve accounts, or the equity injecting additional cash into the deal -- their CLO for example hasn't experienced any credit events in the portfolio -- with a vaccine on the way, I tend to think all parties involved will continue to work together to salvage value and get to the other side.  Now is the time to get long some of these asset plays with a catalyst, the market exuberance hasn't quite made its way down to publicly traded private credit vehicles with actual real assets, but I think it eventually will.

CLNC has confidence in the future, I like when management at least acknowledges what the market is thinking, this is an external vehicle, so their options aren't ideal, but they've already hinted they'll reinstate their dividend in Q1 2021 and are making new loans today (, you don't do that if you're on the ropes:

We also recognize that our current share price is a deep discount to our book value. This discount is also greater than that of our peer group. The current market valuation effectively implies that there are approximately $1.2 billion of future potential losses. We feel the best way to address this disconnect is by shifting the focus and momentum of the CLNC team beyond the challenges of COVID-19 and toward playing offense.

In our effort to close this gap, we are committed to continuing to protect the balance sheet while redeploying capital into new investments, building earnings and reinstituting a quarterly dividend.

In summary, while not fully out of the woods, we have accomplished many of our goals during this challenging time. We are now focused on executing our business plan to grow earnings. We have already begun to originate new loans while continuing to remain vigilant on asset, liability and cash management. The continued risks of COVID-19 can, by no means, be dismissed. However, through the efforts of the CLNC team and the support of our counterparties, CLNC is now in a position to lean forward.

CLNC does have a mix of financing, a CLO, repurchase agreements, they should have decent amount of flexibility to handle any problem loans.  Leaving out a lot here, but at 50-55% of book value, I think the setup is more important than the actual assets -- I trust Ganzi to make something positive happen here both for CLNY and CLNC.

Disclosure: I own shares of CLNC and CLNY

Wednesday, December 2, 2020

Medley Capital: Internalizing Management, Sale Seems Likely

Apologies for the recent string of relatively small and/or illiquid ideas, here is another one from the trash bin: Medley Capital (MCC) is an orphaned BDC that will likely be sold in the next several months.  The story begins in August 2018, when MCC's external manager, Medley Management (MDLY), orchestrated a three way merger that would combine the manager with its two BDCs, publicly traded MCC and non-traded Sierra Income.  That deal met a lot of resistance from shareholders as it appeared to be a non-arms length way to bailout the overleveraged MDLY at the expense of the BDC shareholders while ensuring underperforming management continued on top.  The deal was in limbo until May of this year, almost a full 2 years after the merger announcement, when the deal was finally put out of its misery and terminated.  I'm skipping a lot of drama in those two years including a proxy fight with the team from NexPoint, but following the termination, MCC continues to retained advisers to pursue strategic alternatives and recently announced that MDLY's management agreement would be allowed to expire at year-end and that MCC will internalize management.

After a 1-for-20 reverse split earlier this year, MCC is trading for ~$26.50 ($71MM market cap) with a 6/30 NAV of $54.83 (MCC's fiscal year end is 9/30, the 10-K should be coming out shortly), meaning MCC is trading at roughly a 50% discount to NAV.  For reference, despite the pandemic, the average BDC trades for 86% of NAV today.

For the uninitiated, BDC is an acronym for business development companies, which typical function as non-bank lenders to leveraged middle market (sub $50MM in EBITDA) companies, often providing financing for private equity buyouts or M&A transactions.  Following the financial crisis, banks can no longer provide these loans on reasonable terms, so non-bank lenders like BDCs of CLOs have filled much of the void.  These loans are all below investment grade and the leverage ratios of the underlying companies is typically 5-7x EBITDA, they can be a bit scummy and certainly shouldn't be pitched as safe dividend payers to retail investors.  There are some 45+ publicly traded BDCs (like REITs, there are also non-traded ones like Sierra Income that are sold through the investment advisor channel), most of them are externally managed, often by household names (at least to anyone reading this) like Ares, KKR, Oaktree, Apollo, BlackRock and others that can essentially use the BDC as a lender for their own PE activity.  If that wasn't enough, they charge hedge fund style fees to the BDC.  These management fee streams are highly valuable as a BDC is technically a closed end fund and the capital inside it is essentially permanent.  So the average BDC trades for 86% of NAV, roughly 10 of the 45 trade above NAV which allows the BDC to issue additional equity, anyone below NAV is generally restricted from issuing shares but they can still grow assets through M&A which has been fairly active in the bottom of the sector.

Given this dynamic of external managers wanting to grow fees and now that MDLY will be out of the way (MCC no longer has to serve two masters in a transaction), the orphaned BDC should make for an easy M&A target, especially considering the wide discount to NAV.  The buyer and MCC can essentially split the discount somehow and both come away happy.  Following the sale of their broadly syndicated loan (larger borrowers, more liquid loans) JV to Golub and paying off one of their two baby bonds, MCC is clearly too subscale (maybe the 40th largest BDC of the 45 by assets) to be internally managed and if the plan was a true go-it-alone strategy, they likely would have refinanced the baby bond versus pay it with cash on the balance sheet.  The new CEO is an activist in MCC, David Lorber of FrontFour Capital, he's also headed up the Special Committee, from the internalization press release they've hired a credit person on what seems like a temporary basis to oversee the remaining portfolio, all sort of signals to me that this is once again for sale.

Of course, everyone has seen the deal, it was shopped previously and the conflicted board (MDLY management on the MCC board) turned down other offers during the go-shop period in order to continue to push the MDLY-MCC-Sierra deal that would have preserved MDLY's management team.  However, now that MDLY is largely out of the way, debt markets are flush with capital (low rates is great for private debt, everyone will be reaching for yield), we're looking at a potential reopening and economic recovery, I'm guessing at least one of those suitors will come back and make a deal for MCC.

Other Thoughts:

  • I haven't discussed the portfolio, obviously given the turmoil this company has been through in the last two years as you'd expect, the portfolio is a bit of an unclear mess of assets.  It is more heavy on equities than most peer BDCs, including 764,040 shares of AVTR which is up ~66% since 6/30 or $8MM in NAV ($3ish per share).  On the downside, the JV they did sell to Golub is about -$7MM in the other direction.  The S&P/LSTA Leveraged Loan Index is now trading about 95 cents on the dollar, up significantly from the lows in March and April, and for reference, on 6/30 it was trading at 89.  Even the junkiest of loans, rated CCC, are today trading at 86.  We'll see in a few days where the 9/30 NAV is struck, but I don't think it should be materially below where it was on 6/30, but I'm not a credit analyst and only spent a little time thumbing through their holdings.
  • This situation reminds me a little bit of RESI, a broken deal, external management being pushed aside and no reasonable path to becoming an internally managed company for the long term.  That one ended very successfully with a quick deal that was then revised upwards after a competing offer came to light (I unfortunately was out by the time of the revised deal).
  • BDCs are no longer included in most indices, MCC doesn't pay a dividend, there really isn't a natural investor base for this and I think that partially explains how its languished here and really doesn't have a future outside of a deal.

Disclosure: I own shares of MCC

Wednesday, November 18, 2020

NexPoint Strategic Opportunities: Exchange Offer

Back in August, I wrote up a quick post on NexPoint Strategic Opportunities ("NHF"), it is a closed end fund that is transitioning into a REIT over the next 18-24 months (they'll technically be a REIT in 2021, but won't fully transition the assets until later, quite a bit of wood to chop here before its a clean story).  To summarize the thesis, NHF is trading at 57% of NAV and they'll be selling much of those assets presumably somewhere near NAV to invest opportunistically in real estate -- there should be no shortage of attractive opportunities coming out of the pandemic -- add in some leverage and it could have quite the multiplier effect (see what the same team has done with NXRT).  And to get the negatives out of the way, NHF hasn't articulated a clear strategy at this point other than saying it will be a diversified REIT and there's the potential for double dipping on fees, much of what NHF owns today are investments that were at one time or are now managed by NexPoint/Highland, it has sort of acted as a dumping ground for them.

The stock's reaction to the conversion news has been muted and it hasn't rallied much recently in comparison to the market or other real estate assets.  The company came out with an exchange offer structured as a Dutch tender that expires 12/10, shareholders can exchange common shares for a combination of 80% in a newly created preferred stock and 20% in cash, the range is set at $10-12 and the stock currently trades at $9.50.  The $10-12 number is highly dependent on the value the market prescribes to the newly issued preferred shares, the company is trying for a 5.5% dividend rate on the prefs, that feels a bit aggressive, but more on that later.

I love the idea of the exchange, the maximum amount is $150MM on a $433MM market cap company, the exchange will essentially force a portion of the shares to be valued at NAV accruing that closed discount value to the remaining shareholders.  It also further tightens the spring when they do fully transition to a REIT, this is already going to be a levered vehicle.  But again, the 5.5% dividend yield feels a bit aggressive on the preferred shares, so thinking through the possibilities of where the preferred could trade after the exchange, I came up with a little table:

The x-axis is where the Dutch tender prices at and the y-axis is where you think the preferred shares should trade on a yield basis incorporating the 20% cash component.

I've also played around with different scenarios based on how many shares are actually tendered and what it would do to the NAV ($16.70/share as of the latest proxy) of the remaining shares, just based on the share price and my uneducated view, seems like the market is skeptical of the exchange.  The minimum amount is $75MM.

Then my last table is using the NAV in the table above, what the price/NAV ratio would be (using a $9.50 share price, or a 57% starting point):

I've spent a lot of time in the last few months on the commercial mREITs (maybe more posts to come), most of them have preferred shares that have yields well above the targeted 5.5% NHF management is shooting for and that might be skewing my view of where the prefs will trade following the conversion.  NHF is likely to be focused on either self storage or single family homes, maybe both, equity REIT preferreds in those sectors do trade below 6%.  I took a look at the holdings of PFFR, a REIT preferred index fund, and here are the names that trade sub-6.0%, some of these didn't surprise me as they're seasoned and/or loved REITs, but others were a bit surprising.  

For example, Office Properties Income Trust's (OPI) 5.875% pref trades just above par, this is an externally managed REIT of RMR Group (RMR) that has a history of abusing minority shareholders and is in the office sector.  Is 5.5% too aggressive?  Possibly, but not by that much in a zero interest rate world.

I've added to my NHF position.  I'm currently thinking about the exchange like this: I'm planning on tendering a portion of my shares somewhere in the middle of the range (could change as we get closer to the expiration date), but still leaving behind a relatively full position.  If there is enough interest where I don't get filled on the tender and it goes closer to the lower-end of the range, common shareholders should benefit as the NAV increases even more and they've obtained cheap financing.  If I get filled, I still feel comfortable that the trading price of the prefs following the conversion should result in a good short term IRR.  Either way feels like a win to me.  NHF could also bump up the yield on the preferred shares if there isn't enough investor interest (they got a rating agency to put a BBB- rating on the prefs, presumably to head off investor skepticism on the proposed dividend yield), even paying 0.5-1.0% more in yield to entice shareholders to exchange would be very accretive to the remaining common.

Disclosure: I own shares of NHF

Friday, November 6, 2020

LGL Group: Warrant Dividend, SPAC Sponsor

LGL Group is an illiquid small (~$55MM market cap) aerospace and defense parts maker I covered once before in 2017 when they did a rights offering while at the same time an acquisition offer was outstanding for their operating business.  That thesis didn't quite work out as planned, the acquisition offer never materialized into a deal, but maybe for the best, the operating business has performed quite well over the last three years, growing revenue 50% (total, not annualized) and EBITDA has jumped by 300%.

The company is effectively controlled by the Gabelli family, they own/manage the top three spots on the shareholder register:

Mario's son, Marc, is the chairman of the board and steering the ship here, although his father hasn't been shy about expressing his views in the past.  The Gabelli's have done a number of corporate actions in the last decade to increase their investment in LGL, the stock is illiquid, so in order to meaningfully increase their exposure to the business, they do things like rights offerings and backstop them.  Back in 2013, the company issued a warrant dividend with a 5 year term and a $7.50 exercise price, despite the stock trading below the exercise price on expiration, Mario exercised the warrant and added to his position.  So clearly they want more of it and are up to a similar transaction announcing a new warrant dividend to shareholders.  Here are the details from the press release, the stock trades at ~$10 as I type this:

The LGL Group, Inc. Declares a Warrant Dividend


ORLANDO, FL, October 29, 2020 – The LGL Group, Inc. (NYSE American: LGL) (the "Company") today announced that on October 27, 2020 the Board of Directors declared a dividend of warrants to purchase shares of its common stock to holders of record of its common stock as of November 9, 2020, the record date set by the Board of Directors for the dividend. Each holder of the Company’s common stock as of the record date will receive one warrant for each share of common stock owned. Five warrants will entitle their holder to purchase one share of the Company's common stock at an exercise price of $12.50. The warrants will be "European style warrants" and will be exercisable on the earlier of (i) their expiration date, which will be the fifth anniversary of their issuance, and (ii) such date that the 30-day volume weighted average price per share, or VWAP, of the Company's common stock is greater than or equal to $17.50. The warrants are expected to be issued on or around November 16, 2020, and the Company intends for the warrants to be listed and traded on the NYSE American on or around such date, subject to NYSE American approval.

Part of LGL's stated strategy is to be an acquisition vehicle, but since that 2017 rights offering the company hasn't made a significant deal and has mostly let cash pile up on the balance sheet, currently at $22MM (including marketable securities which is in a Gabelli fund and can swing net income around a bit).  Thus another rights offering probably doesn't make sense, but a warrant dividend could as a way to get more exposure to the company, either through adding in the secondary market if the warrant trades poorly or just in another five years, exercise the warrant again.

LGL has two main operating businesses, MtronPTI and Precise Time and Frequency, both sell highly engineered products into the aerospace and defense sectors.  The operations did about $4MM in EBITDA in 2019, with a market cap of $55MM and $22MM in net cash, you're paying about 8.25x EBITDA for the business today.  They do other things to signal the operating businesses might be undervalued, like break out the accumulated depreciation of their PPE which is multiples of the carrying value of the assets on the balance sheet.  But the most interesting asset inside LGL is an ownership stake in a SPAC sponsor, its 2020 after all, the SPAC is LGL Systems Acquisition Holdings (DFNS) which is targeting a defense business, thus the ticker.  

Being the SPAC sponsor is a great deal, depending on the final details of the deal, but often the sponsor ends up with ownership in the proforma company worth 20% of the SPAC trust fund.  If DFNS does an attractive deal and doesn't negotiate a discount of the sponsor shares, the result could be a material asset for LGL.  DFNS raised $172.5 million and trades at a 1.7% discount to the net asset value of the trust.   DFNS has about another year to find a merger, the deadline is 11/12/21, otherwise they'll send the money back to the SPAC shareholders and the sponsor is out of luck.  Here are the details on the SPAC investment:

In November 2019, we invested $3.35 million into LGL Systems Acquisition Holdings Company, LLC, a subsidiary that serves as the Sponsor of LGL Systems Acquisition Corp (NYSE: DFNS), a special purpose acquisition company, commonly referred to as a “SPAC” or a blank check company, formed for the purpose of effecting a business combination in the aerospace, defense and communications industries. Prior to a business combination, the Sponsor holds 100% of the shares of Class B convertible common stock outstanding of DFNS (the “B shares”) along with 5,200,000 private warrants at a strike price of $11.50. The B shares equal 20% of the outstanding common stock of the SPAC. Upon the successful completion of an acquisition the proforma ownership of the new company will vary depending on the business combination terms.

The Company is expected to own approximately a 43.57% interest in the Sponsor through its direct investment. Assuming the terms of the business combination are identical in capital structure as that of DFNS, the Company anticipates its economic interest will include approximately 8.7% of the SPAC’s pro-forma equity immediately following a successful business combination. There can be no assurances that this scenario and the resulting ownership will occur, as changes may be made depending upon business combination terms.

If DFNS is able to come to a deal, the value of the shares attributable to LGL could be worth ~$15MM, certainly material for a company of this size.  A couple of the DFNS executives joined the LGL board in August, possibly signaling that being a SPAC sponsor isn't a one-time affair (the mania is showing signs of cooling, so maybe that's a bit of a stretch).  Either way, it is some built in optionality inside of LGL, and could have a bit of double leverage, the SPAC shares and warrants inside of LGL and then the LGL shares and warrants.

Even though I play around with options quite a bit, not an expert at valuing the warrant itself, but if you plug in terms of the warrant into a calculator and use a 50% implied volatility, spits out about a $0.75 per warrant (need 5 of them for one share of stock).  Could trade a bit like a spinoff and certain shareholders might be inclined to sell it immediately.

Disclosure: I own shares of LGL

Catabasis Pharmaceuticals: Selling at 50% of Cash, Reverse Merger Candidate

Here's another entry in my sporadic biotech reverse merger candidate investment theme, Catabasis Pharmaceuticals (CATB) is a clinical stage biopharmaceutical company that recently announced their lead product candidate, edasalonexent -- a potential treatment for a form of muscular dystrophy, did not meet its primary or secondary end points of their Phase 3 trial.  I'll keep this pretty brief, from the sounds of the press release it sounds like this is game over for Catabasis:

BOSTON, MA, OCTOBER 26, 2020 – Catabasis Pharmaceuticals, Inc. (NASDAQ:CATB), a clinical-stage biopharmaceutical company, today announced that the Phase 3 PolarisDMD trial of edasalonexent in Duchenne muscular dystrophy (DMD) did not meet the primary endpoint, which was a change from baseline in the North Star Ambulatory Assessment (NSAA) over one year of edasalonexent compared to placebo. The secondary endpoint timed function tests (time to stand, 10-meter walk/run and 4-stair climb) also did not show statistically significant improvements. Edasalonexent was observed to be generally safe and well-tolerated in this trial. Catabasis is stopping activities related to the development of edasalonexent including the ongoing GalaxyDMD open-label extension trial. The Company plans to work with external advisors to explore and evaluate strategic options going forward.


“We are deeply saddened and disappointed by the results of our Phase 3 PolarisDMD trial,” said Jill C. Milne, Ph.D., Chief Executive Officer of Catabasis. “I want to sincerely thank all of the boys, their families and caregivers, investigators and the trial sites that participated in and enabled this program. The entire Catabasis team has worked tirelessly to find a treatment for this progressive disease. We hope that our data and work to date can be used to benefit ongoing and future research in DMD.”


The Phase 3 trial was a one-year placebo-controlled trial designed to evaluate the safety and efficacy of edasalonexent in boys ages 4-7 (up to 8th birthday) with DMD. The global trial enrolled 131 boys across eight countries, with any mutation type, who were not on steroids. Edasalonexent was well-tolerated, consistent with the safety profile seen to date. The majority of adverse events were mild in nature and the most common treatment-related adverse events were diarrhea, vomiting, abdominal pain and rash. There were no treatment-related serious adverse events and no dose reductions. The global COVID-19 pandemic had no meaningful impact on the trial or its results. Data from the PolarisDMD trial will be further analyzed and are expected to be presented at an upcoming scientific conference and published.


“These results are disheartening for the Duchenne community, and specifically for the boys who participated in this trial and their families. However, the results contribute to the natural history data of Duchenne and add to the knowledge base that will one day produce a foundational, long-term therapy for this disease,” said Pat Furlong, Founding President and Chief Executive Officer of Parent Project Muscular Dystrophy (PPMD). “The continued advancement of research and the development of possible treatment options will remain of critical importance to our community. We appreciate Catabasis’ efforts and commitment to every family that is or has ever been affected by Duchenne.” 


The Company expects to report Q3 2020 financials in November of 2020. As of September 30, 2020, Catabasis had cash and cash equivalents of approximately $52.9 million.

The company is pre-revenue, R&D is likely at a full stop now, general and administrative expenses have run a little under $3MM:

Now that the company is a cash shell, the burn rate should be lower, but let's just call it $1MM a month going forward.  Cash and marketable securities were ~$54MM as of 6/30, Catabasis does have an ATM program they have been hitting for incremental cash, so to square the cash burn against the $52.9MM they reported in their press release, let's assume they've issued another 1 million shares, bringing their total to approximately 20 million shares outstanding.  At a price of $1.36, that gives us a market cap of $27MM versus a cash balance of ~$50MM, almost a 50 cent dollar.  And since CATB never generated revenue, we have a large NOL here as well of approximately $200MM. 

The most likely outcome is in the next few months a privately held biotech will merge into and come public through a reverse merger with CATB.  Effectively using CATB as a capital raising transaction with a deSPAC like transaction except here a target has more certainty in the actual amount of cash raised.

Disclosure: I own shares of CATB

Tuesday, October 6, 2020

BBX Capital: New BBXIA, Form 10 Notes

BBX Capital is a familiar name, I wrote it up about three years ago when they were floating a 10% piece of timeshare operator Bluegreen Vacations (BXG) with the idea that the rest of the enterprise was trading at a negative value due to the HoldCo discount and shady management team.  That strategy was largely unsuccessful, (not one of my better pitches in hindsight), next BBX tried to take Bluegreen private again but then the timeshare operator got into a dispute with their largest marketing partner, Bass Pro Shops, and BBX pulled the offer.  And now just recently, BBX is at it again, this time engineering a spin where they've separated their 90% BXG stake as Bluegreen Vacations Holdings (BVH) - mind you, BXG still trades separately - and then spun out the rest of their assets as "new" BBX Capital (here's the form 10).  New BBX Capital (BBXIA) trades for a significant discount to its net assets, even when considering a significant discount for the grifter management team (Levan's son is now set to run new BBX).

New BBX Capital has a few attributes that make it a potentially cheap spinoff, although due to management, I do not want to be caught holding this for the long term:
  1. Taxable spin - some investors might treat it as a dividend, already getting taxed on it, sell
  2. Trades OTC - some investors might not be able to hold over the counter securities, or might worry that a few weeks after the spin it might be too illiquid to hold, sell now when there is some liquidity
  3. Grab bag of assets without GAAP earnings - new BBX is largely cash and a promissory note from BVH, but the other asset include real estate in Florida and a door manufacture, Renin, that both could benefit from covid-induced tailwinds
For every share of old BBX Capital, investors got 1 share of new BBX (there is a dual share structure here, again, grifter management with a history of run ins with the SEC) for a total of approximately 19.3 million shares outstanding.  Shares have been volatile since the spin, but I'm going to use ~$4.00 as the current price for the write-up, which gives us a market capitalization of approximately $77MM, here are the proforma assets of new BBX Capital:
  • $96.5MM of cash
  • $75MM promissory note from BVH, as part of the spinoff and to provide some cash flow to BBX, BVH will be paying 6% on the note put in place between the two entities, BVH is essentially a levered bet now on BXG (I assume the longer term play is for the two Bluegreen entities to merge, but I'll leave that aside for now).
  • $162MM book value of real estate assets, much of which are new construction developments in Florida, the historical BankAtlantic real estate assets have largely runoff, but there's still some upside in the book value.  Post financial crisis, BBX has been reasonably good real estate investors, some of that was helped by marking the assets at extreme lows following the financial crisis, but there could be some acumen here.
  • Additionally there some other assets including a bankrupt IT'SUGAR chain of candy stores (appears they're using Chapter 11 to get out of some unprofitable leases, BBX is providing the DIP financing), Renin the maker of doors which should benefit from a housing boom and did a little more than $2 million of EBIT in 2019, and a restaurant in Florida, for the purposes of this simple math, we'll throw these assets in for free.
  • On the minus side of the equation, there is $42MM of debt and then however you want to capitalized the oversized corporate G&A, which was a proforma ~$21MM in 2019, maybe 5x that?  So call it -$150MM in debt and overhead in the sum of the parts.
So on a very basic back of envelope math, I come up with a value of roughly $9.50 per share, more than double the current price, feels crazy but book value is around $15.50 per share (I'm backing out the carrying value of IT'SUGAR), ~60% of book value seems reasonably discounted for the all the hair involved here considering it's not a melting ice cube.  I assume the end game with new BBX is to eventually do a take under by management, making it a taxable spin and OTC listed, seems intentionally designed to sell cheap.  I don't intend to stick around that long, but I bought a few puked out shares, unfortunately didn't get them late last week when they traded much cheaper -- pays to be on top of these small spins.

Disclosure: I own shares of BBXIA

Friday, September 18, 2020

Marchex: Joint Tender Offer

Marchex (MCHX) is a small (~$80MM market cap) software company that has gone through a few iterations over the years, now they're focused on call and text analytics, basically trying to capture data on customer interaction to increase sales and improved customer satisfaction.

On 8/31, Marchex and Edenbrook Capital (which owns 19.5% of MCHX) formally launched a 50/50 joint tender offer that expires on 10/7 to acquire up to 10 million class B shares (approximately 25% of the publicly traded B shares), the tender is slightly unique in that it has a tiered payment structure.  If less than 6 million shares are tendered, Marchex and Edenbrook will pay $1.80/share, if between 6 million and 10 million shares are tendered, the price will be $1.96/share.  Above 10 million shares tendered and you'll be pro-rated, but with the shares trading at the lower bound $1.80, it seems like the market is saying that less than 6 million shares will be tendered.

The company has a lot of cash in relation to their market cap, $46.8MM as of 6/30, they did get a $5.3MM PPP loan, so depending how you want to account for that, the enterprise value is roughly $40MM.  They've made several acquisitions in the last few years to bolster their call analytics business that total up to more than that, either some poor capital allocation or the market is missing the transformation.  To highlight that core call analytics business, in parallel with the tender offer the company is selling their legacy business to management in a complicated transaction, it certainly looks a little strange and isn't arms length, but they've tried to unsuccessfully sell it for a couple years now and is essentially a quickly melting ice cube.  It's an attempt to remove the bad business that might be hiding a good business.

Edenbrook clearly thinks there is value here, from their initial letter to the board highlighting the undervaluation:
We believe Marchex’s trading price of $2.63 per share (as of December 21, 2018) demonstrates a substantial discount to comparable industry valuations. Similar analytics-based public companies are trading at 4-6 times revenue, while private companies are being financed at 6-10+ times revenue. If Marchex were valued at 3 times analytics revenue (which is still a substantial discount to the market and less than Marchex just paid for Callcap), and approximately $44 million in cash were factored in, this would yield a value today of approximately $4.65 per share, which is 75% above today’s trading price of $2.63 per share (as of December 21, 2018). Adding in discounted values for the legacy business and the NOL carryforward would yield another approximately $1.60 per share, totaling approximately $6.25 per share, more than double today’s price. Further, given the continued profitable growth of the business, we expect these values to continue to expand in the coming years.
The business doesn't quite click for me, but clearly Edenbrook wants more of the asset (if fully subscribed they'll increase their stake from 11.50% to 36.67%) even though this is a dual share class structure with management owning the super-voting Class A shares.  Edenbrook isn't the only one, another investor has opined publicly, Harbet Discovery Fund (owns 6.4% of MCHX):

After years of investment in the analytics products and platform, which we estimate exceeded $150 million, the Reporting Persons look forward to breakout sales growth in 2020. As the Issuer’s management team mentioned on the last earnings call, early momentum with the Sales Edge Rescue product and the expected expansion into a key OEM client could each independently drive material growth. With accelerating growth, the Reporting Persons can see a path to the Issuer’s stock trading over $5.75 per share (+186% upside from current levels), assuming 10% analytics sales growth in FY20, a 4x sales multiple on that business, and stable cash balance. Over the next twelve months, higher valuations could be reached if the market begins to ascribe the value of the marketplaces business and data library.


Absent a significant increase in growth in 2020 in the analytics business, the Reporting Persons anticipate the Issuer may consider a broad range of strategic options to maximize the value of its business units, balance sheet, intellectual property, and data library. Conversely, with rapid growth in the analytics business and the gross margin expansion that should accompany it, the Reporting Persons wonder if the analytics business will ultimately receive the maximal value as a standalone company, and also anticipate the company taking measures to simplify its structure and streamline its model over time. The Reporting Persons also expect the Issuer’s long-term track record of returning capital to shareholders through buybacks and special dividends to persist for the foreseeable future.

So the stock might be worth looking at post tender, some of these large tenders can attach the stock price to the offering price and then afterwards the stock takes off.  I'm not comfortable enough with the business to take that view but either way it makes me a little more comfortable if the tender is oversubscribed and I end up with some orphaned shares.  Edenbrook and management aren't tendering, Harbet Discovery is likely not tendering, so there may be limited shares participating if other institutional shareholders also sit it out.  In the more likely scenario and less than 6 million shares tender, I get my money back and just lose some opportunity cost, for it to work out perfectly and get the $1.96, it is a bit of a thread the needle proposition, but I don't see much risk in attempting it.

Disclosure: I own shares of MCHX

Lubys: Asset Heavy Restaurant Business Opts for Liquidation

Luby's (LUB) is a small restaurant business based out of Houston, TX.  Currently, they operate two restaurant chains (previously a third, Jimmy Buffett themed "Cheeseburger in Paradise", all of which are now closed), the namesake "Luby's Cafeteria", a Texas comfort food buffet chain and "Fuddruckers", a fast casual burger concept that is partially franchised but has seen better days.  Luby's also has a contract food service business that caters their cafeteria style menu to hospitals, senior housing facilities, sports arenas, etc.  Luby's has struggled as their concepts are a bit stale (maybe that's being kind), mature, and operate in hyper competitive market segments like Fuddruckers with burgers.  Luby's has been treading water for several years -- management has reshuffled some senior leaders and fought off a proxy contest (from Jeff Gramm, author of Dear Chairman), but none of the turnaround plans really came to fruition.  Then of course, covid hit and suddenly going out to a buffet/cafeteria style restaurant like the namesake Luby's sounds pretty unappealing or simply impossible due to local shutdowns.

Last year, Luby's commenced an effort to explore strategic alternatives, but on September 8th the company kicked up the effort by formally announcing they were pursuing a liquidation (requiring shareholder approval) by selling their operations and assets in several transactions, then returning the proceeds to shareholders along the way.  Disclosed in the announcement, possibly to convince shareholders to vote for the liquidation, management announced an estimated distribution amount:
While no assurances can be given, the Company currently estimates, assuming the sale of its assets pursuant to its monetization strategy, that it could make aggregate liquidating distributions to stockholders of between approximately $92 million and $123 million (approximately $3.00 and $4.00 per share of common stock, respectively, based on 30,752,470 shares of common stock outstanding as of September 2, 2020)
The stock trades for $2.35 today.

Luby's is a throwback to the old world, they own much of the real estate for their restaurant locations versus leasing them, that's where most of the value is in the liquidation.  They've even previously considered selling the restaurant operations and converting to a REIT at one point.  In the proxy statement they've disclosed the current post-covid value of the real estate (they've hired two separate real estate appraisers):
As of August 26, 2020, we owned 69 properties, consisting of the underlying land and buildings thereon, most of which operate, or have operated in the past, Luby’s Cafeterias and/or Fuddruckers operations. The estimated value of those properties as of August 26, 2020, was $191.5 million.
Hidden Value Blog did a nice write-up on the situation a few months ago and did more diligence than me on the underlying real estate portfolio in order to validate the company's appraisal, worth a read.  Most of the real estate is in Texas, which should hold up fairly well, major cities like Houston, San Antonio and Dallas all annually rank near the top of job growth and new home construction.

The company has ~$63.7MM of gross debt, $10MM of which is a PPP loan that will likely be forgiven by the government.  Without giving value to the restaurant operating entities or on the downside expenses regarding the liquidation, the value of the real estate is potentially worth just over the top end range of $4/share.  There's reason to believe that management might be understating the distribution range, in the background section of the proxy statement, Luby's financial advisor presented the following range on 7/20:
Duff & Phelps noted a reference range of aggregate potential liquidation proceeds available to holders of Luby’s common stock from $127.0 million to $172.1 million or $4.15 to $5.62 per share of Luby’s common stock, based on an estimated 30,625,470 shares of common stock outstanding and the Company’s estimates of value for its owned real estate.
Later in the proxy, its mentioned that the Duff & Phelps estimate didn't reflect the current real estate portfolio, but that seems odd since any real estate sales in the interim would be netted off against net debt.  Or it could just be a financial advisor telling a management team what it wants to hear.

Timing and the duration of a liquidation are always a big risk, these take twice as long to wrap up as you'd think, especially the last puff which can be frustrating if you're late to the situation.  However in this instance, much of the distributions will likely take place in the next 6-12 months as the company has been in active discussions on each of the assets for months.  It is mentioned a few times in the proxy that the distribution estimation is based on actual indications of interest for each asset, reading the tea leaves, it seems likely we'll see significant asset sales in the near term.  I wouldn't be surprised to wake up and see news that Franchise Group (FRG, still long) was buying Fuddruckers after their failed attempt to buy another struggling chain in Red Robin (RRGB) last year.

I've participated in a few liquidations over the years, the only time it worked out poorly for me is NYRT, in that instance an activist came in with overly lofty projections in order to win over shareholders so they could earn management and incentive fees.  Here the liquidation is more of a white flag, management has been in place for two decades and should have a sense of the value of their assets, they also own 30% of the shares and thus aligned to get maximum value within a reasonable time frame.

Disclosure: I own shares of LUB

Monday, August 31, 2020

NexPoint Strategic Opportunities: CEF to REIT conversion, Possible NXRT Replay

Back in 2015, closed end fund NexPoint Strategic Opportunities (NHF) (then known as NexPoint Credit Strategies) spun out NexPoint Residential Trust (NXRT), a value-add class B multi-family REIT it had incubated inside the CEF, NXRT went on to 4-5x over the next several years (unfortunately I only caught about 2x of that).  Last week, news came out that NHF shareholders voted to convert the fund to a REIT, possibly setting up another similar opportunity for a multi-bagger as the valuation metric evolves from a discount to NAV story to a multiple on FFO story.

The thesis here is a bit incomplete at this stage but promising if you followed NXRT, NHF trades at $9.45 or 55% of net asset value (pre-covid that discount was more in the 15% range), as part of the conversion to a REIT they'll be selling non-REIT related assets presumably near NAV of $17.19 per share, capturing that discount by then buying distressed real estate in the post-covid fallout.  By applying a similar NXRT value-add strategy, NHF will look to sell newly stabilized assets and then recycling that capital back into opportunistic real estate, rinse and repeat, creating sort of a multiplier effect.  The new-REIT will have a pretty wide investment mandate, essentially any asset class is fair game according to the proxy although I assume they'll stay away from multi-family and hospitality/lodging as NexPoint already has publicly traded REITs that focus on those sectors.  The public REIT market likes simple stories, this doesn't appear like it will be one, at least not initially, but NHF does intend to maintain a monthly dividend, so it could entice retail investors interested in yield.

NHF's current portfolio is sort of grab bag of assets, looking at it and its seems a bit incoherent, many readers will recognize some of the individual equity names, several bankruptcy reorgs and other special situations, NHF even has 8 shares of NOL shell Pendrell for those looking to pick some up in the coming months.  They also own CLO debt and equity, which has generally held up well through the crisis and are probably worth more than where they're marked.  But 25% of the portfolio is in a wholly owned REIT they've once again incubated, NexPoint Real Estate Opportunities, which owns self-storage facilities, a Dallas office building (City Place Office Tower), a new construction Marriott hotel in Dallas and a single family rental operator.  Again, not a real coherent strategy, this idea is a bit of a leap of faith based on their past track record and we'll likely know more in the next 6-9 months through this conversion.  I picked up a smallish position with the intention to add more as the story unfolds.

Other quick thoughts:
  • NHF post REIT conversion will be externally managed, the fee agreement has an expense cap at 1.5% of assets for the first year and there are no incentive fees.  This is a similar setup to NXRT, I believe some of the "investor friendly" aspects of the fee agreement are related to being a historical 40 act mutual fund and not just out of the kindness of management's heart.
  • Speaking of management, James Dondero will be the CEO, he has a litigious reputation (feel free to Google), but again, hard to argue with what the team did with NXRT and he owns 11.5% of the fund/stock.
  • They have a repurchase plan in place that allows them to repurchase 10% of the stock over a one year period (plan was put into place on 4/24/20), unclear if they've acted on it at all or if they would with the new change in plans.
  • One big benefit of being a REIT over a CEF will be index inclusion, joining the REIT indices should improve the valuation and analyst coverage.
Disclosure: I own shares of NHF

Front Yard Residential: Internalizing Management, Covid Tailwinds

I'm slow and full warning this is a completely unoriginal idea, feel free to read better write-ups here and here, but I took a position and as part of my process I wanted to write it up.  Front Yard Residential (RESI) is a REIT that owns approximately 14,500 single family home rentals ("SFRs") primarily across the south and southeast.  Front Yard has a mixed history, it was created and externally managed by Altisource Asset Management (AAMC) to house a non-performing loan portfolio that has since morphed into an SFR REIT.  Prior to the covid-shutdown, Front Yard agreed to be bought by Amherst (PE firm that has a SFR strategy) for $12.50 per share, that deal was terminated quickly once the severity of covid came to light in what looks to be in hindsight an overreaction.  Several months later, the stock has partially recovered, Front Yard trades at ~$9.60 and seems to be in a better position than it was pre-Amherst deal, the elevator pitch:
  • Front Yard's liquidity and leverage improved as a result of the termination, Amherst paid a termination fee of $20MM in cash, plus bought $55MM of newly issued stock from Front Yard at the deal price, $12.50/share, making Amherst one of the largest investors in Front Yard with a 7.5% stake.  Lastly, Amherst also agreed to be the lender on a $20MM loan that is currently unfunded.
  • There has been a quick and dramatic reversal of the popularity of cities, now they're seen as problematic both for pandemic/distancing reasons and recent social unrest, pushing people out to the suburbs in search of affordable space and relative perceived safety.  Single family homes have been one of the largest beneficiaries of this crisis, home prices are up, mortgage rates are way down.  But for many, home ownership is not an attractive option due to a lack of savings/credit or the desire to be mobile, thus a SFR could be a reasonable option.
  • Front Yard has long been sub-scale, only recently in the last year or so did they internalize the property management function and then this month they announced the internalization of their corporate management.  The incentives are finally aligned, but it doesn't fix the sub-scale part as it is only a fraction of the size of larger publicly traded SFR peers in INVH and AMH.  The board sold it once and there's been continual consolidation in this decade long SFR theme following the housing fallout from the last recession, it seems likely that Front Yard would once again be a consolidation target when things settle down further.
Invitation Homes (INVH), which is the legacy Blackstone and Colony portfolios, and American Homes 4 Rent (AHM) are the two scaled SFR REITs, both have good investor presentations that lay out the investment thesis for SFRs:
The addressable market is large, fragment and growing which should be a tailwind for institutional platforms, part of the argument for large platforms like the SFR REITs is the professional property management, which could equal more peace of mind to the customer.
The big non-covid related tailwind is the aging of the millennial generation, the largest cohort was born in 1990 and thus are turning 30 this year, entering a time when they'll likely want more space and start families.  The downside of the model is well known, its hard to gain scale and positive operating leverage unless you have a high concentration of homes in a locality.  INVH talks about 5000 being the scaled up number in a city, back to Front Yard, they only have one market even approaching that number with 4200 homes in Atlanta, the next largest market is Memphis at 1275 homes, again highlighting Front Yard's lack of scale, it's not just about total units but the number of units in a market.  Front Yard's properties are also generally older and cheaper than their two larger peers making their problems even more challenging (higher maintenance capex as a percentage of rent, oh and of course, actually collecting rent as covid related aide starts to slow down).

Not to pile on, but the other problem with Front Yard is leverage, they're highly levered which will make it difficult for the company to reach scale given where the stock trades.  High leverage and a low stock valuation should essentially handcuff the newly internalized management from pursuing a go-it-alone strategy as additional capital raises will be difficult to justify as it no longer just raises fees for the external manager.  The only reasonable option seems like another sale.

Given Front Yard's recent troubles and warts, its hard to value it just based on a cash flow metric, single family homes are gaining in value, especially recently with record low interest rates and limited home building since the last recession crimping supply.  Front Yard puts out an adjusted investment in real estate number that lines up when they've purchased homes or made capital investments and the appreciation in the time since those investments were made.
Obviously there should be a lot of caveats when using that number, a true one-by-one liquidation of Front Yard would take a substantial amount of time and expense to complete, and some depreciation is certainly real in these rentals, but I think it provides some additional context to the valuation.  After giving effect to the Altisource termination payments of $54MM (part of that is RESI acquiring some assets from AAMC), the enterprise value of Front Yard is ~$2.1B or about an 80% of unlevered asset value, given the high leverage of $1.5B of net debt, Front Yard is trading close to 55% of levered net asset value of ~$17.50 a share.  Again, I don't anticipate an acquirer paying a full price, but given recent trends in home prices and a migration to the suburbs, I could see Front Yard being acquired for more than the $12.50 Amherst agreed to in February.

Disclosure: I own shares of RESI

Sunday, August 16, 2020

Colony Capital: SOTP to Earnings, Digital Infrastructure Pivot

Back in April, I wrote up Colony Capital (CLNY) from the perspective of buying the preferred stock (read it for some background), today I'm going to take a shot at making the bull case for the common stock.  Colony has burned many real estate and value investors by going almost straight down since it merged with NorthStar Asset Management (NSAM) and NorthStar Realty Finance (NRF) in 2016. Back then it was going to be the next Brookfield Asset Management (BAM) by managing and co-investing in publicly traded REITs and private equity style real estate funds.  Last year, Colony announced a plan to focus on digital infrastructure, here's the quick new elevator pitch for Colony today:
  • Marc Ganzi took over as CEO (from Tom Barrack who is now Executive Chairman) of the company to effectuate the company's pivot from owning/managing traditional real estate to digital real estate (think towers, data centers, fiber, etc).  Ganzi has been a deal maker in the digital infrastructure space for a couple decades, in 2002 he co-founded Global Tower Partners, a private tower REIT, and ended up selling it in 2013 to industry leader American Tower (AMT) for $4.8B including debt.  Subsequently, Ganzi founded Digital Bridge Holdings ("DBH"), a PE fund with 6 digital real estate portfolio companies, which Colony invested/acquired DBH to bring him into the fold and lead the transition.  He has a good reputation as a deal maker with a legitimate track record, pair him with the tailwind of consumer demand for data being accelerated by work-from-home and other corona trends, the new strategy seems potentially promising.
  • Colony fits the "buy on the balance sheet, sell on the income statement" thesis that many investors (including me) look for, the value of the legacy assets today cover the market cap, as the company shifts to a manager/owner of more attractive digital infrastructure properties, the stock should earn a multiple on earnings versus languishing as a discounted sum of the parts story.
  • Colony doesn't have a natural investor base, many investors have been burned by the continual strategy shifts over the years. It is a REIT that doesn't pay a dividend, is overly complex and it is in the early days of their strategy shift -- so they're still a year or two away from being picked up by tower and data center investors.  The digital REITs dominate the top holdings of REIT index funds and trade at very lofty valuations.
On 8/7, Colony reported second quarter earnings and it was the first real chance for Ganzi to articulate his vision for the go-forward version of the company, and with it, released an investor day style presentation.  It's always a bit scary (be skeptical!) when you feel like a presentation was targeted directly at you, but Colony laid out the following few slides on why to invest in Colony:

During the quarter, the company took $2+B impairments to their legacy real estate holdings ("legacy" in this context means anything not digital, which is almost all of the balance sheet assets), basically kitchen sinked to reset the table for Ganzi, Colony spun it as covid accelerated the need for them to move quickly into their digital strategy given the demand on data/technology, but it also means potentially selling legacy assets in hard hit sectors to fund that pivot at an inopportune time.

At the top of slide is the digital pieces of the business, they primarily have two balance sheet investments in two separate data center business, the first is DataBank which they purchased for $186MM from Ganzi's DBH, possibly a less than arms length transaction but its also possible that they got a reasonable deal, who knows the business better than Ganzi?  The other thing to note is they've revalued their digital investment management company, Digital Colony, in this SOTP slide for the recent capital raise they did with institutional investor, Wafra, that bought 31.5% of Digital Colony for $250MM.  After that sale and a convertible bond offering which is now above the strike price, outside of the preferred stock, Colony has a net cash position at the corporate level.

The debt at the legacy assets is all non-recourse and generally asset specific, each asset/portfolio can almost be thought of as a call option in these times, the value of hotels or senior living facilities are clearly down, but depending on the pace of the economic recovery, these values post write-down might prove to be too low on certain assets.  In my preferred stock post, I wrote off the hotel assets completely and just assumed they'd hand back the keys, and that still might be the case as some industry rags have reported.  But Colony's hospitality portfolio is really divided into 7 separate entities (6 of which are reported under hospitality, 1 of which is under "Other Equity & Debt" as it was acquired through foreclosure), some of these are very likely going back to the lender, especially the 4 that have CMBS financing where their is little negotiating that can happen with the lender as the special servicer is generally bound contractually to foreclose.  The other 3 it's a bit murkier, but there's potential value there if things recover and Colony is able to hold on for another year or two before selling.  The healthcare facilities while down, seems salvageable to me, most of the properties in here are triple net lease and while covid has destroyed the senior housing sector (who in the right mind would place a love one in a senior housing facility right now unless that was the only option?), CLNY's rent collections have recently come in at 96%.

Another chunk of the legacy book is Colony Credit Real Estate (CLNC), a publicly traded credit REIT, they both manage the company and own 36% of it.  CLNC recently brought on former Ladder Capital (LADR, disclosure, still long) executive Michael Mazzei to take over the management of the company, I have a lot of respect for the Ladder Capital management team and see this hire as an important step in the turnaround of CLNC.  Historically, CLNC was originally thrown together from a pile of CLNY assets and a few NRF sponsored non-traded REITs, non-traded REITs are generally indiscriminate in what they buy in order to fund growth and increase the management fee to the external manager.  CLNC plans to eventually internalize although that plan is on ice for now as the stock trades for roughly half of book value (book value is a decent proxy for net asset value here).  CLNC has a large CRE CLO that they manage and use as balance sheet financing, to-date all the assets in that vehicle are current, its hard to tell if servicers are advancing funds or borrowers are using interest reserves to make payments, but given all the other assets and liquidity sources in CLNC, if a loan did go into default, they'd be able to buy the problem loan out of the CLO and maintain the coverage tests and all valuable cash flow to the junior tranches which CLNC owns.  Unlike other mortgage REITs, CLNC didn't have any securities portfolios liquidated due to margin calls, and given the current support credit markets are receiving, including possibly new supportive legislation, I can see a world where CLNC trades back up closer to current book value in the next 12 months.

Elephant in the room, most of the value in the legacy portfolio is in their "Other Equity & Debt" sleeve, they've slightly improved their disclosures here but its hard to know what's what and the overall value here:
Some of this portfolio seems like nonsense in a REIT, like the partnerships with Sam Zell in oil & gas, and the rest of it sounds risky and heavily levered to commercial real estate quickly recovering from the covid-crisis.  I'm taking a bit of a leap of faith here that management has indeed brought the carrying values down to market.

Moving to the future, Colony explicitly calls out the opportunity to eventually be valued off of an earnings multiple, again, be skeptical!:

*If* Colony can meet these management projections, the stock is a multi-bagger from the mid-$2s.  I don't know the digital infrastructure space well (possibly at all), but obviously part of the trick here is buying assets in the private space below what public market investors are paying for the same assets.  The math works better at lower valuations, but it still could possibly be attractive here as the Colony gets a little added leverage by the management fees.  For example, if they only invest in 20% of the company via their balance sheet (as with DataBank) they get the benefit of their management fees across 100% of the asset, thus bringing down the proforma multiple paid.  It's not clean and what public market investors will pay up for immediately, but makes some logical sense.

Another interesting, potentially irrelevant data point, the stock was around $5 when Ganzi came on, but you can get a sense of what the business plan looked like at the time when looking at his incentive package:
In addition, in connection with entering into the employment agreement, the Company granted Mr. Ganzi a sign-on performance-based equity grant (the “Sign-On Award”) in the amount of 10,000,000 long-term incentive units in CCOC (“LTIP Units”). The LTIP Units will vest if the closing price of shares of the Company’s Class A common stock, par value $0.01 (the “Class A common stock”) is at or above $10.00 during regular trading on the New York Stock Exchange over any 90 consecutive trading days during the five-year period beginning on the Effective Date. The Sign-On Award is generally conditioned on Mr. Ganzi’s continued employment until the performance-based condition is satisfied.
A cool $100MM (not Elon Musk incentives, but still a nice chunk of change!) if he can reach the projections outlined in the investor presentation at current market multiples, which initially seem pretty out there, speculative sure, but the transformation seems possible to me.  That upside is mostly a jockey play, Ganzi isn't super well known outside of the digital infrastructure space, but he can now sort of be viewed as the new founder of "Digital Colony" (likely only a matter of time before the company adopts that name), spent the last 7 years building out DBH/Digital Colony, sure he did cash out partially when Colony bought his firm but part of the consideration was OP units at $5+ share price equivalent, plus you'd assume he's got some reputational capital behind the proforma company.  At the end of the latest quarterly call (transcript from, in a bit of salesmanship and possibly a bit (or a lot) of hubris, Ganzi compared Colony's stock price today with industry leaders like American Tower and how it once traded at $2 as well, AMT now trades at $250+.  A bit crazy, but maybe not?
Well, listen, thank you. It's been an incredible first half of the year. Once again, I want to thank our Board. I want to thank our Chairman, Tom Barrack. I want to thank our team. This is an incredible team we have here at Colony Capital. I think we unveiled some of that to you today. But this doesn't happen without a great team focused on continuing to find the right home for our legacy assets and continuing to grow our business going forward. I think we've made the case today why this is a great moment in time to buy Colony. And I'd ask all of you who've been investing in the sector for 2 decades, who've watched my career, to remember those sort of seminal moments when American Tower and Crown and SBA were all trading sort of sub-$2. Those were really interesting points in time to buy digital infrastructure. Colony today trades slightly under $2. I'd encourage you guys to look at your history books, think about this management team, think about our business model and think about where we're going.
A good question to ask is how else does Marc Ganzi get paid? He gets a few different pieces of revenue like the 10% of the incentive fee allocation, are his equity grants too far out of the money to be meaningful? He's clearly a rich guy with a big monthly budget (big polo player, owns/founded a polo club); lives in Boca Raton and is managing the business from there, town has a bad reputation among investors for businesses headquartered there.  Colony's common stock is a bit speculative from here, but I flipped my preferred stock for the common after the earnings call.  It rhymes with a few other investments over the years that have worked out well, basically a complex grab bag of assets that's moving into an easy understand company in a sector public market investors adore.

Disclosure: I own shares of CLNY