Thursday, September 9, 2021

Atlas Financial: Senior Bonds Should Reject RSA, Reopening Play

At a certain point, I should probably turn this blog over to a few of my smarter readers, Atlas Financial Holdings (AFHIF) has been mentioned a few times in the comment section by ADL.  Be warned, Atlas has a lot of hair on it, thinly traded and the common stock is a nano-cap (sub $10MM).

Atlas is in the early innings of a business transition, previously they were an insurance company to the niche light commercial auto market (think taxis, limos, shuttle buses, etc.), that wasn't a great segment prior to covid and then really got crushed during the pandemic with rides down 90+%.  Anyone that has tried to get a ride-share or taxi lately knows, there's a massive driver shortage and fares have spiked significantly, eventually this will normalize and drivers will return.  The insurance subsidiaries of Atlas are now in receivership/liquidation, the remaining business and the go-forward strategy is a managing general agent ("MGA") model (d/b/a Anchor Group Management) where Atlas originates and services insurance policies for a fee but the risk is borne by third-party insurance company partners.  In addition, they've developed a mobile app targeted at ride-share drivers that offers micro-duration policies (essentially an hour-to-hour type thing) that would have sounded very SPACable earlier this year, but at the moment is more of a call option and not super material to the business as far as I can tell.

If they can return to writing the same volume as they did in 2018 (~$285MM, approximately 15% market share) under the MGA model (management put this goal out there in their recent investor call), this could be a multiple bagger (they take a 20% commission and guided to 20-30% pre-tax margins), but the path between here and there is highly uncertain and probably not realistic.  To put that goal in context, they currently have only 5% of that in-force, writing a bit more than on a run rate basis as new business is inflecting with the reopening.  To make it even hairier, the company has a quickly approaching $25MM debt maturity in April 2022, that security is a baby bond ($25 par, exchange traded) under the symbol AFHBL.  

The company missed the July payment on these bonds (although you would have no way of knowing unless you owned the bonds) and then last week the company announced it had come to a proposed restructuring support agreement ("RSA") with 48% of the noteholders to exchange the current bonds for a new security with similar terms (same headline 6.625% coupon, but the company has the option to PIK at 7.25% for the first two years) but pushing the maturity out 5 years in an amend and extend.  Troubling, alongside the restructuring of the bonds, Atlas is receiving rescue financing from "certain supporting noteholders" in the form of a 12% $2MM convertible term loan with an additional $1MM delayed draw.   As a "setup fee" the supporting noteholders are also getting a free 2,750,000 shares (and up to 5 million shares if the delayed draw is fully drawn), which is close to $1.4MM at current prices, quite the setup fee for a $2MM loan!  The loan has a conversion price of $0.35, which is in the money at today's $0.50 share price, so if fully drawn and converted, this rescue financing could end up with over 13.5 million shares compared to the current share count of just over 12 million shares.  The convertible loan is also senior secured and senior to the proposed restructured bonds, effectively these "certain supporting noteholders" are extracting value from the rest of the noteholders.  In a normal bankruptcy proceeding, all noteholders would be treated equally and would likely receive a pro-rata combination of new bonds and equity.

The bonds (AFHBL) did trade up on this news to $11-$11.50ish (par value is $25) creating a yield-to-maturity in the mid-to-high 20% range if the proposal is approved.  But I think there is an opportunity for a better, fairer deal for AFHBL noteholders, if you own the bonds feel free to reach out to my email and I can put you in touch with a group that is pushing for a better deal.  I plan on rejecting the RSA.  Either way, seems like an interesting quirky way to play a reopening or normalization of the post-pandemic economy.

Other thoughts:

  • Atlas has its corporate headquarters for sale (953 American Lane, Schaumburg IL) for $13MM, they do have a $6.5MM mortgage on the property that is held by the estate of one of their former insurance companies that are now in receivership.  So there should be some equity in the property, providing meaningful liquidity to a company of this size, potentially negating the whole need for the egregious convertible loan if they could get it sold quickly.
  • Atlas is heavily tied to two insurance providers, so this isn't quite the "originate to distribute" model it sounds like but more of an outsourcing model with two customers, so the customer concentration risk here is quite high.  National Interstate Insurance Company is the partner for shuttle buses and Buckle Corporation is the partner for the taxi and limo business.
  • It appears that Uber and Lyft are being more rationale in their pricing post pandemic, both are public now and no longer have near free cost of capital to sustain negative gross margins, maybe some market share stabilizes or inches back for taxis and limo services where Atlas's business historically focused.
  • The same CEO that drove this into the ground is still the CEO, which gives me some pause on the likelihood that they'll be successful executing the turnaround.
  • This likely isn't a takeout candidate, in the 10-K, they mention that as part of the insurance company liquidations, Atlas agreed that if they choose to sell the MGA operations, the insurance company estates would receive 49% of the proceeds.

Disclosure: I own AFHBL

Tuesday, August 17, 2021

PFSweb: Another Asset Sale, Cheap RemainCo Situation

PFSweb (PFSW, ~$280MM market cap) is reader suggestion to the recent theme of companies that have sold a major business segment leaving the proforma stub business looking cheap, and here again, the company is continuing to pursue strategic alternatives, which will likely lead to a sale of the remaining segment.  

PFSweb has an interesting history, they started out as "Priority Fulfillment Services" but changed their name to "PFSweb" (as any e-commerce adjacent company did at the time) and IPO'd in December 1999, popping over 160% on their opening day, as you can imagine, it has been an ugly ride since the IPO.  Ostensibly the company helps enable mostly old line retailers with their ecommerce strategy and fulfillment operations.  This has historically been done in two business segments, LiveArea is their e-commerce consultancy/advisory business and the PFS business is some combination of a third-party logistics ("3PL"; warehousing, fulfillment, returns) and a business processing outsourcing ("BPO", call centers, etc) operation.  

Somewhat unexpectedly, PFSweb sold their LiveArea business to a subsidiary of the Japanese conglomerate Dentsu International for $250MM in cash (roughly a 20x EBITDA multiple on LiveArea's 2020 segment EBITDA), the deal is expected to close this quarter and net PFSweb between $185-200MM in proceeds after taxes and fees.  Included in the press release is a line regarding the remaining PFS segment:

"With the divestiture of LiveArea underway, PFSweb has also engaged Raymond James to lead the exploration of a full range of strategic alternatives for its remaining business segment, PFS, to maximize shareholder value."

And from the investor presentation:

That all sounds like a sale to me, the remaining PFS business is in the hot 3PL space, I personally have a hard time distinguishing between what is really 3PL and what is just a BPO, how much of it is a commodity business, etc., it has almost become a buzzword like SaaS or cloud in the technology space.  But the industry has been a significant covid beneficiary with branded manufacturers and retailers scrambling to become more omnichannel and improve their ecommerce capabilities.   

Look no further than the recent XPO Logistics spinoff, GXO Logistics, it was XPO's 3PL/warehouse outsourcing business that has taken off since the spin (~+35% in a month) and now trades at something like 15x 2021 EBITDA (I spent 5-10 hours on GXO, couldn't wrap my arms around it).  They're not an apples-to-apples comparison, GXO has something like 100x the warehouse/logistics space that PFS currently operates (about 1.6 million square feet spread across Vegas, Dallas, Memphis, Toronto, the UK and Belgium), but more just to illustrate the opportunity and growth investors are pricing into the industry.  This is a pretty fragmented industry, PFS is subscale (bloated SG&A expenses), seems like there would be any number of buyers that could fold it pretty quickly into their operations.

Here's the current proforma situation (PFSW is late on the 10-Q, noting they want more time to adjust the financials for the sale of LiveArea, so I could be off on this):

One question I had is how the company is presenting the remaining PFS segment, in the investor slide above they guide to 8-10% "standalone" adjusted EBITDA margins, yet in their quarterly segment reporting PFS did ~$26MM in LTM EBITDA.  I asked their outsourced IR, got sort of an unhelpful non-answer, but I'm assuming that standalone includes a portion (but it wouldn't be all) of their previous corporate overhead that was a bloated $20MM in 2020.  So on a segment basis (what a strategic acquirer might be looking at) the proforma PFS is trading for only 4.2x EBITDA.  For my back of the envelope valuation, I've assumed that some of that corporate overhead (going with a round 50%) really should be distributed to the segments.  They've hinted at moving some SG&A to the segments on earnings calls and mentioned in a recent 10-Q that an increase in property tax (sounds like an operating expense) bumped SG&A up.  The top row of each scenario is the EBITDA multiple assigned to the PFS segment.

As of the 10-K, PFSweb did have $56.5MM of NOLs, but based on the LiveArea sale, hard to know if there is any tax shield remaining for a sale of PFS, I'm backing into about a 23% assumed tax rate on LiveArea and applying it to PFS in the "Fully Taxed" scenario.  But of course there are ways to avoid the double taxation and simply sell all of the remaining PSFweb in a cash or stock transaction.  We also don't know what PFSweb plans to do with the LiveArea proceeds other than paydown their debt, similar to LAUR, I tried to map out what a tender offer might look like if they went down that path and used 1/3 of their proforma cash position to repurchase shares.  Just a guess and playing around with numbers.  But either way, assuming the LiveArea deal closes (make your own determination if that's a good assumption), then the remaining 3PL business is extremely cheap to acquirer, maybe just sort of moderately cheap as a subscale standalone, but should have downside reasonably protected given the industry tailwinds.

Other miscellaneous thoughts:

  • The industrial/logistics REITs are trading for high multiples and experiencing a lot of M&A (i.e. Zell fighting off others for MNR, Blackstone buying WPT), growth in 3PLs is a large part of that (PSFW is guiding to 5-10% topline growth over tough 2020 comps at the PFS segment with expanding EBIDTA margins), this is a different angle at a similar theme (I continue to own and like INDT as well).
  • Transcosmos owns 17.5% of PSFW, they're a Japanese call center/BPO business, they made a strategic investment several years ago, but unclear how much influence they have, just semi noteworthy as PSFW's largest investor.
  • PSFW has a little bit of noise in their financial reporting, they will pass along certain third-party expenses (like last mile delivery) to their clients but book it as revenue with an offsetting expense, so it might screen as lower gross margin than the business is in reality.  In addition, they have one client (Ricoh) where they will briefly take ownership of the inventory they're managing so that causes some fluctuation in working capital.
  • PSFW does have options available, I don't own any but they could be interesting, with LAUR the company already has a significant buyback ongoing with the prospect of a tender offer to support the price and limit the downside, here we don't know PSFW capital allocation plans outside of debt repayment.  Feels pretty similar otherwise.

Disclosure: I own shares of PFSW

Monday, August 2, 2021

Laureate Education: Asset Sales, Informal Liquidation, RemainCo Cheap

After my RVI post, a reader pointed me to Laureate, a setup that rhymes with RVI -- a large asset sale that is obscuring value in the RemainCo which will also likely be sold.

Laureate Education (LAUR) is a global for-profit education company that went private in 2007 (KKR in an LBO), was re-IPOed in 2017, and at the time of the IPO owned or operated over 70 universities across 25 countries, about half the business was in Latin America.  The IPO had a lukewarm reception and the company pivoted to selling their assets, usually at multiples that well exceed where public markets were valuing Laureate.  Today, the company has a pending sale for their U.S. for-profit school (Walden University), once that deal closes with Adtalem Global Education (ATGE, fka DeVry) in Q3, the company will have a net cash position of $1.66B and down to just five universities in two countries (Peru and Mexico) that management is guiding to $280MM in 2022 EBITDA against a $2.9B market cap ($1.25B EV adjusted for the Walden closing).

Laureate is not done selling assets, while Peru and Mexico are presented as continuing operations in their filings, they make it clear that they're still entertaining offers for both segments (transcripts courtesy of TIKR).

From Q4 2020 Earnings Call:

"...the decision to focus on a regional operating model in Mexico and Peru does not preclude further engagement with potential buyers for these businesses as we are committed to pursue the best strategy to optimize shareholder value."

From Q3 2020 Earnings Call:

"However, we will continue to explore strategic transactions for our remaining operations in both Mexico and Peru, and we'll pursue opportunities that can generate superior value for our stakeholders, net of friction costs versus retaining those operations as a publicly traded company."

The strategy of focusing on Mexico and Peru seems unintentional and more just the pace and sequence of asset sales.  It is unlikely that a smallish U.S. headquartered company providing higher education in Mexico and Peru will be valued properly or have much need to be public.  Management agrees, they've been consistent and clear in their belief that the stock price doesn't reflect the intrinsic value of the company, and their plans to return capital to shareholders to close this gap.  A few more snippets from recent earnings calls:

From Q1 2021 Earnings Call (5/6/21, stock was trading at $13.70):

"In addition, I am pleased to report that our Board has approved an expansion of our stock repurchase plan by an additional $200 million, bringing the total authorization to $500 million. Since beginning the plan in November, we have repurchased approximately $250 million worth of stock. We continue to believe that returning capital to shareholders through stock buyback is very accretive use of capital for investors given the significant discount of our stock price versus the intrinsic value of the individual institutions in our portfolio."

From Q3 2020 Earnings Call: 

"Let me now close out my prepared remarks by providing some guidance on the use of our excess liquidity. Our capital allocation strategy remains unchanged: first, support our business operations; second, repay our debt only if needed; finally, return excess capital to shareholders in the most tax-efficient manner possible.

...the most tax-efficient manner to return capital to shareholders is in the form of open market purchases, so share buyback, like the program we've just announced, as well as other means, such as a tender offer. So at this point in time, we are not thinking of distributing cash or excess cash to shareholders in the form of dividends. Obviously, that may change. But our priority is really to do it in the most tax-efficient manner."

The company has been a significant buyer of their own shares and that has likely continued as their share repurchase authorization was increased alongside their first quarter earnings release (we'll see how much on Thursday when LAUR reports Q2 earnings) and will presumably be increased again or in the form of a tender following the closing of the Walden transaction.

In my usual back of the envelope way, here's the simple EV for LAUR following the sale of Walden (due your own due diligence if assuming Walden will close is a good assumption):

The 2022 EBITDA guidance includes corporate overhead, in 2020, the individual segments did $113MM in EBITDA for Mexico and $189.5MM for Peru respectively, any strategic buyer could likely cut the corporate overhead, so the EBITDA multiple is somewhere in the 4-4.5x range for proforma ongoing operations.  Their Brazilian segment was recently sold for close to 10x EBITDA.

And what might a tender offer look like?  I'm really just guessing here, but let's say they use roughly half of their net cash to do a Dutch tender and it gets done at $17/share, what might that do to the stock after an ultimate exit of the Peru and Mexico operations?  Below is a range of possibilities.

Looking at that scenario analysis, its probably best to think of the tender as a special dividend than shrewd capital allocation, although in the higher multiple scenarios it would begin to make a difference.

The big risk might be in the Peru segment, mostly for political reasons.  Laureate took a sizable ($418MM) write-down on their Chile segment in 2020 and sold it for a very cheap multiple (sub-2x EBITDA), in their words from their Q3 2020 earnings call, due to "the risks and uncertainties that the market perceives around operating higher education institutions in Chile given the current political and regulatory environment as well as the possibility of a new Chilean constitution that could come into effect as early as 2022."  Last month, Peru elected a new President, Pedro Castillo, that ran a similar far left campaign that investors fear will upend the economy with plans for a new constitution.  But maybe that's already priced in?  It could mean that a sale isn't imminent, instead the company waits for covid to fully get in the rear view mirror and more political certainty before selling the remaining businesses.  In the "Peru is only worth 2x" scenario, then the current market price is valuing Mexico at 8x, which is probably about right, hard to see a lot of downside here.

Other thoughts:

  • The proforma net cash number of $1.66B does include taxes paid on the Walden sale, its unclear to me what the tax basis is on the Peru and Mexico segments or what local taxes might be due, they do have some NOLs, Laureate seems at least tax sensitive and could do a stock-for-stock deal or sell the remaining company outright which would eliminate the corporate level taxes versus doing a piecemeal liquidation and then distributing the proceeds to shareholders after.
  • Laureate took a write-down on the value of the Laureate network brand name in the first quarter, which hints that it won't be used much longer and confirms that a two country RemainCo is not the end state for the strategic alternatives process.  They also exercised the right to terminate their corporate headquarters' lease early, it now only goes through 6/30/22.
  • Management's incentive package is tied to an undisclosed "Total Value Factor" which includes both total valuation and more interestingly speed as inputs, meaning there's alignment, less risk of management kicking the can to keep their jobs.
  • Vaccine rates in Mexico and Peru are well behind developed markets, there's significant foreign currency risk (although lessened a bit now that their USD debt is gone), and September is a big enrollment period for them, if the delta variant impacts enrollment, that could throw a wrench in their guidance.
  • Prior to covid, they did get a bid for all of their Latin American operations for $3.3-$3.6B in cash but the buyer backed away because of the pandemic.  The company has sold about $1B of operations in the region since, if they were able to get this price again, that would be about a 8-9x multiple on EBITDA for Peru and Mexico.
Maybe an interesting way to play this is via options?  Others investors have explained how to think about event-driven options strategies better than I can, but here it seems like an interesting setup, similar to ones I've had success with in the past.  The recent past volatility won't look like the near future where we potentially have several catalysts that could move the stock price significantly higher: 1) Walden deal closing; 2) continued share repurchases or a large tender offer; 3) sale of the remaining company.  I supplemented my common shares with some call options, specifically the December $15 strike price, these could be too short term, but ATGE expects the deal to close this quarter and that should give LAUR enough time to announce a capital return and/or another sale.

Disclosure: I own shares of LAUR and some Dec $15 calls

Wednesday, July 21, 2021

Retail Value Inc: PR Portfolio Sale, Liquidation De-Risked

Retail Value Inc (RVI) is a retail strip center REIT that was a 2018 spin of SITE Centers (SITC, fka DDR) and has always been on my watchlist.  There were a few of these "good REIT/bad REIT" spins during that era, this is the "bad REIT" as it contained the Puerto Rican assets (along with some of their lower quality continental U.S. properties) that were largely offline due to Hurricane Marie.  From the beginning, RVI was designed to liquidate the portfolio and return capital to shareholders, over the last several years they have made slow progress on this goal by selling the continental U.S. properties piecemeal.  The question in my mind was always what value to put on the Puerto Rico portfolio?  That question has been answered which substantially de-risks the situation, last week, the company announced a bulk portfolio sale of their Puerto Rican assets for $550MM, which post-closing would leave 8 continental U.S. properties and a pile of cash.  By triangulating a few numbers, I have the remaining portfolio trading at approximately a 13% cap rate, which even for secondary/tertiary markets, seems too cheap.

Here's my back of the envelope math, feel free to point out mistakes:

Now there could be some frictional costs that I'm completely omitting, but I'm also not including any ongoing cash flow from the remaining properties, make your own assumptions there.  But here are some of my assumptions:

  • Much of the restricted cash is Hurricane Marie insurance proceeds and reserves for their CMBS financing, the insurance proceeds were to be used to rehab the properties from hurricane damage, in their Q1 10-Q they mention only needing $6MM of restricted cash to complete restoration work.  Additionally, the PR asset sale 8-K mentions that the deal doesn't include restricted cash and the CMBS will be paid off following the closing, I'm assuming the restricted cash becomes unrestricted at that point, but double check my work.
  • In the PR asset sale 8-K, the company mentions their current CMBS mortgage balance is $214.5MM, in order to get there and based on the asset sales that have closed in Q2, it appears they've spent another $20MM in cash towards the CMBS above the asset sales.
  • RVI is externally managed by SITC, the external management agreement is pretty reasonable towards RVI, there's no termination fee or incentive fee, but there is a little incentive fee built into the preferred stock that SITC is holding.  You'll see the preferred stock on the balance sheet at $190MM, but if the total disposition proceeds are above $2B, its $200MM.  I have the current total disposition at around $1.66B, and with the additional sale of the 8 remaining properties, they'll likely cross over that threshold.
  • RVI provides NOI guidance in their quarterly supplemental, it excludes assets sold to-date, they estimate $35-40MM in NOI for the continental U.S. properties.

Doing a very basic scenario analysis for what the remaining properties are worth yields anything from $26.50-$33.90/share in my estimates, versus a $25/share price today.  

Just to smell check these estimates, based on the delta between the 2021 NOI guidance given in the Q4 and Q1 supplemental, the three continental U.S. properties RVI has sold this year for a combined value of $34.4MM generate about $3MM in NOI for a 8.7% cap rate.  The Puerto Rico portfolio is being sold at an approximate 9% cap rate.  Another way to look at it, on a square foot basis, RVI will have 3.779 million square feet remaining, in 2020 they sold properties for $107/sqft, applying a similar number to the remaining portfolio would yield a value equivalent to a 9.3% cap rate.  So somewhere in that 9% range seems reasonable now that we're recovering from covid.

In summary, assuming the PR deal closes (maybe that's the biggest risk, we are in hurricane season), RVI will have no debt, approximately half their market cap in cash and only 8 properties left to sell.  I could see this taking a similar path to the MIC liquidation discussed recently, where they have back-to-back portfolio sales (although they'll probably wait until after the PR deal closes, supposed to be by end of Q3) to clean up the liquidation quickly.  Similar to MIC, not a home run, but with the situation largely de-risked, a potential ~20% upside seems pretty attractive.

Disclosure:  I own shares of RVI

Friday, July 16, 2021

CorePoint Lodging: Strategic Alternatives, Another Hotel REIT for Sale

CorePoint Lodging (CPLG) is an old friend of the blog that I've tried hard to forget, it is a hotel REIT that was spun from LaQuinta (LQ) in 2018 simultaneously with Wyndham's (WH) acquisition of the LQ franchise/management business.  It is a unique public lodging REIT in that it targets the economy and midscale select service segment (essentially all LaQuinta branded), most public REITs own upscale and luxury hotels.  Looking back at the spin, it was a garbage barge spin and performed like the moniker suggests.  

Hotel REITs are a tough asset class because as a common shareholder, you have a lot of mouths to feed ahead of you.  REITs can't be operating businesses so hotel REITs need management companies to run the hotels themselves which runs 5% of revenues, then you have the franchise fee which is another 5% of revenues, if you rely heavily on online travel agencies, that's another big hair cut. On top of that, you have a lot of fix costs and a heavy asset base with real depreciation, interest expense, etc., these aren't good businesses for public markets generally.  For those reasons, hotel REITs tend to avoid the economy and midscale segments because the average room rates are low and don't provide enough scale to justify all the overhead costs involved.  These hotels tend to be run by local mom and pop type operators who don't have the corporate costs and can avoid the management fee by operating the hotel themselves.  

CorePoint executives clearly understand this even if they don't say it explicitly and have been selling off their older, economy level hotels to individual operators at multiples that are way above where the common stock traded.  Which is sort of the opposite of what you'd expect, but if the buyer is purchasing the hotel unencumbered by the management fee, gets an SBA loan, and they get a tax depreciation shield, it starts to make some sense.  This week, CorePoint essentially put the rest of the company up for sale by announcing they are pursuing strategic alternatives.

Going back to the logic I used recently with Condor Hospitality (CDOR), another hotel REIT that is in the process of selling themselves, I came up with a very rough back of the envelope calculation for what CorePoint is currently valued at off of 2019 Hotel EBITDA (again, I understand the faults of that math, but it's what other comparable transactions are quoting as a valuation metric).  With Condor it was relatively simple because their hotel portfolio has remained constant since 2019, but CorePoint has sold a significant portion of their hotels in the last 18 months.
In CorePoint's 2019 10-K they gave us a "Comparable Hotel" EBITDA number which adjusted for those hotels that were sold or non-operational (CorePoint had some hotels hard hit by hurricanes a few years back) of $158MM.  From there, I attempt to back into what the comparable-"Comparable Hotel" 2019 EBITDA would be adjusted for all the asset sales that have taken place or are pending.  For the Q2 and pending sales, I'm using a 15x EBITDA multiple, I didn't see it directly in their filings but management mentioned 15x on their last earnings call.  From there I get about a $118MM "2019 Hotel EBITDA" number for the remaining hotels, please check my work if you're interested in the situation.  On an EV of about $1.1B, that's a 10.75% cap rate or 9.3x 2019 Hotel EBITDA, well below where the company has been selling its less attractive non-core assets and where other hotels have transacted recently.

Similar to the extended stay segment, economy and midscale hotels held up better through the pandemic and have recovered faster than urban or group oriented hotels.  Alongside their strategic alternatives announcement, CorePoint updated us on the performance of their hotels in the second quarter:
It's not an apples-to-apples comparison since CPLG has sold off a number of lower RevPAR hotels since 2019, but here's a snip from the Q2 2019 earnings release, so business is either back to 2019 levels or at least near it.
Blackstone owns 30% of CorePoint, a legacy of taking LaQuinta private in 2006 and public again in 2014.  Blackstone is obviously a big real estate investor and recently partnered with Starwood in a club deal to buy out Extended Stay America (STAY), maybe they'd do something similar here as CorePoint's hotels serve a similar segment (but clearly without the franchise business like STAY) and select-service hotels could over time look more like extended stay models with less than daily cleaning, etc., driving higher margins.

I'm a little gun-shy on putting a target price on CPLG, the stock price has run significantly and I still have mental scars from my last go around, but to a private buyer who can detach the management contract, it could be worth a decent amount more than where it is trading today at $13.75.  A 9% 2019 Hotel EBITDA (my number could be flawed) cap rate would be around $18 and would still be a lower valuation than where they've been selling their lower quality assets during a pandemic, maybe that's too high, but shouldn't be too far out of reasonableness.

Disclosure: I own shares of CPLG (and CDOR)

Tuesday, July 13, 2021

Communication Systems: Liquidation with a Speculative Kicker

Communication Systems Inc ("CSI", Ticker: JCS) is a mini conglomerate that announced earlier this year they would be selling their operating businesses and real estate assets, returning the capital to shareholders and then merging the empty public shell with privately held Pineapple Energy, a recently formed company intending to pursue a rollup of residential solar businesses.  By my estimates, the sale proceeds from the legacy businesses could roughly equal the current market cap (~$67MM or $6.75/share), with a $3.50/share special dividend coming shortly and 90% of the remaining via a contingent value right within 18 months, leaving pre-deal shareholders with a stub position in the new Pineapple Energy (ticker will switch to PEGY) as a speculative kicker.

This is a strange transaction, CSI is effectively liquidating and as part of the garage sale is getting paid in PEGY stock for the public listing "asset", it is almost a SPAC (the merger deck resembles a SPAC deck) but Pineapple is not getting any SPAC trust cash, only the PIPE they're raising alongside the closing of the deal.  In SPAC-language, CSI is almost the SPAC sponsor and getting sponsor shares in PEGY for putting the deal together and getting it public.  The current Chairman of CSI will become the Chairman of the Pineapple and the CFO is staying on board too, so the start-up Pineapple is buying some public company management infrastructure and a public currency to pursue M&A.  But it is still a bit puzzling why either side is doing this particular deal with each other, other than both companies management teams and headquarters are based in Minneapolis, maybe they run in the same social circles.

Two events have happened since the initial merger announcement:

  1. CSI sold their largest operating business unit to Lantronix (LTRX) for $25MM in cash, plus an earnout of $7MM if the business unit's revenue roughly returns back to 2019 numbers in the 12 months after the close.
  2. Pineapple announced a PIPE financing that includes convertible preferred stock, warrants and a term loan to be used to fund operations (again, pre-merger cash is being returned to CSI shareholders) and close on two M&A transactions Pineapple intends to complete concurrently with the merger deal.
Interestingly, the convertible preferred stock "will have no liquidation or dividend preference over CSI common stock and no voting rights until after converted into CSI common stock", the conversion price is $3.40/share, the PIPE investors are also receiving warrants at the same price, but this provides a reference price for the post-merger PEGY common stock of somewhere above $0 and below $3.40 (depending how you value the warrants).

With these two events announced, the total sum of the parts value is coming together:
  • Cash and investments of $21MM
  • $25MM from the sale to LTRX, plus an earnout of $7MM
  • CSI owns their corporate headquarters in Minnetoka, MN, it is on the market for $10MM and a manufacturing facility in rural MN that is leased out to the purchaser of a business they previously sold, that facility is on the market for $975k.
  • Their remaining business segment (JDL Technologies and Ecessa) has yet to be sold, the Ecessa business was purchased in 2020 for $4MM, the combined segment did $8.8MM in revenue last year.
Back of the envelope math, in a pretty bullish scenario, pre-deal CSI investors can hope for up to $6.62 back and still be left with the Pineapple Energy stub that raised capital with a $3.40 strike on the convertible preferred stock.
Feel free to stress test it on your own, maybe the earnout should be valued at zero and some discount applied to the real estate.

Why does the opportunity exist?  First, it's small and illiquid, roughly half the liquidation proceeds will be in a non-traded CVR that might not pay for 18 months.  Second, no one interested in Pineapple Energy would buy this yet.  Post merger it might catch a bid as solar is over indexed in ETFs and ESG mandates.  I know nothing about residential solar other than being frequently approached by Sunrun reps at Home Depot, but Pineapple *might* be something worthwhile.  The CEO, Kyle Udseth, seems like your prototypical founder type, he's a Stanford MBA, well spoken, did a tour of duty at McKinsey, stints at Caesars and Netflix, and has worked for several previous residential solar names before branching off on his own with Pineapple.  Public policy is pushing solar, people are building new homes, moving to warmer/sunnier climates, etc.  Maybe it actually works, maybe it's zero or maybe it just gets lucky and catches fire with retail investors, its sort of a free upside kicker in the liquidation.

  • Deal fails to close, but then it likely turns into more of a straight liquidation and your downside is somewhat protected.
  • Cash or sale proceeds that should be distributed via the CVR gets used for the new business, doesn't appear to be the intention of the transaction, but funny business does happen with CVRs.
  • My estimates are wildly off or missing something big, there shouldn't be material taxes as they do have an NOL, but there could be unforeseen expenses or the real estate assets might sell well below list price.

Disclosure: I own shares of JCS

Wednesday, June 30, 2021

Mid Year 2021 Portfolio Review

It has been a surprisingly great start to the year, a continuation of an almost straight line up from November -- my personal account returned 38.27% during the first six months, for a reference point the S&P 500 had a total return of 15.25%.  The biggest positive performance contributors in the first half of 2021 were DigitalBridge Group (fka Colony Capital), MMA Capital, NexPoint Strategic Opportunities and PhenixFIN, the only significant detractor to performance in the first half was CIM Commercial Trust. 

Despite the headline overvaluation in markets, the current environment seems ripe for special situation investing.  There is a post-recovery mess to be cleaned up, companies will look around in the changed operating environment and likely need to be consolidated or otherwise restructured, split up, taken private, etc.

Thoughts on Current Positions

  • After my update post on MMA Capital (MMAC), I kept thinking as long as MMAC's capital partner was willing to continue contribute to the Solar Ventures after the February ERCOT storms, their problems were likely only temporary.  I bought more thinking those with the most information regarding the problem assets were continuing to increase their exposure and might be a possible exit for MMAC.  On 5/24/21, MMAC announced that Fundamental Advisors (their capital partner) would be buying the company for $27.77/share in cash.  The company didn't run a full sale process, the merger agreement includes a 40 day go-shop period that expires next week, the deal premium to the prior day's trading price was certainly a nice surprise but the deal is being done at a fairly cheap multiple to book value.  Given the structure of the joint ventures however, it seems unlikely that someone else would make sense as a buyer, but I'm holding through the go-shop period at the off chance there is an overbid.
  • BBX Capital (BBXIA) has a current tender offer outstanding for $8/share, the 3/31 book value is a little over $16/share and likely reasonably higher than that when they report 6/30 after selling some real estate at a gain, bringing IT'SUGAR out of bankruptcy and just general covid beneficiary tailwinds of their businesses (mostly Florida real estate development).  For me this situation seems similar to others over the years, management's reputation to abuse minority shareholders causes the stock to trade at a considerable discount which then incentivizes management to continue to transfer wealth to insiders.  I won't be tendering shares this time around as I could see the stock trading higher after the tender is complete, it will be accretive to book value, and I doubt it will be the last time they attempt it.  For me, this situation is a combination of DVMT (reflexivity in how the market views management and it encouraging management to close the valuation gap for themselves), TPCA (tender offer on an illiquid OTC stock, afterwards shot up) and ASFI (family controlled, disliked management that eventually took a company private that had no business being public, essentially using cash on the balance sheet to do it).
  • For the next two I'm going to outsource to a couple other posts:
    • My thesis on ECA Marcellus Trust (ECTM) in the last portfolio review generated a little bit of chatter, my liquidation thesis turned out to be wrong and I got lucky with a natural gas rally which has turned the tiny trust right side up again.  Here's a great explanation of the current thesis here, I might exit after it flips to long term gains for me as the thesis changed and I'm not a great commodity investor, but that post is worth a read if you're interested in ways to invest in natural gas.
    • After the MMAC deal closes, Franchise Group (FRG) will be my second largest holding, it is not exactly an event-driven name anymore, it graduated to a jockey bet on Brian Kahn, who recently bought a million shares in the open market.  Modeling the company is a bit difficult as there's constantly moving pieces, but Michigan Value Investor over on Seeking Alpha did a nice job of presenting the current situation today.

Previously Unmentioned Positions

  • Capitala Finance Corp (CPTA) was another "ADL" suggestion, it rhymes with other ideas I've done well with over the years, a BDC (can be any externally managed YieldCo) that went astray with its previous manager, cut the dividend, the mostly retail investor base fled and it trades at distressed prices, new manager comes in to right the ship and eventually reinstates a market dividend.  With Capitala, the new manager is Mount Logan, an affiliate of BC Partners which manages Portman Ridge (PTMN), a BDC that was once KCAP Financial, BC Partners has gone on to consolidate three BDCs into PTMN over the last two years.  They have a playbook and have executed it reasonably well, this situation is slightly different as they're just taking over the management contract, possibly because this parallel tracked another PTMN acquisition in Harvest Capital (HCAP, I did own it for the arb).  But I think the results should mirror an acquisition (and might become a formal one at some point), albeit over time as they'll reinvest the portfolio much the same way PTMN is managed today.  CPTA trades at 55% of NAV, PTMN is around 80%, that discount probably narrows.

Closed Positions

  • My biggest performance detractor this period was CIM Commercial Trust Corp (CMCT), the original thesis of a proxy battle being either conceded by management or won by activists has been thwarted as the company went ahead with a rights offering at ~40% of their own stated NAV (same NAV that serves as the fee basis amount for their management fee).  It shows incredible distain for minority shareholders, I can't imagine the board won't get sued.  The rights offering, along with getting booted out of the Russell may create some technical selling right now, so while I sold a few days after the rights offering was announced and still have a few days to go to avoid cancelling my tax loss, CMCT could be an attractive post-rights recovery swing trade if that's your thing and you can stomach the management team here.  Still surprised CIM damaged their reputation for this small sleeve of their overall business.
  • I did the buy-write (June expiration) strategy on Pershing Square Tontine Holdings (PSTH) that was suggested by Andrew Walker last December, it worked out largely as planned.  As everyone is well aware, Bill Ackman announced a complicated transaction with Universal Music Group that will also create two other securities.  I don't have a strongly held opinion on UMG, there is a lot of great analysis going on around it on Twitter and elsewhere, but for me how the trade was structured, I have short term gains from selling calls and now a loss on the PSTH shares.  It makes sense for my tax situation to sell PSTH to offset some of the income generated, then re-evaluate as we get closer to the transaction closing and the three pieces being distributed later this fall.
  • The Medley LLC (MDLQ/X) bankruptcy is getting dicey, it appears the proceedings have pivoted to a liquidation and wind down of the company versus trying to pursue a going concern restructuring with Medley Management (MDLY).  In an asset management business, there aren't a lot of assets with value other than the management contract revenue streams, with Medley's separately managed accounts fleeing and Sierra Income Corporation pursuing strategic alternatives (there is no termination fee on the Sierra contract), it appears there is a little value left at Medley LLC or Medley Management.  MDLY has some meme like day trading happening in it, I sold my baby bonds for a negligible gain on a day when MDLY spiked.  I'll still follow the situation, but mostly just for curiosity.
  • I have a few themes that I tend to like, one is when a clinical stage biotech misses on its primary candidate, sometimes the stock will drop below net cash and the company puts itself up for sale.  Often they'll do a reverse merger with another pre-revenue biotech, so by buying the cash shell you can get in before the "IPO pop" of the new exciting company.  That's essentially what happened with Catabasis Pharmaceuticals (CATB), Catabasis also got wrapped up in some of the speculative retail trading in the first quarter, but on 1/29/21 Catabasis announced the acquisition of Quellis Biosciences, the stock popped and I sold that morning (a bit too early, hard to put on my day-trader hat and time these perfectly right).  Unfortunately, the market has seemed to catch on to this trade and other failed biotechs haven't traded down quite as cheaply recently.
  • I exited Five Star Senior Living (FVE) over concerns about the RMR relationship, FVE has a lot of cash on its balance sheet for an asset-lite management company, wouldn't be surprised if RMR makes an acquisition within FVE to increase their revenue share agreement instead of doing a buyback or some other capital return that would benefit minority shareholders.  Management at FVE clearly had their hands full during covid, but a year on since the recapitalization and they still haven't really laid out a clear capital allocation plan.
  • Perspecta (PRSP) was a 2018 spinoff of DXC, basically a replay of CSRA, both of which got sold shortly after the two year spinoff window lapsed.  Last year, I sold PRSP common stock near the bottom in covid as it went down less than others due to the government link, but jumped back in with naked calls on the rumors it was being shopped, got lucky, Perspecta was taken private by Veritas Capital, a PE firm that already owned a significant stake.
  • I closed both sides of the Madison Square Garden (MSGS/MSGE) split in the last month.  MSGS is kind of cheap on an NAV basis, depending on how large of a "Dolan Discount" you think it should receive, but I'm just finding better more actionable opportunities.  Premier market sports teams are a scarce asset that should hold their value over time, public markets are volatile, might make sense to sell puts occasionally when the discount gets particularly wide.  MSGE is a grab bag of development assets that I typically like but I just can't get comfortable with the Sphere project.  It's a bet the company style project, it could work, but reminds me a bit of the mess with the Seaport for Howard Hughes, delays, might have to get repurposed and shift strategies part of the way through, etc., add in the strange deal with MSGN, I decide to exit. 
  • Macquarie Infrastructure Corp (MIC) worked out pretty quickly and about as expected, rather than wait around for the big distributions and potential headaches, I sold and moved on, might return if there is forced selling after the Atlantic Aviation deals closes and the company converts to a partnership.  If you run the IRR based on the expected distributions of $37.35 for AA and $3.83 for MIC Hawaii, you get a healthy upper teens IRR, so it could still be a good liquidation play depending on your tax situation.
  • Acres Commercial Realty Corp (ACR) also worked out pretty quickly, this was a strange mispricing potentially because of a name change, but similar to CPTA and others, it was a broken mREIT that got rescued with a new manager.
  • Ladder Capital (LADR) was another commercial mREIT recovery trade that has mostly played out.  The company was hyper conservative over the last year raising a lot of cash, letting their short duration loans roll off, while at times a bit frustrating as a shareholder, it validated the original thesis during the covid-crisis that their investment/loan book was high quality.  I'll continue to listen to their conference calls as Brian Harris runs a fun fireside chat format where he provides his views on all corners of the real estate market.
  • As mentioned in my year end 2020 post, I was selling calls against my Wyndham Hotels & Resorts (WH) position until it got called away, it did shortly after in February as the reopening trade has hotel franchise/management companies trading above where they were pre-pandemic.
Current Holdings

No cash was added or withdrawn during the period.  

Potential Changes
Going forward, the format and transparency of these portfolio updates could change, when I started writing no one read the blog and now that my personal and professional circumstances have evolved, it might not make sense anymore.  I also may finally move away from Blogger, similar to other Google properties, it has been neglected for years now and Google is discontinuing the email feature in July which I'm guessing is how most people receive my posts.  TBD on the next direction there, if any.

But as always, thank you to anyone who has reached out, offered an idea to look at, pushed back or commented on a post, I genuinely appreciate it, it is the primary reason I keep active.  Always looking for more ideas, currently kicking around HFRO, RMRM, FWP, AAMC, WHLRD, SOHO prefs, CVEO and a few others .  Enjoy the holiday weekend.

Disclosure:  Table above is my taxable personal account.

Wednesday, June 23, 2021

Condor Hospitality Trust: Covid Deal Break, Renewed Strategic Alternatives

Condor Hospitality Trust (CDOR) is a small (~$80MM market cap), illiquid (50+% owned by two funds), lodging REIT that owns 15 hotels primarily across the upscale and upper-midscale segments, with an emphasis on extended stay layouts, both of which have held up better than the upper-upscale or gateway/convention market type peers.  Back in 2019, Condor had an agreement to be purchased by NexPoint's lodging REIT (NHT in Canada) for a $318MM enterprise value or $11.10/share (it trades for $5.00/share today with a $260MM EV), that deal was delayed during the outset of the pandemic last year, later broke, and now that hotels are in recovery mode, Condor is once again putting itself back up for sale.  Given private equity's interest in hotels and particularly the extended stay segment, I could see Condor receiving plenty of buyer attention and selling for a price above where it trades today.

Condor used to be similarly positioned to CorePoint (CPLG), focusing on the midscale and economy select-service segment with a couple hundred hotels, but over a decade or so, they sold off most of that portfolio and repositioned themselves into the 15 hotels (1,908 rooms) they have today:

Most of these hotels were acquired since 2015 for a total purchase price of $288MM.  The portfolio is in reasonably good shape, and in healthy markets where covid restrictions have been relatively minimal (TX, FL, etc); just two of their hotels closed briefly in April 2020, only to reopen a couple months later by the start of July.  Hotel level operating metrics have improved dramatically, the company as of March was no longer burning cash, April occupancy was over 70% largely on the back of leisure travel, with management also optimistic on business travel "We anticipate that business travel led initially by local business demand, and then regional demand, will begin late in the second quarter and improve over the remainder of 2021."  Take these types of metrics with a grain of salt, but the company also likes to tout how they're outperforming their peer set on a relative basis:

Either way, best I can tell, this portfolio is of reasonable quality and likely not at risk for obsolescence in a post-covid recovery.  Hotels are generally are in recovery mode, STR has a good report here with some interesting charts, longer term I think there could be some tailwinds, people might extend vacations knowing they can work remotely and hotels themselves have shed operating expenses (daily cleaning, guest services via mobile app versus the front desk, etc.) some of which could become permanent.  And if you're in the market for real estate recovery plays, hotels just seem better positioned longer term than the other bombed out sectors like office or retail. 

So you have a relatively bite sized portfolio that held up well comparatively through covid, some emerging tailwinds as people begin traveling again, plenty of PE money sloshing around the industry (thinking about CLNY selling their big select-service/extended stay portfolio, BX/Starwood buying STAY, etc.), and a company that's already sold itself once before and clearly motivated to do it again.

A quick review of the capital structure, this is fairly leveraged entity, like many of the lodging REITs they had to raise capital to make it through the crisis.  But here's where things get a little harry, the company issued a "bridge loan" in the form of convertible debt to one of the two funds that own a significant portion of the common stock and the preferred stock.  The convertible debt has a 10% coupon (bumps up under certain scenarios) and is convertible at $2.50/share, it was in the money from the beginning compared to where the stock was trading at the time in November.  The proceeds were used to pay down the KeyBank credit facility and the convertible will likely convert to equity here in the coming days as a requirement for the one of the many amendments to the credit agreement.

With that dilution, we have about 16 million shares at a ~$5/stock price, for a $260MM enterprise value.  Now obviously valuation is a little tricky these days, 2020 was an extraordinary year for the hotel industry, most transactions I've seen quote a "2019 cap rate" as a normalized value, we can argue if that's realistic, it'll likely take a couple years to get back to 2019 run rates, but that's how others are quoting transactions that are happening today.  In 2019, Condor generated $26.2MM in "hotel EBITDA" which is a reasonable proxy for net operating income, on the $260MM enterprise value, that's an approximate "2019 cap rate" of 10%.

Recent Lodging REIT transactions, each of these are better located/quality properties than CDOR, but still good relative data points as they're all similar brand/format sales/purchases:

  • Park Hotels & Resorts (PK) sells two hotels in May (better located, but two brands CDOR has in its portfolio) for a 7-7.4% 2019 cap rate
  • Somewhat close peer, Apple Hospitality (APLE) in their recent earnings release "The company has acquired five hotels for a total purchase price of approximately $161 million since the beginning of the COVID-19 pandemic."
  • Chatham Lodging Trust, another somewhat close peer, in December, sold a Residence Inn in San Diego for $67MM, a 6.5% 2019 cap rate

Again, probably none of these are a perfect comparable, but they've all moved at much lower cap rates than what the CDOR equity implies, seems like an interesting setup.  Per the background section of NexPoint deal proxy, the company began to explore a sale in 2018, they actually received 7 initial all cash offers for the REIT, before settling in with NexPoint.  Times have clearly changed, but given the concentrated ownership here, I think the company will almost certainly be sold again, an 8.5% "2019 cap rate" (the quotes mean I know its a bit of a silly valuation metric) would be $7.40/share.

Other thoughts:

  • Probably only 1% of the thesis, but I like that Matt McGraner from NexPoint led the acquisition negotiations in 2019, he's the brains behind NexPoint's real estate strategy and from what I gather quite talented.  Obviously things have changed, he's an asset gatherer so maybe wasn't the most price sensitive, but another point in the "these assets are decent enough" bucket.
  • The OSK X mortgage loan listed above is financing one property, the Aloft in Leawood, KS (suburb of Kansas City), that was purchased from a local bank by O'Brien Staley Partners.  Condor had previously gotten covenant waivers from the local bank, but O'Brien Staley Partners has put them into default on the loan.  Condor believes they can refinance the loan with another lender, but there's a possibility that property goes back to the lender in foreclosure.
  • My guess is they've received inbound inquiries already and that the sale process won't take more than a few months, again, lots of interest in the sector, we're at a tipping point, I think those that have a bullish thesis on hotels want an opportunity to express it before the recovery becomes fully obvious.

Disclosure: I own shares of CDOR

Tuesday, June 1, 2021

Regional Health Properties: Inadequate Pref Exchange Offer

Reader "ADL" mentioned this one in my ill-fated Medley post the other week and I took a small position but the write-up hung out in my draft folder, this afternoon the company announced an exchange offer that appears inadequate to me.  Regional Health Properties is offering 0.5 shares of common stock for each preferred share, on a headline basis its a healthy 20+% premium on today's closing prices (RHE closed at $12.04, RHE-A closed at $4.90), if fully exchanged the preferred stock would only receive 45% of the proforma shares when it should be 90+% (similar situation would be the AHT preferred exchange last year). The exchange offer requires an amendment to revise the terms of the preferred stock (liquidation value to $5/share, eliminate the accumulated dividends) that would require 2/3rds preferred shareholders voting for the amendment (non-votes are the same as no votes).   Below is the original write-up, but now that things are in motion, seems like an even better opportunity as the company attempts to recapitalize.

Original Write-up

Regional Health Properties (RHE) (fka AdCare Health Systems)  is a real estate investment company (but technically not a REIT) focused on senior housing in the southeast United States.  It's another small and illiquid idea, the common stock is probably uninvestable and the preferred stock has a market value of $12.4MM. The company has a rough history, some previous fraud accusations, multiple CEOs in a short time frame, etc., but if you look past the mess to the underlying assets and the recent announcement of a possible recapitalization of the balance sheet, there might be an interesting personal account type opportunity here.

High level summary, the company's primary business is owning or leasing 24 senior housing properties and then leasing or subleasing those properties on a triple-net lease basis to operators.  A few of these properties the company now either manages or operates on a temporary basis due to operators failing.  Of the 24, 12 are owned and leased out under traditional triple-net leases, meaning the tenants pays for all expenses, the rent is virtually the same as net operating income to calculate a cap rate.  I don't quite understand the leased model where they then turn around and sublease the properties, seems like a dangerous spread trade to me where you have to reach for risky tenants to make it work.  It appears that's how its played out with most of the distress in their tenant base happening in the subleased book, so we'll ignore that for the purposes of the pref thesis.  Below is the rent-roll for the owned properties:

This portfolio is financed with an assortment of government guaranteed debt (generally a negative, means the borrower couldn't get reasonably commercial terms without the government guarantee), total debt is approximately $55MM.  

Add in the $12MM as the market value of the preferred and through the preferred stock you're buying the owned triple-net portfolio for $67MM or an ~11.5% cap rate, as usual with me, pretty back of the envelope math.  The preferred stock trades for $4.50, has a standard liquidation preference of $25, but hasn't paid a dividend in several years. The total liquidation preference is over $35, but it almost doesn't matter, the preferred stock is unlikely to be made whole so any incremental value above the senior debt accrues to the preferred stock, it is the fulcrum security despite the common having a current market cap above $20MM.

In their recent earnings release, RHE added this line:

In early 2020, the Company began on-going efforts to investigate alternatives to retire or refinance our outstanding debt of Series A Preferred Stock through privately negotiated transactions, open market repurchases, redemptions, exchange offers, tender offers, or otherwise. Costs associated with these efforts have been expensed as incurred in Other expense, net and were approximately $394,000 and approximately $144,000 for the three months ended March 31, 2021 and March 31, 2020, respectively.

Apparently they initially started down this path just before covid, now that things are opening up and rent collections are largely back to normal, the time is right to address the capital structure as it clearly doesn't work anymore.  My guess is RHE will attempt to exchange the preferred shares for common stock, maybe something similar to what happened over at Ashford Hospitality Trust (AHT).  Just for a quick example, if you valued the triple-net lease portfolio at a 9.5% cap rate (a higher quality but smallish triple-net like CareTrust REIT (CTRE) trades at 6-7% cap and has been buying properties this year in the 8-10% range) then the preferred might be worth $25MM, or a double.  But that's just a guess, the upside seems highly variably in mind but the downside is fairly well protected.

Other thoughts:

  • Senior housing obviously suffered during covid, but with vaccinations now widely completed for the elderly and front line workers, new residents can begin to move into facilities.  There might be a temporary ramp up as move-ins were delayed the last year, but there's certainly an open question at least in my mind if covid permanently impaired senior housing and whether alternatives might become more popular than housing the most at-risk all together in close quarters.
  • Whatever the common stock is doing is a mystery to me, it might be caught up in meme stock trading or other pump and dumps, ignore it, its almost certainly going to get completely diluted.  The unpaid preferred is $30.1MM, so the total due to prefs is ~$100MM, you have to be pretty optimistic on their leased/operated properties to see any value to the equity, and if you are optimistic, the preferred is still the better risk/reward.
  • I don't know who owns the preferred stock, it's hard to parse out with publicly available data sources, and surprisingly/concerning that despite having the right to nominate board members to represent the preferred stock, no one has to-date.
  • RHE should probably just sell themselves, but in their press release and 10-Q they hint their strategy is in the opposite direction, they want to go in growth mode, difficult to fully understand how they could do that but certainly couldn't without first resolving the preferred share overhang somehow.

Disclosure: I own shares of PHE-A

Thursday, May 13, 2021

Medley Management: Reorg BDC Manager, Better Offer Coming?

[This is marginal idea day, I have a few of these small positions I've started but don't really have the conviction to make them more than that, but others might find them interesting and in the interest pushing out some content, here we go]

Medley Management (MDLY) is an asset manager of private-credit or middle-market leveraged loan vehicles, it was previously the external manager of PhenixFin (PFX), a business development company ("BDC") that was formerly known as Medley Capital (MCC) prior to BDC's board terminating Medley's management agreement at year end 2020.  The loss of the MCC management agreement, alongside years of underperformance, dinged Medley's assets under management to the point the company's operating subsidiary filed bankruptcy protection on 3/7/21.  Today the company has about $1B in AUM, split between their non-traded BDC, Sierra Income Corporation ("SIC"), and some other separately managed accounts or private funds.

A little history, Medley Management was 5-6 years ago a semi-popular way to play the "permanent capital" trend, traditional asset managers were facing the same headwinds they do today with outflows and competition from cheaper indexed alternatives, however permanent capital managers were popular since they managed closed end funds like BDCs or REITs.  The closed end nature and generally punitive termination clauses in external management agreements make them highly valuable.  Medley took this valuable revenue stream, IPO'd it, took on leverage in the form of baby bonds (bonds that trade on exchanges, typically $25 par value like preferred stock) and paid a handsome dividend.  These baby bonds trade under the symbols MDLX and MDLQ, as part of the proposed bankruptcy plan, the baby bonds will be converted into MDLY common stock.  But prior to the current troubles, Medley had been underperforming for years, MCC had been trading a persistent discount to book value and was unable to issue shares.  In 2018, they came up with a plan to do a three-way merger that would combine MDLY, MCC and SIC together to form one large internally managed BDC (similar in nature to the ill-fated NSAM/NRF/CLNY merger), but that merger was challenged by shareholders from the get-go as a non-arms length transaction designed to prop up MDLY and enrich insiders, the merger was ultimately scrapped during the worst of the pandemic.

With that out of the way, here's where the story gets a bit more complicated, MDLY technically represents shares of Medley Management which is just a holding company that in turn owned a portion of the operating subsidiary partnership, "Medley LLC", Medley LLC is the now bankrupt entity that is the asset manager, where the majority of the employees technically work, etc., and most importantly, where the baby bonds were issued.  The remaining portion of Medley LLC was owned by two twin brothers, Brook and Seth Taube who were until recently co-CEOs together, they had the option to convert their units in Medley LLC for MDLY shares, normally you would never do this for tax reasons, but once it was clear that Medley LLC was in trouble and formally filing for bankruptcy, the Taubes converted their units in Medley LLC for shares in MDLY to maintain control of the company.  Their reason for this transaction was a fear that a change of control through bankruptcy would trigger clauses that would allow clients out of their management contracts.

Prior to the unit conversion, MDLY had 670k shares outstanding (after a reverse split), after the Taubes Medley LLC unit conversion the company has just over 3 million shares outstanding.  As part of the restructuring plan, MDLY will be issuing new shares to both classes of baby bonds and to Strategic Advisors, who were a minority investor in the entity that manages Sierra Income.  In 2018, MDLY bought out Strategic using seller financing, MDLY defaulted on the Strategic note in early February 2021, same time the company failed to pay interest on their baby bonds.  Here's what the plan contemplates for both sets of creditors:
Notes Claims. On the Effective Date, each holder of an Allowed Notes Claim shall receive: (i) if such holder votes to accept the Plan, 0.600 shares of newly-issued Class A Common Stock of MDLY for each $25 principal amount of 7.25% senior notes due 2024 (“2024 Notes”) and/or 6.875% senior notes due 2026 (“2026 Notes”) held by such holder; (ii) if such holder does not take any action and does not vote on the Plan, 0.450 shares of newly-issued Class A Common Stock of MDLY for each $25 principal amount of 2024 Notes and/or 2026 Notes held by such holder; or (iii) if such holder elects to Opt-Out of the Third Party Release contained in Article VIII of the Plan and/or votes to reject the Plan, the lesser of (x) 0.134 shares of newly-issued Class A Common Stock of MDLY for each $25 principal amount of 2024 Notes and/or 2026 Notes held by such holder or (y) a pro rata share of the Rejecting Noteholder Pool.

Strategic Claim. The holder of the Allowed Strategic Claim shall receive: (i) 218,182 shares of newly-issued Class A Common Stock of MDLY; (ii) $350,000 in Cash on the Effective Date or as soon as practicable thereafter; and (iii) a secured promissory note, the form of which will be negotiated between the parties prior to the Confirmation Hearing, which provides for 10 consecutive quarterly payments of $225,000 in Cash, commencing on the last Business Day of the first full calendar quarter following the Effective Date.

The baby bonds are getting the short end of it here, clearly the equity is impaired at Medley LLC, but due to the structure of MDLY, management was able to remove themselves from the bankrupt entity and then now is forcing mostly retail investors to approve the plan or get less if they forget (which seems like fair amount would) or straight out reject the plan.  The SEC seems to agree, the SEC has an open investigation into MDLY, they recently had this to say in a court dock filing:

B. The Debtor’s Bankruptcy Case and Restructuring Plan

8. On March 7, 2021, Medley filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code in the Bankruptcy Court for the District of Delaware (the “Court”). That same day, Medley filed the Plan which would exchange the debt owed to holders of the Notes for equity in MDLY.  The noteholders are among the Debtor’s most senior class of debt, as the Debtor has scheduled no secured or priority claims. Under the Plan, holders of the Notes are estimated to receive a recovery between 5% and 22.4%, depending on whether the noteholders vote in favor of the Plan. But because the recovery hinges on the market value of MDLY stock, noteholders could receive much less under the Plan. The Debtor has scheduled only $7.7 million in general unsecured claims, all but approximately $86,039 of which relate to one creditor. These claims are also impaired.

 9. The Plan gives equity special treatment. Specifically, the Plan treats the Debtor’s equity interests as unimpaired and contemplates that unitholders—i.e., MDLY—will continue to own the reorganized Debtor. According to the Debtor’s CFO, equity interests remain unimpaired under the Plan in order to avert “material adverse consequences.” See Allorto Decl. [Docket No. 5], at 12. Specifically, “[t]he Plan is designed to avoid a change of control event through the Chapter 11 Case and limit the potential for client defections.”  

10. It is clear from the first-day declaration and testimony at the Section 341 Meeting of Creditors that at no time prior to the petition date did the Debtor consider any strategic alternative that would have impaired the pre-IPO owners’ interests in the Debtor.

And then in a footnote, SEC hinted that a new revised plan might be coming, presumably one that would give the baby bonds more of the reorganized entity:

1 The SEC staff has informed the Debtor that the Plan is fatally flawed in a number of respects. In response, the Debtor has represented that the objectionable provisions of the Plan, including provisions violating the absolute priority rule, will be addressed in a forthcoming amendment, that the current hearing date will be adjourned, and that the SEC will have an opportunity to review and object to any amended disclosure statement. Although the Debtor has informed the SEC staff that the structure of the Debtor’s Plan may change, as of the date hereof, an amended plan and disclosure statement have not been filed, and the Debtor has not agreed to further extend the date on which the SEC must object to the retention applications. As such, the SEC has no choice but to file its objection based on the currently-filed Plan. The SEC reserves the right to amend this objection if and when such an amended plan and disclosure statement are filed. 

So a better outcome might be coming thanks to the SEC pushing back, but even if the current plan remains in place, the baby bonds look interesting, both on their own and relative to where the common stock trades.  These are all fairly illiquid securities, but as I write this, the two baby bonds (MDLX and MDLQ) trade for approximately $2.30, MDLY trades for $5.70, at a rate of 0.60 MDLY per baby bond that's $3.41 of "value", 46% upside to where the bonds trade.  MDLY is extremely volatile and seems subject to the occasional pump and dump, so maybe the bonds are reflecting the true value and MDLY is just a meme stock trading sardine.

Some back of the envelope math, ignoring the $9.5MM investment in SIC and other cash/assets on MDLY's balance sheet, I get an enterprise value of approximately $23MM through the baby bonds for an asset manager with $1.2B in AUM, a lot of which is paying upwards of 1.75% in base fees.

Seems kind of cheap?  Proforma normalized earnings is probably something like $1MM per quarter.  Now of course you have the Taubes still in control of this thing and assets to continue to flee, but loan mutual funds have seen huge inflows recently in anticipation of higher rates, defaults are at lows, I could see this market making a recovery and potentially benefiting even the marginal players like Medley.

Risk/Other Thoughts: 

  • Please do your own work on this one, the MDLY shares are highly volatile and appear to occasionally caught up in pump and dumps or "meme stonk" trading patterns.
  • The bankruptcy process is uncertain, the plan still needs to be approved by the courts, a lot could go sideways and I'm not a reorg expert by any stretch.
  • Sierra Income Corporation makes up a majority of their assets and the Investment Advisory agreement between SIC and Medley needs to be renewed each year, Sierra can terminate the agreement at any time.  SIC does file with the SEC, in their latest proxy they detailed the events leading up to renewing Medley's contract for another year despite the bankruptcy proceedings, noting that the reorganization would be good for Medley and SIC.  I would also note that none of the independent directors of SIC own any material amount of stock, are paid handsomely in cash, and likely don't want to interrupt that gravy train, but as with MCC, SIC could decide to terminate the agreement and then Medley would be in serious trouble.
  • Medley recently disclosed in an amended 10-K filing that a client representing 18% of their AUM terminated their investment agreement with Medley, the funds will take a couple years to leave the firm (middle market loans are illiquid, they'll runoff in 2-3 years), but again, shows this is a melting ice cube business.
  • I'm bullish on private-credit going forward, say what you will about the Fed's actions but the result is to push people out on the risk spectrum, especially fixed income or yield oriented investors.  To meet desired total returns, the fixed income portion of a typical portfolio is going to have to be riskier than it has in the past.  If the Taubes come to the realization that their name or the Medley name is tarnished, I imagine they'll have a few interested parties in buying them out, or a recut of the Sierra Income internalization transaction could be back on the table again.
Disclosure: I own shares of MDLQ (and PFX too)

Macquarie Infrastructure: Liquidation, Possible Forced Selling Later

[I bought a little of this, did more work on it and its a little tighter than I'd normally like but wanted to post on it in case I'm missing something or others see more value here, and there's potential for some forced selling down the road]

Macquarie Infrastructure Corp (MIC) is the rare externally managed vehicle that is in the process of liquidating, but only after it was clear the incentive fee was well out of reach.  MIC is essentially a publicly traded private equity fund that invested in infrastructure or infrastructure-like businesses with the external manager charging a base management fee plus a carry.  They initially announced strategic alternatives in October 2019, with the first major asset sale (International-Matex Tank Terminals) closing in December and the resulting first special dividend being paid out in January.  From recent management commentary, it appears the liquidation is moving along quickly and we'll likely see transaction announcements in the coming months for the two remaining businesses, Atlantic Aviation and MIC Hawaii (dba as Hawaii Gas).  I think the gross upside is around 17%, with the IRR being a bit better considering most of the value should be returned to shareholders around year end.

Atlantic Aviation is a provider of fixed based operations ("FBO") for the general aviation ("GA") market, which basically means they provide jet fuel, hangar space and other services for private aircrafts at 69 airports throughout the United States.  This business is firmly in the "infrastructure-like" category, it is heavily reliant on the amount of GA traffic through the airports where it operates.  Atlantic experienced a quick but relatively brief covid downturn as private flights have rebounded much quicker than commercial flights.  Atlantic is one of the larger players in FBO industry, behind Signature Aviation (SIG in London), Signature recently agreed to a go-private transaction, after multiple bidders made offers, valued at 16x 2019 EBITDA.  In 2019, Atlantic did $276MM in EBITDA, but with corporate costs fully allocated, its probably more like $260MM on a standalone basis, at a similar 16x multiple the total value would be $4.16B, and after subtracting out $1B in debt at Atlantic, the sale would net $3.4B to MIC shareholders or $36/share (this is before Macquarie's incentive fees, etc.), above where the stock is trading today at ~$34/share.

MIC Hawaii, which operates as Hawaii Gas, is the state's only regulated natural gas distributor.  Natural gas makes up a small portion of the state's energy needs, their client base is more heavily concentrated in the restaurant and hospitality industry, both which suffered during covid from strict local lockdowns and travel restrictions.  Recently, travel to Hawaii has restarted from the US mainland, still limited from Japan and other parts of Asia, but trending in the right direction.  Prior to covid, Hawaii Gas was a very steady but no-growth business of about $60MM in annual EBITDA, converting to $40MM in FCF.  I don't have a great sense of what this business is worth, there's no perfect comp, but this is a stable business once the Hawaiian economy returns to somewhat normal, let's says its worth 8x EBITDA, or $480MM, subtract out the $94MM term loan on the business and its $4.40/share in value.

Proforma cash is approximately $250MM, which accounts for the remaining convertible senior notes that the company is actively retiring in the market.  Now Macquarie isn't liquidating the company simply because it is the right thing to do, they are getting a huge fee per the Disposition Agreement, which was intended to convert a termination fee into an incentive fee for maximizing value in a liquidation.  Above about $4.6B in total net proceeds, Macquarie earns a 6.1% share in cumulative payments on the entire net proceeds, it appears they'll likely meet that threshold and thus on my math, Macquarie would earn approximately $378MM (only somewhat confident that's directionally right), $28MM of which has already been paid as part of the IMTT disposition.  The net effect is approximately a net -$100MM cash position or -$1.15/share (leaving out any interim free cash flow generated by AA or Hawaii Gas), add it all up and its a little over $39/share in total value.

As always with a liquidation, the timing of the payments and the order of events is important.  To this point, the company will be converting to an LLC (a partnership for U.S. tax purposes) just prior to the closing of an Atlantic Aviation sale.  In a perfect world, MIC Hawaii would be sold first, its about 1/10th the size of Atlantic, any capital gains would be relatively trivial to the overall value of the company, but because MIC Hawaii is regulated, it may take over a year to secure approvals and close the deal.  I don't want to understate this risk, several years ago I owned the state's electric utility, Hawaiian Electric Industries (HE), which at the time had a deal with NextEra Energy (NEE) to buy HE and spinoff their bank subsidiary.  The regulators ultimately killed that deal, I forget the technical reasons, but it was largely local pride and not wanting to give up control to a larger mainland entity.  Less risk of that here with natural gas being a low-single digit piece of the energy grid, but still something to keep in mind as the liquidation unfolds, a dragged out process will turn a somewhat attractive IRR to a pedestrian one pretty quickly.  MIC will first sell AA (likely this year, with a close and special dividend in 2021), convert to a partnership so any capital gains would be at the individual shareholder level and then the sale of MIC Hawaii would be structured as a sale of the partnership units and wouldn't have any associated tax consequences.

Often with liquidations, there is an opportunity around the big bulky distribution, either just before or just after the payment, I could see a scenario where that effect is magnified here with the company also converting to a partnership and those remaining investors that can't own partnerships by their mandates or because its held in a tax deferred account, might be forced to sell, creating an opportunity for those willing to go through the tax and paperwork headaches of a partnership.  Something to keep on the watchlist even if the current spread isn't particularly appealing by my estimation.

Disclosure: I own shares of MIC