Wednesday, November 24, 2021

Sonida Senior Living: Out of Court Restructuring, fka Capital Senior Living

Sonida Senior Living (SNDA, fka Capital Senior Living under the old symbol CSU) recently completed an out of court restructuring led by Conversant Capital, the same investor that has been instrumental in institutionalizing and providing growth capital to INDUS Realty Trust (INDT).  While clearly different, the industrial/logistics asset class has covid tailwinds versus senior housing having covid headwinds, the results could rhyme with each other longer term as this micro cap "grows up" (to steal a tweet from "Sterling Capital" @jay_21_, also h/t for the idea). Sonida is now positioned to use their reset balance sheet to take advantage of a fragmented senior housing market with plenty of distress (looking over at our friend RHE), but also with long anticipated demographic tailwinds finally being realized with an increasingly large population aging into senior housing.

Below is the standard investor relations overview slide.  Unlike some others in senior housing, SNDA is not a REIT (more similar to BKD), but owns and operates the vast majority of their facilities as they exited locations the company formerly leased from others (VTR, WELL, PEAK etc) in recent years.  There's embedded real estate value at SNDA as a result, which may someday lend itself to some kind of REIT transaction.  They also have a small management business that resembles Five Star's (FVE) business model (got there in a similar way too when SNDA restructured their leased properties) that helps offsets some G&A in the meantime.


The restructuring agreement took a few twists and turns, including heavy opposition from 12+% shareholder Ortelius Advisors, but was eventually approved by shareholders in October and closed earlier in November.

A total of $154.8MM (net $140.8MM) was raised through a combination of:
  • $41.25MM in convertible preferred stock (11%, conversion price of $40) to Conversant plus an additional $25MM accordion to the convertible preferred stock if needed for growth capital 
  • $41.25MM in common stock at $25/share to Conversant, plus warrants to purchased an additional 1 million shares at $40/share
  • $72.3MM through a rights offering at $30/share to all company shareholders
  • Conversant previously provided a $16MM rescue bridge loan to the company, it was repaid in full upon closing of the transaction on 11/3/21.
Most of the capital is going to be used to stabilize the company's balance sheet and take care of some deferred maintenance capex the company likely punted on the last two years.  The capital basically allows the company to recover and get back to some kind of normalized operating environment.  Senior housing has had the unfortunate position of getting hit by covid from both the revenue and expense side.  It's not fun to mention but obviously covid caused a lot of deaths in this age group and likely prevented a lot of move ins as family members stayed home and turned into caregivers to avoid subjecting love ones to senior housing during a pandemic.  On the expense side, first they had PPE expense and now a tight labor market which is squeezing their margins.

But attempting to look through to what their results could look like in a year or two as the world normalizes, the key numbers to run a scenario analysis are the occupancy and NOI margin (I'm going back to YE 2017, no good reason just seemed "normal", for their owned properties they did 88% and 38% respectively):
To be clear, they're a ways away from normal, as of their last earnings report, occupancy was 82.3% and NOI margin was 21%.

For the cap rate, it's a bit tricky too, senior living is similar to hotels where if you're the owner operator it's less of a real estate business and more of a service business.  But Ventas (VTR) recently purchased Fortress controlled New Senior Investment Group (SNR) for $2.3B:
"The transaction valuation is expected to represent approximately a 6% capitalization rate on expected New Senior Net Operating Income ("NOI").. the acquisition price implies a 20% to 30% discount to estimated replacement cost on a per unit basis.. the transaction price represents a multiple of <12 times estimated 2022 New Senior normalized FFO per share including full synergies."  
It's not an apples-to-apples comparable, New Senior didn't operate their properties, just leased them out which is arguably less risky (although a lot of senior housing REITs have had to take back properties) but at least allowed them to be a REIT and lower their cost of capital.

The proforma debt and share count is a little messy, I've probably made some errors here, so those who know better, please feel free to correct me.
That compares favorably to today's share price of ~$32 per share, but that's an asset/takeout value (doesn't include corporate overhead, etc.) and assumes a full recovery.  But also doesn't include any additional growth or deal making which will likely come in the future, based on who they've brought in, the re-branding, it all signals that this is going to be more of a growth platform (similar to the GRIF to INDT rebrand).  
On sort of a going concern basis, using normalized numbers, including the convert but excluding the effects of the warrants, I have it trading at 12.5x normalized EBITDA (below where other senior housing companies trade, but to be fair, they'd trade lower on a normalized number too).  Not screaming cheap on an absolute standalone basis, they probably need additional scale to create some operating leverage on the G&A and corporate expenses.

Other thoughts:

  • I don't have the stats to back it up at my finger tips, but the dynamics in senior housing appear to be similar to those in single family residential.  There was significant overbuilding of senior housing in the middle of the last decade, then it dropped off a cliff, now we're finally seeing the long promised demographic wave moving into the 80+ cohort which could cause supply to tighten and rent/occupancy to rise.
  • I like the new board of directors.  The new Chairman is Dave Johnson, he was previously the President of Wyndham Hotels (WH) and is a board member of Hilton Grand Vacations (HGV), two companies I've followed/respected for several years.  Then to repeat the tie in with INDT, Conversant is bringing in Ben Harris as a board member, formerly the president of Gramercy Properties Trust (fka GPT) which was a blog favorite, most of the other key members of that team are at INDT now.
  • While not as great of an inflation hedge as multi-family due to the greater percentage of variable/labor costs in senior housing, inflation should be able to be mostly passed onto to the residents.  SNDA disclosed in a recent call that they were increasing rents by 5+% next year, VTR is targeting 8% in their owned properties, etc.
  • Sonida has a fairly high concentration in Texas, Wisconsin, Indiana and Ohio.  Their facilities tend to be smallish and on the older side, about an average age of 23+ years.
  • The company recently announced they'd be managing an additional 3 properties for Ventas starting 12/1, while not material yet, perhaps the managed segment could be a growth business for Sonida.  It's a fee business, not exposed to lease expense or capex of an operator, etc.
  • The company is going to restart giving guidance for 2022, presumably with Q1 earnings, which could give some needed visibility to investors as I fully admit my back of the envelope math is mostly a guess at this point.

Disclosure: I own shares of SNDA (plus INDT and RHE-A still too)

HMG/Courtland Properties: Microcap REIT Liquidation

*Disclaimer: Please note that is this a $18MM market cap that is closely held and illiquid*

HMG/Courtland Properties (HMG) is a tiny REIT that recently announced intentions to hold a vote early next year to approve a plan of dissolution and liquidate.  HMG was founded in 1974 by Maurice Wiener, he is 80 and is still the CEO of the company (technically this is an externally managed REIT, but there is no incentive fee), he controls 56% of the shares through various entities leaving little doubt the liquidation proposal will be adopted.  

The company's assets are a bit of mess (this liquidation will probably take several years), but the largest asset is a 25% equity ownership in a newly constructed Class A multi-family apartment building ("Murano at Three Oaks") in Fort Myers, FL.  Construction began in 2019, the building was completed in March and is already 97% leased as of the recently released 9/30 10-Q.  With inflation running hot and migration to the sun belt, cap rates on multi-family assets like this one are being quoted below 4%.  This is a hidden play on the craziness in multi-family M&A.  


Disclosure on the property is limited.  But checking the building's listing on apartments.com, it appears the going rate for their units is around $25 annually per square foot, there are 318 units and 312,000 square feet of rentable space.  Let's round down a bit for some vacancy to $7.5MM top line revenue, again back of the envelope, let's use 40% of gross rent goes to some combination of property management, operating expenses and taxes (I spot checked a few multi-family REITs for this, could be off!), that gets you an NOI of $4.5MM on the property.  

I'm sure I'll get the comment that this asset would go for less than a 4 cap but let's use that for now too, since it just started leasing this year, guessing there's not a lot of rents that need be reset to market as leases rollover like other properties.  There's a $39.5MM construction loan on the property, so the net value to the equity under my math is ~$73MM with HMG's share of that being $18.25MM, or roughly the market cap of the company.  Their equity investment in the apartment joint venture is held on the balance sheet at $3.3MM (HMG put in $3.6MM into the project, but due to equity method of accounting, HMG recognizes the proportional losses of the project has experienced since it has been in lease up mode).  Again, sounds a bit crazy, the asset was built for $54.1MM and now seemingly worth double that or more.  Given the debt here is a construction loan and the asset is freshly stabilized, even if the equity group doesn't sell it outright, they'll likely refinance and pull a decent amount of cash out that could be used for an initial liquidation dividend.

The rest of the REIT sort of looks like someone's personal portfolio/family office, in this case the CEO's:

  • The external advisor's "Executive Offices" at 1870 South Bayshore Dr in Coconut Grove, FL.  This appears to be a single-family home (unclear if the CEO uses it as his primary residence) that has a Zestimate of $2.5MM, it has a tax assessment of $1.5MM and a book value of $590k (it was purchased in the 90s).  There's no debt on the property, let's call it $2MM net to HMG or roughly another $2/share in value.
  • 28% interest in a 260 River Street in Montpelier, VT, carrying value of $870k.  Tricky to tell what this really is but they had some environmental abatement issues that are seemingly behind them, a new tenant took possession of the property in March.
  • About $4MM in net cash (after subtracting out ~$800k of current liabilities)
  • $2.8MM of marketable securities, much of which is equities and preferred stock in undisclosed large cap REITs
Then it gets a little strange (if it hasn't already), there's $4.85MM (as of 9/30) in carrying value in 46 individual private investments, it appears like most of these are real estate related (including some multi-family which could have embedded gains) but also includes non-real estate related stuff like technology and there's an energy investment hidden in here somewhere too.  Below is the breakout from the last 10-K, the carrying values have moved around a bit but gives you a sense of the asset classes.  

These investments are carried the lower of cost or fair value, there could be some diamonds in the rough, a few excerpts from recent monetization events: 
"During the nine months ended September 30, 2021, we received cash distributions from other investments of approximately $1.03 million. This included distributions of approximately $584,000 from our investment in a multi-family residential property located in Orlando, Florida which was sold during this quarter. We recognized a gain of $315,000 from this investment." 

And this one: 

In August 2021, one of our other investments in a private bank located in Palm Beach, Florida merged with a publicly traded bank, and we exchanged our original shares for shares in the publicly traded bank. Accordingly, we have reclassified this investment as marketable securities, and as of September 30, 2021 this investment with historical cost basis of $35,000 has an unrealized gain of approximately $128,000.
But also this one:
The other OTTI adjustment in 2020 was for $175,000 for an investment in a $2 billion global fund which invests in oil exploration and production which we committed $500,000 (plus recallable distributions) in September 2015. To date we have funded $658,000 and have received $206,000 in distributions from this investment. The write down was based on net asset value reported by the sponsor and takes into consideration the current disruptions in the oil markets because of the economic fall out of the pandemic.
Even stranger there are some ~$1.5MM in loans they've made, apparently mostly all to the same person.

On the minus side of the ledger, there's about a $1MM in annual expenses between the management fee and G&A, we should probably capitalize that for at least 4 years given it's going to take time to unwind all the mess here and I get approximately ~$30/share in value and it trades for about ~$17.25/share today.  

The key with any liquidation is the timing of the cash flows.  Here it could be a reasonably attractive IRR since the largest asset just stabilized and it would make sense to either sell or refinance cash out of it in the near term.  Once most of your basis is out of the stock, it's easier to be patient on later monetization events.

Disclosure: I own shares of HMG

Sunday, November 7, 2021

Advanced Emissions Solutions: Another Informal Liquidation

We're at the end of earnings season for small caps, this could be stale in under a week (ADES reports 11/10), Advanced Emissions Solutions (ADES) is a $130MM market cap with no debt and by year-end should have ~$90MM in net cash as one of their two business segments is running off due to the expiration of a tax credit.  The company announced strategic alternatives in May, likely intending to sell the remaining business segment and effectively liquidate the company.  Similar to other informal liquidation ideas lately (LAUR, PFSW, RVI, JCS, BSIG, etc), the downside is protected by the cash generated from monetizing one business segment that could be returned to shareholders either by a tender offer or a special dividend, with upside coming from an M&A event for the remaining segment.

This is an unoriginal idea, it appeared in the comment section of my Laureate Education post (might have appeared earlier but I can't find it) and other investors have shared their views with me given the similarity to others I've written up, there is also an excellent VIC long thesis on the situation.  If you've read it, you can probably stop here.

In 2011, the U.S. government implemented a 10-year tax incentive program (IRS Section 45 Tax Credit) to motivate electric utilities to use cleaner burning coal and reduce emissions.  That tax credit is expiring at the end of 2021.  Within ADES's refined coal segment, they own a 42.5% interest in Tinuum Group, which is basically a royalty business on the tax credits power plants receive utilizing their services.  In their Q2 press release, ADES is projecting $30-$40MM after-tax to be distributed to ADES from this runoff segment by year end.  Add that to the $57.3MM of cash on the balance sheet as of 6/30, and the cash balance should be roughly $90MM.  There are 18.85 million shares outstanding, that's $4.75/share in net cash on a ~$7.00 stock.

The remaining segment is an activated carbon business, Advanced Purification Technologies ("APT").  Out of their Red River Plant in Louisiana, APT produces chemical products primarily used to purify coal fired power plants (reduces mercury emissions) but they've also made efforts to diversify into other end markets like industrials and water treatment plants that aren't in secular decline.  APT was acquired by ADES in late 2018 for $75MM from Energy Capital Partners who had originally built the Red River plant for $380+MM (*correction, ADES originally built it, see first comment*).  Coal usage has declined faster than was underwritten a decade ago when the plant was built; the original greenfield investment wasn't money well spent.  Although, with natural gas prices moving up significantly this year, maybe the coal-to-gas fired plant conversion theme will slow?  As part of the acquisition, ADES also acquired the on-site lignite coal mine (Five Forks) that is used as an input to produce activated carbon, interestingly the mine operations are subcontracted out to old friend of the blog NACCO Industries (NC).

The APT business continued to struggle after ADES acquired it, covid didn't help either, but back in September 2020, ADES entered into a 15 year supply agreement with competitor Cabot (CBT) to supply activated carbon in North America that results in two important things: 1) diversifies the APT business away from coal into other end markets (also provides some revenue certainty to a buyer); 2) rationalized the competitive market by facilitating Cabot's exit from the industry.  Earlier this year, they entered into a second supply agreement with Cabot to supply international markets for 5 years.  On the negative side, Cabot had ADES take ownership of their Marshall Mine (on-site lignite mine of Cabot's plant) and immediately shutter it, reclamations efforts have begun (again, being performed by NACCO), but importantly for Cabot, the asset retirement obligation moved from its balance sheet to ADES.  The remaining ARO is about $12MM to ADES (there is a cost sharing agreement between ADES and CBT), 70% of the work/cost is to be completed in the first two years, but it could have a long tail and make a sale of APT more challenging.

Currently the APT segment is roughly breakeven, but appears to be inflecting, per the press release describing the Cabot supply agreement inked in Q4 2020:

We expect our production to ramp up incrementally during a 4-5 quarter transition period, which when complete is expected to yield the following net impacts to our current operations:
Incremental annual revenue growth of 30% - 40%;
Incremental annual EBITDA growth of $10 million to $15 million; and
Diversified end markets will reduce our power generation exposure to less than 50% of product portfolio.

Presumably ADES should start to see some improvements in Q3 results given that 4-5 quarter timing (the backdrop for their remaining coal exposure seems positive as well) and hopefully hear some hints the Red River plant's utilization rate is ramping, this is a high fixed cost business so the operating leverage can be pretty huge.  ADES bought the business for 4.2x EBITDA back in 2018, implying $17-18MM in EBITDA, it doesn't seem unreasonable that the post-covid run rate (including the CBT supply agreement) is above that number.  Conservatively assuming that the APT segment is worth what ADES paid in 2018, $75MM, netting out the $12MM in ARO, gives a $63MM "remainco" valuation or $3.35/share.  Add that to the net cash and its at least an $8.10/share stock, that's probably conservative on both sides, coal is surprisingly hot (meaning the remaining royalty could be closer to $40MM) and APT should be worth more than $75MM post CBT deal.  But I'm not an engineer, only have a loose idea of what activated carbon is based on YouTube, this is clearly more a situation I like (rhymes with others that have done well with recently) more than the business itself.

Other thoughts/notes:

  • ADES has $93.8MM of federal NOLs, in order to protect against a change of ownership that would eliminate the NOL, the company put in a plan in place effectively prohibiting anyone from acquiring more than 4.99% stake in the company.  Given the small market cap, the plan limits the potential pool of investors.  Also leads itself to a liquidation mindset as the NOL should provide a tax shield.
  • In March, ADES felt confident enough in the trajectory of the business to institute a price increase.
  • The Red River plant is a low-cost (reportedly the lowest-cost AC producer), underutilized asset, that thesis alone could appeal to PE buyers.

Disclosure: I own shares of ADES

Friday, October 29, 2021

Orion Office REIT: Form 10 Notes

Similar to my last post on Loyalty Ventures (LYLT), this is a half baked idea, it hasn't started trading yet but it might help others if I put my thoughts on paper and help me if anyone else has spent some time on it and would be willing enough to share thoughts, especially if you have a different view.

I love a good merger-spinoff combo, the latest one is a result of the merger of two large net lease REITs, Realty Income (O) (which is the bluest of blue chip in net lease land) and VEREIT (VER), the merger closes 11/1, the two are combining their office properties and spinning them off as Orion Office REIT (ONL, presumably for "Office Net Lease") mid-November.  About 2/3rds of the portfolio is coming from VEREIT and 1/3rd from Realty Income, VEREIT has spent the last few years selling down their office exposure to look closer to Realty Income and other high quality peers, so there is some risk these are their lower quality office assets.  Office properties usually aren't a great fit for a net lease REIT, they're less mission critical to the operations of the tenant as a restaurant location would be or a casino or an auto body shop.  Caesars Entertainment is not going to leave Caesars Palace (net-lease owned by VICI), but they can change a corporate office building without impacting the business.  Add covid into the mix where people are generally living their lives as normal other than returning to the office and it makes sense that Realty Income would use this opportunity to spinoff their office exposure.  This could be viewed as a BadCo or garbage barge spin, here's the Form 10.

The Realty Income management team is going to stay in place, while much of the VEREIT team is moving to the spinoff.  Orion is positioning itself as a single-tenant, long-term leased (resemble a triple-net if not explicitly one), suburban office REIT with the thesis that in a post-covid world, suburban office is going to make a comeback as millennials move to the suburbs and white collar employees generally want shorter commutes.  Orion wants to be a growth vehicle, taking advantage of any covid induced dislocations and a lack of competition, targeting properties in fast growing sun-belt metro arears.

Anecdotally, my friends that pre-covid worked in the suburbs are back in the office at least part time, others that worked downtown are still fully virtual.  I think it will be difficult to get people, especially those with families, to return to the old normal routine of an hour plus on a commuter train when the labor market is this tight.  Try taking a dog treat away, the dog won't be happy, everyone has adjusted and proved many formerly cube farm jobs can be done in pajamas from the comforts of home.  But maybe suburban office makes a comeback, suburban office would generally feature shorter/more flexible commutes as employees drive-to the office versus take public transportation on set schedules.  Again anecdotally, in my typical office job, we're trying to get people back to the office, it's difficult to train new people in fully virtually environment and we're generally having trouble keeping the previous corporate culture together almost two years removed from the beginning of covid.  Many people have never met face to face (even with their manager), there's resulting infighting, clients hate us, etc.  I have an uninformed view that how big corporates handle their return to office/remote strategy might be more important for long term success than their go-to-market strategy with clients in the next 1-3 years.  Office space will likely have a place in the future, but clearly a smaller footprint, more communal layouts and possibly different locations than pre-covid.  Maybe Orion gets sold off on the perception that it is a garbage barge spin but is instead well timed at the inflection points of both a return to office theme and suburbs over central business districts themes?  I'm not fully there on that thesis, but I'm intrigued by the idea.

The biggest problem is while it might be Orion's go-forward strategy, the starting portfolio doesn't resemble a long-term leased sun-belt suburban office portfolio.  The weighted average lease life is less than 3.5 years and many of their 92 properties are large headquarter like campuses in the northeast and midwest.  For example, they will own the old Merrill Lynch Princeton, NJ campus now occupied by Bank of America and the Walgreen's corporate campus down the street from me in the northern suburbs of Chicago.  The headline portfolio metrics seem good, it's 94.4% occupied (I assume this means leased, would be interesting to see the percentage where the tenants have returned), 72% investment grade tenants and 99% rent collection through covid.


Below is the lease expiration schedule, many of their leases are expiring in the next 3.5 years, depending on your view of the pace of return-to-office, this could be a challenging time to re-lease these properties at or near the same levels of base rent or square footage.
I'm going to compare Orion to Office Properties Income Trust (OPI) which also focuses on long-term single tenant office buildings, it differs from Orion positively as its weighted average lease term is 6 years (plus has more central business districts properties) and on the negative side, it is externally managed by RMR Group (RMR) which comes with conflicts that deserves a discount and has less net leases leading to more capex and lower FFO to AFFO conversion.  OPI is one of the cheapest office REITs and might be a good bogey for where Orion will trade initially.

Part of OPI's strategy is to sell assets with upcoming lease expirations that are not net leased and thus require the owner to upkeep the property and pay for capital expenditures.  I found their recent commentary on the Q3 earnings call surprising:

Ronald Kamden

And then just on the disposition side, can you just maybe comment on who are the buyers, what the market - like who sort of looking at these properties and any comments on pricing would also be helpful, whether it's cap rates or you're seeing increased interest would be helpful. Thanks.

Chris Bilotto

Yes. So I think from who the buyers are, I mean these - given kind of the size of these assets, a lot of these properties are kind of more local, local, regional groups, not necessarily institutional investors. And so it really is a mix, just kind of given the fact that these properties, it's not necessarily a portfolio, but they're individual dispositions. And so I think from kind of looking at the financial aspect, I would say that from kind of a cap rate for these assets and at least what we've sold, we're seeing kind of collective cap rates in between 7% and 8% and that can kind of vary on one side or the other depending on the circumstances.

And I think it's just kind of important to note that these are buildings we're selling as part of our capital recycling strategy because they're buildings that we feel like where we would rather maximized value. These are buildings that are older in age, capital intensive and in some cases kind of have short-term fault and so by way of example from what we've sold to-date, as I noted, the weighted average lease term was 1.2 years.

Again, those are surprising cap rates for a property type that many, include me, believe to be potentially obsolete. If these properties are trading for a 7%-8% cap rate, ONL should probably trade somewhere in there, maybe closer to the 7% range since the governance structure will be better and these are true net lease properties.

FFO is a fairly standardized number, while it's not GAAP, most REITs follow the same industry methodolgy, adjusted AFFO can vary, it is supposed to further adjust FFO (which is primarily just net income + depreciation, then adjusted for acquisitions/dispositions) by removing recurring capital expenditures to maintain the properties, a closer true cashflow/earnings number.  In a net lease REIT, FFO and AFFO should be very similar since the tenant is responsible for maintaining the property.  

That is what we see with ONL:

For the Realty Income office assets (FFO is proforma for the new capital structure, it does include the anticipate debt, overhead, etc.):

For the VEREIT office assets:

FFO and AFFO match up pretty well, call it ~$150MM in combined AFFO for the pro forma ONL.  There will be 54.2 million shares outstanding at the time of the spin (1 share of ONL for every 10 of O), or ~$2.75/share of LTM AFFO for Orion.  OPI trades for 8x AFFO, if ONL traded similarly it would go for ~$22/share.

That might be a bit harsh, the broader net lease REIT group trades for a high-teens AFFO on average, but I don't think this will trade like the others.  Based on the Form 10, I come up with about $170MM in NOI for the ONL portfolio, they're going get spun with $616MM in debt, if we put a 7% cap rate on that it should trade for ~$33.50/share and at an 8% cap rate it should trade for ~$27.80/share (the range where OPI is selling assets).  I could have a few mistakes in here, so please do your own work, but if ONL trades well below this range I'd be interested.  In post-covid/pre-merger calls, VEREIT was looking to sell office assets in the 6-6.75% range, possibly I'm being conservative again like CCSI.  

Other thoughts/notes:

  • This is another lightly talked about spinoff, in this instance I couldn't even find an investor deck or any materials on either Realty Income or VEREIT's websites.  Realty Income in particular has a highly retail oriented shareholder base as it has marketed itself as "The Monthly Dividend Company", with low rates, many retail investors have migrated towards the net lease REITs as bond proxies and Realty Income is the king of retail net lease.  I expect most retail investors to sell ONL and treat it like a dividend since it will only be 3-4% of the total value of O if my estimates are in the right ballpark.
  • All REIT spinoffs are taxable, another reason why O/VER shareholders are likely to sell because it is effectively a dividend anyway.  It also means that an acquirer doesn't need to wait the two year safe harbor period to avoid becoming taxable like regular spinoffs.  I don't have it in front of me, but back in 2016, two office REITs merged, Parkway and Cousins (CUZ), with the two entities doing a similar spin at the time of the merger.  Back then they spun off their Houston properties (this was shortly after the oil crash) in a "new Parkway" entity that was public only for a short while before it went private.  Something similar could happen here if the valuation precludes them from embarking on their growth plans.
  • Orion does plan to pursue a growth strategy, they're going to have $616MM of debt at the time of the spin which seems fairly modest here and in relation to most spinoffs.  So I think that strategy seems reasonable, suburban office likely doesn't have a lot of buyers right now, they should at least have a chance to begin executing on that strategy immediately given their capital structure.

Disclosure: No position, but interested depending where ONL begins trading

Tuesday, October 26, 2021

Loyalty Ventures: Form 10 Notes

Alliance Data Systems (ADS), after a few years of speculation, is spinning off their LoyaltyOne segment as Loyalty Ventures (LYLT) in an attempt to become a more pure-play private label credit card company.  The spinoff's primary business (~80% of  EBITDA) is the Canadian loyalty program "AIR MILES" where consumers ("collectors" in LYLT speak) shop at participating retailers ("sponsors") and earn points that can be redeemed for travel, cash/gift cards or other rewards.  AIR MILES collects a fee from sponsors at the time of purchase but only recognizes revenue fully when the collector redeems the reward, creating an attractive negative net working capital business.

AIR MILES is similar to the old Blue Chip Stamps business that was a Warren Buffett favorite from a generation ago. AIR MILES is an independent rewards program, it is not formally connected to an airline or hotel chain which is common in the U.S., instead they partner with retailers offering rewards on everyday recurring consumer purchases like groceries and gas. The other business under the Loyalty Ventures corporate umbrella is "BrandLoyalty", it is more of a targeted short-term promotional business that primarily caters to grocery store chains globally. I haven't seen their promotions at any grocery stores I frequent, but the campaigns BrandLoyalty runs seem analogous to the Monopoly game promotion McDonalds occasionally does to generate a short-term bump in sales.  It doesn't appear to have the same float dynamics and its results are rather lumpy.

The spinoff setup reminds me a bit of the recent one from J2 Global, Consensus Cloud Solutions (CCSI), an historically underinvested yet steady cash flowing business the parent had harvested cash from to pursue M&A in other segments.  While I continue to have my doubts about Consensus (the market clearly doesn't share my view) not being a melting ice cube, Loyalty Ventures should be a low-single digit revenue grower inline with GDP.  It is not an exciting growth story but it will produce plenty of cash that now instead of sending up to ADS corporate, can be used to deleverage (starting off with ~3x net debt), invest in the business or return to LYLT's own shareholders (no plans for a dividend).

This is a business with some baggage and requires a little leap of faith to assume it will get back to its normalized earnings.  Back in 2016, the AIR MILES segment made a pretty terrible public relations blunder (here's a local news story on it), they had previously quietly added a 5 year expiration date in 2011 to their reward miles, all historically issued miles would then at year-end 2016 unless they were redeemed.  Due to the revenue recognition dynamics, this created a windfall in 2016 as collectors rushed to redeem their miles or have them expire, either outcome is generally good for the company's financials.  But people don't like the rules changed mid-game and AIR MILES faced significant backlash (they also reportedly didn't have enough rewards/merchandise to meet demand), eventually it became a legislative issue and the company caved to pressure a month before the deadline, removing the expiration feature from the program.  The miles once again never expire, but many long time collectors redeemed their miles for unwanted rewards just to risk not losing them and they weren't allowed to return their rewards after the expiration policy was reversed.  Naturally if you had been saving miles for a dream vacation for a decade and instead had to redeem for a fancy vacuum, you'd be upset.  Management in charge during this time have since moved on, it is not the same team that will be in charge of the spin.

The AIR MILES segment was just about back to normal when covid hit which reduced the appeal of a travel awards program and due to travel restrictions, mile redemptions (and thus revenue/earnings) dropped significantly in 2020 and 2021.  In Q2 2021 business is potentially inflecting, miles created is up (+8%) and redemptions (+32%) are following, albeit against an easy comparable Q2 2020.  The company is anticipating $187MM in adjusted EBITDA in 2021, but a normalized number is probably something closer to $200-210MM, this is something of a leisure travel recovery story.

There is not a great public peer for Loyalty Ventures currently public, Aimia previously owned Aeroplan (spun from Air Canada and repurchased by the airline a couple years back for $370+MM) and AeroMexico's loyalty plan that was sold for 9x EBITDA.  The U.S. airline carriers used their loyalty programs as collateral to raise financing for themselves last year, for example United raised financing with a 12x EBITDA multiple valuation on their rewards program.  Probably not apples-to-apples.  I have no clue where LYLT will trade, but I'm going to throw a 9x multiple on it as a guess.
When issued trading was supposed to start today under the symbol LYLTV but I didn't see any trades, regular way trading is set for 11/8.  As always, I'm very open to hearing from those more knowledgeable about the situation, especially those more comfortable with the accounting and piecing out the true cash flow of this business.

Other thoughts/notes:
  • This spin seems a bit off the radar, ADS has been kind of quiet about it too, the investor deck is about as sparse on details as the Trump/DWAC one, there hasn't been an investor call made public (guessing there's one for the debt or will be one).  Most pitches for ADS (previously was a bit of a hedge fund hotel, some potential investor fatigue here) have always been focused on the card business and the loyalty segment has been a throw away afterthought.
  • The company likes to tout that 2/3rds of Canadian households have an AIR MILES account, but many collectors are probably only loosely active in the program, the top 15% of collectors make up 70% of new miles created.  This is both good and bad, collecting miles seems like a habitual exercise, it gamifies shopping, you need the power users but you also need to keep them active and happy.
  • BMO is their largest sponsor with 15% of revenue, I believe this is their primary credit card partner, their contract comes up again in 2023.
  • ADS is retaining a 19% stake in LYLT, like other recent spins, they'll divest the retained amount over the next year or so to reduce debt.  ADS calls out that 27% of their shareholders are index funds that might be forced to sell LYLT, so there could be a bit of an overhang.  The distribution ratio is 1 share of LYLT for every 2.5 shares of ADS, if LYLT is worth $50 then its about $20 of ADS's $100 stock price.
  • I don't know the full history, but LYLT pays a 1% royalty fee to Diversified Royalty Corp (DIV in Canada) for the use of the AIR MILES brand name, rather insignificant but also kind of odd.
  • LYLT invests the "float" rather conservatively, mostly cash equivalents and some corporate bonds (most miles are redeemed after 2-3 years, so the portfolio probably matches the duration).  While their miles never expire if an account is active, miles do expire if an account is abandoned and not used for two years, so there is some breakage still despite the 5-year policy being reversed.
  • It wouldn't surprise me if we see a goodwill write-down on the BrandLoyalty business, it accounts for $542MM of goodwill and is expected to generate $52MM of EBITDA, so that would value the segment at 10x EBITDA.  They acknowledge the risk in the Form 10 noting that the fair value is less than 10% above the goodwill carrying value.  Or one could spin it that if BrandLoyalty's intrinsic value is 10x, the overall company should be at least that as the AIR MILES segment is a more valuable business model.
Disclosure: I have a tiny position in ADS $100 Jan 2022 calls, basically just a FOMO trade in case LYLT takes off out of the gate similarly to CCSI (seems like one of those situations where both parent and spin will trade up), look to add LYLT directly once it starts trading.

Tuesday, October 12, 2021

Bluerock Residential Growth REIT: Messy Balance Sheet, Possibly Pursuing a Sale

Multi-family REITs have been one of the stronger real estate beneficiaries of covid, particularly those with properties located in the sun belt.  The WSJ recently reported that national asking rent rose 10.3% in August, with asking rents rising more than 20% year over year in sunbelt cities like Phoenix, Las Vegas (HHC!) and Tampa.  With the tailwinds of migration trends, increased inflation driving rent growth and plenty of liquidity looking for safe returns, all of these factors have driven down cap rates significantly to the 4.0-4.5% range.  

One bit of semi-surprising M&A news/rumors, in mid-September, Bloomberg reported that Bluerock Residential Growth REIT (BRG) was exploring a potential sale, the company hasn't commented on the report or confirmed they're exploring strategic alternatives.  Bluerock is a complicated story, one filled with related party transactions and a mess on both sides of the balance sheet, but if the reporting is accurate, Bluerock's common stock could be significantly undervalued.  BRG was formerly an externally managed REIT, however in 2017 the structure was technically internalized, but only kind of, management maintains several related interests in other Bluerock entities that earn fees off of BRG making the market skeptical of a sale.

Starting with the left side of the balance sheet, Bluerock has interests in 60 multi-family properties, mostly in the low class-A, high class-B range, think $1300-$1400/month garden and midrise style apartments in the first rung of the suburbs in sun belt cities like Phoenix, Austin, Atlanta, Raleigh, etc.  

Of those 60, 35 are consolidated properties where BRG owns the vast majority and operates the property like a normal multi-family REIT and the remaining 25 are more credit style investments where they have a preferred equity, mezz loan or ground lease interest in the multi-family property (some of these are new developments).  

This second credit investment bucket can cause issues when trying to screen BRG as you need to back out these investments to determine an implied cap rate for the operating portfolio when coming up with a sum-of-the-parts valuation.  The credit investments bucket also has the potential to make a sale trickier, the operating portfolio should have plenty of buyers, but if they insist on including the miscellaneous other credit stuff it would shrink the buyer pool.  The credit investments are also often tied to related party developments that management has an outside interest in (obvious question would be if these are truly market/arm's length terms), in a sale, management might have to take this pool and buy it into one of their other vehicles or sell it to a commercial mREIT like entity.

On the right side of the balance sheet, Bluerock has a heavy slug of preferred stock in their capital structure essentially making the common stock an equity stub.  There are currently four separate series of preferred stock outstanding, the series C and D preferred are pretty traditional in that they have a $25 liquidation preference and are exchange traded.  The series B (still outstanding, but discontinued) and T are non-traded and placed through RIA channels with investors (similar to a non-traded REIT) via an affiliate of management, Bluerock Capital Markets LLC, where management receives a 10% commission/fee (broken up into a 7% and 3% component) of the total money raised.  The B/T also have a strange feature where after 2 years, the company can redeem the preferred shares for common stock, so naturally management pitches this as an attractive capital raising method where they can continuously issue the preferred and then convert the preferred to common at opportune times.  There's some validity to that, but clearly some conflicts of interest too.  The problem is the stock has continued to trade at discount to peers and a theoretical NAV, they've converted some preferred over to equity this year, but where private assets are being valued after this recent spike in rent growth, it's probably value destructive to continue to convert the preferred stock.  

The the bull case is why management might actually be looking for an exit, they do own a lot of the stock (technically units in the operating partnership) thanks to their incentive plan and the 2017 internalization transaction, the capital structure is stuffed full of preferred stock, how much more can they realistically issue?  From the Q2 conference call (tikr.com):
We have a buyback in the market that provide support for the stock. So I wouldn't be surprised if you saw us redeem part of the B cash. I wouldn't be surprised if we take a break from redeeming the B, to a lot of stock -- the common to absorb and recover. We have -- as you know, we own north of 30% of the equity -- common equity here as management. So we're very sensitive to the stock price, making sure that we deliver value for the shareholders.  
Since the capital structure is so levered to the common, the upside if someone is willing to pay top dollar could be pretty huge.  On the bear side, management could keep issuing preferred stock, earn their 10% levy, continuously convert those shares after two years in perpetuity and drain a lot of value from minority shareholders.  Again, this is technically internalized structure but still feels externally managed.  Here is BRG mapped out in my typical back-of-envelope style, this is for a sale scenario so doesn't include overhead or some of the other accounting noise in BRG's financial statements, and there could be errors:
Then a super basic scenario analysis based on potential transaction cap rates and assuming the credit investments are valued at book value:
The combination of high upside in a sale scenario with the uncertainty that management would actually sell even if a great deal presents itself pushes me to like call options in this case.  I can participate in the upside if a deal happens and limit my downside if it ends up being an unfounded rumor or something management planted to get the stock price up so they could convert the preferred at more advantageous terms.

Other thoughts:
  • REIT M&A activity is above or near all-term highs as a result of a combination of low rates, PE money sloshing around the system, plus it seems like private values for real estate didn't fluctuate nearly as much as publicly traded REITs did during the pandemic. Some of that mispricing is being fixed through take private transactions.  One example, Condor Hospitality's (CDOR) proxy statement came out, as expected there were plenty of buyers and they all coalesced around the same value (I'm also anxiously waiting for a similar result at CorePoint Lodging (CPLG)).  If BRG is indeed running a similar process, I'd expect similar results, plenty of buyers and offers coming in at or below a 4.5% cap rate.
  • BRG has a value-add component to their portfolio, similar to the Nexpoint Residential Trust (NXRT) thesis, they can earn 20% IRRs on their capital by doing some surface upgrades to things like kitchens and bathrooms or adding smart-locks to their doors.  About 4,300 of their 11,500 operating units are still unrenovated, providing some additional growth levers, or it could be part of the thesis of a new buyer that makes paying a low 4s cap rate palatable.
  • Another odd related party transaction that is probably nothing, but BRG does have an Administrative Services contract with other Bluerock entities where BRG pays another entity the expenses to the run the REIT, it is done at cost, but just another strange arrangement for a supposedly internally managed REIT.
  • In 2018/2019, Harbert Special Opportunity Fund offered $12.25/share (below where it is trading today) but got the cold shoulder from management, likely another reason the market seems to be discounting the Bloomberg sale report.
  • Management consistently talks about getting into the MSCI US REIT Index (RMZ in ETF form), they're currently outside the index, one of management's stated reasons they've converted the Series B preferred stock to common is to increase the float/market cap to meet index inclusion parameters.  I do sympathize with this thesis, I believe (don't have any real data) that REITs are over owned/represented in ETF/indices because retail investors like REITs and their yields.  It's another possibly reason other than the clear conflicts why BRG is undervalued, its also part of my NexPoint Strategic Opportunities (NHF) thesis, which should be officially converting soon to a REIT and shortly after will be eligible for the index.
Disclosure: I own call options on BRG (along with shares in CDOR, CPLG and NHF)

Monday, October 4, 2021

Capstead Mortgage Corp: Reverse Merger with BSPRT

Capstead Mortgage Corporation (CMO) is one of the oldest publicly traded mortgage REITs dating back to 1985.  Capstead has a fairly simple business model, they own adjustable rate residential mortgage securities issued by a government sponsored entity like Fannie or Freddie, then lever it up 7-8x and pay out substantially all the resulting net interest spread in the form of a dividend.  Capstead is historically well managed, they were one of the few mortgage REITs to maintain their dividend throughout the pandemic and didn't get portions of their portfolio liquidated due to margin calls like so many others.

But times change, the returns available doing this "arbitrage" aren't what they used to be, forcing higher and higher leverage to the point where it doesn't make a lot of sense.  In July, Capstead agreed to a reverse merger transaction with a public but non-traded traded REIT, Benefit Street Partners Realty Trust ("BSPRT"), with the proforma entity moving forward with BSPRT's management team and current middle market CRE loan strategy.  Capstead is currently an internally managed REIT, the market likes those better as the incentives are more directly aligned, but as part of this reverse merger, the new combined entity will switch to an externally managed structure.  To compensate Capstead shareholders and entice them to vote for the transaction, BSPRT and their management entity are paying a 15.75% premium over Capstead's book value in cash plus CMO shareholders will receive shares in the new entity on a book-for-book basis.  The new entity will be called "Franklin BSP Realty Trust" and trade under the ticker FBRT, the external manager Benefit Street Partners is a subsidiary of Franklin Resources (BEN).

The 6/30 book value of CMO was $6.35/share, 15.75% of that is approximately $1/share in cash.  The stock is trading for $6.77/share, if the proforma trades for book value, that's 8.5% upside for a deal that likely closes in the next month or two.  This is a fairly simple investment thesis, really two questions you need to have some confidence in answering:

  1. How much, if any, has the book value moved in CMO since 6/30?
  2. What premium or discount to book value should FBRT trade at?
For the first one, agency ARMs have little to no credit risk and less interest rate risk compared to other fixed income securities.  Just taking a glance through agency bond ETFs, they seem pretty stable since the middle of the summer, might be some slight fluctuation but I don't think its a stretch to think that the book value has been relatively stable.

The second is a little trickier, most of the larger (FBRT will be ~4th on this list in size) externally managed commercial mortgage REITs are trading near or above book value.  You can probably toss out the top and the bottom on this list, Starwood Property Trust is the original and best run of the bunch and STWD bailed out TPG RE Finance Trust during the pandemic as TRTX had a CMBS securities portfolio that was margin called and liquidated.
Most of these are household names, Benefit Street Partners is not what I would call a household name but they are a large CLO manager and have been utilizing the structure within BSPRT for some time now with success.  They launched the non-public REIT about 5 years ago, have had no losses in the portfolio in that time and the portfolio looks reasonably healthy today with only one potentially problem loan (rated 4 below, its a self storage loan, guessing its not materially underwater).  Despite being non-traded, BSPRT is public and does file with the SEC, you can find their filings here.
This is effectively a big capital raise for FBRT/BSPRT, they'll let the old CMO portfolio run off or sell opportunistically to fund their pipeline of new CRE loans, I like that they have a fairly clean portfolio free of legacy issues and dry powder to put to work in the post-covid world, there should be plenty of low risk opportunities as we know which sectors/markets are the most impacted by the pandemic, what developer business plans make sense, etc.  If you're a growing mREIT, problem assets if they pop up naturally become smaller and smaller.

Additionally, the reverse merger has two structural features as part of the deal that should help support the stock once the proforma company is listed:
  1. $100MM repurchase program, with $35MM being funded by an affiliate of management, the repurchase program would kick in post close if FBRT is trading below book value.
  2. Approximately 94% of BSPRT shareholders will be locked up for 6 months post merger, so there shouldn't be the fear that this is an immediate liquidity event and all BSPRT shareholders will sell at the first chance they get.
On top of those, they are also going to pay a significant dividend, they cite they've done over 10% ROEs and are going to pay it all out in a dividend, meaning if this trades even moderately below book value it would have a double digit dividend yield which should attract retail investors.  Overall, a pretty simple and hopefully short duration idea, I'll flip the shares if they trade for book immediately, otherwise I'll be content to wait a quarter or two, collect some dividends and wait for the discount to narrow.

Disclosure: I own shares of CMO

Wednesday, September 22, 2021

Consensus Cloud Solutions: Quick Thoughts on Garbage Barge Spin

Just to get this out of the way early, I don't own J2 Global (JCOM) and this spinoff is pretty dicey, but I find the setup pretty fascinating from several angles, more from a case study perspective and want to throw this out there in case others want to share their thoughts as well.  

Consensus Cloud Solutions (CCSI) will be spun off from J2 Global in the coming weeks, Consensus is JCOM's legacy eFax business.  It is a high-margin subscription business, one of those that people often forget they even have especially if their employer is paying for it, that allows you to receive faxes in your email.  Surprisingly, many industries, particularly health care and financials are still heavy users of fax as it's viewed as a secure communication method.  Even if you only get a fax occasionally, you still want to have that capability to receive them and end up keeping your subscription until your last client stops faxing, even then you might keep it just in case.  But unlike Jackson (okay, some may disagree with that), eFax is a melting ice cube, faxes are converting everyday to other communication methods and I can't imagine many use cases converting from something else (snail mail?) to fax.

Over the past decade or so, JCOM has been using the cash flows from eFax to diversify their business by buying a bunch of legacy internet media companies, the parent after the spin will be renamed Ziff Davis (and trade as ZD) which is the old holding company name of PC Magazine.  In one more attempt to extract value from the eFax business, JCOM is effectively selling the company via a spinoff.  Their tax basis is too low to just sell it outright for cash, so instead they're going to encumber Consensus with $800MM in debt, which is about 4x EBITDA.  Probably not too different than what they'd be able to sell the business for entirely and possibly more than they'd get after tax.  Additionally, they're retaining just under 20% of the CCSI shares to divest over time, so it's really economically and strategically a sale from the parent's perspective.  That's going to leave a levered stub equity in a declining business, the textbook "garbage barge" spinoff.

What makes Consensus different than many other garbage barge spinoffs is while it is a declining business, the business itself has some attractive qualities to it.  It's reasonably sticky (as said earlier, you want to keep your subscription just in case), it is high margin (50+% EBITDA margins) and fairly asset-lite, despite the debt, they're projecting $100MM of free cash flow to the equity on $200MM in EBITDA.

A few quick thoughts on the investor presentation which you can find here.

 


They're doing what most declining businesses are doing and split themselves up into two segments, one that is the slow-or-declining business (SoHo, which is their small and home office segment) and corporate which is where they're focusing on the healthcare vertical and is showing growth.  Now the big question that always been around JCOM, how much of the growth is organic versus M&A, many of the bear writeups in the past have made that argument.  And its hard to tell, they do a good job obscuring their financials, in the Form 10, the proforma financials only show the proforma numbers for 2021 and 2020 and everything prior is obscured by JCOM's segment reporting (only the eFax business is being spun, JCOM is retaining the rest of their cloud segment). 

But if this is really a mid-single digits grower on an organic basis with 50+% EBITDA margins, CCSI would trade multiples of where this is likely to trade.  It seems reasonable that the revenue growth guidance includes M&A, but hard to tell how much, and thus hard to trust that FCF number, how much of it is really capex via M&A?


Again, showing growth even in the legacy segment, one question could be how much was this business a covid beneficiary?  I could see them gaining some marginal subscriptions from people moving from the office to home and instead of buying a fax machine, employers signed everyone up for eFax.  Maybe that's a permanent shift as with each passing day it seems like a full return to office is off the table.


Management is saying this is a $100MM free cash flow business, mirrors their LTM proforma net income which makes sense for a business like this with limited capex.  I've only seen one sell side report thus far, but they're comparing this business to other declining businesses, oddly in cable networks, but pegging this at 5x EBITDA.  At 5x, the EV would be approximately $1B, with $770MM of net debt, the equity stub would be $230MM with $100MM of earnings/free cash flow, obviously on a very levered basis, on an unlevered basis CCSI would only be a ~15% UFCF yield.

They plan to de-lever, the proforma income statement seems to suggest the bonds will have a 6.5% coupon (second thought, this will probably have a term loan above the bonds, so the bonds will have a higher coupon which makes sense), maybe that could be interesting to some fixed income investors.  Could be a great short if management misses guidance early and the market questions the sustainability of their business, but could also work tremendously well if they can steady the business for a few years, de-lever and harvest the cash flows into something with a longer term growth profile.  But with the debt, they'll really need to thread the needle, I'll probably stay away and just watch as a spectator.  Curious if others have more complete thoughts.

Disclosure: No position

Jackson Financial: Spin/Demerger, Technical Selling

Jackson Financial (JXN) is the largest variable annuity provider in the U.S. and was recently spun (or "demerged" in ex-US terms, good Google alert term btw) from Prudential PLC (different than Prudential Financial) which is a London listed insurance company that primarily operates in high growth areas of Asia and Africa.  Jackson is only listed in the U.S. and much smaller than its parent, as a result it is likely experiencing (or has already in the when-issued market) some forced selling by both geographically filtered and market cap filtered investment mandates or indices.  Directly from the Form 10:

Index funds that hold Prudential ordinary shares likely will be required to sell their shares of Class A common stock received in the Demerger to the extent we are not included in the relevant index. In addition, a significant percentage of Prudential Shareholders are not residents in the United States. Many of these shareholders may sell their shares immediately following the Demerger. The sale of significant amounts of our Class A common stock for the above or other reasons, or the perception that such sales will occur, may cause the price of our Class A common stock to decline.

In a variable annuity, the client deposits funds into a separately managed account in mutual funds that Jackson's asset management arm selects to be on its platform, then Jackson guarantees some minimal performance for a fee.  Jackson takes those guarantee fees and purchases hedges to protect against a sustained market downturn that would turn these insurance contracts upside down.  The hedges are marked-to-market in GAAP accounting while the corresponding liabilities are not, so a combination of opaque accounting with long dated market/longevity risk leads these variable annuity insurers being valued like death.  Jackson is insuring against the market collapsing, which seems like a difficult risk to forecast, especially in this environment when arguably the market is overvalued.  To see this in action, look towards Brighthouse Financial (BHF) which was spun from MetLife a few years back, BHF trades for 2.4x LTM adjusted earnings and 37% of adjusted book value (basically ex-AOCI), torturing value investors like David Einhorn for years.

Jackson just reported Q2 earnings last Friday, LTM adjusted earnings come in at roughly $2.4B or $25/share and adjusted book value at $91.38/share, versus the current trading price of $26/share which is 1x LTM adjusted earnings and 28% of adjusted book value.  So it's absolutely cheap and somewhat relatively cheap, but does have a lot of black box type risk to it, hard to fully grasp all the market risk they're taking and believe in their hedging strategies.  But just the math of something that's not a melting ice cube, trading at 1x adjusted earnings (feel free to pick at the adjustments), not a lot has to go right for that to work out reasonably well.

Other ways to look at the valuation:

  • Last summer, Jackson offloaded their fixed annuity risk to Athene (ATH, soon to be acquired by APO) and concurrently, Athene took an equity stake in Jackson.  Athene invested $500MM for an 11.1% economic stake in the business, which equates to a ~$45/share price, or 70+% above where it is trading today.  Apollo via Athene might have slightly overpaid, need to probably consider it in context of the reinsurance transaction as well, but unlikely they severely overpaid, especially when markets were still a bit dicey last summer.  I don't think ATH/APO would purchase the entire company as its now a pure play on variable versus fixed annuities (much different profile in my opinion for APO and investing the float), but a good valuation point nonetheless.
  • In the Form 10 and throughout their investor presentations, Jackson makes it clear that they will be a significant returner of capital to shareholders.  In year one, they expect to distribute $325MM to $425MM out in shareholder yield during the first twelve months.  At the midpoint of $375MM, that's 15% return of cash, either in the form of dividends or share repurchases.  Again, seems more of a black box than a melting ice cube, but over time that 15% return of capital should at least mirror the shareholders ultimate return without any re-rating of the rock bottom multiple.
  • Their statutory capital is about $4.4B, maybe a more conservative way to look at the book value, that would be $46.50/share or roughly trading at 56% of this more conservative number.  This is also an important number in context of the above bullet as they've guided to distributing 40-60% of the annual growth in statutory capital out to shareholders over time.
Other miscellaneous thoughts:
  • Another way I've thought about the cadence here, London based funds are selling and soon this will be have to be picked up by U.S. based funds and indices, so there could be a time period here where the stock is orphaned and as a result trading at an artificially depressed multiple.
  • Prudential PLC held back 19.7% of the JXN shares, they're going to monetize that over the next year, so maybe similar to the situation over at Technip Energies (THNPY), it could provide a small overhang until their divestiture is completed.
  • PPM is their internal asset manager, they mostly invest the corporate balance sheet in fixed income securities, they do manage some external capital for Prudential PLC related entities which may be at risk (they've had some of their funds withdrawn already) now that the companies are separate.
  • We all know about the long term demographic trends in this country, baby boomers are retiring and might look to annuities to offload that market and longevity risk.  They've even made some regulatory headway getting these products in 401(k)s, now I wouldn't recommend anyone actually buy them.  To that point, this is more a product that is sold rather than bought, maybe similar to a timeshare in that sense, and possibly the market is punishing this business similarly/unfairly.

Disclosure: I own shares of JXN

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