Altisource Asset Management: Preferred Overhang, Cash Shell w/ Optionality

Many readers will know this situation, Altisource Asset Management (AAMC) is a cash shell with approximately $80MM in the bank after their only asset management client, Front Yard Residential (RESI), terminated their external management agreement with AAMC resulting in RESI being internalized (AAMC was a 2012 spin, was trendy at the time to spin the management company).  Front Yard later sold itself to private equity (Ares and Pretium) which likely will turn out to be a great deal (even after they hiked the offer) for the buyers given how single family rentals have traded since.  Friend of the blog, Andrew Walker did an excellent podcast (and even answered one of my questions on it) with Thomas Braziel and Jeff Moore pitching AAMC.  They go into some of the background, particularly on the controversial Bill Erbey, who was formerly an executive (back in the early-to-mid 2010s, Erbey ran Ocwen and a few satellite entities like AAMC), but now is *just* a 39% shareholder in AAMC after legal trouble forced him out of the day-to-day operations.

Long story short, Altisource has a large preferred overhang (originally $250MM, currently $150MM after two exchanges), the stock previously traded north of $1000/share (now for $17.90) and issued a zero coupon convertible preferred stock with a strike price of $1250.  The cash from the convertible preferred was used to buyback shares, presumably to boost the shares above the strike price making everyone happy, but instead the stock collapsed.  Now that piece of paper is hopelessly out of the money, it is basically a zero coupon bond with a mandatory redemption date of 3/15/44.  However starting in March 2020, every five years the preferred holders can request a full redemption:

(b)    Each holder, at its option, shall have the right, in its sole discretion, to require the Corporation to redeem all of its outstanding Series A Preferred Shares by providing written notice to the Corporation within fifteen (15) Business Days (but not more than thirty (30) Business Days) prior to a Redemption Date of its intent to cause the Corporation to redeem such holder’s Series A Preferred Shares on such Redemption Date (each, a “Holder Redemption Notice”) which will specify (i) the name of the holder delivering such Holder Redemption Notice and (ii) that such holder is exercising its option, pursuant to this Section 5, to require the Corporation to redeem shares of Series A Preferred Shares held by such holder. The Corporation shall, within fifteen (15) Business Days of receipt of such Holder Redemption Notice, deliver to the holder exercising its rights to require redemption of the Series A Preferred Shares a notice specifying the date set for such redemption, which date shall be no more than thirty (30) Business Days after the Holder Redemption Notice (the "Holder Redemption Date"). The Corporation shall redeem for cash on the Holder Redemption Date, out of funds legally available therefor, all, but not less than all, of the outstanding Series A Preferred Shares held by such holder at an amount equal to the Redemption Price.

The larger holders did indeed request redemption last year.  But the trick is AAMC has to redeem the entire class at once, and obviously they can't redeem the $150MM outstanding with only $80MM in net cash.  The preferred stock is closely held, two holders (Putnam and Wellington) have settled with AAMC and exchanged for either a combination of cash and stock in the case of Putnam or just cash in the case of Wellington.  Both worked out to approximately 11-12 cents on the dollar.   The remaining significant holdout is Luxor Capital which is pursuing litigation against AAMC.

I have never subscribed to the "preferred stock has no teeth" thesis, here is where my views differ (again, I'm often totally wrong):

• Luxor is not anchored in any way to the previous two settlements, they're the largest holder (basically the only remaining holder) of the preferred stock and still have leverage.  I'm a structured finance guy, they're almost the "controlling class" in this situation, without them the overhang isn't resolved.  Additionally, Putnam included a "most favored nation" clause in their settlement which effectively hitches their settlement to Luxor, it gets Putnam out of the lawsuit but also allows them to retain the optionality of a better deal.
• Altisource won't risk consummating a new business combination/merger before the preferred stock overhang is resolved.  If the deal is successful, then AAMC could potentially be on the hook for the full $150MM down the road or at a minimum increases the recovery rate for Luxor.  I don't see anything happening until Luxor settles, maybe there's a settlement and merger simultaneously but it feels highly unlikely that the preferred can just sit out there until 2044 (for either side).  So this is a game of chicken until then, and those situations can last longer than people want to believe (I would have thought RHE would have settled by now).

But the price has fallen considerably in the last several weeks to $17.90 today, at this price the thesis seems more interesting (basically back to where it was before Wellington settled) and allows some margin of safety in the circumstance that Luxor strikes a significantly better deal than either Putnam or Wellington did.

Here's the current situation, obviously the capital structure is upside down at full face for the preferred, I'm discounting the net cash for two quarters of cash burn, dealers choice there.

How I'm thinking about a post-settlement proforma: I'm assuming that the Putnam settlement is the best case.  Putnam held $81.8MM of the preferred stock and received 288,283 shares of stock and $2.863MM in cash (split in two payments), if we applied that ratio to the remaining $150MM outstanding, I get about a $25 NAV.

But if Luxor was going to settle for the Putnam deal, they would have already, so applying a multiple to that, let's say they negotiate a 25% or 50% better deal than Putnam, I get an NAV of $23.28 and $21.50 respectively.  Against a $17.90 stock, that seems like a reasonable discount, if you did a goal seek on the multiplier to get to the current price, Luxor would need to strike a deal more than 100% better than Putnam (also includes the incremental benefit to Putnam for MFN clause) to get to the current share price.

I'm not going to speculate on a deal target, the podcast interview I referenced does a bit of that if you're interested, but AAMC included in the below in their Q3 earnings release:

Mr. Thomas K. McCarthy, Interim Chief Executive Officer, stated, “The Company’s attention and focus continues to be the evaluation and pursuit of certain business opportunities and acquisition targets in which to focus the Company’s resources and enhance shareholder value. The Company has liquidated its equity holdings and is now in an all-cash position in preparation of an acquisition event.

During the third quarter, the Company also engaged the services of both an investment bank, Cowen and Company, LLC, and the law firm, Norton Rose Fulbright, LLP, to assist us in identifying and reviewing potential acquisition and merger opportunities. While no final decision has been made, the Company is in discussions with several potential acquisition or merger targets including cryptocurrency and brokerage related businesses”.

The company is probably mid-process, I'm guessing that a settlement with Luxor is announced at the same time (if they take shares, they could participate in the upside, removing the litigation overhang will likely cause the stock to bounce significantly), plus there are some "meme able" buzzwords in there and a relatively low float, I agree that something crazy could happen with this one and at today's price you're not paying much, if anything, for that optionality.  But there are hundreds of SPACs also competing for similar buzzy deals, so who knows, could be challenging to get a deal done and there could be a frustratingly long stretch with no news.

Disclosure: I own shares of AAMC 

Front Yard Residential: Internalizing Management, Covid Tailwinds

I'm slow and full warning this is a completely unoriginal idea, feel free to read better write-ups here and here, but I took a position and as part of my process I wanted to write it up.  Front Yard Residential (RESI) is a REIT that owns approximately 14,500 single family home rentals ("SFRs") primarily across the south and southeast.  Front Yard has a mixed history, it was created and externally managed by Altisource Asset Management (AAMC) to house a non-performing loan portfolio that has since morphed into an SFR REIT.  Prior to the covid-shutdown, Front Yard agreed to be bought by Amherst (PE firm that has a SFR strategy) for $12.50 per share, that deal was terminated quickly once the severity of covid came to light in what looks to be in hindsight an overreaction.  Several months later, the stock has partially recovered, Front Yard trades at ~$9.60 and seems to be in a better position than it was pre-Amherst deal, the elevator pitch:

• Front Yard's liquidity and leverage improved as a result of the termination, Amherst paid a termination fee of $20MM in cash, plus bought $55MM of newly issued stock from Front Yard at the deal price, $12.50/share, making Amherst one of the largest investors in Front Yard with a 7.5% stake.  Lastly, Amherst also agreed to be the lender on a $20MM loan that is currently unfunded.
• There has been a quick and dramatic reversal of the popularity of cities, now they're seen as problematic both for pandemic/distancing reasons and recent social unrest, pushing people out to the suburbs in search of affordable space and relative perceived safety.  Single family homes have been one of the largest beneficiaries of this crisis, home prices are up, mortgage rates are way down.  But for many, home ownership is not an attractive option due to a lack of savings/credit or the desire to be mobile, thus a SFR could be a reasonable option.
• Front Yard has long been sub-scale, only recently in the last year or so did they internalize the property management function and then this month they announced the internalization of their corporate management.  The incentives are finally aligned, but it doesn't fix the sub-scale part as it is only a fraction of the size of larger publicly traded SFR peers in INVH and AMH.  The board sold it once and there's been continual consolidation in this decade long SFR theme following the housing fallout from the last recession, it seems likely that Front Yard would once again be a consolidation target when things settle down further.

Invitation Homes (INVH), which is the legacy Blackstone and Colony portfolios, and American Homes 4 Rent (AHM) are the two scaled SFR REITs, both have good investor presentations that lay out the investment thesis for SFRs:

The addressable market is large, fragment and growing which should be a tailwind for institutional platforms, part of the argument for large platforms like the SFR REITs is the professional property management, which could equal more peace of mind to the customer.

The big non-covid related tailwind is the aging of the millennial generation, the largest cohort was born in 1990 and thus are turning 30 this year, entering a time when they'll likely want more space and start families.  The downside of the model is well known, its hard to gain scale and positive operating leverage unless you have a high concentration of homes in a locality.  INVH talks about 5000 being the scaled up number in a city, back to Front Yard, they only have one market even approaching that number with 4200 homes in Atlanta, the next largest market is Memphis at 1275 homes, again highlighting Front Yard's lack of scale, it's not just about total units but the number of units in a market.  Front Yard's properties are also generally older and cheaper than their two larger peers making their problems even more challenging (higher maintenance capex as a percentage of rent, oh and of course, actually collecting rent as covid related aide starts to slow down).

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

Given Front Yard's recent troubles and warts, its hard to value it just based on a cash flow metric, single family homes are gaining in value, especially recently with record low interest rates and limited home building since the last recession crimping supply.  Front Yard puts out an adjusted investment in real estate number that lines up when they've purchased homes or made capital investments and the appreciation in the time since those investments were made.

Obviously there should be a lot of caveats when using that number, a true one-by-one liquidation of Front Yard would take a substantial amount of time and expense to complete, and some depreciation is certainly real in these rentals, but I think it provides some additional context to the valuation.  After giving effect to the Altisource termination payments of $54MM (part of that is RESI acquiring some assets from AAMC), the enterprise value of Front Yard is ~$2.1B or about an 80% of unlevered asset value, given the high leverage of $1.5B of net debt, Front Yard is trading close to 55% of levered net asset value of ~$17.50 a share.  Again, I don't anticipate an acquirer paying a full price, but given recent trends in home prices and a migration to the suburbs, I could see Front Yard being acquired for more than the $12.50 Amherst agreed to in February.

Disclosure: I own shares of RESI