Mid Year 2016 Portfolio Review

Brexit free discussion ahead, it was a fairly crazy first half of the year even before the last week, at one point in February my blog portfolio was down almost 20% before climbing back to gain of ~6% at the halfway point of the year.  The significant winners have been MMA Capital, NexPoint Residential, American Capital and Gramercy Property Trust - the significant losers have been CSRA, Liberty Global's LiLAC Group and Par Pacific Holdings.

Current Position Updates:

• Crossroads Capital (XRDC) is soliciting a shareholder vote to convert to a liquidating trust, cash makes up about $1.40 of the $2.05 current share price, it may take a few years to fully liquidate but I assume much of the cash will be distributed to shareholders (technically unit holders) shortly after the liquidating trust conversion reducing the basis and pulling some of the potential return forward.  I added a little more since I first discussed the idea, there might be some indiscriminate selling from those who don't want the illiquidity of a non-tradeable security ahead of the conversion.
• Another current position I recently added to is CSRA (CSRA) which is the U.S. government services spinoff of Computer Sciences Corp (CSC).  I had the original idea right that CSRA should be sold after the spin and CSC held as it was the buyout candidate of the two (HPE is doing an Reverse Morris Trust with CSC) but ended up calling a poor audible and holding CSRA instead for tax reasons.  CSRA is down 25-30% for little reason since then.  The U.S. government has a budget for the first time in years and most government agencies (including the Department of Defense) have seen funding increases.  Leidos (LDOS) is buying the services business of Lockheed Martin (LMT) later this year in a Reverse Morris Trust transaction (could be an interesting split off special situation) for 10x EBITDA, no reason that CSRA should trade for a couple turns below that.
• NexPoint Residential Trust (NXRT) has had a nice run recently on minimal news and is basically at my estimation of fair value in its current external management form.  I want to continue to hold as I like the strategy and their target markets in the Southeast and Southwest but it's hard to fully commit to an external management structure (despite significant insider ownership) as the principal-agent problem is strong and management's best interests are often at conflict with shareholders.  I've sold a little bit and will likely continue to do so, just being slow about it to hedge against Highland selling the company outright in the $20-22 range.

Closed Positions:

• The spread has come in on the American Capital (ACAS) deal with Ares Capital Corp (ARCC), but in the wrong way with ARCC falling since the deal was announced.  After letting the deal settle in my head, I decided merger arbitrage isn't my strong suit so I sold around $16 and moved on.
• I ended up selling Gramercy Property Trust (GPT) this month around $9 after owning it for nearly five years, at that time it was a busted commercial mortgage REIT that held the junior debt and equity in three CRE CDOs that were in various levels of distress.  The old board brought in Gordon DuGan and team in the summer of 2012 to transform the company into a net lease REIT focused on industrial and office properties.  New management grew the company quickly through several large acquisitions and corresponding capital raises which was topped by the merger with Chambers Street late last year.  The market didn't initially respond well to that deal, likely because of Chambers Street's previous private REIT status and corresponding messy asset base and unsophisticated retail investors.  REIT mergers are great because of the scalability of the business, once a management team is in place, there's significant operating leverage.  Gramercy was able to eliminate most of the Chambers Street expense structure and recycle the random assortment of office and industrial properties into a more streamlined portfolio that public REIT investors would assign a premium valuation.  That process is far enough along and investors are once again giving Gramercy credit, I have the shares trading for about a ~6.5% cap rate, and given it's new larger size and wider coverage, just don't see a lot of additional alpha remaining.
• Sycamore Networks (SCMR) drew me in with it's large NOL asset and two activist investors who were looking to stop the ongoing liquidation and preserve the tax asset.  However, the company is set on a liquidation and made an additional distribution during the first half of the year, making it even more unlikely that the tax asset can be monetized (and as we see with Par Pacific and others, even with management focused on the tax asset, not always easy to actually make a dent in it quickly).  It was already a small speculative position for me and after the liquidation distribution it was even smaller, wasn't worth mental effort any longer and I sold for a small loss.

Current Portfolio:

My watchlist is a bit short on new ideas other than a few nano-caps, if any readers have their eye on anything interesting that I should be looking at, please reach out.  Otherwise, have a great holiday weekend for those in the United States and thanks for reading.

Disclosure: Table above is my blog/hobby portfolio, its a taxable account, and a relatively small slice of my overall asset allocation (most of which is restricted) which follows a more diversified low-cost index approach.  The use of margin debt/options/concentration doesn't represent my true risk tolerance.

Pinnacle Entertainment: Tax Attributes, Remaining Real Estate, Insider Buying

This post is mostly a promo for this month's Special Situations Research Forum meeting hosted by the CFA Society Chicago, I'll be leading the discussion on Pinnacle Entertainment (PNK) and the recent sale of its real estate to GLPI.  We usually get anywhere from 6-12 people, it will be held in the loop on 6/27 at 5:30pm, if you're in the area and would like to attend, sign up here or shoot me an email.  Here's the original post from last month, and then below are some additional thoughts around assets that add to PNK's undervaluation to complete the picture.

Tax Attributes
At the time of the GLPI transaction, old Pinnacle had significant NOLs along with the standard D&A tax shield that made it an insignificant federal income tax payer.  The NOLs were exhausted through the taxable spin of the OpCo and even though the D&A of the real estate will still flow through the GAAP financial statements, they can only depreciate the assets they own for income tax purposes.  But due to the structure of the spinoff, Pinnacle Entertainment will continue to be a minimal income tax payer, below are explanations from both PNK and GLPI executives:

"However, we did receive a step-up basis in our assets.  That step up just to give some shorthand for it.  You look at the enterprise value of the company as a whole.  We had a tax basis on what was spun of roughly about $1 billion and the difference between those two will be amortized over a 15 year period evenly.  That will create a deduction going forward, main point being, that our effective tax rate will be materially lower than the statutory one by virtue of the deduction" - Anthony Sanfilippo, Pinnacle Entertainment CEO

"..and the reason we did it this way [spin the OpCo and merge the PropCo with GLPI], was obviously to help solve for some tax problems.  It also, some people expressed some concern that the Pinnacle NOLs would be going away but the reality is, on the spin they will be getting a stepped-up basis of the NOLs as well as to the extent that we pay gain above and beyond the NOLs, their assets will get stepped up actually higher than their NOLs.  So in the end they should be, from a tax perspective, in very good shape going forward with a higher asset level basis for depreciation." - William Clifford, GLPI CFO

Back to the EBITDA to free cash flow bridge slide:

Pinnacle is projecting only $4MM in cash taxes annually on the current business (including the Meadows acquisition), gaming companies typically aren't significant tax payers due to their considerable fixed assets, but even with the sale of their real estate to GLPI, Pinnacle via the stepped up basis of their assets/goodwill that they'll be able to amortized over 15 years have maintained similar same tax efficiency.  I'd be curious to hear anyone's thoughts on how much their tax attributes could be worth?

Real Estate Remaining at Pinnacle Entertainment (OpCo)
GLPI is a net lease REIT and thus uninterested in development assets, their investors want predictable cash flows and not excess land sitting around generating insufficient revenue for dividends.  As part of GLPI's sweetened offer to buy Pinnacle's real estate they sent a letter to Pinnacle's shareholders outlining the increased value of the second offer, and specifically called out the property assets to be left behind at the operating company.

Belterra Park

In 2013, old Pinnacle began the redevelopment of the River Downs racetrack outside of Cincinnati to be refashioned as Belterra Park (to create an association with the Belterra Casino Resort across state lines in Indiana) a "racino" with video lottery machines and six full service restaurants.  The all-in redevelopment price was approximately $300MM, it opened in the spring of 2014 and almost immediately began to under-perform expectations.  By the time GLPI came knocking with an offer to buy Pinnacle's real estate on an earnings basis the Belterra Park property was generating almost nothing - making it a hard fit for a REIT - it would have to be valued at almost zero for it to make sense to GLPI shareholders who demand a current yield on their assets.

William Clifford, CFO of GLPI said on a call discussing the deal:

"The primary reason why we left off Belterra with the operating company is because on a historical basis it has fairly low levels of EBITDA which meant that we weren't really paying very much for it.  And what we were able to do by leaving it behind, was to take the tax basis of the property and transfer that to OpCo which will eventually save us taxes on the gain relative to spend.  That represented probably somewhere north of $50 million worth of tax savings.  So even on a multiple basis, it seemed to make sense and quite candidly, we think it adds value for OpCo and will depreciate by the Pinnacle team."

The decision to leave Belterra Park with the OpCo was made almost a year ago, since then the property has begun to turnaround its performance.  Ohio built 4 casinos between 2012 and 2013, plus granted licenses to many similar racinos, all that development at once hurt the entire market in the state and is just now beginning to recover, Beltera Park included.  Net win at the racino is up 31% year over year through April of this year.

GLPI valued it at $75MM in its letter, typically I would discount this valuation as GLPI was attempting to convince Pinnacle shareholders the deal was in their best interest.  But if anything, $75MM seems low compared to the initial development costs even considering the properties initial struggles - but improving - and additionally new Pinnacle will benefit from the depreciation tax shield in addition to the step up basis on the sold assets discussed earlier.  It's also clear that Pinnacle's management is willing to sell real estate and may look to do a sale-leaseback of Belterra Park once it fully stabilizes.

Excess Undeveloped Land - Lake Charles & Baton Rouge
Staying with Pinnacle Entertainment is roughly 500 acres of undeveloped land, about 50 of those acres are adjacent to their flagship L'Auberge Lake Charles resort which is positioned as a regional destination with non-gaming amenities (concerts, restaurants, golf course) and has an equally positioned Golden Nugget resort next door (which was supposed to be an Ameristar Casino, but Pinnacle had to divest it at the time of the Ameristar-Pinnacle merger).  This land could potentially be valuable as an additional redevelopment asset for this growing market and could benefit from the Golden Nugget casino as well building up the overall market and land value around the two casinos.

The other 450 acres around the L'Auberge Baton Rouge resort looks a bit more uncertain given its size and isolated location (at least according to Google Maps).  GLPI valued the excess land near both properties at $30MM or roughly $60,000 per acre which seems within reason.

Insider Buying
While the new Pinnacle Entertainment isn't your normal spinoff since all the employees came with the spinoff, it's still encouraging to see management has been buying shares in recent weeks (maybe with proceeds from GLPI shares?) giving more validity to their own thesis that the shares are undervalued.

In addition to the insider buying, the company also announced a $50MM share repurchase plan signaling both confidence in their free cash flow and again that their shares are undervalued.

Summary
Profroma for the Meadows acquisition that should be completed this fall, Pinnacle Entertainment trades for 6.5x EBITDA whereas its near identical peer in Penn National Gaming trades for 7.5x EBITDA.  Yes, the structure is leveraged unconventionally and has some risk, but for a $700MM market cap company with almost no tax liability going forward and ~$105MM in real estate provides additional margin of safety at this valuation.  Additionally, management and the company itself are significant buyers of the company's shares.

Disclosure: I own shares of PNK

Par Pacific Holdings: Wyoming Refining Acquisition, Rights Offering

I wrote a poorly timed update of Par Pacific Holdings about six weeks ago, since then the shares have dropped over 20% as crack spreads continued to tighten at the same time as Par Pacific's principle refinery asset in Hawaii is shutting down for a period to undergo significant maintenance.  Crack spreads are of course volatile, however management has guided to the Hawaiian business generating $100MM in mid-cycle EBITDA keeping the valuation thesis largely intact.  The growth story relies on Sam Zell's handpicked team making additional acquisitions in the currently distressed energy sector in order to finally start making a dent in the large tax asset.

This past week, Par Pacific announced the acquisition of Wyoming Refining, it operates a small refinery (18,000 bpd) and related logistics assets in Newcastle, WY which supplies the Rapid City, SD market and nearby Ellsworth Air Force Base.  The refinery is in the attractive Rocky Mountain region (PADD IV) where oil supply outstrips local refining capacity and where demand is growing due to the increased industrial activity (although much of it is oil and gas related) in the region, this creates wider average crack spreads.

Par Pacific is paying $271MM for Wyoming Refining from a private equity owner and its expected to generate $50MM in EBITDA, or a 5.4x multiple, which unfortunately doesn't appear like a particularly distressed asset.  The previous owners have invested significant capital recently to increase the capacity of the refinery which should minimize near term capex needs, but I was hoping the next deal would be a fire sale asset from a distressed E&P company, but onto the deal details and resulting change to the valuation.

Note the rights offering and quick July 15th close, more details will follow on the structure of the rights offering but any current shareholders should be prepared to fully participate or face dilution.

The crack spreads for this niche refinery are pretty huge, at least in comparison to the high single digits seen at Par's Hawaiian refinery, much of that can be attributed to difference in the supply chain, Hawaii has to source crude oil from at least half an ocean away whereas the Wyoming refinery is close to new fracking supply that's come online in recent years.

Proforma Valuation
Using the same basic frame work from a couple months back and updating for the recent Q1 results and Wyoming Refining acquisition:

The market is roughly assigning no value to Par Pacific's ownership in Laramie Energy (which is maybe right? I'm not smart enough to value an E&P) and no value to the NOL as well (which could be right as well, quickly finding out its not easy to generate taxable income in the energy sector).

Disclosure: I own shares of PARR

American Capital: Agrees to Deal w/ ARCC, ARES, AGNC

Well this news was a bit anti-climatic, today American Capital (ACAS) agreed to a series of transactions with Ares Capital (ARCC), Ares Management (ARES), and American Capital Agency Corp (AGNC) that total up to a $17.40 stock and cash deal for the activist targeted BDC.  The deal represents about an 11% premium to Friday's close, the shares traded only marginally higher leaving the merger arbitrage spread at about 9.5% (ARCC traded down).  While the premium was initially a bit disappointing, the deal is a good one for all sides (including ACAS management) and creates a few interesting opportunities in some of the secondary entities around the deal.

Details:

• Ares Capital Corp (ARCC), the largest BDC and externally managed by ARES, will pay ACAS shareholders $6.41 in cash plus 0.483 shares of ARCC.
• American Capital Agency Corp (AGNC), the larger of the two ACAS managed mortgage REITs will internalize management and pay $2.45 in cash to ACAS shareholders.
• Ares Management (ARES) will pay $1.20 in cash - presumably for the non-mortgage REIT related asset manager businesses (CLOs, PE Funds, and the orphaned ACSF).

There is some conflicting information on when the deal will close, the presentation and corresponding call mentioned end of 2016 (or six months was referenced a couple times on the call), while the press release stated 12 months.

American Capital's non-diluted NAV was $20.14 on 3/31, so despite the recent ~$600MM in announced asset sales at or above book value, plus the huge share repurchases below book value, most of that activity only semi-masked the management incentive compensation dilution, losing the deferred tax asset (change of control) and a cool $200MM in estimated deal related costs (unsure if this includes management's golden parachutes - see page 35).  The dangers of investing in BDCs.

The merger arbitrage spread is fairly wide for a deal that's almost certain to close as it has clear benefits for the acquirer and has been fully shopped by ACAS.  If the deal does close by year end as mentioned in the presentation/call that creates a very attractive annualized return.  I'll probably hold onto my shares a while longer and wait for that spread to close a bit.

Additional Thoughts:

• The ACAS portfolio is a jumbled mess (middle market loans, private equity deals, and the asset manager), a small reason in comparison to overpaid management for the discount to NAV, but ARCC by contrast is much cleaner with a portfolio consisting mostly of leveraged loans that enable them to pay a high dividend, more of a BDC 2.0 that followed the original BDCs of the 1990s that ARCC has now swallowed up (ACAS, Allied).  Ares Capital is going to recycle the acquired portfolio and reinvest in more straight forward assets, the market places a higher value on simplicity (similar to what Gramercy Property Trust is doing with the Chambers Street merger), so I can see this being a slight win to ARCC shareholders.  Acquire a messy portfolio at a discount, hopefully sell most of the portfolio for the marked value, and then reinvest in something investors will pay up for like leveraged loans that enable dividends.
• After the externalizing management trend of 2012-2014, it seems to be reversing into an internalizing management trend, similar to how conglomerates go in and out of style.  We saw Colony Financial acquire their manager Colony Capital and now the merged Colony Capital (CLNY) is buying Northstar Realty Finance (NRF) and its manager Northstar Asset Management (NSAM) only a short time after NSAM was spunoff from NRF.  Ashford Inc (AINC) and Fifth Street Asset Management (FSAM) are facing similar activist pressure regarding the inherent conflicts of interest between fat asset management fees and a captive permanent capital entity.  The ACAS news is positive for AGNC shareholders now that they will be internalizing their manager, and even better news for the smaller ACAS managed mortgage REIT, American Capital Mortgage Investment Corp (MTGE), as it seems likely MTGE (which will now be externally managed by AGNC) will be folded into AGNC.  Maybe they could sell the cute ticker to an ETF company for additional consideration.
• The smallest of the ACAS captive entities is American Capital Senior Floating (ACSF), a BDC with just a $100MM market cap and trading at 85% of NAV, hard to imagine that Ares will keep this as a standalone entity, it could easily be folded into ARCC at something short of NAV and be a win for both sides.
• Ares Management (ARES), the asset manager, is also making out nicely in the deal, they'll add about $4B in assets to their externally managed ARCC.  It's a backdoor way of justifying a capital raise for a BDC that's trading below NAV.  At a 1.5% base management fee that's additional $61.5MM annually (they are waiving $10MM in fees for the first 10 quarters post close), plus they get a 20% incentive fee on income as long as they meet their 7% hurdle rate, it's good to be the manager of a BDC.

Disclosure: I own shares of ACAS

Pinnacle Entertainment: GLPI Deal Complete, OpCo Spinoff

In the fall of 2013, regional casino operator Penn National Gaming spunoff Gaming & Leisure Property Inc (GLPI) to hold their real estate assets and lease them back to Penn on a triple-net lease basis where the tenant is responsible for all the maintenance, taxes, and insurance.  The idea behind the move was a simple one, the market places a higher multiple on net lease REITs than it does gaming companies, so by separating the two, value is unlocked.  More recently, MGM did a similar move with MGM Growth Properties, and Caesars is contemplating the same within bankruptcy, it's becoming the industry standard operating model.  However, the IRS is starting to take a harder stance on REIT spinoffs which may lead to more scrutiny and give an advantage to those like GLPI who are already operating as REITs.

Following the Penn transaction, many investors looked to Penn's closest rival in the regional gaming sector, Pinnacle Entertainment (PNK), and pressured them to do a similar real estate spinoff transaction.  Concurrently, GLPI investors had been pressuring the REIT to diversify their tenant base as nearly all their casinos were leased back to Penn, a more diversified tenant base would lead to a higher valuation.  In July 2015, Pinnacle and GLPI came together in a deal that closed last month where GLPI acquired all of Pinnacle Entertainment and then simultaneously spunout the operating business under the same PNK ticker, creating "new" Pinnacle.

In the transaction, Pinnacle shareholders received 0.85 shares of GLPI and 1 share of new PNK for every share of old PNK they owned.  In effect, its a special dividend that recapitalized the company, much of the old debt moved to GLPI with the real estate and was replaced by a big capitalized lease payment.  The master lease has an initial term of 10 years, plus 5 options periods at Pinnacle's option for 5 years each.  The lease payment functions as an interest payment, except Pinnacle doesn't have to repay or refinance the debt, making it less risky in the event capital markets shutdown for a period of time.  While the lease is essentially debt, and I would treat it that way, it's not quite the same and when looking at the implied leverage ratio including the lease.

New Pinnacle Entertainment

The company now operates 15 properties (casinos, racetracks, hotel combinations) across 7 states but is relatively concentrated in Missouri (both Kansas City and St. Louis) and Louisiana with no exposure to Las Vegas or Macau as its larger peers.

Their biggest revenue generating casino is the L'Auberge Lake Charles in Louisiana that opened in 2005, in 2014 the Golden Nugget Lake Charles opened up next door creating competition, but in a "frenemy" sort of way as it's expanded the market, creating more of a regional weekend destination.  Visitors from nearby Houston (and it's energy economy problems) like the ability to easily go from one venue to the next, both have golf courses, spas, complementary restaurants and shuttles between the two properties.  In listening to recent earnings calls across the sector, gaming appears to finally be picking up around the country as consumers have more money to spend and have been moving away from retail to more experienced based spending.

One benefit of having casino REITs is their ability to acquire gaming assets at accretive prices given their low cost of capital, turn around and sell the operations to someone like Pinnacle and make the deal a win-win for both, essentially doing the REIT spinoff in reverse with the same benefits.  GLPI is doing just that with a racetrack and casino property, The Meadows, in Pennsylvania where it paid $440MM in December and sold the operations to Pinnacle for $138MM, which will close in the third quarter.  Ideally, the casino REITs aren't going to want to run the casino operations (GLPI has two they operate for spinoff tax reasons), but they'll be the most flush acquirers of properties that come up for sale giving operators like Pinnacle a source of new deals.  For The Meadows specifically, Pinnacle purchased the property for 6.4x TTM EBITDA and believes they can get an additional $10MM in synergies as it has been run as standalone business dropping the multiple below 5x EBITDA.

Proforma for The Meadows acquisition, Pinnacle did $645MM of TTM EBITDAR (R is rent to account for the capitalized lease expense), they have $130MM in cash, $968MM of conventional debt, and the lease obligation is $2.78B for a total enterprise value of $4.33B or an EBITDA multiple of 6.7x.  Penn National Gaming, it's closest peer in both markets and structure, trades for 7.4x EBITDA, which doesn't sound like a big difference, but when they're both as levered as they are PNK's market cap has some catching up to do.  Without the lease obligation and subtracting out the related rent payments, Pinnacle trades just under 6x EBITDA.

If the market valued Pinnacle at the same EBITDA multiple as Penn, it would be $18-19 versus ~$11.50 today.

Management in their roadshow presentation also laid out the case that Pinnacle was undervalued based on FCF (although a highly levered free cash flow).  On a free cash flow basis bumping it up to PENN gets closer to a $13-14 share price, still a fairly significant disconnect, it's probably worth somewhere in between the two metrics at $14-18 per share.

Overall, we have a slowly improving economy that's bring back some discretionary spending, a quality management team that has consistently driven margin improvements across their properties paired with some spinoff and odd accounting dynamics that are creating a temporary (hopefully) discount in Pinnacle's share price.

Risks:

• Leverage - Management will point to their conventional debt leverage in most discussions, which isn't entirely the wrong way to look at it since it's how their covenants are structured, but it's important to view the GLPI lease as debt when considering the entire picture.  With the GLPI lease, Pinnacle is about 5.6x levered, high for a cyclical consumer company and that leverage can cut both ways in a recession.  On just the convention debt, it's 3.6x levered.
• Lake Charles - Their Lake Charles casino is facing new competition at the same time as the downturn in energy is taking its toll on the Houston and Louisiana economies.
• Competition - Regional casinos were overbuilt in the last two decades, new supply is slowing outside of the northeast, Pinnacle doesn't anticipate any significant new competition coming online in their markets soon.  But local and state governments are always looking for new tax sources and as the economy picks up and casinos do well, its probably only a matter of time before additional gaming licenses are issued.

Disclosure: I own shares of PNK

Par Pacific Holdings: Update, Distressed Energy M&A Thesis

I received the Par Pacific Holdings (PARR) annual report in the mail this week and thought it made sense to revisit my initial thesis in an updated post now that I've spent more time on the company in the past 20 months I've owned it.  Last fall Par Pacific changed the holding company's name from Par Petroleum, and renamed their Hawaiian operations Par Petroleum, which coincided with Bill Pate being appointed CEO and signaling the future direction of the company.  Par Pacific traces its roots back to 2012 when it was known as Delta Petroleum, a failed natural gas producer that went through bankruptcy and ended up in the hands of creditors, the largest of which was Sam Zell's organization through the Zell Credit Opportunities Fund.  In the reorg, $265MM in debt was converted to equity and the $1.4B in net operating losses were preserved giving Par a significant tax shield as they pursue an acquisition strategy.

Sam Zell built his reputation and wealth as a distressed investor, and with much of the energy industry in distress, Par Pacific Holdings is a way to invest alongside him and his management team in an environment that should see plenty of attractive deal opportunities.  The bulk of Par Pacific today was created through two acquisitions of refining and retail assets in Hawaii.  In 2013, they bought Tesoro's Hawaiian operations for $75MM plus a $40MM earn out and in 2015 they paid $120MM for Mid Pac Petroleum (primarily retail locations).  Last year alone these assets generated $110MM in EBITDA.  Distress in the upstream oil and gas sector is migrating down to pipeline and retail players, Par Pacific's main focus going forward.

In current form, the company has three primary assets: Par Petroleum (Hawaiian downstream business), Laramie Energy (Colorado based natural gas E&P), and the tax assets.

Par Petroleum: Refinery, retail distribution network and related logistics assets located in Hawaii.

• Tesoro had mothballed their Hawaiian refinery and related assets, running them as an import, storage and distribution terminal while running an asset sale.  Most everyone passed, Tesoro wrote down the refinery to nothing, and then eventually Par came along and scooped it up for $75MM plus working capital/inventory.  Why did Par get a deal?  Tesoro made the strategic decision to exit Hawaii and focus on a new large acquisition it made with BP's old refinery in Southern California that could be operationally leveraged with Tesoro's in the same vicinity.  The Hawaiian business provided limited operational synergies and was a small piece of Tesoro's overall refinery business.  With no other buyers, Tesoro was able to effectively reallocate $325MM of net working capital to a more productive project for them with Par as the beneficiary.
• Being isolated in the Pacific Ocean, in order to drive profitability Par needed to increase it's on island sales otherwise it's expensive to ship refined product to either the west coast or Asia ($6 per barrel).  In 2014/2015 Par announced and closed on the acquisition of Mid-Pac Petroleum - 80 retail sites throughout the Hawaiian Islands.  The Mid Pac deal helps Par sell their refined product locally and internalizes consumption allowing Par to get both retail and refinery margins.  On a standalone basis the price wasn't outstanding, but the operational synergies Par will be able to squeeze out of their refinery makes it a transformational one.  They also own the land under 20 of the retail locations, so they have the ability to do a sale leaseback in the future.  With the Mid Pac retail locations, Par currently has 91 locations under the Tesoro and 76 brands, about 20% of the overall Hawaiian market.
• Management still believes there are acquisition opportunities in Hawaii, most likely additional retail to further drive the on island sales to match the output at the refinery, limiting the need to export.
• Later this year they will need to spend $30-35MM in maintenance capex at the refinery.  I assume/hope they will do their best to run at peak capacity around the scheduled down time in order to minimize impact.  Management has guided that the refinery will run at 1/2-2/3 capacity in the 3rd and 4th quarters.
• The refinery competes with one other in Hawaii, also located on Oahu, it was previously owned by Chevron and had shopped extensively until it was recently acquired by a private equity firm this month.  It's about half the size and Par was optimistically thought to potentially be a buyer of some Chevron assets, but regulators probably wouldn't have it.  The sale is likely just neutral for Par until we know more about the new owner's intentions.
• Par recently started breaking out their logistics assets as a separate reporting segment even though all sales are inter-company transactions and consolidated for reporting purposes.  But this change potentially signals further midstream acquisitions and in a distant future where MLPs make sense again they could sponsor their own and drop assets down.
• The combined Par Petroleum segment did about $110MM in 2015 EBITDA, which will probably come down some in 2016 with crack spreads coming in and the planned downtime at the refinery.

Laramie Energy: A minority interest in a privately own natural gas exploration and production company located in the Piceance Basin in Colorado.  This started as a legacy asset of Par's predecessor Delta Petroleum.

• In March, Laramie Energy completed a bolt on acquisition of nearby acreage for $157.5MM with Par contributing $55MM.  As a result of the deal, Par Pacific now owns 42% of the common equity and accounts for the position using the equity method.  Par's additional investment essentially created their own balance sheet write-down as of 12/31/15, the better the deal for Par the larger the write-down they needed to take.  But proforma for the acquisition, Laramie has a book value of $131MM.
• The timing of when the new acreage came up for sale wasn't ideal, management had been out in the investor community discussing mid and downstream acquisition targets but since this was adjacent to their existing JV the deal had a lot of strategic/operational value similar to what Mid Pac accomplished in Hawaii.  They know the area, and can spread their overhead costs over a larger asset base giving them additional leverage if the natural gas market recovers.
• Bob Boswell runs Laramie Energy, he's an industry veteran, currently serves on the board of Cabot Oil & Gas and has a history of starting and selling oil and gas producers.  In 2007, the first iteration of Laramie Energy was sold to Plains Exploration and Production for $1B, three years after the company was setup for $200MM (plus bank loan debt).
• Management seems realistic about this asset and has limited drilling planned for the near future.  They've also hedged much of Laramie's production through 2018, giving it the ability to wait out the cycle for a few more years.  It's mostly an upside option on natural gas prices.

NOL Tax Asset: $1.4B in net operating losses that can be used to offset future taxable income.

• Why do I like NOLs?  They attract long term investors that understand the importance of capital allocation and generally create an incentive to purchase cheap free cash flow businesses in order to monetize the NOL quickly.  The sooner the NOL is used up, the more valuable it becomes.
• Having the NOL reduces Par Pacific's cost of capital allowing them to be more competitive (pay a higher price) for acquisitions.  It also gives them additional flexibility in an asset sale (Laramie Energy for instance) where they could be more agreeable to a deal well above their cost basis knowing they have an NOL in place to shield capital gains.
• It is slightly tough having energy assets in an NOL heavy corporate structure, many energy businesses have built in tax shields to their business.  Par hasn't made much, if any, progress yet in monetizing the NOL, they're going to need a couple sizable acquisitions in coming years to start making a dent.

Valuation:

Below is a quick and dirty valuation for Par Pacific, refiners trade for 4-6x EBITDA, midstream trades 12-15x EBITDA, and retail seems to trade around 8x EBITDA.  For Laramie Energy, it's probably simplest to use the equity method book value; I'm thoroughly ignorant to how oil and gas companies are valued.  If anyone has any specific thoughts on Laramie's value, I'd love to hear them. 

At current prices, you're paying a cheap to fair price for the current assets and you get the acquisition runway/management as an upside option.  But I understand if non-shareholders would want to wait to see the next acquisition, it could create a better buying opportunity especially if it's paired with a rights offering.

Additionally, it seems like once a year the stock tanks for no apparent reason, in the summer of 2015 the company filed a shelf registration per the Shareholder Rights Agreement with Zell and other large shareholders which gave them the option to sell, but didn't actually mean they were going to, the stock sold off as if everyone was exiting and it went on to recover fairly quickly.  Shareholder Rights Agreements are one of those filing events to look for as some people sell first and ask questions later.

Risks:

• Hawaii - The state is a difficult place to do business, its heavily regulated and communal, they don't like outsiders running critical businesses in their state as can be seen with the Hawaiian Electric - NextEra merger drama.  Politically the state has a long term plan to move away from fossil fuels and have their energy needs provided 100% by renewable energy sources by 2045.  I would assume its safe to say that the military, tourism and other industries will still require refined products but there might not be room for two refineries long term if Hawaii meets its renewable energy mandate.
• Roll-up/Acquisition Strategy - Par Pacific describes itself as a growth company and most of that growth will come from repeated acquisitions funded through repeated capital raises.  The serial acquisition platform companies of the recent cycle have made roll-ups a dirty word as cheap debt and giddy equity markets led to some questionable deals and following meltdowns.  With Par Pacific you must believe in management's ability to identify attractive deals and not overpay for them.
• Equity Raises - Par Pacific will be a serial issuer of private placements or stapled rights offerings to fund its larger acquisitions in order to maintain the NOL asset.  Rights offerings are usually done at a discount, so shareholders will need to participate in them or be diluted.  I don't have any evidence to back this up, but it also seems to create a ceiling on the share price as investors become concerned that as the share price rises that management will use it as an opportunity to issue more equity.
• Natural Gas - After the recent bolt on acquisition, Laramie Energy is now a larger part of the company at a time when natural gas is as cheap and abundant as it has been in a long time.  Many oil and gas companies are going bankrupt, others have pulled way back on production, maybe at some point in the distant future natural gas prices will rise again, but they're likely to stay low for the foreseeable future.

Disclosure: I own shares of PARR

Interval Leisure Group: Reverse Morris Trust with Starwood

The bidding war for Starwood Hotels (HOT) between Marriott International (MAR) and Chinese insurance company Anbang grabbed a lot of headlines in the past month as Marriott eventually won after Anbang mysteriously dropped out. Caught up in the bidding war and subsequent merger arb trading are shares of timeshare vacation company Interval Leisure Group ("ILG" shares trade under IILG).  ILG struck a separate deal on October 28, 2015 for Starwood's timeshare subsidiary named Vistana Signature Experiences (previously set to be spunoff by Starwood) in a reverse morris trust transaction where Starwood would spinoff Vistana and immediately merge it with ILG.  The transaction will be tax free to Starwood shareholders, and after the merger, Starwood shareholders will own 55% of the new ILG with pre-deal ILG shareholders owning the remaining 45% of the shares.

The two Starwood deals happening parallel creates two technical, maybe non-economic, reasons why ILG's share price has fallen 35% since the deal announcement (there are other reasons discussed below as well): 1) if a Starwood shareholder was going to sell the Vistana spinoff anyway, well now they have a currency in ILG stock to do so before the spin date, essentially pulling forward some of the typical spinoff selling dynamics, 2) merger arbitrage investors are shorting ILG along with Marriott shares to capture the Starwood/Marriott spread.  While in both cases, the ILG shares sold short will be covered with new shares issued at the end of April when the deal closes, thus not creating a short squeeze, but after the deal is completed investors will begin to look forward and see a cheap company trading at ~7x EBITDA while its closest peers trade 9-10x EBITDA.

Any timeshare related bull thesis has to first acknowledge this is an industry with a questionable end value to its customers.  Most timeshares are sold, not bought, via free seminars where high pressure salespeople pitch people while they're on vacation to drop tens of thousands of dollars on a timeshare so they can relive their vacation year after year in perpetuity.  For most travelers this transaction is dubious, but maybe for a small subset who want to return to a resort year after year and stay in a suite larger than your typical two queen hotel room, a timeshare might make some sense.  But for many I suspect that they fall for the romanticism of owning a tiny piece of paradise without fully considering the annual maintenance fees and quickly depreciating (in many cases to $0) initial investment, it's a vacation home for people who can't afford vacation homes.  Even so, billions worth of timeshares are sold annually and the business of servicing and managing those timeshare units can be a good profitable one.

Interval Leisure Group was a 2008 spinoff of Barry Dillar's IAC which at the time was 30% owned by John Malone's Liberty Media, that ILG ownership has since been transferred to Liberty Ventures (LVNTA, a tracking stock of Liberty Interactive).  Historically, ILG has operated in the asset lite timeshare exchange business where they run Interval International, the second largest exchange behind Wyndham's RCI, allowing timeshare owners who pay a $89-129 annual subscription fee to trade their weeks/points with other timeshare owners.  Developers sign up with Interval International and often pay the initial year or two subscription in order to sweeten the pot and make timeshare ownership a bit more appealing to buyers by giving them flexibility to visit other locations/resorts.  This is a sticky business with a 90% annual renewal rate.

Over the past several years, ILG has also gotten into the vacation rental business (primarily in Hawaii) and other attractive management fee revenue businesses around the timeshare ecosystem.  In 2014, they purchased the timeshare development and management business from Hyatt where they have a licensing agreement to use the Hyatt name to develop and manage more timeshares, they build resorts and sell off the timeshare units while collecting an ongoing management fee.  As the timeshare industry has continued to consolidate, ILG's exchange business has faced competitive pressures as larger developers create their own internal/closed exchange network and don't sign up with ILG.  In order to feed the exchange and management contract businesses, ILG needed to increase their development/sales arm as more timeshare companies become vertically integrated.

Vistana -  Starwood's timeshare resorts under the Sheraton, Westin, St. Regis brands - will give ILG exactly that, it dramatically increases the timeshare (vacation ownership) sales piece of ILG.  Timeshare sales is a capital intensive and cyclical business, much more so than the legacy ILG business, so this feels like a defensive merger to quickly vertically integrate and protect the fee revenue businesses going forward.

The less enticing reason why ILG has fallen significantly since the merger announcement is the market believes they overpaid, at least when looking at near term multiples.  It's a stock for stock deal, but at the time of the press release the deal was valuing Vistana at $1.5B on only $125MM of EBITDA, at least two turns above where peers were trading and it looked to dilute ILG shareholders.  But in order to get comfortable with the multiple paid you have look a little longer term, Vistana includes over $500MM in timeshare mortgages that could be securitized and turned into cash, 5 standard hotel resorts that will be refashioned into timeshare properties, and additional development opportunities at Vistana's 22 current resorts.  All in, they estimate that Vistana comes with $5.5B in future timeshare inventory that can be sold, and then added to ILG's recurring fee ecosystem.

Tucked away in the merger documents (page 98) Vistana breaks out their long term projections all the way out to 2024, likely in response to the market's reaction to the sticker price, but also to show the value in the inventory pipeline:

Be a little skeptical but it provides some perspective on the headline price tag.

Valuation
To keep things relatively simple, ILG is expected to do $185MM in EBITDA in 2016, Vistana is expected to do $148MM (both from the most recent prospectus), assuming no deal synergies (guided to $26MM annually after 5 years) and subtracting out $18MM of stock based compensation gets a proforma 2016 EBITDA run rate of $315MM.  The new share count will be just under a 130 million, at $13.35 per share, that's a market cap of $1.733 billion, the new ILG will have $464MM in net debt (ignoring non-recourse securitizations).

Proforma EV/EBITDA = ~7x

Marriott's timeshare business, Marriott Vacations Worldwide (VAC), is a good comparable for ILG, both will be a mixture of recurring management/exchange fees and development sales, both operate on the higher end of timeshare brands, and they're both pure play vertically integrated companies.  Marriott Vacations trades for ~9x 2015 EBITDA, at the same valuation using my EBITDA estimates gets you to a $18.35 share price for Interval shares, or 36% higher than today which would just about make up the difference in performance between Marriott Vacations and ILG shares since the 10/28 Vistana deal announcement.

Risks

• Regulatory - The Consumer Financial Protection Bureau (CFPB) is investigating timeshare operator Westgate, shining a light on the industry's sales practices.  Diamond Resorts is in a similar situation and was recently profiled in a long New York Times piece.
• AirBnB/HomeAway - Condo/homeowners in vacation towns can compete more effectively with timeshare developers thanks to AirBnB and HomeAway, provides a similar room option without the upfront and ongoing expense.
• Secondary Market - Most timeshares can be purchased at significant discounts to developer pricing in the secondary market which puts a lid on new unit pricing and/or really shows unsavory nature of the sales process.
• ILG shareholders still need to approve the deal, there's a shareholder meeting set for 4/20/16, Liberty and management have already agreed to vote for the deal.

Disclosure: I own shares of IILG