Description

Colony Financial (CLNY) is a compelling long as it has minimal downside (~10%) and a couple of meaningful catalysts to value creation (30%+) over the next year. And in the meantime investors get paid a 6.5% yield to wait for value to be unlocked.

VIC members should remember CLNY. Colony has been pitched a couple times before, most recently in June 2013 by gary9 and in 2011 by frankie3. You can refer to both of those write-ups for background on the business and opportunity. A lot about the business is essentially unchanged since the middle of 2013, except that the separation of the Colony American Homes (CAHS) business never happened because the IPO was pulled due to market conditions during the dramatic rate move in the summer of 2013.

Why Again?

With an extra year or so, the CAHS business has seasoned, and its competitors have started to gather investor support and acceptance (see AMH, ARPI, SBY). So the ultimate separation of CAHS continues to be a likely event, and should occur in 2015. The possible IPO of Blackstone’s Invitation Homes, the leader in the single-family rental (SFR) space, should also drive incremental investor focus and interest on SFRs. The competitors in single family rentals now trade at ~1.1x BV, and they are all starting to generate positive and nicely growing EPS, that should support continued value creation for this business in the next year. This value unlock was the core of the last CLNY pitch in VIC.

What makes this time unique versus last year is the possible internalization of Colony Capital. On June 12, 2014, CLNY announced that they received a proposal from Colony Capital regarding a potential transaction for an internalization of the management of CLNY’s current business and the contribution of certain asset and rights of Colony Capital. The Colony Capital proposal envisions that CLNY’s current external manager would stay in place, and that CLNY would pay CLNY common equity to internalize and buy Colony Capital assets and rights.

Other than this announcement, there has been very little disclosed by CLNY about the details and exact nature of this proposed transaction. However, the rationale for the transaction seems rather obvious. CLNY management has watched the rocketship ride and investor love affair with NRF (HoneyBadger wrote up NRF/NSAM on VIC most recently on November 2, 2014) over the last 12-24 months. Colony Capital management has a larger real estate franchise and a longer track record than Northstar, and likely believe that they can create a similar structure for themselves. Colony Capital has been around since 1991 and has invested $60b over the last 2 decades. It currently manages $20b of assets with 400+ employees in 12 offices in 9 countries across the US, Europe, and Asia. The structure and path to monetize the related fee streams from this large asset manager has been clearly laid out by NRF.

So What’s It Worth

The existing Colony Financial before internalization is best valued as a SOTP, given management’s intent to separate CAHS. CAHS has book value of $550m, which at 1.1x BV, in line with peers, is worth $5.50/share. The remaining commercial mortgage business generates $1.45/share of dividends, which is worth $18.67/share at a 7.5% yield. Adding 1 year of dividends, yields $25.65/share, or 15% upside within the next 12 months (assuming dividend is not raised).

Downside protection is provided by reported fair value, which was $21.39/share as of Q2 earnings. CLNY has not traded more than 3% below fair value in the last 2 years. Using 10% discount to fair value (or 3x more than the last 2 years), yields a near term downside of $19.25/share or about 15% below the current price, but with $1.45/share of dividends in the next year, investors get back to $20.70/share or 8% below the current share price.

The above analysis makes CLNY marginally interesting as there is good downside support, and a reasonable 2:1 up vs. down case in the next 12 months. Additional upside is provided by the internalization, where CLNY shareholders can ultimately benefit from the growth of AUM. This is either through a NRF/NSAM structure where a combination of a high multiple asset manager and a capital heavy yieldco provide substantial multiple expansion. Even without a NRF/NSAM structure, CLNY should be revalued higher as internally managed structures get higher multiples than externally managed ones.

The math behind the internalization requires many assumptions at this point. Looking at several traded asset managers shows a value range of 4.5%-5.5% of market value to gross AUM (e.g., ARES, APO, FIG, CG). At the low end of the comp range, this would suggest Colony Capital could get ~$900m of value if all of its AUM was internalized, which equates to about 40m shares of CLNY. This is 36% dilution on share count. But the question becomes how much earnings power this adds. Assuming a base management fee of 1.5% on the $20b of AUM and 30% operating margins (low end of comp range of 30-40%), would suggest $90m of operating profit. This would be either an earnings neutral event assuming a full 35% tax rate on this income, or 15% accretion to earnings assuming no tax on the income (assuming a LLC or other pass through structure is used for GP income). In addition, there would be incentive fees, which would create further accretion. Just to throw some numbers at this, assume that CLNY earns 5% incentive fee above their hurdle rate per year with a 20% carried interest, this would create an additional $200m of revenue and $60m of operating income at 30% margin. This generates 15-25% of additional accretion, depending on the assumption of tax treatment. So the total accretion range based on the math above is 15-40%.

The point of this analysis is that it is possible to create a lot of value through an internalization transaction. The magnitude will depend on exactly what assets are bought in from Colony Capital and at what price. After the internalization, there is the NRF/NSAM or a similar GP/LP structure that can be created to create value through a sum of the parts. And even without such a separation, CLNY equity and earnings will finally be levered to AUM growth – a reason in itself for the stock to re-rate.

Using the low end of the internalization upside, 15% accretion and no re-rating, yields 30% total upside after adding the 15% upside in the SOTP from the CAHS separation highlighted above. There are options for additional upside with further accretion and re-rating of CLNY stock.

Risks:

No internalization occurs, in which case the base case moves to 15% upside and 8% downside in next 12 months.

Internalization happens, but in a “bad” transaction for CLNY shareholders. This risk is mitigated as disinterested shareholder approval is required to approve the internalization. Also, Colony Capital management is clearly interested in substantial ownership of CLNY shares post the transaction, and are less likely to want tie themselves to a security that becomes heavily discounted for poor shareholder treatment.

Materially higher interest rates. This lowers credit quality of tenants and lowers real estate asset values in general, neither of which would be good for CLNY or its commercial mortgage competitors.

Catalyst

Details of internalization transaction.

Separation of Colony American Homes.