Description

We believe Fortress Investment Group is among the least expensive asset management firms in the market today, regardless of whether you consider traditional asset managers or alternative asset managers. Moreover the company’s strong balance sheet and 4.6% dividend yield will likely provide substantial downside price support in the event of a major market dislocation. We believe that the best way to value Fortress is based on a sum of the parts based on the various different divisions and assets of the company. To do so, we divide the 2013 p&l from the asset management division into what we view as its component parts. Importantly, this does not include earnings from the company’s balance sheet investments, because we would otherwise double count them. We also apply a full corporate tax rate rather than the lower partnership based tax rate that the company currently realizes, in order to conservatively account for the risk that Fortress is ultimately forced to realize a normal corporate tax rate. On this basis, we see the trailing p&l as follows:

Part #1: Base management fees from the Alternative Asset Management Business

As can be seen in the P&L above, I estimate that Fortress earned $0.29 per share in 2013 from the alternative asset management business, which includes the credit business, the liquid hedge fund business, and the private equity business. These earnings are based on average AUM of $34.6 billion, as can be seen below:

AUM in the alternative asset management business at year-end stands approximately 5% higher than the average AUM on which the 29-cents of EPS was calculated. Moreover, at year-end Fortress had an additional $7.1 billion of uncalled capital or “dry powder” of which $4.9 billion was available for general investment purposes, which would represent an additional 14-21% growth in AUM that is already raised and available for Fortress to invest. On a fully-invested basis, assuming 40% incremental margins and counting only the capital raised that is available for general investment purposes, we believe that alternative asset management EPS would increase by 20% to $0.35 per share. In addition, we think that Fortress is well setup to raise additional capital given the strong performance of its credit products, sector-focused private equity, and liquid hedge funds even though the hedge funds have hit a rough patch year-to-date. This was evidenced in 2013 when Fortress was able to increase alternative assets under management by 11% net of redemptions and capital returns. Putting all of this together, we value the management fees at 18.2x actual trailing fully-taxed 2013 EPS, which is the average 2013 multiple of traditional asset managers, which equates to 15.1x EPS after deployment of uncalled capital available for general investment purposes. This equates to $5.31 per share:

Part #2: Incentive Income

We value the incentive income that we think Fortress should earn in an average year based on 10% returns after payment of the management fee. For the purposes of calculating incentive income, we exclude all Private Equity investments with the exception of permanent capital vehicles and healthy, recently-raised funds such as the MSR Funds and Holiday Fund due to the unlikely ability of the legacy funds to reach their incentive thresholds. We then apply a 5.5x multiple to our expected average earnings to reflect the low valuation currently being attributed to these earnings by the market. On this basis, we see the incentive income as being worth $1.43 per share:

It is also worth noting that we would expect the earnings power from incentive income to increase as Fortress calls its dry powder. While we do not include it in our valuation, the remaining $4.9 billion of AUM available for general investment purposes has the potential to be worth another $0.27 per share based on the above assumptions:

Part #3: Balance Sheet Value

In addition to its asset management earnings, Fortress has significant balance sheet value based on both its net cash and investments as well as on its earned but not yet collected incentive income. Importantly, the company has indicated that it does not perceive the need to keep as much net cash and investments on its balance sheet and that it is likely to reduce these through returning cash to shareholders. To that end, Fortress recently repurchased 60.6 million shares or 12% of its then outstanding shares. Pro forma for this repurchase, we see total balance sheet value of $3.98 per share, including both the company’s net cash and investments as well as its embedded incentive income:

Part 4: Logan Circle

Although Fortress is best known for its alternative asset management business, it also has a growing traditional asset management business known as Logan Circle. In fact, Logan Circle currently manages 41% of the total fee-paying AUM at Fortress. Because Logan Circle is not yet profitable due to its heavy investment for growth, we value it at 1% of AUM, which represents a 50% discount to the average peer. On this basis, it is worth $0.59 per share:

Part 5: Tax Shield

Finally, we would be remiss not to point out that all of the above valuations have been based on EPS after applying a 37% tax rate even though Fortress only reports a 12% tax rate. This difference may be permanent or it may be fleeting, but it accrues $0.22 per share in value each year that it remains in place:

Putting it All Together:

Based on the above, we believe that Fortress is worth approximately 62% above its current trading price:

Another way to look at this is that after deducting the net cash and investments as well as the earned but uncollected incentive fees, you are paying only about 10x actual 2013 management fee EPS and attributing nothing to the other assets such as Logan Circle, Incentive Fees, etc:

Catalyst