Description

LAACO – compelling risk/reward for a patient investor

LAACO is an illiquid $270M microcap with ~70% insider ownership. While more suitable for a PA investment, given the significant undervaluation, this publically-traded partnership warrants sharing with VIC. LAACO has never been written up on VIC (or Sumzero).

We believe that at today’s unit price, this virtually unlevered storage and real estate business is trading at a significant discount to our range of fair values (70% to 140% upside). 

LAACO operates in 2 segments:

·         Self-Storage: LAACO owns and operates 49 self-storage facilities across Southern California (22 facilities from Los Angeles to San Diego), Phoenix (13 facilities), Las Vegas (13 facilities), and Houston (1 facility) under the brand Storage West.  Not including anticipated expansions to existing facilities and 5 new facilities in Houston, Storage West has nearly 4 million sq. ft. of self-storage. 

·         Downtown Los Angeles Real Estate: LAACO owns over 1 acre of contiguous property in the Historic Core of downtown Los Angeles (DTLA).  Sitting on one of the three (roughly) equivalent lots is the iconic Los Angeles Athletic Club, an 184,000 sq. ft. venue with a 73 room hotel, athletic club, commercial retail space, and event/dining facilities.  The two other lots include a multi-story parking garage and an empty lot.  We believe that LAACO management will in the future construct a luxury condo tower to leverage the increased value of this prime real estate and the facilities and amenities of the Los Angeles Athletic Club.

What is our estimate of Fair Value?  At $1585 per unit, we are purchasing units at a large discount to intrinsic value. Moreover, this discounted valuation is based on a virtually unlevered real estate entity which is operating in a relatively non-cyclical segment of real estate. 

Why does this opportunity exist?  In addition to being an illiquid microcap, our conversations with industry participants suggests a lack of awareness that the company even has publicly available shares.    For example, the self-storage contacts with whom we spoke were familiar with Storage West’s business, yet were unaware that it was part of a publicly traded entity.  Similarly, owners of neighboring parcels in DTLA who are actively involved in the market did not realize that LAACO had publicly available units.

A Bit about Self-Storage

The self-storage industry is a perverse irony. In an industry where density and scale offer advantages, the 4 large publicly traded self-storage REITs (Public Storage, Extra Space, CubeSmart, Sovran Self Storage) and U-Haul, collectively own, operate, and/or manage roughly 12% of the facilities and 15% of the rentable sq. ft. in the United States.  Over 60% of facilities are owner/operators managing only one facility and another 20% of facilities are managed by owner operators with between 2-9 facilities.  These large competitors, recognizing the benefits of scale, have leveraged the recent funding environment to grow through acquisitions and joint ventures.  As these larger players expand, there are fewer portfolios of storage assets that are meaningfully accretive to them (or other potential buyers such as private equity).  It appears that only 4% of the facilities in the United States are controlled by companies not publicly listed on major exchanges and that have more than 10 self-storage facilities.  In fact, a recent IPO (National Storage Affiliates) was established to consolidate operations and scale this 4% of the market.  Among the non-consolidated portfolios, it is our understanding that Storage West is one of the highest demanded due primarily to the concentration of its portfolio in areas such as Southern California where finding property and attaining permits is not easy and where population density and median household incomes are high.    

Why is Self-Storage such a good Business?

·         Fixed cost business structure requires modest utilization levels to breakeven: A property that is well located and run by efficient management can cover its fixed costs with as little as 25% of the facility utilized.  Other facilities might require upwards of 40+% utilization to cover fixed costs.

·         Incremental utilization yields net margins exceeding 90% (after covering fixed costs).

·         A diversified tenant base is a highly cash generative cash flow stream due to minimal maintenance costs.

·         The average tenant stays for over 19 months, partially due to the high costs and hassle of switching.  This has generally provided the industry with pricing power over time. 

·         While there is some economic sensitivity, the customer base tends to be driven by life cycle changes (e.g. marriage, divorce, death, renovation, relocation, summer vacation, military service).

·         Ancillary sources of income such as insurance are increasingly cash generative.

The Storage West Portfolio

In the late 1970s LAACO entered the self-storage business through a 1031 exchange.  The company has conservatively used the cash generated by its Storage West assets to purchase and develop additional facilities and, ultimately, expand into new geographies.  Over the past four decades, Storage West has built an operating portfolio of 49 facilities (including 2 under Joint Venture) with roughly 3.9 million square feet of rentable self-storage space (http://www.storagewest.com/).

We approach valuation of the storage segment from two different vantage points:

Peer Multiples

Storage West has gradually increased its revenues over the past few years and we expect this to continue.  In Q1 2015, revenues grew by over 10% y/y.  While the quarterly and annual financials going back to 2003 can be found at the OTC website (http://www.otcmarkets.com/stock/LAACZ/profile), here are recent annual results for Storage West (all figures below in millions). 

·         Storage West Revenue:  $35.8 (2011), $38.5 (2012), $41.5 (2013), $44.5 (2014), $48.0 (2015E)

·         Storage West FFO: $15.5 (2011), $16.6 (2012), $18.0 (2013), $19.2 (2014), $22.7 (2015E)

Our estimate for a 7% increase in revenue in 2015 is based on management’s guidance for an increase in occupancy from 83% to 85% in 2015, a 2% improvement in pricing, and a 3% growth in square footage due to the late 2014 acquisition (via 1031 exchange) of a facility in Mesa, Arizona, as well as (at least one) additional facility in Houston coming online. FFO growth is predicated on a 55% FFO margin on incremental revenue and a $1M reduction in interest expense versus 2014 due to the refinancing of LAACO’s $29M mortgage note. 

Public comps are generally trading at 20x-24x 2015 FFO.  Based on a more conservative range of multiples below, we arrive at various valuations for Storage West. 

At 16x FFO (Bear): $360M

At 19x FFO (Base): $431M

At 22x FFO (Bull): $499M

On an EV to Trailing Revenue basis, self-storage companies are trading at 12x-16x.  Based on a more conservative range of multiples below, we arrive at various valuations for Storage West:

At 8x TTM (Bear): $372

At 10x TTM (Base): $455

At 12x TTM Revenues (Bull): $538 

In both of these ranges of comps, we assume that the (unaccounted for) Houston portfolio in construction roughly offsets the $20M in net debt at LAACO. 

Replacement Value

LAACO is a partnership that has been under the stewardship and control of the Hathaway family for multiple generations.  Considered one of the ‘founding families’ of Los Angeles, the Hathaways are well regarded civic patrons, who have done a good job building this business. Nevertheless, we do believe that the Storage West operations would generate greater revenue and higher profitability if these assets were owned (or managed via a JV) by one of the larger storage REITs.  Although LAACO lacks both the scale of its larger publicly traded peers and probably doesn’t have as sophisticated online pricing strategies (self-storage is increasingly a Google business and not a Yellow Pages business), much of its property is well located.  This locational advantage helps overcome some of the deficiencies in scale relative to LAACO’s largest peers.   

 ·          Enterprise Value for LAACO is reduced by $85M to account for Los Angeles Real Estate and Houston Portfolio in Development

The following chart provides a general breakdown of Storage West’s regional portfolios and our estimates of the replacement value on a per sq. ft. basis:

·          These calculations exclude 2 Joint Ventures in the Los Angeles Region and the 5 Houston facilities in various stages of development

Based on our channel checks, we arrive at a replacement value for the 47 operating, non-JV facilities of $659M (Bear), $738M (Base), and $817M (Bull).  Assuming a 30% discount for prospective buyers or just to be conservative as a basis of valuation and adding $10-$20 million for the two JV assets not included in the valuation, we arrive at various valuations for Storage West:

Replacement (Bear): $471M

Replacement (Base): $531M

Replacement (Bull): $592M

This estimate of replacement value aligns roughly with our base case estimated takeout value based on NOI which was $620M for the Storage West business (including JVs). This was predicated on a 5% cap rate on a Storage West’s roughly $30M in NOI (which nets out roughly $5-$6M in G&A via acquisition). A self-storage competitor would pay this multiple because based on a combination of improved pricing, utilization, and a more levered capital structure, a competitor is really buying in closer to a 7.0% cap rate. 

In summary, we believe that the Storage West business is conservatively worth $419M to $555M with a Base Case Value of $487M, and potentially much more in a take-out scenario.

For anyone skeptical about the value that buyers would place on these assets, we would bring your attention to a very recent acquisition of Smart Stop by Extra Space for $1.4B.  This deal suggests that we are probably being somewhat conservative on valuation.

In short, Smart Stop has a higher occupancy rate (87% to 83%) and roughly 20% lower REVPAF (25% lower REVPOF) than LAACO.  Smart Stop’s lower quality portfolio running at higher occupancy (implying less upside) received an offer for roughly $135 per sq. ft. of self-storage space.  This implies an estimated value of roughly $170/sq ft. for Storage West.  This implies a $660M valuation to LAACO’s real estate.  Adding back 4% to adjust for utilization, gets you to roughly $700M.  At $700M, LAACO’s units should trade at $4000 per unit (more than double) before taking into account the Downtown LA assets.  

Los Angeles Athletic Club: A Downtown LA (DTLA) fixture for Generations

The Los Angeles Athletic Club (LAAC) is an institution in downtown Los Angeles with a rich history.  Founded in 1880 by forty of the leading business and athletic patrons of the city, the site of the existing building was opened in 1912.  The list of former politicians, actors, and athletes who have been members of the Club is long and distinguished. 

Athletes from the Club have earned 97 Olympic Medals.  Johnny Weissmuller, Rudolph Valentino, and Mary Pickford considered the LAAC a second home and Charlie Chaplin lived in the building.  Besides the assorted facilities (73 room hotel, banquet hall, athletic facilities, bar/lounges, wine cellar, etc.), the Club is well known nationally for sponsoring the John R. Wooden award to the year’s best men’s and women’s college basketball players.  As an example of its “additional assets”, the Club actually owns the trademark for the most prestigious award in men’s and women’s college basketball.  Every once in a while the Club will sell assets like artwork and sculptures that adorn the building, assets not included in our valuation.

A Renaissance in Downtown Los Angeles

Similar to many urban centers in the United States, downtown Los Angeles is experiencing a renaissance. 

http://www.ey.com/Publication/vwLUAssets/EY-outlook-on-downtown-los-angeles-real-estate-2015/$FILE/EY-outlook-on-downtown-los-angeles-real-estate-2015.pdf

Much of the urban revitalization is happening within blocks of LAACO.  For a sense of how close much of this new development is to LAACO’s property, all you probably need to know is that Whole Foods opens two blocks from their front door on November 4^th.  Nevertheless, the link below highlights developments in the South Park neighborhood which the property borders upon: 

http://la.curbed.com/archives/2015/04/south_park_development_map.php#more

• Empty parking lots are being redeveloped.  In this regard, in December, LAACO sold its non-contiguous parcel in the South Park neighborhood at 845 South Olive Street for $470 per sq. ft.  The development of empty lots, like those surrounding this lot, are bringing life to the area as 3,500 residential units are to be constructed or completed within a 3 block radius of the Club in 2015 alone. 
• The self-reinforcing cycle is attracting purchasers even to buildings that have been abandoned for decades.  In this regard, the parcel next door to the LAAC was just purchased for $39.25M (or $268 per square foot).  The Giannini Building, which was originally constructed in 1922 and served as the headquarters for the Bank of Italy, has been abandoned (and left to decay) for nearly 30 years.  Applying this price per sq. ft. on a distressed property to LAACO’s immaculate Club implies a $50M dollar value to the Club alone.  LAACO’s three contiguous parcels stretch across an acre of land and have almost 4x the footprint of Giannini.  Perhaps our Bear Case of $40M is obscenely low, but it illustrates the margin of safety in this investment.  Management has noted that it has ample air rights to (basically) do whatever redevelopment it would like on those parcels (even adding stories to the Club) at the time of their choosing. 
• Finally, another valuation reference is the April 2015 sale of the ACE hotel from Greenfield Partners to Chesapeake Lodging Trust for $101.7M.  This hotel is situated 3 blocks from LAACO and includes both dining, a 182 room hotel, and an event hall (concerts) which Chesapeake has indicated could do $2M in income.  We apply a 20x multiple to this event hall income stream and imply a $62M valuation to the 74,000 sq. ft. of hotel and dining.  On a pure price per sq. ft. basis, this implies that the Athletic Club alone is worth over $150M.  Applying roughly $325,000 per key, this implies that the hotel portion of LAACO (3 stories of the 12-story building) is likely worth $25M.    

Although we will approximate the value here based on the existing footprint (and not the redevelopment potential), we believe the path for the downtown assets are to complete the multi-year renovation of the hotel (http://www.laachotel.com/rooms-suites/) and athletic/spa complexes by the end of 2016 (http://www.latimes.com/business/la-fi-property-report-club-20141127-story.html) and then benefit from an anticipated surge in membership as residential complexes around the Athletic Club become occupied.  At some point down the road, the family will likely undertake a significant development joint venture. 

In terms of monetization, this is a family that has consummated major transactions in the past.  Among various transactions, the most famous was the sale of the venerable Riviera Country Club to a Japanese buyer in the late 1980s.  When asked by the LA Times why they sold the Club, the LAACO spokesman said that “the price was too good to turn down”.  In our conversations with management, we believe that they will sell assets when timing makes sense and, in the meanwhile, will continue to grow the assets and cash flow of the assets while generating a 10% unlevered free cash flow yield and paying out roughly half of this in quarterly partnership distributions (4%+ annually) while reinvesting the balance in their Storage West portfolio and DTLA assets. It would not surprise us to see the storage business sold in the coming years given the significant roll-up in the space

In summary, we believe that LAACO is conservatively worth:

Risks

Self-storage multiples decline on materially higher interest rates.

DTLA real estate transformation is not sustainable and will prove to be a false dawn (seems highly unlikely).

Management is tax inefficient when it monetizes assets (seems unlikely given insider ownership alignment and previous use of 1031 exchanges).

Dead money/value trap: Monetization events are not clear.  We do believe that the family will seek to further unlock the value of real estate through development and monetization, but their timeline is uncertain.  We are comforted by the fact that (in the meanwhile) they are generating strong free cash flow and paying out a healthy annual distribution while the NAV grows over time.  .

Catalyst

Awareness

Any transaction or development of the incredible downtown LA real estate

A sale or JV of the Storage business

Capital restructuring based on newly attained credit facilities

Cash flow and distribution grows over time