Description

Overview

This is a ‘deal stock,’ whereby NRF, NSAM and CLNY are doing a tri-party merger-of-equals; it’s an all-stock deal and exchange ratios are in the table above. So you could own a piece of the combined entity (Colony NorthStar, ticker CLNS) by owning any of NRF, NSAM, CLNY.

The shareholder votes are in mid-Dec and the deal closes in January. We chose NRF because it appears to be trading at a discount to the value implied by the exchange ratios. It shouldn’t matter too much though as the pro forma company is crazy cheap and there is sufficient upside in all three stocks.

Valuation: A conservative 11x multiple on $1.70/share FFO in 2017E = $19/share (30% upside)

Plus, the PF company will pay $1.08/share in dividends (>7% yield).

Here, you will find presentations that a) summarize the deal, b) provide background on the three companies, and c) offer details about the pro forma company including guidance. The June 7 2016 presentation is the merger presentation, two appendixes were also posted in July and September.

Valuation / Exchange Ratios

The table above walks through valuation and exchange ratios. Colony NorthStar’s stock price will based off NSAM’s stock price (NSAM closed at $14.72/share), and CLNY and NRF have exchange ratios of 1.4663 and 1.0996 respectively. With the 1.0996:1 exchange ratio for NRF shares, the implied value of NRF based on NSAM’s stock price is $14.72 * 1.0996 = $16.19/share. NRF closed at $15.09/share, so it’s trading at a discount to the value implied by NSAM’s stock price.

In terms of valuation, Colony NorthStar has guided to $1.55-$1.75/share of FFO in 2017E. The guidance range is wide because NRF and CLNY are selling assets / going to sell assets over the next 12 months. However, we believe they’ll get to the higher end of guidance because they can buy back a lot of stock. With the contemplated asset sales Colony NorthStar will have >$1.3BN of liquidity versus $8BN market cap. We model $1.70/share of FFO, which is within their guidance range.

A conservative 11x FFO on $1.70 = $19/share price target versus NSAM’s last close of $14.72/share (30% upside). Additionally, Colony NorthStar will pay $1.08/share in dividends (>7% yield, conservative payout ratio of 65%).

Quick background / pre-merger history

There are prior VIC write-ups on each of NRF, NSAM and CLNY that provide a decent amount of detail on what each of the companies do, but here’s a super quick refresher.

NRF is a multi-strategy, externally managed REIT that invests in multiple verticals, the largest of which are Healthcare, Hospitality and Real Estate (RE) debt.

NSAM is an asset manager which was spun out of NRF in mid-2014. The largest piece of NSAM’s earnings (~70%) are the fees it earns for managing NRF and NRE which are two publicly traded REITs (i.e. permanent capital). The contract is basically forever (20 year term with automatic 5 year renewals), and the Base fee cannot go down. NSAM also owns a non-traded REIT business and an asset manager Townsend that advises and manages RE funds. 

CLNY is a multi-strategy, internally managed REIT that invests in multiple verticals, the largest of which are RE debt, opportunistic RE equity, single family homes, and a light industrial portfolio.

A quick note on external management before we get into the pre-merger history... REITs can be internally managed (just as most public companies are internally managed) with regular-way employees who get paid salaries, or externally managed where the REIT basically has no employees and contracts out to a “3^rd party” to manage all of its operations (investment decisions, reporting, etc.). External management structures are more common in mortgage REITs, but there are also externally managed equity REITs. An external management contract is usually structured as a “Base fee” and a “Performance fee.” Base fees can vary but are typically structured as a % of equity issued by the REIT, although some Base fees are structured as a % of market cap. Given these structures, it’s easy to see how an external management structure creates a conflict of interest as the manager is incentivized to grow the REIT by issuing equity irrespective of accretion/dilution (as opposed to growing FFO or earnings per share). Whether or not the conflict of interest is realized depends on the actions of management (and there have been blow ups) but it’s safe to say that as of today, investors generally view this structure negatively.

CLNY was an externally managed REIT whose external manager was private. In mid-2014, CLNY decided to internalize its manager and this transaction closed in early 2015. NRF was internally managed and decided to spin off its asset manager (NSAM) in late 2013 and become externally managed. Unlike CLNY’s manager who was private, NRF decided to spin off its manager NSAM into a public company to try to be as transparent as possible and let investors choose which entity they would prefer to own. The NSAM spinoff closed in June 2014.

So over the late 2013 to early 2015 time period one company was internalizing, while the other company was externalizing. Things were generally pretty good in the market and shareholders were willing to give credit to the external management structure… and we wouldn’t be surprised to hear if some investors were buying CLNY (after bringing in its asset manager) in 2015 and playing for the eventual spinoff of “Colony Asset Management” into a public company given how NRF/NSAM was trading.

NRF/NSAM did fine for about a year after the spin-off, they did some smart deals, some ok deals. In early 2015, NRF was a SOTP story where it traded at a discount to its NAV or wtd average FFO multiple / dividend yield. NRF paid a 9% dividend, but it was complicated, levered, and externally managed so it remained to be seen whether it could fully close the gap. NSAM was a relatively clean asset manager that was superior to asset management comps as 70%+ of its earnings were from permanent capital vehicles, NRF and NRE, and the fees could not go down. Given NSAM’s stable cash flows (its management fee was easily covered by NRF’s cash flows) it should have traded like a bond, and for a short while it did.

Over the back half of 2015, NRF got crushed and NSAM got crushed in sympathy. It’s hard to attribute it to any one specific thing (REITs in general also sold off over the back half of 2015), but at the 2015 AGM it was announced that the NorthStar entities were going to pay their Chairman David Hamamoto $100M, which is a very large amount of money for two companies whose market caps maybe peaked at $7BN. In one fell swoop, this appeared to create a conflict of interest at NRF as it appeared as though NSAM/Hamamoto was exploiting it for fees. The goodwill/trust seemed to evaporate and NRF got destroyed through the end of 2015. NSAM got destroyed too, partially in sympathy and partially over concerns that NSAM’s fees from NRF could never grow as NRF was trading at such a big discount to its NAV.

CLNY didn’t have a great 2015 either, due to general weakness in REITs and potentially also due to the fact that it had a similar shareholder base to NRF/NSAM.

In January 2016, NSAM announced that it was exploring strategic initiatives. This could have involved any number of corporate actions, including a) NSAM sells itself, b) NSAM sells its NRF/NRE contracts to one party and its non-traded REITs/Townsend to another party, c) NRF/NSAM recombine. There was a decent amount of interest initially; the proxy said 4-5 bids in the 1^st round. The 1^st round bids were submitted at the market lows (Feb 2016), and as such some bids were crazy low-ball offers. One bid was $13.50/share all cash. NRF was also a bidder in this process, they were contemplating using cash/stock to buy NSAM which would have been one way to recombined and internalize the management contract. Another way might have been a merger of equals.

The deal that was eventually announced was the tri-party all-stock merger that we have today, NSAM/CLNY/NRF are merging to create an internally managed REIT that a) has a great asset management platform, b) is levered 50% debt/cap (in line with REITs), c) has a v modest payout ratio of 60-70%, and d) >$1.3BN of liquidity (vs $8BN market cap) at deal closing which can go toward buy backs and deleveraging. Since all 3 companies have similar market caps the PF ownership is approximately 33%/33%/33%. See the June 7 merger presentation for all the details behind the deal.

So what is the PF company worth / could the deal break?

PF company positives

-          $8BN REIT, which is big and should have decent trading volume

-          Leverage issue is solved. NRF was 70%+ levered but PF company has 50% debt/cap

-          Colony NorthStar will be internally managed, so the external management issue is solved

-          $120M of synergies which is almost exclusively from cutting executive compensation and therefore realizable on day 1 of closing. Colony and NorthStar have hinted that there could be incremental expense synergies, e.g. office rationalization, headcount reduction, etc.

-          PF company can generate superior returns to a comparable REIT because of its co-investment model

o   Typical REITs buy a property 50%/50% debt/equity and hope to earn a 10-15% IRR on their equity

o   Colony NorthStar’s plan is to fund the equity cheque with 20% company equity and 80% 3^rd party LP capital from funds that they are managing. In this way, the 3^rd party LP funds co-invest with management and the 10-15% IRR on Colony NorthStar’s equity cheque can be “turbo-charged” by the LP fees to yield something in the 15-25% range. The merger presentation has a slide that explains this

o   Importantly, this co-investment model is not easily replicable as most REITs do not have asset management platforms. Colony NorthStar’s asset management platform will have substantial size, scale and access to institutional capital through the Colony funds and NorthStar’s Townsend, and retail capital through NorthStar’s non-traded REITs. They could raise money via closed end funds, open ended funds, non-traded REIT capital, etc.

o   Additionally, Colony NorthStar’s asset management platform could separately raise 3^rd party LP tactical funds to take advantage of market opportunities outside of the REIT’s balance sheet investments. These funds would generate incremental fees in a relatively capital light manner, e.g. maybe the only capital commitment would be owning a slice of the equity in order to align interests with LPs

-          Thus, Colony Northstar is strategically advantaged compared to your average, run-of-the-mill REIT and the PF company will likely get to the high end of its $1.55-$1.75/share 2017 FFO guidance. Notably, they should find opportunities to grow beyond that base in 2018 and beyond

-          Today, Colony NorthStar trades at 8.5x FFO. This is crazy cheap; the worst REITs trade >9x. E.g. hotel REITs that are basically operating businesses with supply risk, macro risk, Air Bnb risk, etc. trade at 9x-12x FFO

-          Colony NorthStar will have >$1.3BN liquidity at deal closing as NRF is in the process of selling assets. This liquidity could move higher as CLNY has said that it’s looking to liquidate its RE debt/equity portfolio (which has $3BN of invested equity) over the next 2-3 years. The most obvious use of this liquidity is stock buybacks / debt pay down and management has clearly indicated that they will buy back stock as they feel that the Colony NorthStar shares are undervalued. NRF has been monetizing assets at a higher valuation than its NAV of ~$23/share

o   Importantly, there appears to be a change in the investment philosophy. The management of Colony and NorthStar previously acted like hedge funds, in that they would be happy to own cheap assets no matter how esoteric they were, and often these esoteric investments got low multiples in the market as they were hard to understand. Over the last few quarters, it appears as though this philosophy has changed and management wants to keep it simple, with a preference towards buying esoteric/cheap stuff in the 3^rd party LP funds. This is evidenced by a) NorthStar selling down its esoteric RE securities and PE fund interests and b) Colony looking to liquidate its esoteric RE debt/equity investments and Richard Saltzman highlighting on the Q3 call that they may prefer to make these investments in the 3^rd party LP funds

-          So Colony NorthStar is stupid cheap today and could easily trade at a double digit FFO multiple, and it should in theory trade at a higher multiple than a SOTP (based on comparable REITs) as the returns via the co-investment model will be superior to those of comparable REITs

-          Corporate governance has also been significantly enhanced

o   After the merger was announced, 3 NSAM shareholders (MSD, Abrams, Land and Buildings) came out and said that they would vote against the deal

o   In mid-October, CLNY NRF NSAM put out a press release where they addressed several shareholders concerns and enhanced the corporate governance significantly. The press release was also issued jointly with MSD who said that they would vote in favor of the deal. A few days later, Land and Buildings also said that they would vote for the deal

§  Board has been reduced from 13 to 10 members, 5 from Colony and 5 from Northstar. 2 of the NorthStar members are newly elected, independent members

§  Board stands for election annually, shareholders have more rights. Hamamoto is out if he sells > 50% of the stock he owns when the deal closes

§  NSAM had a change of control payment (payable in stock) whose price would have been set as the 5 day VWAP post deal-close. This appeared to create an incentive for management to keep the stock price low going into the closing of the deal, but there’s now a $15/share floor. So price is now set at the max of a) the 5-day VWAP post deal-close or b) $15/share

-          The stocks have acted well since the Corporate Governance press release came out in mid Oct but Colony NorthStar is still crazy cheap. Additionally, MSD and Land and Buildings are on board, and there hasn’t been any major public dissent from CLNY or NRF shareholders, so it is pretty likely that the deal will go through

PF company negatives

-          The merger call was far from ideal given how complicated the deal was; management basically said they did not know what go-forward verticals were going to be, but things have gotten substantially better since then

o   Management has now communicated that the core verticals of Colony NorthStar are going to be

§  Light Industrial

§  Healthcare

§  Hospitality

§  Investment Management

o   The other RE equity and debt investments (which tend to have attractive returns but are more esoteric) will be monetized over the coming years. And as mentioned before, Colony NorthStar will not exit this business completely but rather look to do these opportunistic debt/equity investments via 3^rd party LP funds

o   This deal takes a step back in CLNY and NRF’s goals to simplify, but it takes a huge step forward in that it creates a diversified REIT with a world-class investment management platform with retail and institutional capital access. This is something that would have taken CLNY or NRF several years to achieve on their own

-          There was some initial confusion when the deal was announced / on the merger call as management did not give FFO guidance and did not do the best job in highlighting how cheap the PF company was, but this has now been cleared up

Conclusion

Colony NorthStar is a super cheap REIT, with substantial liquidity at deal close to buy back shares, deleverage, and deploy towards investments (if any are suitable to the core verticals). Over the coming quarters, you will see a rationalization of the portfolio, as the company strengthens the core and rotates out of the periphery/non-core. This will hopefully be enhanced by a pick-up in fundraising as the company looks to deploy more capital in a co-investment model; the evolution of Colony’s Light Industrial portfolio over the past couple of years provides a good playbook for their actions going forward. Lastly, you may see additional expense synergies from office rationalization and headcount reduction.

A conservative 11x FFO multiple on $1.70/share = $19/share (30% upside). You also get a >7% dividend.

The shareholder votes are in mid Dec, and the companies are targeting an early Jan close. At these levels we don’t see a lot of risk. Many of the issues that concerned each of CLNY, NSAM and NRF have been solved and the management team is intelligent and understands that it has a) a set of verticals to rationalize and b) a valuation discount to close.

Catalyst

Deal closes

Stock buy back / deleveraging 

Earnings

Additional asset sales / portfolio rationalization