By John Sheehy :
After the recently announced 4Q17 results and conference call Colony NorthStar ( CLNS ) looks like a dog's breakfast instead of the promised " World Class Platform ". The company is unenthusiastic about its underperforming Healthcare, Hospitality, and Credit assets. The company is not attracting nearly enough managed assets to deliver the promised " turbocharged economics ". Disappointing results, disappointing outlook, and an unclear strategy are fairly reflected in a sharply lower share price. It's hard to imagine any catalyst for a quick rebound, but the company can deliver incremental progress by improving the performance of the listed units NorthStar Realty Europe ( NRE ) and Colony NorthStar Credit Real Estate ( CLNC ) and articulating its strategic plan, whatever that is.
Merger Math 2 + 2 + 2 = 3
Prior to the merger, the three partners each had a market cap of about $2Bn. After the merger, the combined company has a market cap of about $3Bn.
The company suggested in June 2016 : " Current valuation spread between Colony NorthStar and its peers implies upside potential through multiple expansion "
At a current share price of $6 and projected 2018 "net cash flow" of $0.44, Colony NorthStar's valuation has risen to a peer average of about 14X FFO. The stock price fell 50% and FFO fell 75%.
The company missed every target for 2017 by reporting "Core FFO" of only $1.16 and providing guidance for 2018 "net cash flow, excluding gains" of only $0.44. CFO Darren Tangen explained in the conference call (note that the transcript on Seeking Alpha has many errors - the audio version is here ):
Guidance at the time of the merger announcement was 2017 Core FFO of $1.55-$1.75/share ( source ). This was reduced to $1.40-1.58/share shortly after the closing of the merger ( source ). The merger proxy statement included these Standalone Projections for what CLNY, NSAM, and NRF would each have earned if they continued to operate independently:
The enormous magnitude of the shortfall vs. 2018 standalone projections makes management's explanation seem inadequate.
If the merger did not destroy value, then it seems likely that the value of one or more of the merger parties was greatly overstated. While it's plausible that NorthStar was a disaster, the 2018 projection is even far below what Colony was expected to earn on its own.
Most of NorthStar Will Not be Retained
Colony's business plan is to focus on "Core Strategic Verticals" where management is confident in both fundamentals and its ability to raise third-party capital. These include Industrial, Digital Infrastructure, and Europe. That leaves nearly all of the assets acquired from NorthStar, such as its large Healthcare and Hospitality portfolios, in the Discard pile. And it's discouraging that such a small portion of Colony NorthStar's assets are currently deployed in areas which management considers to be attractive as shown on this chart from the November investor presentation with added Koneko notes.
Management has not offered any detailed explanation for why it decided not to retain Healthcare (described in November as a "Core Strategic Vertical") and Hospitality (described in November as a "Potential Strategic Vertical"):
Aside from NRE and NRF, NorthStar Asset Management's contributions to the merger were the Townsend institutional business (which has already been sold at no gain/loss) and the NorthStar Securities retail distribution channel for non-traded REITs. Two of the existing NorthStar non-traded REITs were merged into CLNC and NorthStar Healthcare Income continues to manage a $3Bn portfolio. However, the conference call explained that retail distribution volume fell to $137mm in 2017 from "past levels in excess of $1Bn per year" and is anticipated to be zero in 2018. The 10-K contains a disclosure (page F-49) that the NorthStar broker-dealer was classified as "held for sale" at 12/31/17. Colony NorthStar announced a new acquisition of a retail distribution business, S2K Financial, and explained on the conference call:
" if there's a group that's going to be able to figure it out they're at the front of the class ".
Planned disposal of most of the acquired NorthStar assets and businesses draws attention to the large balance of NorthStar-related goodwill on the 12/31/17 balance sheet .
After the impairments and dispositions recorded in 2017, the remaining NorthStar-related balance of $854mm is probably overvalued by about $854mm.
Net intangible assets look less problematic with the exception of the NorthStar Asset Management trade name, which is being carried at a value of $77mm. Positive $77mm.
This team of overpaid former all-stars is looking like the Brooklyn Nets. They spent an enormous amount of money to end up in last place.
The company needs to deliver improved returns for shareholders of NRE and CLNC
Management highlighted the role of "permanent capital vehicles" in its new strategy. NRE and CLNC will pay substantial and predictable annual fees that deserve a high valuation multiple (15-20X), and these fees could grow over time through secondary offerings and acquisitions paid for in shares.
This October 2016 article about NRE compared its expense level unfavorably with Dream Global ( DUNDF ). Since then, Dream Global has increased its net assets by C$829mm, while NRE net assets declined by $30mm. Dream Global now trades at about a 4% premium to NAV while NRE trades at over a 40% discount. Colony has identified Europe as a "Core" vertical with attractive fundamentals so it would be enormously beneficial if NRE were trading at a level where it could raise and invest new capital accretively. The new management contract eliminates the most onerous and unusual terms of the prior NorthStar agreement. NRE's 3Q17 conference call described significant cost reduction measures. NRE is likely to continue trading at a discount to peers while its expense level remains high, but it appears to be moving in the right direction.
The formation of CLNC is described in its January investor presentation. The company merged two NorthStar private REITs with a portfolio of credit-related assets held by CLNS. The benefits of this transaction are:
- NorthStar Real Estate Income I and II shareholders now have a larger more diverse asset base, lower operating costs, and a liquid investment with appreciation potential.
- Colony NorthStar satisfies the goal (but not the obligation) described to the non-traded REIT investors of arranging a "liquidity event". A portion of CLNS complex "Opportunistic Debt" investments will now be held in a vehicle providing increased transparency into their valuation. CLNC is established as a captive permanent source of management fees that can grow over time.
The immediate problem with CLNC is that former shareholders of the non-traded REITs see a significant decline in the quoted value of their investment. There has not been any explanation for the loss of book value between the "estimated book value" as of 3/31/17 disclosed in the merger proxy and the actual book value of CLNC shares received (based on an exchange ratio calculated in January 2018). CLNS cited " impairments and lower returns in our residual real estate private equity secondaries and CDO securities portfolios" as one of the reasons for lower 4Q17 earnings. It's possible that the same factors led to losses at the NorthStar REITs after 3/31/17.
If CLNC trades at a 10-20% premium to book value like peers (Starwood Property Trust ( STWD ), Blackstone Mortgage Trust ( BXMT ), Apollo Commercial Real Estate Finance ( ARI )), then it will be a favorable outcome for the NorthStar Real Estate investors and set the stage for profitable future growth. But the company has not yet offered compelling arguments to bring new investors to CLNC and close the valuation gap.
The strategy described by the company will take many years to implement
Analysts on the conference call received disappointingly soft answers to some hard questions about the company's strategy:
Discarding most of the acquired NorthStar assets creates uncertainty over the designation of "Core" business lines:
- Why did the company acquire NorthStar if all of its business units are now deemed unattractive?
- The "Core" business lines like Industrial and Digital where Colony wants to invest currently trade at high valuations. The Non-Core business lines like Hospitality and Healthcare that Colony wants to divest trade at low valuations. Is a huge turnover of the company's portfolio the best way to maximize asset value?
- Capital earns a high return when it is scarce. There's no doubt that it's easier to find third party capital for a popular sector like digital infrastructure, but are there contrarian opportunities to maximize value over time in out of favor sectors like hospitality?
- How did Colony decide which assets/sectors to retain and which to divest? Opportunistic Equity and Debt is "Non-Core", but what does that mean for CLNC? Hospitality is "Non-Core", but what does that mean for the recent news about the acquisition of AccorInvest ? And what about the Debt-to-equity conversion of the THL Hotel Portfolio ?
Discarding the acquired NorthStar assets and distribution channels greatly extends the time that would be required to complete the transformation of the business plan. It might take 3-5 years to attract $20Bn of third party capital alongside $10Bn of balance sheet investments. But if "Core" assets are currently less than $2Bn (Industrial and several small pieces), then it might take 5-10 years to invest $8Bn in new verticals and attract $20Bn of partner capital.
What is it Worth?
With guidance of weak profitability and uncertainty about the corporate strategy, the most optimistic outlook is that CLNS is worth book value adjusted to exclude NorthStar-related goodwill and intangible assets.
Successful transformation to a co-investment business model would provide independent valuation of the different business units (sometimes referred to as "Verticals" and sometimes referred to as "Spaces"). For example, analysts value BAM based on the sum of the market values of its stakes in its listed units. Colony NorthStar's stakes in NRE and CLNC represent only about $1Bn of the company's $24Bn in assets at 12/31, but their market valuation does provide a signal about the fair value of CLNS shares.
It would not make sense for CLNS to trade at NAV (equity value per share) while these units trade at a discount. But if these units appreciate to trade close to their own NAVs, then it would no longer make sense for CLNS to trade at a large discount.
Can It Bounce?
CLNS shares have fallen over 50% since 9/30/17 and were already down sharply year-to-date prior to the poor results and conference call. The stock is now trading at a large discount to equity value, but that makes sense while the return on equity is poor. If investors had confidence in the company's strategy to improve returns, then the share price would begin to reflect some optimism about the potential for success. When analyst Mitch Germain ( JMP ) suggested that investors would like a better understanding of the company's strategy, Colony CEO Richard Saltzman replied " Thank You ". "Thank you" is not a strategy.
Possible near-term catalysts for appreciation:
- NRE will announce 4Q17 results on 3/13 . It would be very positive if the company could provide an update about cost savings plans. Overhead expense (including equity comp) was a crippling 5% of NAV in 1H16, but down to about 4% in 3Q17. It would be great if expenses could drop to a run rate of 3% by the end of 2018. CLNS identified Europe as a Core area for future growth so improved performance at NRE could play a meaningful role in that expansion.
- CLNC will hold a results call before the end of March. It would be very positive if the company could move past the vague claims in its investor presentation (" world class expertise ") and provide tangible details about how it plans to deliver an attractive return to investors (investment strategy, capital appreciation potential, earnings guidance, dividend payout, and share repurchase). CLNC claims to have a "flexible and differentiated investment strategy" but has not explained what it is. An improved valuation for CLNC shares would establish it as a vehicle for future growth, deliver a satisfactory outcome for the former shareholders of the non-traded REITs, and provide insight into the fair value of CLNS itself.
- CLNS Strategy could be better explained at any time, but it's possible that the company itself is unsure, hence the initiation of an " iterative " consultation process with Morgan Stanley. It would be helpful if CLNS could issue press releases to draw investor attention to achievements like the infrastructure fund with Digital Bridge and the formation of a consortium for AccorInvest which shareholders read about in the media long before they are disclosed by the company.
- Share Repurchase would be highly accretive to asset value. Last year's $300mm buyback was executed at an average price of $12.82 which suggests that management did not grasp the scope of the company's problems. This year's $300mm buyback could be executed at a large discount to equity value per share and would enhance future earnings per share if the company is successful in raising its long-term returns.
- Insider Buying would signal that confidence in the company's prospects. The person most knowledgeable about NorthStar (ex-director David Hamamoto) was a significant seller of shares beginning in December. Did he know that NorthStar assets would lead to disappointing 4Q results? Colony's independent Directors made notable open market share purchases on 3/6/18.
Perception of CLNS is now so poor that a little good news could make a big difference. Analyst Jade Rahmani ((KBW)) even felt compelled to ask on the conference call whether to the company had " existential risk " (i.e. bankruptcy). Until the company begins producing some good news investor chatter will continue to be dominated by complaints about high management compensation and speculation about hidden problems at NorthStar.
The author is a shareholder of CLNS and NRE. The author does not make any recommendation regarding any investment in any company mentioned in this article. Investors are encouraged to check all of the key facts cited here from SEC filings prior to making their own investment decisions.
In preparation of this article, the author sent questions to CLNS Investor Relations representative, Lasse Glassen of ADDO Communications, but did not receive any response. CLNS mentioned in the 4Q17 conference call that it hoped to reduce expenses through elimination of outsourcing contracts. Perhaps cancellation of the contract with ADDO Communications is one case where internal management could save money and ensure better service.
If any company mentioned in this article can point out any factual errors in the text using public information as of 03/08/18, then corrections will be made as promptly as possible.
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