- Near-term earnings are a bit weaker than expected and it will take years to realize the expected benefits of the merger
- The stock trades at one of the lowest valuations in the sector because the balance sheet and income statement remain difficult to analyze
- The market may have overlooked the benefits of the recently announced formation of a Colony mortgage REIT
- Successful execution of the business plan would simplify the company and could raise fair value to $25/share in 3-5 years
Colony Northstar (CLNS) was formed through the merger of Colony Capital (CLNY), Northstar Realty Finance (NRF), and Northstar Asset Management (NSAM). Detailed descriptions of these companies and their merger were provided in prior articles. CLNS shares have been relatively weak recently because it may take several years to achieve the strategic goals of the merger and the company has avoided any bold guidance about future earnings, valuation, and dividends.
This uncertainty may create an opportunity for investors to profit from an assessment of whether the company is making progress in the right direction and what the company would be worth if it reached the intended destination. This article takes a relatively optimistic view, but readers should keep in mind the biggest risks are 1) the business transformation may not be successful, 2) it may take much longer than expected, and 3) it may not be rewarded with a higher share price.
Overview of Colony Northstar
- Market Cap of $7.1Bn makes it approximately the 29th largest REIT and a significant component of indices/ETFs
- Internal management (rather than paying fees to an external advisor)
- Detail of $22.5Bn of owned assets at 6/30/17 from CLNS presentation is shown below. The company intends to dispose of the gray slices:
- $40Bn of third party assets under management
- Strategic goals of growth in Assets Under Management (AUM), Industrial Real Estate, Real Estate for Technology Services, and Europe
- Well regarded Colony Capital management team. Colony was founded in 1990 by its Chairman Tom Barrack with funding from Robert Bass to acquire distressed S&L assets. Colony subsequently made large investments through new funds in Asia following the 1997 crisis and in the US after the 2008 crash. The company’s public company record following its September 2009 IPO was satisfactory with a total shareholder return (BVPS + dividends) of +54%.
- Diversification. The company is unusually diversified across sectors (office, hotel, healthcare, industrial) and capital types (owned property, lending and debt, and fund investments)
- Established asset management channels:
- Co-investment business model that will use third party capital to reduce risks and enhance returns. It will take time to extend this model across all the assets acquired through the merger.
- Large size provides access to attractive funding through many channels:
- Complexity – the company’s large size, diverse assets, and diverse funding channels make it very difficult to analyze. REIT investors award higher valuations to every type of simpler story:
All assets held by NRF and NSAM were recorded at their fair value at the time of the merger (January 2017). All assets held by Colony Capital prior to the merger were brought forward with no adjustment to carrying values, some of which are below fair market values. Mixing these sources together makes it very difficult to analyze CLNS on a Net Asset Value basis.
- Soft near-term earnings due to merger integration and business model transition. The company has deleveraged by selling non-core assets faster than it has invested sale proceeds. A lower balance of income earning assets has reduced near-term revenues.
- Goodwill of $1.8Bn was recorded after the fair value of all NRF/NSAM assets was assessed at the time of the merger. There would be a tax benefit from recording higher depreciable goodwill, but even if the true goodwill were somewhat lower the merger valuation still incorporated some optimism about the intangible value of the existing Northstar businesses. A current owner of CLNS shares must be confident that this value will be realized over time through synergies and new business opportunities created through the merger. Failure to deliver on such expectations would diminish potential returns for CLNS investors.
One thing partially balancing the goodwill is that the Colony Capital assets were not revalued at the time of the merger. Their higher fair value will be realized in coming years through rising earnings as indicated in the forecast of Colony Standalone Projections provided in the merger proxy:
Recent Actions demonstrate progress by CLNS in taking advantage of its strengths and addressing the weaknesses that have held back the valuation of CLNS shares:
- Mortgage REIT. Last month CLNS announced that it would contribute $1.8Bn of fixed income assets to a merger with two Northstar private REITs (see presentation) and then seek an initial public offering for the combined company within 9 months. This transaction will deliver significant benefits to CLNS:
- It will provide visibility into the fair value of complex assets. Instead of trying to figure out what these loans, CMBS, and private equity holdings are worth, CLNS investors will be able to simply look at the market price and reported Net Asset Value of the new listed company. Comparable REITs are currently trading at premiums to book value so the merger and IPO are likely to be successful unless there is a dramatic change in market conditions.
- It will deliver improved value to the current shareholders of the private REITs. The REITs currently pay management fees of 1.25% of invested assets. At approximately 1:1 debt:equity that equals 2.5% of equity. The private REITs pay additional fees related to any asset acquisitions or dispositions. The combined expense level made the private REITs poor investments. It was also nearly impossible for holders to sell, but Northstar provided a non-binding indication that a “liquidity event” of some kind would be sought 5-7 years after launch. The merger and listing would deliver on this promise while also shifting investors to a structure with better economic potential (industry standard management fee of 1.5% of equity). A positive outcome for shareholders of these two private REITs should enhance the long-term marketability of other non-traded retail companies managed by CLNS and the value of the distribution network.
- It will be a platform for increasing future AUM. Colony Credit will probably seek to raise $250mm – $500mm in new funds at the time of its IPO. For comparison KKR Real Estate Finance (KREF) raised $210mm in May and TPPG RE Finance (TRTX) raised $220mm in July. Colony Credit should be more attractive because it will begin with a large pool of seasoned cash-generating assets and will not have to work through a slow process of investing IPO proceeds. Over time Colony Credit will be able to grow through secondary offerings and acquisitions paid in shares. For example, outstanding shares of Apollo Commercial RE (ARI) grew from 10mm at its 2009 IPO to a current level of 105mm.
- CLNS retained assets after the spinoff will be more heavily weighted towards those real estate sectors (e.g. Industrial and Healthcare) that receive higher market valuation multiples.
- Stabilization of NRE. In December an activist investor disclosed ownership of 7% of NRE, demanded cancellation of the management agreement, and offered to acquire the company for $13/share (LINK). The management fees paid by NRE are excessive, but the gross amount was not a significant factor in the negotiation of the CLNY/NRF/NSAM merger. Colony believes that the commercial real estate cycle in Europe is 4-5 years behind the US and offers much more attractive investment opportunities. A successful and profitable NRE could be one vehicle through which CLNS takes advantage of these opportunities and there have been some positive developments in recent months:
- CLNS acquired the Bow Street stake at a price of $12.75/share and raised its holding to 9.0% through additional open market buys (LINK). This eliminated the threat of a proxy fight and loss of the NRE management contract, provides better alignment of interests between NRE shareholders and CLNS, and the acquisition was made at a 26% discount to NAV so CLNS has potential for appreciation in the value of its holding.
- NRE’s G&A expense has been reduced to 4.0% of net assets in 2Q17 from 5.0% a year earlier. NRE is likely to continue trading at discount to NAV until expenses can be brought closer to 2%
Colony Northstar’s CEO commented on NRE during the 2Q17 conference call:
- Share buyback. CLNS approved a $300mm share buyback plan in February (LINK) and the company purchased 12.9mm shares for $168mm in 1H17 (average cost of $12.99). The company’s CEO recently explained that execution was market sensitive and he suggested that a price of $13/share was “very attractive”.
Outlook and Potential Future Valuation
Successful execution of Colony Northstar’s business plan would generate higher earnings through increased fees on external AUM and deserve a higher valuation multiple due to decreased complexity and volatility. The company has cited Brookfield Asset Management (BAM) as a model. BAM assets under management grew from $71Bn at 12/31/06 to $250Bn at 12/31/16 and the company structured most of its own assets into independently listed entities (source: BAM presentation)
Despite the breadth of its assets, the public listings of individual business units allow investors to easily estimate the fair value of BAM shares. In contrast, it is currently very difficult for analysts and investors to calculate a Net Asset Value for CLNS. It will take years for Colony Northstar to execute a similar transformation, but a successful listing of Colony Credit would be an extremely positive step whose value may not have been sufficiently appreciated due to announcement during a slow week in the market.
CLNS earnings and asset value are difficult to forecast during the business model transformation, but successful execution could generate earnings and valuation as shown in the following table:
The estimate does not assume a large increase in FFO from the current year, but a shift towards more stable rents and management fees rather than interest and capital gains. This very simple estimate does not consider many factors such as dilution from equity compensation and accretion from share repurchase. Most importantly, the company has not yet proven that it can earn its suggested return from 14-23% in each sector targeted for long-term investment.
Considering the relatively low risk of CLNS due to high quality management and diverse assets/liabilities, I believe the stock price is attractive at the $13 level where the company has been buying shares. If the business transformation is successful then investors will earn a yield of 8% plus annual capital appreciation of 12-25% as the share price rises towards its $25 potential.
The author is a Colony Northstar shareholder and believes that greater public awareness of the facts in this article could be of benefit to himself and other public shareholders. Investors are encouraged to check all of the key facts cited here prior to making their own investment decisions.