Colony Capital Bottom Seekers – How Big Is The Cushion?

• Colony Capital has fallen 62% since the January 2017 Northstar merger
• The stock trades at 8 times forecast 2018 FFO, one of the lowest multiples in the sector
• Management has made slow progress at simplifying the business
• Tangible assets are worth about $0.3Bn less than carrying value, Healthcare overvaluation partially offset by Industrial and Hotels
• The company is aggressively repurchasing shares below their fair value of $10.24

Colony Capital (CLNY) shares have been a disaster by nearly every measure:

It’s a mess, but the share price has fallen far below the $10.24 fair value estimated in this article and it’s tempting to hope that a bottom has been found.

 

Unfortunately, the market is likely to continue discounting the shares due to disappointing news from the healthcare segment, excessive complexity, and lack of confidence in management.  Long-term investors may wish to accumulate at this valuation, but there is no catalyst to entice short-term investors.

CLNY trades at one the lowest multiples in the sector

Colony Capital trades below the multiples of each of its business segments (data from Nareit REITWatch July 2018):

 

Performance and valuation of Colony’s segments has been obscured by the diversified business model and substantial remaining “Other” exposure.

Management has made slow progress at simplifying the business

Successful execution of the promised “co-investment” business model would enhance returns with management fees, provide third-party validation of the value of CLNY segments, and improved visibility into their performance.  As an example, Brookfield Asset Management can be easily valued based on the sum of the retained stakes in its listed subsidiaries plus a multiple of the management fees paid to the parent company.  Each listed unit provides its own detailed public reporting and is covered by specialist analysts.

CLNY’s lack of progress has been disappointing.

• No Healthcare co-investments.  Northstar’s agreement (disclosed with 3Q16 earnings) to sell an 18% interest in its healthcare portfolio seemed highly promising, but nothing has happened since then.
• No Hospitality co-investments
• No sales through acquired Northstar investment management distribution channels.  The Townsend institutional business ended up being sold.  The retail business died.
• “Other Equity & Debt” remains the largest contributor to earnings.
• Unclear role for new businesses.  Despite promising to simplify the business and wind down “Other” and “opportunistic” investments, Colony has aggressively pursued high profile transactions such as the closed transaction with AccorInvest, possible acquisition of Abraaj funds, and abandoned attempt to acquire Weinstein & Co.  Such transactions might generate very attractive returns, but it’s unclear how these investments fit in the story that Colony described to shareholders.

The breadth and complexity of the business means that strengths, weaknesses, results, and outlook for the individual segments receive limited attention.  The company provides a lot of disclosure, but makes too little effort to guide investors towards an understanding of what is  meaningful.  Inability to update its investor presentation since November 2017 suggests that the company itself may not know what it is doing and where it is going.

Healthcare assets may be $1.0Bn overvalued, but industrial assets, hotel and other may be $0.7Bn undervalued

Colony Credit (CLNC) is the only segment with an independent listing that provides good visibility into operating results and asset value.  Third party “co-investment” in other segments has been through private structures which provide little disclosure.  Valuing the segments using peer FFO multiples suggests that the fair value of the Colony’s tangible assets is $0.3Bn below carrying value:

Healthcare: fair value of assets is $1.0Bn less than carrying value, property debts are in default, and lease restructurings may reduce triple-net lease NOI by 10%. 

• Colony’s largest healthcare exposure is Skilled Nursing Facilities (SNF) which are currently the weakest part of the industry with cap rates around 9%.  Cap rates for other segments are around 6-7%.

• Healthcare REITs trade at an average Price/FFO of 13.3, however the REITs with the largest SNF exposure have been trading at lower valuations (OHI 10.5. LTC 14.2, SBRA 8.7)
• Cap rates and FFO multiple both suggest that the fair value of the Colony’s share of the Healthcare assets is about $1.0Bn less than carrying value:

 

• Taikang Insurance Group’s $350mm purchase of an 18% stake in the Northstar healthcare properties (8k filed 01/25/17) at a 5.6% cap rate seemed to validate the “fair value” of these assets in accounting for the Colony merger which closed on 1/10/17.  From a financial perspective it now appears that Taikang overpaid, however it is developing a network of elder-care communities and services in China (see Taikang Community) and may see strategic benefits from the Northstar partnership.  I don’t think Colony has mentioned the partnership since the transaction closed.
• A substantial amount of Colony’s Healthcare segment debt matures in 2019 and will have to be refinanced (source: 1Q18 Supplement)

• A significant balance of healthcare debt was in default or not in compliance with covenants at 3/31/18:

• Colony mentioned in its 1Q18 conference call that it expects to negotiate some lease modifications.  Low coverage ratios suggest that over 50% of triple-net lease NOI is from underperforming properties and a reduction of 10% of NOI might be required to bring these leases to comfortable coverage ratios (keeping in mind that net lease operators need to retain some cash to cover maintenance).

• It’s likely that the properties with low coverage overlap with those out of compliance with debt covenants so those are two sides of the same problem.
• I did not study any individual Colony healthcare properties.  If they were premium assets then they might deserve above average valuations based on FFO and cap rates.  However the poor coverage ratios suggest that these are not premium assets.
• Within 10 years the current surplus of nursing home space will be filled with aging baby boomers and reimbursement rates will have to settle at levels to maintain current facilities and incentivize new construction.  A well capitalized operator could position itself to profit from that turnaround in the sector.  At this point Colony has not yet figured out what it wants to do.  CEO Richard Saltzman said in May: “I think what we’re going to do long-term is still a question mark”

Hotels: undervalued by about $0.2Bn, may provide some good news through asset sales and/or co-investment

Hotel REITs trade at an average Price/FFO of 10.8.  REITs with select and limited service properties similar to Colony trade at slightly below average valuations (Apple 10.3, RLJ 9.3,  Hersha 10.2, Summit 10.3)  Hotel occupancy and rents are currently benefiting from a strong economy.  The fair value of Colony’s hotel assets appears to be about $0.2Bn higher than the carrying value:

 

Colony CEO Richard Saltzman suggested in the 1Q18 conference call that several options are being considered for the hotel assets:

Industrial: undervalued by about $0.4Bn with steady growth from fundraising and property acquisition

Industrial property REITs trade at an average Price/FFO of 19.8.  The fair value of Colony’s assets appears to be about $0.4Bn higher than their carrying value which is historical cost (these assets were not revalued in the merger).

Other: possibly undervalued by about $0.1Bn (Albertsons)

Colony explained in its year-end conference call that the remaining potential for realizing gains (from sale of assets above carrying cost) had shrunk:

The Albertsons/Safeway investment is carried at $50mm.  The Northstar merger proxy disclosed that Colony held 8.45mm shares for which Evercore estimated a per share valuation range of $20-25.  The pending acquisition of Albertsons by Rite Aid has an effective exchange ratio of 10 shares of RAD for each share of Albertsons which implies that Colony’s stake is worth about $154mm (8.45mm shares x $18.30), or about $0.1Bn over carrying value.  The proxy vote for the acquisition will be held on August 9.  Seeking Alpha contributor Chris Lau does not like this deal.

There may be other undervalued holdings, but there’s not much detail available to provide a basis for estimation.

The company is aggressively repurchasing shares below their estimated fair value of $10.24

Writing off the Northstar related goodwill+intangibles and adjusting the segments to the fair values calculated above leaves $10.24 in value per share:

Colony announced a $300mm share repurchase plan with 4Q17 earnings on March 1 which was executed very aggressively and completed in less than 3 months.  A new $300mm plan was announced in May.  Execution of this plan would be hugely beneficial to shareholders:

How could I leave this behind?

Colony Capital shares appear to be significantly undervalued, but may remain so until the company demonstrates greater progress.  Negative factors include:

• Healthcare will deliver bad news from lease restructurings and debt refinancing.
• Fair value of each segment is unlikely to be recognized without greater visibility into segment performance.  CLNY shares are likely to continue trading well below a sum-of-the-parts value because valuation of the parts is too complex.
• Management has lost the confidence of investors.  It sounds disappointingly as though they treated Northstar like an abandoned storage locker where they could figure out what it held after they won the keys at auction.  This year’s share repurchases are highly accretive, but execution of last year’s share repurchases at an average price of $12.84 was a blunder.  CLNY’s 2018 proxy statement says: “The Compensation Committee determined that the payout percentage of target for the individual goals & objectives component was 80% for each of Messrs. Barrack and Saltzman and 90% for each of Messrs. Tangen and Traenkle“.  So that’s two A- and two B-.  Shareholders lost $3Bn and these guys still made the Honor Roll.
• Tax loss selling will weigh on shares later this year.
• Investors holding a taxable loss in CLNY may wish to switch exposure to Northstar Realty Europe (NRE) or Colony Credit (CLNC) which are attractively valued, have delivered better recent operating results, and have simpler investment theses.

Possible favorable factors that could provide an attractive return over a multi-year horizon:

• Stabilization of the Healthcare segment (following lease restructuring and debt refinancing)
• Continued growth of the Industrial segment and the new Digital segment.
• Beneficial outcome in Hotel segment (sale and/or co-investment)
• Recycling of capital from the “Other” segment into share repurchase and attractive new investments.
• Strong performance from the listed companies managed by Colony (CLNC and NRE)
• Vision and visibility.  Management needs to figure out where it is going and make it easier for investors to understand the value of the diverse business segments.

Disclosures:

At the time of publication the author is a shareholder of CLNC 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.

Segment valuations were rounded to hundred millions to reflect the imprecision of the valuation inputs.  A more precise number would not be more meaningful.

If any company mentioned in this article can point out any factual errors in the text using public information as of 07/24/18 then corrections will be made as promptly as possible.