Colony Credit Needs More Time To Reach Targets

• Target level of leverage and earnings now expected in 2H19
• Asset level performance is satisfactory with unlevered yields in line with expectations
• Portfolio return below peers due to lower yielding non core assets (real estate and Private equity) and low leverage
• The company remains under-owned (held by only 6 ETFs) and undervalued (12% discount to BVPS compared to average premium of 24% for peers)

Colony Credit Real Estate (CLNC) 2Q results (Press Release, Financial Supplement, 10Q, and conference call transcript) were satisfactory, but the company extended the time it expects will be needed to become fully invested.  The price appreciation potential is unchanged, but it may not be achieved until later in 2019.

CLNC remains significantly cheaper than peers based on book value:.

If CLNC successfully invests ts capital and earns returns inline with peers then shares should appreciate.  If CLNC is unable to grow its portfolio or earns below target returns then shares will stagnate.  This article will review developments since my last article Colony Northstar Credit: Underowned & Undervalued which provided a more detailed introduction to the company.  Topics:

• 2Q18 Operating Results
• Asset Level Returns
• Leverage
• Expense Ratio
• Ownership
• Problem Assets

2Q18 OPERATING RESULTS

This was the first CLNC report with a full quarter of activity following the amalgamation that closed on 1/31/18.  First quarter results included the assets contributed by Colony Capital (CLNY) for three months, but the Northstar non-traded REITs for only two months.

Income Statement:

Interest Income stands out as a line that should have increased more in 2Q due to holding the Northstar assets for a full period.  A flat result is likely attributable to a loan placed on non-accrual as described in the conference call:

One example of this [investment recapitalization] includes the potential modification and/or restructuring of $261 million unlevered first mortgage and mezzanine investment secured by Ney York City Hotel, which is now on non-accrual status and negatively impacting CLNC’s quarterly core earnings by approximately $0.03 per share [$5mm]. Ultimately, we believe this asset performance will improve as the New York City hospitality market emerges from recent oversupply issues. Through the first six months of this year, the asset is already seeing positive top and bottom line growth, and 2018 projected NOI has increased approximately 70% from the beginning of the year.

The 10Q included this description:

In March 2018, the borrower on the Company’s four NY hospitality loans with an unpaid principal balance of $260.2 million failed to make its interest payment. The Company has placed the loans on non-accrual status and has commenced discussions with the borrower to resolve the matter. Interest income is recognized on a cash basis. No provision for loan loss was recorded during the three and six months ended June 30, 2018 as the Company believes sufficient collateral value exists to cover the outstanding loan balances. During the three months ended June 30, 2018, the Company received and recognized $1.0 million in interest income on the loans. These discussions typically include numerous points of negotiation as the Company and the borrower work towards a settlement or other alternative resolution, which can impact the potential for loan repayment or receipt of collateral.

Core EPS of $0.31 fell short of the quarterly dividend of $0.435, but restructuring the hotel loan could bring back $0.03 in EPS and the company mentioned in the conference call that investments closed since quarter-end will add approximately $0.05/share going forward.

Balance Sheet:

Loan growth of $263mm reflects $460mm of new funding partially offset by repayments.  The company probably needs to add $3Bn of assets in order to reach targeted levels of leverage and potential returns.  The earnings press release disclosed that $855mm of new investments were allocated since 6/30, but the company did not mention how much of this was offset by sale and maturity of existing assets.

ASSET LEVEL RETURNS

CLNC’s presentation provides this guideline for targeted returns:

Leverage is below optimal levels, but 2q results show that unlevered yields are generally in line with expectations.

Loans: The 2Q18 financial supplement shows average unlevered yields of 6.4% from senior loans and 9.6% from mezzanine/preferred.

CMBS:   Yields averaged 8.0% on the portfolio held at 6/30.  The investment grade securities can be leveraged.  The non-rated securities should produce double digit unleveraged total returns.

Net Lease Real Estate:  Annualized NOI of $43.4mm provides an unlevered 6.3% on undepreciated carrying value.

Non-core assets:  The “Other Real Estate Equity” has annualized NOI of $44.4mm which provides an unlevered 5.8% yield on undepreciated carrying value.  Sale of these office and multifamily assets will provide funds for rising holdings of loans, CMBS and Net Lease Real Estate.

Private Equity interests provided a 2Q cash yield of 4.8% on carrying value which is 86% of NAV calculated by the General Partners.  The carrying value is based on market pricing of double-digit total returns so CLNC should realize some appreciation as these funds liquidate (1.2 year average remaining life).  Proceeds will be redeployed into loans, CMBS, and net lease real estate.

LEVERAGE

The modest net increase in CLNC’s portfolio during 2Q leaves it still significantly less levered than peers:

The company may need to add at least $3Bn in assets to reach comparable levels of leverage, risk, and returns.  If new assets are higher risk then they will carry below average leverage (similar to ARI).  If new assets are lower risk then returns will be boosted by higher leverage (similar to BXMT).   In the 1Q conference call CEO Kevin Traenkle suggested that pricing of new senior loans was more competitive leaving better opportunities in mezzanine and preferred.  However most of the company’s new assets this year have been senior loans and net lease real estate and the “Active Pipeline” described in the August investor presentation is mostly lower risk:

In the 1Q conference call  CFO Sujan Patel suggested that the company could reach its leverage target by the end of 2018, but that’s obviously not going to happen.  During the 2Q call CEO Kevin Traenkle responded to a question about dividend coverage by saying: “Plus or minus mid-2019 after we have fully deployed all the liquidity plus levered up the balance sheet the way that we want to get it levered up.”

The company has not taken advantage of its $300mm share repurchase authorization.  If the stock comes under pressure later in the year due to market weakness or tax loss selling from investors in the former Northstar REITs then it would be appropriate for the company to buy shares up to a threshold price of 15 or 20% below book value.  Many investors see share repurchase as a litmus test of corporate governance so even a modest buyback would help in attracting new shareholders.  Repurchase would also excuse management from having to make lame excuses like “good opportunities to put the capital to work” as CEO Kevin Traenkle said on the 1Q conference call.

EXPENSE RATIO

The first full quarter of operations suggests that CLNC may be able to operate more efficiently than peers.  2Q18 overhead was 2.4% of equity compared to 2.9% for ARI and 4.2% for BXMT.

OWNERSHIP

CLNC was admitted to the Russell 2000 index in June leading to purchase of shares by related ETFs, but the company is still under-owned relative to peers.  CLNC is still only covered by one research analyst and lags in attracting institutional investment.

PROBLEM ASSETS

A credit portfolio generating a yield of 11-13% requires active asset management and will inevitably have some loans that require restructuring.  In addition to the New York hotel backed loan mentioned above, the 10Q includes these references to problem assets:

This hotel is the Hilton Dallas Lincoln Centre:

Disclosures

The author is a shareholder of CLNC.  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 and other sources prior to making their own investment decisions.