Colony Credit: Satisfactory Progress & Bargain Valuation

• The company remains under-owned and undervalued (31% discount to BVPS compared to average premium of 8% for large cap peers)
• Earnings expected to cover dividend rate by 2H19
• Portfolio return currently below peers due to lower yielding non core assets (real estate and Private equity) and low leverage

Colony Credit Real Estate (CLNC) 3Q results (Press Release, Financial Supplement, 10Q, and conference call transcript) were depressed by previously identified credit issues but showed progress towards targeted earnings potential and leverage.  Successful execution of the company’s investment plan would provide investors an extremely attractive return from the current share price.

CLNC remains significantly cheaper than peers based on book value:

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 Credit Needs More Time To Reach Targets.  Topics:

• 3Q18 Operating Results
• Asset Quality
• Ownership
• Governance (Colony Capital and Share Buyback)
• Investment Considerations

3Q18 OPERATING RESULTS

Colony Credit 3Q results were disappointing due to $71mm of impairments and “Core Earnings” of $0.30/share substantially below the $0.435/share quarterly dividend payout.  Positive developments were deployment of capital into new assets and good credit performance aside from the few impaired assets which had been previously disclosed.

This was the second CLNC report with a full quarter of activity following the amalgamation that closed on 1/31/18.  1Q18 results included the assets contributed by Colony Capital (CLNY) for three months, but the Northstar non-traded REITs for only two months.

Excluding the markdown of the private equity interests “Core Earnings” would have been $0.35/share for 3Q or $0.37/share if we also exclude the jump in credit related transaction costs.  The earnings run-rate is improving.

During the 3Q18 conference call CEO Kevin Traenkle was asked about the increased allocation to Net Lease assets and he explained that they are appealing due to their long duration and potential for capital appreciation.  CLNC’s loan portfolio has a weighted average term of 2.3 years (up to 3.8 with extensions) while the Net Lease assets have an average remaining lease term of 9.5 years.  Increased allocation to these long duration assets could provide CLNC with stability and a risk profile that differentiates the company from ARI (weighted average portfolio maturity with extensions of 2.7 years) and BXMT (weighted average portfolio maturity with extensions of 4.0 years).

The modest net increase in CLNC’s portfolio during 3Q leaves it still significantly less levered than peers:

Colony’s portfolio will probably need to grow by at least $2Bn in order to reach return and risk levels comparable to peers.  CLNC says it has allocated over $2Bn year-to-date to new transactions, but this has been substantially offset by asset sales and loan repayments.  While excess capital is currently holding back earnings, it could end up being an advantage in the current volatile market conditions.

ASSET QUALITY

CLNC reported several impairments during 3Q18, but no additional assets became troubled. (Source CLNC 3Q18 10-Q):

The disclosure of “Impaired Loans” at 9/30 includes the $261mm NY hotel package and a $109mm package of loans “collateralized with 27 office, retail, multifamily and industrial properties with an estimated aggregate fair value of approximately $137.1 million.”  Aside from these only $31mm of other assets were deemed to be impaired.  (Source CLNC 3Q18 10-Q):

Overall credit performance for commercial real estate remains strong with low delinquency rates for CMBS and bank loans (see Mortgage Bankers Association Research for more):

Federal reserve data (LINK) shows the 30-day delinquency rate for bank loans backed by commercial real estate is at an all time low (data since 1991).   The decline in share prices of CLNC and peers over the past month appears to be more of a stock market phenomenon than a sign of any real estate credit crisis.  To the extent that lending markets are under pressure CLNC is well positioned with an underleveraged balance sheet and a recently increased credit facility.

OWNERSHIP

Institutional ownership of CLNC has been gradually rising, but is still below peers:

GOVERNANCE (COLONY CAPITAL & SHARE BUYBACK)

Colony Credit is tainted by the poor shareholder return of its manager Colony Capital (CLNY).  The recent retirement of the CLNY’s CEO and his replacement by Chairman Tom Barrack seems to have been accompanied by a more realistic and aggressive approach to addressing the problems resulting from the Northstar mergers (described in more detail on the CLNY 3Q18 conference call):

• CLNY Healthcare and Hospitality assets will be sold at every opportunity.  CLNY has apparently given up on the rationale for the Northstar merger that returns on these assets could be enhanced through addition of fee-paying co-investors.
• CLNY agreed to a $70mm termination payment for the Northstar Realty Europe (NRE) management contract.  It was challenging for NRE to deliver reasonable shareholder returns due to its small scale and high overhead on a portfolio of low-yielding prime quality assets.  As a result of the termination CLNY is likely to record an impairment of the intangible asset value associated with the contract.  Termination is a very favorable outcome for NRE shareholders who will receive fair value for their shares through liquidation or sale of the company and it’s a positive governance signal for public shareholders of CLNC.
• CLNY will be “getting away from the donkey end of these real estate assets”.  Nobody wants to be holding the donkey end – so that’s good I think.

Colony Credit has a significant $300mm share repurchase authorization, but did not buy any shares through 9/30.  CEO Kevin Traenkle explained in the 11/06/18 conference call:

Many investors see share repurchase as a litmus test of corporate governance so this vague answer was disappointing.  I don’t know what calculation was the basis for Kevin Traenkle’s statement, but it’s possible that he is correct.  Assuming that CLNC has “Core Earnings” equal to its annual dividend of $1.74/share and that CLNC realizes $100mm of cash (net of debt repayment) from sale of assets with an 8% ROE then EPS accretion from reinvestment at a 12% ROE is higher than from share repurchase at a 30% discount to NAV:

Share repurchase provides CLNC an opportunity to reinvest in its existing portfolio at a discount, however the return generated by the existing portfolio is sub-optimal due to non-core assets (Other Real Estate and Private Equity).

Nevertheless, I believe that it would be beneficial for the company to repurchase shares at current prices (>25% discount to NAV) for these reasons:

• Accretion from buyback is certain while higher earnings from new assets carry credit risk
• BOTH options are accretive and can be executed simultaneously.  CLNC is underleveraged and can realize significant proceeds from asset sales.  The company is far from fully invested.
• Investors will see repurchase as a positive governance signal.  An improved reputation would be beneficial to the company in the long-term.

CLNC shares showed some stability in December so it’s possible that the company is buying shares this month.

INVESTMENT CONSIDERATIONS

Dividends:  Colony Credit pays an above average dividend yield, but dividends transfer value rather create value so it is unwise for investors to use yield as a basis for security valuation.  A fully invested portfolio should generate Core EPS of about $2.30/year (a 10% return on book value) which would provide scope for a dividend increase.

Earnings:  Colony Credit is earning a below average return on book value.  If earnings rise to peer levels then shares should appreciate to a valuation in line with peers.  If Colony management is uniquely incompetent then earnings and valuation will remain low.

Shareholder Turnover:  Colony Credit was formed through merger of two non-traded Northstar REITs with assets contributed by Colony Capital.  The Northstar investors have seen a sharp decline in the stated value of their investment.  About 1/3 of the decline is due to revaluation of the Northstar assets in the merger and 2/3 from the currently discounted valuation of CLNC shares.  It’s very likely that these shareholders have been dumping their stock as we approach year-end.

Disclosures

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 and other sources prior to making their own investment decisions.

The author is not currently a shareholder of Colony Capital.  It is trading far below tangible book value, but still has to work through significant challenges in its healthcare portfolio because it is holding the donkey end.