- Colony Credit delivered a disappointing 2018 GAAP loss of $168mm (-$1.41/share) and non-GAAP “Core Earnings” of $86mm ($0.70/share)
- Share price has fallen to a wide 28% discount to book value while peers trade at an average premium of 19%
- Management commentary has been consistently overoptimistic
- Get it right or get out. If returns don’t improve in 2019 then sale of the company would be the best outcome for its public shareholders and its manager Colony Capital.
Colony Credit Real Estate (CLNC) could provide an extremely attractive shareholder return if the adverse impact of previously identified credit issues is fairly reflected in the financial statements.
CLNC remains significantly cheaper than peers based on book value
However those peer premiums have been earned through steady performance. CLNC failed to meet the expectations it provided for rising core earnings and failed to quickly address the known valuation issues in its portfolio. CLNC’s share price is likely to remain depressed until it delivers a reliable book value and earnings. If improvement is not evident within 6 months then the company is likely to attract the attention of activist investors as happened at its sister company Northstar Realty Europe (NRE) and its parent company Colony Capital (CLNY).
4Q18 Operating Results
Portfolio Review
Colony Credit 4Q operating results (press release, financial supplement, conference call transcript, and 10-K) were disappointing due to $154mm of impairments, loss provisions, and writeoffs. Aside from the limited number of troubled assets, CLNC’s returns have been held back by slower than expected deployment of capital into new assets.
Excluding the markdown of the private equity interests, loan loss provisions, and deferred taxes, “Core Earnings” would have been $0.33/share for 4Q and a weak 6% rate return on $21.81 of undepreciated book value per share. Last Spring CLNC indicated that it hoped to be fully invested and covering its dividend by year-end 2018. After 2Q18 earnings this goal was deferred to mid-2019. After 4Q18 earnings the goal has been deferred to the end of 2019.
CLNC remains less levered than peers. Unfortunately CLNC’s operating income did not really improve in the past 9 months despite adding $1.0Bn of debt.
Colony boasts that it allocated $2.2Bn of capital to new investments in 2018, but this was substantially offset by repayments, asset sales, and loss of income on impaired loans.
CLNC”s peers noted that 4Q18 financial market volatility led to a slowdown in industry activity rather than sharp change in transaction terms. Ladder Capital took advantage of these conditions by shifting capital from loans to acquisition of publicly traded CMBS at wide spreads. It’s disappointing that CLNC did not take similar action despite its claim to pursue a flexible investment strategy.
ASSET QUALITY
CLNC reported several impairments during 4Q18 and unfortunately showed new loans past due (CLNC 10-K):
Comparing 4Q18 losses and impairments with prior company commentary suggests that management was overly optimistic about resolution of its impaired assets:
NY hotel loans: It’s disappointing that CLNC took an additional 4Q charge after prior comments about the $258mm loan. Note that this is a senior loan interest so substantial recovery is certain.
Source: 1Q18 10-Q: No loss provision
“In March 2018, the borrower on the Company’s $260.2 million NY hospitality loan failed to make its interest payment. The Company has placed the loan on non-accrual status and has commenced discussions with the borrower to resolve the matter. No provision for loan loss was recorded during the three months ended March 31, 2018 as the Company believes sufficient collateral value exists to cover the outstanding loan balances.”
Source: 2Q18 conference call: No loss provision
Source: 3Q18 Conference Call: $35mm loss provision
Source: CLNC 2018 10-K: Additional $18.8mm loss provision
“During the fourth quarter of 2018, the borrower entered into a listing agreement with a real estate brokerage firm and as a result, the Company believes sale of the underlying collateral and repayment of the four loans from the sales proceeds is the most likely outcome. As such, the Company recorded an additional $18.8 million of provision for loan loss on the four NY hospitality loans in 2018 to reflect the estimated proceeds to be received from the borrower following the sale.”
Source: 4Q18 Conference Call: Continued optimism :)
As New York City hotel room additions are being absorbed, we continue to be optimistic on the New York City lodging market recovery and the ability to exit this recent credit impaired asset.
28 Property Package: It was disappointing that CLNC took a 4Q charge on this loan package after prior comments about the $137mm exposure. Note that this is a senior loan interest so substantial recovery is certain.
Source: CLNC 2Q18 10-Q: No provision:
“At June 30, 2018 and December 31, 2017, there was one mezzanine loan previously modified in a TDR with carrying value before allowance for loan losses of $28.6 million. The loan had been modified in 2015. The Company also has three other loans with a combined carrying value of $108.5 million that are cross-defaulted with the TDR loan to the same borrower. Two loans matured in November 2017 and were in default at both June 30, 2018 and December 31, 2017, while the third loan remains current. All four loans are collateralized with 27 office, retail, multifamily and industrial properties with an estimated aggregate fair value of approximately $137.1 million. In February 2018, the borrower and the Company entered into a forebearance agreement to allow both parties to review the exit strategy. In May 2018, the Company extended the forbearance agreement, which now expires in September 2018. 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. No provision for loan loss was recorded at June 30, 2018 or December 31, 2017 on the two defaulted loans as the Company believes there is sufficient collateral value to cover the outstanding loan balances in aggregate.”
Source: CLNC 3Q18 10-Q: No provision
At September 30, 2018 and December 31, 2017, no provision for loan loss was recorded as the Company believes sufficient collateral value exists to cover the outstanding loan balances.
Source: CLNC 2018 10-K: $36.8mm provision
We commenced foreclosure proceedings under the mezzanine loan to take control of the 28 cross-collateralized properties, which was completed in January 2019. As such, we recorded a $31.7 million provision for loan loss on the four loans to reflect the estimated fair value of the collateral. We recorded an additional $5.1 million of provision for loan loss associated with a receivable for operating expenses paid by us on the borrower’s behalf during the year ended December 31, 2018.
Private Equity Interests: It was disappointing that CLNC took a 4Q writedown on these assets after prior comments, especially indications that they would naturally run off in a short time.
Source: CLNC 2Q18 10-Q: $5.6mm unrealized loss, 1.2 year average remaining life
“Our other non-core holding consists of our interest in real the private equity funds with the total carrying value of $241 million at quarter end. The weighted average life of this portfolio is approximately 1.2 years. And as these positions liquidated in the near-term, we plan to redeploy the excess liquidity into our higher yielding targeted asset classes. During the quarter, our PE interest contributed approximately $3 million to core earnings or at 4.8% yield on average carrying value, which was the below our expectations for the second quarter and was driven largely by timing delays and asset realization events in the underlying funds in which we own interest. Since the difference is largely timing related, we expect to make up the shortfall in later periods.”
Source: CLNC 3Q press release and Financial Supplement: $6.9mm additional unrealized loss, 1.4 year average remaining life, no commentary
Source: 4Q18 Conference Call: $35mm “adjustment”, no disclosure of expected life
“… non core holdings in real estate private equity fund had a total carrying value of $161 million at quarter end, net of the $35 million mark- to- market adjustment recognized during the quarter. Given our passive secondary interest in these funds and the volatility and timing of cash flows, we are now exploring sales and other strategic alternatives for these interests.”
“… the real estate private equity interests as you may know they don’t fit well into a public company. Their earnings are a little bit lumpy; they’re hard to predict. So we thought it was in the best interest just to kind of clean up some of the noise around the quarter-to-quarter kind of mark-to-markets that we’re seeing is just to sell the portfolio. And in fact, it is for sale right now. We’ve have a lot of interest. There are a number of parties that have been in the data room and yes we think it’s going to trade at a number that it will be acceptable to us.”
What next? Management’s overly optimistic past comments about these assets undermined confidence in the reliability of CLNC’s book value and was questioned by the company’s only brokerage analyst:
StephenLaws (Raymond James analyst)
“And I guess bigger picture on the whole portfolio. Q3 we had a New York hospitality and then some operating real estate took an impairment, and couple of issues in Q4. What kind of confidence do you guys have after reviewing the portfolio? The last three are really six months, the things are marked correctly especially with the new accelerated plan to address the non-core assets. So how do we think about the risk for additional write -downs from here on the existing portfolio?”
KevinTraenkle (CLNC CEO)
“Yes, no, so the risks are very low. We’ve gone through the portfolio pretty extensively kind of asset by asset, loan by loan. Our focus has been on a number of lower yielding assets that we have on the books. And we kind of just looked at the opportunity that we have to kind of increase the yield that those assets was redeploying the capital we can get if we sold them. And it came to the conclusion that it’s — better just to sell those and kind of redeploy that capital into our pipeline, which is very robust.
So we took a big long, hard look and everything in the portfolio and everything that we have, we’re generally happy with the yield that we’re getting. These handfuls of assets where we realized these impairments we did so and we thought it was in the best interest for a long-term kind of earnings and growth potential for the firm. The assets that we’re going to put up for sale and we are confident that we’ll be able to get very attractive prices likely kind of clear these trades in the coming months here. And kind of really focus on our pipeline going forward.”
Tom Barrack plainly stated on CLNY’s 4Q18 call that CLNC’s results “fell short of our expectations formed at the beginning of 2018 for CLNC’s first year of operations”. It will take time for CEO Kevin Traenkle and Colony Credit’s management team to earn the trust of investors after several quarters of unreliable outlooks and disappointing results. The company had seven analysts participating in its first conference call last May, but only one on the most recent call in February.
CORPORATE ISSUES (SHARE BUYBACK, COLONY CAPITAL, & POTENTIAL SALE)
Buyback: Colony Credit has not used any of its $300mm share repurchase authorization. Many investors see share repurchase as a litmus test of corporate governance and arithmetic competence. CEO Kevin Traenkle explained that the earnings accretion from making new investments at 12% yields is greater than from repurchasing shares. Colony Credit is not capital-constrained so I believe these options are not mutually exclusive. The company should be able to simultaneously invest in new high return assets, sell or resolve its low return assets, and retire shares when they trade at a large discount to NAV. Including share repurchase as part of the business strategy would restore some of the investor confidence which was undermined by poor 2018 performance.
Colony Capital: Colony Credit is tainted by the poor shareholder return of its manager Colony Capital (CLNY). The recent retirement of 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 recently signed a standstill agreement with activist investor Blackwells Capital requiring the formation of a Strategic Asset Review Committee of the Board of Directors:
“… the responsibilities of the Strategic Asset Review Committee include: (i) conducting a comprehensive review and evaluation of all of the Company’s assets, businesses and business configuration; (ii) assisting and advising on a long-term plan to optimize the Company’s assets, businesses, and business configuration; (iii) providing the Board with periodic updates summarizing its progress to date; and (iv) from time to time as it determines appropriate, making recommendations to the Board regarding actions to be considered in furtherance of the Strategic Asset Review Committee’s purpose. The Strategic Asset Review Committee will be empowered to hire additional advisors, as necessary, to assist in its review.”
The Committee is very likely to evaluate strategies for maximizing the value of CLNY’s interest in CLNC through improved portfolio returns or sale of CLNY’s 48mm shares and the management contract.
Potential Sale of CLNC: My prior CLNC article stated:
“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.”
CLNC delivered uniquely poor results for 2018. If CEO Kevin Traenkle is not able to deliver significant improvements in coming months then it would be best for all parties if CLNC were sold. A peer company such as ARI or BXMT could accretively acquire CLNC by paying 100% of CLNC’s book value using its own shares currently valued at a premium to book. The external manager of the peer company could acquire the CLNC management contract from CLNY. Benefits:
- CLNC shareholders would receive fair value for their shares, a significant premium to the current depressed market price, and the opportunity to continue as shareholders of a company with a long-term record of value creation.
- Colony Capital would receive publicly traded shares worth approximately $1.05Bn that could be sold over time to strengthen its balance sheet and deploy to new opportunities. Colony Capital could sell the CLNC management contract for approximately $280-420mm (based on 10-15% of equity).
If Colony Credit is unable to deliver improved performance in 2019 and reduce the discount of its share price to book value then it is likely to come under pressure from activist investors just as Colony Capital and Northstar Realty Europe did. In the case of NRE, Colony Capital accepted a reduced termination payment that provided a fair outcome to all parties.
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 CLNC portfolio should generate Core EPS of about $2.20/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.
Activism: Colony Credit has not provided steady performance for shareholders. Investors in CLNC should understand that disappointments and blunders may continue, but that internal and potential external pressures should force the elimination of the discount to book value.
Prior Comments: My 12/24/18 article Colony Credit: Satisfactory Progress & Bargain Valuation was wrong to assume that portfolio problems had been adequately addressed. The slight rise in the share price since then is a disappointing result, but the low 12/24 price provided investors with sufficient margin of safety to avoid losses.
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.
Koneko Research 