|Shares Out. (in M):||536||P/E||0||0|
|Market Cap (in $M):||2,335||P/FCF||0||0|
|Net Debt (in $M):||5,682||EBIT||0||0|
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Colony Capital (CLNY) – VIC Writeup
Colony Capital (Ticker: CLNY; the “Company”) is a publicly traded REIT. The Company is an alternative investment manager that historically focused on traditional real estate but is undergoing a major transformation towards digital infrastructure assets – cell towers, data centers, fiber, small cells and DAS. Under new leadership, the Company is actively rotating out of its legacy assets and redeploying balance sheet capital into digital infrastructure investments, as well as raising third party capital in digital infrastructure focused private equity funds. Given the Company’s tainted history that stems from poor performance, bloated operations, subpar governance, a disastrous tri-party merger, and a Founder with a tarnished reputation, the stock had been left for dead. This transformation is only recently starting to catch investors’ attention, and despite the recent run from all-time lows, we believe CLNY represents a multi-bagger opportunity from here with numerous catalysts ahead that will help ensure value realization.
Founded in 1991 by Tom Barrack, Colony Capital primarily employed a real estate private equity model towards traditional real estate sectors – the focus was on hospitality assets, although several of the deals completed appear to have been Barrack’s “personal projects” that came with media attention. Over time, Colony expanded into other real estate verticals such as industrial buildings, healthcare/medical buildings, commercial, oil & gas, etc. The Company became a complex conglomerate of directly owned assets and real estate private equity funds. Over the past few decades, Barrack led Colony into one disaster after another, many of which are chronicled in a Harvard Business Review case study called “Colony Capital: Unbelievable.” It costs about $9 to download (link) and is well worth a read.
Colony Capital raised 15 funds in the 1990s through 2000s, but only 2 of them had performance in the top quartile of real estate private equity funds (per Preqin). Performance was mixed, driving Barrack to shift strategies somewhat and seek out alternative capital sources. In 2009, Colony launched a publicly traded distressed real estate debt REIT called Colony Financial (today known as Colony Credit, trading under ticker CLNC). The launch raised half as much capital as expected (Colony acts as its external manager earning a management fee stream). In 2015, Barrack decided to take Colony Capital, then a private holding company, public through a reverse merger with Colony Financial. Judging by the share performance following the merger, it did not live up to its promises as shares declined roughly 33% (excluding dividends) through the NorthStar tri-party merger.
In 2017, Tom Barrack decided to merge CLNY with two other publicly traded affiliated REITs, NorthStar Asset Management Group and NorthStar Realty Finance. These NorthStar companies were founded and led by David Hamamoto. They focused on real estate equity investing and primarily raised capital from retail investors through broker dealers with hefty upfront fees or “loads.” Despite poor shareholder returns, Hamamoto had become one of the top ten highest paid CEOs in the United States due to excessive fee generation driven by these questionable capital raising activities. After years of a declining share price, Hamamoto began discussions with Tom Barrack regarding a tri-party merger between the two main NorthStar public companies and Colony Capital. The discussions were complicated, and the parties agreed to use their publicly traded values (roughly equal at ~$2 billion each at the time) for the merger value. Despite Hamamoto overseeing two of the three companies, he agreed to let Tom Barrack become Chairman and CEO of the combined company. After speaking with several former employees, it became abundantly clear that the deal was driven by Barrack’s ego – he wanted to be “in the leagues of Blackstone and KKR” and was drawn by headline pro forma AUM figures while paying little attention to the assets’ underlying quality. Put another way, this was Hamamoto’s ticket out of a ticking time bomb.
The Colony / NorthStar merger, completed January 10, 2017, was advertised to produce several benefits, including: 1) create a larger and more scalable real estate investment firm, 2) expand holdings into hospitality and healthcare real estate (from NorthStar), 3) enhanced ability to raise capital across multiple sources: private and public, institutional and retail, and 4) reduce overall operating costs and offer an attractive dividend to shareholders. The merger was done hastily, and Colony appears to have failed to do proper diligence on the NorthStar assets. It likely didn’t help that Barrack effectively delegated negotiations to his underlings while his focus turned elsewhere, namely the world of politics. The planned synergies did not offset a substantial shortfall in earnings during the first year of the merger in 2017 and by November Hamamoto announced his resignation. It was later revealed that he had already begun selling significant amounts of stock on the open market prior to his departure. In 2018, Colony slashed its common dividend by 60% and announced a series of large impairments and write-downs. As you can probably guess, the stock had been soaring like the Hindenburg throughout this episode with nearly every sellside analyst covering the stock jumping ship.
Reeling from the disastrous NorthStar deal, Barrack realized he had to make a dramatic pivot in order to set the Company on the right trajectory and set his sights on digital infrastructure. Later in 2018 Colony Capital decided to partner with Digital Bridge Holdings, a real estate private equity firm co-founded by Marc Ganzi that focused on digital infrastructure. Colony and Digital Bridge decided to jointly market and launch the first of its kind digital infrastructure real estate private equity fund Digital Colony Partners I (“DCP I”). The original target of $3 billion was handily exceeded; DCP I closed in June 2019 at $4.1 billion.
Soon after, Colony Capital acquired Digital Bridge in July 2019 for $325 million and announced that Marc Ganzi would become CLNY CEO in 2021 with Tom Barrack stepping back into the Chairman role. The Company began a major transformation of exiting all legacy Colony businesses with a goal towards recycling its entire capital base into digital infrastructure by 2023. Following some pressure from activist firm Blackwells Capital, the Company accelerated its plans to install Marc Ganzi as CLNY CEO and appointed him to the role on July 1, 2020. Despite these changes, CLNY shares continued to decline dramatically in 1H 2020 as the COVID-19 pandemic hit Colony’s legacy assets hard which drove the Company into negative FFO territory and forced them to suspend the common dividend entirely. However, the Company has since returned to positive FFO, recapitalized the balance sheet (pushed corporate level maturities out to 2023) and monetized several legacy assets. The pathway for this transformation is now clear and largely rests on Ganzi & Co.’s execution.
Ganzi brings decades of operational and investment experience in the digital infrastructure space. Prior to co-founding Digital Bridge, he was the Founder and CEO of Global Tower Partners (GTP) which grew into the largest private cell tower company at the time, culminating in a sale to American Tower Corp. (AMT) in 2013 for $4.8 billion. He is joined by new CLNY CFO Jacky Wu who was previously at AMT as head of finance and M&A and was on the other side of the table of the GTP transaction. Ganzi and Wu have hit the ground running and we’ve been very impressed by the transformation’s speedy progress to date. In fact, ~50% of Colony’s $47 billion AUM is now digital infrastructure. With CLNY shares effectively “left for dead,” we believe there is ample downside protection at current levels which presents an incredible asymmetric risk/reward opportunity as this transformation unfolds.
Legacy Assets – Overview
Since the sale of its Hospitality portfolio in September 2020, Colony is left with four legacy segments: 1) Healthcare / Wellness Infrastructure, 2) Other Investment Management (which is essentially the management contract for CLNC), 3) a 36.4% equity stake in CLNC, and 4) Other Equity & Debt (OED) which is basically a hodgepodge of various real estate assets. The only things these legacy assets have in common is that they contribute to an overly complicated and bloated operating structure, they are non-core to the digital infrastructure strategy, and through the transformation underway they will all expected to be gone over the next year or so.
OED consists of nearly 60 disparate investments (~$1 billion net carrying value) of which the Company is monetizing at a pace of $100-200 million per quarter. Management expects several more dispositions by year end. The Company is actively shopping OED assets.
We believe the CLNC management contract and the equity stake in CLNC will likely be sold together. We suspect that closer to a $10/share CLNC share price plus a fair value for the management contract could get a deal done. The Company has hired Morgan Stanley to run the sale process.
Management believes the Healthcare / Wellness segment, which has been performing decently through the pandemic-driven downturn, will likely be sold in 1H 2021. This portfolio consists of senior housing, medical offices, skilled nursing facilities and hospitals.
As we witnessed with the Hospitality sale a couple months ago, any major monetization of legacy assets is a huge positive for the stock – it frees up capital (likely at a gain relative to heavily impaired book values) for digital infrastructure investment and further debt repayment. As those dollars are rotated into digital infrastructure, shareholder capital should be rewarded with a higher valuation multiple.
Colony Capital 2.0: Digital Colony
The digital infrastructure team within Colony Capital operates under the name Digital Colony – they are making it a clear distinction from the legacy mess that the Company is moving away from. By 2023, Colony Capital will effectively be Digital Colony, and we would not be surprised if an official name change took place. For now, this will be the only digital infrastructure REIT focused on the broader ecosystem, not just one-point solutions – as a CLNY shareholder, you’ll gain diversified exposure to the whole digital infrastructure space at an extremely attractive entry point relative to peers. Below is a snapshot of the Digital Colony portfolio as of Q3 2020:
Source: CLNY Investor Presentation
There are three main Digital segments: 1) Digital Investment Management, 2) Digital Operating, and 3) Digital Other.
Digital Investment Management is the digital infrastructure private equity business – the segment earns management and incentive fees (carried interest) from third-party capital raised in funds and co-invest vehicles. The key metric to observe here is FEEUM (fee-earning equity under management). Any announcement regarding a new fund launch or new co-invest capital raised is a step-function up for segment revenues as well as a disproportionate increase to profits due to scale. The segment reports fee-related earnings (FRE) which is comparable to other public alternative asset managers. The segment earns a blended ~1% management fee on FEEUM and we believe all Digital Colony fee-earning vehicles earn incentive fees of 15-20% on gains over an annual 6% hurdle (represents notable upside to CLNY shareholders if funds perform well). They are targeting “low teens to low 20s” IRRs in their funds. Again, this is all comparable to other large private equity firms. The Company launched DCP I last year and there are several rumors in the media that the second flagship fund, DCP II, is targeting $6-7 billion and aiming to launch in the coming months (DCP I is fully invested). There is also discussion of a credit fund and liquid funds (long-only and long/short) in the works. In the meantime, Colony has raised $2+ billion in FEEUM through co-invests in 2020 YTD, driving ~30% YTD growth in digital infrastructure FEEUM.
Importantly, in July 2020 the Digital Investment Management segment received a $250 million strategic investment from Kuwait’s Wafra for a 31.5% ownership stake – Wafra will help CLNY raise additional capital for future funds and has committed $150 million to future funds as a GP. SEC filings related to the Wafra deal disclose that Wafra’s future commitments will go towards DCP II and “the initial Digital Colony commingled fund making credit investments relating to Digital Infrastructure.” This, along with the hiring of dedicated digital infrastructure credit investment team, is largely why we believe those two funds are very much on the way.
Digital Operating represents balance sheet investments in digital infrastructure. Two of their largest balance sheet investments are Databank (data centers) and Vantage Stabilized Data Centers. The segment earns revenue from property operating income and reports Adj. EBITDA and Core FFO. Key metrics to observe are multiples paid for new balance sheet acquisitions, Adj. EBITDA and/or Core FFO. Earnings will grow organically at the portfolio companies as well as due to new acquisitions.
Digital Other consists of Colony’s balance sheet investments in Digital Colony investment vehicles, such as its GP stake in DCP I. The Company reports net carrying value every quarter.
As the company sheds its legacy assets and grows Digital Colony, it will right-size the cost structure tremendously. We have spoken with CFO Jacky Wu for several hours and strongly believe he is very well-aligned with shareholders with an intense focus on efficiency and ROIC. Colony has about 380 employees today and this will reduce to ~180 net of hiring on the digital side. The Company had ~20 offices globally – this will shrink to ~5. The corporate jet will be off the books soon (if not already). And many back-office employees will be relocated out of high-cost cities (New York City, Los Angeles) to Boca Raton, Florida. Back office functions altogether will be dramatically simplified as we will no longer be dealing with complicated portfolios of legacy assets (OED in particular). For example, the sale of the Hospitality portfolio will unlock $7 million in G&A savings. Their G&A reduction goal for 2020 was originally $40 million which they’ve already exceeded (as of Q3 2020) and have increased the goal to $60 million. Over the next 2 years we believe there’s another $60-80 million of G&A savings to realize as they complete the pivot to 100% digital. This will be meaningful in helping the Company re-initiate the common dividend (we expect an update on the Q4 2020 earnings call) and achieve its 2023E long-term financial targets detailed below:
Note: Quarterly figures are annualized
Source: CLNY Investor Presentation
The above 2023 targets assume a 100% rotation to digital infrastructure and exclude any value stemming from Digital Other. They also exclude any upside from carried interest, which could be substantial. By 2023 about ~35% of the Company will be Digital Investment Management and ~65% Digital Operating. Upon completion of the transformation, total revenue growth should exceed 10% p.a. and EBITDA growth should exceed 20% p.a. Lastly, on a Consolidated Core FFO basis, the 2023 target range is $200-275 million. These goals are largely dependent on the pacing and magnitude of capital raising and deployment, completing the monetization of legacy Colony assets, and continued organic growth of directly owned assets on the balance sheet.
Digital Infrastructure – Industry Overview and Digital Colony’s Differentiation
There is a plethora of information available through public peers’ investor presentations as well as sellside research (initiation reports and industry pieces). We suggest you look at any of these for key public peers (in addition to Colony’s own investor materials):
Towers: AMT, SBAC and CCI
Data centers: DLR, EQIX, QTS, CONE, COR and SWCH
Fiber: UNIT, LUMN, CCI, ZAYO (acquired by CLNY), CBB (acquired by Macquarie)
Small Cells / DAS: WIFI, CCI
In a nutshell, we believe digital infrastructure represents one of the best, if not THE best, real estate sectors to invest in. There is a reason why digital infrastructure equity REITs have outperformed the broader market and REIT index for the past several years and trade at significantly higher multiples. The digital infrastructure industry has very strong underlying tailwinds, driven by an ever-increasing demand for internet bandwidth and connectivity across various types of wired and wireless environments. Network capacity is mission critical and demand is growing rapidly, yet underlying infrastructure remains insufficient around the world. This in turn sets the stage for long-term, high organic growth in the space. The COVID-19 crisis and advent of 5G digital infrastructure investment will continue to accelerate these major secular trends within a $240 billion TAM (per CLNY Investor Presentation). These real estate assets garner a high-quality tenant base consisting of the largest technology companies, service providers, governments, and other highly successful enterprises under long-term multi-year contracts (5-20+ years) which provide for strong recurring revenues and very attractive margins. The opportunity for digital infrastructure is a global one, whereas most large public digital infrastructure companies to date have mainly focused on the U.S. In other words, we are arguably “just getting started” on a global scale.
Colony’s development and go-to-market strategy is predicated on two emerging themes: 1) the “Edge” and 2) converged solutions. The “Edge” is a broadly used term that is generally used to describe the migration of information and processing closer to end users, typically to provide lower latency and support a range of applications from autonomous vehicles to artificial intelligence to robotic surgery. The “Edge” essentially resides in digital infrastructure in secondary markets. The key driver for the interest in Edge deployments is targeted latency – the amount of time it takes for a user to retrieve data from the source – of 10 milliseconds (ms) compared to LTE’s average latency of 50 to 100 ms. Colony’s portfolio company Databank, which is the largest private “Edge” datacenter player in the US today, estimates its latency to be 3 to 5 ms within a 10-mile radius of its data centers with limited need to develop additional “micro” deployments to deliver targeted latency within its current markets. You will hear Ganzi talk a lot about the “Edge” at public conferences over the past year, and you will now start to hear other public peers begin their foray in this area. Today less than 1% of workloads are processed at the “Edge,” and we believe this figure rises to 10% of total global workloads in the next 5 to 7 years.
Source: CLNY Investor Presentation
Traditionally a customer (e.g., Verizon) would have to deal with multiple vendors for each point solution (data center, tower, fiber, small cell, etc.). Colony’s portfolio strategy of playing across the entire digital infrastructure ecosystem will serve as a significant differentiator versus other peers that are just a point solution. Colony portfolio companies will work together to provide a holistic hyper-converged architecture that will act as a differentiated “one-stop shop” to the world’s largest operators.
As networks move towards denser models, network deployments will consist of multiple layers. Traditional macro cell towers provide a blanket of coverage, while underneath this “umbrella” a combination of other technologies is deployed to increase network capacity, particularly in dense urban areas. As fixed and mobile devices become more technologically advanced and able to handle data transfer over an increasing number of technologies, consumers will enjoy faster coverage and higher capacities (less network congestion) as device connectivity can easily switch from antenna to antenna (i.e., DAS to Wi-Fi to small cell to macro tower) to consistently ensure the highest quality experience. These various layers working together represent a new “hyper-converged” network approach towards delivering data signal for various services used by mobile devices, all of which are underpinned by fiber connectivity.
CLNY management is already approaching large customers as a unified portfolio of solutions. One example of strategic partnership within the portfolio is their investment in a “micro” data center company called Edge Presence which partnered with Vertical Bridge, Colony’s largest cell tower portfolio company. This company places very small, modular data centers (like a shipping container) at the base of cell towers – the two will share backend infrastructure (fiber, power, etc.) and can be offered to customers as a unified solution. This partnership also enables the deployment of data centers in additional “Edge” locations. Given that Vertical Bridge is the largest private cell tower company in the country with ~20,000 towers, there is a strong and unique growth opportunity that Colony can capture. This is merely one example of how Colony’s portfolio strategy will enable a differentiated go-to-market approach as a holistic converged solutions provider.
Management is also busy getting all their portfolio companies to optimize their business needs with one another. Data centers, cell towers and small cells all need fiber – all those portfolio companies should begin procuring fiber from Zayo. The Zayo fiber business is the glue that holds the entire ecosystem together. Most people don’t realize that wireless connectivity depends on vast quantities of fiber nearby as the wireless portion of the transmission is only the last part of the journey for information consumed over wireless networks. Zayo has 13 million fiber miles covering 133,000 routes. This sounds impressive, but every fiber company has big fiber mile numbers. The real secret here is the metro buildouts that Zayo has been undertaking for years. Zayo has the most extensive dense metro fiber builds across key cities in U.S., Canada, and Western Europe. This can be seen in numbers when you unpack the 13 million fiber miles – 9 million of the miles are in metro areas and there are over 35k buildings and 18k small cell and macro towers directly connected on the network. Zayo is a top five player in 24 of the top 30 MSAs. Zayo also offers direct connections to 370 cloud destinations and data centers around the world (AWS, Azure, Google, and Oracle).
Another example is the Vertical Bridge / Edge Presence strategic partnership detailed earlier. There is also plenty of synergy to be had between cell towers and small cells. This “portfolio synergy” strategy will juice returns as it drives instant revenue with virtually no sales expense. It is a very similar strategy that Vista Equity implements in their portfolios by having all their software companies buy software from one another. It works extremely well.