|Shares Out. (in M):||20||P/E||0.0x||0.0x|
|Market Cap (in $M):||177||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||22||EBIT||0||0|
[Table: Financial Results]
Resource America is an alternative asset manager that focuses predominantly in two segments: real estate management and financial fund management (primarily credit assets). The Company has been growing assets under management ("AUM") at rates between 7-12% over the past three years. Trading at ~12x LTM (and normalized) EBITDA and 8-9% FCF yield, we think the Company is modestly priced given the potential to grow earnings 20%+ (FCF yield >11% on FY2014). Based on our conversations with management as well as our analysis of historical margins, we believe REXI has great leverage in its platforms, with new asset contributing ~50% incremental fee margins. The current opportunity stems from non-cash receivable charge-offs in the Commercial segment of the business, which has depressed reported earnings, and which is running off. In FY2013, the Commercial segment reported $10.7 million in run off provisions. The Commercial segment has eclipsed all the real progress made in real estate and financial funds in the past couple years. We believe shares could re-rate once these charges run off, and the leverage of the business flows begins to materialize in the reported earnings.
Resource America makes money primarily from asset management fees (around ~2% for real estate and ~.45% for credit assets), and hence revenue is largely driven by assets under management. While the business appears simple, it is quite complex given the myriad assets REXI manages. In a continued recovery scenario in the U.S. (a muck-along like 2012, 2013), we believe Resource America should be able to raise assets in line with FY2013 and double its EBITDA over the next 3 or 4 years. We acknowledge that a "double" requires putting faith on macroeconomic growth, but we think the downside is somewhat protected by a sticky asset base with "floor" fees in real estate, and with management fees in CLOs that "have never been impacted, even in 2009" (per conversations w/ management). Hence, while we can be quite certain AUM would not increase much if at all in another financial crises, the 8-9% FCF yield seems modestly stable barring a global collapse. In addition, real estate continues to be the primary revenue driver for the business, and there seems to be more room for recovery there than in certain other assets (say, bonds or equities).
Another positive is the shareholder base. The business is closely held with executives owning 27% of shares, mostly by the CEO and the former CEO (now chairman, related). Other shareholders of note include Leon Cooperman (11.9%), William Martin (10.5%), Donald Yacktman (7.9%) and Dimensional Fund Advisors (6.0%).
Back of the Envelope
If we "model" (as loosely used as possible) EBITDA increases of ~$5 million a year for each of the next 3 years, we will exit 2016 at roughly $30 million in EBITDA. Fully taxed, our cash net income may be around $20 million. Management has told us that they will pay no taxes in 2014, "probably none" in 2015, and may begin to start paying taxes in 2016. We will assume tax rates spike from 0% to 35% in 2016.
At 12x - 15x P/E (I believe this to be reasonable, given the FCF yield nature of the business, as well as its growth potential), REXI would be valued at $240 to $300 million, representing 35-70% upside. In addition, we will build cash in interim - ~$15-20 million in 2014, $20-25 million in 2015, and ~$20 million (fully taxed) in 2016. This $65 million represents another ~37% on the current market cap, for cumulative returns of 68-107%. I acknowledge this is a bit of funny math, but the general idea is: cash earnings will increase, multiple should expand as the business is recognized as a growth company, and cash will accumulate on our balance sheet.
Below are the most recent 8 quarters of performance (June 2013 was depressed due to a $2.7 million one-time charge at 44% JV CVC credit partners for startup costs- excluding that adjusted EBIT should've been around $2.4 million)
[Table 2: quarterly financials]
Highlights for the year ending FY2013 include:
• Adjusted cash from operations (per mgmt.) was $14.6 million, hitting REXI's FY 2014 goal (a year in advance)
• Increased assets under management by $1.5 billion (~10%)
• Guided to 2014 adjusted cash from operations of $15-$20 million
The Business - Real Estate
[Table 3: RE financials]
Under Real Estate, REXI manages a number of REITs (public and private) as well as a number of multifamily properties. The most important revenue drivers in this segment are RSO (Resource Capital, a public REIT), and Opportunity REIT (a private REIT that invests and sells commercial real estate, including distressed properties).
Broadly, the thesis behind real estate isn't complex:
1. Resource America earns base and incentive fees (in the vicinity of 2%) on AUM
2. With the current base of assets, real estate is generating run-rate before tax profits of $12-13 million.
3. Management is targeting ~$400 million in capital raise in FY2014, in line with FY2013. As of November 15th, they had raised $~150 million in equity and $100 million in convertible debt. Given the success so far, we believe they should be able to achieve that target barring a collapse of the commercial RE market.
4. We think incremental margins are approximately ~50% (mgmt states this is a "fair" assumption). Hence, each $100 million increase in AUM will contribute $1 million to before tax profits (2% fee at 50% margins)
5. Make money
[Table 4: AUM]
Resource Capital (NYSE:RSO) - External Manager:
[Table 5: RSO financials]
As an external asset manager for Resource Capital (RSO), Resource America earns ~1.5% base management fee on the equity of RSO, and an additional ~25% of EBIT above an 8% return. The base fee serves as a "floor" to earnings, since the return proposition is asymmetrical. Over the last 8 quarters, the average fee has been 2.09%, largely driven by a few quarters with gain on sales (depicted below)
The 4 quarters where ROE was above 8%, 3 were driven predominantly by asset sales. Management has stated that these occasional gains are part of the management process (buying and selling of assets), and are unpredictably recurring in nature. More importantly, as RSO's equity has increased from $430 million to $783 million since 2011 (with a large $120m gain in the June quarter), the Company has deploying capital at a lagged rate, making a hurdle on ROE more difficult to achieve. Once the capital is fully utilized next year, management believes that the platform should earn incentive fees excluding any gain on sales. It's clearly quite impossible for us to verify this, but we think RSO has a unique platform to originate commercial loans (see it's latest RSO securitization!) and has been able to flip assets at high IRRs. We will track this to see if management can bring ROEs above 8% excluding sales. While not particularly fair to RSO shareholders, the structure of the base + incentive fee is great for us, as we are still paid a 1.5% fee even when ROE falls to ~3%.
Assuming a floor 1.5% base fee, the current equity of $783 million translates to ~$3 million a quarter ($12 million a year) in base fees. Using Q4's results (see below), if we adjust RSO management fees from $4.6 million to $3.0 million, income from continuing operations drops from $3.8 million to $2.2 million. Hence, a "bottom" seems to be established at ~$9 million of pre-tax profits (all else equal).
[Table 6: quarterly financials]
A ~2% fee seems reasonable (and implies a 10% ROE at RSO, not particularly aggressive in light of the entire REIT universe. See the latest NAREIT RSO presentation, where management lays out 14-17% ROE targets ) and implies run-rate quarterly RSO fees of $3.9 million (instead of $4.6 million). Adjusting Q4 numbers down slightly gets us to income from continuing operations of $3.2 million, and annual income of ~$12.5 million (keeping expenses Q4 annualized - this would probably come down though if fees earned were less).
The story gets a bit more exciting from here.
RSO's mortgage platform with in-house origination has been able to accumulate capital reasonably well, growing from below $200 million in 2008 to ~$800 million in 2013. Management has stated that there is good appetite for these assets, and plans to raise another $200 million in FY2014 (the latest convertible issue won't become equity until 2018). When we broke down the margins of real estate as a whole, we estimated that incremental margins were ~50% (albeit the interval was quite wide. To calc this, we took the QoQ change in total revenues, ex Resource Residential and compared it to change in total expenses, ex Resource Residential). When probed, management said that this was a "fair way" to look at the contribution margin. Hence, with $200 million in potential equity at 1.5%-2.0% fees, we could see $1.5-$2 million of additional profits before tax in FY2014.
Of course, the leverage will continue to exist post FY2014 - so if we sustain growth at $200 million for a few years, we could see ~50% increase to the current run rate EBT. With downside at ~$9 million EBT, and upside much higher in the medium/long term, we think RSO management is a pretty attractive asset.
Within Real Estate, there are 2 other fees: asset management fees and resource residential fees. Resource Residential fees are just enough to offset resource residential expenses (this is the segment that manages a number of multifamily properties). This has been the case for the last 5 years. REXI provides this as a service in order to generate leads for potential deals. As such, it will likely be quite static on the bottom line going forward, and we can sort of ignore it. Actually, we will ignore it.
The other driver in Real Estate is Opportunity REIT. Opportunity REIT is a private REIT that is marketed through RSO's network of brokers and invests in commercial (sometimes distressed) properties. The program had ~$44 million in equity in the first quarter of FY2012 and ended with $390 million year end. From the numbers, the increase in asset management fees over the same period of time is likely attributable to Opportunity REIT, as other REITs and programs saw flat AUM increases ($566 million to $573 million), and "Other" AUM fell by 1/3.
Attributing the increase in asset management fees to increases in Opportunity REIT AUM suggests that Opportunity REIT ("OpREIT") earns ~2.5% in fees. If we lump up all the AUM except commercial debt and use that as the base AUM, fees are in the low to mid 2% (this is not really accurate, as it assumes commercial RE debt is all held at RSO, and also lumps together other REITs and legacy assets).
Either way, the assets here generally have fees than in RSO. This sanity checks with Allan Feldman's (SVP of this segment) comments that OpREIT should do at least $60 million in revenue over the next 5 years (on target AUM of $600 million. The OpREIT offering closes December 2013, and was at $538 million as of November 15th, up ~$150 million from FY2013 end).
I want to take a pause here and explain how OpREIT makes money before you decide to stop reading this long, exhaustive piece and shop for something fun online:
• REXI raises capital and buys assets generally levered 1:1 debt:equity
• REXI earns 2.0% on the acquisition of the asset, and debt placement fees of 0.5%. Per management, assets can be flipped in 2-3 years (particularly with distressed assets that recover in value), so over the course of the REIT REXI can get "multiple turns" at utilizing this capital, earning acquisition and debt fees each turn
• REXI earns a 1% fee ongoing each year on the asset value
• REXI raises $600 million in equity, issues $600 million in debt to buy $1.2 billion in assets,
• REXI earns 2%*$1.2 billion = $24 million in acquisition and .50%*$600 million = $3 million in debt fees, $27 million cumulative for asset and debt issuance
• 1% asset fee on $1.2 billion comes out to $12 million a year, so $60 million over 5 years.
• Cumulatively, that $600 million of capital raised can earn $87 million in total revenue, or $4.4 million a quarter. If we get a "second turn" at the asset, then we may earn up to $87+$27 = $114 million over 5 years
At the end of FY2013, OpREIT had $408 million in assets. This means we still have $600 million + to go to fully utilize the equity capital (assuming approximately shy of 1x debt). The annual fee on $600 million in assets at OpREIT itself is $6 million. At 50% incremental margins, this is an additional $3 million in profits before tax a year (exclusive of the acquisition and debt placement fees, which should be >$13 million). The question is also how quickly OpREIT can deploy its capital base.
Allan Feldman in the latest call once again brought up OpREIT 2.0: "while entering the final phases of fundraising for the OpReit, we're also focused on preparing for our next non-listed REIT, which is currently in registration. This REIT will keep us busy raising capital for several years." There seems to be quite some runway for these REITs. REXI itself expects the private REIT business to surpass RSO in terms of recurring profitability next year.
What does it all add up to?
Normalized earnings of ~$12.5 million + $2 million from RSO + $3 million in OpREIT means we could potentially exit 2014 at $16.5-$17.5 million in operating profit. While this might seem aggressive, recall we are not giving any credit to acquisition and debt placement fees, new products like real estate mutual fund, and potential ramp of OpREIT 2.0.
I'm not clear what kind of multiple this should warrant given the unique nature of a publicly traded external real estate manager. From the following articles regarding the internalization of external managers, the valuations seem pretty lofty, to the tune of ~12-13x forward FFO and/or ~11-12x EV/EBITDA (see latest Cole presentation regarding internalizing of its external asset manager. I am not going to sugar coat the fact that external managers are not universally loved) . I'm not sure how useful comps are given the discrepancy of assets under management, as well as the respective growth rates of those assets, but I don't believe these sound like far-off valuation metrics, given that these businesses have near 100% conversion to FCF (no capex) and can grow income with the minutest commitment of capital (or none). In the example of OpREIT, REXI put in $2.5 million for a vehicle that aims to manage assets over $1 billion and with projected revenues exceeding >$60 million. The business is also generally quite stable and sticky given the long term nature of CE real estate investments.
Horizon Kinetics had a good piece about REITs (why they like managers more than the actual REIT) which is apropos: http://www.horizonkinetics.com/docs/December_Commentary_Canadian_REIT.pdf.
Anyhow - for academic purposes let's slap a 11x EBITDA multiple on next years run rate EBITDA (~$17 EBT + ~$1 D&A +$1 interest) and we get a giggly $209 million in EV, vs an enterprise value of ~$179 million today. This actually might sound cheap if we think EBITDA can grow ~$3-$5 million a year after depending on the level of asset raises. 12-13x forward FFO will give us similar results, albeit come 2016 taxes will become important.
The Other Business - Financial Funds
The other segment of the business is the financial funds business, which holds a number of investments in CLO's, other debt instruments, as well as a 33% joint venture in CVC Credit Partners, a JV with CVC that currently manages a bit over $9 billion in assets.
CVC - The Main Driver
CVC Credit Partners is a JV with CVC Capital that manages CLO's and is moving into publicly managed assets (publicly listed investment vehicles), as well as managed accounts (pensions, sovereigns, etc.). The JV was started a couple years ago when REXI merged its own CLO business with CVC, giving CVC its legacy Adipos CLOs and acquiring a 33% joint venture in the business.
Let's get to the dirty first - there is a lot of regulatory rumbling with regards to the CLO landscape (in Europe as well as the US, there are proposals that the manager should hold on to 5% of issued CLOs) . This is a known unknown. Management has told us that the general feeling of the people around the CLO market is that the proposal will not go through in its current form, and the government may end of focusing on some portion of the capital stack as opposed to the whole stack (i.e. 5% of the sub investment grade portion, which is what CVC credit partners generally owns).
Passage of the proposal as it stands would end up shrinking the CLO market but also focusing it in the hands of large private equity players. Large PE players can raise capital through their pools to invest in tranches to fulfill that obligation, while smaller managers may not be able to do so. REXI's JV with CVC should put it in the "winners" (or "less of a loser") bracket. Any changes would also be grandfathered in, in which case the current $9+ billion of assets will still run out the remainder of their long lives (regulations come into effect with a 2 year delay as well, so earliest would be 2016, meaning we might see a flurry of activity before new rules kick in).
"Somewhat" alleviating, CVC Credit's team interchangeably manages the sovereign/public/managed accounts as well as the CLOs, so in a world where CLO regulations come into effect as is, the team isn't "redundant" and would shift its attention to managed accounts. I am not sure how to cap the downside risk of this. But in that scenario, CVC might become a long run off (CLO's being issued have expirations in mid to late 2020's), and I imagine that the team would either 1) be cut and so harvested cash flows would be much higher or 2) the team "proves its worth" because other assets or managed accounts become an increasingly larger portion of the business.
So back to the business:
Management stated that the average fees REXI is being paid on the existing CLO pool is around 35 basis points, and newly issued CLO's are somewhere in the 45-50 basis point region, a level in line with rates between 2005-2009. In the Q3 press release, management alluded to ~$4.9 million annual revenue associated with the raise of Adipos CLO XIV ($617 million) and Adipos CLO XV ($500 million) in July and October of 2013. This comes out to 44 basis points in annual management fee, which is in line with their commentary. As of Q4, we can see that fees are around ~45bps.
Incremental fees have been higher (Q3 had some accounting nonsense related to placement fees and one time charges), bringing average fees up from 27bps to 45bps. CVC manages both CLOs as well as managed accounts/public funds (i.e. a sovereign fund, or a fund trading on the LSE) - these generally come with 85bps in management fees and a 15% over an 8% hurdle. Hence, as CVC aggregates more managed accounts (as well as underwrite new CLOs at higher fees), the fees should trend upwards and stabilize.
In the last year, we believe CVC raised > $1 billion in CLOs and $400-500 million in managed accounts. Going forward, management told us they would be "disappointed" if they did not do at least $400-$500 million this year in managed accounts.
It is hard to decipher the profitability of the CVC segment because there have been a number of one-time events flowing through the business (underwriting the new CLO public funds, partnership in Australia, recruiting an "experienced group of new hires from Goldman Sachs"). While we think, and are told, that leverage is going to kick in after the ramp up of these expenses, the short history of the business makes the story more risky. As it stands, CVC manages long term sticky assets generating $1.8 million ($0.6 million to REXI) a quarter of net income.
Management indicated to us that incremental operating margins here are also ~50% - we could see the leverage in the numbers prior to Q3'13 this year. Assuming we grow managed AUM by $500 million and CLOs by $1 billion (which is ~2013), we get:
• $1,000 CLO AUM at 45bps of fee = $4.50 million * 50% margins *1/3 ownership = $740k to REXI
• $500 managed AUM at 85bps of fee = $4.25 million * 50% margins * 1/3 ownership = 708k to REXI
This would bring total net income from CVC up from ~$2.4 million run rate to $3.8 million. CVC Credit Partners actually raised a $625 million CLO due 2025 in November, so we're already quite a bit of the way there towards $1 billion .
I am not going to attempt to guess the trajectory of the CLO market - 2013 has been extremely strong and issuance is likely to reach or exceed ~$80 billion , the highest levels since pre-crises peaks . CLOs cater significantly to institutional money, and alternative managers like Blackstone and Apollo have been busy in the markets .
I am not well versed in the market and I believe another financial crisis could send the CLO markets to rock bottom again. It is fascinating that 2 years ago we had articles stating the danger of extinction for Europe's CLO market ,and 2 years later we have "European CLOs set for big 2014." I really liked this piece from the LTSA - it seems difficult to argue that CLOs are not a useful innovation to aggregate and tranche risk, particularly since "CLO note impairments have been all but non-existent" - 98.57% of CLO notes between 1996 and 2012 remain unimpaired.
Other Parts of Financial Funds
Fund management fees have been on the rise due to a contractual nature of the legacy CLOs that REXI gave CVC when they created CVC credit partners. REXI claims 75% of the incentive fees from those assets and those have recently begun to flow. The latest quarter was an absolute blowout as a result of high gains on trading as well as a $2 million placement fees for a third party CLO. The gains on trading (essentially traders buying and selling CLO tranches) in Q4 was clearly outsized. Our understanding is that traders are allocated a "small" (not sure what that means) amount of capital to hold and sell positions in proprietary accounts. The positions they take can be equity positions that banks might be trying to shed, tranches where cash flows are currently turned off but on the verge of being turned on, etc.
Management states this is a going concern of the business, but will become smaller in importance since they are not allocating any additional capital to it (which is great, since the "gains" from proprietary trading could swing the other way). As mentioned above, REXI also made $2 million in placement fees as the underwriter for a European CLO. Management is optimistic they can underwrite more deals (though they won't guide to one every quarter or couple quarters). We should treat this as a one-off until a pattern emerges.
If we take the 2 year average for gains on trading and other income, we should normalize EBT to ~$1.5 million (this includes the CVC income). I don't have a better way to slice and dice this number, since the remainder of financial funds is profitable but very black-boxey.
Ex-CVC I think the remainder of financial funds might do $1 million or so in EBT. I assume that will continue to hold and that performance in financial funds will largely be driven by any AUM raises at the CVC level (other assets in the financial funds segment have been static and slowly running off, from $5.1 billion in Q3 2012 to $4.6 billion in Q4 2013).
What does it all add up to?
I think CVC probably deserves a multiple at least in the low teens (which is in line with peers like Blackstone, Apollo, Och Ziff, etc.). The base of the business is still small and underleveraged such that CVC doesn't really impact the bottom line of REXI's overall business. Either way, alternative asset managers are trading at roughly ~11x P/E . Applying 11x to Q4 annualized earnings means this segment is worth $26-27 million (CVC income is reported net of taxes). Under the scenario outlined in the previous pages (hopefully you didn't skip them), we might hit $3-4 million of earnings next year, putting the business at mid-$30 to mid-$40 million valuation.
I think there are probably a couple other data points that suggest valuation could be higher (on the thesis that our opex has been increasing quite rapidly and is not optimized for the current asset base). However, I remain cautious of their conclusions, since CLO's are so wide and varied in between.
KCAP, a publicly traded asset manager, retains a small CLO management section under "Asset Manager Affiliates" (see page 45 of their 10Q). KCAP conducts fair valuation on this segment every quarter, and as of 9/30/2013, the business had annualized net income of $5 million, $3.6 billion in AUM, and was recorded at a fair value of $82.5 million. On a P/E and P/AUM basis, CVC would be worth ~$40 million to ~$70+ million today. If anyone has a database to share CLO manager acquisition or CRE manager multiples, we would be delighted to hear from you.
Average corporate expenses over the last 4 quarters have been ~$1.8 million a quarter. As we don't have any reason to believe this should change much, we will use assume this is appropriate.
We harp back to our introduction and recap:
• At 2% fee for real estate, EBT is $12-$13 million. Financial funds is running at around $1.5 million, and corporate expenses is roughly $1.8 million. Our total EBT is around $11.5-$12.5 million, plus D&A (minimal D&A) of $2 million gets us to cash flows of approximately $13.5-$14.5 million
• Cash taxes have been ~$1 million a year from 2010-2012. We do not expect to pay taxes until 2016 as the Company has $38.5 million of gross federal NOLs and more non-cash write offs.
• Going forward though, assuming management hits raises of $400 million in real estate and $1.5 billion in CVC, EBT would increase by ~$4-5 million at Real Estate and ~$1-1.5 million at Financial Funds. Our EBT would increase from ~$14 to ~$19-20 million, the higher range of REXI's FY2014 estimate of cash earnings
• On a forward basis we would be trading at <9x cash earnings, with a business that grew EBITDA > 30% LTM and can continue to grow EBITDA >20% ($5 million) each year, assuming flat AUM raises.
• 3 years out, at a valuation of 12-15x fully taxed P/E, along with cash returns and cash build (REXI bought back 1.6% of shares so far this quarter, so they are cognizant of shareholder returns), we re-iterate our thesis that the shares could return >70%. Our outer year projections more or less fall in line with the ramp modeled by REXI at flat AUM . We acknowledge that a higher ramp could result in net income exceeding $30 million by 2016/2017 (as modeled by REXI on page 13, tax affected), but we also acknowledge AUM might slow down in protracted weakness. Either way, the downside seems to be limited at ~8-9% LTM FCF on a sticky, sticky asset base.