|Shares Out. (in M):||31||P/E||0||0|
|Market Cap (in $M):||589||P/FCF||8||0|
|Net Debt (in $M):||-62||EBIT||0||0|
The RMR Group is one of the most attractive businesses and cheapest stocks I have come across in quite a while. The Company is in the business of managing 4 large and well capitalized publicly traded REITs under 20 year management contracts that are virtually impenetrable. The Company tip-toed into the public markets in mid-December, via a very quiet spin-off transaction whereby a tiny sliver of market value was distributed to the shareholders of 4 very large REITs – creating the perfect set of circumstances for an under-appreciated spin. They came to market amidst market chaos, hedge fund redemptions and the holidays, not to mention little to no shareholder communication and being an operating business spun out to REIT holders. This is a business with ~50% EBITDA margins, contractual cash flows, little/no capex and a fortress balance sheet, trading at 5.5x 2016 EBITDA (3.5x when including a large incentive fee). Sound too good to be true? It did to me as well, but I was surprised at what I found researching this business – makes me feel like its 2009 again.
The thesis is simple: (i) impenetrable contracts with 4 large, well-capitalized REITs make for exceptionally consistent and growing cash flows for decades to come, (ii) we are able to invest at a ridiculously low valuation due to the spin-off dynamics noted above, (iii) the Company will report a huge incentive fee for 12/31/15 from HPT which will be a big surprise to both RMR and HPT shareholders (one might consider shorting HPT as well), and (iv) we believe investors are wary of investing in a “Portnoy” entity which is contributing to the current valuation paradigm – we think that investors are wildly missing the mark here and misreading the overall situation and the reason for the spin-off.
We have a base case target price of $42.50 per share, and can’t see any rational scenario where RMR is worth less than $30. I can envision upside scenarios in the $50-60 range when using the logic that analysts apply to NSAM (a pretty decent comp).
Business Discussion and Valuation
RMR generates fee based revenue as shown below. As you can see the primary revenue driver is the 4 large managed REITs (GOV, HPT, SIR, SNH), followed by the Managed Operators (FVE, TA and Sonesta) and then a sliver of revenue from managing the RIF closed-end fund. The Company ceased earning management fees from EQC in 2015.
|Government Properties Income Trust||GOV||16.8||18.3||18.6|
|Hospitality Properties Trust||HPT||38.0||40.9||38.6|
|Select Income REIT||SIR||13.4||17.2||27.8|
|Senior Housing Properties Trust||SNH||34.6||37.2||45.2|
|Equity Commonweath (terminated)||EQC||71.6||81.6||6.6|
|Managed Operators (collectively)||FVE, TA, Sonesta||23.1||23.4||25.5|
|Total Management Services Revenues||$197.5||$218.8||$162.3|
|Revenues Excl. EQC and Reimbursable||$128.0||$139.4||$158.1|
|Margin (excl. pass through)||58.2%||60.1%||55.4%|
Management Fee Revenue is made up of the following:
Base Business Management Fees (70%): Calculated at roughly 50bps on the lesser of (i) enterprise value (which they refer to as “market capitalization”, but it is in fact EV) and (ii) historical acquisition cost of real estate. Note that because this revenue stream is based on EV, any declines in the equity value of the REITs will have an impact on fees but will be muted as the EVs of these entities are roughly 50% debt today. Further, historical acquisition cost is close to or below EV for a few of the REITs, thus making those fee streams fixed in nature, until TEV were to decline below historical acquisition cost. I will point out, though it is probably not a debate to delve into for purposes of this writeup, that the REITs are undervalued today and are likely to appreciate from here.
Property Management Fees (30%): Calculated based on (i) 3% of gross rental revenues plus (ii) 5% of construction cost on improvements renovations and repairs.
Incentive Fees (not material in historical financials): RMR has the potential to earn an incentive fee, each year, on each REIT which is calculated as follows: 12% of the aggregate outperformance of the Managed REIT vs. its relevant Index over the prior 3 years, not to exceed 1.5% of the equity value of such REIT. As an example of this calculation, at 12/31/2015 HPT had generated an aggregate return of 16% during the reference period, vs. 2% for the SNL Hotel Reit Index over the same period. The excess performance of 14% (16-2%), applied to HPT’s market capitalization of $4b, multiplied by the 12% fee to RMR, gets to a figure of $72mm. The fee however is capped at 1.5% of the market cap, and is thus reduced to 1.5% of the $4b market cap - $62mm. Much of this outperformance of HPT vs. its index occurred at the very end of 2016 and investors were unaware of this development (and may still be) as it occurred over the span of a few weeks in Q4 leading up to the final day of the year. RMR had not been accruing for any incentive fee in its financial statements and had not earned any meaningful incentive fees in recent years – hence, the 12/31/2015 quarter for RMR (their fiscal Q1) will look significantly different than any period that the Company has presented in its historical financials. I think that it will serve to highlight the incredible value in RMR shares and be a strong catalyst for appreciation. Fiscal Q1 will include the entire $62mm incentive fee – causing fiscal Q1 EBITDA to come in at ~$86mm or so.
Note that because it is a multi-year lookback period on performance, for 2016 HPT is already “in the money” on potentially paying an incentive fee – i.e. unless HPT materially underperforms the relevant index in 2016 it will owe RMR another full incentive fee at 12/31/16. Said differently, if HPT merely performs roughly inline with (or even modestly underperforms) the index in 2016, it will owe another full ~$60mm incentive fee to RMR.
Here is how I handicap potential incentive fees over the next few years:
2016 – driven by the relative performance from 2014 - 2016
HPT is in the money going into 2016, ahead of the index by 14%. They are also yielding significantly more than the index. For this reason we think it is more likely than not that HPT pays an incentive fee to RMR again for 2016, and I would say it is more than a 50/50 chance that it is the max fee (if the year were to end today, they are already above the maximum performance threshold – they could underperform this year and still generate the max incentive fee).
The rest of the Managed REITs – virtually no chance of generating an incentive fee.
2017 – driven by the relative performance from 2015 - 2017
HPT actually underperformed its index in 2014 and significantly outperformed in 2015. Hence there is an even stronger tailwind behind a potential HPT incentive fee for 2017, because the 2014 underperformance will roll off. Of course there is more uncertainty as well as we have 2 new years that will drive the calculation.
The rest of the Managed REITs – 2014 rolls off and they still have underperformance from 2015 to re-coup, but you are betting on three separate horses. There is a good chance one (or perhaps a few of them) outperform in the next 2 years.
2018 on – I happen to believe that the Managed REITs are undervalued and the entire RMR complex will outperform over the next few years. We are starting at a very low base – the REITs are trading at very high yields, are well capitalized and own good assets. I also think that the terrible reputation of the RMR complex is wildly off (more on this later) and will improve over the coming years which will lead to a re-rating, though I concede that this part of the thesis is likely to stir a healthy debate.
In the table above, we show revenue excluding the pass-through reimbursable revenue as well as excluding revenue from EQC in order to show how the ongoing management fee revenue streams have trended in recent years. As you can see they have been growing consistently along with the REITs. RMR has a track record of growing its REITs consistently over the past 15 years and we expect that growth to continue over time. This is a business that requires no capital to grow – all growth will result in additional cash flow and value accruing to the equity. Furthermore, RMR believes that their business platform is currently underutilized in light of the loss of EQC – in other words, they think they can grow without adding significantly to the cost structure of the business.
Below we lay out a very simple form of valuing the business. We think about RMR value having two components: (a) the value of the base management fee income stream (subject to 20 year contracts, very likely to grow over time along with the REITs), ~50% EBITDA margins, no capex, which we think is easily worth 10x EBITDA, and (b) the value of any annual incentive fees that RMR earns – this component of value is much more difficult to assess because in some years the incentive fee is likely to be zero and in other years it is likely to be quite substantial (as it was in 2016, amounting to $62mm).
Here is the rough math on valuation:
|Equity Market Cap||$589.0|
|Dividend Paid on 12/15/2015||16.3|
|RMR portion of 2015 Incentive Fee||35.6|
|Cash Flow from base business in 12/31 quarter||15.0|
|Cash & Equivalents at 9/30||34.5|
|Run Rate EBITDA (mgmt fee only, excl. incentive fee)||$95.0|
|GAAP EBITDA (incl. incentive fee)||$157.0|
|Enterprise Value / EBITDA (base mgmt fee only)||5.5x|
|Enterprise Value / EBITDA (incl. incentive fee)||3.3x|
|Unlevered FCF Yield (base mgmt fee only)||11.0%|
|Base EBITDA (from mgmt. fees)||$95.0|
|Value of Base Mgmt Fee Income||$950.0|
|Value of Future incentive fees||$300.0|
|Implied Stock Price||$42.54|
I think there is enough margin for error on valuation here that the debate is basically a moot point, but we happen to think that the base management fees are probably worth in excess of 10x EBITDA. I think it should be self-evident why these income streams deserve a high multiple, but here are a few points:
· 20 year contracts with onerous termination provisions provide for incredible long term visibility
· Asset light business, very little capex
· Extraordinary returns on capital – no capital required to grow
· There is in fact a long track record of growing this business for a very long time dating back to RMRs beginnings in the late 1980s – thus the growth is not theory, there is a strong track record
· 4 well capitalized REITs, with good assets, are excellent platforms for growth over time
· Exceptional margins – EBITDA margins in excess of 50% when adjusting out the pass through revenues/costs
· RMR as a platform is underutilized today given the loss of EQC. They are actually under-earning and can support a much bigger business on their existing cost structure.
· NSAM trades at 10x EBITDA, but the makeup of their EBITDA includes incentive fees, fees from non-traded REITs which may be in decline and sales commissions. Not to mention NSAMs biggest client (NRF) is highly levered and trading at a dividend yield in excess of 20%, calling into question the sustainability of that capital structure. All that said, we happen to really like NSAM even at 10x EBITDA and own a small position in that one as well.
· Research analysts who cover NSAM argue that their base management fees, given the 20 year contracts (structured similar to RMR), should be worth 20-30x after tax earnings (which corresponds to a significantly higher than 10x EBITDA multiple). See Deutsche Bank’s report report on NSAM on 11/12 (page 4) to see how they think about the relevant multiples on NSAMs earnings streams.
· Recent strategic transactions confirm this – NSAM’s purchase of Townsend a few months ago at 12.7x total EBITDA (which includes various fee streams which are not of the same quality as RMR’s base management fees). Why Townsend would be worth a higher multiple than RMR is an unknown to me.
· AINC’s recent purchase of Remington, valued at 9.6x EBITDA, provides a similar data point vs. the Townsend multiple. The quality of Remington’s income stream is unknown (how much is mgmt. fee vs. incentive, what entities they manage, how long the contracts run).
· We are very well aligned with the Portnoys, who own 50% of the business, and thus are very motivated to continue to grow RMR as they have for years.
Background, the Portnoys
As you may be aware, there have been questions about conflicts of interest between RMR Group and the Managed REITs for years – with REIT shareholders essentially arguing that RMR is incented to simply grow the balance sheet of the Managed REITs through acquisitions, equity offerings and debt financings in order to maximize management fees.
This controversy came to a head in the fight with Sam Zell over Commonwealth REIT (now known as Equity Commonwealth). Commonwealth REIT was RMR Group’s largest managed REIT and the fight with Sam Zell culminated in the RMR Group’s loss of control over Commonwealth (the largest fee generator at the time for RMR).
Fearing that the same might happen at the other Managed REITs, RMR took the cue of Northstar Asset Management (NSAM) and hatched an ingenious plan. They sold half of RMR to the Managed REITs at an absurdly low valuation of about $12/share in cash. Incidentally, we think that when the spin occurred investors were incorrectly anchoring to this $12/share valuation for RMR (that is where it opened in when-issued trading). This misses the point – the consideration for selling half of RMR was partly the $12/share, but the vast majority of the consideration came in the form of the Managed REITs agreeing to 20 year management agreements with RMR, with virtually impenetrable termination provisions and generous terms. In fact if you dig through the Managed REIT financial statements you will find that the total transaction value was placed at approximately ~$26/share when including the value of the management contracts to RMR.
In the wake of the Commonwealth fight, the Portnoys had a strong desire to both cement their relationship with the managed REITs for the longer term as well as to improve relations and reputation with Wall Street. By placing 50% of the management company’s ownership in the hands of the REITs it is much harder to argue that incentives are not well aligned- anything that benefits RMR also benefits the REITs through their ownership in RMR. A significant part of the consideration in the RMR sale was also in the form of stock in the REITs that is subject to a 10 year lockup agreement. Thus, a significant portion of the Portnoys wealth is now tied up in the REITs which creates further alignment. These steps, taken together, will change some of the negative perceptions about the RMR entities over time. As you likely know the RMR entities are trading at a fairly significant discount to market. I think that this discount – though it may never go away entirely - is likely at its peak in light of the events of the past two years and the gap will slowly but surely close over time.
A logical question to ask (as did I) is, “why shouldn’t this entity also trade at a discount just like the other Portnoy entities?” And a related question, “should we trust the Portnoys?”
The most important answer to this question of course, is that RMR is the primary entity that generates wealth for the Portnoys. This is their “gravy train” so to speak. This is the entity that has benefitted over time from the significant expansion of the Managed REITs. Every equity offering, every acquisition at the Managed REITs that shareholders have had a disdain for, has benefitted RMR. Simply put – this is the entity where the Portnoys make excellent capital allocation decisions – this is the one that they care about. This is the entity where decisions are made to maximize value. So the logic that it should trade at a discount like the REITs is completely illogical. In fact one could make a strong argument that the RMR entity should trade at a premium for the exact same reason that the REITs trade at a discount.
The question of “should we trust the Portnoys?” is an interesting one. I have to admit when I first looked at this idea I was immediately skeptical, based on a loose knowledge of the events that transpired around Commonwealth and the other Managed REITs over the past few years and a perception that the Portnoys are bad actors. I was very surprised what I learned when I started to dig in and talk to longtime employees of RMR and others who know the company well. I heard very consistent feedback such as “highly ethical”, “worked there for 10 years and it was a wonderful experience”, “extremely hard working, tough, no nonsense”, “very savvy, always does things in the best interest of the REITs”, “there was never any conflict of interest from my perspective”, “pays employees very generously”, “very tough negotiators and savvy dealmakers”. I was surprised to hear this feedback very consistently – as it is directly at odds with the common perception of the RMR Group and the Portnoys. There are a few conclusions I might be able to draw: 1) my research is wrong, I have talked to the wrong people, 2) Wall Street is way off the mark in its opinion of the Portnoys, 3) the Portnoys treat everyone well except for shareholders of any entity, or 4) the Portnoys tend to act in their own best interest, which is the interest of RMR Group but not the interest of the Managed REITs. I think that 4) is probably the most accurate, but I also think that 2) is correct as well – Wall Street is overly negative in their opinion of the Portnoys. From my research (and I encourage you to do your own of course as this is an important issue), I do not think that these are horrible, unethical people – I think they are very good, successful businesspeople who act in their own best interest. Perhaps a slightly different way of saying something similar – I think 2015 will likely prove to have been the trough of their reputation – they are working to improve it and have very good reason to do so. So, as I see it, I am happy to be alongside them as an equity investor in the business entity that they are most motivated to maximize profits in.
I would note as well, while we are on the topic of incentives, in an Up-C structure such as this one, there is a strong motivation to maximize the trading price of the C Corp. shares. As LLC shares (those owned by the Portnoys) are converted into C Corp. shares, the C Corp gets a step up in tax basis (in the amount of the value of the C Corp. shares at that time). Through the related tax receivable agreement, 85% of the value of that step up in basis will go to the RMR Trust (owned by the Portnoys). The value of that tax receivable agreement is likely to be quite substantial – especially if RMR trades where it should and they continue to drive value over time. Thus, as LLC units are converted into C Corp. shares, to the extent this can be done at the highest price possible, it will result in the maximum amount of tax basis step up and thus the maximum amount of value transferred to the RMR Trust under the tax receivable agreement.
Key contract terms
Along with the sale of 50% RMR to the managed REITs last June, the REITs entered into new management contracts with RMR. These were filed on form 8-k on 6/8/2015 by each of the managed REITs (they are nearly identical for each REIT). I would suggest you read these in detail as you will find that the nuances of the agreements are favorable to RMR at every turn and reading the agreements will help you appreciate the strength of the contracts. Here are a few of the key terms of these agreements (using the HPT agreement as an example):
Section 10, Management Fee calculation: take a read through the definition of “Average Market Capitalization”, you will see that it is essentially enterprise value, though it doesn’t take a deduction for the cash. Thus, any equity, debt or preferred stock offerings, even if there is no use of proceeds, results in an immediate increase to the management fee.
Section 11, Incentive Fee calculation: this one is really interesting as it lays out the exact math for how these are calc’d. There are interesting nuances throughout such as the numerator of the total return calculation, the “Final Share Price”, is defined as the highest 10-day average closing price in the last 30 trading days of the year. Details like this make a significant difference – in the case of HPT on 12/31/15 for example the “Final Share Price” was in excess of the closing price of HPT on 12/31 by 3-4%. Little advantages like this one make it all the more likely that incentive fees will be triggered with some regularity over time.
Section 18, Term of the Agreement, Termination: in force until December 31, 2035; and on each Dec. 31 the term shall extend out for another year – thus the remaining term on the agreement is always 20 years (the term of the agreement has thus already been extended out to Dec. 31, 2036).
Termination can occur for a few reasons
· For convenience – a REIT can terminate any time they want, the only catch is they have to pay the discounted value of the remaining management fees under the contract (ie 20 years of discounted fees). This will never happen – and if it did, it would be wonderful for RMR stock because it would represent a payment of about $2 billion or so to RMR from the REITs.
· For performance – starting in 2019, if a REIT underperforms its index 3 years in a row AND underperforms 2/3 of the REITs in its index in each of those three years, then the REIT can exit the contract by paying 10 years of future fees.
· For cause – anytime, with zero termination fee, if there is fraud that causes a material adverse effect on the REIT. As you are aware terminating for cause is an exceptionally high threshold to hit.
In any case, thinking about what needs to happen in order to terminate a management agreement – it would have to be a two step process – first replacing the trustees of the REIT and then, if you manage to pull that off, paying the required termination fees.
Taking all of this together, I find it exceptionally unlikely that RMR will lose another REIT. They learned their lesson with Commonwealth, and designed this structure to entrench RMR permanently as the manager of these REITs.
Why does the opportunity Exist
I think virtually any investor who looks at this in detail will agree this stock is a great buy at this price. I am frequently skeptical of things that look too good to be true, so I thought I might review a few reasons this opportunity exists.
First, the spin-off dynamics. Im not a believer that most spins are under-research or ignored these days, but this one is really unusual. It is unusual in the sense that there were 4 separate companies distributing stock and further to that point it was 4 REITs distributing shares of a C Corp. Many of the REIT shareholders are retail and many of the REIT shareholders are specifically REIT investors and don’t want to own shares of an operating business. Furthermore, lets think about the relative value of the stock that was spun off to shareholders – roughly $100mm in value of RMR stock was spun out of a collective $10 billion in equity market value. Put another way, if you owned $1,000 of HPT stock, you got $10 of RMR – just a distraction in someone’s fund or portfolio. This was also a spin-off that was not marketed at all, there was little or no communication with investors. The timing couldn’t have been more perfect either, just before Christmas when few investors were thinking of cracking open an SEC filing on a new investment idea. There was also the dynamic of the surprise incentive fee, which materialized towards the end of the year and there was no reason to think there might be one based on a review of the historical financials. In short, this was the perfect set up for a security that was radically mispriced out of the gates.
Second, there is the fear of Portnoy entities – what I call Portanoia, or Portphobia. I think this was another factor that caused any shareholders and event driven investors in particular to pass this one over. As discussed earlier I think the Portphobia is misguided since we are investing in the same entity that the Portnoys for many years have managed extremely well and created significant value in – our incentives are aligned.
Third, there are some businesses that look similar on the surface and are trading horribly right now. Probably a discussion for another time, but I happen to think there are incredible opportunities across the board in asset managers right now (a lot of stuff is cheap in this space). NSAM is an interesting situation and discussed thoroughly on VIC – they are trading at about 10x EBITDA, but they have a primary client (NRF) that is trading at a 20% plus dividend yield and is looking highly leveraged. They also have a significant portion of their income stream that comes from non-traded REITs – an asset class under intense scrutiny right now which likely has long term headwinds. All of that said, we happen to like NSAM for many of the same reasons that we like RMR – but the point being - if you like NSAM you probably really like RMR. If we had to choose just one, we would clearly pick RMR – dramatically cheaper, simpler business, more diversification of income streams from better capitalized entities. To reiterate, valuing RMR the same way that analysts value NSAM yields a stock price target for RMR well in excess of our $42.50 target price.
The BDC managers have also traded terribly – stocks like FSAM, Medley Management – have been complete disasters. These businesses are tiny, they manage BDCs, and frequently have just a single client. Many of these situations have activists involved who are working to terminate management agreements. Many of the BDCs that these entities manage are poorly capitalized and have made questionable investments over time that are difficult to assess the value of. They look similar on the surface, and I think they are good values (though they are completely illiquid which makes them difficult to do anything with), but I do not view them as particularly relevant comps.
How often do you get the chance to invest in an asset light business, with decades of earnings visibility, customers that can’t go away, with 50%+ EBITDA margins and no capital expenditures at a price of 5.5x EBITDA? We haven’t seen it in years – we are partying like its 2009 again. We see the potential for this idea to be dramatically re-rated over time, it could very well turn into a “compounder” of a business that makes us multiples of where we are trading today through a combination of multiple expansion, cash flow, growth and dividends. That is the upside. From a downside perspective you are buying a business with a clean balance sheet, the cranks out the cash every single quarter, that is already trading at a bargain basement multiple. Thank you for getting this far. Let me know if you have questions.
people do the math and the work to analyze the business and understand it. They report a huge incentive fee in a few weeks. future expansions of the managed reits and leveraging the RMR platform to manage more real estate assets. sentiment regarding the portnoys is at its worst and will improve from here - this will take time, but we are at the bottom.