Resource America Inc. REXI
November 13, 2006 - 4:37pm EST by
spence774
2006 2007
Price: 24.00 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 478 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Resource America, Inc. (REXI)

 
Price:                           $24.00
Shares Out (f/d):           19.9 mm
Market Cap:                 $478 mm
Debt:                            $19 mm
Cash:                            $25 mm
Enterprise Value:          $472 mm
 
Thesis
 
Resource America (REXI) is a fast growing alternative asset manager with an impressive investment track record and excellent relationships with the broker/dealer channel. Over the next three years the company will continue to raise money for its various operating segments and will realize significant operating leverage that is inherent in a young asset management business.
 
At $24/share, an investor in REXI has significant asset value of cash and investments of $9/share, along with an operating business that will earn $.58/share in EPS in FY 2007 and $1.62/share in FY 2009 as the company begins to recognize the operating leverage that comes with scale in an asset management business.
 
Backing out today’s cash and investments, REXI is trading for 9.2x 2009 earnings. 20x earnings is an appropriate multiple for a fast growing asset management company with significant operating leverage and a fantastic management team. With the increased earnings, multiple, and cash build we believe the stock is easily worth $46/share (92% upside) in 2-3 years.
 
In addition to this upside there are many valuable call options that are likely to be realized which will significantly increase our estimates of intrinsic value from today. Realistically we think we will more than double our money within the next 2-3 years.
 
 
Business Description
 
Resource America is a fast-growing alternative asset management platform with over $10 billion of assets under management. The company is in the late stages of a transition from a holding company that historically invested its own capital on an opportunistic basis to a fee-based asset manager that now invests 3rd party capital in the same opportunities in which management has significant experience and an impressive long term track record.
 
The asset management platform currently consists of four distinct business groups:
 
  1. Resource Financial Fund Management (RFFM): RFFM executes and manages collateralized debt obligations (CDO’s) in the trust preferred, asset-backed securities, and leveraged loan markets. RFFM currently manages $9 billion in approximately 18 different CDO’s. RFFM derives management fees ranging from 25-50 bps as well as structuring fees which vary.

RFFM has also recently launched a $30 mm hedge fund focused on structured credit opportunities as well as a $50 mm private equity fund focused on small cap and de novo banks. Both funds are 2% management fee and 20% carry.

  1. LEAF Financial Corporation (LEAF): LEAF originates and manages small-ticket equipment leases in the medical, computer, and industrial markets among others. LEAF does not use its own balance sheet to originate and hold these leases to maturity. 3rd party equity is raised through partnerships to provide the capital to own the leases originated. LEAF derives fees from managing these assets (110 bps), originating the leases (200 bps), and providing the capital to hold the leases until they are sold into the partnerships (200 bps). LEAF currently manage $550 mm of leases and is originating new leases at a $500 mm and growing run-rate.

While management has run the company since 1983, LEAF’s current incarnation as a manager of outside capital began in late 2001. In our opinion they now have the best business model of any independent leasing company in the industry as their growth will not be constrained by having enough balance sheet to support the leases they originate. In fact, LEAF has been able to acquire additional leases from other smaller independent leasing companies (and entire leasing companies) that could not hold all the leases they originated due to lack of equity capital.

LEAF recently relocated to a new building and is now operating independent of the Resource America parent. This business could easily be spun-off into its own publicly-traded company if management decides this is the best way to maximize shareholder value.
  1. Resource Real Estate (RRE): RRE manages real estate investment partnerships and tenant-in-common (TIC) programs to acquire multi-family real estate for yield-oriented investors. Approximately $100 mm of equity capital is currently invested in $314 mm of assets (16 different properties). RRE derives fees from the acquisition (175 bps), debt placement (175 bps), property management (100 bps), and investment management (100 bps) of these assets. Incentive fees of 25% over an 8% hurdle are also earned (the partnerships have compounded at 12% IRR’s after fees to-date). RRE is also building out its real estate debt securitization business in which they have completed and now manage their first CDO.
 
  1. Resource Capital Corporation (RSO): REXI is the general partner of Resource Capital Corporation (RSO) which is a publicly-traded Mortgage REIT on the NYSE under ticker RSO. RSO currently manages $225 mm of equity in $2.2 billion of real estate and commercial finance assets composed of mostly RMBS, CMBS, and bank loans. As the general partner of RSO, REXI derives a management fee equal to 1.5% of the equity of RSO as well as an incentive fee of 25% of any profits over an 8% hurdle rate. REXI owns 1.9 mm shares of RSO.
In addition to the operating businesses described above, REXI has cash and investments (net of all liabilities) of $175 mm or $9/share which consist of:
  • $20 mm of net cash.
  • $32 mm ownership of RSO shares (the 1.9 mm shares REXI owns).
  • $52 mm of legacy real estate investments from the company’s prior history of investing its own capital opportunistically. REXI has reduced these investments from $200 mm to the current $52 mm and plans to continue to opportunistically divest these assets. Fair value of the remaining real estate is $10-25 mm more than their $52 mm book value.
  • $95 mm of other investments in the assets and as a limited partner in the various investment partnerships that REXI manages.
  • These assets are offset by long-term debt, minority interests, deferred revenues, and other liabilities of $42 mm.
 
Supporting Evidence and Valuation
 
For our low-case scenario we assume that the company does not grow their businesses from this point forward and only continues to manage them to a steady-state scenario. We assume the different businesses perform below-average in that they do not earn any incentive fees and operate at a below-average operating margin versus other asset managers. We estimate after-tax earnings from the operating businesses of $17 mm ($10 mm from FFM, $2 mm from RRE, $11 mm from LEAF, $2 mm from RSO, and -$8 mm from corporate overhead). We apply a low 12x multiple to these earnings to derive a $10/share valuation for the operating businesses, to which we add the $9/share of cash and investments to reach a low case outcome of $19/share. In this scenario the operating businesses are not worth much relative to their potential but the downside is protected by the significant cash and investments on the balance sheet.
 
For our base case scenario we assume the company continues to grow the different business segments as they have guided to or we have estimated and more importantly that the different segments begin to realize the operating leverage inherent in growing their fees relative to the infrastructure that has been built out over the last 2 years. Some assumptions include:
  • FFM continues to originate 2-3 CDO deals per year for each of their groups and realizes 80% incremental operating margins.
  • LEAF grows originations from $500 mm to $800 mm over the next 3 years which results in acquisition fees and expense reimbursements covering operating expenses allowing management and spread income to fall to operating income.
  • Corporate G&A grows from $9 mm to $16 mm in 2009.
These assumptions result in fully diluted net income from the operating businesses growing from $.58/share in 2007, to $1.09/share in 2008, to $1.62/share in 2009.
 
 

9/30/07

 

9/30/08

 

9/30/09

 

FYE 2007E

 

FYE 2008E

 

FYE 2009E

Base Case  
F/d shares outstanding (mil)

                 19.9

                19.9

 

                 19.9

Pre-tax income/share by division:  
FFM $0.67 $1.16 $1.59
LEAF $0.54 $0.73 $0.94
RRE $0.34 $0.51 $0.76
Corporate G&A ($0.66) ($0.72) ($0.79)
Total operating income $0.89 $1.68 $2.49
Tax rate 35% 35% 35%
Total F/D EPS from operating businesses $0.58   $1.09   $1.62
 
 
Not factored into our estimates are many potential positive events (“the free call options”) such as the following:
  • Resource Capital grows its equity base beyond $225 mm through equity issuances and REXI begins earning additional management and incentive fees on a larger capital base. It is not unreasonable to believe that at some point in the next few years RSO has $1 billion of equity. It is worth noting that RSO had initially planned on raising $125 mm of additional equity in its IPO but was downsized to $30 mm of because the deal was brought to market at an inopportune time. RSO managing up to $1 billion of equity would be worth up to an additional $15/share to REXI. We expect a $150 mm equity raise within the next few months.
  • The business segments could grow faster than our conservative expectations and thus more fee income would be derived. For example we assume that the hedge fund and private equity fund stay at $30 and $50 mm of AUM, when in fact these funds have just been launched and there could be capital raises for both funds in the future. Just the base management fee (no incentive fees) on an additional $200 mm of equity is worth up to $2/share.
  • Incentive fees are earned on the CDO investment partnerships, real estate investment partnerships, hedge funds, and private equity funds. All of these partnerships earn 20-25% carry on profits above certain hurdle rates. We assume only the base management fees are earned. While it is impossible to know what the performance fees will end up being, it is worth noting that all of REXI’s investment partnerships have had excellent returns since inception and have earned carry. We can however estimate the magnitude; with reasonable return assumptions (12%) these partnerships can earn incentive fees of over $10 mm per year or $.50/share of eps. Applying a multiple of 5-15x results in incremental value of $2.50-$7.50/share just with the current AUM.
  • REXI will buy back its stock. We have assumed zero stock buybacks but the company has been an active repurchaser of shares (roughly 3% of the shares outstanding in the last 6 months) as they believe their stock is undervalued. Management has indicated that they plan to continue repurchasing shares. As an aside, insiders have recently been purchasing shares of REXI and RSO on the open market.
Note: Management guidance for FY 2007 EPS is $1.05 - $1.35/share. We estimate that income from investments is equal to $.40/share. Adding this to our estimate of operating EPS of $.58/share results in total EPS of $.98/share, below the low-end of management’s guidance. We believe the difference lies in our being conservative in our assumptions.
 
 
Management
 
Resource America was run by Edward Cohen from 1988 until 2004 when his son Jonathon Cohen took over in conjunction with the spin-off of Atlas America (ATLS) from Resource America. Ed now runs Atlas America and Jonathon runs Resource America. Jonathon has been with Resource America in different positions since 1999.
 
We have had the pleasure of getting to know Jonathon very well over the last 2-3 years. Jonathon is incredibly focused and passionate about growing Resource America into a large diversified asset manager. Jonathon’s work ethic is very impressive; he is constantly traveling to help market REXI’s various investment products and investigate opportunities to grow the business.
 
While intent on growing the business quickly, Jonathon and the rest of management are extremely risk-averse when it comes to committing REXI’s own capital. Typically to help raise money for one of their investment partnerships REXI will commit some of their capital as a limited partner. For example to get a CDO launched the manager of the CDO must commit to acquiring a piece of the equity tranche (REXI typically buys 10% of the deal). Management views these investments not as working capital but as investments in a deal that should be viewed as a separate investment. Therefore REXI will often divest its stakes in various related deals if they believe their capital can earn a better risk/adjusted return elsewhere.
 
Management is very conservative when it comes to maintaining liquidity. While in the past we would have preferred management to be more aggressive in repurchasing shares, we are reminded from past experience that opportunities come to those with strong hands and a big enough balance sheet.
 
To grow the different asset management businesses the company has hired highly-regarded veterans of their respective industries and incentivized them to be paid very well for succeeding in profitably growing the businesses.
 
The Cohen family, consisting of Ed and his wife Betsy along with their sons Dan and Jonathon, has a distinguished track record of creating value for outside shareholders. From 1999 to 2005 the Cohen’s launched and have run 6 different publicly-traded companies that have each had greater than 20% IRR’s to date. These companies are Resource America (Ed and Jonathon), Resource Capital Corp (Ed and Jonathon), Atlas America (Ed and Jonathon), Atlas Pipeline Partners (Ed and Jonathon), the Bancorp (Betsy and Dan), and RAIT Investment Trust (Betsy). In addition Dan Cohen runs a very successful private investment bank called Cohen & Co.
 
If you are interested in meeting Jonathon Cohen, he will be presenting at the FBR conference in New York in late November.
 
Ownership
 
Spencer Capital Management:              14%
Ed Cohen:                                            13%
Jonathon Cohen:                                   8%
Cobalt Capital Management:                 8%
Omega Advisors:                                  6%
 
 
Why is the stock so undervalued?
 
There are a few reasons as to why the stock trades at such a meaningful discount to intrinsic value.
  • There is no sell-side coverage of Resource America.
  • The profitability of the business will be very different three years from now than from today due to the significant operating leverage inherent in a young and fast growing asset management business. Current earnings are understated as the company is spending money through the expense line to build out the different business.
  • The financial statements are very difficult to understand due to the significant changes that have occurred at the company over the last 3 years. There are many moving parts that require detailed analysis to correctly separate and value.
  • There are many related party transactions that at first blush make people feel uncomfortable with corporate governance.
In our opinion, the reasons that have the most merit are that it is extremely difficult to understand the financials and potential corporate governance issues. However, after 2 years of getting to know the management team and putting in over 1,000 hours of work on the company we are very comfortable with our knowledge of the business dynamics and integrity of management and the Cohen family.
 
 
Risks
  • Returns from the various investment partnerships are poor enough where they destroy the relationships and brand value that Resource America has built over many years with the broker/deal channel. We think one of the competitive advantages of REXI is their ability to raise capital and any threat to this is a potential risk.
  • There is a liquidity crunch where the real estate and/or corporate credit markets get hit hard enough to prevent FFM from launching future CDO’s and have impairments to their current investments in their CDO’s and RSO.
  • While management has spent a lot of money building a deep bench at the different operating businesses, Jonathon Cohen is the irreplaceable driving force behind the growth at the company and his loss would impact our growth assumptions.
 

Catalyst

- Continued growth in the asset management business that reveals the significant operating leverage and increased profitability.

- Additional equity raises for Resource Capital Corp.

- New investment management business opportunities. Each current business unit was at one time a new idea that was pursued to fruition.

- Continued divestitures of legacy real estate and other investments.

- Continued share repurchases.

- Monetization of LEAF through a sale or spin-off. Management has a history of spinning-off subsidiaries (ATLS, RAS) as a means to create shareholder value.

- FBR conference presentation in late November.
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