I posted my first write-up on Fortress Investment Group (FIG) in May-2012, when the share price was only $3.11. At the time, buying and writing about the shares felt much like being in the thick of battle - perhaps trying to defend a breached portcullis in a last-ditch effort. [In hindsight, the more revulsion I hear about a write-up/company, the more promising the investment opportunity often proves to be...] But the situation certainly looked much safer by December (with the share price at $4.38), when I posted a follow-up piece: Another Assault on Fortress. And now here we stand, on the ramparts, masters of all before us - the share price is $7.77, and even traded over $9.00 recently.
But ramparts are not about the view, they're designed for spotting danger. My last fair value price target was $8.84 per share - we need to do a fresh survey. How much upside potential is now on offer? And more importantly, has our margin of safety been eroded to unacceptable levels?
OK, let's do a quick wrap-up of 2012, and then take a closer look at progress year-to-date. I plan to stick with (roughly) the same valuation methodology, so I definitely recommend you revisit my last two posts (linked above). However, it would be handy to reproduce this table here:
Fortress finished 2012 with $53.4 billion of Assets under Management (AUM) - up 22% year-on-year, and obviously well ahead of an average $48.6 billion of AUM for the year. Full year management fees were $479 million, while incentive fees contributed another $278 million - or 0.99% and 0.57% of average AUM, respectively. The decline in management fees (as a % of AUM) is not a cause for concern - it's simply a by-product of the continued fund-raising success of Fortress' traditional fixed-income unit (Logan Circle Partners). [Which obviously charges a far lower fee rate, plus it currently operates at break-even. We'll price accordingly, but note the 2010 acquisition of Logan has been a resounding success - AUM has doubled since to $23.6 billion as of end-September]. Incentive fees have continued to rise (on average, from their 2007 nadir), driven by an acceleration in private equity realizations. And finally, fund management distributable earnings of $277 million - which approximates operating profit - delivered a 37% operating margin.
Of course, 2013 has been a banner year for Fortress. Latest (end-September) AUM's now at $58.0 billion, up 13% year-on-year, with average AUM of $55.4 billion year-to-date. Management fees hit $397 million to date, nearly matched by incentive fees of $357 million (equating to just over a billion dollars of annualized fee revenue). Which amounts to 0.96% and 0.86% of average AUM, respectively. Plus fund management distributable earnings are at $294 million year-to-date, an operating margin of 39%. Now, let's highlight some key performance drivers for 2013, and the future:
Well, we should obviously first mention performance itself - Fortress actually has a great story to tell this year: Its private equity and hedge funds have delivered strong double-digit returns this year. Credit Opportunities Fund and Credit Opportunities Fund II have delivered net IRRs since inception of 25.9% and 18.4%, respectively. And all 16 of Logan's fixed income strategies have outperformed their benchmarks since inception. The company and its funds have also garnered numerous awards this year. More importantly, multiple funds are now in a position to deliver current and future incentive fees - in fact, Fortress now has $807 million of gross embedded incentive income that has not yet been recognized in distributable earnings.
Next, let's examine Fortress' focus on 3 major investment themes in its PE funds (and credit funds, to some extent): i) Financial Services and Mortgage Servicing, ii) Transportation and Infrastructure, and iii) Senior Living and Care. You will notice each theme offers attractive scalability, consolidation and growth opportunities. In my opinion, this grants a compelling edge to FIG and its investors in terms of risk/reward (versus its peer group). [For example, Fortress funds appear to rely on/require far less leverage than KKR (NYSE:KKR) or Blackstone Group (NYSE:BX) to deliver attractive returns, particularly on a risk-adjusted basis. I suspect underlying LBO risk is often under-appreciated by investors when evaluating certain alternative asset managers].
Newcastle Investment Corp (NYSE:NCT) has been listed for years now, while Nationstar Mortgage Holdings (NYSE:NSM) IPOed last year. In May this year, NCT spun-off New Residential Investment Corp (NYSE:NRZ). And since then, Newcastle's announced another plan to spin-off of its media assets into New Media Investment Group, a deal to be completed in early 2014. Fortress also hinted at a spin-off of Newcastle's senior housing assets. [Which would nicely complement another portfolio holding: Brookdale Senior Living (NYSE:BKD)]. Their latest success is the IPO of Springleaf Holdings (NYSE:LEAF) - at the current share price, they're looking at a 13x multiple of invested capital in just under 3 years!
I suspect we will see something similar to come with transportation and infrastructure, in due course. Fortress already intends to list a new investment vehicle, Worldwide Transport & Infrastructure. And it has very interesting plans lined up for its assets in Florida (see the Q and A). Despite well-established European (and Asian) models, infrastructure remains a huge and relatively untapped investment opportunity in the US. But with federal and state budgets already stretched to pay for current spending, debt and pension/health entitlements, this dam will inevitably burst (they need to repair those too). New and required capital spending on infrastructure will inevitably demand massive private, or public-private, investment.
And just in the last week, we see Penn National Gaming (NASDAQ:PENN) spin-off what I believe is the first casino REIT: Gaming and Leisure Properties (NASDAQ:GLPI) - this was a highly original and attractive unlocking of value for shareholders. Finally, let's also remember Fortress has considerable exposure to German residential & commercial property, via Gagfah (OTC:GGFHF) and Eurocastle Investment (OTC:EUIVF). Both vehicles have recently been re-capitalized and/or re-financed, setting them up nicely to participate more actively in what I believe is a very attractive market.
Fortress' emphasis on permanent investment vehicles should be highlighted here - it's a very deliberate strategy, and offers welcome reassurance on revenue and earnings stability. After the Springleaf IPO, nearly half the NAV of its PE funds is now invested in public companies. This stands in marked contrast to most alternative asset managers, who are generally in divestment mode once they IPO a portfolio company. It's also testament to the potential investment opportunities and returns Fortress continues to expect from these listed companies. [We see the same alignment in Fortress itself - insiders still own 52% of the company. Plus Nomura Holdings (NYSE:NMR) owns a long-term 12% holding].
Finally, let's cover a couple of exciting new investment strategies that Fortress is currently/potentially pursuing: In April, Logan hired David Shell away from GSAM, where he was Co-CIO of the growth equities investment team, and responsible for $20 billion of AUM. It will obviously take time to begin delivering results (and AUM), but he's essentially tasked with re-building his previous operation. To date, he's hired a team of four ex-Goldman colleagues, and Fortress have now seeded four distinct equity strategies. Speaking of seeding, there was an intriguing article on Bloomberg this week, which confirms Fortress is considering seeding a spin-off of a new hedge fund firm. This would be headed by Adam Levinson, who is currently CIO of their Singapore hedge fund unit. We will have to see what comes of this, if anything, but it's potentially a great introduction to an exciting new seeding strategy. [I've already highlighted Tetragon Financial Group (OTCPK:TGONF) is currently pursuing such a strategy].
The other obvious trillion dollar opportunity for Fortress, and every other alternative asset manager, is in European distressed assets. Pete Briger, Head of Credit, is refreshingly honest about prospects for the credit markets, and Fortress' credit AUM - he acknowledges huge potential in Europe, but still hasn't found much in the way of compelling opportunities. This appears to be due to a combination of unrealistic sellers and unsuitable opportunities. The problem for Fortress is they generally like situations with a bit of hair on them, but which also offer good long-term growth and consolidation opportunities. But to date, a real estate and/or liquidation mindset is required to buy what's actually on offer. However, I'm confident Europe will ultimately prove a large-scale and rewarding investment destination for Fortress - though I suspect via the purchase of distressed companies, rather than portfolios of distressed properties/loans.
OK, let's home in on an up-to-date FIG valuation. Assuming FY-2013 stays in-line with the year-to-date (Q1-Q3) trajectory we have seen, and using the table above, we now have seven years of data to work with. Considering the continued/increasing impact of Logan and its lower fee rates, it's safer to assume management fees (as a % of AUM) won't revert to higher levels - so let's use the latest 0.96% of AUM fee rate. Incentive fees are obviously on a rising trend at the moment, but they will continue to remain volatile - let's opt for the long-term fee average of 0.74% of AUM. Operating margin is a little more stable - the 3 year and long-term averages are 37% and 41%, respectively. Either way, I think that deserves at least a 3.5 Price/Sales multiple (which is a small bump-up from the 3.25 Price/Sales I have used previously). We also need to factor in net cash and investments. No issues here, Fortress has zero debt, while cash and investments have been increasing rapidly as realizations have accelerated. As of end-September, the company had $311 million of cash & $1,263 million of investments on the balance sheet. Putting all this together:
$58.0 billion AUM * 1.70% Total Fees * 3.5 Price/Sales + $1,575 million Net Cash/Investments = $5,024 million / 489 million Shares = $10.27 Fair Value per share
Actually, this valuation might well prove conservative - consider the following:
- Dry powder is committed but uncalled capital, which most alternative asset managers include in their reported AUM (even though it usually generates no fees). Fortress specifically excludes it - my valuation incorporates none of the firm's $7.2 billion of dry powder.
- As I mentioned before, Fortress currently has $807 million of gross embedded incentive income in its funds, which has not yet been recognized in distributable earnings. I also haven't included $100 million of option value (related to Newcastle, etc.) in my cash and investments - this should be realized as incentive income/cash in due course.
- Results continue to be impacted by Logan, which has sacrificed margins to date in pursuit of AUM. Ideally, with continued AUM growth, increasing economies of scale, and a decent contribution from their new equity strategies, we can hope to see a significant improvement in Logan's fee rates and margins within a reasonable time-scale.
- FIG's annual dividend rate is now $0.24, a still attractive 3.1% yield - and we can reasonably expect a step-up to (at least) a $0.28 dividend and a 3.6% yield next year. But annualized pre-tax distributable earnings are now running at about $0.85, and FIG paid out over 100% of DE last year (in dividends, plus share repurchase). If we assume (say) 50% of incremental earnings gets paid out as a top-up dividend, that would amount to nearly $0.55 in total dividends & a 7.0% yield for FY-2013. Share repurchase would also present a strong signal/incentive for both new and existing investors. Management's repeatedly affirmed its commitment to returning a significant portion of annual earnings and slimming down the balance sheet.
- My valuation approach pegs the asset management business at 5.95% of AUM, on an ex-cash basis. Over time, the asset management industry has established some well-defined market/M&A multiples. On average, a high quality fixed income manager might attract a 0.67%-1.0% of AUM valuation, while an alternative asset manager might command 7.5%-10% of AUM (or even higher). Relying on these metrics, one can quickly arrive at a very similar valuation for Fortress' business.
My $10.27 Fair Value per share offers an additional Upside Potential of 32%. I currently have a 5.1% portfolio holding allocated to FIG.
- Fortress Investment Group
- Market Price: $7.77
- Mkt Cap: $3,800 M
- Dividend Yield: 3.1%-7.0% (based on a $0.24-$0.55 div)
- Price/Cash: 2.4
- Ex-Cash % of AUM: 3.8% of AUM
- Target Mkt Cap: $5,024 M
- Tgt Div Yield: 2.3%-5.3% (based on a $0.24-$0.55 div)
- Tgt Price/Cash: 3.2
- Tgt Ex-Cash % of AUM: 5.95% of AUM
- Tgt Mkt Price: $10.27
- Upside Potential: 32%