Resource America (REXI) is a specialized alternative asset manager that focuses on real estate and credit investments managing a gross aggregate of more than $16 billion. The company recently restated their financial statements for 2012 and their 10-Qs for 2013 to incorporate their unconsolidated variable interest entity, Resource Capital Corp. (RSO). There is an opportunity to get into the name before the non-cash charge-offs in the commercial side of the business, which have suppressed their reported earnings, run off and will help show stronger results going forward. But the underlying thesis rests in the firm reaching an inflection point where the incremental margins on the real estate side of the business are over 50% boosting profitability as demand for their REIT products explodes. This will likely translate into earnings growth at 20%+ over the next several years, something which the stock price does not currently reflect. The stock has zero sell-side coverage to make investors aware of this opportunity.
As a specialized asset manager, they seek to develop investment funds for outside investors. As of the end of September 2013, the company managed $16.5 billion in assets, an increase of 10% over the year ago quarter and nearly $475 million from the end of June. The company operates through 3 segments: real estate debt asset management, real estate equity asset management, and the credit asset management business. Most of the assets reside in their credit strategies, with over $9 billion in CVC Credit Partners, which falls under the financial fund management category below:
However, the real estate business generates far more revenue given the higher fees - approximately 2% of assets - compared to the credit business, which generates roughly 45 bps per dollar of assets on new money and 35 bps on legacy capital.
Financial Fund Management
Within the financial fund management operations, they conduct business through six operating entities. 1) CVC Credit Partners, a joint venture between the company and an unrelated third party, which finances and structures investments in bank loans, high yield bonds, and equity investments through CLO issuers, separately managed accounts and a credit opportunities fund. Prior to April 2012, they conducted this under the banner of their Apidos business. 2) Trapeza Capital Management (TCM), is another joint venture that manages trust preferred securities and senior debt securities of banks and bank holding companies through CDO issuers. 3) Resource Financial Institutions Group (RFIG) serves as the general partner for seven company-sponsored affiliated partnerships, which invest in financial institutions. 4) Ischus Capital Management, finances, structures, and manages investments in ABS including RMBS and CMBS. 5) Resource Capital Markets acts as an agent in the primary and secondary markets for structured finance securities and manages accounts through their own broker-dealer. 6) Resource Capital Manager (RCM) is an indirect wholly-owned subsidiary, which provides investment management services to RSO under a management agreement between the two entities.
Their real estate operations focus on four different areas including: 1) The acquisition, ownership, and management of portfolios of discounted real estate and real estate related debt, which are purchased through their two sponsored real estate entities and joint ventures with institutional investors. 2) The sponsorship and management of real estate investment entities that primarily invest in multi-family housing. 3) the management, principally for RSO, of general investments in commercial real estate debt. 4) The management and resolution of a legacy portfolio of assets that include real estate loans and property interests acquired between 1991 and 1999.
The float is less than half of the total shares outstanding. The largest shareholders are the current and former CEO along with other top executives who together own approximately 27% of shares. There are other notable major holders including legendary value investor Leon Cooperman who owns roughly 12% of the shares. William Martin of Raging Capital Management, owns 10.5%, Yacktman Capital owns nearly 8%, and Dimensional Fund Advisors owns approximately 6% for their underlying funds.
Resource Capital Corp.
On September 19, 2013, the audit committee of the board of directors concluded that it was necessary to restate the audited financial statements set forth in the 10-K and 10-Q. The restatement reflects the consolidation of RSO, which the company previously treated as an unconsolidated variable interest entity. The move also changed the fiscal year end to December 31.
all images from REXI company presentation
RSO is a publicly-traded commercial REIT that Resource America sponsors and manages. Effectively, Resource America is a sub-adviser manager for RSO. The deal is structured so that Resource America earns a base fee rate of 1.5% on the equity of RSO, plus an additional 25% of EBIT above a hurdle rate of 8%. In other words, the average fee rate can be lumpy but will never drop below 1.5%. Resource America management stated on the third quarter conference call that the average fee generated over the last two years has been just above 2%. In addition, they receive reimbursements in direct expense payments.
RSO has over $805 million of managed equity, including preferred equity. The company's floating rate assets provide protection against rising interest rates and assets are predominantly term-funded. The company has access to new financing and has a loan origination program, along with a pipeline of deals all while maintaining liquidity.
Through the end of September, RSO raised over $184 million in new equity capital while originating $94.2 million of commercial real estate home loans. The firm anticipates that the pipeline will originate over $600 million of real estate loans in fiscal 2014. RSO also acquired a residential mortgage company and started a middle-market corporate loan platform. As noted in the call:
Both efforts will need more equity by the end of 2014. RSO's strong liquidity and access to capital enables it to make larger loans and expand its products. As the operations of the business grow, RSO shareholders and REXI shareholders will also benefit.
The segment has been a very strong player in the space greatly outperforming its peers.
Other Revenue Drivers
As an asset manager, the high-level revenue driver is fairly simple with revenue derived from asset management fees, which is applied to assets under management. Thus, all else being equal, the higher the management fees and the more assets managed, the higher the total revenues generated. That's the simple part. The more difficult part is analyzing the multitude of individual investment vehicles that generate those revenues.
In aggregate, we need to analyze the underlying investment funds, the markets they reside, and make assumptions about flows and performance going forward. Much easier said than done.
Starting with the financial funds management side of the operation, CVC is the largest product by assets under management for the company. Resource America owns 33% of CVC Credit Partners LP (CCP), a partnership jointly owned with CVC Capital Partners. CCP is an independent credit asset management and investment group focusing on sub-investment grade corporate debt in the US and Europe. They manage $9.6 billion in AUM ($7.1 billion in the US and $2.5 billion in Europe) through 32 investment vehicles (22 in the US and 10 in Europe). The venture was started almost two years ago when Resource America merged its legacy CLO business with CVC, giving them their Adipos CLOs.
Over the last 18 months, CCP has closed 5 CLOs with assets over $2.4 billion while completing a $450 million European IPO for CVC Credit Partners European Opportunities Fund. In total, CCP has raised $3.3 billion in assets over the last 18 months, a prodigious sum.
Within real estate, there are several moving parts including a number of REITs, both public and private, and multi-family properties around the country. The primary revenue drivers within the real estate segment are RSO and their non-listed Opportunity REIT (OpREIT), a private REIT that invests and sells commercial real estate, including a large distressed properties piece where they renovate and sell off to purchase more properties.
OpREIT makes money similar to other private placement endeavors, raising capital and buying assets generally levered at a 1-to-1 ratio between debt and equity. The company earns 2% on the acquisition of the asset, and debt placement fees of 0.5%.
As I noted above, the company derives most of its revenues and profits from its real estate operations. The company operates the properties they purchase through their property management business, though this is generally a lower-margin function than the acquisition or asset management sides of the operation. However, the firm considers it a vital component of their strategy of buying and renovating multi-family assets, which they believe it critically differentiates them from their competition.
Third Quarter Results
Assets under management grew by $1.5 billion to $16.5 billion over the trailing twelve months and grew by over $475 million since the sequential quarter end. Adjusted cash flow from operations grew $244,000 over the year ago quarter to just over $6.9 million. Flows were strong with the firm raising over $507 million for their REITs as compared to the same period a year ago, when they raised $265 million over the trailing twelve months.
The real estate equity asset management division raised $375 million through July for its non-listed REIT, OpREIT. The CEO of Resource Real Estate, Alan Feldman, noted that the past quarter was the busiest and most productive in his 11 years at the company. Their primary focus of raising capital for OpREIT where they hope to add an additional $175 million to $350 million by the close of the REIT. As of November 15, 45 days after the quarter end, they had already raised $538 million, almost breaching their lower goal. Their fundraising level will enable the OpREIT to purchase approximately $1 to $1.2 billion of real estate assets by the end of 2014.
Management has already deployed several million dollars of capital to purchase. In the latest quarter, the OpREIT purchased 4 properties, representing 1,120 units generating $2.5 million of acquisition revenues for the overall firm. Currently, the OpREIT has $408 million of real estate assets in its portfolio, representing 25 assets, 6,600 apartment units in 15 states. Additionally, they have over $100 million in cash and available credit capacity to make added purchases.
On the financial fund management side of the business, CCP closed Apidos CLO XIV and Apidos CLO XV for par values of $617 million and $500 million, respectively. In connection with these CLO issuances, CCP expects to receive approximately $4.9 million in asset management fees in the future. Overall, AUM in the segment rose 9%, or $1.1 billion, in the quarter compared to the year before, reaching $13.8 billion.
The company has also been rewarding shareholders for the growth by repurchasing 205k shares. Since August 2012, the company has repurchased over 588k shares under its repurchase plan. In addition, the board has upped the dividend payout from $0.04 to $0.05.
There are several opportunities that lay at the feet of the company. The CEO has noted over the last several quarters that they are at a 'tipping point' for earnings and EBITDA.
The largest opportunity rests within their OpREIT product. The company has raised a record sum of assets over the last 15 months hitting $101.5 million. Total assets of $382.6 million as of the end of September, an increase of $234 million or 157% over the same quarter a year prior, reflect the acquisition of several properties that I noted above. The current OpREIT closed its window at the end of calendar 2013 with approximately $635 million in total, raising almost $195 million since October 1, 2013. The run rate in the fourth quarter creates a large tailwind going into 2014 as they start raising for OpREIT 2.0.
The opportunity lies in how they generate revenue and profit. If the company raises $650 million in equity, they would then issue $650 million in debt and buy $1.2 billion in assets. The OpREIT has reached a leverage level where incremental capital carries strong incremental margins above 50%. The revenue generated would be as follows:
However, the real opportunity for investors and the company is if they can turn the assets more than once during the five-year life of the fund. Management stated that assets can be flipped in two to three years, just as they do on the shows on HGTV where people buy, remodel, and sell the property for a profit. This is particularly true on their distressed assets where value is realized fairly quickly upon upgrading the property. If that is the case, they can earn another acquisition fee and debt placement fee on the same capital again. The question surrounding this opportunity is how quickly can they find properties that fit their acquisition criteria.
The company believes this business has the potential to be so successful that the CEO of the division mentioned a second OpREIT fund to follow the first, probably sometime in early 2014. Institutional demand for REITs have been steadily increasing over the last several years as investors attempt to get into the late-early to mid-stages of the recovery within the sector. Management thinks that their private REIT business will surpass RSO in term of cash flows this year. Most of the sector research I have read states that demand will continue given the lack of inventory and demand for higher-yielding asset classes.
But a little internal competition shouldn't be discouraged as RSO isn't just sitting on its laurels. As I stated in the above RSO section, the company earns 1.50% base fee plus an incentive fee of 25% of EBIT above an 8% return on equity. Over the past two years, ROE has been above 8% half the time, but most were driven when the company made large asset sales resulting in large gains. The key positive about the RSO business is the fact that the money is very 'sticky'.
The internal origination business has helped accumulate capital very well with RSO growing equity value from $186 million in 2008 to $783 million in 2012. The company stated on their conference call that they plan on raising another $200 million in 2014 with incremental margins on the fees on those assets greater than 50%. At 1.5% to 2% fees, this equates to an additional $3- $4 million in revenues and $1.5 to $2 million in EBITDA. This is not likely to be a one-off event either as there is effectively no capacity. The firm could continue to leverage the existing infrastructure and sustain growth of $200 million for several years at 50% margins.
Remember, the assets of the two pieces I have described above are much higher margin businesses compared with the financial funds which will help push up the overall firm EBITDA margin rate.
Management has also indicated that this ramp up in leverage of expenses and expansion of operating margins could occur in CVC. If they can grow assets under management by $500 million and CLOs by $1 billion, it would equate to added revenues of $8.75 million at 50% incremental margins at one-third ownership level or $1.45 million in added operating income. This would be added to the current $2.4 million run rate on assets and get the piece to approximately $3.8 million. In November, CVC raised a $625 million CLO so they've demonstrated an ability to reach those objectives.
In summation, all three main pieces have, in the CEO's words, reached a tipping point with added capital raises within each adding nicely to the bottom line.
This is all happening while the commercial financing business continues to wind down from natural runoff of the lease portfolios, which has depressed reported results over the last several years. Below is revenue by segment by year:
Over the next few years, true organic growth is going to materialize as the commercial business ceases to be a headwind to the overall financial results. Couple this with the very high incremental margins and growth potential in underlying assets managed, and you have a strong potential for EPS to grow above 20% for several years hence.
So where do we see the value of shares after looking at all these disparate pieces, the opportunities, and the recent results? Let's start off with the current valuation. The company is modestly priced at 12x normalized EV/EBITDA while growing AUM at a high single digit clip over the last several years. At nearly 9% free cash flow yield, the story is being overlooked as the commercial segment weighs down the results and obscures prospective earnings growth.
We'll go through the company piece-by-piece and sum it all up, starting with the real estate segment.
Management fees within the real estate business should top $35.5 million in fiscal 2013 but expand to over $44 million by fiscal 2015. Margins in this business are lumpy due to the RSO businesses performance fee but in general, they should realize low-to-mid 20% on that revenue, especially given incremental margin levels. At a $44 million revenue level and a 23.5% margin rate on EBITDA, we get $10.3 million in EBITDA.
The financial funds segment is not a high growth area but does represent a stable and profitable business to the overall company. The segment is a bit of a black box to determine the exact and consistent cash flows out of the CVC segment specifically due to the underwriting of new CLO funds, Australian partnership, and other lumpy expenses. Management is expecting this part of the business to also ramp up and see a large expansion of margins similar to the RSO and OpREIT businesses but I'm more hesitant on that materializing, so for now, we'll keep this piece treading water. Currently, the piece is generating approximately $2.4 million in net income flowing to REXI. There is no interest expense nor depreciation or amortization so that is EBITDA as well as the segment is reported net of taxes.
There are other smaller financial funds that the company manages but they are not material to our analysis at this point and come free with purchase.
The RSO operation is likely to generate revenues of $110 million in 2013, up from $104 million the year before. In fiscal 2015, we estimate that revenues could grow to $116 million. But the real story here is the growth of margins and equity (given how REXI gets paid on the RSO business). Equity has been growing at a compounded rate that is unsustainable (on their presentation they highlight the fact that it has grown at a 196% CAGR since 2010). But as I noted above, they can easily, and expect to, grow equity by $200 million per year for the next two years. Again, this adds an additional $1.5 to $2 million in EBITDA each year to the current run rate of approximately $8.8 million summing to roughly $12.8 million in 2015.
I used an 11x multiple EBITDA, down from the current 12x normalized trailing twelve-month multiple. I also used 2015 forecasted data to develop a 12-month time/price target for the end of year 2014.
I feel this is a fairly conservative estimate of intrinsic value as the projections and assumptions embedded within the model assume low AUM growth and a ramp in revenues/margins that is in-line with the company's management. In reality, if they have set these benchmarks at levels whereby they can easily outperform them, then the upside is even larger. Book value of REXI reached $7.82 as of the end of September, which provides a nice floor to the shares and an asymmetric return to the investment.
There are significant risks surrounding the CLO business mostly stemming from potential regulatory risk. This is developing in both the US and European regulatory rule-making bodies. There are several proposals in the early stages of passage so it remains to be seen what eventually is passed. As one of the premier CLO players in the market, if one of these bills are passed, it is likely the lesser players would be harmed more than the top players.
The company recently restated its financial statements for all periods to consolidate in RSO's results and reflect the corresponding change in the company's fiscal year end from September 30th to December 31st to conform to the fiscal year of RSO. While minimal, there is always the risk that something may pop-up in the 10-K that spooks investors.
- Reaching a tipping point where margins should expand rapidly and EBITDA growth should accelerate
- Highly complicated and misunderstood business presents opportunity
- Regulatory overhang is over-hyped given they are the premier player in the industry
- OpREIT success providing a very high-margin return on assets and the prospect of a second REIT compelling given assets raised
- Headwinds from the commercial financing operations will cease from here showing stronger organic results
This shadow stock is complicated to understand given all the moving parts, joint ventures, and disparate business lines. However, when you boil it down to 1) how they make money and 2) the growth opportunities going forward, it is fairly straightforward. Due to the lack of coverage by analysts and poor reported results primarily stemming from the commercial leasing operation, the stock is being tossed aside. If the company's internal objectives are met, they should realize a nice boost to margins thanks to the operating leverage of the business- what the CEO refers to as the company's 'tipping point'. This should ramp up their EBITDA in the next two years providing investors with a very strong return.