In the past, Altisource Asset Management Corporation (NYSEMKT:AAMC) was one of my short ideas, due to it having surpassed any kind of rationale when compared to Altisource Residential Corporation (NYSE:RESI), even in light of the very generous management contract which AAMC held.
Meanwhile the stock has plunged due to several problems, including:
- Troubles within the Ocwen Financial Corp. (NYSE:OCN), leading to fears of less supply and worse terms for RESI investments in NPLs (Non-Performing Loans).
- The overvaluation, which I identified.
- And finally, most recently and most importantly, the extreme changes which affected the AAMC management contract.
This article verses on those changes, as they're really quite radical.
Before The Changes
AAMC earned an incentive fee in proportion to the cash distributable by RESI, with the actual proportion being on a sliding scale which could hit up to 50% of that cash. AAMC also had rights to expense reimbursement, so in the end, the case could be made for AAMC to be worth as much as RESI.
After The Changes
Now, everything's changed.
Since April 1, AAMC entered into a new Asset Management Agreement with RESI, which replaces the previous incentive fee with a much less generous scheme structured as follows:
The AMA, which became effective on April 1, 2015, provides for a new management fee structure which replaces the both the expense reimbursement (except costs related to RESI) and the incentive fee structure under the original asset management agreement. The new management fee is structured as follows:
- AAMC is entitled to a quarterly base management fee equal to 1.5% of the product of (NYSE:I) Residential's average invested capital for the quarter multiplied by (ii) 0.25, while Residential has fewer than 2,500 single family rental properties actually rented ("Rental Properties"). The base management fee percentage increases to 1.75% of invested capital while Residential has between 2,500 and 4,499 Rental Properties and increases to 2.0% of invested capital while Residential has 4,500 or more Rental Properties;
- AAMC is entitled to a quarterly incentive management fee equal to 20% of the amount by which Residential's return on invested capital exceeds a hurdle return rate of between 7% and 8.25% (depending on the 10-year treasury rate). The incentive management fee increases to 22.5% while Residential has between 2,500 and 4,499 Rental Properties and increases to 25% while Residential has 4,500 or more Rental Properties; and
- AAMC is entitled to a quarterly conversion fee equal to 1.5% of the market value of the single-family homes leased by Residential for the first time during the quarter.
- (Source: AAMC 8-K)
This agreement is supposed to run for 15 years (and up to 25% of the incentive fee can be paid in RESI shares).
Given the new agreement, there's a need to try and project how much AAMC will now be roughly worth. This is what I will attempt in this article.
Model
First off, after the massive change in the management contract, it's obvious that AAMC is now steering RESI in such a way as to maximize whatever value it can still have. This is evident in the change in focus towards buying SFRs (Single-Family Residences/Rentals), whereas previously, RESI bought NPLs which would over time transform into SFRs.
For instance, AAMC announced that RESI will buy up to 1,325 SFRs, with the transaction closing this month:
We negotiated Resi's agreement to purchase up to 1,325 single family rental homes from Invitation Homes and we expect this transaction to close latte this month.
- (Source: Q2 AAMC earnings call)
Why might this change in focus be taking place? Well, all of AAMC's new compensation structure relies on the number of SFRs bought and held. It's particularly important for RESI to cross the 4,500 SFR threshold, which I expect it to quickly, to have access to the higher rates in its new agreement.
However, even at the higher rates things look dicey. For instance, my model sees at most a $25.3 million annual base management fee, based on the present invested capital (at the higher 2% rate). And while this invested capital might grow, the impact is not that large given the low rates AAMC will collect from it.
The conversion fee, on the other hand, also looks limited in the potential to generate large revenues. For instance, 1,000 SFRs @ $200k each would produce just $3 million in one-off revenues. This is never going to be a massive earner.
Finally, AAMC might be depositing its faith on the incentive fee. But this fee is at zero now, and while AAMC sees it starting to matter in the future as the SFR portfolio expands, the growth isn't likely to provide much in the way of revenues, either. Just check this chart from AAMC's Q2 2015 earnings presentation:
Even at 12,000 SFRs, the lowest hurdle rate and the highest incentive rate (25%), AAMC would be earning just $2.325 million per quarter, or $9.3 million per year in incentive fees.
Add it all together, and very optimistically one gets:
- $25.3 million in base management fees.
- $9.3 million in incentive fees.
- And a non-recurring (except in the sense that the SFR portfolio would need to be perennially expanding) $12 million or so in conversion fees (assuming the addition of 4,000 SFRs @ $200k per year or 6,000 @ $133.3k).
In total, this would bring in $46.6 million in revenues per year if we are very optimistic (the present run rate is below $25 million). But that's just the revenue side.
On the cost side, we have a present run rate of around $30 million in administrative costs, plus we should apply a tax rate to whatever earnings this produces (I will assume 35%). Here, it's important to notice that the $4.5 million or so in administrative costs during Q2 2015 are understated, as they were favored by a $3 million litigation reserve reversal; hence, I considered $7.5 million in recurring costs per quarter, or $30 million per year - this too is optimistic, as it would imply no cost inflation in spite of a much higher level of activity).
What this gives us is ($46.6 - $30 million) * 65% = $10.8 million. That's a best-case scenario in net earnings for AAMC. Looking at the company trading at $64.20, or $141.7 million in market capitalization, you might be tempted to day "it will one day be reasonable at just 13.1x earnings". Also, keep in mind that without the litigation reversal, it would already be running at a loss.
But it isn't so easy. You see, AAMC went on a rampage buying its own shares, and financed the whole thing with preferred stock maturing in 2020, to the tune of $250 million. Now, these $250 million divided by $10.8 million already implies a 23.1x earnings multiple, and they'll be ahead of AAMC common under liquidation preference. 23.1x for an optimistic "in the future" earnings scenario is already quite an elevated multiple.
Since 23.1x is already a large multiple on an optimistic scenario, and the preferred shareholders have the right to have it paid in cash - and AAMC will have no such cash lying around - this means that come 2020, the company should be at the behest of preferred shareholders. This scenario renders AAMC shares worthless today. And it gives credence to me talking about "liquidation preference".
There is the chance, however, that if and when the optimistic scenario produces itself, AAMC will look "optically reasonable" for common shareholders, since the preferred stock earns no dividend. This could keep the stock at somewhat elevated levels for longer than warranted. Anyway, the existence of the large preferred stock position means that for now, no value can be found here, even after the stock dropped so much.
Conclusion
Due to the unfavorable change in its management contract with RESI, its ongoing administrative costs and its large preferred stock issue which matures in 2020 and needs to be paid in cash, AAMC common stock looks to be worthless.
This conclusion is reached even while modeling a very optimistic scenario for AAMC.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
