*Note: This article first appeared in the Premium Service "The V20 Portfolio"
Company: RMR Group Inc.
Ticker: NASDAQ: RMR
Year End: September 30th
RMR Group Inc. (NASDAQ: NASDAQ:RMR) (RMR Inc.) is a real estate management company, whose value is concealed by a complex organizational structure and a lack of coverage, as it recently went public quietly through a distribution of existing shares on December 14th, 2015.
Due to the company's complex organizational structure, we will first analyze the company without dealing with the corporate structure.
Understanding The Company
RMR Inc. is a holding company of RMR Group LLC (RMR LLC), the company's operating subsidiary. RMR LLC was founded in 1986, so it's got quite a history. Its primary business activity consists of providing business and property management services to real estate companies (e.g. REITs).
RMR LLC currently has four REITs (Managed REITs) and real estate operating companies (Managed Operators) as clients. The majority of the revenue is derived from service provided to REITs (80.5%). This is important because the revenue from REITs is supported by a "perpetual" 20-year agreement, in that the agreement is automatically extended every year so that the agreement will end on the twentieth anniversary of every year. In the event of termination without cause, RMR LLC will be entitled to the present value of the payments.
Also worth noting is that the management fee scales with the growth of the REITs. The management fee is calculated based on either total market cap (equity and debt) or the historical cost of real estate properties, whichever is less. The rate is 0.7% for the first $250 million and 0.5% for any amount beyond that.
In addition to the management fee, RMR LLC is also entitled to incentive payments, which is based on the total return (i.e. including dividends) over a selected SNL index. What's great about the incentive payment is that there is no high-water mark.
To protect themselves, the REITs can also terminate the agreement for performance. However, the definition of poor performance is rather lax. The REIT in question must underperform the SNL index by 5% for three consecutive years and have a total shareholder return that is in the bottom tercile (bottom third) of the SNL index. Furthermore, even if the agreement is cancelled for performance, the REIT would still have to pay the present value of the management fee for 10 years.
Revenue from Managed Operators is not as protected. A term is only for one year, though it does have automatic renewals of one year. From a growth perspective, however, the terms are similar to the REITs in that revenue is not based on profit earned by the Managed Operators (in this case it's revenue, i.e. will benefit from growth).
There are several other non-material revenue sources, but I think a particularly interesting one is RIF (RMR Real Estate Income Fund). RMR LLC is entitled to 0.85% of the fund's managed assets, defined as NAV attributable to common plus liquidation preference of preferred shares plus any debt. In other words, RMR LLC will also benefit from the fund's growth similar to how it benefits from the growth of Managed REITs and the Management Operators. Although the revenue collected from RIF is small now (1.8% in FY 2015), there could be significant growth in the future depending on the fund's growth trajectory.
RMR LLC is also entitled to 0.6% of RMR Trusts' GAAP revenue (whose role in the organizational structure we will get to later) as well as other miscellaneous fees.
Now that we have an idea of how the company operates, we can carry out the valuation.
We first have to figure out how to model the fees from the Managed REITs. If the fees are currently based largely on total market cap (i.e. influenced by equity prices), then the fees will not be as stable. On the other hand, if the fees are largely based on the historical cost of assets and lags invested capital, then we know that the fees will be fairly stable.
To determine how the fee is calculated, we can refer to the following table.
Source: Data From 10-Qs and estimates
Actual Q4 revenue to RMR LLC is derived from actual expenses recognized by the relevant REITs in their respective 10-Qs. As we can see, with the exception of GOV, the estimated revenue is similar using both methods, meaning that revenue will be correlated with equity movements (illustrated by "% Of Revenue At Risk," calculated as equity market cap divided by total market cap). However, as we shall see later, price movements are not a big concern over the long run. There is some discrepancy between the estimated fee revenue and the actual fee revenue since the balance sheet doesn't perfectly capture the historical cost of the real estate properties.
For HPT, there is a mismatch between actual revenue and estimated revenue, since the revenue does not conform to neither assets nor the market cap. The reason is that HPT's management elected to include estimated incentive payments totaling $8.56 million for the quarter. Subtracting this amount, we find that the pro forma total of $8.83 million is closer to the fee based on total market cap.
For the purpose of valuation, we will use the most recent market price to project future revenue for all the REITs except for GOV, whose annual fee will be extrapolated using actual fees of $2.4 million in generated Q4.
Source: Own calculation
There are three Managed Operators: Five Star Quality Care, Sonesta, and TravelCenters Of America. As mentioned earlier, RMR LLC takes a cut of revenue. The percentage is 0.6% for all three Operators. For FVE and Sonesta, the process is straight forward, as the fees are mostly based on GAAP revenue. The terms are more complex for TA. RMR LLC's fee will be based on the net fuel margin plus non-fuel revenue. Because TA's management is aggressively expanding right now, it will generate significant value for RMR LLC in the future. FVE also has a history of growth, hence it may also deliver growth in the future. Because Sonesta is a private company, there is not sufficient information, although fees from Sonesta grew 23% in 2015, from $1.5 in 2014 to $1.8 million.
There is an immediate catalyst for growth. TA's management has been aggressively expanding its convenience store locations. It has already acquired 150 locations year to date, with 44 more pending at the end of Q3 (RMR's Q4). In Q3 alone, TA acquired 105 stores. Due to timing (locations were acquired in late Q3), their revenue was not fully reflected in Q3's financial statement, and hence not on RMR LLC's financial statement. TA's management projects that each store will add $1.35 million of non-fuel revenue on average and 1.25 million gallons of fuel ($0.19 million at $0.15/gal). Based on the above information, the new stores should generate $229 million of annual revenue.
*Sonesta's revenue is estimated using fee paid to RMR LLC in 2015.
Source: Own calculation
RIF, and RMR Trust
While RIF invests in monetary securities, its NAV fluctuates with the market as well, hence the fee it pays to RMR LLC may not be consistent, much like the REITs. For that reason, the most recent NAV calculation will be used to estimate future revenue. Since RMR Trust is private, we will use 2015's revenue as a guideline.
Source: Own calculation
Since we now have many pieces of the puzzle, we can begin to find out the company's combined value. Adjusted EBIT margin is used to measure RMR LLC's normalized margins.
Due to a loss of a major client (which we will get to later), we will use Q4 2015 as guidance.
Source: Data extracted from 8-K dated December 18th, 2015
Keep in mind that the above only takes into account the base management fee and does not include any potential incentive payments.
Using the adjusted margin, we can construct a simple discounted cash flow model.
Source: Own calculation
As we can see, assuming that the REITs will never grow and will never pay incentive fee, RMR LLC is worth $518 million. The above model also excludes a complex tax treaty with RMR Trust, inflating the tax rate and decreasing FCFE. Nevertheless, this should provide us with a general idea of how much RMR LLC is worth in a poor scenario.
Modelling the incentive fee is quite difficult. It is almost impossible to accurately predict how much the company will get in a year given the equity market's innate volatility. However, it is reasonable to assume that some incentive fees will be paid once every three years on average. The reason is because performance is based on a three-year period (i.e. the cumulative total return over the past three years is calculated every year), poor equity performance in one year will set the stage for better performance later (i.e. mean reverting). The lack of high water mark also makes this possible. Take HPT as an example, although HPT's shares have not risen above its all-time high, RMR LLC is still entitled to receive incentive fee.
The terms of the incentive fee is very lucrative for RMR LLC. RMR LLC is entitled to receive 12% of the value of outperformance, defined as the equity market cap multiplied by the percentage by which the total return of the REIT exceeds the relevant index. To illustrate, if during the three-year time frame, the total return for a REIT is 10% and the total return for the index is 5%, the difference (5%) is multiplied by the equity market cap. Suppose that a REIT has an equity market cap of $2 billion, the value of outperformance would be $20 million. RMR LLC is then entitled to 12% of the $20 million, or $2.4 million. Given the average market cap of the existing REITs (~$2.7 billion), the payouts could be very large.
For the purpose of modeling, we will assume that the REITs will outperform the index by 3% once every three years, or 1% on average. This does not imply that the REITs will truly outperform the index in the long-run. The REITs could very well decline 50% in one year and RMR LLC could still be compensated through incentive payments in later years, as is the case with HPT. Using the above assumptions, we can find the approximate value of future incentive fees.
Source: Own calculation
Adding together the value of incentive fees and the value of the base management fees, we arrive at a total value of $598 million for RMR LLC. This is the basic value of RMR LLC. Due to the nature of the business (since revenue is somewhat dependent on market fluctuations), there are a variety of other factors that could increase the upside. However, they are not included in the basic valuation since their realization is less certain. Nevertheless, it's worthwhile to explore the potential upside.
Market Cap Growth
Since the compensation to RMR LLC is tied to equity movements (based on the market cap method), one may come to the erroneous conclusion that since price has not moved much for the Managed REITs, management fees cannot grow. However, keep in mind that RMR LLC is entitled to fees based on the total market cap, including preferred, and debt. Furthermore, it is the equity market cap, not the price, that counts. This means that although share price meandered, the total market cap can still grow.
The chart above contrasts the difference between the price, equity market cap (Market Cap in chart), and total market cap (using EV as a proxy). Evidently, every single REIT has grown consistently in terms of EV and equity market cap despite the poor performance of their shares.
In the DCF, we assumed that the REITs will not grow. Evidently, history tells a different story. Because of this, it may be worthwhile to look at how much growth value can the REITs generate. A sensitivity analysis is conducted using the previous DCF model.
Source: Own calculation
The "Value" column illustrates the additional value that growth can provide depending on the growth rate. Evidently, should the REITs continue to grow (even if at a slow pace), there will be significant upside.
Currently RMR LLC has no debt. Considering its stable revenue source, the balance sheet has the capacity to carry out a leveraged recap, whereby a special dividend is paid using debt. See below for an illustration.
Source: Own calculation
Base Value Of The Stock
Up to this point we've been talking about RMR LLC, the operating subsidiary of RMR Inc. From a purely economic perspective, RMR Inc.'s share of value is quite straight forward. Through its ownership of 15 million class A units and class B units of RMR LLC, RMR Inc. has 51.6% of economic interest in RMR LLC. Class A common shares (the class that is currently public, i.e. the stock) represent 93.7% of economic interest in RMR Inc., or 48.4% in RMR LLC.
Using the above information, we arrive at a base value (management fees and estimated incentive fees) of $289 million for Class A common shares. At $13.98, the price at which the stock closed on December 28th, 2015, the current market cap is $210 million. Using the base case, the potential upside is 38%.
Corporate Structure And Why It Matters
Up until now, we've explored the quantitative side of the stock. For RMR Inc. however, this is only half of the story. To fully appreciate RMR Inc.'s potential value, we must start by understanding its history and corporate structure.
RMR Inc. was conceived as a part of a complex transaction on May 28th, 2015. During the transaction, the Managed REITs (GOV, HPT, SIR and SNH) acquired 100% (15 million) of Class A common shares in RMR Inc. 47% of the shares were distributed to the respective shareholders of the REITs. The Class A shares represent 94.7% of the economic interest in RMR Inc. The remainder (6.3%) is owned by RMR Trust, which is owned by father-son duo Barry Portnoy and Adam Portnoy through 1 million Class B-1 common shares which entitles their owners (i.e. RMR Trust) 10 votes per share, but are otherwise similar to Class A common shares. RMR Trust also owns 15 million of RMR's B-2 common shares, giving RMR Trust 85.7% of voting interest in RMR Inc., effectively giving it control of RMR LLC.
In addition to the 1 million Class B-1 common shares, RMR Trust also has 48.4% direct economic interest in RMR LLC through 15 million class A units. Adding this to RMR Trust's economic interest in RMR LLC (through B-1 Common Share in RMR Inc.), RMR Trust owns 51.6% of RMR LLC.
Thus far we've learned that RMR Trust has significant economic interest in RMR LLC, and RMR LLC depends on the Managed REITs and Managed Operators for revenue. As mentioned earlier, the base management fee does not completely depend on share price movement, hence the best scenario would be for the REITs to grow their market cap or assets and for the Managed Operators to grow their revenue.
This is where it gets interesting. The owners of RMR Trust (the Portnoys) are also on the board of directors of all the public REITs as well as RIF; and the father, Barry Portnoy, is the Managing Director of the two public Managed Operators (FVE and TA). It is clear that the Portnoys are in the position of power to create value for RMR LLC. Unsurprisingly, all the moves pulled by the management of each company have benefited RMR LLC. For example, TA's aggressive acquisition of convenience stores will boost non-fuel revenue, increasing fees paid to RMR LLC. Similarly, Five Star rebuffed an offer to purchase its 33 senior living facilities, which generate revenue for Fives Star, and hence fees for RMR LLC.
The takeaway is that RMR LLC has every incentive to extract as much value as possible from its clients; and its indirect benefactor, the owners of RMR Trust, is in a controlling position to do so. Holders of Class A common shares will benefit from this since they own roughly half of RMR LLC.
The question to ask is: why did the Portnoys make RMR public? Clearly RMR is a very lucrative business. The biggest risk to RMR LLC prior to the transaction was shareholder activism.
Prior to RMR Inc. becoming public, one of RMR LLC's clients, CommonWealth REIT, became the target of activists. The message was very clear, the activists thought that RMR LLC was managing CommonWealth REIT for its own gain. After a year of battle, the entire board (i.e. including the Portnoys) was removed and replaced with the ones appointed by the activists. Just like that, RMR LLC lost $116 million of revenue (or 41% of 2014's total revenue) from CommonWealth REIT.
Portnoys are quick to learn however. During the battle for CommonWealth, the Portnoys amended the management fee structure to its current form from a mostly asset based formula. Unfortunately, just four months later, the board was removed. Clearly, the reform was not enough.
RMR Inc. is the brainchild of Portnoys that was born out of necessity in order to protect themselves from further losses. Now that the REITs have become owners in RMR Inc., the interest of the REIT investors are more aligned with that of the Portnoys, at least on paper (e.g. the incentive fees).
While the current organization structure gives less reason for activists get involved, it does not remove the risk. However, now that the Portnoys have already been through one battle, they should be ready to deal with the next one.
Source: Own calculation
The above table shows that the potential upside for the stock at the current price of $13.98 is 50%. The "% Of Realization" column is included for illustrative purposes only. The only number that can be reliably estimated is the management fee. However, as mentioned earlier, there could be substantial upside depending on the future growth of the Managed REITs and the Management Operators.
In conclusion, RMR Inc. provides a unique opportunity for shareholders to participate in an extremely lucrative business that has benefited the Portnoys for decades.
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Disclosure: I am/we are long RMR. 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.