Colony NorthStar (NYSE:CLNS) management did an admirable job of bringing its three-way merger to completion. NorthStar Asset Management's (NSAM) shareholders have earned a total return of more than 50% since I wrote last July that shares had potential for a 60% return. What next?
CLNS has not updated its future guidance since the initial merger presentation released on June 7, 2016. This article will comment on developments since that time and current uncertainties about the post-merger outlook:
- Key factors for CLNS post-merger valuation.
- Issues in the transformation of the business model.
- What about NorthStar Realty Europe (NYSE:NRE)?
- Near-term expectations.
Until more detailed information is available, I believe that fair value for CLNS's shares is still about 10X FFO.
Key factors for CLNS post-merger valuation
Future performance of Colony NorthStar shares depends on execution in these areas:
- Expense Savings. Guidance is for annual savings of $115mm (about $80mm in cash) and should not be hard to achieve.
- Co-Investment Business Model. The company suggests that gross IRR could increase from 13% on proprietary investments (current business) to 19% from management of investments with 80% outside partners (future business):
CLNS has a strong foundation from which to pursue this compelling opportunity, but the transformation will probably take 3-5 years.
3. Multiple Expansion. Colony NorthStar will be a somewhat unique business. The merger brings increased scale, should bring improved reputation, and promises lower risks. Will investors perceive it as a REIT (13-20 FFO Multiple), a mortgage REIT (8-12 PE Multiple), an asset manager (10-18 PE Multiple), an alternative asset manager (8-15 PE Multiple), or a special company?
The most optimistic outcome would be if the market awards a blue chip REIT valuation multiple to growing asset management income. The most pessimistic outcome would be if the market awards a discounted balance sheet valuation to the entire business due to complexity and unpredictability.
Issues in the transformation of the business model
After the June 2016 announcement, new details about the post-merger business plan have been scarce:
- Five "verticals" were mentioned on the CLNY 3Q16 conference call:
- Opportunistic Equity & Debt
- Investment Management
- Opportunistic investments will be wound down (excerpt from 3Q CC transcript):
The perceived risk, complexity, and unpredictability of the Opportunistic Equity & Debt investments held back the valuations of Colony Capital and NorthStar Realty Finance (NRF), so winding down these proprietary holdings should enable the company to trade at a higher future valuation multiple. But the Opportunistic Equity & Debt investments have also been a source of high returns:
- NRF's real estate debt holdings had an average yield of 11.9% at 9/30/16
- NRF's private equity holdings earned 17.1% on their average balance in 9ME 9/30/16
- NRF's CMBS assets had an average yield of 11.4% at 9/30/16
- CLNY earned an FFO yield of 12.0% on CRE debt in the 12ME 6/30/16
- CLNY earned an FFO yield of 15.4% on CRE equity in the 12ME 6/30/16
- Colony NorthStar's current balance sheet is quite far from the long-term goals implied by the co-investment business plan.
Full execution of the co-investment business model implies a major restructuring of current holdings and attracting $10-20Bn of new third-party capital. This may take 3-5 years. It has taken Colony about two years to attract about $0.5Bn from outside investors for its industrial unit.
It's hard to assign a premium valuation multiple right now without more clarity into the level of investment risk and earnings growth potential over the next few years. We don't know the pace at which earnings from high-risk assets will fade as they are liquidated. We don't know the pace at which investment management income will increase. The co-investment business model looks great in a four-line spreadsheet, but CLNS has not yet made a detailed explanation of how it will be implemented in the real world.
What about NorthStar Realty Europe?
Bow Street, LLC offered to acquire NRE last month for $13/share (see NorthStar Realty Europe - Activist Sees Opportunity in Advisor's Change of Control). NRE and NSAM made no public comment on the offer and whether Bow Street is correct that the CLNS merger will require shareholder approval of a new NRE management contract.
The value of NRE shares has been severely impaired by the onerous terms of the agreement (see No Real Excitement for NorthStar Realty Europe). Contract cancellation would immediately benefit NRE shareholders and harm CLNS. Purchase accounting for the CLNS merger valued the NRE management contract at $110mm, about 1.3% of pro-forma book value and the annual base management fee of $14mm contribute approximately 1% of CLNS's funds from operations. Bow Street may have hoped that making an offer shortly before the CLNS merger vote would create extra pressure, but CLNS was probably advised that a change in the status of NRE was not material enough to require shareholder notification and a proxy revision.
While CLNS would undoubtedly like to retain the current value of the NRE management contract, the current arrangement does not serve its long-term interests. The merger proxy disclosed that Colony considered acquiring the NRE management agreement, "which would have met one of Colony's objectives of expanding its European business by managing a European based publicly traded vehicle." In its current condition, NRE cannot play a role in growth of the CLNS co-investment business model because NRE is unable to acquire assets while its shares are valued at a large discount to NAV. CLNS could acquire NRE (as it acquired NRF) and launch a new managed European real estate company in the future. But it's also possible that a significant restructuring of NRE could be a win-win for all parties if it incorporated some of these elements:
- New management agreement with standard duration and renewal terms (three years)
- New management agreement with fees close to industry averages and a hard cap on total expenses
- Acquisition of new assets by NRE from CLNS in exchange for shares valued at a premium to market or at NAV
- A tender offer by CLNS for NRE's shares at a premium to the recent market price
- Introduction of strategic investors who buy new NRE shares at a premium to the recent market price
Lower fees, larger scale, and better governance would deliver significant value to NRE shareholders. The management fee paid to CLNS would be a lower rate, but the larger scale could offset the near-term impact while also establishing a vehicle capable of long-term growth through accretive acquisitions using fairly valued equity.
I have no indication that any of these measures are under consideration and offer them only as a way to suggest that there could be appealing alternatives to both the status quo and the $13 BS buyout offer.
CLNS's shares are likely to be under near-term selling pressure as catalyst-driven NorthStar shareholders realize the gains earned in the past year. 2017 performance will depend on management's ability to build investor confidence in the outlook for long-term earnings growth. Some areas of opportunity:
- Will existing NorthStar owned and managed assets be restructured to fit the new model? Will CLNS take a direct ownership stake in current and/or future non-traded REITs? Will the healthcare and hospitality assets be placed in ownership structures with new third-party investors?
- Will existing Colony business lines be marketed through NorthStar distribution channels (non-traded REITs and Townsend)?
- What performance have Colony and NorthStar delivered to existing third-party investors? NorthStar focused excessively on fees earned, but "best in class corporate governance" should incorporate measures that show whether Colony NorthStar is building a sustainable high-quality, long-term business by delivering an attractive risk-adjusted return to third-party stakeholders.
- What about NorthStar Realty Europe? (As described above).
- How will CLNS allocate the capital recovered from the NorthStar sales initiatives and gradual wind-down of opportunistic debt and equity holdings? A July presentation update stated: "In an effort to maximize shareholder value, Colony NorthStar intends to (i) repurchase its common stock and/or (ii) further deleverage, in an amount up to $1.0 billion, following the closing of the transaction and subject to market conditions."
- Will CLNS redeem/refinance the five outstanding series of NRF Preferred shares with coupons from 8.25% to 8.75%? These yields were appropriate for NorthStar's high-risk balance sheet, but appear expensive if CLNS deleverages and gradually exits from its Opportunistic Debt/Equity investments.
The Colony management team deserves credit for steps that brought the merger to completion:
- Direct engagement with disgruntled NorthStar shareholders (MSD Capital/Partners and Land & Buildings)
- Small compromises to earn NorthStar shareholder support (modest increase to NSAM special dividend, governance promises, reimbursement of some L&B expenses)
- Negotiation of exit agreements with tainted NorthStar executives at a discount to contractual obligations
Considering these achievements, it's possible that the same management team will follow up by delivering an attractive post-merger vision that will bring new investors to support the share price. Until that happens, a 10X FFO multiple provides a fair valuation for the current portfolio of owned and managed assets.
Disclosure: I am/we are long CLNS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.