Repositioning Of The REITs Should Help The Share Price Of RMR

Summary

• RMR's repositioning in three of the client companies will help the share price of the managed REITs. The higher the share price of those REITs, the higher RMR's revenues.
• While I think an acquisition would be the quickest way to enter the multifamily segment, I think RMR will not obtain favorable terms. Instead, they should go organic.
• By going organic, RMR could redeploy most of its cash on hand to repurchase 17.5% of its shares.
• I recommend buying RMR with a target price of $86.

Source: Entertainment Weekly

The share price of The RMR Group Inc. (NASDAQ:RMR) is down almost 7% since our bullish thesis in November. In this article, I will provide an update, my view regarding M&A and why I think RMR should opt for organic growth into managing multifamily properties. Please consider this article a follow up to my initial article where you can find more details on valuation, the operation and my investment thesis.

Repositioning

RMR has been focused on repositioning the assets of three of the four client companies to control the leverage of the client companies. Senior Housing Properties Trust (DHC which was listed before as SNH) and Office Properties Income Trust (OPI) are highly levered. Service Properties Trust (SVC) seems to be at the right leverage level after the latest acquisition.

OPI has sold (or is selling) 731m USD of properties, DHC has sold (or is selling) 564m USD of properties. RMR seems to be obtaining good prices for those properties as the average CAP rate is around 5.6%. I think that RMR will use the funds mostly to control debt while strategically attempting to buy high-CAP-rate opportunities. Currently, RMR’s fee is based on the market cap of the client companies rather than the AUM as prices of those REITs have dropped. By deleveraging, RMR hopes that share prices recover. However, I think RMR won’t be very aggressive on debt reduction as RMR’s fees will eventually be based on AUM once the shares recover.

SVC agreed to acquire assets from Spirit MTA REIT (SMTA) for 2.4bn cash. Those assets are mainly retail-focused. This seems like a good acquisition as the new assets have an annual cash base rent of 171m, strong cash flows and a diverse tenant base. As the assets of SVC would increment to 12.6bn USD, RMR’s EBITDA would increase by 6.8m as detailed below.

Source: Company presentation

Cash on hand and M&A

The reason that RMR is hoarding so much cash (358m) on its balance sheet is that it has been exploring growth opportunities, mainly inorganic ones. The rationale is that RMR lacks exposure to multifamily properties and an acquisition would make sense. They are also analyzing organic growth in that space as well. According to management, cultural fit has been the main reason nothing has been acquired so far. If in 2020 nothing is crystallized, RMR will return most of that cash to shareholders by either dividends or buybacks.

Does an acquisition make sense?

While acquiring exposure to multifamily properties sounds attractive, I think there are more efficient ways of achieving that. By expanding the platform to more properties, RMR could benefit from economies of scale and diversify its risk. However, those synergies should be minimal in my opinion.

The rational of an acquisition would be to obtain experience managing multifamily properties, a client multifamily company and cost synergies. All the cost synergies would come from reducing SG&A of the merged company. As most of SG&A is composed of personal cost, a reduction of SG&A would entail reducing headcount.

The talks have been with private organizations, meaning that management and owners may be the same people. So, the only way a target company would agree to sell is if they are guaranteed a spot in the new company or if the price paid is high enough. If RMR agrees to the former and does not reduce its own headcount, there won’t be any synergies. If it agrees to the later, the synergies would be transferred to the seller.

This is validated by the comments of RMR management in the latest earnings call:

...it's really a cultural and strategic fit issues that are really driving most all the conversations. And it's like anything these are private organizations we're talking with largely. And there are large social issues involved in terms of who's going to be involved going forward and who's not going to be involved going forward.

So tossing the synergies out the window, acquiring an operation would be to acquire the talent and the contract to manage a specific multifamily REIT.

However, organic growth in multifamily properties sounds more attractive. While it would take longer than an acquisition, the organic option would ensure the integration of the new business to the legacy platform. RMR could hire any talent gaps rather than acquiring the entire company, saving on the severance costs.

Also, as an organic route would require less money upfront, RMR could return cash to shareholders either via a special dividend or a buyback of shares. As RMR stock price is heavily discounted to my fair price estimate of $86 per share (read here), I think a share buyback would add more value to shareholders than a special dividend. If RMR would allocate 250m of its cash to share buyback, it could retire 5.5m shares or 17.5% of total shares (class A + class B). RMR has no debt and a steady stream of cash flows, so RMR could take on some debt and buy back more shares reducing the share count even more.

Conclusion

The efforts to reposition the client companies seem to be on track and should help the recovery of the client companies’ stock price. While an acquisition of a business focused on multifamily properties would be attractive, I don’t think it could be done on terms favorable to RMR, I think an organic route makes more sense. If no acquisition is crystalized in 2020, a large share buyback could add significant value to shareholders.

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.