Sotherly Hotels Common and Preferred Shares ($1.80/$17, ~300%/~70% Upside)

I think Sotherly Hotel (NASDAQ: SOHO/SOHON/SOHOB/SOHOO) common and preferred shares present an attractive risk reward today. Travel to drive-to, upscale, southern U.S. destinations should be red hot this summer, and I believe over the longer term will also settle in at structurally higher levels given increased knowledge worker location flexibility. The preferreds create the entity at ~$160K/key which is too low vs. both replacement and comparable comps, and the common could see $0.80+/year in AFFO which means they currently trades at 2-3x AFFO. The prefs should be worth par+accrued, (~$29.50) or about 70% upside from today’s levels and the common could be worth $5-$10/share or about 300% at the midpoint though the distribution of outcomes is fairly wide. I’d expect that there’ll be material pushback on the impact of a potential recession on hotels generally, but the valuation is compelling and a recently completed hotel sale and refinancing of their Tampa hotel bolsters the balance sheet.

Macro backdrop is quite favorable

Let me outline the macro bull thesis for hotels:

1. Demand, especially for drive-to leisure destinations and for the upper end of the hotel spectrum, will ultimately settle at a structurally higher level. There’s an increased ability for some workers to work remotely (see: TikTok product managers), which will make extended weekend getaways possible where they didn’t make much sense previously. Moreover, there should also be more business travel as more remote workers result in more visits to corporate headquarters.
2. Supply is currently constrained due to a couple reasons. One, I suspect that there was a pause in new hotel construction because of higher labor and material costs and likely few were willing to finance hotel projects in 2020. Two, some hotels were actually shutting down and being converted to other uses like affordable housing.
3. Inflation generally should benefit existing hotels. Room rates reprice daily, while mortgage interest rates are often fixed over many years. Of course, stagflation could be a problem, though at the upper upscale hotel class higher gas prices should impact demand less.
4. And currently, *knocks on wood*, the worst of the pandemic-induced economic drag on the travel industry is well behind us. There also should be a huge summer 2022 domestic travel season (I see your social media vacation pics!).

Recent results from STR is supportive of this view, revenue per available room (RevPAR) has been 5-10% higher than 2019 levels in the past two weeks.

Source: https://str.com/press-release/str-us-hotel-results-week-ending-18-june

Raleigh hotel sale and Tampa refinancing materially derisks the situation

One reason why the Sotherly prefs and common is interesting today is that Sotherly completed its previously announced sale of its Raleigh hotel to a student housing buyer on June 14th and extended its Tampa hotel mortgage by 3 years with ~$8M more in principal and at a lower interest rate on June 29th. The sales price for the Raleigh hotel is $220K/key, well above my previous $100K/key estimate for the property and the $164K figure for the remainder of the portfolio needed to cover the prefs at par+accrued. Further, if you look at the portfolio, this hotel had the 3rd lowest RevPAR in 3Q:21 and the 4th lowest in 1Q:22. Net of the mortgage, we should see about $20M of cash inflows due to Raleigh, which along with cash on hand and the $8M in additional cash from the Tampa mortgage will allow them to pay off their $20M in stressed COVID financing completely.

Asset-based valuation demonstrate preferreds should be money-good and material upside for the common

Sotherly hotel’s portfolio fits particularly well with the current themes: upscale to upper upscale hotels that are in predominantly leisure, drive-to destinations in relatively built-up southern cities. Below is my rough valuation of each of the hotel properties using a rudimentary price/key valuation metric (see Appendix A for more detail on 4 most valuable properties). Note that I have left out the two condop hotels that Sotherly also owns which should be worth something as well.

The above valuation would get to roughly an enterprise value that would comfortably cover the preferreds at par+accrued, so those should be money-good.

Note: Pro forma secured loans balance will be $0 with debt paydown from Raleigh hotel sale and Tampa hotel refinance, I chose the lazy approach and just added all the Raleigh proceeds to the cash line and ignored the Tampa refi here.

Now for the common, we can take the $680M in asset value and subtract out $460M in EV through the prefs which would give us the remaining value to the equity of $220M, which would be over $11/share with about 19M shares out. Is this too high? Definitely debatable, but I think if you look at current comps the price per key assumptions aren’t unreasonable.

AFFO sanity check supports equity valuation

I want to try my hand at a rough AFFO valuation as well in the table below. We know that RevPAR improved throughout 1Q:22, with March 2022 actually slightly eclipsing March 2019 RevPAR. If we assume 1Q:22 revenues to be equal to 1Q:19, it implies around $0.21 in incremental AFFO or about $0.26 pro forma, which annualizes to about $1/year. Applying an 8x multiple, this implies a common equity valuation of around $8/share or more than 300% upside. I realize run-rating will be slightly problematic because going forward SOHO will have ~400 fewer rooms but that should hopefully be offset by the fact that RevPARs have continued to improve vs 2019, 1Q is a quieter quarter, and also by using a lower AFFO multiple.

Broader hotel transaction market is red hot

The underlying fundamentals currently look pretty darn good, with the most recent STR projections forecasting 2022 RevPAR to exceed 2019 RevPAR by 7% and for an extremely strong 2023 as business travel returns.

The transaction markets are also red hot, I’ll just do a link dump here if you’re inclined:

1. 1Q:22: Austin and Nashville hotels transact at new high water marks for their respective markets
2. December 2021: Trump International in Washington DC going for $1.4M/key
3. December 2021: 2 La Jolla, San Diego hotels went for $667K/key and ~$500K/key, commenting that “it’s as if COVID never happened” (paywall)

Interest rate setup for SOHO is favorable

An investment’s performance in an increasing rate environment is determined in part by the structure of its balance sheet. A good hedge against inflation would be assets that can match inflation combined with fixed rate debt with term. Sotherly’s mortgages are about 80% fixed (see graphic below), and fortuitously, most of the fixed rate mortgages has longer term compared to the floating rate mortgages. Out of the 3 remaining floating rate mortgages (remember Raleigh just got sold), Tampa was just extended with Fifth Third Bank to mature in Jun ’25 and the other two mature on Feb ’23 and Oct ’23. 3-month LIBOR has gone from 0.2% at the beginning of this year to 2% today and current rates are at around 5.50% for hotels though Tampa was just refinanced at around 4.4% (1.60% SOFR +2.75%). Eyeballing it, refinancing today would add at most $0.10/year in incremental interest expense. It’s not immaterial, but you still get a ton of leverage off of the fixed rate debt which are now all at below market rates.

Summary

I think this is fairly straightforward: I believe the asset value comfortably exceeds the preferreds at par+accrued, and it’s also reassuring that the covenants for the prefs are fairly well written (see Appendix B). Also, transaction comps are nuts right now so it would seem that worst comes to worse even in a liquidation scenario significant value would trickle to the common shareholders and make preferred holders whole. With the way things are going, the preferreds should comfortably be 70% higher, while the common has a very asymmetric payoff with more than 300% upside based on earnings power. Yes there’s risk of a travel slowdown, particularly if energy costs continue to stay high (or rise further), though I do think travel is currently high on people’s priority lists and will remain so due to the Instagramification of American culture (beach pics>Peloton pics). Finally, it’s unclear to me if ADRs can stick at today’s elevated rates, though some of it surely is driven by inflation.

Long a mix of prefs and common, heavier on the common. Thanks to @alluvialcapital for his writeup sparking the idea years ago. Thanks to @SomeHotelGuy for color on the industry. A hat tip to @GSRevelator and @MSVCap for their continued collaboration on due diligence on this name.

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APPENDIX A: Top 4 Sotherly Hotels

As promised, here’s an asset-by-asset of the top 4 properties. There are obviously problematic assets as well (most notably the Arlington/Washington D.C. hotel which is also subject to a ground lease) but because most of the financing is non-recourse mortgage debt with no cross-collateralization it really becomes an exercise of scoring “points” for assets worth more than their mortgage debt (e.g.: could walk away from D.C. hotel if absolutely necessary).

DoubleTree Resort Hollywood Beach (Ft. Lauderdale, FL)

Sotherly’s Miami-area 4-star hotel has 311 rooms and faces the bay. Sotherly held a 25% stake and subsequently bought out Carlyle Group’s 75% stake in August 2015 for $296K/key. Florida and Miami in particular have been red hot for domestic tourism. Notably, Pebblebrook REIT bought Margaritaville (which is about 2.5 miles due north) for $732K/key in mid 2021, a 50% increase over when the property last transacted in 2018 and the Diplomat Hotel which is within walking distance just transacted in 1Q for $850K/key. While both properties are clearly superior, I think that $500K/key may be reasonable at 66% above 2015 levels. Crypto, though…

DeSoto Savannah Hotel (Savannah, GA)

The 4-star DeSoto is in another white-hot tourist locale, Savannah. It looks to be in the midst of a beautiful neighborhood as well with all those pretty park squares. It has the rates to match, with hotel rooms going for $300+/night currently on weekends. In 1Q:22, the better located (and nicer) Alida Hotel changed hands for $595K/key.

Hotel Ballast Wilmington (Wilmington, NC)

This is a 5-star hotel and is about 11 miles from the beach and right on the river in downtown Wilmington. It’s a bit of a challenge to find comps but a Holiday Inn Resort on the beach sold for $164K/key in December 2020.

Georgian Terrace Atlanta (Atlanta, GA)

The Georgian Terrace is somewhat surprisingly just a 3-star hotel, despite a gorgeous interior. It’s immediately across from the Fox Theatre (which reopened July 2021). Element Atlanta Buckhead recently sold in July 2021 for $232K/key. Granted this is an extended stay hotel, but if you look at the rates Georgian Terrace is about 30% higher and it’s also 6 miles outside of downtown.

APPENDIX B: Preferred equity terms

There are a couple of protections to look for with preferred equity in particular:

1. SOHO’s preferreds have a change of control provision which grants each shareholder the right to convert their preferred shares to common shares (subject to a cap of around 8.5 common shares/preferred). While there is a remote chance of a “take-under”, I’d assume most acquisitions would be done at a higher price than the ~$3 implied “breakeven” price of a preferred conversion (and in any case I don’t think it’s likely SOHO will be sold).
2. SOHO’s preferreds cannot have their terms adversely changed unless they vote to agree as a class.

I’ve seen cases where each of the above two rules would have helped preferred shareholders in recent years, so these covenants are definitely reassuring.

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$ECTM: ~$8M Market Cap Natural Gas Play, High Teens IRR

Keeping this one light and sweet (but not crude…). $ECTM is a nanocap ($8M market cap) oil and gas fixed-term royalty trust (the “Trust”) that receives a share of profits in 52 wells located in the Marcellus formation in Western Pennsylvania. By my calculations, I think assuming $3 natural gas and 7.5% decline rates, this yields around a 17% IRR to the end of life for the royalty trust at the recent high of $0.50.

There are 52 producing wells that the Trust and the operator (“Greylock Energy” or “Greylock”) share an 82% royalty interest in. The distribution between the Trust and the Greylock is as follows:

1. 90% to the Trust for the 14 wells drilled prior to the establishment of the Trust
2. 50% to the Trust for the 38 wells drilled post establishment of the Trust

The Trust was created in March 2010 during a heady time in oil and gas world (“Peak Oil” was a serious conversation topic back then) and I believe retail investors were (unfortunately) attracted by a superficially high yield. Since then, they’ve made about $10 per unit in distributions, but the Trust price has declined from $20 to as low as $0.07 last year, a pretty incredible record of shareholder destruction. Today it’s rebounded a bit to the $0.40-$0.50 range.

While the return profile is less attractive today than at $0.07, it’s a safer bet now with natural gas steadying around $3. I think this can still generate a 17% IRR to termination of the Trust. $ECTM announced a $0.031/unit quarterly distribution for 1Q, so you should get about a quarter of the price back pretty quickly. The distribution will continue to decrease over time because the last well in this Trust was drilled in July 2011, but if you look at typical Marcellus horizontal well type curves the 10-year decline rates for a 9-10 year well is around 6-7% CAGR (CADR?).

Source: https://www.researchgate.net/figure/Marcellus-Production-Decline-Curve_fig6_228367795

I’ve got a (slightly) more complicated model behind this, but here’s what I’m expecting in terms of distributions:

	Projected Distribution	Y/Y Decline
2021	$0.15
2022	$0.13	-12%
2023	$0.11	-12%
2024	$0.10	-13%
2025	$0.08	-14%
2026	$0.07	-15%
2027	$0.06	-17%
2028	$0.05	-19%
2029	$0.04	-22%
2030	$0.05	45%
Total	$0.84

The 2030 distribution is based on the fact that on or about March 2030, 50% of the royalty asset will revert to the operator, Greylock, and the remaining stake will be put up for auction. I’m projecting cash flows in the run-off time period using a much lower $300K/yr G&A cost with an 8% discount rate for future cash flows, which gets me to roughly $0.05 in 2030. Distributions in the meantime are subject to my 7.5% decline rate/yr assumption and an assumed 2%/yr increase in G&A costs.

The main bet here is that natural gas prices will remain around where they are today, I’m assuming realized prices hold around 1Q levels going forward. A quick peek at natural gas futures supports this view, at least through at least March 2022. Of course if natural gas ever moons (like they did in Texas in February…) the returns could be sweeter.

To finish tying the numbers the Trust is currently setting aside some money every quarter to boost up reserves to $1.8M, as of 3/31/21 they have $1.1M in cash set aside already. In 1Q this additional reserve was $90K (half a penny/unit), adding that in would foot with my full $0.15/yr projection. If you want to dock the next 2 year’s returns by 4 cents it still yields an IRR of around 14%. I’d note that $1.1M to wind down a trust (including contingent liabilities) feels a bit excessive already, and I’d imagine that we’d see some return of the $1.8M reserve they’re building in 2030 as well.

Primary risk here is uncertain commodity pricing. Secondarily, the Trust terminates if gross proceeds are less than $1.5M in any trailing 4 quarter period, in which case the Trust will be put up for auction and it becomes subject to take-under risk due to its small size (most natural buyer is the sponsor, Greylock).

My rough calculations gets a fair value of around $0.65-$0.70.

Credit goes to David Flood and Clark Street Value for sparking the idea initially, thanks to Catahoula for chatting on oil royalty trusts generally.

Long a 3% portfolio stake

$PMD: Trucking Along Into A Potential Big Catalyst ($20 PT)

$PMD is a $39M market cap (similar for EV assuming PPP loan is forgiven) hair follicle testing company. It pioneered the first commercially-available drug test for hair in 1986, and states that they have the best hair follicle test on the market currently, 2-3x better than any other hair test. $38M in revenues in 2019, $25M on TTM basis ($5M in MRQ), historically operating margins range from 5% to 25%, although generally it hovers around ~20%. At peak Brazil was about 30% of revenues and was part of an expansion initiative, but Brazil sucked even in 2019 (revenues down nearly 30% y/y) and has since dropped basically to zero revenues. If we run-rate 3Q revenues to $20M, I think they can achieve 15-20% operating margins, or $3-$4M in operating income. So pretty cheap as is.

There’s four reasons for excitement today:
1. The federal government is in the process of allowing hair testing as an alternative for the transportation department. If you read the public docs (link below), it appears that there’ll be either 1.5M or 3M hair tests (the numbers are different in two different spots…) once this fully ramps and hair tests appear to cost about $40 (maybe $20 goes to $PMD? just guessing…). Maybe $PMD takes 1/3 of market share, or 500K-1M tests (although I think there’ll be some cannibalization as some trucking companies already require hair tests). $20/test…is $10M-20M, which is quite material vs ~$30M in U.S. revenues in 2019. If incremental operating margins are 25-30%…that’s $2.5M-$5M+ in operating income and you can see how this gets pretty exciting pretty quick. https://www.federalregister.gov/documents/2020/09/10/2020-16432/mandatory-guidelines-for-federal-workplace-drug-testing-programs
2. Peter Kamin took a 5.9% stake in December. His historical investments have generally been excellent (loved what he did with $CLWY), and his MO is to buy legacy cash flowing businesses and really turbo-charge the earnings.
3. The 2Q:20 10-Q disclosed that they were approached by third parties and hence are undergoing a strategic review. That language dropped off in 3Q:20 strangely…but it seems that there does exist takeover interest. Quest Diagnositics would be a natural buyer IMO, since Quest also operates in Brazil in addition to the U.S. I think this actually is off the table now with Kamin invested.
4. Management was awarded 35K in options ($4.07 strike price) and 150K in RSUs on 11/11/20.

So I think in a “normal” world they return to $30M in revenues at ~20% operating margins (~$6M operating income), and we’ll likely see another $2.5M-5M with the passage of the law. $8.5M-$11M in operating income, $39M current EV. I think fair value could push this to $110M EV or even higher, so this could be a near-triple to ~$20 even with the recent runup. Not to mention, Brazil could be worth something still, and Kamin could work some magic on the expenses side. We probably find downside support around where Kamin bought his shares, which ranged from $3.74 to $4.68.

I think this is a pretty good business assuming a “normal” environment. While they do have 9 patents, I don’t think the technology is the key competitive advantage (pops who is a chemist says the rough science is pretty straightforward). I think it’s really the process, reputation, and relationships in a regulated industry that’s built up over the decades. Historical returns on equity/capital/etc. are all pretty strong.

This business is economically sensitive and basically is levered to hiring levels of blue collar workers (those who operate heavy machinery such as truck drivers, oil and gas workers, construction workers, etc., where the legal liability for accidents is high). In 2009, revenues fell by 28% and operating income by 45% but the company remained profitable. COVID has been worse, and they’ve lost money in 2Q and 3Q. However, I think we should be somewhere around breakeven in 1Q:21, with trucking tonnage indexes inflecting back positive y/y (https://www.bulktransporter.com/fleet-management/article/21153185/atas-truck-tonnage-index-jumps-74-in-december).

While they’ve been losing money this year, there’s no credit risk here IMO. They were slightly net cash as of 9/30/20. There’s potentially a bit more PPP loans as well. Their 3Q 10-Q stated that they expect to have sufficient liquidity for the next 12 months, and that was filed on 11/10/20 which basically coincided with the vaccine announcements so their projections are likely conservative.

Risks
1. There’s some lawsuits about hair tests not being sufficient to disqualify job applicants, but the solution seems to be implementing an additional test (urine) when someone tests positive: http://masscases.com/cases/app/90/90massappct462.html
2. Competition. LabCorp and Quest are large. However I think $PMD’s ability to stay in business since 1986 (and is used as a lab by federal gov’t) demonstrates sufficient staying power.4.
3. Trucking hair test regulations scrapped. I view this as unlikely as this regulation has already entered public comment phase and some of the largest for-hire public trucking companies (Knight, Schneider, JB Hunt) are all pushing to allow hair tests. The FAST act of 2015 mandates the development of hair testing as an alternative testing method. I do expect that implementation of the regulation will be delayed, not the least because there’s pushback from the American Trucking Associate who doesn’t want to also have a urine test to confirm positive hair tests. As an anecdote, the timeline for the last major piece of trucking legislation on electronic logging devices suggests it could be another 5 years before actual enforcement:

1) June 2012: MAP 21 act passed

2) April 2014: Public comment period opened (we’re roughly 4 months after public comment period opened for hair tests)

3) February 2016: becomes law

4) December 2017: early adoption allowed, beginning of 2-yr trial period

5) December 2019: electronic logging becomes mandatory

Long

EDIT: errata in writing that the hair test is “mandatory”, it’s actually just allowing hair testing as another accepted testing method. The “mandatory” language in the document appears to refer to establishing guidelines. Revising PT down to $20 to reflect contradictory data in primary source doc.

Hunting Grounds

I generally prefer to avoid spending significant amounts of time on things that are in the public conscience, so I won’t speculate too much on how COVID-19 will progress. When circumstances change significantly, however, I do want to shift where I hunt for ideas.

For the past year and change, I’ve been primarily digging through equity special situations, with an emphasis on balance sheets and cash flows. The thought is that I wanted to look for places where management was doing something different that demonstrated confidence in the underlying business.

On the other hand, I wanted to avoid “technology”, and viewed implosions such as WeWork, $APRN, $GRPO, $HMNY, and a number of other “tech” companies as signs of increasing duress. I’m putting the quotes on “tech” companies because I believe these companies are actually rudimentary businesses in a more tech-savvy manner.

Of course, the above wasn’t an ideal set up going into COVID-19, as technology is one of the big winning sectors while somewhat surprisingly solid balance sheet businesses with good “normalized” cash flows got sold off. But as with most situations in life, one must live looking forwards. So here are the new hunting grounds:

1. Financials: Many banks remain off 30%-50% from levels that weren’t that expensive to begin with. Yes, financials were “ground zero” in the last crisis (2009), but it’s hard to fathom a world where the economy (read: software companies) does well and financials do extremely poorly. Yield curve flattening is certainly an issue, but it’s not like it was a great rate environment even before this crisis and banks were earning decent ROEs.
2. Industrials: This industry is a mess due to weakness in adjacent businesses (oil and aerospace). Historically, industrials are full of small niche businesses (as detailed in this book about “hidden champions”), which makes for a good sector to deploy a small/microcap strategy.
3. High upside/downside plays: There exist bonds, preferreds, and other less vanilla securities where the prices don’t make much sense relative to equities. Bond prices should not trade like equities for the most part, unless the borrower is in severe distress. Most of the juiciest bits are related to travel, although I’m reverting to looking for asset protection or defensive cash flows in these areas.
4. Energy: I distinctly remember sitting in an Ivy League classroom back in 2011 listening to a guest speaker talk about how we’ve reached peak oil. I wonder where the poor soul is today. Probably giving lectures in classrooms of other Ivy League institutions telling students how we’ll never see oil prices go up again.

I’m still avoiding technology for the most part, although I have picked up a couple secular growers in $NTDOY and $MTCH. Looking forward, there should also be opportunities to look at some distressed investment opportunities.

Long $NTDOY and $MTCH, no positions in other named companies although I do own $WFC, $COF, and $OGZPY which are part of my financials and energy holdings.

Also, buying the listed book through the referral link will net me a commission. Not that I’m expecting any $$$ from the viewership here but still :).

$WFC: Company-Level Punch Cards

Wells Fargo ($WFC) is a $1.9T asset, $119B market cap money center bank. You may have heard of them. Thesis is that banks should not trade at discounts to tangible book and yet $WFC had $32.90 of tangible book value as of 3/31/2020, or a price to tangible book value multiple of 0.86x. The range I typically see for large banks without esoteric derivatives exposure is generally 1.2x to 1.5x. At the low end of that range, it implies almost 40% upside. In the meantime, you receive a nearly 7% dividend.

Almost everyone knows $WFC had issues. And the issues are symptoms, not the root cause, so it’ll take time for problems to be fixed. But, as a Chinese parable says, “good news, bad news, who can say?” I count three promising aspects of this situation:

1. The issues are what caused the stock price to drop. No issues, no discount stock price.
2. As a result of the problems, the Fed has imposed an asset cap on Wells Fargo. This is effectively a company-level “punch card”, which should force Wells Fargo to generally pursue more attractive business opportunities and cut less promising prospects in favor of dividends.
3. The new CEO, Charles Scharf has a solid background. I like how blunt he is too. On $WFC’s 4Q earnings call, he said that parts of the bank are “extraordinarily inefficient.” He also bought $5M shares on the open market on 3/16 at $28.69/share.

The risks:

1. Uncertain environment with risk of losses. However, I’d note that bank GAAP accounting requires building reserves to account for expected future credit losses. In 1Q:20, $WFC added $3.1B to loss reserves, which had a $0.56 impact on current quarter EPS. They also saw a $950M impairment in securities. Tangible book value of course can go lower still.
2. Bank turnarounds can be tricky as these are large organizations with lots of legacy processes. Large bank failures are surprisingly frequent, but typically involve banks with more aggressive asset strategies.

Overall, I think the discount to tangible book provides the cushion needed. I generally don’t love big companies as I don’t feel like I have much of an edge, but in times of dislocation it’s good to add a business that’s been around forever and survived multiple crises. I’ve got a 1% portfolio stake and may add more opportunistically.

Long $WFC

$TSLAQ experiment

Hope this note finds everyone well. Won’t dwell too much on the portfolio, the quick assessment is I’m down 20% from the high water mark…slightly worse than the S&P 500 but materially better than the Russell 2000 (especially the “value” variant), which is a significant improvement from lagging by as much as 10pp. There’s been a bunch of stuff that I’ve moved in and out waaay too quick to do any sort of writeups on (hello mREIT world).

Anyways. $TSLAQ. I’ve long been inclined to take the under for 7ish years…but never did as I still had vague recollections of the tech bubble from the late 90s. Current thesis:

1. The auto industry is broadly taking a hit. $FCAU, which has one of the more unlevered balance sheets in the business, is down nearly 50% year to date. There may be a lot of used cars hitting the market soon. And auto vehicles and parts moving via rail has fallen 80%+ y/y this week and last week. Production is currently on hold for many automakers, including Tesla.
2. Historical short sellers tend to be value investors. This recent drawdown has hit value investors harder than most, and thus there’s increased chances of redemptions and margin calls. Short interest in the past month is the lowest it’s been in a year.
3. Sentiment check supports a bearish viewpoint. Bulls are celebrating. Bears are laying low. Not linking to the related Twitter posts. But if you’re so inclined…here’s the Twitter home page :). I thought I saw a magazine cover on the short burns too earlier in the year. There doesn’t seem to be any particular reason to be especially bearish on Tesla’s fundamental prospects vs. its competitors in the near term. Precisely the most dangerous hour.
4. Market Cap and EV of around $130-$140B makes it an unlikely acquisition target, thus removing one potential big risk. It’s simply too big for all but a few companies to buy.
5. Is it really that differentiated? Fair warning: fairly hot take. The companies that are dramatically more valuable than Tesla are generally more novel and/or profitable. At its core, at best, Tesla came up with a better car. There’s a big hardware component to its business. There’s only one more valuable company that built a dominant business with a heavy hardware component, That’d be Apple. And in my opinion Apple is significantly more unique. Apple revolutionized the music and phone industries and built unquestioned category killers. Could Tesla do this? Certainly possible for electric vehicles to become iPhones…certainly has the buzz factor and the early fans. But it’s not immediately clear to me that Tesla’s products will be as utterly dominant as Apple’s products are today. Of the other companies more valuable, almost all have incredibly profitable software and/or cloud-based businesses (Microsoft, Google, Facebook, Netflix). In short, I have a hard time fathoming that Tesla could be a $400B business, a hypothetical that would result in a loss 200% of my current investment.
6. Low oil prices are generally unfavorable to electric vehicles.

This call really is 1) a valuation call and 2) a sentiment call. While I never liked valuation shorts and this certainly could burn me, it’s a very small part of the book (hence, “experiment”). Constructive feedback always welcome. And if you want to provide unconstructive criticism and/or make fun of me, feel free, it’ll further support thesis point 3 above.

Short $TSLA small. Long $MSFT. No other positions in other named securities.

$RMR revisted (PT: $60, ~60% upside)

Just added to my $RMR position this past week. I originally wrote it up here: https://lightbluevalue.wordpress.com/2020/01/06/rmr-group-high-floor-with-upside-pt-65/

There isn’t much to add, except that this is now a $25 net of $12/share of cash stock with ~$2.40 in base earnings (4Q annualized) with upside if/when incentive fees come in. Market selloffs can be scary but I always find it interesting when stocks with large cash positions track the broader indices since the enterprise value falls more than the market cap does. When I wrote $RMR up it was trading at $45, or $33 net of cash, so now it’s down 24% on an ex-cash basis vs. down 18% if you keep the cash in. The underlying REITs managed are down 15-20%, but the management fee is on enterprise value so at 50% EBITDA margins base earnings probably are down similar to the underlying REITs. At 20%, that’s $1.90 in earnings, so this is trading at ~13x market cap ex-cash. Can probably get a more precise number, but this should be directionally right and I think is cheap enough to warrant a position.

Long

FVE: Five Star Opportunity for Five Star Senior Living (PT: $7, 50% upside)

Executive Summary:

Five Star Hospitality (“FVE”) is a senior housing manager that was recapitalized on January 1, 2020 via a distribution of equity shares to the REIT (Diversified Healthcare Trust, or “DHC”) which owns the properties it manages in exchange for cash, and the REIT subsequently distributed most of the shares to its unitholders. The distribution of C-Corp shares to REIT unitholders and small size of the distributed entity ($150M market cap) relative to the REIT ($27B market cap) likely resulted in significant selling pressure in a classic (if unorthodox) Greenblatt-style special situation. The financials are messy and there are currently no analysts covering the name (zero analysts bothered to ask questions on the 3Q:19 conference call last November).

I don’t have a precise price target but I think fair value is at least $7 (9x a conservative EBIT estimate of $20M). I’d also note that there are some similarities between this and RMR, which is the ultimate parent of this set of related REITs and companies, which was a C-Corp distributed to REIT unitholders in December 2015 and dipped to a price of ~$14 before marching up to $96 in mid-2018 and settling in around $45 today.

Change in Business Model:

As part of the restructuring, FVE reworked their business strategy. Most importantly, they are transitioning from a business that primarily leases their properties (and pays rent) to a manager of the properties. This can be seen in the pro forma adjustment of rent payments in the first 9 months of 2019 from $121M down to $3M (the remaining rent payments appear to relate to its smaller Ageility physical therapy clinic which is on a $50M/year revenue run rate). As part of this deal, FVE is also pushing $568M of costs related to operating the properties to DHC.

Going forward, FVE will receive a management fee equal to 5% of gross revenues plus expense reimbursement and an annual incentive fee of 15% of EBITDA in excess of a target. The contracts are for 15 years, with two 5-year renewal options. Beginning in 2023, DHC can cancel up to 20% of contracts if they underperform. Underperformance is defined as failing to earn 90% of the EBITDA target in two consecutive years or in 2 of 3 consecutive years.

Effectively, FVE is changing into a management company. Now that they are no longer leasing properties from DHC, the business is much less capital intensive and it should be easier to match costs and revenues.

Pro Forma Financials:

It’s difficult to envision exactly what the pro forma financials will look like. Revenues for the first 9 months of 2019 on a pro forma basis was $170M, which annualizes to about $230M. Management said that pro forma EBITDA for 3Q:19 was ~$8M and pro forma net income was ~$4M. Annualizing EBITDA results in EBITDA of $32M. Pro forma depreciation was $8M, annualizing to $11M. Consequently, pro forma EBIT should be slightly higher than $20M, which is an EBIT margin of ~9%. Pro forma cash by my calculations is around $37M (see table below). By any metric, the current valuations are cheap.

Assets
Cash	100.8
Due	6.4
Investments	21.4
Restricted cash	25.05
Total Assets	153.65
Debts
Current Lease Liability	-2.8
ST Mortgage notes	-0.4
Security deposits	-0.7
LT Mortgage notes	-7.3
Lease liabilities	-20.4
Insurance Reserve	-31.9
Total Debts	-63.5
One-Time
Transaction costs	-10.10
Lease inducement	12.9
Lease termination cost	-55.7
Total Adjustments	-52.90
Pro Forma Net Cash	37.25

Note that RMR, a related entity, collects a 0.6% fee on FVE GAAP revenues (less “any revenues reportable by Five Star with respect to properties for which it provides the management services”). I believe this means that they will not need to pay a fee any more for anything other than the Ageility business going forward as the remaining business will basically exclusively be managed services.

Risks:

Five Star had to be restructured due to poor financial results, and while the new entity is significantly different, there’s no guarantee of success either. Senior housing in general was a “hot” sector a short while ago, and while I don’t know the sector that well I suspect there may be some continuing supply overhangs. Insider ownership is also light for my taste, around 6-7% by my calculations.

Long

SSNT: Son of…Who? SilverSun Technologies (PT: $6, ~90% upside)

SSNT is a ~$8M enterprise value ($14M market cap) value-added software reseller. It recently sold off a subsidiary for $11.5M that generated $2M of revenues which helped fund a $0.50 special dividend as well as a war chest of cash to pursue further bolt-on acquisitions. Pro forma revenues are $40M, so the EV/Revenue multiple is about 0.20x. Gross margins are ~37%, and the company has targeted EBITDA margins of 8%. Assuming they can get to 8% EBITDA margins, this equates to an EV/EBITDA multiple of about 2.6x and assuming capex of ~$800K/year, an EV/(EBITDA-CapEx) multiple of about 3.4x. The CEO owns 45% of the common shares, although he does collect a pretty sizeable salary of ~$700K in 2018. I think the valuation should be closer to 8x normalized EBITDA-CapEx, and my target price for this is $6.00 which is 90%+ upside.

Long a bit

RMR Group: High Floor with Upside (PT: $65, 44% upside)

Executive Summary:

RMR Group (NASDAQ:RMR) is a $1.4B market cap REIT management company with $33B in AUM. It trades at 15x base fee earnings (net of cash) derived from 20-year evergreen contracts. The founding family continues to control the entity and owns just over 50%, and RMR pays a dividend in excess of 3%. There’s additional upside if underlying REIT performance improves as they’ll collect higher management fees (which are pegged as a percentage of the lower of cost or market cap) and incentive fees. I think that given the highly recurring nature of its base fee earnings and possibility for further upside from incentive fees, RMR is worth 25x earnings which would result in a fair value of around $65, more than 40% upside from current levels.

Reason the Opportunity Exists:

It’s difficult to figure out exactly why RMR trades at the multiple it does today, but here’s my best guess:

1. RMR was initially distributed to the REITs and most of these shares were quickly distributed to REIT shareholders. On July 1, 2019, the remaining ~8M shares (of 16M float) that were not distributed by the REITs were sold in a secondary offering to investors at a price of $40.
2. Underlying REIT performance has been problematic as of late. Notably:
   1. SNH’s largest tenant (and another RMR-managed entity) FVE had the dreaded “going concern” disclosure, which seemed to have trickled through and caused a dividend cut.
   1. OPI performed similarly poorly in its past life as GOV, and addressed its problems by merging with its sister REIT, SIR, on top of a dividend cut.
   1. TRMT underwent a dilutive equity raise at $5 on May 21, 2019, significantly below its IPO price of $20 on September 18, 2017.
3. The share structure and financials can be confusing.
4. The company is a controlled company (by the founding family, the Portnoys).

Share Structure:

Normally the share structure isn’t all that important, but this one is a bit unique. There are 31.2M total shares outstanding. 15M of non-traded Class B shares are owned by the founding family (the Portnoys) via a trust. There’s 16.2M of publicly traded Class A shares, of which the Portnoys own another 1.1M of. Thus the Portnoys own 16.1M shares in total or 51.6% of the business. A word of caution: data sources (including Yahoo) sometimes get really confused and list inconsistent market caps ($1.4B, which implies the 31.2M share figure) and share counts (15.2M, which implies a $700M market cap).

The Contracts:

RMR has 20-year evergreen contracts with each of its 5 underlying REITs. This came into being after Sam Zell went activist on Equity Commonwealth and successfully wrested the management contract away from RMR. Now it’s very, very difficult to pull the same stunt and remove RMR as the REIT manager. Even if you have cause, it’s a 10-year term until the REIT can get out of the management contract.

These are the terms of the management contracts:

• 0.5% fee on assets (the lower of historical cost of AUM of total market capitalization)* managed REIT, excluding the first $250M which has a 0.7% fee: 70%
• 0.6% fee on revenues of the real estate operating companies: 15%
• Property management fees for the managed REITs including 3.0% of gross rents collected from tenants and a 5.0% construction supervision fee for any construction, renovation, or repair activities: 15%.

*Note: It’s important to understand here that “total market capitalization” is more like enterprise value and is defined as equity plus debt plus preferred shares.

Benefits of Closing Gap Between Market Capitalization and Cost

Right now, RMR’s REITs are collectively have a market capitalization that’s lower than cost by $7B. With management fees at 0.5% on the lower of market capitalization or cost, RMR is shot $35M in base management fees. Management commented on its 3Q:19 call that all of this $35M falls into cash flows. RMR has roughly 31M shares outstanding, so a recovery to cost would result in more than $1 of incremental operating income per share.

Moreover, because underlying REIT performance has been wanting, incentive fees are also low. For 2019, they’re expecting just $4M from one of their REITs (Service Properties Trust). However, if the underlying REIT’s economic prospects improve, there’s a significant chance that RMR will be receive higher incentive fees. The incentive fee is structured as a 3-year performance period vs. a relevant benchmark with no high-water mark. I’ve always struggled a bit with figuring out a good way to pull SNL index data in a cost-effective method, but at the current valuation any incentive fee can be viewed as a bonus rather than a necessity.

Virtually Non-Existent Capital Needs

RMR is a service business, and spent an average of $700K on capex per year over the past 3 years. This is relative to operating income of $200M in 2019. In addition, RMR’s EBITDA margins hover between 50% and 60%. This is a high quality business where it takes little capital to grow, while downturns can be readily managed via lower compensation costs.

Management

Adam Portnoy is son of the founder who unfortunately passed away in 2018. He makes $4M a year, which is very small relative to his 16.1M in share holdings which are worth north of $700M. Moreover, his compensation is more or less in line with the other two EVPs (one is higher at $4.6M while the other is lower at $3.3M).

Risks

The big concern is underlying REIT performance. For example, RMR has stated that SNH may have to divest up to $900M in assets, which would result in a reduction of roughly $4.5M in base management fees (or $0.14/share).

Valuation

The best part remains the valuation. RMR trades at $45/share but roughly $12/share of net cash so the effective price you’re paying is actually around $33. RMR’s earnings next year should be roughly around $2.20/share, so the P/E net of cash is right around 15x. Perhaps you can argue that given Portnoy owns more than half there should be some discount both on the multiple and in the net cash. On the other hand the $2.20/share earnings stream is as predictable as they come and can almost be considered a bond-surrogate, not to mention that there’s further incremental upside if the incentive fees come in, which they eventually should given that they reset on a 3-year rolling basis. The way I view this, it’s a buy on the base recurring earnings, and becomes a strong buy if any incentive fees start coming in. I think a 25x multiple is reasonable, putting fair value in the high $60s.

As a rule of thumb sanity check, investment managers which receive higher incentive fees tend to be worth 2.5%-7.5% EV/AUM (hat tip: this awesome blog post on asset managers by Wexboy). Alternatives that charge incentive fees typically are closer to 7.5%. $65/share on 31M shares puts us $2B, or $1.6B net of cash. On $33B of AUM, that’s basically precisely on the midpoint of 5%. On $26B, which is the actual fee-paying AUM (due to book value exceeding market capitalization), it’s 6%.

Long