NorthStar Realty Europe Corp (NRE:NYQ)

NRE is a NYSE listed REIT with a focus on European commercial real estate; its portfolio predominantly consists of prime office properties in Germany, UK and France; and it is the only NYSE listed REIT with a European focus. I believe that at current share price of $8.70, NRE trades at a significant discount to my estimated NAV of $15 per share.

Key stats

The key stats above assume a 15% drop in cash flow per share and a 5%-10% fall in value of NRE's property portfolio owing to currency risk further to recent events in the UK (see discussion on currency risk & NAV calc below). It is worth bearing in mind that only ~22% of NRE's in place rents come from the UK. 
   
Investment case

My investment case for NRE is as follows:

1.       NRE’s portfolio comprises mainly of prime office properties in key cities of Germany, UK and France (represents 76% of the total portfolio); the overall portfolio has a weighted average lease term of 6.2 years and is 88% occupied; tenant quality is solid with the top tenants being blue chip and creditworthy. See below for more details on the portfolio.

2.       At current price the stock offers a solid 6% dividend yield compared to 1.38% paid by the 10-year U.S. Treasury note and the 2.1% yield for the Standard & Poor’s 500. NRE’s dividend yield compares well with comparable European REITs where continental office focused REITs offer a 4.8% dividend yield and UK REITs offer a 2.85% dividend yield.

3.       My conservative NAV per share forecast for NRE is $13 - $15 per share, implying a 50% - 70% upside to current share price.

4.       The current economic outlook in Europe should prolong the low interest rate environment and a continued period of quantitative easing by both ECB and BOE is likely. This should continue to support cap rates.

5.       I acknowledge that the outlook for rental growth, particularly in the UK, may be negative following Brexit; my valuation assumes no rental growth. It is worth bearing in mind that only ~22% of NRE’s in-place rents come from UK; and that too consists of prime office properties leased to quality tenants. Bar a disastrous economic situation, the portfolio & current rents should hold. In summary, NRE’s 6% dividend yield along with current significant discount to intrinsic value offers a buying opportunity. The market appears to have overreacted to the current uncertainties in the UK, and seems to have failed to acknowledge the quality and geographic mix of NRE’s real estate portfolio.

Currency Risk

Given the recent big drop in GBP against USD, currency is a risk area. ~22% of in place rents come from the UK which will be negatively impacted given the fall in GBP against USD. Assuming the GBP depreciation results in a 30% drop in income from the UK, and allowing for a 10% drop in income from Europe due to EUR risk, cash flow per share would fall from $0.90 per share to ~$0.77 per share, giving a cash flow yield of ~9%. If NRE maintains its dividend payout of 70%, this would give a dividend per share of $0.54 with a dividend yield of 6%. This should still support my NAV per share estimate of $13 - $15 per share. 

Valuation

NAV

Below is my NAV per share estimate for a range of valuation of NRE’s portfolio – starting with the most recent valuation undertaken by Cushman & Wakefield and ending with the implied portfolio value based on current share price. 

The current share price of $8.70 implies a ~20% discount to the most recent valuation undertaken by C&W. I believe this to be overdone and think that a more realistic NAV in the range of $13 - $15 per share is a better reflection of intrinsic value. My estimate is supported by both comparables.

Comparables

In the below table I have shown the Price / NAV and dividend yield for comparable European REITs – both continental office focused REITs and UK office focused REITS.

As can be seen, UK REITs currently trade at a significant discount to NAV following the UK’s vote to leave the EU. Continental European REITs continue to trade at close to NAV. NRE’s portfolio is split 75:25 between continental Europe and UK; applying this split to the comparable P/NAV, I get an implied NAV per share for NRE of $15 per share.

Further, using NRE’s portfolio split, the comparable universe offers a dividend yield of 4.3% compared to NRE’s dividend yield of 6%. Applying the comparable universe’ dividend yield to NRE would support a price per share of $14.

Cash flow

I forecast cash flow per share for NRE of $0.90, implying a cash flow yield of 10% based on current share price. My range for intrinsic value per share of $13 - $15 implies a cash flow yield of between 6% - 7% and a Price / Cash flow of between 14x - 17x (both reasonable).

Implied Cap rate

My forecast FY16 NOI for NRE of $129.4m implies a cap rate of 6.35% based on Enterprise Value of $2bln. My intrinsic value per share of $13 - $15 would give a cap rate in the range of 5.4% to 5.7%. Given NRE’s portfolio mix and quality and the anticipated prolonged low rate environment in Europe, I believe these cap rates are supportable.

 NRE’s real estate portfolio quality and mix

The below tables and graphs are taken from NRE’s financial statements and presentations to market and provide a snapshot of NRE’s portfolio mix and quality.

Portfolio overview

Portfolio overview by geography

Rent concentration by geography

Major tenants

Source for portfolio information shown above - NRE's financials and management presentation

Other considerations

·         NRE is a newly created REIT, having listed in NYSE in November 2015 when it was spun off from NorthStar Realty Finance Corp. It have limited analyst coverage and it is the only US listed REIT with a focus on European real estate. I believe that due to these reasons, it has traded at a discount to its peers in Europe; the recent fall in European markets has broadened this discount. I think this is overdone and at some point down the line, may be as analyst coverage improves, this disconnect between NRE and its peers should narrow.

·         NRE pays a fixed management fee of $14m per annum to NorthStar Asset Management which, per my calculation, equates to a PV of $233m or $3.84 per share (applying a 6% discount in perpetuity to the $14m). The NAV needs to be perpetually discounted for this management fee.

·         In addition to the $14m fixed management fee, NRE is obliged to pay additional management fee of 1.5% of any new equity issuance. NRE currently has $187m of stock settable notes which are due to mature at the end of FY2016; it can either pay down the notes at maturity, or convert them to equity. If the notes convert to equity then NRE’s management fee will increase by $2.8m per annum (1.5% * $187m), implying an additional discount to NAV of $47m (or $.77 a share). Such a scenario should still support a NAV per share of $13 - $14. However, I see the risk of the stock settable notes being converted to equity being low on the basis that NRE started off with $340m of stock settable notes and has bought back $150m of the notes from open market purchases so far. Given NRE’s cash flow generation, I believe that the company continue to buy back the notes or repay it at maturity. Further, management are incentivised to increase cash flow per share more than they are incentivised to increase the management fee (management fee reduces cash flow per share and the higher incentive fee payable to NSAM).

·         The company has repurchased 4.3m shares from November 2015 for a total of ~$50m. If the current discount to NAV persists, I expect the company to continue to repurchase shares. 

Gener8 Maritime Inc. (GNRT:NYQ)

Gener8 Maritime Inc. is a leading U.S.-based provider of international seaborne crude oil transportation services. The company is a result of the merger between General Maritime Corporation and Navig8 Crude Tankers Inc. It IPO'd in June 2015 @ $14 a share. It has a fleet of 45 tankers, including 33 vessels currently on water & 12 more coming on stream over the next 9 months. Its current on the water fleet consists of 16 VLCCs, 11 Suezmax vessels, 4 Aframax vessels, and 2 Panamax vessels, with 12 new VLCC's to be delivered in the next 6-9 months.

Note – forecast P/E and forecast EV/EBITDA based on projected financials post stabilisation of full fleet towards end of FY17 / beginning of FY18.

Investment case

At current price, Gener8 Maritime is a buy. Although it is very difficult to predict intrinsic value due to the highly uncertain nature of the business – tanker spot rates, oil demand/supply equation, and new tanker order book are the 3 key variables which drive value & remain uncertain – at current price, I believe that the risk is largely priced in and offers a decent upside potential.

My buy thesis is built on the following narrative:

·         Come the end of 2017, post-delivery of all its new ECO VLCC’s, Gener8 will have a modern high quality fleet of crude tankers with an average age of 5 years and with significant growth potential in EBITDA, free cash flow and earnings. From 2017 onwards, the company is likely to initiate substantial return of capital to shareholders via dividends and share buybacks.

·         Oil supply equation will continue to remain favourable for the industry - the Saudis will continue current policy of defending market share as well as rapid Iraqi and Irani expansion will continue to ramp up exports from the Middle East. In general, increased supply is good for the crude transporters like Gener8.

·         The supply glut will continue to keep oil prices low – consensus forecast from all major institutions (World Bank, IMF, EIU) are for oil to trade at ~$60 per barrel to 2020, and continue to be at current levels of ~$50 per barrel in the medium term. In general, low prices are good for the crude transporters as they should support worldwide demand for oil.

·         I acknowledge that significant imports from the Chinese since the oilprice fall as part of their policy to increase their strategic petroleumreserves has been a massive boost to the oil tanker industry and Chinese demand is a big unknown. But at current and projected prices of ~$50 - ~$60 per barrel, based on my research, I believe that the Chinese will continue to buy. In addition, India has huge infrastructure spend plans and has recently entered buying agreements with Iran as it ramps up supply. Furthermore, the economic recovery in Europe is at early stages, and favourable outcomes from Brexit, Greek negotiations, Italian banking crisis, could provide an added fillip.

·         In addition to natural demand, congestion at key land based storage chokepoints continues the need for “forced” storage at discharge ports, adding to the length of voyages & revenue for super tankers. Further, oil price contango (current low spot prices compared to projected forward prices is increasing demand to buy and store) continues to promote demand for storage.

·         One area of risk is the tanker order book, and whether there is a risk of oversupply of tankers in the market, pushing down rates. Highly favourable conditions over the last few years – with new build prices falling due to fall in steel prices, sever distress and excess capacity in the shipbuilders – resulted in a flurry of orders to mid 2015. This was expected to continue given the current favourable trend for the crude carriers. However, surprisingly, the order book as a percentage of on-the-water fleet remains near all-time lows at 2.2% and 4.0% fleet growth for 2015 and 2016, respectively (data from Company presentation). New orders have more or less ceased in 2016 and the VLCC fleet is ageing, providing Gener8 with a considerable advantage owing to its young/modern fleet.

      Gener8’s investor group consists of Oaktree (16%), BlueMountain (10%), Avenue (9%), Aurora (8%) and Monarch (7%) all of who own over 5% of the company and are likely to ensure focus on return of capital via dividends/buy backs as soon as the new fleet has stabilized and revenue and cash flow has ramped up. In addition, Gener8 has a solid management team who are highly regarded, with substantial industry experience and with alignment of interest with shareholders.   

Valuation

As discussed at the very beginning, it is difficult to value this business due to the highly uncertain nature of the key variables – particularly tanker spot rates – which drive value. In addition, a number of additional assumptions need to be made such as fleet utilization (e.g. number of days in a year a tanker will operate), bunker fuel rates and operating costs. The difficulty of predicting revenues can be gauged by the fact that tanker spot rates spiked to over $100k towards end of 2015 and early 2016, before coming down to ~$60k a day towards latter part of Q1 2016.

For my base case valuation, I have made the following assumptions:

·         long-run 10 year industry average tanker rates for VLCC’s of $41.2k (which below recent spot rate trend), keeping Suezmaz, Aframax, and Panamax rates constant at of $37k, $27.5k, $22.5k respectively;

·         assuming all vessels, including new builds are delivered and deployed at spot rates (consistent with current trend); and

·         operating expenses based on Q1 2016 cost structure with a 1.5% growth in expenses annually (consistent with recent trends).

Based on the above assumptions, I get projected EBITDA for base case and optimistic case of $400m and $425m respective on the fully stabilised Fleet by end of FY17 / beginning of FY18. Assuming the company continues to trade at its current EV/EBITDA multiple of just over 6 (peers currently trade at ~7x), I get a forecast EV of $2.4bln - $2.6bln. My forecast net debt is just over $1.5bln ($1.7bln of total borrowings including additional borrowings on remaining instalments for new builds, and $200m of cash), giving an equity value of between $900m - $1bln, or per share value of $11 - $13 based on 83.68m of shares outstanding. At the current share price of $7.05, this equates to a return of 56% - 82%. 

If one assumes a multiple of 7x, the value per share goes up to ~$15 - ~$17.5 a share for a return of between 118% - 150%; I believe this to be too optimistic but not unlikely.

My forecast EPS on a fully stabilised fleet comes to $2.8 - $3 per share, equating to a forward P/E of just over 2. I expect the company to payout most of its earnings as dividends or for share buyback.

In addition, a good margin of safety is provided by the following factors –

·         book value per share of $17 (current share price equates to 60% discount to book) for modern fleet with an average age of 5 years; and,

·         based on conservative assumptions, I get a total value for the fleet of $2.47bln, equating to a net of debt value of $940m, or $11.4 per share.  

Other factors worth noting

·         The company’s new VLCC’s (21 of the 28 VLCC fleet) deliver substantial fuel savings compared to older/existing fleet. The savings per vessel per day could average $6,300, assuming a bunker fuel price of $350 per ton, and provide the company with a competitive edge compared to peers. In addition, large oil major customers are likely to favour quality vessels/safety which should give the company edge given global fleet age and mix.

·         Majority of tanker owners also own other offshore assets and dry bulk carriers and are currently experiencing difficult conditions in their other businesses due to the fall in oil price and distress in offshore assets. Therefore, they are unlikely place significant new orders or have the ability to find the financing to do so. Gener8 has no such issues as it has no other exposure, and financing for its new build is fully secured from existing facility.

·         Finally, the company has said that it may sell down some of its older Panamax and Aframax fleet if a suitable offer/price is available. Currently, the company sees no need to do so give the arbitrage between high tanker rates and relatively lower asset values. But any sell down could be a net positive for the net debt position with relatively low impact to earnings. Approximately $1.5 of my $11 per share value for my base case is backed by the Panamax and Aframax fleet. Majority of the upside comes from the VLCC fleet, followed by Suezmax.  

Restaurant Group PLC

What happens when a stock priced for growth stops growing? It tanks. And what happens when a stock priced for growth reverses trend and starts recording fall in revenues? It gets pummeled. Take a look at Restaurant Group Plc (RTN:LSE), the UK based restaurant operator with over 500 establishments and with principal trading brands including Frankie & Benny's, Chiquito and Coast to Coast. Its stock has lost over 51% of its value since the high of £7.24 in November 2015, wiping out £747m from its market cap in the process. It currently trades at £3.52, this after having fallen to £2.72 recently. The recent uptick is mostly on the back of rumors that a private-equity backed takeover may be coming.

I want to take a look at whether this fall offers a value opportunity. Has the market overreacted? Could the fall in sales simply be a hiccup, with no structural or fundamental reasons, offering a great opportunity to buy and wait for mean reversion? Let’s investigate.

First some key facts on the company. In the below table I look at cheapness (EV/EBIT) & quality (ROIC). I have also shown these ratios for before the fall in the stock (i.e., Nov15). 

As can be seen from the table above, the company’s EV/EBIT ratio has fallen from a high of 17.24x in Nov15 to 10.55x today. If one back’s out market’s implied growth & ROIC estimate for this fall, assuming a cost of capital of 8% and a tax rate of 15%, then this implies that the market has wiped out all or most of its growth & ROIC expectation from the stock. For example, the 17.24x multiple would imply that the market had priced the stock for a ~5% growth with a ~13.25% ROIC; and at 10.55x multiple, growth would be almost non-existent, with a fall in ROIC to ~10%. Note that my assumption of 8% cost of capital and 15% tax rate is based on my calculation of the company’s WACC and effective tax rate, and for completeness, I calculate my implied growth & ROIC percentages using the following formula for the multiple.

From ~5% implied growth and 13.25% ROIC to ~0% growth and >300bps fall in ROIC, has the market overreacted? Does one trading update from a company signalling poor trading conditions and a potential 2.5% to 5% fall in like for like sales merit such a pummeling?

This company has grown sales at a CAGR of over 7% over the last 5 years (FY11 – FY15); is extremely cash generative with a free cash flow from operations yielding ~9%; and it has a dividend yield of ~5%. Surely it is a buy, and it is only a question of waiting for mean reversion to take its natural course and revenue growth will come back, giving a handsome return for the value buyer? Not so fast. 

I dug up the last 5 year financials to piece together the pattern in sales growth, knowing that the company’s 7% CAGR growth in revenue has come from both like-for-like sales growth, and from new store openings. Take a look at the table below.

As the table above shows, LFL revenue growth has been falling, and was at its lowest level over the last 5 years in FY15, just a 1.5% LFL revenue growth. In particular, over the last 3 years, majority of the growth in sales have been coming from new restaurant openings, with 81% of the growth in sales for FY15 coming from new openings. This is at the heart of the challenges facing the company. Growing revenues by opening new restaurants is fine as long as your ROIC is greater than your cost of capital (which seems to be the case for the company at present, and as long as it stays that way, it should go on opening new restaurants); but LFL revenue growth is the better indicator of the company’s long term health. If LFL sales are faltering, then it is only a matter of time before it starts biting into new openings and on ROIC. So what’s the story here? The answer in one word – competition.

Michael Porter in his classic 1980 book - Competitive Strategy - described that the intensity of competition in an industry is determined by five forces: threat of new entry, pressure from substitute products, bargaining power of buyers, bargaining power of suppliers, and the degree of rivalry among existing competitors. As this recent FT article nicely sums up, UK restaurants are having to fight multiple battles at the same time:
with new entrants in the traditional eating out space (rivalry among existing & new competitors is intense); new rivals offering the online/delivery options are thriving and gaining ground (substitute products); more people are choosing the option of ordering at home more often and even when they eat out they have plenty more options to choose from (bargaining power of buyers); all of this makes the cost of leasing out space in the best locations more expensive (bargaining power of suppliers). Data from Euromonitor show that growth in home delivery and takeaway food has outpaced that of restaurants each year since the financial crisis. Between 2009 and 2014, the UK market for take away and delivery expanded 2.7 per cent to £6.5bn, while the value of food bought in restaurants fell 5 per cent to £17.1bn. Restaurant Group is heavily exposed to this trend as it does not deliver, and hardly has an online presence which could compete with rivals. In addition to the intense competition, the increase in national minimum wages from this year is going to eat into margins further (for Restaurant Group this will add at least £2m to its cost base this year). 

If an entire sector is in distress, then distressed companies within that sector could be good bets – as the sector recovers, those companies could bring great returns. But if a sector is thriving overall – overall revenues for the consumer/retail food sector is growing and people are spending more on food – and there are pockets of distress due to rapid changes in the industry, then it calls for caution when inspecting distressed stocks in that sector. There could well be a valid reason for the distress.

Given the intensity of competition in the sector, and the difficult / uncertain trading conditions faced by Restaurant Group, the approach to determining its intrinsic value needs to take account of the many possible outcomes. I have used a scenario based approach, with intrinsic value being the expected payoff taking account of the various outcomes. I have analysed intrinsic value under 5 scenarios which combine various assumptions for revenue growth  & decline and for development capex (determined by the number of new openings or closures). My analysis concludes that the intrinsic value per share for Restaurant Group Plc is in the range of £3.5 - £4. Given the current share price of £3.52, I don't believe that the stock offers adequate margin of safety for a value investor.

You can see a table with my summary of probability weighted intrinsic value, including detailed DCF calculations for each scenario, in the tables at the end the end of this write-up. My sources and reference material have mostly been the company’s last 5 years financial statements (FY11 – FY15).

Finally, my thoughts on the recent news of a private equity takeover of the group. Any takeover of a public company would have to be at a premium of at least 20% - 30% to current the share price, giving a target price of at least £4.23 to £4.58 a share based on closing share price of £3.52 on 20 May 2016. Given that a private equity buyer will have a return (IRR) expectation of at least in the mid-teens, I find it difficult to see that level of return for at current price. I am not ruling a bid out, or the fact that a buyer with an edge and detailed knowledge of the portfolio on a restaurant by restaurant basis may well know how to generate that return. But any buyer will need to get their hands very dirty with the operational aspects and I suspect will also need to place a lot of faith in growth reverting.

This stock could yet be a value buy. There could well be a sell-off - e.g. if market's recent expectations of a private equity buyout in the near future does not materialize. Secondly, it is worth watching closely the outcome of the strategic review being carried out by the management, the results of which are to be announced in August. This situation merits monitoring on an ongoing basis. 

Probability weighted intrinsic value per share under various scenarios

DCF valuation for Scenario 1 - LFL sales continues to be a struggle; development capex continues, but at a lower rate, with restaurant numbers growing. 

DCF valuation for Scenario 2 - LFL sales continues to be a struggle; development capex is discontinued from FY17, with restaurant numbers falling.

DCF valuation for Scenario 3 - LFL sales fall is arrested & mean reverts; development capex continues, but at a lower rate, with restaurant numbers growing. 

DCF valuation for Scenario 4 - LFL sales fall is arrested & mean reverts; development capex is discontinued from FY17, with restaurant numbers falling.

What’s ailing Utilitywise Plc?

The shares in Utilitywise Plc (UTW:LSE), a company that helps small businesses find the cheapest energy and water supply contracts and takes a cut from suppliers, have fallen 30% over the last year. Its shares currently trade at a low P/E of 9.4 and EV/EBITA of 8.3. For a company that is growing revenue at 36%, with healthy gross and EBITA margins of 40% and 20% respectively, the stock looks cheap. Quality, which I measure as Return on Invested Capital (ROIC), is not bad at all at 26%. The market it caters to is huge and largely untapped – there are over 4.5m small businesses in the UK and many more in Europe where the company has just started operations. My Discounted Cash Flow valuation for various scenarios comes up with an intrinsic value per share of £2.6 - £2.8, implying a potential 60% to 75% upside on the current price of £1.60 per share.

So why this sell-off? Shouldn’t this stock be a screaming buy?

Two major concerns merit market’s skepticism. The first is to do with revenue recognition and risk of future write-downs, and the second is a lack of moat and increasing competition which seems to be eating into margins and putting the sustainability of growth and returns at risk.

Revenue recognition

Utilitywise earns a significant chunk of its income as commission from energy suppliers; a fair amount of this commission is paid over the life of the contract (typically 5 years) that the end consumer signs with the energy supplier. The commission paid by energy supplier is based on actual energy consumed by the end consumer over the life of the contract. However, the group recognises revenue on the entire contract at the point when the contract goes live; using a fair value method, the group applies a 15% variance discount (for variance in projected consumption) & present values the projected cash flows using a 3% discount rate. There are obvious risks associated with such an approach – a) the end consumers are small businesses and the risk of a default will be high; the 3% discount rate that the company uses is based on the credit rating of the energy suppliers not the small businesses, and b) it cannot be easy to project energy consumption over the life of long contract period with any degree of certainty; any variance in consumption could have a material impact on prior year revenue already booked.

This approach means:

1. A significant chunk of the revenue is sat as trade receivables and accrued revenue on balance sheet and takes a fair amount of time before converting to cash; and,

2. There is constant downward pressure on this prior year revenue both due to variance in projected versus actual consumption and due to risk of default by the end consumer.

The group has already taken significant write-downs against its FY14 and FY13 receivables and accrued income claiming that its initially projected consumption variance was lower than actual. To put this into context, the group in its FY15 accounts wrote off a total of £6.35m of accrued revenue and trade receivables booked in FY14 and FY13 (net of tax). Adjusting the group’s operating profit in FY14 and FY13 for these write-downs would result in operating profit after tax falling by 42% for FY14 and by 52% for FY13. This is significant and throws into question any DCF valuation based on group’s revenue numbers in the accounts (out of the window goes my intrinsic value estimate of £2.6 to £2.8 per share when such uncertainty exists in revenue recognition). Furthermore, the FY15 financial statements say that no adjustments have been made for years prior to FY13, not because none exist, but because it would be difficult to estimate due to lack of information.

Competition, moat, and falling profitability

When a sector offers juicy margins, a large & untapped market, and low barriers to entry (Third party intermediaries are currently unregulated), one can bet top dollar that competition will come. This is evident in the company’s results - operating margins have fallen from a peak of 31% in FY11 to 20% now, and arresting the fall will be difficult. The company also seems to be facing significant difficulty in retaining sales staff – the high staff attrition rates are a clear sign of high competition  in the sector. The company looks to be trying to counter competition by diversifying (it has made some technology acquisitions – i.e., enabling energy consumption tracking, providing energy consulting services etc.) and expanding into new markets (it has recently commenced operations in Europe). It has also recently put new management team in place to counter the challenges. But given the low barriers to entry, it is difficult to see how the current high margins and ROIC can be sustained.

In conclusion

If one were investing simply based on attributes – cheapness (low P/E & low EV/EBITA) & quality (high ROIC) – Utilitywise Plc would be a buy. But as Michael Mauboussin has repeatedly said in his writings circumstances trump attributes when it comes to investing success. To paraphrase a quote of Michael’s – “Sometimes our nostrums work, but more often they fail us. The reason usually boils down to the simple reality that the theories guiding our decisions are based on attributes, not circumstances.”

I highly recommend buying Michael Mauboussin’s two books - More Than You Know and Think Twice; both are great investment in time for a value investor, but I would pass on Utilistywise Plc’s stock for the time being.