Description

This was my application idea, submitted 11/17.  It took a little while with the holidays to get it approved.  Its up over 35% since my submission, so not quite as cheap as initially written, and I've made some updates to the numbers as necessary, but the general thesis is the same and playing out pretty quickly.  Here's a link to the original, as submitted 11/17:  https://www.dropbox.com/s/ukd60d7xvcdgnj0/Ashford%20Inc.pdf?dl=0

Developments since submission:

Ashford Inc has moved quickly post spin to increase the fee generating AUM, aka Total Market Capitalization", here are some of the relevant developments since submission:

- AHT recently completed refinancing of its debt on certain properties, increasing the debt from $354 to $478, taking $107m in cash out (to do another deal) resulting in an increase to "Total Market Capitalization", as they define it.

- AHT has bought Prudential out of its JV for the Highlands property.  The deal price implies significant equity value, they paid $250m for Pru's 28.26% stake, netting out the $25m preferred, that implies an equity value of $796m or so.  They were carrying their equity investment at $145m under the equity method of accounting.   They're also assuming Pru's pro-rata share of the debt, $331m or so.  The deal is supposed to close by 3/31 and refinancing the debt is a condition, so I would anticipate another significant cash out refinancing once the deal closes.  This would increase "Total Market Capitalization" substantially.  

- AHP filed a shelf registration for $300m of common & preferred equity and debt.

- Their hedge fund product launced on 1/5.  It returned 15.1% net in 2014, with about 40% net exposure.  

- The CEO, Monty Bennett, has made nearly $10m in open market purchases of AINC, at prices up to $131/sh, almost immediately post-spin.  

In short, the thesis has begun to play out.  The cash out refinancings and deal making are actually going a little quicker than we'd thought. 

Ashford Inc.

We are long shares of Ashford Inc. (AINC). AINC is the asset management company for two publicly traded hotel REITs: Ashford Hospitality Trust (AHT) & Ashford Hospitality Prime (AHP). Ashford Inc. also owns 60% of Ashford Investment Management (AIM), the advisor to a new long/short equity REIT hedge fund with a decent 3 year track record that is being launched in January.

Presently, the market is valuing AINC equity @ $210m (diluted estimate, adj for deferred comp stock conversion). Over the next 12-18 months we think the company is worth $260m+ in a base case, representing ~20% upside from the current quoted price. However, we think the company has levers to pull that can drive revenue with high incremental margins and our bull case 1 yr estimate is north of $370m, or 67%+ upside potential. Additional upside could come from incentive fees on the HF or from the management agreement and from additional spin offs from AHT (most notably the Select Service Hotel platform).

AINC is an undervalued investment for a variety of reasons, which we will detail below. The bottom line is that management is spinning the company out in an attempt to line its own pockets in big way & they will actually own more of the management company post-spin while concurrently did everything they could to make it unattractive for institutions and their current investor base. While we don’t completely trust these guys, and we don’t think they could be confused with “Outsider CEOs”, we don’t think we can go wrong by betting with them that they’re successful.

The Business

Owning the management company is appealing for a few reasons.

First, the base management fees are relatively predictable and captive to AINC, which makes them extremely high quality. The fees are based on “Total Market Capitalization”, which is basically EV of the two REITs without subtracting any cash.

Second, the asset management business has nice operating leverage. A very high percentage of incremental revenue falls to the operating income line. The management company calls the shots for the REITs and the management company is incented to have the REITs do deals, and it gets paid whether they are funded with debt or equity. For example, a billion dollars of equity/debt issuance increases annual revenues by at least $7m and a very high % (north of 80%) of that should fall to operating income.

Third, if the REITs perform they also get a kicker in the form of an incentive fee, which is calculated as 5% of the amount (expressed as a percentage) by which the annual “Total Shareholder Return” of Ashford Trust or Ashford Prime, as applicable, exceeds the average TSR for its respective peer group, multiplied by the fully diluted equity value of such company at December 31 of the applicable year.  The percentage by which the TSR of either Ashford Trust or Ashford Prime exceeds the TSR of its peer group will be limited to 25% for purposes of calculating the incentive fee payable to us. So if the peer group was flat and AHT/AHP was up 25%, they would get 5% of that amount or 1.25% of the diluted equity value. It’s paid over 3 years in either cash or AHT/AHP stock. There’s no claw back in years where AHT/AHP underperforms.

The Spin Off was Structured to Confuse AHT’s Investor Base & Make AINC Unappealing to Institutions:

Here are the ways management structured the deal to make it unattractive to current investors and prospective institutional investors:

Current Investors

• The distribution ratio is tiny and was subject to change if the stock performed well in the when-issued market. They told shareholders they anticipated distributing 1 share for every 55 if they distribute 100% of the equity, it could be as low as 1 share for every 137 if they only distribute the minimum 40%. It wound up being 1 for every 87 shares. There are no fractional shares and most small investors will get a few shares; many will simply choose to sell their AINC “dividend”.

• The current shareholder base is comprised mostly of REIT indices, income/REIT mutual funds, and mom & pop income investors. The new mgmt. co will not be a REIT & pay no dividend. So either by preference (income investors) or mandate (REIT index and actively managed REIT mutual funds) current investors may be unwilling or unable to own AINC.

• It is a taxable distribution.

Prospective Institutional Investors

• Small size: management provided fairness opinions showing an pro forma equity value of $60.

• Small float: the distribution ratio was 70% of shares outstanding with management owns 17% of AINC directly now, and AHT retained 30% of the outside shareholder float, the PF tradable float could be less than 35% of what we expect the fully diluted shares to be.

  • The bottom line is that AINC will be too small for bigger funds as it will be difficult to get a meaningful position due to the limited float.

Management Incentives

Management was actually incented to have AINC trade poorly initially (which hasn’t happened), in order to get the spin off done completely and not have AHT retain any of AINC (among other reasons we’ll get to). Since it traded too well in the when issued market, AHT reduced the shares distributed, because the value of those shares is taxable to the REIT and doesn’t qualify as REIT income, distributing all of it at too high a price could potentially jeopardize AHT’s REIT status. We think this is a convenient excuse and management didn’t provide details on how much bad income would be too much, but they settled on a 70% distribution rate. We think changing the quantity of shares distributed was a smoke screen to confuse current and potential investors. This was consistent with everything else AHT management has done to make sure it gets AINC distributed at a low price.

AHT management has further tried to obfuscate the value of the management company and confuse current/potential investors by:

• Providing limited pro-forma data and inconsistent commentary

  • Getting the spin off done before the AINC’s value becomes obvious in the financials

    • AINC didn’t even file pro forma Q3 financials, despite AHT/AHP reporting earnings on 10/30.

  • AHT also filed an 8k where it provided a lowball estimate of 2015 Revenue ($38.5m) & EBITDA ($3.5m).

    • Revenue assumed no deals, the lowest base management fee, and didn’t seem to incorporate the hedge fund platform. It is also a change in tune from when the spinoff was announced.

      • AHT/AINC CEO Monty Bennett’s comments on the call following the spin detailed the economics: “There are $38 million in fees if they were paid today, just basically is with(out) incentive fees. And it’s hard to estimate those are, but that will be on top of. And then our allocation of allocated expenses that we see right now is associated with this platform there is something like $28 million.”

    • We think Ashford management is trying to make the spinco appear less profitable than it really is by laying in excess expenses in the pro formas and understating the base management fees year 1.

      • This is a little like asking what someone’s income is, how they answer depends who you are. Are you the IRS, their spouse’s divorce attorney, or the mortgage company when they’re trying to get a loan?

• Keeping information about a potentially lucrative hedge fund under wraps.

  • We believe that the hedge fund has capacity of $1b and commitments at launch of $100m (see dropbox link for fact sheet).

• Getting fairness opinions that appear to justify the lowest possibly EV and market cap for personal reasons and for its less sophisticated shareholders to anchor to.

  • The fairness opinion comes to an equity value of about $60m but only counts $10 of the estimated $34m of cash on the balance sheet as excess.

This begs the question, management owns 17% of AHT and will own 17% of AINC, why would they get fairness opinions justifying the low valuation, intentionally confuse investors, and try to keep institutions out?

• The answer is so management can own a lot more of the company post-spin, more than the 17% they own now. How much more is dependent upon the valuation and that number being low. The key is in the deferred compensation plan:

  • Currently, the CEO Monty Bennett & his father have 1.6m shares/or ~$18.1 dollars worth of AHT stock in a deferred compensation plan.

    • Since it is deferred comp and “at-risk”, and an obligation of AHT, it is not reported as ownership of AHT.

  • As part of the spin, AINC will be taking on the deferred comp plan and we anticipate the Bennetts exchanging the $18.1 in AHT for an equivalent amount of AINC.

    • While outsiders get a small number of shares for each share, management, in their deferred comp plan is getting a 1 to 1 exchange ratio. They’re essentially buying AINC hand over fist.

      • The exchange amount will be established based on a VWAP and weak trading allows them to get more shares and a greater % ownership of the management company.

      • At current share prices, the CEO & his father could increase their stake in AINC by about 186k shares (increasing the share-count from 1.99m to nearly 2.18m and pushing insider ownership near 35%).

Valuation, Bear, Base Case, and Bull Upside Case/Optionality

We think AINC is undervalued & "underearning" today, we think this will be realized as time goes on:

• Management indicated on the initial call there is PF Revenue of $38m, but based on the Total Market Capitalization of about $5.7b for AHP/AHT that gets us to about $39.9m in PF Rev, plus there is another $100m or so committed to the hedge fund @ 1.5% which AINC will receive $1.05m from for a total of $40.95m.

• We think management padded the expenses to justify a low valuation, but splitting the difference from the $28m they were at initially with the $35m they’re at now gets us expenses of about $32m and initial EBIT of about $8.5m.

However, as time goes on, we expect AINC to have AHP and AHT do deals and expand their Total Market Capitalization with both debt and equity. We also expect AINC’s base fee to increase and AIM to expand the asset management platform, increasing revenues and operating income. Here are some other things to consider as it relates to revenues going forward:

• We believe fees will increase, almost immediately from the stated management estimates.

In the 1^st year post-spin, AINC will get a base fee based on the “Total Market Capitalization” of AHT & AHP. “Total Market Capitalization” is the market cap of the common plus the debt outstanding & preferred equity. Currently, this is about $5.7b between AHP & AHT, the minimum base fee is 0.70%, implying $39.9m in PF revenue. The fee could be more than that as it is actually the greater of 0.70% or a “General & Administrative (G&A) Ratio”. The calculation is based on a simple average of peer’s the “G&A Ratio” expenses plus dead-deal costs minus non-cash charges as a % of their “Total Market Capitalization”. The peers are hand selected by management and blessed by the board. Management notes in an old AHP spinoff presentation that is no longer on its IR site that this number has averaged 85bps over the 9 years preceding AHP’s spin. The 2013 number was consistent with this. While there’s no example of the calculation provided anywhere in any Ashford filing, our conservative estimate of what could go into this number leads to a base fee increase of more than 8.5% to about 76bps, this is based on the current annualized run rate of the peer group. See below:

• We are modeling base fees of 70bps in the bear, 76bps in the base case, & 85bps in the bull case.

• We also expect AINC to direct AHT/AHP to do deals, right now management could refinance debt and take cash out, lever that and do a deal. They alluded to as much on the last conference call. They also made mention that they haven’t been attempting to close deals while this spin is going on, but they were going to be more aggressive with the deal making post-spin. We suspect sometime shortly after the spin is complete, or perhaps Q1, AHT/AHP will refinance debt and pursue acquisitions, perhaps building up their Select Services hotels which they appear to be readying for a spin at some point. A stand alone with its own cap structure might have the potential for even more deal activity. We don’t know what additional deal capacity that would bring, but our assumption on deal flow is that they do $500m in the bear, $1000m in the base case, $1.25b in the bull case. We think it’s entirely possible (probable, watching these guys) that they were holding deals back until the AINC spin transaction was complete.

• We expect the new hedge fund be additive. It is a long/short REIT and has done well, especially compared to the REIT indices on an absolute and risk adjusted basis. We think they can get additional subscriptions with it, investment consultants we spoke with confirm this. This comes with a management fee ranging from 1.5% to 2% and an incentive fee of 15-20%. In our base case we think they can attract $300m, in the bear case we have $100m already committed, and in the bull case we model $500m, though we believe capacity is around $1b. We are not factoring in any incentive fees.

  • We’ve reviewed a recent fact sheet/pitch book and it looks investable to us. Here’s a link to the overview of the strategy & the track record: https://www.dropbox.com/s/crjjfokh8bjnb24/aim_june2014_presentation.pdf?dl=0 https://www.dropbox.com/s/5fikjai6jei9cxb/AIM%20Long%20Short%20REIT-July%202014.pdf?dl=0

  • The Ashford Investment Management platform could realistically be expanded to offer a debt fund or any number of offerings, they could also raise a Non-Traded REIT.

• In addition to management & incentive fees the company will be getting paid for the capital markets (debt issuance) activity of the REITs and is looking at building out capabilities in real estate brokerage to capture revenue from the actual transactions the REITs complete. We are not factoring this option into our valuation.

• We use a 10x multiple in the bear case, a 12x in the base, and 14x in the bull. We also looked at earnings multiples, using 16x in the bear, 18x in the base, and 20x in the base.

It is important to note that we think that AINC can force deals on AHT/AHP for the foreseeable future, possibly several billion dollars worth over the next several years. Ignoring some of the levers we discussed, including launching more funds and earning incentive fees, and just assuming they continue with what they’d already done in our 12-18 month scenario over an additional 24-36 months yields considerable additional upside:

Risks

• There is a history of self-dealing, specifically insiders bought 40% of AIM for a sum of $1.2m, when we believe they are about to launch a hedge fund strategy that has $100m committed and substantial interest from allocators.

• There is a property management company, Remington Hospitality Services, that is owned/operated by the CEO Monty Bennett and his father. We believe is likely this gets folded into AINC at some point, though management has indicated it won’t be happening soon. This makes some sense because AINC and AHT/AHP have mutual exclusivity agreements with Remington and if AINC is going to push deals on AHT/AHP, then Remington directly benefits and selling now would be selling low. It is possible the price at which it is purchased will be too high. The management agreement with the hotels appears to be industry average, so it may not be an egregious price. Paying too much will be mitigated some by the 40% PF insider ownership, but while we anticipate a sweetheart deal, how sweet the deal is would be difficult to handicap.

• There’s some other form of self-dealing we haven’t thought of yet.

• The L/S REIT hedge fund is a bust, fails to raise AUM.

• The hotel REITs become grossly mismanaged and over leveraged, as the incentive is to do almost any deal, despite the incentive fee.

• Standard capital markets risks as the growth relies on openness of markets (debt & equity), as well as stable/increasing asset prices for the real estate.

Conclusion

We think ~$115 is a reasonable estimate of what shares are worth as management executes their plan and could be low based on the opportunities the management company has. Management is betting on this and putting their money where their mouth is with the deferred compensation. With the levers they can pull from forcing deals on the REITs, cash out refinancings, and the increases in revenue from the change in base management fee calculations we can see valuation being significantly higher than this in the out years. That would be reflected in the financials and the multiple applied to the results. Buying AINC today gives you a chance to bet with management on that future happening.

Catalyst

Cash out refinancings

Launch of Hedge Fund & other investment platforms (Debt, Non-Traded REIT, etc)

Select Service Hotel Acquisition/Spin