Value Investors Club / COLONY CAPITAL INC (CLNY.PH)

Description

2020.10.26 CLNY H Pref Writeup ($21.24 per share)

I think CLNY Series H Preferreds are an attractive long investment. After years of persistent capital destruction, impairments, broken promises, excessive leverage, and repeated misses, CLNY is in the later stages of a complete revamp.

I expect these preferreds either to trade back to par or to be redeemed at par, generating somewhere between strong to excellent risk-adjusted returns (depending on how long it takes). For instance, the yield to par (i.e. IRR) for CLNY H Prefs is ~25% over 1 year, ~16% over 2 years, ~13% over 3 years, etc. as can be seen in the following table:

The hopelessly complex smorgasbord of legacy assets and “proprietary deals” of Colony (and Northstar) are getting monetized at an increasing pace. The proceeds are being recycled into the new Digital Infrastructure platform and debt paydown. Legacy management has been replaced. New CEO Marc Ganzi is incredibly impressive. Q2 results were accompanied by a “big bath” of impairments which finally went a long way towards writing down the legacy assets closer to market.

While the consolidated financial statements still show over $9 billion of gross debt, the vast majority is non-recourse primarily relating to the legacy assets that should be gone in less than 2 years. When looking at the creditworthiness of the preferred, my primary focus is on the corporate level, recourse debt.

In July, Ganzi took decisive action to rapidly repair the balance sheet with the issuance of $300 million of Exchangeable Notes at a conversion price of $2.30 per common share. While dilutive to the common, this was a major credit positive. Around the same time, CLNY sold a minority stake in its Digital Investment Management business to Wafra (the Kuwaiti Sovereign Wealth Fund) at an implied valuation of $805 million (a huge premium to its acquisition price a year prior). So far in Q3, $771 million of near-dated corporate debt has been repaid that we know of – the entire revolver balance of $400mm and $371mm of the converts which come due in January 2021.

The dramatic improvement in the debt maturity profile over the current quarter is demonstrated in the following table:

As you can see, what was over $800mm of near term debt has been reduced to $31.5mm (soon to be $0). And while the 2025 Exchangeable Notes issued in July were dilutive to the common, they are now trading ~166% of par as they have moved deep in the money. At this rate, I’d expect CLNY to exercise the soft call in July 2023 to force conversion. On as-converted basis, CLNY’s corporate level debt is already down to just $279 million.

With minimal corporate level debt remaining that is senior to the preferred, I’d expect spreads to continue to tighten. Last month, CLNY announced the sale of almost $3 billion of its most challenged Hospitality assets. While the net proceeds will be minimal given the tremendous amount of non-recourse debt, the important part is that CLNY should have excised itself from that business upon closing without throwing any more good money after bad. And from an optics or screening perspective, billions of debt will suddenly disappear from the consolidated financial statements.

A sale of the legacy healthcare portfolio is targeted for 2021. Besides the elimination of another several billion of non-recourse debt, several hundred million of net equity proceeds are expected. That leaves an array of “Other Equity and Debt” or OED investments to be monetized. Finally, CLNY retains a 36% equity stake (or 48 million shares) in CLNC worth $240mm at market along with the management and incentive fee streams of CLNC which ultimately should all be monetized too.

Earlier this year, CLNY looked like a hopelessly overleveraged group of assets with a looming tower of recourse maturities in the near term. As the runway has been extended with decisive actions taken, the preferreds have traded up materially. But there remains further upside as the transformation from legacy to digital continues and as the balance sheet continues to be repaired and refinanced.

The bonds of investment grade digital REITs (such as AMT, CCI, DLR, EQIX, SBAC, etc) generally yield ~2% to worst for 10 year paper and ~3% for 30 year paper! It seems logical to me that CLNY should ultimately be able to issue straight debt at much lower yields than the CLNY preferreds, ultimately making it a no-brainer to redeem the CLNY preferreds. As shown in the first table, the preferreds have a current yield in the mid 8% range – a seemingly massive spread to the longest dated digital REIT bonds.

While the preferreds are technically equity and lack the “teeth” of bond covenants and associated potential defaults and maturities, the rating agencies still treat them as partially or majority debt. And from the common equity’s perspective, the advantage of these preferreds becomes more and more limited over time as the balance sheet improves (being able to temporarily suspend the cumulative preferred payments is of minimal benefit when there is no longer any prospect of distress, especially when the common is expecting a dividend of its own). Notably, the investment grade digital REITs mentioned above do not have preferreds of their own outstanding today.

As another set of comps, KKR and APO both have preferreds that are inferior to CLNY’s in that they are non-cumulative. Yet the KKR and APO preferreds trade above par today despite having lower coupons and despite being callable today. They trade at 0-2% YTW and 6 - 6.5% current yields. For CLNY preferreds to approach those levels, they would have to trade above par and thus generate better returns than shown in my initial table which assumes an ultimate exit at par. Said another way, in time there could well be the opportunity to redeem the existing CLNY preferreds with the proceeds of asset sales or bond refinancing proceeds, but also with the proceeds of future preferreds issuances at lower dividend rates.

CLNY preferreds are trading at under $900mm of total liquidation preference at the current market price. This compares to a fully diluted common equity market cap that is now over $2.2 billion, as seen in the following table, and representing a sizable “downside cushion”:

While I think all 4 series of CLNY preferreds are attractive and should generally trade within a rather narrow band, I chose the Series H for simplicity. I’d expect the Series G to be redeemed first – besides already being callable, they have the highest coupon and the smallest outstanding balance. I’d expect the Series H to be redeemed second (or simultaneously with the Series G) considering they are also already callable.

Catalysts

Sale of hospitality assets removes nearly $3 billion of debt from consolidated financial statements and excises CLNY from troubled assets without needing to invest more equity as many had feared

Sale of healthcare portfolio to eliminate another $2+ billion of non-recourse debt from consolidated balance sheet and generate several hundred million $ of net equity proceeds

Monetization of OED assets, reducing another several billion $ of non-recourse debt and more importantly generating nearly $1 billion in net equity proceeds

Issuance of new straight debt at lower yields

Issuance of new preferreds at lower coupons

Continued increase in common market cap as transition to growing digital platform unfolds

Tender / call / refinance 2023 Converts as maturity approaches and make-whole amount diminishes

Soft call / force conversion of 2025 converts in July 2023

Preferreds get called with proceeds from legacy asset sales and refinancing

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst