The Rational Cloning: Weekly Ideas #12
Clark Street Value on Realty Income/Alliance Data Systems Spin-Offs, Horizon Kinetics on Having No New Ideas, Clearbridge on Being Overweight Energy, and Silver Ring on Garrett Motion
Welcome to the 12th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Clark Street Value: Orion Office REIT: Form 10 Notes (October 29, 2021)
I love a good merger-spinoff combo, the latest one is a result of the merger of two large net lease REITs, Realty Income (O) (which is the bluest of blue chip in net lease land) and VEREIT (VER), the merger closes 11/1, the two are combining their office properties and spinning them off as Orion Office REIT (ONL, presumably for “Office Net Lease”) mid-November.
The Realty Income management team is going to stay in place, while much of the VEREIT team is moving to the spinoff. Orion is positioning itself as a single-tenant, long-term leased (resemble a triple-net if not explicitly one), suburban office REIT with the thesis that in a post-covid world, suburban office is going to make a comeback as millennials move to the suburbs and white collar employees generally want shorter commutes. Orion wants to be a growth vehicle, taking advantage of any covid induced dislocations and a lack of competition, targeting properties in fast growing sun-belt metro arears.
The biggest problem is while it might be Orion’s go-forward strategy, the starting portfolio doesn’t resemble a long-term leased sun-belt suburban office portfolio. The weighted average lease life is less than 3.5 years and many of their 92 properties are large headquarter like campuses in the northeast and midwest. For example, they will own the old Merrill Lynch Princeton, NJ campus now occupied by Bank of America and the Walgreen’s corporate campus down the street from me in the northern suburbs of Chicago. The headline portfolio metrics seem good, it’s 94.4% occupied (I assume this means leased, would be interesting to see the percentage where the tenants have returned), 72% investment grade tenants and 99% rent collection through covid.
That might be a bit harsh, the broader net lease REIT group trades for a high-teens AFFO on average, but I don’t think this will trade like the others. Based on the Form 10, I come up with about $170MM in NOI for the ONL portfolio, they’re going get spun with $616MM in debt, if we put a 7% cap rate on that it should trade for ~$33.50/share and at an 8% cap rate it should trade for ~$27.80/share (the range where OPI is selling assets). I could have a few mistakes in here, so please do your own work, but if ONL trades well below this range I’d be interested.
(2) Clark Street Value: Loyalty Ventures: Form 10 Notes (October 26, 2021)
Alliance Data Systems (ADS), after a few years of speculation, is spinning off their LoyaltyOne segment as Loyalty Ventures (LYLT) in an attempt to become a more pure-play private label credit card company.
The spinoff’s primary business (~80% of EBITDA) is the Canadian loyalty program “AIR MILES” where consumers (“collectors” in LYLT speak) shop at participating retailers (“sponsors”) and earn points that can be redeemed for travel, cash/gift cards or other rewards. AIR MILES collects a fee from sponsors at the time of purchase but only recognizes revenue fully when the collector redeems the reward, creating an attractive negative net working capital business.
AIR MILES is similar to the old Blue Chip Stamps business that was a Warren Buffett favorite from a generation ago.
There is not a great public peer for Loyalty Ventures currently public, Aimia previously owned Aeroplan (spun from Air Canada and repurchased by the airline a couple years back for $370+MM) and AeroMexico’s loyalty plan that was sold for 9x EBITDA. The U.S. airline carriers used their loyalty programs as collateral to raise financing for themselves last year, for example United raised financing with a 12x EBITDA multiple valuation on their rewards program. Probably not apples-to-apples. I have no clue where LYLT will trade, but I’m going to throw a 9x multiple on it as a guess. (TARGET PRICE/SHARE: $50.54)
Disclosure: I have a tiny position in ADS $100 Jan 2022 calls, basically just a FOMO trade in case LYLT takes off out of the gate similarly to CCSI (seems like one of those situations where both parent and spin will trade up), look to add LYLT directly once it starts trading.
(3) Horizon Kinetics 3rd Quarter 2021 (October 2021)
Absence of New Ideas?
This one had me flummoxed for a while. I came to think that there could only be two reasons for thinking that there haven’t been many new investments in our portfolios.
One reason might be that some of the holdings in older-vintage accounts have become so dominant, and so much the subject of questions and response in prior quarterly reviews, that it might seem that little else is going on. TPL and Wheaton Precious Metals, as well as Grayscale Bitcoin Trust and Brookfield Asset Management, for instance. Been hearing about them for years and years. But there has actually been significant refinement of portfolio holdings in the past few years as we pre-position for the contingency of a chronic and possibly serious period of inflation – which would mean severe purchasing power erosion for people’s savings and capital.
By our standards, we’ve actually been pretty active. These businesses predominantly share the characteristic of being ‘asset-light’ or ‘hard asset’ – they don’t require an asset-heavy balance sheet in order to operate and, so, are less exposed to the ravages of cost inflation upon their operations. Would I rather be a manufacturer, or just a fee collector?
As in, would I want to be a car manufacturer during an extended inflation, burdened with rising replacement costs for my enormous plant and equipment base, and with compensation increases for my large employee base? Or would I rather be a car dealer: basically, an upgraded parking lot with short-term inventory and a certain pass-through margin on sales? That margin generates proportionally more dollars of profit as car prices rise, but without much increase in operating costs. Would I want to own a fleet of container ships or oil tankers, subject to constant physical depreciation and replacement spending, with little control over my primary operating cost – fuel? Or would I rather be a shipping broker, which sells information, and whose fees are ad valorem, meaning they’re based on – and rise with – the lease prices of the charters I broker?
The commentary is quite long (29 pages) but worth a read. Will post my notes on Twitter later this week, so look out for that.
(4) Clearbridge All Cap Value Strategy Third Quarter 2021
Conversely, ESG could be the best thing that ever happened to the shale companies as it restricts investor capital, supports company discipline and forces companies to prepare for terminal demand. The result is that our energy company investments should generate the highest free cash flow and cash dividend yields in the market in 2022.
Our largest energy holding, Pioneer Natural Resources, will pay a cash dividend of over 10% while achieving a fortress-like balance sheet that will allow stock buybacks. The ideal market solution is higher energy prices while we transition from disciplined supply, as it will incentivize innovation and smart transition. However, underinvestment could result in energy spikes that derail or delay transition. Complex problems need many adaptions.
The transition will also require substantial amounts of natural gas, a reality that remains mispriced in the market. The most levered to this dynamic in the portfolio is EQT — the largest natural gas producer in North America — which is poised to generate 50% of its market cap in free cash flow by the end of 2023, based on current forward prices. While much of that will go toward debt reduction, a fortress-like balance sheet is in sight, meaning a substantial portion of that 50% will return to shareholders in dividends and share repurchases.
Further down the value chain is natural gas pipeline company Kinder Morgan. We expect the company’s pipes will remain fuller for longer than currently embedded by the market, as gas plays a vital role in displacing coal power production and in backstopping variable power generation from renewables. Similar to Pioneer, Kinder boasts the fourth-best dividend yield in the S&P 500. Looking forward, the company has a medium-term upside from energy transition initiatives as its assets transport and sequester carbon and longerterm from hydrogen transportation if that fuel takes off as a hydrocarbon alternative.
The result is that the energy sector remains our largest overweight, as we think we are witnessing adaptive change and are getting rewarded for it. Energy transition is effectively driving free cash flow yields that support much higher business values if they persist beyond the very short term, which we think is much more likely than what market prices currently embed. The energy transition is also creating long-term options from companies directly involved in rebuilding the grid, electrification and renewables. Our goal is to invest in companies that are already generating earnings and free cash flow that supports current business values and getting the long-term option at an attractive price. Examples include AES in battery storage, Quanta in rebuilding the grid and Eaton in electrification.
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