Friday, December 9, 2011

Gramercy Capital (GKK)

Gramercy Capital (NYSE: GKK) has been mentioned relatively frequently among some insightful contributors splattered over the web. I’d highly suggest reading up on VarientPerception’s 4 part series listed below (and rest more comfortably knowing some being out there has spent 6 months following this stock and has yet to change his/her conviction about its intrinsic value). In backwards order:

 The trustee reports for the 2005/2006 CDOs dating from Q1 of this year are also available with a simple search, and are fundamental for those of you who want to do the math around the tranche waterfall yourselves.
The accompanied Indaba (hedge fund) letter:
More recently, a post on gurufucus by Whopper Investments:
In summary, the thesis here is that GKK is undervalued, as are its preferred, and that if you’re able to stomach exposure to a volatile sub 200 million cap company, then you should spend some time dissecting the company as it may present itself to be of value (disclosure: long GKK).

Gramercy Capital is a CRE business operating (previously) under Gramercy Finance and Gramercy Realty. The 10Q and 10K will provide more color over the business, but the past financial statements are hard to decipher due to a muddying of recent events that no longer pertain to the modus operandi of the existing company. Thus, I would hesitate to spend much time on those and would spend more time deciphering the CDO waterfall under Gramercy Finance, valuing the cash flow stream from Realty, and applying a simplified sum of the parts valuation to approximate the value of the equity (good non-recourse assets on the balance sheet).

First off, a quick discussion of Gramercy Realty (and not to spend too much of our precious time here, as the segment is no longer part of the business): Realty was subject to a series of losses which has resulted in the collateral transfer of a majority of its properties to its creditors, in exchange for a mutual release of claims (~$550 million of mezzanine debt). Subsequently, Gramercy Capital will continue to manage the collateral for a fixed fee of $10 million annually, plus an incentive fee that will be floored at $3.5 million (this is subject to termination, with exception for the $3.5 million unless for cause. The incentive fee itself is a poopoo to understand, so I’m just assuming the floor for the sake of conservatism). This comes out to $13.5 million of annual revenue, barring any reason for management termination. -- Long story short, management bought into certain estates prior to the Great Recession, and ended up losing their shirts (but just their shirts) as they were unable to pay the interest on the mezzanine debt on which the assets were collateralized. Now the segment has become a small revenue stream – that’s it!

As for the holding company assets, GKK did release pro forma adjusted financial statements on December 7 ( Looking at the core holding company, real estate investments total $80 million, cash and equivalents total $155 million, and restricted cash of $8.7 million. Total assets are $260 million and total liabilities are $40.5 million (including $21 million of dividends in arrears for the preferred shares). This means cash and restricted cash, less dividends in arrears is $142.7 million, is in excess of the $134 million market cap at a share price of $2.65 (this though does not take into account the $85 million preferred shares we'd have to take into account if we were liquidating for value.). The value of the preferred dividends more or less offsets the value of the real estate investments held at the holding level. And remember, the holding company is non-recourse to Realty and Finance.  Since Realty already “went bust”, it is now simply a revenue stream of $13.5 million. The only complex item to pursue then is the valuation of Gramercy Finance.

Gramercy Finance is the (you guessed it) “financing” arm of the company, and dabbles in the loan originations, CDOs, and whatnot of a general REIT. The CDOs represent the Variable Interest Entities on the balance sheet, and seem pretty grotesque with $2.0 billion of assets matched to $2.7 billion of liabilities – primarily the outstanding CDOs . But before you nag at me for wasting your time, please let me waste a bit more of it before you decide to close your Chrome or Mozilla or whatever window in contempt. Gramercy Finance owns the J, K, and preferred tranches of three CDOs, each named after the year which they were constructed (2005, 2006, and 2007). As long as a CDO meets certain overcollateralization measures, the cash from the interest collection flows down the waterfall, and the residual is paid all to the preferred tranche. If you refer to the latest Q press release, you will encounter the following chart (I apologize for not remaking this in nicely formatted excel – you may choose to do so if you find it to be a good use of your time):

As you can see, CDO 2007 is completely bust, with compliance margin so far below its limit that it’s safe to assume it’s incurable at this point. CDO 2006 on the other hand, has always been in compliance, despite a slight narrowing in the margin due to the reinvestment period closing earlier this year. CDO 2005 failed compliance marginally after having passed compliance in the last quarter, meaning that all excess interest is going down to retire the senior tranche principals. Slightly below this chart is the summation of collateral manager fees and CDO distributions.

In essence, collateral manager fees comes out to roughly ~$7 million a year for the 3 CDOs, 2006 distributions come out to ~$30 million a year, and 2005 CDO distributions come out to ~$22 billion a year if the OC tests are met. This comes out to a relatively predictable cash flow of $37 million from Gramercy Finance, with potential up to ~$60 million if OC is met for 2005. Prior to the release of the 8K, I did some quick excel work as well, given what we had of the outdated trustee reports (the quarterly funds for distribution at the end of last year was higher at $6.4 million FCF to Gramercy vs $5.5 million in 3Q 2011):

Now, I did the liberty of summing up the FCF from the two CDOs (which were not far off from the true cash flows, provided that 2005 is compliant. Otherwise, we would likely reduce to a low estimate of FCF or subtract out 2005 in all entirety for a more conservative assumption. However, please do note that given the 115.3% compliance ratio on 2005, it would only require a ~ $15 million purchase of the F/G/O tranche, given the trustee Q1 collateral balance of $845 million, to bring the CDO up to compliance and the ~$22 million FCF coming), along the Gramercy Realty management, participation, and incentive fees, along with an annualized SG&A cost to come to FCF.
These numbers are more conservative, but not too far from the values provided by Variant Perceptions ($.80-$1.10), and from those assumed by hedge fund Indaba of $.83-$1.11). While I hesitate to put a “value” on the equity from these FCF numbers, Indaba gives a range of $4.05 to $7.11 using asset value + a 2-4x cash flow multiple. Variant uses NCT’s FCF multiple (another cheap trading REIT) of 4.3x to come to a valuation of $6.60-$7.70. Needless to say, I believe the stock is undervalued where it stands today, and leave it up to the reader to come up with his own perception of fair value.  Essentially the balance sheet itself is worth noticeably more than the market cap of the company, and the cash flow from CDO 2006 itself along with CDO management fee is practically breakeven to SG&A.

Thus, it is up to the company to continue to build shareholder wealth through smart deployment of capital. There is no surefire way to upside, and GKK may end up mismanaging its nonrecourse cash or deciding to issue equity and thus diluting current shareholders – the risks are real for any CRE company here, but I believe the rewards are asymmetrical. The company has recently begun repurchasing the senior tranches of its 2005/2006 CDO at a 70% haircut to face value, as they seen. I did a quick calculation to see principle return assuming 70% purchase price, and a $25 million principle quarterly pay down (again, please see the trustee reports for the best estimated numbers). Thus, it does seem that GKK has the potential to buy back its own senior tranches at a nice bargain to receive the principle back at a decent return, or to retire the tranches in order to receive distributions if such a strategy exceeds the prior return. I can’t speak for what management plans to do, but I hope to emphasize that Gramercy Finance is very much of value to the composition of the company.

Last but not least, before I end this far too long discussion, GKK has also put itself up to sale for potential PE candidates. While no value should really be ascribed to speculative action, the teeny potential of a near term catalyst still resides in the air, EVER SO MAGICALLY.
Happy Investing,