NexPoint Residential Trust Passes My Stress Test, Has Room to Improve

NexPoint Residential Trust (NXRT) is a dividend growth play. They own and operate apartment buildings in the south. I view NXRT as having both defensiveness and optionality.

Defensiveness comes from the fact that NexPoint invest in Class B apartments, which are actually more defensive than high end Class A’s because tenants live there not out luxury, but of necessity. Growth optionality comes from their strategy of buying apartments that they can rehabilitate, which then allow them to raise the rent.

The company's geographic exposure is below. In this article I want think through a stress case on NXRT, then some of the more qualitative factors.

Defining the Stress Case

Rental vacancies for the South Region, where NXRT operates, peaked around 13.5% during the great recession of 2007-2009. There are large local variations though. Spot checking MSA level data on some of NXRT’s cities I get the following rental vacancies (using 1Q to 4Q 2009 as proxy):

• Atlanta: 14.6% - 18.4%
• Charlotte: 10.9% -14.6%
• Dallas: 9.9%-14.2%
• Nashville: 5.7%-10.9%
• Orlando: 18.2%-28.1%

How about rental prices? According to Axiometrics, class B rent growth went negative for about 7 quarters from 4Q2008 to 1Q2010. Importantly, rent never declined more than 10% before it rebounded.





So I think a reasonable stress case for NXRT would be 85% occupancy and 10% rent cut from current levels. Since we’re modeling stressful times, I assume they cut down a little on G&A expenses and shut off all capital expenditures, which is not good but understandable.

In this stress scenario NXRT can still get to ~$16mm of funds from operations (FFO) which, along with cash on hand, should let them maintain current dividend of $17.5mm per year. Realistically, if they get to that point I would expect a dividend cut, but the point is even in stress scenarios NXRT will generate enough cash to have options.

The credit and liquidity picture looks fine. They are highly leveraged but no big maturities until 2020+.

Quality of Apartments - Need to Get Better

I googled around Nexpoint's properties for ratings, and ended up settling on www.apartmentratings.com since this is the one site I know of that has all NXRT’s properties. Since people tend to write reviews only when they have negative things to say, the key is to see how NXRT's properties stack up relative to their peers. For example, if an NXRT apartment in Dallas has 20% of reviewers recommending it, while the average apartment in Dallas gets has 60% its reviewers recommending it, then the NXRT property probably have some room to improve.

In the table below I listed out NXRT’s properties. The four columns on the right (highlighted in green) shows 1) number of reviews, 2) percentage of reviewers that recommend that particular apartment, 3) average percentage of “recommends” for apartments in that city, 4) difference between NXRT’s property versus city average.

This is not pretty. Nexpoint’s properties in Texas generally get much worse reviews than city averages. Some of their Florida properties get excellent reviews. In general though, this is a picture of lower quality versus peers.

I understand NXRT’s strategy is buy apartments and rehab them, so arguably it’s the migration of ratings that matters, not ratings at a snapshot in time. Unfortunately, NXRT do not have any rating improvement data. The only related data are improving occupancies and higher rents – which are functions of not just quality, but also overall industry demand.

On the positive side, clearly they have lots of room and options for improvement.

Valuation

For valuation I have always struggled to determining an appropriate amount of “maintenance capital expenditure” to deduct from FFO. This gets a bit hazy as some of the natural decays of the building might be offset by regular maintenance and repair expenses, which are already charged through the income statement. (The IR person I spoke to argues that it’s all accounted for in the income statement, so there’s no need for a separate maintenance capex deduction. But I think that’s a bit aggressive since repairs are expensed, but you still get one-off replacements like roofing/tiles which are not).

I ended up using an extremely rough proxy. Maintenance capex from fellow apartment REITS UDR and Post Properties are stated at $1150-1250 per unit. For NXRT that works out to ~16mm of maintenance capex. The company currently has about $34mm of FFO (which mirrors cash flow from operations excluding working capital); deducting $16mm maintenance capex would leave $18mm of free cash flow, which is almost 100% used toward paying dividends.

Since free cash flow mirrors dividend payments, this also means FCF yield = dividend yield = ~6.2% at the current price of $13.2 per share.

I would give this idea a B. It has enough defensiveness and growth optionality, but the apartment reviews are something to monitor. That NXRT is externally managed is another ding. I have a small amount of NXRT in my IRA account.

Omega Protein: Low Expectations and Activist Presence

Omega Protein ("OME") catches fish then processes them into fish meal and fish oils. It has two segments, Animal Nutrition and Human Nutrition, corresponding to the use of its products. Profit mostly came from the former while the latter is currently losing money.

In the Animal Nutrition segment, fish meal and fish oils are used as feed in aquaculture, swine, and pet food industries. Aquaculture customers have become more important in recent years. I expect this tailwind to remain the next few years as the Atlantic salmon producers increase capital expenditure and production.

Catalysts

Earning expectations through 2017E are now reasonable and beatable. Valuation is undemanding at 11x forward PE.

Wynnefield Capital is trying to get OME to dump the money losing Human Nutrition segment. The company has been conducting a strategic review and is scheduled to announce a decision in a couple quarters. The activist wants to nominate their own directors, further putting pressure on the company.

For now I see the activist stuff as bonus. Given the valuation, the key is to make sure earnings are not going to fall off a cliff.

The Core Animal Nutrition Segment

After the latest earnings OME stock took a hit and earnings estimates have been cut, so there’s already some de-risking here.

Currently sell-side expects 10% and ~6.7% EPS gains for 2016 and 2017, respectively. Much of the growth can be fulfilled by just 2015 revenue getting pulled into 2016. 4Q15 was weak on revenue but productions sold forward were up some 20% yoy. Given the big jump in inventory, Omega should be able to fill these orders. Here are details on the forward contract from the 10K.

“As of December 31, 2015, Omega Protein has sold forward on a contract basis approximately 72,000 short tons (1 short ton = 2,000 pounds) of fish meal and 10,000 metric tons (1 metric ton = 2,204.6 pounds) of fish oil for 2016, contingent on 2016 production and product availability… As a basis of comparison, as of December 31, 2014, Omega Protein had sold forward on a contract basis approximately 54,000 short tons of fish meal and 14,000 metric tons of fish oil for 2015.”

Pricing has marched steadily upward the past few years. Management says the 1H2016 forward sales are generally at or slightly below 2015 levels. Global productions of fish meal and fish oil have been depressed the past few years, providing some support for pricing.

Cost per unit is driven by production volume (93% R-squared the past 5 years), which itself is catch volume multiplied by yield percentage. As the company explains it, yield is basically luck.

o The “total yield,” or the percentage of fish meal, fish oil and fish solubles products derived from the menhaden fish has fluctuated over the years and from month to month due to natural conditions relating to fish biology over which Omega Protein has no control “
o The Company believes that fish oil yields are influenced by multiple factors, including but not limited to, fish diet, weather, water temperature and nutrient content, fish population and age of fish, but such possible relationships and inter-relationships are not generally well understood.”

It sounds awful that a key driver should be left to chance, but that’s actually positive in this case because yield has been well below average (see chart below), so mean reversion would lead to higher yields.

Fish catch volumes are in line with historical norm. Combining a stable fish catch volume with better yield percentage should mean improved production, so cost per unit could improve over the next few years. The company is also investing $18mm on equipment to increase productivity.

Margins should hold up given these unit price and cost outlooks. Add in 15-20% increase in volumes, I can certainly see big revenue and earnings bump from Animal Nutrition segment in 2016.

If they ditch or fix that money losing Human Nutrition segment then earnings have further upside.

Downside and Conclusion

This is simply a crappy business. There’s little competitive advantage or moat. The fish processing business is growth constrained – harvest volumes are capped by quotas and fish in the sea which is gradually deteriorating. The company can make it up with higher prices but price is constrained by substitutes (fish farms can use vegetable based protein instead of fish based, even though the latter is considered higher quality). The company has little control over key drivers of production, as yield is basically luck of the ocean.

Management has not done well. The company takes impairment and “non-recurring loss” almost every year. In recent years the company has ramped up capital expenditure. Acquisitions have been questionable.

The unattractiveness of the business are mitigated by the fact that stock trades at ~11x PE – hey you get what you pay for. Throw in low expectations through 2017E and some activist presence, I’m inclined to roll the dice on this one.

When Does it Make Sense to Adjust for Amortization of Intangible Assets?

Buffet’s 2015 annual report contained his usual warning about amortization charges.

“… serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality

Buffet goes on to say about 20% of Berkshire’s amortization charges are “real”, therefore adding back about 80% of amortization charges in his non-GAAP presentations.

For a lot of companies, non-GAAP earnings routinely doubles that of the GAAP version after adjusting for amortization of intangibles and stock-based compensation. Clearly these are no trivial matter. Since Buffett already criticized the latter, here I want to focus on the former.

Most Intangible Amortizations are Real Expenses

If the key question is, as Buffett suggested, whether the intangible asset depletes over time, then I would say most of them do. They are called “finite-lived intangibles” for a reason. Software and patents are fairly obvious - they deplete due to technological obsolescence and legal expirations, respectively. But even customer relationships and brands depletes overtime. 

Buffett cited customer relationship as an intangible asset that does not deplete. But I would argue even that decays overtime as your customers change (they move out of your geography, retire, move to another company…etc.) and competitors try to steal your customers. Brand value decays as well. If you literally buy out the Coca-Cola brand for a gazillion dollars and then subsequently spend zero on marketing, advertising, or promotional budgets while Pepsi continues their efforts, I believe even Coke would gradually lose “mind share” and its revenue will slowly decay overtime.

Criteria for Adding Back Amortization Charges

So when is it ok to add back amortization of intangibles? I think the real question is not whether something depletes – they pretty much all do. What really matters are 1) whether the company is spending to replace or maintain that earning power and 2) whether that cost is already accounted for.

Due to the quirks of accounting, intangible assets are capitalized when they are acquired. But the costs to internally replace that earning power (think R&D, advertising expense, marketing expense, and so on) are usually expensed. This means they already flow through the income statement, as opposed to getting capitalized on the balance sheet then amortized later.

Go back to the Coke example. Let’s say you buy out the Coke brand, and now you got a massive intangible asset and lots of amortization expenses. But instead of letting it rust, you actively incur expenses on sales/marketing/advertising to maintain or increase that brand value. Since these costs are already reflected in the income statement, not adding back amortization expense would be double counting.

Compare this to depreciation of hard assets. Since ongoing cost of maintenance would be capitalized and not expensed in the income statement, an accurate earning measure would either treat depreciation as a real expense, or add it back but subtract an estimate of maintenance capex.

The Verdict

To conclude, adding back amortization of intangibles makes sense. Not because they are not “real expenses”, but because the cost of replacing that intangible asset is likely already reflected in the income statement and you don’t want to double count. It is “likely”, but not always, because the appropriate treatment would differ company by company, and asset by asset. There’s no one size fits all answer.

Berkshire Hathaway is unlikely to skimp on spending to maintain its earning power, so Buffett’s adding back 80% of their intangible amortization seems sensible.

On the other hand, if a company’s core business model is acquisition of intangibles (say patents for drugs), yet does nothing to maintain or replace its decay (no R&D capability in house), then adding back amortization would be voodoo math.



Notes:

1) Whether a number is “correct” will depend on how it’s used. So if you add back amortization to earning or free cash flows per share, then apply a low multiple to account for the gradual depletion of earning power, then I have no problem with that. But more often than not people add back amortization of intangibles to come up with EPS or FCF/share, then apply 15-20x or even higher valuation multiple – therefore implying the earning stream is perpetual.

2) Intangibles have to be judged on a case by case basis because the same thing could be expensed or capitalized depend on situation (as this article explains, it depends on whether the intangible is acquired versus internally generated, and “identifiable” vs “unidentifiable”)

Fidelity National Financial Ventures (FNFV) - at $10 This is a Buy

Fidelity National Financial Ventures (FNFV) is a tracking stock that mirrors the investment arm of Fidelity National Financial, Inc (FNF). FNF’s management team, led by chairman Bill Foley, has a strong track record of making good investments, including Fidelity National Information Services (FIS), and Sedgwick CMS (now a KKR owned money machine). Management are have strong operating experience, as evident by FNF’s core title insurance business being the best run, highest margin compared to its peers.

An introduction to FNFV’s structure, portfolio investments, and track record can be found here.

The thesis is a simple one – sum of the parts asset play. FNFV's main portfolio investments are American Blue Ribbon (“ABRH”, owns restaurants and bakeries), Digital Insurance (employee benefits platform), and Ceridian (human capital management software). My analysis is shown below. At ~$10/share FNFV has limited downside.





The main uncertainty comes from Ceridian and that’s the variable in my scenario analysis. Other than that, both ABRH and Digital Insurance are fairly stable; while Fleetcor and Del Frisco’s are simply marked at current market prices.

Ceridian

Ceridian “provides human resources, payroll, workforce management, talent management, tax compliance, benefits, employee assistance and wellness programs to more than 100,000 clients in over 50 countries”. Basically it competes with guys like Oracle, SAP, and Workday. Ceridian has traditionally been a strong player in the payroll business but was late to the cloud/software-as-a-service game. It has been playing catch-up on SAAS with its main Dayforce product. Checking around the web, DayForce does have fairly good reviews (an example here).

Note that Ceridian is extremely leveraged at 9-10x Debt/EBITDA. So this is either home run or bust. That’s why I assign value of $0 for Ceridian in my downside case. I do think more likely than not Ceridian will work out though. In the latest earning call, management provided the following comments (emphasis mine):

“I think you’re seeing finally kind of an inflection point and we highlighted this earlier this year…will the growth in the cloud business outpace the decline in the harvest business? The harvest business means that we have a lot of customer – payroll customers are sitting on our service bureau platforms and we’ve been converting those to Dayforce as well as getting net new customers…. But we’re starting to see – as we speak, the growth of the cloud is outpacing the decline in the harvest business. “

Basically growth in cloud business is starting to outpace decline in legacy business. This is good news. I also think the entire HCM industry have some growth runway as U.S. now only have ~5% unemployment. 

There are certain factors that made the stock cheap. As a spin-off this is kind of under the radar. Being a tracking stock in a complex FNF corporate structure does warrant some discount. FNFV is not very liquid. All these factors cause me to discount the stock by some ~15% in my base and downside cases.

In the hands of savvy management, however, these can also be upside levers. When the time is right they can provide more color around Ceridian (currently very little). Cleaning up the corporate structure would surely help. Low liquidity also means buybacks can have greater positive effect on its stock price.

Reasons for Declining Medicare Part D Reimbursement - and What They Mean for Healthcare Stocks

In its 3Q15 earning call, CVS explained that its margins declined due to higher proportion of lower margin Medicare and Medicaid business. Here I want to focus on Medicare, and specifically Medicare Part D (the drug portion), which obviously have big impacts for the PBMs (CVS, ESRX), pharmacies (WBA, RAD), and the rest of pharmaceutical supply chain from distributors to drug manufacturers. 

Pharmacies like WBC have been talking about drug reimbursement pressure for a while. Much of that stems of their weaker bargaining position relative to PBM and payers. But what has not been discussed enough is that Medicare Part D revenue per member has deteriorated several years in a row.

Reimbursement Pressure Starts at Health Plans and Propagate Through Supply Chain

There are lots of online articles on drug costs to the enrollee, but figuring out what the government pays health insurance companies is not straight forward. Fortunately, chapter 6 of this Medpac report has a detailed explanation of how Part D reimbursement works, and even an example of how plans bid. From the same report (shown below) is Medpac’s measure of government outlay in Part D plans.




From this chart it’s clear that “expected reinsurance” has been steadily increasing, while “base premium” and “direct subsidy” have been steadily decreasing. A quick note about how this works. “Direct subsidy” is what government pay to health plans directly. “Base premium” is what enrollees pay. “Expected reinsurance” is what government reimburse the plans after drug costs exceed some catastrophic threshold. 

Since reinsurance is used to cover catastrophic drug costs, what the plans really get is direct subsidy and base premium, or what CMS calls the “National Average Monthly Bid Amount”. This is a good proxy of a health plan’s revenue, from which it needs to cover drug costs (below the catastrophic threshold) and administration costs, with the remainder going to plan profit *. The table below show that the average bid amount has been declining steadily, which led to reimbursement pressures throughout the entire drug value chain. For 2016, the industry will see another steep drop of 7.6%.

Reasons for the Decline

Why is this happening? First, what is not an adequate is the argument that health plans are not actually seeing reimbursement pressure, because the overall bid amount including reinsurance has actually been increasing. From the plan’s perspective, reinsurance just compensates for extraordinary costs and does not add to the bottom line. As for the base elements, even the MedPac report cited above - which alleges that sponsors use clever bidding strategies to maximize profits - the example given (page 163, table 6-11) clearly shows that gaming the bid system would lead to higher, not lower bid amounts (Case 3 in the example is what the plans have been doing. Based on actual claim experience the direct subsidy and beneficiary share should have totaled $46.50, but the plan bid totaled $60.00 those items).

So the way to reconcile a) ever higher reinsurance payments with b) ever lower bid amounts is that government and private sectors are both sharing the pain of higher drug costs. The government has been taking on more catastrophic risks, while private sector focused on efficient day to day administration. In this way both utilize their comparative advantage.

So the fact that bids amount have been lower every year is not about plans ripping off the government, but due to genuine industry competition. There are various explanations:

• The “National Average Monthly Bid Amount” is weighted by enrollees. So as low cost plans win over more enrollees the weighted average would be dragged down.
• The larger plans have been aggressive as scale allows them to lower operating expenses and push through formulary changes. 
• Generic conversion have lowered regular drug cost, while government took on the tail risk of the Sovaldi/Harvonis of the world.
• Medicare Advantage plans with drug benefits (MA-PD plans) can bid lower as the Part D is small portion of overall revenue (Part D bid amount will be $64.66/month in 2016E, while Part C benchmarks are easily $750-800/month)

Investment Implications

The above drivers are not about to go away soon, so this trend of lower bids and worse economics for entire drug value chain could continue for a while. In the longer term though, large players like CVS and UnitedHealth might actually benefit as lower margins drive out smaller competitors. In terms of ability to withstanding constant Part D reimbursement pressure, I would rank the various players from best to worst as follows.

• Managed care companies. (UNH, AET, HUM) Medicare Part D in general is a smaller part of their business. If the Aetna/Humana merger goes through, the combined entity will be a major player in MA-PD plans and can continue to push bids lower to take market share.
• Standalone PDP / PBMs (CVS and ESRX). Both CVS and ESRX are large players in the standalone PDP space. They are at a disadvantage relative to managed care companies but have been able to exert strong bargaining power over the rest of the supply chain.
• Pharmacies (WBA, RAD) and drug distributors (MCK, ABC, CAH). These have weak bargaining power. The pharmacies in particular have been beaten up by PBMs. Their only hope is more consolidation as in the Walgreens Rite Aid deal. The major pharmacies and drug distributors have also teamed up to get more market power.

All the industry participants above have low margins. The managed care companies even have legal caps on their profitability. So going forward the big costs savings will have to come out of the drug manufacturers, specifically the specialty drug companies. The specialty drug companies are a totally different game. On the one hand they are prime targets for price cuts. On the other hand it’s hard to cut prices without political action, and even if price cuts go through these manufacturers have some fat margins anyways.

I am holding on to my UNH and AET shares despite the political rhetorics sure to come in 2016. I particularly like the idea of a combined AET/HUM dominating the growing Medicare business. CVS is a tough call as it a well-run company but its pharmacy business will likely bear reimbursement pressure for years to come.

* Notes: Some analyst reports calculate plan revenue as average bid amount + enrollee premium. That is incorrect, as the enrollee’s base premium is calculated as a percentage of the National Average Monthly Bid Amount, which implies the latter is inclusive of enrollee premiums)

Gold Call Options

I bought a small amount of GLD call options today.

I got into the June $115 call for $1.59. I think this is a much better way to gain exposure than going outright long. With GLD trading at $103.5, maximum loss on this trade is only 1.5% of the long exposure obtained. I'm also long USD (currently against NZD and EUR), so some gold will help in case the Fed hike thesis falls apart.

Gold has been beaten down to multi-year lows and I can understand why. The Fed can't stop talking about raising rates. Inflation is no where in sight. Marginal costs for gold producers keep declining over the years, and will get lower if the US dollar strengthens. Jewelry demand, roughly 50% of total demand, will likely be weak in a low growth environment. Finally, after a massive build up over the past decade, ETFs has been decreasing their gold holdings the last couple years.

So why a long position? These call options are a low risk, high reward way to go contrarian on the consensus view that Fed will raise rates in December.

First take a step back. Gold has four functions: 1) as a safe haven/physical currency, 2) inflation hedge, 3) jewelry, 4) industrial use. Right now the only reason for anyone to own gold is the first one - gold as a currency. This is really the flip side of US dollar strength, which has everything to do with market's expectations of a rate hike.

Expectations

It wasn't that long ago (just September!) that the Fed failed to raise rates and cited risks in China and low inflation. Every other day some Fed officials (Lacker, Bullard, Lockart, Brainard...etc) took their turn going rogue on media and gave contradictory statements.

Now, just a couple months later, everyone is supposed to have suddenly fell in line and agree to raise rates? That hardly seems credible to me.

Last year's experience made clear a few things about the Yellen Fed regime. First, the Fed takes into consideration a lot more than its dual mandate of inflation and unemployment. Some of these unstated factors include general market stability, US dollar strength, and yes - China. Second, the Yellen Fed does not like to surprise the market, so October's hawkish Fed statements was just a way for Yellen to raise expectations of a December hike in the market. Put another way, October's Fed statement was just to keep their options open. Finally, we learned that it doesn't take much for the Fed to delay that rate hike -- perhaps permanently.

Given the lessons above, and all it takes is a weak inflation number, a couple bad numbers out of China, or another market meltdown to lower the probability of the December hike.

As for gold, market expectations about the rate hike is what matters. If any of the above happens, the call option will likely be a winner. There's also very little downside. Depending on how macro data comes out, I might increase this option position.

What’s Dragging Down Core Retail Sales?

One of the biggest questions in corporate earnings is how the US consumers are doing. We know housing continues to recover, if in a sluggish fashion. We know auto sales are doing well, driven by light trucks. How about retail sales? 

Headline retail sales have continued to increase but showing signs of deceleration. This number is heavily influenced by auto & auto parts though –which we already know is strong. On the other hand, gasoline prices have dropped significantly and that drags down the headline numbers even though it should benefit consumers.

So I consider “core” retail sales – excluding auto and gasoline sales – as a more accurate reading for U.S consumers. The growth in this number is shown below.





Notice that post 2008, growth in “core” retail sales have hovered around 3-5%, slower than the 5-7% range pre-crisis. So I dug a little deeper to see which sector is dragging this down.

The Census Bureau report divides retail sales into 13 categories - motor vehicles, furniture, gasoline, building materials, and so on. Going through the data, I found the biggest drags come from 2 sectors: general merchandise stores and building materials.

The contributions of these 2 sectors to core retail sales growth are shown below.

The declining growth in general merchandise stores might have something to do with offsetting growth in online shopping (although apparently not enough to offset overall sales since the headline number does include e-commerce.) .

The other major drag on growth is the “building materials & garden equipment & supplies dealers” category. Growth has recovered but has not yet reached pre-crisis levels. The good news here is that new home sales – as shown by the link in the first paragraph – should have plenty of room to grow.


Looking out the next few years, I can see a housing pick up driving core retail sales up toward pre-crisis levels. Gasoline prices will also stabilize and be less of a drag on headline growth.