Getting the toes wet with Gramercy Capital (GKK)
After reading Whopper Investments’ take on Gramercy Capital, then Plan Maestro’s in-depth analysis I just couldn’t help but buy a few shares. One of my New Year’s resolutions was to buy less generally undervalued stocks and more ‘story’ value stocks with an identifiable catalyst. Gramercy Capital seemed to fit that mold. It’s a broken REIT. It suspended its dividend in 2008 and last September struck a deal to transfer the assets and liabilities of its Real Estate division back to the lenders in a two-step process that should have been completed by year-end 2011. That leaves Gramercy capital with 3 basic assets:
- Corporate assets
- 58 real estate properties at the corporate level (with non recourse financing)
- Cash, investments and some other working capital
- Gramercy Real Estate management – managing its former properties for a fee of $10 million annually
- Gramercy Finance, a division that manages and owns interests in 3 CDOs that had an original face value of $3.1 billion and are non-recourse to the parent
There are detailed descriptions of these assets in the write-ups mentioned above. If you want additional information you should review the 10Qs and 2010 10K filed with the SEC. Additionally, a pro forma balance sheet with the Real Estate Division separated out was finally filed in December; you can view it here.
When I initially read Whopper Investments’ analysis I must admit I was quite excited. A net-net with the potential to double or even triple, all with a significant margin of safety. What could be better! Just what I was looking for, an event-driven value stock. And there is even an activist investor involved! The activist investor here is Indaba Capital who filed a 13d on Sept 30 disclosing ownership of 23% of the preferred shares . The filing included a letter sent to management and the board which laid out why the preferred dividend should be reinstated and requested a special meeting of preferred shareholders to elect a preferred shareholder director to the board (as allowed under the terms of the preferred shares).. The letter also contained a valuation of the common shares. I have included a summary of this valuation below (only the low valuation) along with my own margin of safety analysis. Note that my figures for cash come from the pro forma balance sheet that was released in December and Plan Maestro’s estimate of the market value of the CDO securities held.
Gramercy Capital Corp.
|PE 3Q 2011|
|Indaba||Long Term Value|
|in mills||per share||in mills||per share|
|Pref. liquid. value||($88.1)||($1.74)||($88.1)||($1.74)|
|Pref. div. arrears||($21.5)||($0.43)||($21.5)||($0.43)|
|Net at Corporate||$121.4||$2.38||$91.1||$1.80|
|Real Estate Mgmt.||$11.0||$0.22||??|
|Finance Div. (CDOs)||$72.0||$1.45||??|
So why does my valuation have so many question marks? As I subsequently read and reread Plan Maestro’s analysis and the recently released SEC filings, I began to have second thoughts. There were a number of questions that I just couldn’t seem to answer, and the more I read the less clear things seemed to become. My estimate of the margin of safety grew slimmer as the uncertainty grew. Perhaps I should have just consigned this company to the ‘too difficult’ pile, but I already had a toe in the water, and besides the upside does look considerable. It’s just that the value that I initially thought was solidly there really isn’t so clear after all. So let’s get on to the sticky questions.
- What is the value of the 58 (or 55?) real estate properties carried on the corporate books (carrying value of $80 million on the asset side of the GKK’s ledger)? How much are the mortgages on these properties? (they are held by the CDOs so are eliminated in consolidation) I read somewhere in the 10K that the mortgages have a face value of $32 million but that doesn’t seem to jive with Indaba’s valuation of $23 million for the real estate (my calculation from the data points would be $80-32= $48 million??). I find I have so little information that I have to ascribe a value of zero to the real estate for the purposes of margin of safety.
- How much in investment securities (CDO bonds) is GKK carrying at the corporate level? According to the 3Q 10Q they purchased $48 million in face value of CDO bonds in 2011 which are being held for investment purposes. Plan Maestro quotes $50.3 million and gives a market value for these of $40 million.What is the difference? Were all the prior repurchases used to either retire the CDO bonds or exchange for other script with the intent of improving the ratios of the CDO tests?
- How do I evaluate the potential for the two CDOs near or above compliance to remain that way (2005 and 2006)? More specifically is CDO 2005 in compliance now? Did it produce any cash flow for corporate in the 4th quarter? It seems to have been in and out of compliance in 2011. What is being done to assure that it stays compliant or bring it back into compliance? And more importantly how much of corporate cash will this require?
I know I should be answering these questions not asking them, but I simply don’t have the information to do so. Despite this, there is still something that attracts me to the investment proposition. The upside is huge. The book value of the preferred in the 2005 and 2006 CDOs is $177 million (over $3.00 as share), which would be paid to GKK when the CDO’s wind down (6 to 8 years from what I understand), if indeed there is any value left in the CDOs. (Actually, there could easily turn out to be no value left). Then there are the cash flows from the CDOs during the interim which could be $40 to 50 million a year (diminishing with time) if both CDOs are compliant. Plus there are the management fees for the CDOs ($1.5 million per CDO per year) and the Real Estate management fees ($10 million annually). So there are significant cash flows that MIGHT come in.
In the end, I’ve come to the conclusion that what one really has to look at here is management. Plan Maestro gives a fairly convincing argument that management is competent, even very skilled. That said, I’m a bit confused about incentives. Top management at GKK get million-dollar pay packages but own less than a million shares of common each. To me that means operating the company is more important to them than a sale of the company where value is realized for shareholders. In September, when first the Real Estate division transaction was announced then Indaba filed its 13d, there was speculation that the preferred dividend would be reinstated, arrears paid and the company would be sold (the company announced they were exploring options). On the news, the common share price jumped to over $3.70. Since then the shares have slowly trended down and now trade around $2.50. Like Plan Maestro I don’t think that preferred dividend will be reinstated anytime soon (why hold the special meeting requested by Indaba to elect a preferred shareholder director if the dividend was about to be reinstated?) Furthermore, I’m not so sure that a sale of the company is in the offing. Remember my thesis that management is incented to keep the operations going and the cash flowing into their pockets (in the form of salaries and bonuses). The recent change to their employment contracts, however, providing management with more security in the event of a transaction, might indicate, or at least leave that door open for, the possibility of a sale. I noted with interest that last Friday Indaba exchanged some of their preferred shares for common shares. Maybe they too have realized that they can’t really force a preferred dividend reinstatement and that management sees maintaining liquidity as more important than boosting the share price. (Remember my thesis again, management wants to keep this thing alive so they can maximize their wealth). That said, what am I doing with my investment? I’m content to hold at these levels on the thesis that there is sufficient value in the common to make it worthwhile to be patient. Management will in all likelihood continue running the company to maximize its operating value. I do think, however, that investors who are convinced that there is transactional value in the preferred shares and, thence by extension, common shares, could, over time, become frustrated and dump the stock. If that happens I’ll be looking to pick up more shares if the common trades down closer to my margin of safety, say around $2.00 to $2.25 a share.
As always, do your own homework. This is a tricky one.