RMR Group's "Up-C" Transaction

RMR Group’s “Up-C” Transaction Author: Nat Stewart, Opus Capital Management

Summary

• Very small size of stock distribution makes RMR immaterial to current REIT holders and potentially unworthy of serious study.
• RMR complex of REITs has a tarnished reputation – Who wants to own shares in a management company that has become a “punching bag” for media and investor criticism?
• 10-K net income figures only include earnings from June 4, 2015 to September 30, 2015. This unrepresentative figure creates an inaccurate picture of RMR’s true profitability.
• All of the above negatives are counterbalanced by RMR’s excellent economics, severe undervaluation and the positive incentives created as a result of the “Up-C” transaction.
• I see 54% upside potential to fair value.

Note: This is my first article since joining Opus Capital Management, a firm I am proud to have joined in August of 2015. One of the benefits of working on a team is that there are more eyes looking for opportunity – for example – this special situation was first brought to my attention several months ago by Opus analyst David Wagner. RMR’s severe undervaluation, terrific economics, and very high dividend yield made it an ideal holding for our small cap dividend strategy.

RMR Group Inc. is an asset management company with $21B of assets under management, including 1300 real estate properties. RMR provides management services, too:

Recent “Up-C” transaction and distribution creates a complicated ownership structure

Many are aware that RMR is the manager of a group of well-known REITs and other real estate assets. As part of an “Up-C” transaction that was announced on June 8, 2015 (to be discussed later in this write-up) the publicly traded REITs received 15M shares of the ownership company, RMR Group Inc. On December 14, 7.1M of those shares were distributed from the REITs to the REITs’ individual shareholders.

It is a bit complicated, but RMR LLC is the underlying management company, of which RMR Group Inc., the publicly traded company owns 51.6%. RMR Trust (Which is owned by the Portnoys – the father-son team who have historically owned RMR Group LLC) owns 48.4% of RMR LLC via membership units, as well as a 6.3% interest in RMR Group Inc. Each trust membership unit is paired with class B-2 shares of RMR Group Inc. The class B-2 shares can be converted into class A common shares in RMR Group Inc., which is the same share class owned by RMR’s other investors.

The below diagram is helpful:

This ownership structure was created as part of what is called an “Up-C” transaction. The “Up-C” transaction creates very powerful incentives for management to boost the public company’s share price, which we will detail later.

The assets and fee schedule break down as follows:

Hospitality Properties Trust, Select Income REIT, Senior Housing Properties Trust, and Government Properties Income Trust are the REITs that RMR Group Inc. manages. The Managed REITs also own properties operated by TravelCenters of America (NYSE:TA), Five Star Quality Care, Sonesta International Hotels Corporation (private) and the RMR Real Estate Income Fund. RMR Group Inc. Earns 60 bps on revenue at TravelCenters, Five Star Quality Care, and Sonesta, and 85 bps on assets under management at the RMR Real Estate Income Fund.

Fee structure creates a stable base of contracted revenue

RMR’s agreement with each Managed REIT provides for a base management fee that is based on the lesser of the historical costs of the Managed REITs’ assets under management or its total market capitalization, and an incentive management fee, which is based on the Managed REITs’ relative outperformance of a specified REIT total shareholder return index.

Key points:

1. RMR’s revenue is primarily from recurring fees earned under long-term contracts
2. RMR’s agreements with the Managed REITs extend for another 20 years
3. 79.5% of revenue is from management services provided to the REIT group

Management incentives are greatly improved

RMR Group Inc.’s Managed REITs have been tarnished by poor performance and incentives between RMR and the Managed REITs. This can be seen by reviewing the substantial number of articles on Seeking Alpha that draw negative conclusions about the RMR REIT family.

Though it is beyond the scope of this write-up, I believe that the RMR Group of REITs are presently undervalued vs. their peer group (A good article on the undervaluation case for Senior Housing Property Trust can be found here). Not only will the Portnoys maintain a 51.6% interest in RMR LLC, they now have substantial positions in the individual managed REIT securities, as seen in the below text from the Nov 11, 2015 prospectus:

The above is very significant. When the Managed REITs purchased shares in RMR Group Inc., they paid with 70% REIT shares and 30% cash. The shares that the Portnoys received in the transaction cannot be sold for 10 years. In other words, the Portnoys will have a substantial economic interest in the performance of the underlying REIT securities. Improving the Managed REITs’ reputation (which will reduce their cost of capital and increase their growth potential) should be a top priority for RMR over the coming year.

New incentives and structure mean that shareholder activism will be much less likely – and much less likely to succeed

Many know that RMR Group took a significant hit in 2014, when an activist hedge fund successfully pried Commonwealth REIT away from the RMR Management Group. Earlier this year, an activist tried to do something similar with Select Income REIT. I believe that the new incentives and ownership structure will neutralize shareholder activists. This will ensure that RMR Group Inc. will be earning its contracted management fees far into the future.

RMR – exceptional economics at a bargain price

As of September 30, 2015, cash and cash equivalents were $34.5M and long-term debt was zero. Total equity was $213,652M, while equity attributable to RMR Group Inc. (less non-controlling interest) was $100,832M.

Q4 EPS attributable to RMR Group Inc. was $.40, or $1.60 annualized. I believe that my annualized figure is conservative in that I am not taking out $1.95M in one-time costs related to the restructuring that should fall to zero in 2016.

Historical numbers are complicated by the loss of Commonwealth in 2014 and the Up-C transaction this year. Applying the $1.60 annualized EPS figure to September 30, 2015 equity gives a return on equity of over 25%.

As good as the return on equity figure is for an unlevered firm with excess cash, return on tangible capital is exceptional – the vast majority of the firm’s balance sheet assets (A $193M “other asset” and a $43M deferred tax asset, both explained on page F-20 of the 10-K) are intangible assets related to the Up-C transaction. RMR Group Inc. is an asset light, high return on invested capital business.

The Up-C transaction – An extra incentive for management to increase RMR Group Inc.’s long-term price appreciation

RMR Group Inc. went public as part of what is called an “Up-C” transaction. An “Up-C” transaction allows the prior LLC owners to maintain their ownership in an entity that is “pass-through” for tax purposes, while allowing part of the company to trade as a public C-Corp. If this was where the story ended, it would not be very interesting.

The “secret” to the Up-C transaction is that it creates a large tax-benefit that accrues to the original LLC owners or founders over time. The following is my understanding* of how it works. The historic owners of the LLC are issued paired “non-economic” class B-2 shares that can be converted into class A stock in the public corporation in exchange for their LLC membership units. When this occurs, the public company is able to “step up” the basis of its assets. The amount of the “step up” is based upon the value of the public company stock at the time of the exchange.

The “step up” in basis is accomplished via the creation of an intangible asset that then amortizes over the next 15 years. This is where it gets interesting: Through what is called a tax receivable agreement, 85% of the value of the amortization tax shield is typically paid out to the selling LLC owners.

Increases to the step-up basis amount will occur any time that the LLC units are exchanged for public class-A shares at a higher price. In other words, it is not a one-time benefit; it can grow over time if the share price increases and units are exchanged at this higher level.

While I see it as extremely unlikely that the Portnoys will be exchanging their units for Class A shares any time soon, I do think that this structure creates an additional, highly favorable long-term incentive.

Conclusion – RMR Group Inc:

1. Selling pressure has set an unsustainably low initial trading range for RMR’s stock
2. Negative sentiment that has yet to factor in much improved incentives between the controlling shareholders and the managed REITs
3. Long term, contracted revenue is superior to the AUM at other asset management firms which can be fleeting during downturns
4. Exceptional economics (Return on equity, invested capital, EBITDA margin, profit margin)
5. The “Up-C” transaction created a tremendous incentive for the controlling shareholder/LLC owners to boost the public company’s stock price
6. Trailing 12 month earnings are hidden by the Up-C transaction – the majority of last year’s earnings were earned prior to the Up-C transaction

At the current price, this high return-on-capital business is trading with a 6.5% dividend yield and an estimated P/E (using my annualized Q4 figure) of less than 10. I see a conservative fair multiple for RMR Group Inc. as 15 times trailing earnings, or slightly below a peer group of asset management firms such as NorthStar Asset Management Group, Inc., Pzena Asset Management, and Diamond Hill Investment Group, Inc.. This would equate to a share price of $24 per share, a 4% yield, and nearly 54% upside from the current price.

Note, this is my present estimate of fair value, not a future projection. I strongly suspect that as the economics of this business are more fully revealed to the marketplace, my estimate of fair value will be moving higher. My conservative estimate does not take into account the potential for RMR to leverage its stable revenue streams, which could also raise my fair value target.

Given the highly favorable incentives and the strong underlying economics, I believe that my initial target will be reached within 12 months – though I admit to hoping for an even larger dip in the short run as REIT index funds and others unload their RMR Group Inc. shares.

Sources:

1. investor presentation
2. Prospectus
3. Understanding “Up-C” IPO structures
4. The Up-C IPO: A structure that keeps giving

*I am not a tax professional. The Up-C transaction analysis contained within this article is based upon my interpretation of the UP-C transaction type utilizing publicly available information. If my interpretation is incorrect, the investment case will not be substantially altered. The Portnoys (as near 50% owners of RMR LLC) will still have incentives that are strongly aligned with the public shareholders of RMR Group Inc.

Additional disclosure: Mr. Stewart is responsible for portfolio management on Opus Capital Management’s Small Cap High Dividend strategy. Opus Capital’s Small Cap High Dividend strategy provides total return and income for investors by focusing on the attractive universe of small cap dividend payers. Historically, these companies have outperformed the broad small cap universe and provided superior downside protection. Opus Capital Management reserves the right to make investment decisions regarding any security without further notification except where such notification is required by law.