NorthStar Realty Finally Gets Serious – A Little

NRF imageIt looks like management at NorthStar Realty Finance (NRF) is finally getting serious about moving its stock up. They’ve begun a series of disclosures that probably already should have been in place years ago, such as breaking out NOI by property type in the press release, but now they’ve also included NAV in their latest quarterly supplemental. Will that help to stem the very irrational selling that’s hammered the stock in recent months? Only if they back it up with buying back stock and shoring up that dividend. Here’s how a strong buyback would save the stock.

Several fundamental factors have driven the stock down, and those have been exacerbated by investor psychology. Investors’ overriding concern is whether that dividend – now at 17% – is sustainable. The market clearly tells you it’s not, but the market can be wrong and often is.

The spinoff of NorthStar Realty Europe, with its lower payout ratio, forced the payout ratio at NorthStar Realty Finance to go higher, in order to maintain the same dividend. Second, investors are worried about the external management structure, afraid that management will make dilutive acquisitions. In fact, that fear was borne out at least a little bit. Management already admitted that an acquisition in Europe hurt CAD per share by several cents. Those are real fundamental concerns.

On top of that we have the selling hysteria and the vicious cycle of investor selling created merely by a stock going down. Not all of this can be blamed on short-sellers, because short sales are just 8.8% of shares outstanding. That’s substantial, but not “this pig is going to zero” substantial. Not even close. But when investors see a yield above 10%, they’re immediately skeptical even without examining the financial statements. The higher that yield goes, the more unsustainable it looks. Of course, that’s a silly knee-jerk reaction, because the market doesn’t dictate a company’s dividend. Instead the dividend relies exclusively on the fundamentals of the business.

Buybacks and value creation

With NAV at $29.07, a whopping 66% above Friday’s closing price, there should be a lot of upside. The company could keep selling off assets and buying back stock for quite a while, to drive NAV higher. But NAV is a long-term measure of a REIT’s value, and REIT prices track that over time, not when the market is in a short-term panic over dividend sustainability. So let’s focus on the dividend.

So let’s see how sustainable that dividend is, in particular by looking at what the announced buybacks would do to CAD per share. In considering the buybacks, don’t forget that the external manager receives 15% of the cut between $0.68 and $0.78 CAD per share, and 25% above that. For the sake of convenience, let’s assume NorthStar’s third-quarter CAD (less $0.05 per share for NorthStar Europe) of $0.80 is the run rate. By virtue of the spinoff, it’s already in the high splits of the incentive agreement.

As of the quarter end, the company had restricted cash of $340 million and $335 million on its credit facility (LIBOR+3.5%). That gives it plenty of liquidity to begin buying back shares, and I suspected it already has been. For the moment, the company doesn’t need to monetize its manufactured housing unit in order to begin repurchases. That allows it to be aggressive while its stock price is low, and with the stock’s estimated return on equity of more than 19%, buybacks are really a no-brainer.

NRF Buybacks 4 - Copy

Above you can see the effect of buying from $100 million to $500 million in stock at prices ranging from $18 to $22. I’ve factored in increased interest expense assuming $300 million in cash and $200 million in credit for the buybacks. As you can see the higher levels of buybacks even at prices 25% higher than today really solidify that dividend. A $500 million buyback at $20 per share saves the company $75 million in dividend payments every year, and that easily covers the increased interest expense and incentive fees to the external manager.

But from my perspective the more important issue is dividend coverage. If they pursue the $500 million option, they can pull the payout ratio to a very sustainable level in the mid-80% range. Even a $400 million buyback gets them below 90%. In other words, just through buybacks the company can deliver me a sustainable 17% annual return. I don’t need them to grow their fundamental business at all.

Now how fast can they get this done?

Average volume over the last three months is nearly 4 million shares a day. So assuming a volume cap of 25% per day, they could buy 1 million shares per day on average. So a $100 million buyback and $18 per share could be accomplished in just six days. A $500 million buyback at $20 per share could be accomplished in just 25 trading days, or five weeks.

How fast management can effect this buyback will be a real signal as to how serious they are about creating shareholder value. For now their moves have been largely informational (excluding a very small buyback earlier this year), but the investors really moving the stock – the institutions and other biggies – should be largely aware of the information they’ve already disclosed. Of course, that doesn’t mean they are, and large shareholders can be just as myopic, if not more so, as small shareholders.

So given how positive a strong buyback would be, I’d be thrilled to hear in a few more weeks that management has completed its $500 million authorization. It would be hard to imagine the stock not zooming on that news.

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