Friday, March 18, 2016

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%

US rental vacancy by region

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.

apartment rent growth

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 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.

Nextpoint property ratings

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.


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.

Monday, March 14, 2016

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.


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.

Omega Protein production yield

Omega Protein fish catch, production, and sold volumes

Omega Protein Unit costs depend on production volume

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.

Thursday, March 3, 2016

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.


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”)