CHCI - Comstock Holding: Opportunity Based On Recurrent Earnings

2023-03-06 23:03:49 ET

Summary

• CHCI is a property manager working for a single client, a related party property developer in the Washington MSA area.
• The company has a clean balance sheet, and contracts that establish recurrent management earnings. Valued on these earnings alone, the company trades at a multiple of 12x.
• However, the company is also entitled to more volatile incentive fees, that depend on milestones for developed properties and profitability for operating properties.
• These fees constitute the upside opportunity of the stock. At current prices, the investor gets a regular yield on recurrent profits and the opportunity for extra incentive fees.

Comstock Holding ( CHCI ) is a property management company that works exclusively for a related party property development company.

CHCI has recently posted significant earnings growth, which put the company at a very low multiple of current earnings. CHCI has also recently exchanged all of its preferred shares for common shares and has incorporated a new significant shareholder.

Although an important portion of recent earnings comes from volatile incentive fees, the company trades at fair value considering the earnings generated from recurrent management fees alone.

This indicates that any incentive fees are upside potential, and therefore the company represents an opportunity at these prices.

Note: Unless otherwise stated, all information has been obtained from CHCI's filings with the SEC .

Business description

Business change : CHCI transitioned from an unprofitable property developer model to a property manager model in 2018. The company made this change after it had generated enormous losses for years. Previously, the company had lost more than 90% of its share value during the GFC.

Property manager : The company's new business model consists in providing property management services to a real estate development company owned by the company's largest shareholder.

The client is called CP Real Estate Services and owns a significant portfolio in the Northern Virginia area of the Washington MSA (Reston, Herdon, Ashburn). The portfolio includes office space, hotels, apartments, parking lots, and undeveloped land.

CHCI obtains revenues from two sources: management fees and incentive fees. Management fees are obtained as a percentage of the property portfolio revenues, with a floor comprising some of CHCI's direct costs plus a margin.

Incentive fees are 10% of the excess FCF of the portfolio over an 8% ROIC to CPRES, plus $1/sqft of leased space. The model improved the company's revenues and operating profitability, as seen below.

Cleaning the balance sheet : CHCI improved its financial condition by repaying debt and canceling preferred shares since introducing its new business model. These financial burdens were a legacy of the previous unprofitable business model.

The company recently repurchased all of the preferred shares outstanding from its affiliate and largest client CPRES , for $17 million ($4 million paid in cash and $13 million paid in the company's stock). As of 3Q22, CHCI has no debt anymore .

Significant insider ownership : CHCI's CEO, Christopher Clemente, was the company's largest shareholder, with 60% of the shares. The company's CEO also owns CPRES, the company's only client.

In June 2022 , the CEO sold half its stake to Dwight Schar, founder and Chairman of the U.S. third-largest homebuilder, NVR ( NVR ). Mr. Schar also participates in CPRES.

This level of alignment is positive, given that the managers and large owners have the same interest as minority shareholders. However, it should be considered that CHCI represents a negligible portion of the CEO and Mr. Schar's portfolios.

Valuation

Recent record profitability : If the company does not have debt or preferred shares anymore and is generating a TTM operating profit of $7 million, why is it valued at a $42 million market cap?

The reason is a significant uncertainty related to the company's recurrent profit generation capacity.

As seen above, most of the TTM operating profit was generated in the latest quarter, 3Q22. Looking under the hood, we see that all that profit came from incentive fees ($3.9 million in 3Q22). Without these, the company would have posted an operational loss or broken even in 3Q22.

Incentives fees and the managerial agreement : In the description above, I mentioned that incentive fees were obtained as the excess FCF over an 8% ROIC for the property portfolio managed by CHCI.

That was true until 3Q22 specifically, when the agreement governing CHCI's business with CPRES was modified . The new agreement can be read here .

After the modification, the fees are calculated separately for operating and development properties. For operating properties, there are annual triggering events. For development properties, triggering events are related to milestones.

The problem is that CHCI recognizes those fees when the triggering event has occurred, that is, once every year for operating properties and once every milestone for development properties.

CHCI comments on its 3Q22 MD&A that the $3.9 million recognized in 3Q22 came from a development property triggering event. This indicates that the revenues should be spread over a much larger period than a single quarter and are not recurrent revenues. The company had already registered a similar peak in 3Q21, this time related to a capital market event .

Average profitability : I prefer to consider average profitability, which spreads the effect of these development properties or capital market event-induced revenues over a larger period. As seen below, the average for the past three years has been $1.2 million in operating profit per quarter or approximately $5 million per year.

Upside potential : With $5 million in operating profit, or $4 million in net income approximately, the company is trading at a P/E ratio of between 10x and 12x, at a market cap of between $40 and $50 million.

On the other hand, the company's operating profit and revenues for 1H22 were higher than those for 1H21 , without considering development property fees. The MD&A mentions that those higher revenues and profits came from managing 7 additional properties.

Considering 2022 profits (three quarters of $1.2 million operating income and one of $3.9 million), we obtain approximately $6 million in net income ($7.5 million operating by 80% after taxes).

Another possibility is to consider recurrent profits of $4 million in net income ($1.2 million operating per quarter * 80% after taxes), to then consider all development incentive fees as a plus. The master agreement lists ten properties in development .

Risks

Customer concentration : CHCI has a single customer, a service company that, in turn, works for a property asset manager. If that customer finds any trouble, CHCI will not have any business.

Related parties : CHCI's single client is owned by the company's CEO, who has been in charge since its IPO in 2004. Companies affiliated with the CEO have done business with CHCI as clients. They have also lent to the company and bought preferred shares from the company in a series of transactions spanning 20 years. There is significant risk in dealing with a single client who is a related party.

Conclusion

CHCI has several desirable characteristics: an unleveraged balance sheet, recurring revenues from operating and development properties, and high insider ownership. On the other hand, its main negative aspect is customer concentration with a single client, more so because this client is a related party.

The company trades at a multiple of 12x to recurrent management earnings, calculated from 1H22 financials. I believe this is a premium over the company's qualities. However, this calculation leaves all incentive fees (that are much more volatile) as upside potential.

For that reason, I believe CHCI is an opportunity at current prices. Incentive fees are volatile and will be a plus to the earnings yield of more recurrent management fees.

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