(Published by Bob Ciura on March 21)
Extremely high dividend yields are tantalizing, but also come with significant risks. While they certainly look appealing, it is important to assess whether the dividend is sustainable.
Colony NorthStar Inc. (CLNS, Financial) has a whopping 8.3% dividend yield. Its largest shareholder, Seth Klarman (Trades, Portfolio)’s Baupost Group, is one of the most well-known value investors around.
Klarman is the CEO and portfolio manager of Baupost.
As of Dec. 31, 2016, Baupost held 18.7 million shares, a nearly 10% investment in the company, which is worth an estimated $279 million.
Colony NorthStar was formed in 2016 as a result of a merger of three different companies.
It is not a Dividend Achiever, a group of 271 stocks with 10-plus years of consecutive dividend increases.
You can see the full Dividend Achievers List here.
Should investors follow Klarman into Colony NorthStar stock?
Business overview
Colony NorthStar is a real estate investment trust (REIT). It invests primarily in commercial real estate. The company has a market capitalization of $7.3 billion.
Source: March 2017 Investor Presentation, page 3
It was formed through a triparty merger between Colony Capital Inc., NorthStar Asset Management Group Inc. (NSAM, Financial) and NorthStar Realty Finance Corp. (NRF, Financial).
Colony NorthStar has 25 years of real estate investment experience and more than $56 billion of assets under management (AUM).
The combined entity has four major investment segments, which are:
- Health care: (26% of AUM).
- Hospitality: (23% of AUM).
- Industrial: (8% of AUM).
- Other Equity & Debt: (43% of AUM).
The “Other Equity & Debt” segment includes private equity fund interests, single family residential rentals, CRE loans and Direct Property & Net Lease investments.
Source: March 2017 Investor Presentation, page 5
It also has a sizable investment management business, which accounts for $39 billion of its $56 billion AUM.
Colony NorthStar’s various businesses should provide growth in 2017 and beyond.
Growth prospects
The first growth catalyst for Colony NorthStar is its shift in investment focus. Going forward, the company plans to de-emphasize its Other Equity & Debt segment.
Instead, it plans to allocate greater investment to the other three core property segments.
Source: March 2017 Investor Presentation, page 8
Colony NorthStar expects this will help diversify the company’s portfolio and scale up more quickly.
Separately, REITs rely heavily on purchasing new properties for growth. Colony NorthStar is no different and will finance investments by raising capital.
To that end, Colony NorthStar is targeting $2 billion of third party capital raising in 2017.
One of the most attractive areas of future investment for the company is health care.
Colony NorthStar has a large portfolio of health care-related properties including senior housing facilities, medical office buildings, skilled nursing facilities and hospitals.
Source: March 2017 Investor Presentation, page 11
This provides Colony NorthStar with exposure to a strong fundamental tailwind in the U.S., which is the aging population.
There are approximately 75 million baby boomers in the U.S., which should result in high demand for health care properties for many years.
Colony NorthStar’s health care portfolio holds 88.1% occupancy, and higher demand could yield growth in rental revenue.
Valuation and expected total returns
In order to value REITs like Colony NorthStar, it is better to use funds from operation (FFO) instead of earnings per share.
The reason is that traditional earnings per share includes a number of noncash items like depreciation and amortization expense.
For most REITs, this suppresses earnings per share too much to be relied upon as a valuation tool. Instead, FFO is a non-GAAP measure that gives a better indication of a REIT’s cash flow.
On this basis, Colony NorthStar expects FFO of $1.40 to $1.58 per share in 2017. This means the stock is valued at a forward price-to-FFO ratio of 8.7, using the midpoint of 2017 FFO guidance.
The company believes its shifting investment initiative will help it earn a higher valuation multiple.
Source: March 2017 Investor Presentation, page 9
Indeed, the stock is significantly undervalued when stacked up against its peer group.
Aside from an expanding valuation, Colony NorthStar stock has the potential to generate strong returns for shareholders.
A reasonable breakdown of future returns is as follows:
- 4% to 6% FFO growth.
- 8.3% dividend yield.
This level of FFO growth should not be difficult to reach. Colony NorthStar can generate revenue growth through new properties and rent increases.
FFO growth will be the result of revenue growth, cost controls and share repurchases.
The company authorized a $300 million share repurchase over the next year on Feb. 23. This amounts to 4.1% of its current market capitalization.
When combined with its huge dividend yield, total shareholder returns could reach roughly 12.3% to 14.3% annualized.
Dividend analysis
Colony NorthStar stock pays a quarterly dividend of 27 cents per share, which means an annualized dividend of $1.08 per share.
Based on its recent share price of $12.99, the stock has a current dividend yield of 8.3%.
This is a high dividend yield. Consider that the Standard & Poor's 500 Index, on average, yields just 2%.
With a dividend yield more than four times as much as the average stock in the S&P 500, the market is expressing some concern that the dividend may not be sustainable.
The first thing to analyze is the balance sheet to make sure the company does not have too much debt.
Source: March 2017 Investor Presentation, page 24
Colony NorthStar maintains a total-debt-to-capitalization ratio of slightly less than 50%.
Its total-debt-to-EBITDA ratio is 6.0, which is a bit high.
At the midpoint of the company’s 2017 guidance, Colony NorthStar expects to generate FFO per share of $1.49.
Therefore, its annualized dividend amounts to approximately 73% of the company’s expected 2017 FFO per share.
The payout ratio is on the high side but is not unusual for a REIT.
While the dividend appears to be sustainable, the company carries a significant amount of debt.
As a result, investors should closely monitor the company’s progress in future quarters to make sure its debt metrics do not worsen.
Final thoughts
Klarman is a renowned value and income investor. With that in mind, it is not entirely surprising to see that Baupost Group owns a significant stake in Colony NorthStar.
Colony NorthStar stock offers an attractive blend of value and income. The shares seem to be undervalued, and the company pays a massive 8.3% dividend yield.
REITs face a unique set of risks, and investors should keep close watch on the condition of Colony NorthStar’s balance sheet.
You can read about a REIT with a lower dividend yield but a higher dividend growth outlook by clicking here.
Overall, Colony NorthStar stock appears attractive for value and income.
Disclosure: I am not long any of the stocks mentioned in this article.
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