One of the cheapest stocks in our All InvestableDeep Value Stock Screen is RMR Group Inc (NASDAQ:RMR).

RMR Group Inc (RMR) provides management services to four publicly traded real estate investment trusts, or REITs, and three real estate operating companies. As of September 30, 2016, RMR had $26.9 billion of assets under management in the companies it manages.

RMR is a wonderfully lean business with strong recurring revenues, high operating margins around 40%, and 30% ROE. The company has a competitive moat through its long term lock-in contracts, a strong balance sheet, and loads of free cash flow. In terms of its valuation, RMR is currently trading on a P/E of 16, 4.79 times operating earnings (ttm), a FCF/EV yield of 14% (ttm), and a dividend yield of 3% (ttm). That suggests RMR is great value.

A quick look at the company’s share price history over the past six months shows that the price has risen 17% to $39.45, fourteen percent off its 52 week high of $44.85 back in December 2016.

As you can see for the diagram below, RMR generated 88% of its revenues ($199 million) through its managed REITs for the fiscal year ending September, 2016. The company has a great business model that allows it to generate a significant amount of recurring revenues from its REITs through long term contracts.

The Managed REITs revenue is broken down into three categories. Base Business Management Revenues (base revenues) makes up 52%, Incentive Business Management Revenues (incentive revenues) makes up 31%, and Property Management Revenues (property revenue) makes up 16%:

Managed REIT’s include Government Properties Income Trust (NYSE:GOV) 10%, Hospitality Properties Trust (NYSE:HPT) 50%, Select Income REIT (NYSE:SIR) 17%, and Senior Housing Properties Trust (NYSE:SNH) 24%.

Recurring Revenue

RMR’s recurring revenues come from the its two largest segments, base fees and incentive fees. The company has a business management agreement with each Managed REIT which provides for a base fee based on the lesser of the historical costs of the Managed REIT’s assets under management or its total market capitalization, and an incentive management fee which is based on the Managed REIT’s relative out-performance of a specified REIT total shareholder return index.

The annual base fee is generally calculated as the lesser of:

  • the sum of (a) 0.5% of the historical cost of transferred real estate assets, if any, plus (b) 0.7% of the average invested capital (exclusive of the transferred real estate assets), up to $250.0 million, plus (c) 0.5% of the average invested capital exceeding $250.0 million; and
  • the sum of (a) 0.7% of the average market capitalization up to $250.0 million, plus (b) 0.5% of the average market capitalization exceeding $250.0 million.

The base fee is payable monthly in arrears, based on the Managed REIT’s monthly financial statements and average market capitalization for the applicable month.

Incentive Fees Provide Potential Revenue

In addition to its recurring base fees, RMR also has the ability to generate potential revenues from its incentive fees as a REIT’s market cap improves. These incentive fees are calculated as follows:

  • An amount equal to 12.0% of the product of (a) the equity market capitalization of the Managed REIT, and (b) the amount, expressed as a percentage, by which the Managed REIT’s total return per share, exceeds the benchmark total return per share, of a specified REIT index. Generally, total return per share measures the change in the Managed REIT’s share price plus dividends. The benchmark return per share is also adjusted if the total return per share exceeds 12.0% per year in any measurement period.
  • The current measurement period is defined as the three year period ending December 31, 2016 and thereafter a three year period ending on each December 31.
  • Generally, no incentive fee is payable by a Managed REIT unless the Managed REIT’s total return per share during the measurement period is positive.
  • The incentive management fee payable by a Managed REIT is also subject to a cap equal to the value of 1.5% of the Managed REIT’s common shares then outstanding multiplied by the average closing price of the Managed REIT’s common shares during the ten consecutive trading days having the highest average closing prices during the final 30 trading days of the relevant measurement period.
Here’s a great example of how RMR was able to generate substantial revenues from its incentive fees, using the company’s latest 2016 annual report, ending September 30, 2016:
 (Source:Company reports)

 

As you can see RMR recorded $62 million of incentive fees from HPT for the calendar year ending December 31, 2015. This $62 million was generated because HPT’s total return per share, exceeded the benchmark total return per share. The number could have been higher but was capped at 1.5% of HPT’s market cap of approximately $4 billion. This highlights the potential value to RMR of its incentive fees in addition to its existing recurring revenues

Up-C Structure

One of the things that some investors find complicated about RMR is something called its Up-C Structure. While I don’t want to go into extensive detail for the purposes of this analysis. What is simply means is that the owners of RMR, a family called the Portnoys, were looking for a way to protect themselves from losing their REIT management contracts, so they set up an Up-C structure where REIT owners were sold shares in RMR as part of their new management contracts.

The purchase price paid by each REIT for its respective ownership in RMR was paid to the historical owners (the Portnoys) by delivery of restricted common shares of each REIT, which are subject to 10 year lock up agreements and which were valued at the volume weighted average trading prices for each REITs’ common shares during the 20 trading days prior to the acquisition, plus a cash component as follows:

(Source: Company Reports)

 

The Up-C structure locks in long-term contracts with the REIT’s as well as providing RMR with additional tax benefits. Furthermore, it aligns all of the stakeholders because the REITs and the REITs’ shareholders own RMR shares and RMR becomes an owner in a significant number of restricted shares of each of the REITs.

 

Strong Balance Sheet

In terms of the company’s fundamentals, RMR has a lean business model and a very strong balance sheet.  A quick look at the company’s trailing twelve month balance sheets (below) shows RMR had $65 million in cash and cash equivalents, zero debt, and $125 million in minority interests at the end of Q4 2016.

Quarterly Balance Sheet (values in 000’s)
Quarter: 4th 3rd 2nd 1st
Quarter Ending: 9/30/2016 6/30/2016 3/31/2016 12/31/2015
Cash and Cash Equivalents $65,833 $81,137 $70,568 $25,081
Long-Term Debt $0 $0 $0 $0
Minority Interest $124,677 $123,304 $122,703 $124,875

(Source: Company reports)

Valuation

With regards RMR’s current valuation, the company currently has a market cap of $659 million. When we subtract the net cash over debt of $65 million and add back the minority interests of $125 million, the company has an Enterprise Value of $719 million. We favor EV over market capitalization as it includes additional liabilities–like debt, preferred equity and non-controlling interests–if you were to purchase the entire company. EV is calculated as:

Market Cap + Preferred Equity + Non-Controlling Interests + Total Debt – Cash and Equivalents

But it’s not until you take a look at RMR’s operating earnings that you get a sense of just how undervalued the company is. RMR had trailing twelve month operating earnings of $147 million, or adjusted operating earnings* of $150 million.

Quarterly Income Statement (values in 000’s)
Quarter: 4th 3rd 2nd 1st
Quarter Ending: 9/30/2016 6/30/2016 3/31/2016 12/31/2015
Total Revenue $56,266 $52,211 $48,333 $110,130
Operating Income $23,411 $21,838 $19,783 $81,668

(Source: Company reports)

With an Enterprise Value of $719 million and adjusted operating earnings* of $150 million (ttm), that means RMR is trading on an Acquirer’s Multiple of 4.79, or 4.79 times operating earnings* (ttm). That places RMR squarely in undervalued territory.

The Acquirer’s Multiple is defined as:

Enterprise Value/Operating Earnings*

*We make adjustments to operating earnings by constructing an operating earnings figure from the top of the income statement down, where EBIT and EBITDA are constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–income that a company does not expect to recur in future years–ensures that these earnings are related only to operations.

Loads of Free Cashflow

The real value of RMR is in its ability to generates loads of free cash flow through its recurring revenues and capex lean business model. A quick look at the company’s cashflow statements (below) for the trailing twelve months shows RMR had $99 million in operating cashflow and capex of just over $1 million. Therefore RMR generated $98 million in free cashflow (ttm) and a FCF/EV yield of 14% (ttm).

Quarterly Income Statement (values in 000’s)
Quarter: 4th 3rd 2nd 1st
Quarter Ending: 9/30/2016 6/30/2016 3/31/2016 12/31/2015
Total Revenue $56,266 $52,211 $48,333 $110,130
Operating Income $23,411 $21,838 $19,783 $81,668

(Source: Company reports)

Summary

RMR is a wonderfully lean business with strong recurring revenues, high operating margins around 40%, and 30% ROE. The company has a competitive moat through its long term lock-in contracts, a strong balance sheet, and loads of free cash flow. In terms of its valuation, RMR is currently trading on a P/E of 16, 4.79 times operating earnings (ttm), a FCF/EV yield of 14% (ttm), and a dividend yield of 3% (ttm). That suggests RMR is great value.

Disclosure: I currently hold a long position in RMR.

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