GNL MERGER ANALYSIS: CATALYST SET TO UNLOCK SIGNIFICANT SHAREHOLDER VALUE
- Daniel Fas
- Aug 24, 2023
- 9 min read
Updated: Sep 7, 2023
GNL is a NNN REIT that is merging with another NNN REIT called RTL. GNL is currently a sub $10 stock and upon consummation of the deal, the merger provides an opportunity to generate a 2-3x return on capital or a 38% IRR within 3 years.
Executive Summary
It's rare to find opportunities to double or triple your money with limited downside risk. This opportunity is in a stock called Global Net Lease, Inc. (NYSE: GNL), a triple net (NNN) lease REIT that is merging with another NNN REIT called The Necessity Retail REIT, Inc. (NASD: RTL). After analyzing the pro-forma financials and reading through the prospectus, I believe this is a unique opportunity to generate a 2-3x return on capital or a 38% IRR within 3 years. GNL currently trades at ~$10.60 and is worth anywhere from $16-$20 per share post-merger (our conservative base-case valuation is $16.15). Additionally, the company announced an annualized dividend of $1.42 per share, which at the current share price is a dividend yield of ~13.4%.
"I don't look to jump over seven-foot bars; I look around for one-foot bars that I can step over." — Warren Buffett
Background
The story behind both REITs are long and quite ugly to say the least, but it's important to understand why this opportunity is present today. GNL and RTL are both externally managed REITs, both being managed by a company called AR Global. Smart fund managers avoid externally managed REITs like the plague, and for good reason. AR Global, similar to RMR Global and other external managers, have a bad history of misaligned economic interests between management and shareholders. AR Global is paid a management fee based on gross real estate value, which incentivizes AR GLobal to grow just for the sake of growing without regard to the stock price, fundamentals or underlying intrinsic value. This usually takes the form of share dilution at value destructive prices just so GNL can buy more properties. Over time this is a painful outcome for shareholders.
See below visual for how destructive external managers can be to shareholders:
The statistic that jumps out to me in the presentation above is this: since 2015 AR Global has collected $838 Million in fees from GNL and RTL while the combined market caps have declined by $3.3 Billion. This lead to an investor, Blackwells Capital(Blackwells), to initiate a position in GNL beginning in February 2022. Blackwells initially tried to engage in productive dialogue with GNL management but after various disagreements on director nominees, Blackwells subsequently launched a proxy fight in December 2022. To thwart Blackwells strategy of ejecting AR Global as external manager, on 5/23/2023 GNL announced a merger agreement with The Necessity Retail REIT, Inc. (RTL), another REIT that is also managed by AR Global. The very next day Blackwells founder Jason Aintabi described the merger as "cockamamie" and asked shareholders to vote against the deal. Part of the merger agreement compensated AR Global ~$375 Million to be removed as manager and subsequently the combined entity would be internally managed. However, this "fee" was essentially a ransom payment. About a week later on June 5, Blackwells reached an agreement with GNL, RTL, and AR Global. As it turns out, Blackwells was issued 2.1 Million shares (495,000 upfront and 1,600,000 later) worth ~$23 Million which GNL/RTL labeled as "consulting and advisory fees". Unsurprisingly, Blacwells did a 180 and publicly supported the merger to be approved. There is also another activist investor circling this deal called Orange Capital, who wrote a letter on June 15 vehemently opposing this merger and slammed Blackwells for essentially accepting a bribe from GNL/RTL/AR Global (Orange Capital eloquently called it "Greenmail"). Orange Capital continues to push for GNL to internalize its management on a standalone basis.
So that's all the drama that brings us to present day. As it stands I think Orange Capital is hoping for a pipe dream that won't happen. Sure, this deal has got some hair on it with ransom payments and bribes left and right, all at the expense of existing shareholders. However, all the drama playing out will be in the rearview mirror once this merger is consummated and management incentives are reset to normal REIT standards. AR Global is going to get paid no matter what. It's a tough pill to swallow since they are just raping and pillaging existing shareholders, but once they are ejected this will be a huge step forward. The merger will re-align management incentives and allow the combined entity to perform in-line with internally managed peers.
Externally managed peers trade at significant discounts to NAV due to misaligned economic interests, as they should. The proposed merger will eliminate existing conflicts of interest between management and shareholders. In fact, AR Global will own anywhere between 14-17% of the combined company, which based on the announced dividend policy, amounts to $41.9 Million in annual dividend payments. So AR Global continues to milk GNL post-merger, but the incentives couldn't be more different. As shareholders, AR Global will be highly incentivized to keep milking this cow, and they do that by increasing dividends and increasing the share price to trade in-line with the NNN peer group. It should also be noted that the merger includes substantial enhancements to corporate governance. The major enhancement being the board of directors will be declassified with 7 of 9 directors standing for election in 2024 and all 9 will stand for election in 2025. The board will be majority independent and led by an independent chair. The poison pill provision will also be eliminated. Initially there will be two co-CEOs, Jim Nelson (current GNL CEO) and Mike Weil (Current RTL CEO). In 2024 Mike Weil will take over full control of the CEO position and as part of the merger, Mike will relinquish all AR Global positions he currently holds. All of these changes are great things on the corporate governance front.
Valuation
On a proforma basis there are substantial synergies with the removal of AR Global management fees from the G&A line-item. The G&A expense load of GNL and RTL is currently 16% and 20%, respectively, as a percentage of revenue. This is very high relative to peers, but this is expected to drop to 6% post-closing. This will mainly consist of $54MM in savings on third party management fees to AR Global and then run-rate savings of $21MM from general back-office consolidation, or a total of $75MM in cost savings.
To put together the proforma financials, I utilized Q2 2023 results that were reported for both GNL and RTL and annualized the results. NNN REITs are not seasonal businesses and if anything are more like bond proxies so my numbers should be pretty darn close. I also made some adjustments on reported EBITDA to get to a normalized number since there are various merger related costs that obscure the reported Q2 results. In total, I was able to back into managements guidance, but there are few key differences where I remain more conservative than GNL management. The largest variable is the share count in which there will be substantial share dilution. After reading through the prospectus, management is guiding to a 226 million share count, but there are various earn-outs that are not being included. I don't want to give this management team any benefit here so I underwrote assuming full share dilution inclusive of all potential share issuances due to earn-outs. This leads to a 237 million share count in my model (~4.8% higher than guidance). I also have revenue coming in a little bit lower than guidance. From my experience mergers will have some messy accounting in addition to movement in the operating company's underlying financial performance. So my underwriting is on the conservative side and if management actually hits their numbers then I consider that icing on the cake
Proforma Financial Model:
I get to $1.49/share AFFO vs. current guidance at $1.68/share, a 12% discount to guidance. Although I believe management incentives will be aligned with shareholders, I have reservations on the quality of the management team and prefer to tread cautiously. The prospectus does include GNL's projections through 2028, in which we can see management is guiding slightly below their internal projections in Year 1 ($1.68 guide vs. $1.77 AFFO projection). They also assume average AFFO growth of 1.5% per annum through 2028.
I am applying a multiple of 11.68x, which is an 18% discount to publicly traded NNN REIT peers. I think this is a reasonable assumption until management proves they can consistently deliver results and also show that they can create shareholder value. This is very much a "show me" stock". Nonetheless the revaluation potential is pretty significant with the peer group trading at an average multiple of 14.3x AFFO.
See below valuation multiple table:
So 11.68x multiple on $1.49 AFFO gets to $17.36 base case valuation. If management hits their guidance then this is easily a $20+ stock. As a secondary valuation method I deployed a NAV model, which basically assumes the company liquidates all its properties and pays off its debts and whatever is left over is the net worth to shareholders. Truist Securities was hired to perform a third party valuation and here's the cap rate range they concluded for the properties held by GNL and RTL, respectively:
Just to be safe I assumed an 8% cap rate across the whole portfolio to account for the "grow for the sake of growth" approach AR Global took to grow their management fees. I do, however, believe that there are good assets mixed in there that GNL could sell at respectable cap rates. This is offset by the office properties that will comprise ~20% of the portfolio, which I think will fetch lower values than the table shown above. So net-net I think an 8% cap rate is reasonable. I get to $14.95 based on my NAV analysis, and blended with my base-case valuation, I land at $16.15 per share. Overall I think my valuation approach is pretty conservative, but I'm perfectly fine if GNL management surprises me and hits guidance or, hold your breath, beats guidance. This could easily be worth $20+.
Investment Thesis
Summing this all up the management teams at GNL, RTL and AR Global clearly have a history of screwing over shareholders. So why would I choose to invest in this now?
A few key reasons:
GNL will be an internally managed REIT, which realigns economic interests with shareholders instead of against them.
AR Global will own 14-17% of GNL shares, which means they now have skin in the game vs. no economic interest in the common equity today.
Internalization will improve cost structure (G&A load of 16-20% down to 6%) by saving $54MM in annual expenses, plus an additional $21MM in merger synergies.
Significant corporate governance changes including a declassified board.
Multiple revaluation in-line with internally managed peer group, which is nearly double current levels.
Governance improvements will attract increased institutional investor ownership.
Significant scale (3rd largest NNN REIT) and asset diversification.
Reduced leverage from 8.3x to 7.6x Debt to EBITDA.
Enhanced dividend coverage from over 100% today to 84% post-merger.
Given base-case valuation, opportunity to double your capital within 3 years or triple your capital within 5 years. If management hits their guidance, the returns only get juicier.
As previously mentioned, this deal provides attractive 3-year IRR targets with a 2x return on capital and 38% IRR at just under 2.5 years. This assumes a base-case valuation of $17.37. Using $16.33 blended valuation this is still a 34.7% IRR opportunity. A sample IRR table of how these returns are derived is shown below.
Also from a strategic standpoint I think adding strong dividend yielders and fixed income to investment portfolios is looking pretty attractive right now. That's something we haven't heard of in a long time. But with the S&P 500 trading at an average P/E multiple of over 20x, this equates to an earnings yield of just under 4% versus GNL at a ~13.4% yield and sub 7x multiple. GNL shares are dirt cheap relative to the entire market.
RISKS
Naturally, given the attractive return profile there are still some key risks present in this deal . I think the main risks outlined below are mitigated due to the internalization of the REIT management team where most of the issues originated from. However, there are still some very real execution risks here.
Key Risks:
Risk that shareholders vote against the merger on September 8.
Leverage at 7.6x Debt to EBITDA is still high
Remaining co-CEO's don't have a great track record.
Historical share dilution
Interest rates continue to increase
As previously mentioned, Orange Capital is actively trying to get shareholders to vote against the deal. If the merger for some reason doesn't go through then this whole analysis goes out the window. I wouldn't touch this with a ten foot pole if GNL remains a standalone externally managed REIT. The remaining risks all seem manageable, but certainly concerning. Debt to EBITDA at 7.6x is still pretty high, however, this should come down over time with an improved balance sheet and reset to the dividend policy. On the Q2 earnings call GNL management repeatedly stated they wanted to get leverage down into the 6's near/intermediate term, which was good to hear. This would probably lead to a credit upgrade, which would lower GNL's cost of capital.
I think a big driver among the remaining risks mentioned (#3 and #4) will be the new management team and a compensation structure that is aligned to creating shareholder value versus the previous structure that enriched AR Global. The final risk I mentioned was interest rate risks, because NNN REITs operate as bond proxies due to the nature of fixed contractual cash flows back by real estate collateral. I think we are closer to if not already at the end of the rate hiking cycle so there should be limited downside from here. But there is a real risk that if the Fed starts hiking rates again and that will lead to an underperformance for NNN REIT's, at least in the short term. I do think this scenario is a low/limited risk, however.
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