Comstock Holding: Big Picture Remains Intact Despite Mixed Q2 Results (NASDAQ:CHCI)

Comstock Holding Companies, Inc. (NASDAQ:CHCI) recently reported Q2 2023 earnings results on August 11. Results were mixed, with some reasons for investors to be comforted and some reasons to be concerned. When it comes to micro-cap stocks, things will usually not be perfect quarter to quarter and the lack of earnings calls and analyst coverage makes earnings a bit more difficult to navigate and digest. This creates some more risk when it comes to analysis and determining business value, but this is also why there is more opportunity in these smaller stocks.

While there are some finer details to sift through in this report, I believe the bigger picture, which I discussed in my previous article, still holds true. Owning Comstock equity provides investors with an opportunity to own the growth of some very high quality commercial and residential real estate assets that are located in a region with secular tailwinds. There will be lumpiness in results quarter to quarter but volatility itself does not change the investment thesis. Rather it’s more important to consider the causes of this volatility to determine if the bigger picture of an investment has changed.

Comstock’s revenue grew 6% year-over-year in Q2, but operating income fell by 42%. Additionally, sequential results when compared to Q1 2023 were even worse as revenue declined 12.7% quarter-over quarter. With this sequential decline in revenue, operating income declined 51% quarter-over-quarter. There has been sequential lumpiness in the past but that has usually been due to the effects of the inventive fee pursuant to the 2022 asset management agreement (AMA) which kicks in with triggering events that have been in Q3 of each of the past few years. This most recent sequential decline was simply due to a decline in revenue from operations.

On a more positive note, both the residential and commercial portfolio lease rates increased to record highs of 97% and 91%, respectively. This is primarily why the big picture is still intact as these rates show just how high quality these assets are. Additionally, Comstock remains competitively advantaged as it will continue to be the preferred asset manager of real estate that is owned or partially owned by Comstock Partners, the entity owned by Chris Clemente and Dwight Schar, who together own 60%+ of Comstock Holding. This is a competitive advantage because means that Comstock will be able to grow as long as Comstock Partners is developing real estate.

This may not seem like a big deal but accretive growth is very difficult to come across with micro-cap stocks. It often pays to search for businesses in a niche industry rather than businesses in a growing industry as there will likely be larger competitors with access to lower cost capital that can outspend their smaller competitors. This makes an exclusive contract like the one Comstock has with Comstock Partners very attractive as an investor.

In this article, I’ll discuss Q2 results in more detail, what may have driven these relatively lackluster numbers, more about the commercial real estate market in comparison to Comstock’s managed assets, and how I am looking at the stock’s valuation.

Q2 Results

Q2 earnings were worse than what I was expecting based off of the trend of results since the company changed its business model away from homebuilding. As I mentioned above, Q2 revenue grew 5.9% year-over-year to $8.97 million, but margins shrunk drastically as expenses outpaced this revenue growth. Gross margin for the quarter was 14.3% compared to 19.3% the year before, and its operating margin was 7.2% compared to 13.2% one year ago.

What makes this quarter more surprising were the very strong results in Q1. Sequentially, Q2 revenue declined by 12.7% and operating income declined by 51%. There is typically some lumpiness to earnings but there hasn’t been a decline like this from Q1 to Q2 in the past few years. The concern for investors is whether this is a blip or if this is what normalized earnings will look like going forward.

The following are breakdowns of revenue in the last 2 quarters.

The biggest detractor of the recent quarter’s results was asset management revenue, which fell 17.7% sequentially. There aren’t many details provided in the 10-Q and management does not host a conference call to discuss earnings so it’s difficult to understand why this happened.

The Q2 10-Q attributes the weaker asset management revenue to “lower supplemental leasing fees due to higher transactional activity in 2022”. The Q1 10-Q simply mentions that asset management revenue was $0.7 million higher than the year before but does not say why.

One more small detail that stood out to me was the removal of the word “improved” in the Q2 10-Q. The Q1 10-Q states that growth in revenue “was primarily driven by the growth and improved performance of our managed portfolio, which included 9 additional assets in 2023″ whereas the Q2 10-Q states that the growth in revenue “was primarily driven by the continued expansion of our managed portfolio, which included 9 additional assets in 2023”. I am assuming this change is simply due to the drop in revenue but these small changes are worth looking out for.

Reduced lease transaction revenue is not something I anticipated when I first analyzed the stock but it makes sense when looking at the lease rates that are published in the quarterly press releases. The commercial portfolio’s lease rate rose from 86.8% in Q4 to 90% in Q1, and it rose to 91% in Q2. The lease rate can’t go up in perpetuity so this slowdown is reasonable. This slowdown in lease activity does not change the quality of these commercial assets but it will likely lead to lower revenue than I had originally expected in upcoming quarters. However this should reverse as more of development pipeline is built out and as there is a continued push for employees to return to the office.

CRE Market

Many commercial real estate assets are likely experiencing reductions in leasing activity but not for the same reason that Comstock’s managed assets are. The commercial real estate market is in a bad spot with very high vacancy rates and financing issues. According to CommercialEdge, the U.S. commercial total vacancy rate hit 17% in July. Washington D.C.’s vacancy rate was slightly better at 14.8%. Cities like Austin, Houston, Chicago and Denver were close to or above 20%.

These vacancy rates, coupled with high interest rates, is making the financing situation for many commercial real estate operators much more questionable. This is in turn is making investors fearful and skeptical of any sort of investments involving office real estate. While Comstock is not on many investors radars due to its small size, I imagine some interested investors are put off by its connection to this dubious market.

Comstock’s management team has consistently stated that its managed assets are of higher quality than most due to its premier location along the D.C. Metro’s newly finished Silver Line, which is something that I agree. I wrote about this in my last article as I grew up in the Washington D.C. area and saw first hand the expansion of infrastructure and buildings in this area. Location is one of the most important factors when analyzing any type of real estate and Comstock’s assets are in a premium location.

This can be seen from their current lease rates which are growing and far superior to those of Washington D.C. and the U.S. overall. While there are risks that the assets in the anchor portfolio pipeline that are currently being developed will not have similar lease rates, all of them are located along the silver line in Reston, Herndon, and Loudon, VA. I believe that these locations will continue to see high demand.

This is the thesis underlying my buy rating and the mixed quarter has not changed it.

Valuation

My valuation framework for Comstock has not changed but I am now using more conservative figures after accounting for less transaction revenue. I try to avoid DCF models for businesses like Comstock that have lumpy earnings by quarter and don’t issue of guidance. These models require many assumptions and there are more chances for errors when this is the case.

I am currently expecting FY2023 normalized operating income after tax per share of $0.43. I am getting to this based on H1 operating income of $1.96 million added to my estimate of H2 operating income of $3.6 million, a 22% tax rate, and 10.07 million fully diluted shares outstanding. My estimate for H2 operating income is based on $3 million of operating income in Q3 primarily driven by the incentive fee pursuant to the 2022 AMA, and $0.6 million of operating income in Q4 based on similar leasing transaction volume as Q2.

This puts the stock at around 10x my estimate of FY2023 operating income after tax. I like this valuation due to the fact that I believe vacancy rates for the anchor portfolio will remain low, and because of the runway for growth stemming from the development pipeline in the anchor portfolio.

Risks

A big assumption in this valuation is that the incentive fee will be triggered by the upcoming October 1st triggering event. Triggering events for the incentive fees are part of the contract Comstock Holding has with Comstock Partners to manage both its assets and pipeline of assets.

I discussed the triggering events in my previous article, but there are different triggering events for operating assets and assets under development. The Q3 2022 10-Q states that “operating asset triggering events are scheduled for specific dates, whereas triggering events for assets under development are tied to various metrics that indicate stabilization, such as occupancy and leasing rates”.

Also in that 10-Q, the incentive fee for that quarter is explained. It states that Comstock Holding “recognized $3.9 million of Incentive Fees, stemming from an operating asset triggering event scheduled to occur on October 1, 2022. This operating asset triggering event is the first in series of annual operating asset triggering events that are scheduled each October 1 through 2024.”

This means another one is scheduled in Q3 2023 and if the conditions are met, Comstock will receive an incentive fee based on the mark-to-market value of the asset in question. In my valuation I am assuming this triggering event condition will be met but if it is not, the stock is clearly not as much of a value as I am suspecting.

Additionally, Comstock’s assets are not immune to higher vacancy rates despite the fact that they are in premium locations. If vacancy rates rise, Comstock Partners, the entity that owns the assets, could run into some trouble due to difficult financing conditions as cash flows from rent drop. This would not only lower the revenue of Comstock Holding due to lower asset management revenue but would also hurt its long term growth prospects as Comstock Partners would focus less on adding to the development pipeline. Along with the incentive fee and triggering events, this is something that investors should keep an eye on.

The stock also remains very illiquid and usually trades with a large bid/ask spread. If there is any reason that an investor may need to sell their position quickly or if an investor is averse to volatility, it is best to avoid owning a position in this stock.

Final Thoughts

Comstock’s Q2 earnings were a mixed bag, but the bigger picture still holds true. The commercial assets that Comstock manages are high quality due to their premium location, and the company has a competitive advantage in that it is attached to Comstock Partners and the growth of the anchor portfolio, which will continue to develop real estate in the Dulles tech corridor along the Metro’s Silver Line. Value accretive growth is difficult to come by in micro-cap stocks so this type of contract is something for investors to be excited about.

The stock is currently trading at around 10x my estimate of normalized FY2024 operating earnings after tax. In my view, this valuation, coupled with the fact that Comstock manages high quality assets and has good growth prospects makes the stock a buy. My estimates are subject to change due to the lumpy nature of earnings but I believe they are reasonable when considering the lowered lease fees that will likely continue throughout the year, and my assumption that the October 1st triggering event condition will lead to the large recognition of an incentive fee in Q3.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.