Fortress Earnings may not be immune to market volatility

Fortress may have capital to invest, but its earnings power is flagging amidst sub-par performance by some of its alternative investment vehicles.

Fortress Investment Group (FIG.N) has always struggled to win the affections of investors: as an asset management company offering alternative investment products like hedge funds to ultra-wealthy individuals and institutions, it’s not an easy company to analyze. For instance, some analysts still struggle with how to translate the fact that Fortress’s “macro” funds outperformed their peers in June into a bottom-line analysis, and then how to reconcile that June performance with the fact that one of Fortress’s key macro funds is down 2% so far this year.

But one thing that does seem clear is that the company’s earnings outlook isn’t as rosy as it was only a few months ago. True, Fortress announced higher-than-expected first-quarter earnings of 11 cents a share (above the 10 cents a share that analysts had anticipated) – but they did so in large part because of lower compensation expenses from a year ago. Since then, the company has shut down its Fortress Commodities Fund, in the wake of the selloff in commodities as an asset class. The fund already had a bumpy performance record and had been dealing with redemptions even before commodity prices began their slide early this year; it lost 12.6% in the first four months and more than 4% in April alone, the company said in a regulatory filing announcing the closure. Its former CEO, Daniel Mudd, stepped down – last December, after becoming the target of an SEC securities-fraud civil lawsuit related to his previous job at the helm of Fannie Mae. So far, the company hasn’t announced a permanent replacement to take over from “interim CEO” Randy Nardone at the helm.

Analysts have been cutting their estimates for Fortress’s earnings steadily over the last 90 days, but the highest-rated analysts and the most recent reports have taken a more bearish view of its earnings outlook. The result: while both the I/B/E/S consensus and the StarMine SmartEstimate (which places a greater weight on those timely forecasts by top-tier analysts) estimate for second-quarter earnings stood at 11 cents a share 90 days ago, the consensus (represented by the gold line) has fallen to 9 cents a share today, while the SmartEstimate (represented by the blue line) is lower still, at only 8 cents a share. That gives the company a hefty negative Predicted Surprise of -13%, telling us that the odds of either a negative earnings surprise or a further decline in the consensus forecast are sizeable.

On a GAAP basis, Fortress’s losses in the first quarter of 2012 were a fraction of what they had been in the year-earlier period: $24 million, compared to $255 million a year previously. While that may seem like a positive, the key metric for an asset management company like Fortress is its distributable earnings (DE), which measures the cash flow available to investors. That figure is actually lower in the first quarter ($56 million) than a year ago, when it stood at $95 million-

Fortress’s fate is tied to the performance of its investment funds, both hedge funds and private equity investment products. A large proportion of its earnings – as with any alternative investment management firm – comes from performance fees, which are levied on the profits that Fortress’s managers are able to generate. To the extent that these offer actual and prospective investors lackluster or disappointing returns, the company won’t be able to collect a reasonable level of performance fees, nor will it be in a position to raise its management fees or solicit new capital for fresh funds. Moreover, there’s the prospect of redemptions, which will leave the company collecting management fees on a smaller asset base.

Of that $56 million in distributable earnings in the first quarter, $23 million came from Fortress’s credit-oriented hedge funds. Collectively, those funds have more than $6.2 billion of dry powder: dollars that remain uninvested (and on which they therefore can’t even collect management fees). Managers are scouring the landscape in quest of investment opportunities – to the extent that quest is successful, this may pay off in the form of higher corporate earnings. But for now, at least, weak global markets may dent its returns on these funds. To the extent that occurs, the possibility remains that managers could face redemptions.

Moreover, the primary driver of the year-over-year improvement in Fortress’s GAAP results was the expiration of the “Principals Agreement”, and other agreements covering compensation expenses, which had accounted for approximately $4.8 billion of losses on a GAAP basis between the first quarter of 2007 and the fourth quarter of 2011. (This was a non-cash item, as none of these sums were paid, nor any equity issued, in connection with this agreement.) The expiry of the agreement at the end of 2011 means it won’t impact Fortress’s financial results going forward (starting in Q1 2012).

For now at least, markets that former CEO Mudd once memorably described as being characteristic of “a nonlinear and untethered global environment” appear likely to keep weighing on the company’s bottom line. Certainly, the company’s large negative Predicted Surprise seems to indicate that Fortress may report a negative earnings surprise when it announces its second-quarter results July 30.

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