Friday, 28 December 2012

HHC: An Interpretation of the Recent Warrant Buy-backs

As you may have seen, HHC entered a few transactions to eliminate the outstanding warrants  from certain of its sponsors in the original spinoff transaction:  Blackstone, Fairholme, and Brookfield. I view this as a favorable event given the fact that shareholders now own ~10% more of the company on a fully diluted basis.  With my most recent NAV estimate of $152/share, the net effect of these transactions was to increase fully-diluted NAV by 4.5% to $159/share (the cash outlay for the transaction + reduction in cash receivable from now eliminated warrants explains why NAV/share doesn't also go up by 10%). 
As will be explained further on in this post, HHC will be "in-the-money" on the Blackstone and Fairholme warrant cancellations when the share price breaks $80.  Even at my low-end NAV/share estimate of $100, this deal is accretive.  However, I believe it will take time for the market to wake up to HHC's intrinsic value; as Grant Herlitz stated in the webcast from the JMP Securities presentation (Sept.'12), HHC's goal is to convert itself into a cash flow vehicle from one that is currently asset based.  Until then, the market will not have any straightforward way to value the stock. Where I stand to be surprised is in how quickly lot sales and thus cash flow from Summerlin and Bridgeland can pick up steam in the coming quarters.
Fairholme and Blackstone sell warrants for $30 each.  With a strike price of $50, this implies a breakeven share price of $80 before HHC is in-the-money.  I can only speculate as to why Fairholme and Blackstone would want to give up now and on terms so favorable to HHC.  Perhaps they see better opportunities to benefit from the housing recovery and view this as an opportune time to rotate their capital.  In Fairholme's case, exercising the warrants and then holding the stock would have entailed a cash outlay of $96 million, whereas instead they received $57.5 million in selling the warrants now to HHC. 
Brookfield enters net settlement for its 3.8 million warrants.  By agreeing to a net settlement wherein Brookfield exercised 1.5 million warrants (would have resulted in $76 million outlay to HHC) and allowed the remaining 2.3 million warrants to be bought back and cancelled by HHC for $89 million, Brookfield received the net difference of $13 million and thus avoided the need to inject further capital. For HHC, the per-warrant cost of $38.69 in this transaction implies that HHC will be in-the-money when the share price breaches $88.69 (cost + $50 strike price). It is unclear why Brookfield received a buy-out price 29% higher than what Fairholme and Blackstone acheived.
The word on the street for more than a year has been that Brookfield was planning to eventually exit its HHC position. We already saw the departure of David Arthur from the board of directors (Brookfield's only representative) in 2011 and last week, the first 13D filing confirming Brookfield's first sales of HHC stock on the open market. I do not believe this was pre-empted by Ackman's recent conflict with Brookfield over General Growth. Brookfield simply doesn't like to own stock in companies it does not have a direct influence in.
The recent clean up of sponsor warrants implies the following:
  • HHC management is very bullish about 2013 and beyond and believes that mopping up these warrants would otherwise be more expensive in the future, as the housing recovery progresses and HHC's development projects continue to move forward.
  • The company has no financing worries regarding capex needs for the Summerlin Center,Ward Village, Riverwalk Marketplace, South Street Seaport, and Maryland. Instead of receiving a potential $304 million from warrant excercises, HHC in fact outlayed $80 million of cash to buy them back from Brookfield, Fairholme, and Blackstone. A slide from the investor presentation posted online details how in a JV scenario, the cash requirement to fund construction is diminished via a combination of HHC's contribution of land for its consideration of equity into joint ventures, and furthermore debt financing. So it must be the case that management figures HHC's cash needs for construction are not significant, or alternatively the deal it got in cancelling the warrants was good enough such that it took precedence over intermediate project funding needs.
  • Pershing Square now the sole remaining sponsor with warrants.  With Bill Ackman as Chairman of HHC, I would have expected no less than for Pershing Square to maintain its warrant position.  HHC represents only a nominal percentage in Ackman's $10 billion plus hedge fund portfolio, and I am sure he would like to increase its weighting.  Exercising his 1.9 million warrants would help in this regard ($96 million), albeit still insignificant in comparison to some of his other investments.

Saturday, 15 December 2012

Howard Hughes Corp - A Textbook "Greenblatt" Spinoff?

It is becoming increasingly evident that I am obsessed with The Howard Hughes Corporation. The vast majority of my net worth is riding on this one company, even though I have no real edge over the average retail investor - nor will I likely ever meet management. 

From the current price of ~$73, this idea does not have the multi-bagger potential that General Growth Properties once had at its low of $0.30.  Indeed, one can say that a lot of the easy money has already been made since the discount to book value has disappeared since the price exceeded $58.  Theoretically, I should be swapping my funds into plays with similar merits and a large margin of safety like HHC once had. Despite being one of the more difficult companies to value, I have vowed to hang on for at least a few more years.

This is the first and last time I will say this: If you haven't read Joel Greenblatt's "You Can Be A Stock Market Genius", get yourself a copy.  The book's intrinsic value is far greater than its retail price as you will be introduced to a life-long, potentially lucrative facet of investing. Anyway, Greenblatt's book was written in 1998, and it is evident that his teachings regarding spinoffs are as relevant today as ever. In this brief note, I will highlight pointers from Greenblatt's book and how HHC has fit the box in textbook fashion. But before I begin, you may wonder why I promote know-how that could reduce my changes of investment success should more people catch on to spinoffs.  First of all, I think of this as my diary. Secondly, value investing doesn't resonate with the majority of investors to begin with, and spinoffs furthermore appeal to only a portion of the value crowd.  So I'm not convinced at all that a few more participants will reduce my chances of success.
Greenblatt Spinoff Pointers
The following are spinoff attributes from Greenblatt's book that I found applied directly to HHC:
  • A high distribution ratio can lead to forced selling
  • In spinoffs, management has an incentive in the beginning to hide rather than advertise value
  • The spinoff may not immediately attract sell-side analyst coverage
  • Entrepreneurial spirits are freed, but operations may not gain momentum until the new company's second year of existence
 What Has Played Out So Far
  • A high distribution ratio can lead to forced selling
    • I believe this is what happened with HHC. I know that at least one hedge fund shorted it out of the gate in Nov. 2010 at around $40 - on the first day of trading. What on earth was he/she thinking??!  
  • In spinoffs, management has an incentive in the beginning to hide rather than advertise value
    • Management has opened up since the November 2010 spinoff; warrant exercise prices were set based on the first several days of trading, and thus management had no incentive to advertise the firm's value in a bullish light before the exercise prices are set (to management's advantage). President Grant Herlitz made the company's first webcast available on the Howard Hughes website in September 2012, almost two years after the start of trading.  There are no quarterly conference calls, which is not inappropriate for a development company. However, CEO David Weinreb has had no media presence; besides his annual letter and the odd quote found in either press releases or articles, the public has had no way of getting to know the big boss. Is David working hard and fully engaged, or is he out of the picture?
  • The spinoff may not immediately attract sell-side analyst coverage
    • It has been two years since HHC began trading on the NYSE, and still no coverage has been intiated by of the bulge bracket brokerages, despite a market cap approaching $3 billion.
    • HHC is a development-focused company, which does not naturally fit with sell-side REIT analysts who already covered General Growth.  How troublesome would it be to write an initiation report claiming expertise in a diverse collection of property types (MPCs, mixed use development, acreage of varying stages of development, retail, office) spread across the U.S.?  Does this neatly fit into a category for sector coverage?
  • Entrepreneurial spirits are freed, but operations may not gain momentum until the new company's second year of existence
    • in a little over two years of existence as a public company, HHC has made the following notable steps: (1) bought and gained Morgan Stanley's part interest in the Woodlands, thereby allowing for acceleration of development, (2) announced plans for South Street Seaport (though I'm sure the flooding caused by Superstorm Sandy is having an adverse effect in marketing to prospective tenants), (3) recommencement of Summerlin Center - Macy's and Dillard's already signed as tenants, (4) announced Ward Center plans, and (5) increased shareholder ownership by ~10% on a fully diluted basis after negotiating the  reitrement and conversion of warrants with Brookfield, Blackstone, and Fairholme
Why the sell-side should want to build a strong relationship with HHC now (this part is me talking my own book - but the logic is sound)
  • The company will need funding to develop its projects; agents will also be needed to find buyers for percentages of projects after full ramp-up.
  • HHC's team is highly competent and a breeding ground for CEOs of future companies
    • I predict that within several years, at least one company will spin-off of HHC. Young talent will branch off into other firms in senior management positions with a highly credible deveopment track record. By covering the stock now, you will also get access to less senior management who will eventually be the trigger pullers.  Think beyond the next quarter.
  •  Despite the price appreciation, HHC is still a good stock pick and will be beneficial for an analyst's career.