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.

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