Sunday, 7 July 2013

HHC: Hard copy is always the best

When I first read Weinreb's annual letter to shareholders in March, I opened it on my iPad and devoured it in probably less than 15 minutes.  But now, after having ordered a hard copy of the annual report from the investor relations department (thereby destroying shareholder value by increasing SG&A expense!), some key words jumped off the page.  Here they are:

"Our long-term goal is to increase the value of the company on a per-share basis. We do this by improving our assets through the development process and by opportunistically deploying excess cash. In the fourth quarter, we purchased approximately 6.1 of the 8 million Sponsor warrants issued as part of our emergence as a public company. These warrants had a strike price of $50.00 per share and a November 2017 expiration date. They were the most expensive and dilutive security in our capital structure. Before their retirement, the warrants represented an economic drag on our per-share progress as every dollar of appreciation of our stock price above $50.00 would require us to generate $1.16 of value. The repurchase of these warrants in exchange for $81 million of cash and 1.5 million shares is a breakeven proposition for the company if our stock price equals $81.10 in 2017, a price which we expect will be well below the potential value of our stock at that time. As a result of retiring the warrants, our shareholders now own 10.1% more of the company."

One can say, "increasing per share value? duh....anyone can say that!"  But no, not every CEO does, and even fewer deliver like Weinreb/Herlitz have in such a short time. It is amazing how many sophisticated investors I know who own this stock were not at all aware of the warrant repurchases mentioned above until I personally told them about it.  I actually think Weinreb was being modest in his annual letter; his timing was quite prescient given the share price rally that has since ensued.

So what is the running tally on value created in the warrant buy-backs? The short answer is $102.5 million for the Blackstone/Fairholme cancellation.  For the Brookfield warrants, this is a less straightforward question since a net settlement swap was used, but I have a few points to make below.

First off, the 2.25 million warrants cancelled for Blackstone/Fairholme was done at $30 per warrant (or cash settlement of $57.5 million), versus the $50 strike price.  At the time, HHC would have needed the stock to appreciate above $80 ($50 strike + $30 warrant) to breakeven.  This also worked out to a ~10% premium above the prevailing price at the time.  Assuming that Blackstone/Fairholme would have demanded a like premium had the warrants been cancelled at today's $110 price, I estimate that the same transaction would have cost HHC $159.8 million dollars ($110 + 10% = $121, minus $50 strike = $71 per warrant, x 2.25mm).  So in other words, Weinreb has thus far saved shareholders $102.5 million by completing the deal in December versus today!  And this is just a running number. When the price crosses $200, I will write up another update!!

The value surrendered by Brookfield can also be worked out... it is substantial, but I don't want to be too explicit because of my respect for this team.  Suffice it to say that Brookfield underestimated the value of HHC in their internal estimates (I guess they are conservative) and would much rather deploy the capital in a non-passive investment.  But I will publish one estimate/guestimate:  Had they waited until today to execute a share swap with HHC, they would have ended up with at least 50% more shares from their warrants (2.3 million vs. 1.5 million) and still received a net settlement of $8 million from Weinreb & company.  How do I arrive at this estimate?  Well, it appears that the swap was designed such that neither Brookfield nor HHC would have to outlay much cash.  The $38.69 buyout price per warrant implied a breakeven price of $88.69, which if I remember correctly was approximately 21% premium to the prevailing share price.  Applying a 20% premium to today's $110 share price, this would imply Brookfield would demand a breakeven price of $132 for HHC, or $82 per warrant ($132 minus $50).  This would mean the scales would be reweighed such that Brookfield could have exercised 2.3 million warrants (vs. 1.5 million in the December deal), while having the residual 1.5 million warrants retired by HHC (vs. 2.3 million warrants in the December deal) at $82...and Brookfield have still received $8 million to settle the net amount.  To sum up, this "finesse" of a transaction by Weinreb/Herlitz/Richardson saved an extra 0.8 million shares from being issued in the net swap settlement. 

When to sell?  Believe me, I've spent many hours pondering over this question.... When you are 90% invested in one stock that has appreciated farther and faster than you originally expected, while seeing other stocks out there that seem more empirically undervalued (e.g. AIG selling at a considerable discount to book value per share), it takes a lot of willpower not to take some profits.  But I've decided that HHC really is a one off opportunity, and it's still early in the U.S. housing recovery. Though it can be argued that execution success is already built in to the current share price, I will not sell a single share until Weinreb, Herlitz or Ackman sells. Ideally, a spin-off or split-off of some of the assets is done in a few years, and structured in a fashion that creates another undervalued security.  Even better would be a spin-off done simultaneously with a rights offering for the REIT assets, as I bet the insiders would use this as a (legal) opportunity to increase their net worth.  And in such an event, I would be a follower.

Final thought: Okay, where's the sell side coverage for this company? With a $4.3 billion market cap, only two brokerages (one very small and another one quite small) have initiated coverage on HHC.  But what is Bank of America, Goldman, JPM, etc waiting for?  These sell side analysts have a habit of all jumping in at the same time.  Just look at all the analysts initiating coverage on Brookfield Residential recently.  They've had more than two years, and now that the stock is up over 100% off the rights offering/spin-off price, they are now interested!  With HHC, watch for the same behavior.

Disclosure: I still own HHC and BRP, but do not own AIG (yet)