Sunday, 6 October 2013

Life after 2017 in HHC? Channeling John Malone...

I have no doubt in my mind that as HHC transitions into a cash flow vehicle, the insiders would have made their killing from their own investments in the company (but most deservedly). However, for long term investors who aspire to own HHC past that point, there remains an unanswered question: how will the upside motivate the insiders versus November 2010 at the bottom of the housing market? Of course, Nov. 2010 was a once in a life time opportunity. But if structured optimally, there is a way for HHC insiders to morph the company and thus their holdings into a position where great future upside is possible. 
I'm sure many of you have invested in and followed Liberty Media for years.  It wasn't until a few months ago though that I read Cable Cowboy (by Mark Robichaux). Since then, I keep thinking about how different my life would be now had I spotted that opportunity. But as a 14 year old at the time and several years away from becoming interested in investing, I suppose it's wrong to obsess over missing the boat.

In a nutshell, Malone split-up (note not spun-off) TCI's content assets into a vehicle called Liberty Media in 1991 via a rights offering. At the time, he was already an accomplished CEO, having built up TCI into the largest cable company.  The problem was that, despite his accomplishments, Malone did not own a significant stake in TCI (though I'm sure he already did quite okay for himself) while his peers in the industry had made billionaires of themselves. By placing a bunch of non-publicly traded minority interest stakes in Liberty, this gave Malone the opportunity to lowball their values.  At the same time, he structured the deal in such a way that not only discouraged investors to participate, but limited equity ownership to those who did.  The result was Malone owning close to 20% of Liberty's equity and a 10 bagger in less than two years.

So let's walk through the Liberty Media math and see how it could make lots of sense for HHC in a few years time.
  • Ownership of 200 TCI shares granted 1 right. Each TCI share traded for $16 at the time. In other words, you would have needed to own $3,200 of TCI stock at the time just to get 1 right 
  • Surrendering 16 shares and 1 right gave you 1 Liberty share. Translation: at $16 per TCI share, this equated to a $256 purchase price per Liberty share (16 shares x $16)
  • TCI had a fully diluted share count of ~415 million shares; so only a maximum of 2.1 million shares would have been outstanding even if all rights were exercised (415mm / 200)
  • Only ~1/3 of the rights were exercised, which translated into approximately 700,000 shares outstanding.  As a result, the initial implied market cap was $179 million ($256 x 700K shares) for a collection of fractional ownership stakes that was worth much, much, much more than that.  Further leveraging the upside for shareholders was TCI's commitment to issue preferred shares at 6% interest for all equity not sold in the rights offering.
From what I read in Cable Cowboy, Bob Magness (founder and largest TCI shareholder) did not see the merits of exercising his Liberty rights until Malone convinced him. So either Magness was withdrawn enough from TCI in 1991 such that this deal slipped under his radar, or the structure of the transaction was complex enough to confuse even him.

When I suggest that a similar approach is possible for HHC's remaining development assets in a few years, I do not mean to say that Liberty Media's 1991 split-up should be used as a playbook. But as the "owner's mentality" that Weinreb writes of in his annual letter is crucial to the success of HHC, structuring the potential spin-off such that insiders are hyper aligned is paramount. It is perhaps way too early to speculate which properties will be selected for the REIT vs. the Splitco in 3-5 years time, though I think it highly likely that the new development company will be granted some income generating properties and liquidity (just as HHC was), such that it can hold its own to begin with.

My hope is that the separation will be effected via a split-up.  The insiders by 2016 should be able to secure debt to exercise their warrants.  Since a dividend will be paid by that time, the debt will carry itself.  Perhaps most importantly, a split-up would allow the insiders to transfer a portion of their ownership into a more leveraged vehicle whose needle is moved significantly with the completion of each new development, while their remaining shares in the REIT would more than cover their living expenses (or so I would hope!)

I also think the odds are in favor of a stock split in HHC by 2017, but for illustrative purposes, here is an example of what could transpire:
  • In 2017, HHC announces a split up of development assets into "Splitco"
  • 1 right is distributed for every 25 shares.  For simplicity's sake, let's assume there will be 50 million shares outstanding at the time. This would max out the number of shares in Splitco at 2 million.
  • If 1 right + 1 HHC share (which will hopefully be at least $300 each by then!) were exchangeable for 1 Splitco share, this would place a value of $600 million on the new company (2 million shares x $300)
  • Now the real artistry will be in the selection of assets to transfer into Splitco... As with HHC, I am sure that management will have a far better understanding of the development possibilities of the selected assets than anyone else.  A lot of the remaining, undeveloped acreage (e.g. Circle T Ranch, West Windsor) could be stuffed into the new vehicle alongside a few income generating malls.
  • At $300 per share, this would imply a $15 billion market cap in 2017 for HHC. If a certain insider at the time owned 5% of the company, this would mean 2.5 million shares or $750 million market value.
  • With the above logic, this 5% insider would have rights to buy 100,000 shares of Splitco (2.5mm/25). And with 1:1 exchange ratio at $300 price, this would mean a $30 million purchase price without outlaying any extra cash from his pocket.
  • BUT......what if the stakes were further raised if HHC guaranteed to replace any unexercised rights with preferred shares on fair terms? In such a scenario, if 50% of the rights were exercised, there would be 1 million shares (worth $300 million) initially outstanding with Splitco and $300 million outstanding of preferred equity. Mr. Insider, who originally would have owned 5% of Splitco had all rights been exercised, now owns 10% of the equity and also has exposure to a more leveraged situation as a result of the preferred outstanding.
Though it is fun to run through scenarios with a split-up, I more commonly see spin-offs with rights offerings WITH oversubscription privilege AND a backstop clause (think Brookfield Residential and Sears Hometown and Outlet).  So maybe the odds favor this type of transaction to eventually occur.
Chances are that by this time (2016-2017), the ownership base will contain lots of dividend and REIT fund managers, who will either punt the Splitco stock (if management chooses a straight spin-off option) or totally overlook the potential of participation in the split-off, if that option should be chosen.
Insiders will then have the best of both worlds: a dividend paying REIT in HHC, backed by top tier properties, and (2) shifted a portion of their HHC holdings into Splitco for exposure to more upside. Also, just to put icing on the cake, with the board's help a similar executive warrant package can be repeated in the new development company (e.g. 7 year non-transferrable, exercisable in year 6). So there you have it: a totally legal way for insiders to maximize ownership and rewards for layman investors shrewd enough to see it coming!