Saturday, 17 May 2014

HHC Annual Meeting

I attended the annual meeting last Wednesday to listen in on the latest news. Though well attended, it was full mostly of employees.  There were only two questions during Q&A; both were from non-employees.  I would hazard a guess that there were fewer than five investors (outside of directors/employees) present.  Is it just me, or is it bizarre that a $6 billion company can stay so under the radar with the investment community?

Bill Ackman conducted the meeting and Q&A, and Dave Weinreb followed up with a few comments. One question from the crowd concerned the company's C-corp structure and whether Ackman thought a REIT conversion would be appropriate at some point. Ackman replied by saying that the C-corp structure made sense given the ability to retain and reinvest earnings. Also, HHC to this day has not paid much in the way of taxes given the net operating losses inherited by the company. Lot sales from MPCs and condo sales do not qualify under the REIT structure, but once core projects underway (e.g. Riverwalk Marketplace, Exxon build-to-suit office buildings) reach stabilization, the proportion of traditional lease-type income will significantly increase; Ackman stated that eventually the company may find itself in two different businesses and that a reassessment will be made to see what the optimal structure should be.

Sounds to me as though some kind of spin-off is imminent. The tax loss carry-forwards will be used up eventually, all the while office and retail NOI will gap up significantly over the next three years. By 2017, I estimate that office/retail income before tax could exceed MPC + Ward condo income. Of course, the margin of error is as wide as one can imagine in such a model.  The point is that a big percentage of income will soon be exposed to tax. 

Speaking of range of outcomes, management's success in their executive warrant scheme is ultra-levered.  If they are as money-centric as me, I lose absolutely no sleep over whether they will do the right thing.  By my calculations, the value of Weinreb/Herlitz's shares if a net settlement were to occur today would be $260.4 million. That's right - a 15 bagger so far!   In layman's terms, a net settlement is a way for management to exercise a portion of their warrants without expending cash from their pockets.  HHC did this to cancel Brookfield's warrant position in late 2012, and the same can be done here.  My estimate shows HHC (at today's price of 145.90) could repurchase ~900K warrants for $93 million from Weinreb and Herlitz.  This would leave the two with enough money to exercise warrants for 1.8 million shares for $75 million and still have $18 million remaining, which would be required to settle the capital gains tax from the sale of the 900K warrants. It goes without saying that the net settlement won't happen today - it will be transacted when the share price is higher, which will put management in a position to realize an even bigger ownership stake from the swap.  Somebody sign me up for one of these deals!!  The only problem is I lack the secret sauce that these guys have to create the value! Heck, these guys have made me lots of money, so how could I complain anyway?

I am not aware of management's intentions, but I don't see why they (Ackman/Weinreb/Herlitz/Richardson) couldn't rinse and repeat the whole thing again in 2018.  The two big x-factors at the time would be where the housing market is in the cycle, and whether they are up for doing it all over again. With a split-off transaction, the MPCs and remaining development properties could be placed into Newco ("HHC Developments"?).  The remaining HHC can convert into a REIT and lever up in order to provide Newco some cash to start off with.  Newco will also be self-sustaining out of the gate, provided the housing market doesn't go into another dive.  An exchange ratio will be set; management can backstop the offering and also have an oversubscription clause.  Ultimately, the transaction will allow interested parties to transfer their interest to Newco, and the exchange will dub as a buy-back for remaining HHC.  If I'm correct in my speculation that Weinreb/Herlitz have an intense love the development game, Newco will make complete sense in two ways: (1) Allow them to focus their time on developing commercial properties. Remaining HHC will in a few years become too big and bureaucratic for their liking, and (2) By maxing out their exchange to Newco, which will be smaller in market cap, their wealth can compound from a smaller base (i.e. escape diminishing returns from law of large numbers). 

Disclosure: The author still owns all his shares...and recommends those on the border of selling to keep delaying that decision.  Do not be a slave to your NAV models; when a large component of the investment outcome hinges on successful deal making, basing your sell decision on cash flow a few years out is likely to give you the wrong answer.  Rather, focus more on the insiders and how they maneuver their ownership stakes around future corporate action. As a wise-man named Joel Greenblatt once said, "it pays to follow the insiders"

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