So it appears FB's Zuckerberg got himself several condos in ONE Ala Moana (article here). Good choice Mark! :)
Sunday, 20 January 2013
Sunday, 13 January 2013
HHC: A few speculations
With the news of Ward Village in October, announcement of recontinuing construction of the Summerlin Centre in September, and Seaport news in August of last year, some of the most anticipated headlines regarding HHC's key development properties have already come to pass. In none of these instances did the stock move materially on the day of annoucement.
Perhaps HHC was waiting until all these press releases were published before offering to buy back the warrants from Blackstone, Fairholme, and Brookfield. But another part of me is thinking that the warrants have been on Weinreb's mind since the spin-off. Here is a purely speculative statement: Weinreb believes the MPC revenues will begin shooting up soon (maybe we'll even see it in the Feb. reporting) and wanted the warrants cancelled now before it would be significantly more expensive to do so. Assuming the stock hits my 2 year target of $100, this would save shareholders $67.5 million (or $1.50 per share) on just the buyout of Blackstone's/Fairholme's 2.25 million warrants alone.
Here's another way to look at it: It cost HHC $30 to cancel each of the warrants. Blackstone/Fairholme held 2.25m warrants combined, so HHC outlayed $67.5 million. The $30 buyout price also implied a $80 breakeven price ($30 + $50 strike), which also happened to be ~10% above where the stock closed on the day of the announcement (Dec. 10). So assuming that the same 10% premium would have applied had the deal been struck later, this would imply that at $100, Blackstone/Fairholme would have demanded $60 for each warrant ($110 minus $50 strike).
At a $60 buyout price for the warrants, HHC would have to pay Blackstone/Fairhome $135 million (2x the settlement in December). In other words, when the stock price hits $100, this would mean that Weinreb and Herlitz (or maybe it was Richardson who was behind the negotiations) doubled shareholders' money on the cancellations. If this happens by December 2014, the 2-year compounded return would be 41% - difficult for the company to beat any other way.
But still, I'd like to "use the force" here...and speculate that either the next quarterly reporting will be excellent, or will include additional news about deals made recently. The news flow regarding commercial property development has been deathly quiet since October, save the few announcements in December about a few tenants signing on. It is likely that management is holding back everything possible because of the bad optics that would result if positive news were to be published shortly after the warrant cancellations. If I look back to the buyout of Morgan Stanley's portion of the Woodlands, it took about 4 months until 3 Waterway Square was announced. Now, I'm not suggesting that there was assymetric information in those negotiations, but rather that the silence after the conclusion of such an agreement can be a hint of things to come.
Perhaps HHC was waiting until all these press releases were published before offering to buy back the warrants from Blackstone, Fairholme, and Brookfield. But another part of me is thinking that the warrants have been on Weinreb's mind since the spin-off. Here is a purely speculative statement: Weinreb believes the MPC revenues will begin shooting up soon (maybe we'll even see it in the Feb. reporting) and wanted the warrants cancelled now before it would be significantly more expensive to do so. Assuming the stock hits my 2 year target of $100, this would save shareholders $67.5 million (or $1.50 per share) on just the buyout of Blackstone's/Fairholme's 2.25 million warrants alone.
Here's another way to look at it: It cost HHC $30 to cancel each of the warrants. Blackstone/Fairholme held 2.25m warrants combined, so HHC outlayed $67.5 million. The $30 buyout price also implied a $80 breakeven price ($30 + $50 strike), which also happened to be ~10% above where the stock closed on the day of the announcement (Dec. 10). So assuming that the same 10% premium would have applied had the deal been struck later, this would imply that at $100, Blackstone/Fairholme would have demanded $60 for each warrant ($110 minus $50 strike).
At a $60 buyout price for the warrants, HHC would have to pay Blackstone/Fairhome $135 million (2x the settlement in December). In other words, when the stock price hits $100, this would mean that Weinreb and Herlitz (or maybe it was Richardson who was behind the negotiations) doubled shareholders' money on the cancellations. If this happens by December 2014, the 2-year compounded return would be 41% - difficult for the company to beat any other way.
But still, I'd like to "use the force" here...and speculate that either the next quarterly reporting will be excellent, or will include additional news about deals made recently. The news flow regarding commercial property development has been deathly quiet since October, save the few announcements in December about a few tenants signing on. It is likely that management is holding back everything possible because of the bad optics that would result if positive news were to be published shortly after the warrant cancellations. If I look back to the buyout of Morgan Stanley's portion of the Woodlands, it took about 4 months until 3 Waterway Square was announced. Now, I'm not suggesting that there was assymetric information in those negotiations, but rather that the silence after the conclusion of such an agreement can be a hint of things to come.
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
- 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.
Monday, 27 August 2012
Bill Ackman's True Genius: Hyper-Alignment
Anyone who follows Bill Ackman's investment career can see that he is a great investor. If you had bought GGP when he did at $0.40, you would have made more than 80x your original investment in a little over three years (including the current market value of the HHC and RSE spinoffs). Of course, opportunities like that rarely come along, and I certainly don't expect Ackman's or any investor's future picks to yield such results. Furthermore, Ackman is not right 100% of the time, as can be seen in some of his retail mishaps such as Target and Borders.
One aspect of Ackman's activist approach that I believe is widely overlooked is his creation of a system to align CEOs he hires into companies. I have discussed this method of Ackman's in an earlier post, so this may sound a little repetitive to those who previously read it. The reason why I think his true genius is on display through the technique of having the incoming CEOs invest in warrants is that, when the writing is on the wall in a few years, I believe we will see the benefits in the stock prices of Howard Hughes Corp. and JCPenney. So how, you may ask, does this intangible factor guarantee success? The answer is that it doesn't. But given the importance I place on having a good management team in place, if you give me a great CEO and further have incentives in place that amplify his long-term up- and down-side, you have my close attention for at least a few hours!
Howard Hughes Corp. Warrants - Purchase Terms
I believe W&H will continue to do their best to surface value by Nov. 2017 because of the leveraged upside both still have from this vantage point. If they are able to build the value of the company to $100 (my intrinsic value estimate for HHC), this would mean a $139m profit [(100-48.53) x 2.7] or a 817% gross return.
Thus far, management has been quietly working away on advancing developments at the South Street Seaport, Riverwalk Marketplace, Columbia MPC, Bridgeland MPC, Woodlands MPC, and the Ward Centers in Honolulu. My bet is that W&H will really pick up the steam in 2015, and by 2017 we will have seen various value realization moves (e.g. spin off a segment, sell partial interests for more than people expect). Don't forget that you also have Bill Ackman, the financial engineer of all financial engineers, to ensure than as much value by then is surfaced.
J.C. Penney Warrants - Purchase Terms
Key Takeaways
One aspect of Ackman's activist approach that I believe is widely overlooked is his creation of a system to align CEOs he hires into companies. I have discussed this method of Ackman's in an earlier post, so this may sound a little repetitive to those who previously read it. The reason why I think his true genius is on display through the technique of having the incoming CEOs invest in warrants is that, when the writing is on the wall in a few years, I believe we will see the benefits in the stock prices of Howard Hughes Corp. and JCPenney. So how, you may ask, does this intangible factor guarantee success? The answer is that it doesn't. But given the importance I place on having a good management team in place, if you give me a great CEO and further have incentives in place that amplify his long-term up- and down-side, you have my close attention for at least a few hours!
Howard Hughes Corp. Warrants - Purchase Terms
- Weinreb and Herlitz ("W&H") bought 2.7m warrants for $17m, or ~$6.30 per warrant on Nov. 19, 2010
- Strike price is $42.23 (closing price on 11/19/2010)
- Breakeven price is therefore $48.53 ($6.30 + $42.23)
- 7-year life; if share price is not at least $48.53 by Nov. 19, 2017, Weinreb and Herlitz stand to lose 100% of their $17m investment
I believe W&H will continue to do their best to surface value by Nov. 2017 because of the leveraged upside both still have from this vantage point. If they are able to build the value of the company to $100 (my intrinsic value estimate for HHC), this would mean a $139m profit [(100-48.53) x 2.7] or a 817% gross return.
Thus far, management has been quietly working away on advancing developments at the South Street Seaport, Riverwalk Marketplace, Columbia MPC, Bridgeland MPC, Woodlands MPC, and the Ward Centers in Honolulu. My bet is that W&H will really pick up the steam in 2015, and by 2017 we will have seen various value realization moves (e.g. spin off a segment, sell partial interests for more than people expect). Don't forget that you also have Bill Ackman, the financial engineer of all financial engineers, to ensure than as much value by then is surfaced.
J.C. Penney Warrants - Purchase Terms
- Ron Johnson bought 7.257m warrants for $50m, or ~$6.89 per warrant in June 2011
- Strike price is $29.92 and breakeven price is therefore $36.81 ($6.89 + $29.92)
- 7.5-year life; if share price is not at least $36.81 by December 2018, Johnson will lose 100% of his $50m investment
- The warrants cannot be sold or hedged for the first six years of their term
Key Takeaways
- Executive Subscribed Warrants are a great tool to align the long-term interests of management
- Under this incentive, the CEO must build value over the next six years or risk losing his entire investment
- Implications: He is much less likely to make decisions for the short term
- Evidence: JCP going against grain of giving back in to couponing to meet quarterly expectations
- Okay, so what if this system is a success? What happens after the 6th-7th year? How is the CEO aligned after this point when the stock is up several hundred percent?
- Answer: I don't, but for the next several years you can bet the CEO will do everything he can to surface value.
- I don't expect this system can be done for every company, so therefore it is not the answer to alignment problems at most companies
- Answer: That is very true. For this warrant system to work, (1) a competent CEO with the financial means to invest a convincing sum must be available, (2) the company must be undervalued and thus be perceived as a great investment by the incoming CEO. So we should not expect to see this implemented well too often. However, if other activist investors do copy Ackman's approach, close attention should be paid to the opportunity.
Saturday, 21 July 2012
JCPenney - worth considering
I initiated a small position for myself in JCPenney yesterday at $20.50. If Bill Ackman is correct, investors stand to make 15-20x their money at the current price (see Pershing Square's May 2012 presentation here).
Just for those hailing from outside North America, JCPenney is a department store chain in the U.S. with ~1,000 locations. It was at one point (in the 1960s) the 2nd largest company in the U.S. by market capitalization, but has since fallen into disrepute because of mismanagement and intense competition. The following points outline why I believe this could be a good investment:
1) Downside protection from real estate value. If we take Ackman's statement that the replacement cost of the real estate is $11 bilion, then after subtracting the $3 billion of debt (not even considering the company's ~$800 million cash balance), we arrive at $8 billion for net asset value. This would work out to a little more than $36.50, or 77.5% above the current price. Using $36.50 as the floor price, of course, assumes that in a worst case scenario of bankruptcy and liquidation, we will be able to realize market value in a bankruptcy sale (which is unlikely). I have come up with something a little more conservative for my own crude calculations. Given JCP's outright ownership of 49% of its stores, this works out to ~55 million square feet of ownership. Using Sears' sale of 11 stores to General Growth in April 2012 as a precedent transaction, the price per square foot was $150 ($270mm paid for 1.8mm sq ft). Applying $150 to 55 million square feet gives us a value of $8.25 billion. Now subtract $3 billion of outstanding debt from the $8.25 billion and you get $5.25 billion ($24/share), which is still a 16.5% premium above the current price.
2) Strong insider ownership. With Pershing Square's 26% ownership stake, we have patient money backing the company's new strategic initiatives, which would have no chance of success if a quarter-by-quarter investor were to be in control. Bill Ackman (founder of Pershing) actually sought out and effectively installed Ron Johnson, who is the current CEO of JCP. Upon taking the helm, Johnson invested $50 million in warrants with 7.5 years to expiry that are not excercisable until year 6. He paid approx. $8 per warrant with a strike price (market price at the time) of $29 - thus his break-even point is $37. Hence an investor entering in today would experience ~80% capital appreciation just to get to the point where Johnson breaks even in year 6 of his investment!! This compensation structure, which no doubt gives the CEO a leveraged outcome (and leaves no room for error on the downside) is unique and present in only one other company I know of called the Howard Hughes Corporation, where Bill Ackman serves as the company's chairman. While this warrant ownership scheme is no guarantee of success and by no means protects you against management misjudgement, one thing is for certain: the CEO is more likely to think for the long term versus appeasing investors quarter-to-quarter.
3) Management's reasoning makes sense. While JCP's earnings are likely to continue hurting for the next few quarters, Johnson's new intiatives make a hell of a lot of sense. I would encourage you to read the presentation (linked to above), as it walks through what management plans to do over the next few years. In a nutshell, JCP was terribly mismanaged by previous leadership through extreme couponing (average of two sales per day at up to 60% off normal price) which led to the perception among suppliers of a lack of price integrity. As a result, most brands refused to sell their wares in JCP and this led to a cycle of decreasing price points. Johnson's strategy is to use JCP's structural advantage, being its low cost ($4 per sq. ft.) leases and direct ownership of stores, to offer incoming (and higher value) brands the opportunity to set up their own mini-stores within each location and thus acheive nationwide distribution. He labels this his "mall within a mall" concept. Secondly, Johnson has targeted $900 million of cost cuts. Considering that $1.8 billion of costs would need to be chopped in order to reach Macy's efficiency level, $900 million hardly sounds unreasonable.
I would argue that the current valuation is already pricing in a grave level of pessimism. However, giventhe fact that this turnaround will take time, I would not be surprised if the share price tanks again on August 10th when the next quarter of earnings is reported. This of course depends on how disappointing sales are. Sales were down 20% in the most recently reported quarter; if an even greater decrease is reported in August for Q2, it could be a sign that the situation is getting out of control and that JCP's previous customer base is running for the exits. In this scenario, Johnson may be pressed to sell some stores to raise cash for working capital to make ends meet until his plans work out. If however the year-over-year sales decrease is less than expected, we could in fact see the share price pop as investors decide to price in a lower level of pessism. The truth is that I don't know whether we have reached the bottom on JCP... if the next quarter is worse than expected, I wouldn't be surprised if the stock crumbles another 50%. However, as I believe the odds of doing well (from the current price) on this bet over the next 5-6 years are good, I have decided to invest ~50% of a full position now vs. speculating over the next earnings release. In other words, I am not letting my long term speculation to be influenced too much by my short term speculations.
Just for those hailing from outside North America, JCPenney is a department store chain in the U.S. with ~1,000 locations. It was at one point (in the 1960s) the 2nd largest company in the U.S. by market capitalization, but has since fallen into disrepute because of mismanagement and intense competition. The following points outline why I believe this could be a good investment:
1) Downside protection from real estate value. If we take Ackman's statement that the replacement cost of the real estate is $11 bilion, then after subtracting the $3 billion of debt (not even considering the company's ~$800 million cash balance), we arrive at $8 billion for net asset value. This would work out to a little more than $36.50, or 77.5% above the current price. Using $36.50 as the floor price, of course, assumes that in a worst case scenario of bankruptcy and liquidation, we will be able to realize market value in a bankruptcy sale (which is unlikely). I have come up with something a little more conservative for my own crude calculations. Given JCP's outright ownership of 49% of its stores, this works out to ~55 million square feet of ownership. Using Sears' sale of 11 stores to General Growth in April 2012 as a precedent transaction, the price per square foot was $150 ($270mm paid for 1.8mm sq ft). Applying $150 to 55 million square feet gives us a value of $8.25 billion. Now subtract $3 billion of outstanding debt from the $8.25 billion and you get $5.25 billion ($24/share), which is still a 16.5% premium above the current price.
2) Strong insider ownership. With Pershing Square's 26% ownership stake, we have patient money backing the company's new strategic initiatives, which would have no chance of success if a quarter-by-quarter investor were to be in control. Bill Ackman (founder of Pershing) actually sought out and effectively installed Ron Johnson, who is the current CEO of JCP. Upon taking the helm, Johnson invested $50 million in warrants with 7.5 years to expiry that are not excercisable until year 6. He paid approx. $8 per warrant with a strike price (market price at the time) of $29 - thus his break-even point is $37. Hence an investor entering in today would experience ~80% capital appreciation just to get to the point where Johnson breaks even in year 6 of his investment!! This compensation structure, which no doubt gives the CEO a leveraged outcome (and leaves no room for error on the downside) is unique and present in only one other company I know of called the Howard Hughes Corporation, where Bill Ackman serves as the company's chairman. While this warrant ownership scheme is no guarantee of success and by no means protects you against management misjudgement, one thing is for certain: the CEO is more likely to think for the long term versus appeasing investors quarter-to-quarter.
3) Management's reasoning makes sense. While JCP's earnings are likely to continue hurting for the next few quarters, Johnson's new intiatives make a hell of a lot of sense. I would encourage you to read the presentation (linked to above), as it walks through what management plans to do over the next few years. In a nutshell, JCP was terribly mismanaged by previous leadership through extreme couponing (average of two sales per day at up to 60% off normal price) which led to the perception among suppliers of a lack of price integrity. As a result, most brands refused to sell their wares in JCP and this led to a cycle of decreasing price points. Johnson's strategy is to use JCP's structural advantage, being its low cost ($4 per sq. ft.) leases and direct ownership of stores, to offer incoming (and higher value) brands the opportunity to set up their own mini-stores within each location and thus acheive nationwide distribution. He labels this his "mall within a mall" concept. Secondly, Johnson has targeted $900 million of cost cuts. Considering that $1.8 billion of costs would need to be chopped in order to reach Macy's efficiency level, $900 million hardly sounds unreasonable.
I would argue that the current valuation is already pricing in a grave level of pessimism. However, giventhe fact that this turnaround will take time, I would not be surprised if the share price tanks again on August 10th when the next quarter of earnings is reported. This of course depends on how disappointing sales are. Sales were down 20% in the most recently reported quarter; if an even greater decrease is reported in August for Q2, it could be a sign that the situation is getting out of control and that JCP's previous customer base is running for the exits. In this scenario, Johnson may be pressed to sell some stores to raise cash for working capital to make ends meet until his plans work out. If however the year-over-year sales decrease is less than expected, we could in fact see the share price pop as investors decide to price in a lower level of pessism. The truth is that I don't know whether we have reached the bottom on JCP... if the next quarter is worse than expected, I wouldn't be surprised if the stock crumbles another 50%. However, as I believe the odds of doing well (from the current price) on this bet over the next 5-6 years are good, I have decided to invest ~50% of a full position now vs. speculating over the next earnings release. In other words, I am not letting my long term speculation to be influenced too much by my short term speculations.
Thursday, 17 May 2012
Negative feedback loops and financing risk
So it appears my first pick on this blog (Tigray Resources) has thus far been an utter stink bomb. Perhaps it goes to show just how important some of Mr. Buffett's concepts are, being Margin of Safety and Circle of Competence. I violated both for three reasons: 1) I have a fascination for spin-outs and thought this was a case wherein management was trying to get in on the best asset of Canaco for themselves, 2) I previously met management at a retail investor's conference and trusted them, and 3) I was lured by the prospect of quick profits.
In hindsight, this was a very expensive way to reinforce things I knew beforehand. By observing many multi-baggers in the small cap Canadian mining market over the past few years (before the bubble burst around the time of the Fukushima incident), I had lost appreciation for what an accomplishment it is for a company to achieve a 15-20% compound annual growth rate in earnings. When metal prices are climbing and the market is in a "risk on" mood, the junior resource companies seem to experience a positive feedback loop where their share prices rise, thereby triggering analyst coverage and subsequent equity issues or IPOs, followed by follow-up sell-side reports loaded with optimism. Before this loop reverses course, investors forget about financing risk (i.e. the fact that these companies are not self sufficient and are thus at the whim of markets when more money is needed).
Tigray has lost more than 80% of its value since I began investing in it. At its current price of $0.28, the stock needs to nearly quadruple in order for me to break even. Even if I had more hard earned savings to average down my cost base at new low, I cannot commit any greater a percentage to speculative stocks than I already have. So where did I go dead wrong? Well, there are two main places. First of all, I did write about how Tigray is effectively tied to the hip of the company it got spun out of (Canaco Resources). Canaco finally reported its initial resource estimate yesterday after delaying it two times, and it was about half of market expectations in terms of number of ounces and grade. Tigray's price was already beaten up before this announcement, but I assume a lot of Canaco investors "pulled the chute" on both holdings upon the news. As you may know, the Canaco management team still runs Tigray as no independent management team has been installed since its spin out in September 2011.
But the primary risk I underestimated here was the possibility of a negative feedback loop triggered by market worries about financing risk. In Tigray's case, I believe that much of the price devaluation has to do with the fact that market participants were aware that the company will need to experience some kind of share dilution in order to continue drilling. The most recently reported cash balance appeared in the slide presentation that was posted on Tigray's website in early April and at the time, there was $2 million remaining in the company's coffers. With a monthly burn rate of ~$1 million, it is possible that the cash balance is near zero. It goes without saying that an equity issue at the current price would effectively restructure the company and wipe out shareholders. For example, if $10 million were to be raised tomorrow at $0.28, this would result in the number of shares increasing by close to 80%! And equally frustrating is the fact that the $10 million raised would not even last one year. But how do I explain the drop from $0.90 just a few months ago to the current level? I think the answer is that as investors realized the company is running out of money and will need to use its stock as a currency, they began to walk out the door. As the price declined and it became more apparent to the market that management has few alternatives besides issuing equity to restore its working capital, more left as the lower price meant that when the share issue happened, it would be more dilutive to current shareholders. On so on and so on...
The only things I see that can snap Tigray out of its funk are the following: 1) A sudden surge in gold/copper prices - maybe QE3? Certainly out of any market participant's control. 2) An unexpected sale of the near-surface gold gossan delineated at the Harvest project (probably contains ~500K ounces) to Sinotech, which would have the financial means to mine this resource. This would provide Tigray with a sum, which I do not care to speculate about here, to use as working capital and continue its drilling program. Otherwise, Tigray will either have to state that it is freezing its second phase of drilling or complete a massively dilutive round of financing. If management were to step in and support another round of financing, this would be positive in a way as it would show their confidence in the project; however, my equity would still get wiped out in the process.
In hindsight, this was a very expensive way to reinforce things I knew beforehand. By observing many multi-baggers in the small cap Canadian mining market over the past few years (before the bubble burst around the time of the Fukushima incident), I had lost appreciation for what an accomplishment it is for a company to achieve a 15-20% compound annual growth rate in earnings. When metal prices are climbing and the market is in a "risk on" mood, the junior resource companies seem to experience a positive feedback loop where their share prices rise, thereby triggering analyst coverage and subsequent equity issues or IPOs, followed by follow-up sell-side reports loaded with optimism. Before this loop reverses course, investors forget about financing risk (i.e. the fact that these companies are not self sufficient and are thus at the whim of markets when more money is needed).
Tigray has lost more than 80% of its value since I began investing in it. At its current price of $0.28, the stock needs to nearly quadruple in order for me to break even. Even if I had more hard earned savings to average down my cost base at new low, I cannot commit any greater a percentage to speculative stocks than I already have. So where did I go dead wrong? Well, there are two main places. First of all, I did write about how Tigray is effectively tied to the hip of the company it got spun out of (Canaco Resources). Canaco finally reported its initial resource estimate yesterday after delaying it two times, and it was about half of market expectations in terms of number of ounces and grade. Tigray's price was already beaten up before this announcement, but I assume a lot of Canaco investors "pulled the chute" on both holdings upon the news. As you may know, the Canaco management team still runs Tigray as no independent management team has been installed since its spin out in September 2011.
But the primary risk I underestimated here was the possibility of a negative feedback loop triggered by market worries about financing risk. In Tigray's case, I believe that much of the price devaluation has to do with the fact that market participants were aware that the company will need to experience some kind of share dilution in order to continue drilling. The most recently reported cash balance appeared in the slide presentation that was posted on Tigray's website in early April and at the time, there was $2 million remaining in the company's coffers. With a monthly burn rate of ~$1 million, it is possible that the cash balance is near zero. It goes without saying that an equity issue at the current price would effectively restructure the company and wipe out shareholders. For example, if $10 million were to be raised tomorrow at $0.28, this would result in the number of shares increasing by close to 80%! And equally frustrating is the fact that the $10 million raised would not even last one year. But how do I explain the drop from $0.90 just a few months ago to the current level? I think the answer is that as investors realized the company is running out of money and will need to use its stock as a currency, they began to walk out the door. As the price declined and it became more apparent to the market that management has few alternatives besides issuing equity to restore its working capital, more left as the lower price meant that when the share issue happened, it would be more dilutive to current shareholders. On so on and so on...
The only things I see that can snap Tigray out of its funk are the following: 1) A sudden surge in gold/copper prices - maybe QE3? Certainly out of any market participant's control. 2) An unexpected sale of the near-surface gold gossan delineated at the Harvest project (probably contains ~500K ounces) to Sinotech, which would have the financial means to mine this resource. This would provide Tigray with a sum, which I do not care to speculate about here, to use as working capital and continue its drilling program. Otherwise, Tigray will either have to state that it is freezing its second phase of drilling or complete a massively dilutive round of financing. If management were to step in and support another round of financing, this would be positive in a way as it would show their confidence in the project; however, my equity would still get wiped out in the process.
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