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)

HHC: David Weinreb buys for first time in the open market

A Form 4 was filed two days ago after HHC's CEO, David Weinreb, purchased ~$1 million of stock in the open market (10,000 shares @ $99.56).  This is the first time since the spin-off in Nov. 2010 that he bought shares, notwithstanding the $15 million in 7-year warrants that he bought when first joining.

One must ask: why now after the huge price spike? I realize that it is difficult for CEO's to buy in the open market, what with the blackout periods and all. But a simple two year chart will show that the price has been far below $100 for the vast majority of HHC's life as a public company.  Has something changed fundamentally in the past few weeks that has further brightened his outlook on the company's future?

I attach great significance to insider buying on the open market; it is one of the "very, very nice to haves" on my investment checklist.  If the person who knows most about the company is buying more shares (with his disposable income) at 150% than what I got in at, I would say it is pretty good validation of my belief that there is still healthy upside in this stock.

 

The Triple Crown

As a first priority, adhere to The Magic Formula

I'm sure you have all heard about Joel Greenblatt's Magic Formula.  If you haven't, I can sum up what it achieves in a single sentence: In a given population of stocks, it brings attention to the companies with the best combination of cheapness (as measured by EV/EBIT multiple) and quality (as measured by Return on Invested Capital).   Sounds easy enough, doesn't it?  It is also based on common sense. If you are a long term investor, why wouldn't you want the best quality company for the cheapest price possible? The truth is that most professional investors would fare better if they just stuck with Joel's formula and did nothing else. Mr. Greenblatt is one of the greatest investors ever. I have never attended his classes at Columbia University, but am a big fan of his writing.  Did you know that at one point, he achieved a 40% compounded annual return over 20 years?  That is absolutely ridiculous in terms of an investment track record.  Joel was able to achieve this through (1) extreme concentration - having his capital deployed in his best 5-6 ideas at any given time, (2) using the Magic Formula, and (3) investing in special situations such as spinoffs and merger securities to take advantage of forced selling.  I believe he really is another Warren Buffet. Where Buffett stood apart from all the other great investors was his creative way of securing permanent capital.  Not only did he do this through taking control of a public textiles company called Berkshire Hathaway, he also vended insurance companies into it and benefitted from being able to invest the float at a negative cost of capital.

The Triple Crown

However, there is third prong I would add to the Magic Formula: alignment.  I have already discussed at length in previous posts about the importance of having your investments run by managers who think as owners rather than as employees, so I will not repeat those points here.  The obvious way to add this criterion to the Magic Formula would be add a column for percentage of shares owned by insiders. However, the problem I've encountered with the information providers I have experience with (Bloomberg, Thomson Reuters) is that this field often is not accurate, at least not for my purposes. So while I cannot claim that the Magic Formula should be altered from a computer screening perspective, satisfying the requirement of strong alignment serves as icing on the cake.  In fact, I find alignment to be so important that when I see the right indications, I am willing to think outside the box a little on the traditional yardsticks of valuation and quality.



So what are some indicators of alignment that close attention should be given to?

In my opinion, there are various ways that alignment can be signalled:

• >10% ownership of stock by founder, a family, and/or notable investor
• a strategic investor or management backstopping a rights offering in a spinout (e.g. Brookfield Residential, Sears Hometown and Outlet)
• insider buying (in the open market, private placement, or executive subscribed warrants)

I almost added share buy-backs as a way management can show alignment, but thought the better of it since good capital allocation is a by-product of alignment rather than a signal of it.

Example #1: Brookfield Asset Management

This investment would probably never top the Magic Formula list, but is nonetheless worth mentioning as an "anti-fragile" phenomenon that grows stronger from each global crisis. Brookfield trades less than the sum of its parts but would not show well on an EV/EBIT basis (it owns a lot of land and other investments that do not subscribe neatly to the screen).  The same applies to ROIC; Brookfield's assets are by their very nature capital intensive, though only from an initial capex perspective.  Whether it is office buildings, infrastructure, or hydro-power stations, all these assets in the portfolio benefit from scarcity (usually due to trophy locations), low maintenance capex, and smart financing in the form of non-recourse debt.  So while Brookfield owns assets that cost a fortune to build or replace, they are financed in such a way that in the worst case of a default, the sinking of a single property does not threaten the whole company as a going concern. Furthermore, inflation escalators are typically built into the contracts. For example, in its Class A office buildings, the leases have clauses which allow for pricing in tandem with inflation, thus protecting the value of its cash flows. 

I believe Brookfield will double in price within six years.  Management owns 17% of the company; this number is likely to increase as it was announced last week that stock buy-back is in play to repurchase up to 10% of outstanding shares in the open market.

Example #2: Brookfield Residential Properties

When I purchased shares in the summer of 2011 at an average of $7.50, this had the makings of a Triple Crown investment. From a valuation standpoint, it provided multiple margins of safety: (1) it traded at a 25% discount to book value, which had already been significantly written down during the recession, (2) I estimated $1 per share of earnings power from just the Canadian portion of operations, so in other words I bought the Canadian half of the business at 7.5x normalized earnings and received the U.S. half for free!  With U.S. housing at the very bottom at the time, profitability from a consolidated perspective was somewhat hidden because the Canadian half was being offset by the loss generating U.S. part.  Homebuilding isn't a bad business; it is however inescapably cyclical.  I was willing to forgo the requirement of a virtuous, in-the-box good company in this case.  After all, how many homebuilders were still cash flow positive and financially strong at the very bottom of the U.S. housing market?  Brookfield Residential stood out in this respect because its Canadian portion (mostly in Alberta) was strongly benefitting from a thriving regional economy, which allowed for deficits from its mostly Californian operations (California by the way was one of the hardest hit regions in the U.S. housing crash) in the U.S. to be carried until the housing market naturally recovered.

Last, and most important, were the signals of alignment during the spin-off process.  The parent company, Brookfield Asset Management (written about in Example #1 above) designed the spin-off thusly: (1) a partial spinoff, (2) via a rights offering, with (3) a backstop provision which allowed the parent company to exercise the remaining rights not acted on by other shareholders.

As per Greenblatt, your interest should always be strongly piqued when this sort of spinoff happens. I will add the personal note that this is because management will set a strike price on the rights which undervalues the company, thereby giving themselves an absolute bargain should shareholders overlook the opportunity.  In fact, in the prospectus, assumptions used in the fairness opinion were disclosed, which included a 20% discount rate used in the DCF!  Talk about conservative!  In this case, the exercise price was $10 per share, which was still a steal.  I didn't buy the rights on the market during the 30 days they traded because the underlying share price was around $10 (meaning I could have just bought the shares on the open market).  I was lucky that the Greek crisis a few months later caused the price to dip as low as $6.50, where I filled half my position. 

Even though the parent company owned ~72% of Brookfield Residential post the spinoff, it proceeded to buy more shares in the open market during the summer of 2011 between $6.50 and $8.00 (if my memory serves me correctly - you can verify via the 13D filings on the SEC website) and thus brought its ownership up another ~1% to about 73%.  What a mouth-watering, incredible opportunity this was: a U.S. housing related investment that was still generating profits at the very depths of the U.S. housing market, trading at an obvious bargain price, and bought by insiders (in this case the parent company) in multiple ways!  If it weren't for the Howard Hughes opportunity, I would've taken a much bigger swing on this one!

I recently sold 1/3 of my position at $24 to recover my initial cost.  I know that I'll end up regretting it because significant upside still exists.  However, I believe the U.S. housing recovery is in its 2nd inning, while U.S. homebuilder stock prices have raced ahead to the 5th inning.  Where I stand to be very incorrect is in the ultimate span of the recovery: as we have just witnessed the biggest bust in U.S. housing history, it may turn out to be the case that the recovery lasts for longer than anyone expects given the pent-up demand that has been built up in the system (in the form of 35 year olds living with their parents).

Disclosure: the author owns HHC, BRP, but not BAM



 

HHC: Estimating Overhang Removal and Mid-Term Upside

As commented earlier, Brookfield (BAM) has been selling its HHC stock since late 2012.  This was trackable via the 13D filings(for insider trading), which BAM was required to submit until March 1st.  As of that date, however, we have no way of knowing exactly when BAM has completely exited its position unless the company makes a public comment.  Why is this important? Because Brookfield's steady selling is likely causing a supply/demand imbalance that once removed could result in share price appreciation.

Admittedly, what follows is all speculation. BAM no longer needs to update us via 13D filings because it has reduced its position below 5% as at March 1st.  If BAM's share of dailing trading increased to 44%, it is possible that the overhang has disappeared as of last Friday's closing.  It is also possible that BAM was out of their position as early as March 6, as volume was unusually high that day (1.95 mm shares traded hands).  Further supporting the possibility that BAM has since completely exited its position is the fact that HHC's shares are up 8.2% since March 1st versus 0.1% for the Dow Jones.

However, if I assume that Brookfield's share of daily volume has stayed at 33% since March 1st, this would mean that they currently have ~460,000 shares remaining on their books (i.e. 4.2mm shares traded since then has allowed BAM to sell 1.4mm).  Extrapolating further, I can estimate that BAM's selling can be completed within 5 more trading days (BAM can sell ~100,000 shares per day based on average of ~304,000 average between March 4-22).

So what is the upside?  HHC trades at less than 1.5x book value vs. 2.2x for a few of its home-building related peers (LEN, BRP, DHI).  Should HHC trade up to 2.2x BV, this would result in 55% appreciation to $129.

Disclosure: I am biased - I own lots of HHC still!

 

Ackman spotted in Tokyo; Brookfield overhang may already be gone

Ackman was spotted in downtown Tokyo today with an entourage of four people.  What could he have been up to?  Rounding up more investors?  Or could Ackman have already have invested in his first Japanese activist effort?  As far as inefficiencies in overhead spending go, Japan should be ripe for an activist to go in and tear things apart. However, from what I've heard, there are good reasons why activists aren't too prevalent in Japan, one being that layoffs aren't an accepted practice.

On another note, it is possible that Brookfield has finished selling out of its HHC position.  This would explain the recent jump in share price.  If Brookfield in fact has shares remaining, it sure will be interesting to see what happens when overhang from BAM's selling finally lifts. 

HHC's Weinreb Presents at Harbor Conference; Brookfield Continues Selling

David Weinreb (CEO) presented in public for the first time (that I'm aware of) on HHC.  It was a great presentation - I highly recommend anyone interested in the company to listen to the replay, which can be accessed at www.howardhughes.com   I will give my two-cents once I have had the opportunity to relisten to it a few times.

Brookfield (BAM) filed a 13D (for insider selling).  It appears they sold ~410,000 between Jan. 25 and Feb. 11, representing approximately 33% of total volume.  If my information is correct that they had ~2.7 million shares remaining as at Feb. 11, my rough math shows that it would take another 13 weeks or so for BAM to completely sell off their position at the current rate.  So despite the big move today as a result of Weinreb's speech, I believe the stock will be somewhat "freed up" sometime in May when the selling pressure from BAM eases away.   My deep respect for the brains in Brookfield was one of my motivators for buying into HHC, so it's a shame to see them go.   But my conviction that HHC is still a multi-bagger from here has been solidified and won't go away anytime soon.

West Windsor

It appears I may have overreacted (article).  HHC expressed interest in doing a mixed used development, but for now just wanted to meet town residents and basically introduce themselves.  I think their approach is sensible: get a feel for want people want or don't want instead of asserting your plans.  The presentation contained no renderings of what the property could look like.

I could be wrong... it is actually quite likely that John DeWolf already knows exactly what he wants out of the acreage and is going through the motions of being stakeholder friendly. Either way, it is a win-win for everyone.  The property is an eye sore and I'm sure anything HHC does will be an improvement. 

An interesting snippet is that Wyeth sold the 658 acres to Rouse Corporation (which was acquired by GGP and subsequently some properties spun out into HHC) in 2004 for $35 million; that works out to ~$53,000 per acre.  In the original spinout prospectus from 2010, West Windsor's net book value is listed at $20.5 million (~$31,000 per acre), implying that a big write-down was taken on this property.   Now, a sceptic would say that land can be worthless.  But again, I'd be willing to bet that when the 60 buildings are cleared and ready for development, each of those acres will have a market value in excess of 10x what Rouse paid for them in 2004.  

Let's assume the land on which my house resides is worth $175,000.  Assuming my lot is around 1/7 of an acre, this would imply that the market value of an acre in my district (which by the way is very middle class) is ~$1.2 million which equates to 22x what Rouse paid and 39x the net book value per acre on the balance sheet.

HHC is an investment that necessarily requires patience.  I made the mistake of taking a 30% gain on some of my stock in 2011 and reinvesting the winnings in low quality companies that tanked thereafter.  At 1.2x book value (and an extremely understated one at that), I still think that a new investor stands to do well in this name. 

Weinreb presenting at Harbor Investment Conference: On Feb. 13th, Dave Weinreb (CEO) will be giving a presentation.  Hopefully this will be available afterward via webcast.   Other than his shareholder letters and comments in press releases, he has remained pretty much a mystery. I realize this is his first gig as a public company CEO and look forward to seeing him open up a bit more.  But... of course there is no hurry.