Friday, March 29, 2019

Howard Hughes: Updated Thoughts 2019 Version

It's been about three years since my last post on Howard Hughes Corporation (HHC) and I wanted to updated my mini-model and walk through some updated thoughts on their progress.

Howard Hughes is a real estate development company that was originally spunout of GGP during its restructuring to hold the master planned communities and non-core assets of GGP.  Since the spin, close to 9 years ago now, HHC has focused its efforts on five key markets: Houston, Las Vegas, Honolulu, Columbia MD, and the Seaport District in New York City.  Their story is pretty well known by now in the investment community but HHC shares still provide a compelling long term value for a few primary reasons:
  1. Howard Hughes is a real estate company that is not a REIT and does not pay a dividend, also because of its mixed portfolio, doesn't screen well or fit into any easy to value bucket.  Additionally, much of its value is in land and large assets that aren't currently producing any cash flow (for example, the Seaport).  A counter to this, many REIT funds are including non-REIT real estate companies, for example, Vanguard's switched its mandate from a REIT fund to a real estate fund and included HHC in the process.
  2. Much has been written about the lack of new home construction since the financial crisis, one day this will normalize and HHC will be well positioned, their master planned community ("MPC") assets are highly sought after, providing the raw material homebuilders need and because of their maturity (hundreds of millions have been spent previously on infrastructure), feature high cash margins.  HHC uses these cash flows to self fund commercial construction (office, multi-family, retail) in these MPCs that HHC holds for investment.
  3. NOI (and thus NAV) should continue to grow at a fast clip without needing to raise any equity capital, additionally the company has further growth levers it can pull via several under appreciated assets outside of their core markets that could have significant value.
The easiest way to value the company is to run an net present value calculation on the land sales in the MPCs and the condo sales in Honolulu and add it to a NAV of the current operating properties and strategic developments minus any remaining construction costs and debt.

Master Planned Communities
The company publishes an undiscounted and unappreciated value of their land holdings in their 10-K, this is simply the average recent selling price of their land multiplied by the remaining acres, it doesn't account for the time value of money or any future appreciation in pricing as the remaining acreage should get more valuable over time as Howard Hughes builds out the amenities.  I took those numbers and simple ran an NPV using a 10% discount rate assuming a straight line selling pace until the sell out date with no price appreciation built into it.  Note: I just used book value for The Summit, which is an ultra-luxury community in Summerlin that's being developed with a JV partner, it's been a big success and likely worth more than book.
In 2018, the MPC assets generated EBIT of ~$200MM, this roughly equates to a 10-11x EBIT multiple for the land business if you value it at $2.3B, which seems reasonable to me.  Using roughly the same framework for the condo development business in Honolulu, ~$1300 square foot average selling price and costs of $1100/square foot and running an NPV using a 10% discount rate until the 2028 sell out date equates to about $833MM in remaining value.  This doesn't account for the retail transformation that will happen over that time, just the condos, which the company has mentioned they'll be increasing their pace of tower construction as they have found a niche in smaller pre-furnished units in Oahu's highly supply constrained market.

The company also provides a lot of detailed disclosure on their operating property and strategic developments segments making an NAV calculation fairly straight forward.  Below, sorry its small, but I've taken each property, assigned a cap rate and deducted any property level mortgages or remaining construction costs on the unstabilized properties.

Office Properties
HHC's office portfolio was heavily weighted towards Houston 2-3 years ago, they clearly made a mistake in overbuilding ahead of the oil rout in 2015 and several of the office assets in Houston remain unstabilized years later.  However, since then they've been focusing office construction on Columbia, MD and in Las Vegas, most of these properties are new in the last three years.  Another asset that didn't get much attention until recently is 110 N Wacker, it was a four or five story building that covered an entire city block along the Chicago river, it was previously the headquarters of GGP and was recently demolished.  HHC along with JV partners (HHC owns 33% now, mostly just contributing their land) have commenced construction with a projected finish date in the back half of 2020.
110 N Wacker - 3/29/19
Bank of America will be the anchor tenant, leasing activity was brisk enough that two additional stories were added to the building to meet demand.  It's a prime location on the river and near transportation, despite the building boom in the Loop, I can't imagine them having difficulty fully leasing the building upon completion.  At that point, I'd expect them to sell their stake as it is non-core in that they don't control any properties or land around it, but anyway it's an asset that was an after thought in NAV models until recently, HHC has a couple others that could be even more significant that I'll touch on later.

Retail Properties
The biggest piece to the retail portfolio is the Seaport District located on the East River in Lower Manhattan, it was a tired yet popular tourist attraction until Superstorm Sandy destroyed it in 2012.  Since then, Howard Hughes has been working on redeveloping the area, it has taken longer than originally expected and gone through a few strategic changes (notably switched from a "regular mall" to more of an experiential shopping experience).  I don't like commenting too much on the Seaport's value as I'm not a New Yorker like many in the investment community who might have stronger opinions on the asset, but I mentioned in my year end post that a similar property in Chelsea Market was sold for over $2.4B.  Chelsea Market is roughly twice the square footage as the Seaport, giving rough credit to the $1.25B value I'm putting on the Seaport before the remaining construction costs.  HHC also bought a parking lot for $180MM near the Seaport that it plans to redevelop, likely into multi-family, as the Seaport stabilizes and increases demand around the neighborhood.

Multi-Family, Hotel, Other
They've heavily invested in multi-family properties in recent years, mostly successfully, less successfully on the hotel properties which are located in the Woodlands and were built right before the oil rout, similar to their office portfolio there, these properties have taken longer than anticipated to stabilize.
These are the random other assets that Howard Hughes owns including the new AAA ballpark they built in Summerlin, a ground lease beneath the Vegas Golden Knights practice facility and the marina in Honolulu.

Two of these other assets that I think are interesting and carried at little value on the balance sheet but could be significant drivers of NAV growth over the next 2-5 years are the Fashion Show air rights and Monarch City.
Fashion Show Mall - Las Vegas
HHC owns 80% of the air rights above the Fashion Show mall on the Las Vegas strip across the street from the Wynn and adjacent to Trump Tower on one side and TI on the other side.  Back in 2017, there were rumors that the company was reaching out to design and construction firms for a potential casino resort development, but nothing more has really come of it and Las Vegas is in a mini-slowdown right now.  The mall was owned by GGP, but Brookfield bought GGP last year and likely makes a more natural development partner for the project as Brookfield's stated strategy is to redevelop many of the acquired malls into mixed use properties. It may be another few years before anything happens here, but it's another potential driver of NAV that isn't included in my model or any that I've seen put out by analysts.

Promotional Deck for Monarch City
Another under followed asset that HHC owns is 280 acres of land in Allen, TX on the corner of two highways that was recently renamed Monarch City and has plans for over 9 million square feet of mixed use development.  To put that scale in perspective, HHC has 14 million square feet of entitlements (only a small fraction of which are currently built) in Downtown Columbia, but Monarch City is still large enough be a significant asset and potentially a 6th core market for HHC.  Allen is an attractive market, it is a suburb north of Dallas and right in the heart of a big housing development corridor, fellow long time holding of mine Green Brick Partners (GRBK) is active in the area with several ongoing communities being built within a short drive of Monarch City.  The Dallas metro area is very popular with corporate relocations given its low taxes, Howard Hughes is likely waiting for a big relocation opportunity to anchor the development before breaking ground or publicizing the asset further, if they're able to sign one, Monarch City is large enough to be a nice call option that's not currently factored into the stock price.

Adding it all up, I get a reasonably conservative "today" price of HHC around $140 per share.
Other Thoughts:
  • HHC likes to point to their control of the markets they operate in and the reinvestment opportunities available to them within those tightly controlled locales.  It potentially limits the risk of oversupplying a market (although they did that to themselves in Houston), plus it gives them an advantage when non-HHC owned assets come up for sale.  They've recently purchased underperforming properties in The Woodlands and Columbia that they didn't previously own and have added them to their redevelopment pipeline, creates some synergies and continunity.
  • Three years ago I got some feedback that Ward Village was unsustainable because of Chinese buyers, similar to the impacts Vancouver has seen, but HHC discloses the types of buyers in Ward Village and Chinese make up a low single digit percent, essentially a non-factor, most of the buyers are locals, Japanese and mainland second homes as you'd expect for that market.
  • Mentioned this previously, but one thing I do like about Bill Ackman recruited senior management is he insists on skin in the game, with HHC, CEO David Weinreb put up $50MM out of his own pocket (one could argue he's rolling his previous warrant payday over, but I think the message is still the same) to buy a warrant package with a strike price at $124.64 expiring on 6/15/22.  There's still plenty of time, but the stock price hasn't moved much despite all the activity over the last five years, I think management will do whatever they can to close the gap between the share price and their perceived NAV (which is much higher than mine) over the next 4 years.  The CFO and COO are under similar incentive packages, but they put up significantly less money, $2MM and $1MM respectively.
  • HHC has started publishing an AFFO metric, it was $5.41 for 2018, for approximately a 20x multiple which given the NOI growth path over the next 5-10 years seems cheap compared to many popular REITs.
  • A similar company that I follow (but don't own) is Five Point Holdings (FPH), it's a developer of three master planned communities in California.  It was created out of a partnership with Lennar (LEN) and is much earlier in its life cycle than HHC, but it has a similar plan to develop/sell lots to homebuilders and then build commercial development for investment once demand occurs.  FPH is a broken IPO, trading about half its IPO price from a year or two ago, if anyone has thoughts on them I'd be grateful and interested to hear.
Disclosure: I own shares of HHC

OncoMed Pharmaceuticals: Merger Arb + CVRs

OncoMed Pharmaceuticals (OMED) is the latest entry in my occasional series on busted biotechs, as the name suggests OncoMed is a development stage company focused on cancer related therapies, it hit a series of setbacks in 2018.  It's now a micro-cap, just $40MM in market cap with $57.3MM in cash as of 12/31 (minus a significant burn rate) and few apparent prospects.  In December, OncoMed announced a merger with U.K. based Mereo BioPharam Group (MPH), the deal is effectively structured as a reverse merger/cash infusion for Mereo resulting in the new combined company being dual listed in the U.S. and U.K thus opening up more channels for inevitable future capital raises.  Mereo is focused on rare diseases, it has an interesting history of acquiring the "dogs and cats" of larger pharmaceutical companies that have received significant previous investment but for some reason or another are no longer strategic priorities.  Mereo is technically public and trades on the smaller AIM exchange, but liquidity is extremely limited with just a few trades occurring over the past couple months.

Mereo is going to create 23.7 million new MPH shares and through a depositary create Mereo ADRs that will trade in the U.S. to issue to OncoMed shareholders.  The exchange ratio is subject to adjustment based on an expected OncoMed cash balance of $38MM at the time of the closing (guided to Q2), it can be adjusted both ways if the cash comes in above or below that line.  At year end, cash was $57.3MM versus $70.9MM at 9/30, indicating about a $13.5MM quarterly burn rate putting that $38MM cash goal in jeopardy unless serious cost cutting as happened since the deal was announced.  But using the 23.7 million shares number, current market prices (again, MPH barely trades, but is quoted at 160 pence) and current GBP:USD exchange rates equates to ~$50MM in stock consideration versus a market cap of $40MM for OncoMed.

OncoMed has two therapeutic candidates currently in their pipeline, each is getting its own non-transferable CVR in the transaction:
Celgene is OncoMed's historical development partner, however, they have declined to exercise several license agreements on OncoMed assets in the last 18 months, TIGIT is the last of those options and based on recent events seems unlikely to get exercised.  NAVI doesn't have a commercialization partner (Celgene already turned it down), finding a new partner is step one before the CVR payment can be contemplated, in even the most optimistic scenario, receiving any payments is a long ways off.

Additionally, earlier this month, OncoMed added a 3rd(!) CVR which seems a bit silly for a tiny micro-cap merger.  However, it might signal that OncoMed is more optimistic that Celgene will opt-in to the TIGIT program than the market believes (okay, I'm probably stretching there), this new CVR will cover any additional payments received (other than the $35MM opt-in payment which would still be paid in MPH shares) from Celgene, so it only becomes a live bet after the opt-in occurs sometime in 2019 and diverts cash from NewCo to OMED shareholders.  This CVR wasn't contemplated at the time of the merger, its likely a result of shareholder feedback and an effort to gain additional support for the merger.

In summary, you have a potential ~25% upside from the arb spread closing (again, using stale/illiquid MPH market cap, I'm not underwriting to that number as it could drop significantly once there is liquidity but I've also had success from these reverse mergers going up after the deal closes) and the possibility of Celgene exercising their option on TIGIT which would add another ~90% return from the CVR before year end.  This is obviously very speculative,  I've sized my position small accordingly.

Disclosure: I own shares of OMED

Friday, January 18, 2019

KAR Auction Services: Insurance Auto Auctions Spin

KAR Auction Services (KAR) will soon be spinning off their salvage car auctions business, Insurance Auto Auctions (IAA), leaving the wholesale used car auction business and their floorplan financing unit at KAR.  It's not entirely clear to me why this spin needs to happen, but the market is valuing the sum of the parts at a significant enough discount to each's standalone peer to make it an interesting spinoff to follow and see where the two pieces end up trading.

KAR Auction Services (RemainCo)
ADESA ("Automotive Dealer Exchange Services of America") is the second largest provider of used car auctions in North America, with about 28%-30% of the market, behind industry leader Manheim, a subsidiary of privately held Cox Enterprises, that commands 42% market share.  ADESA's auction sites link large volume car sellers (off-lease, rentals, repossessions, excess dealer inventory) with used car dealerships utilizing a consignment model where the company doesn't take ownership of the vehicles, but charges buyer/seller fees, transportation fees, and other fees that help prepare a car for sale (paint, small dent repair, detailing, etc.).  Each car sold through ADESA represents about $600 in revenue.  This is a reasonably good business, there are significant barriers to entry (for one it would be difficult to replicate their auction site footprint), low capital expenditures and limited working capital requirements, but it does feature some cyclicality to it via the supply and price of used cars.

There are two big sources of used vehicles for ADESA: 1) cars going off-lease, as leasing has become a more popular option in recent years (although leveling off now) it provides ADESA with a strong tailwind as lessees turn their cars into the lessor, who then sells through an auction provider to used car dealers; 2) repossessions, on one call management described themselves as "Repo Kings" since KAR has an active repo business inside of ADESA, auto lenders are not natural sellers of cars on their own, so they sell to used car dealers through an auction provider.  More people financing cars at greater and greater loan balances translates into more cars falling into default and repossession.
AFC ("Automotive Finance Corporation") is the second piece of RemainCo, AFC provides "floorplan financing" to independent used car dealers to help facilitate sales at ADESA.  Floorplan financing is a short term loan secured by the car that's paid back once the car is sold by the dealer.  Because the loans are short term (65 days on average), 50% of the revenue ends up fee based generating mid-teens ROE and adding to the attractiveness of the business.  Additionally, there are tens of thousands of independent dealers making this a difficult business to replicate at a nationwide scale and AFC's securitization financing provides a cheap competitive funding source.

In 2017, KAR purchased the remaining 50% in TradeRev that it didn't already own, TradeRev is a dealer-to-dealer mobile app that facilitates real time auctions between dealers versus a traditional auction platform where the dealers are typically only on the buyer side.  With the spin dividend cash from IAA, KAR will continue to invest heavily in TradeRev as they're in the midst of a nationwide dealer by dealer roll-out of the platform.  Additionally, KAR has international ambitions and recently bought an online auction platform that serves much of Europe with stated desires to continue to pursue international acquisitions.

Insurance Auto Auctions ("IAA Spinco" in the Form 10 or just "IAA")
IAA will be a standalone salvage auction business, when a car is totaled in an accident or has aged out of useability (think car donation charities) the car will be sold at a salvage auction for parts or scrap.  Salvage auctions are similar to whole used car auctions in its transaction based ($500/car revenue, slightly lower due to fewer add-on services) where IAA doesn't take ownership of the car, however it's a more predictable business as cars will always need to be salvaged regardless of the economic cycle.
IAA in their Form 10 forecast the salvage vehicle auction industry will grow at 5%-to-7% annually for the foreseeable future driven by 3 main tailwinds:
  1. Growing automotive car parc -- Industry speak for the total number of cars on the road, now just under 300 million, the average age of vehicles continues to rise, older cars getting into an accident are more likely to be a total loss.
  2. Increasing vehicle complexity leading to higher total loss frequency -- there are more electronic components and repair labor costs are rising making car repair more expensive, if the repair costs are more than the car is worth, it of course results in a total loss.
  3. Increasing accident frequency --  here they cite more cars on the road and more distracted driving (texting and driving, etc.).
The stated reason to spinoff IAA is to create a standalone company that compares directly with their competitor Copart (CPRT).  Copart maintains a similar ~40% salvage market share but has superior margins partially due to owning the real estate beneath their auction sites (IAA leases their sites), the rest of the margin difference is hard to parse out and might be an opportunity for improvement post-spin.  IAA has been managed separately from KAR (different auctions sites, different customer bases, separate headquarters) and the soon to be CEO, John Kett, has been running IAA since 2014, eliminating some of the risk of IAA stumbling out of the gate that we often see with spinoffs.

Valuation
New KAR Auction Services doesn't have a direct North American public competitor since Manheim is privately owned by Cox Enterprises, but it does have a peer in the leading wholesale auction provider in the UK, BCA Marketplace PLC (BCA.LN).  The combined KAR has $2.74B worth of debt and $345MM of cash, KAR is going to raise $1.3B of debt (not finalized) at IAA, sending $1.25B back to new KAR after gifting IAA with $50MM in cash, leaving new KAR with $1.145B in net debt.

Copart (CPRT) trades for 15.5x EBITDA, but its better run and has minimal debt so it should trade at a significant premium to IAA.  For the sum-of-the-parts, I'm going to use 10.5x for new KAR (1x discount to BCA) and 12x for IAA (2.5x turn discount to CPRT):
Adding to the two pieces together, I get a price of $60, not a ton higher than today's $52 share price.  Despite that I added a smallish position going into the spinoff, IAA in particular interests me as an interesting long-term spinoff:
  1. IAA doesn't have to make a significant change to its business model to succeed, instead there is both a discounted valuation and a margin gap, if both of these close it could be a home run; 
  2. Deleveraging, as mentioned, since IAA doesn't have to do anything transformational or reinvent the business, and its growing at a healthy clip, they'll have plenty of FCF to deleverage and/or return cash to shareholders via buybacks or dividends; 
  3. Management has been running this company as a separate unit, we should see some animal spirits unlocked now that their comp will be directly tied to the success or failure of IAA and the operating performance gap between IAA and CPRT will be on full display.
I'm not worried about autonomous cars eliminating all accidents and thus total losses, or Americans giving up their cars entirely for ride sharing services, both of these risks seem far off into the future and may only capture a small niche in the end.  I do worry that this thesis is too easy, KAR provides extensive and transparent segment reporting, investors should be able to see through the sum of the parts here?  And I prefer when spinoffs have different shareholder bases, that's not the case here, but the business model interests me and given that the combined company trades below where both pure play peers trade, I think there's some margin of safety going into the spin, its worth keeping on your watch-list.

Disclosure: I own shares of KAR

Wednesday, January 16, 2019

Spirit MTA REIT: ShopKo Files Chapter 11, Plan Accelerated

SMTA's primary tenant, ShopKo Stores, filed for bankruptcy protection today and thus the reason for SMTA's existence is coming to an end.  As a reminder, Spirit Capital Realty (SRC) spunoff their Shopko assets alongside their asset-backed securitization vehicle ("Master Trust A" or "Master Trust 2014") as SMTA in order to clean up the portfolio at SRC and make it comparable to peers in the triple-net lease space.  SMTA's stated mission was to workout the ShopKo assets and other non-core properties and use the proceeds to fund more Master Trust notes.

Back in November, SMTA entered into a $165MM non-resource mortgage collateralized by the Shopko assets to put a floor under the valuation.  That looks incredibly smart in hindsight as they mentioned in their press release today that they are "working with the lender under the non-recourse mortgage loan, including potentially to satisfy the loan by relinquishing to the lender the ShopKo Stores securing the loan."  They're going to mail back the keys, and for the most part sit out the bankruptcy process (other than their $35MM term loan B to ShopKo, likely worthless but was instrumental in getting timely financial statements and might have triggered the mortgage financing transaction), they'll be rid of their ShopKo exposure in short order.  As a result the company announced a process to explore strategic alternatives, so what's left?  In my year-end post, I laid out an NAV of around $13 a share, that appears to be close with what the company disclosed in their presentation accompanying today's announcement:
At the time of the Master Trust refinancing (end of 2017), the collateral value of the Master Trust assets was $2.596B, using the contractual rent number above, that's about a 6.8% cap rate, seems reasonable in today's environment, add in the restricted cash inside the securitization and the mortgage loans but leaving out the vacant properties nets us $690MM in equity value within the Master Trust.  Let's exclude the Academy distribution center, workout/vacant assets, and the ShopKo term loan, but obviously include the cash, gets us to $792MM of asset value, subtracting out the termination payment to SRC and preferred to SRC gets an NAV of $13.70 per share.  This number is highly sensitive to the cap rate used to value the Master Trust, at a 7.5% cap rate the NAV under the same methodology would drop below $9 per share.

Who will buy SMTA?  I think there's a wide range of buyers for the Master Trust (typical equity buyers in structured products: insurance companies, hedge funds, etc.), but there is a new public REIT that's run by former SRC executives and pursues a similar ABS funding strategy, Essential Properties Realty Trust (EPRT) that would make sense as a buyer.

I increased my position a bit first thing this morning, but still keeping it fairly small due to the leverage, plus SRC will be a beneficiary of any strategic transaction as it will further simplify SRC making clearly apparent its undervaluation compared to peers like O and NNN.

Disclosure: I own shares of SMTA, SRC