Monthly Archives: January 2012

Rouse Properties (RSE)

General Growth Properties (GGP) is a real estate investment trust with a 15B market cap that emerged from bankruptcy at the end of 2010 and has Bill Ackman/Pershing Square as an influential investor. Directly coming out of bankrupcy the company spun off Howard Hughes Corporation (HHC). The idea was that GGP contains the developed cash flow producing malls in a REIT structure, while HHC contains undeveloped assets and other types of real estate such as master planned communities.

HHC has Bill Ackman as chairman, has a lot of insider ownership and the new CEO bought $15M of warrants when he joined the company. T2 values the company in this presentation between $77 and $141/share while the current price is $52. Maybe I’m going to do another write-up on HHC in the future, it’s also interesting, but the focus of this post is going to be on Rouse Properties. It’s a more recent spin off from GGP (spin off date was 12 January 2012). RSE is going to be an REIT and it contains 30 Class B malls located all over the USA. The B-malls have worse metrics such as tenant sales per square foot and occupancy rates than the other properties inside GGP, resulting in potentially improved public market valuation metrics for GGP post spin-off. A company presentation about the Rouse Properties spin-off can be found here.

Share holders of GGP have received just 0.0375 shares of RSE for every GGP share, creating a classic spin-off situation were existing holders might decide to dump the new insignificant position. And there is some indication that that might be the case. The company is currently trading at roughly $12/share while it has planned a rights offering at $15/share to raise 200M in capital to redevelop and refresh properties. The rights offering will be back stopped by Brookfield Asset Management, a big asset management company that owns a 37.2% of GGP and as a result an equally big part of RSE. Brookfield has a lot of experience in real estate and would presumably not agree to backstop a $200M rights offering for just a $6M fee if it didn’t think the company wouldn’t be worth $15/share. Rights offerings are usually done at a discount to fair value to create an incentive to participate.

Valuation

Valuing real estate is not exactly my core competency (that’s arguably true for most things on this blog by the way!), but the easiest way to value real estate is by looking at the cap rate: the expected yield a property will generate after subtracting operating costs and assuming it would be bought without leverage. If a fair yield for some property  for example would be 10%, and the property would be generating 100.000 of income a year the value of the property would be 1 million. The previously linked company presentation contains indicative equity values based on the 2010 financials and cap rates between 7.5 and 8.5 percent.

I created a quick excel sheet that gives us a equity value based on the most recent “Core NOI” (approx. 150M this year, down from 160M last year), various cap rates, subtracting the debt and adding back the cash that’s going to be raised.If we would assume that the range of cap rates that the company is using is reasonable it would imply that the equity is worth between $17 and 21$ per share: significantly more than the current $12 share price. Problem is that the company has a lot of debt and the valuation is quite sensitive to changes in cap rate or core net operating income (Core  NOI). A cap rate around 8 percent seems pretty reasonable. GGP itself is currently trading for a bit less than 7 percent, but it also has higher quality properties so it deserves to trade at a lower cap rate.

Another valuation check is to look at the book value of the real estate. The Form 10 filled before the spin-off contains the following table with balance sheet data:If we would take the investments in real estate at cost value/total assets as valuation, add the $200M in cash that is going to be raised and divide by the number of shares out standing post rights issue we get a share price of $13.3. Not as high as the valuation based on cap rate, but still above the current market price.

Conclusion

Although RSE seems at the moment under valued, part of the under valuation is also the leverage at work. If we would assume an 8% cap rate the total real estate value is 1875M while the market is currently valuing it at 1560M: a discount of 17%. Because of the leverage this translates to a 43% discount in the share price, but the fundamental margin of safety is the underlying 17% discount.

The value of real estate is less volatile than that of other asset classes and therefore having a relative high amount of leverage is not that problematic. A 65% LTV ratio is very common in commercial real estate, and buying real estate post the 2008 financial crisis in the USA doesn’t sound that bad. But before making any decision to buy or not I’m going to take a look at some other real estate companies, and figure out if there are better alternatives and if the leverage is acceptable to me or not. What do you think?

Disclosure

None, but might initiate a position.

Integrated Asset Management (IAM.TO)

Integrated Asset Management (IAM.TO) is a company that resembles Argo Group in many ways. It’s also a small asset management company, it is a net-net with more cash and cash equivalents than it’s market cap, it is profitable and paying a big dividend (current yield is 8.5%). Some key statistics from Yahoo Finance:

Last Price: CA$0.59
Shares outstanding: 28.31M
Market Cap: 16.70M
Trailing P/E (ttm): 3.27
Price/Book (mrq): 0.86

IAM.TO focuses on alternative investments such as real estate, managed futures and private equity, and services both institutional investors and retail investors. Two weeks ago the company announced that a major client (good for 8% of revenue and 15% of AUM) would terminate his account, so we do have to keep this in mind when looking at the financials. The latest annual report is easily readable and contains graphs with financial data for the past 10 years for key statistics such as AUM, revenues, EPS, cash flow and dividends. Wish this would be standard!

Valuation

The company last reported for the period ending 30 September 2011, and at that date it had no debt, 8.2M in cash and 11.7M in investments in funds managed by the company versus a market cap of 16.7M. It would not be totally fair to value the company based on it’s current assets plus the value of the business itself, since a decent amount of money is used in business activities such as providing seed capital for new funds. The company could probably return most of this cash to share holders, but it would hurt the business to some degree. But when the market values the business at a negative number it’s not that important to be very precise (EV is minus 3M).

Average EPS over the past 10 years have been 0.042 (latest year: 0.15) and average cash flow per share has been 0.128 (latest year 0.14). If you would throw an 8.5x no growth multiplier on those averages you would get a per share business value between 0.357 and 1.088. Add the cash and equivalents (0.70/share) and we get a target share price between 1.06 and 1.79 while the current share price is just 0.59. One reason for the big difference between EPS and cash flow is that the company wrote down a significant amount of goodwill in 2009 related to the acquisition of BluMont Capital (the retail alternative investments business of Integrated Asset Management).

These numbers are a very rough estimation of value, but the low end of the valuation is probably on the pessimistic side. AUM have grown significantly the past 10 years and are - after accounting for the loss of the big client - still higher than the 10 year average. The company also has large unrealized performance fees and tax assets related to the BluMont Capital acquisition. On the other hand: assets management companies might be facing increased pressure to reduce fees, undermining profitability as this column at Bloomberg from Alice Schroeder argues.

Insiders

The majority of the company is owned by insiders. Employees control more than 60% of the outstanding shares, with the CEO controlling 38.3% (most shares are held in a corporation that also has the CFO and a director as share holders). The CIO of the company owns another 17.2%. I would prefer insiders to own a little bit less, but having insiders own too much is better than them owning too little. In the previous year there has been a little bit of insider buying, but nothing significant. The number of common shares outstanding has remained almost constant the past years, but there are 2.57M options outstanding with strikes between 0.70 and CA$1.50.

Conclusion

Mr. Market seems to be very negative towards asset management companies and financial companies in general, and while there are some good reasons to not be overly optimistic (or even neutral) it also seems overly pessimistic to value a company with a long history of profitability below the market value of the cash and securities it owns. It should at least be worth something!

I have been discussing, and buying a decent amount financial companies in the past months and that is potentially becoming a bit problematic. Having a portfolio that is highly concentrated and correlated is asking for trouble. My position in ARGO.L is on the small side though since it hard to buy due to the limited liquidity, so I do have some room to add IAM.TO to the portfolio as well. In general I try to scale my position size in relation to the ranking I give the stock, but portfolio diversification is more important to me so I will keep the combined position size of ARGO.L and IAM.TO in check.

On a scale from 1 to 10 I give the stock a 8.5: the company has a strong balance sheet, is profitable, has a lot of insider ownership and a high dividend yield. I don’t like the expensive acquisition in the past, and the lack of insider buying or share buy backs.

Disclosure

Author is long ARGO.L and IAM.TO.

Pharmasset Merger Arbitrage update

It has been a bumpy ride being long VRUS calls. Pharmasset announced on 16 December that it had detected abnormalities associated with liver function in subjects receiving PSI-938, and while this did not trigger the “key product event”  clause it was enough to pressure the stock price below 124$. Fortunately that was the only negative development, and today the Gilead announced that it has almost completed the tender offer. The calls have returned a quick 20 percent in one month, but it’s hard, if not impossible, to evaluate if it was a good trade or not. Could easily just have been luck.

Argo Group (ARGO.L)

Today I’ll be looking at Argo Group, a small asset management firm that runs several emerging market funds. The company is trading for significantly less that net current assets, is profitable, paying a healthy dividend, and buying back shares. It’s listed on the AIM market in London, but reports results in USD, so all numbers in this write-up will be in dollars unless otherwise noted. Some key statistics of the company:

Last Price: 14.50p (0.226 USD)
Shares outstanding: 67,428,494
Market Cap: 9.8M GBP (15.25M USD)
Trailing P/E (ttm): 7.91
Price/Tangible Book (mrq): 0.57

The biggest attraction of the company is the balance sheet. The biggest items are 10.25M in cash, and 15.72M in investments while the market cap is 15.25M: roughly a 40% discount. The 15.72M in investments are all in “The Argo Fund”, the main fund of the company. The company last reported for the period that ended 30 June 2011, and the value of these investments most likely dropped since (The MCSI Emerging Market index is down 15%). The company does not disclose the holdings of the various funds. If we would apply a big discount of 30% to the value of the investments we still have a company with 20M in assets trading for 15M.

The Business Value

That discount is not directly huge, but the best thing about Argo is that unlike most net-nets it does have a profitable business that should have significant value as well. It’s not a pile of cash doing nothing, or a company burning cash. They currently have almost 400M in AUM. Traditional asset managers trade on average at 2.5% of AUM. If we discount the value of the AUM with 15% we would get a business value of 8M, add back the already discounted 20M of assets and we get a conservative valuation of 28M versus a market cap of 15M.

This valuation is pretty pessimistic since Argo Group is a hedge fund with a 2+20 fee structure, making the AUM way more valuable than those of a traditional asset manager that might have an 1~1.5 percent fee on AUM. With a more hedge fund like multiple of 10% of AUM the company should be worth 32M, and with 20M in assets we would get a valuation at 52M. This is too optimistic though since most funds are significantly under the high water marks, and it’s questionable how succesfull the company will be in attracting new assets (more on this later). The company disclosed that at the end of 2009 the Argo Fund needed to increase NAV by 51% reach the high water mark. It gained 12% in 2009, and 8.5% in 2010, and possibly dropped in 2011, so there is still a long way to go before they will start earning performance fees again. The following table provides an overview of the various funds the company runs, and the AUM:
While checking some multiples is a nice way to get a ballpark figure for the business value I prefer looking at the actual cash that the company is producing: that is what matters in the end. The table belows shows the income statement for the past 3 years:

The income statement clearly shows how management fees have dropped after 2008 as a results of NAV/share dropping below the high water marks. The company has remained consistently profitable though, and there are some items that make things even better. The company has a significant amount of intangible assets on the balance sheet, and the amortisation reduces the reported operating profit, but it does not influence the cash flow. There have also been significant legal costs, but these should be something of the past. The company reported on 7 Jun 2011 that the plaintiff that initiated litigation against the company would not appeal, concluding the matter in favor for Argo (more about the back-story later).

If we would remove these costs from the picture, the company would be generating a free cashflow of 2.5M per year. Throw in a conservative 8.5 multiple on those earnings and we get a business value of roughly 21M: accidentally almost exactly between the 8M and 32M estimations based on AUM.

Why is it cheap?

Usually a stock is cheap for a good reason. For Argo that reason can be found in it’s history. The company was founded by Andreas Rialas in 2000, and sold to ACMH in 2007 for 50.46M GBP (6M GBP in cash, remainder in ACMH shares). Unfortunately for the Rialas brothers the ACMH stake was not worth much. The founder, Florian Homm, promptly quited in a spectacular fashion that resulted in the stock price crashing down with more than 90%. Besides that it became also apparent that he stuffed various funds with worthless illiquid OTCBB/pink sheet stocks, and manipulated the stock prices. He has been charged in the beginning of 2011 by the SEC for “portfolio pumping”.

The Rialas brothers were obviously not happy that their funds got in the mess Florian Homm created, and in 2008 the Argo business was quickly demerged from ACMH. Since the brothers had a 33.2% stake in ACMH, they only got back 1/3 of their original business as well (they currently hold 36%). ACMH itself was taken private by the Rialas family with a tender offer of 2.5p a share (it traded as high as 576p before all the troubles). Because Argo was briefly part of ACMH, it was sued by a major investor in the ACMH funds. The court dismissed the claims of the plaintiff, and the company released 7 June 2011 the follow update:

Further to the Company’s announcements of 1 April 2011 and 12 May 2011, the Company is pleased to announce that it has learned that The Cascade Fund, LLLP (“Cascade”) will not appeal the order of the Colorado court issued on 31 March 2011 dismissing its claim against the Company.

This development concludes this matter.

So it seems that Argo can finally leave the past behind. There is my opinion no reason to believe that the Rialas brothers had anything to do with what happened at ACMH, and that we should expect that Argo is heading towards a similar future. They got burned just as badly as investors in the company and it’s funds. It serves as a good reminder that a risk of fraud is always a possibility though.

What will happen with the cash?

Unlike most net-nets the company is actively creating shareholder value by buying back significant amount of stocks, and paying a big dividend. The company paid a 1.2p dividend per share this year (giving it a 9.2% yield) and in addition they also cancelled 8.5% of all outstanding shares. The latest regulatory news items reported at the LSE are all significant share buy backs.

Also positive is that management and share holder interests are aligned. Not only do the brothers have a 36% stake in the company, the directors and employees have 5,900,000 options outstanding that have a strike at 24p. Twice the share price when they were granted, and still 65% below the current share price. It would dilute current share holders by almost 9%, but given the strike I don’t see that as a negative.

Conclusion

Argo is an obscure company with a troubled past, but with the litigation out of the way there is less risk, less money is wasted on lawyers, and maybe they will finally be able to attract new AUM. But even if that’s not the case the company is very cheap based on both book value and cash flows, and best off all management is incentivized to create shareholder value, is paying a big dividend and buying back stock. It would be nice though if they disclosed more information, such as fund holdings and current NAV.

On a scale from 1 to 10 I give the stock a 8.5: the downside is well protected thanks to the balance sheet of the company, management interests are aligned with shareholders and they are using the cash productively. Liquidity is very limited though.

Disclosure

Author is long ARGO.L

More reading

Wexboy has two good posts (part one, part two) online with his thoughts on ARGO.L.