Thursday, March 24, 2016

Observations from 2015 The Howard Hughes Corp. (HHC) CEO Letter [3/24/2016]

Link here to 2015 Shareholder Letter (worth a read if interested in the company) LETTER or Here

Summary:

This letter is always a good read, as CEO David Weinreb goes into detail each Master Planned Community (MPC) and the primary locations of the Operating Assets. In a sense, each letter he does his best to share how to value The Howard Hughes Corp. (HHC). Even with him sharing how HHC should be valued, the stock still remains undervalued at ~$98/share and also represents a good investment over the 'long-term'.

I prefer owning companies that are run by capable management, have attractive assets, is inexpensively priced, and has a clear runway for reinvestment at above-average rates of return. Some of the best companies in the world have issues with the last quality: reinvestment runway at high rates of return. These companies often use their cash flow to pay dividends, repurchase shares, and make an occasional acquisition. For HHC, their pathway for reinvestment is fairly clear for at least the next 5 years, and they don't need to make any acquisitions to grow at above-average rates of return. 

Observations from 2015 Howard Hughes CEO Letter [released 3/23/2016]

Ownership:
  • Pershing Square Capital Management
    • 2014: owned 9.0% of outstanding common stock, excluding shares issued upon warrant exercise
    • 2015: owned 12% of common stock and warrants and an additional 12% economic interest through total return swaps (total 24%) 

Progress:
  • Increased Net Operating Income (NOI) from $43 million in 2010 to $120 million based on annualized Q4 2015
  • When stabilized, commercial properties under construction or completed expected to achieve approx. $219m NOI by 2019 (excludes South Street Seaport/Pier 17 projects)
  • Expect a 9.0% yield on approximately $2.0 billion costs (excludes legacy assets inherited via spin-off from General Growth Properties GGP)
  • Cap rates should be lower in NYC and Hawaii, versus Las Vegas and The Woodlands
  • Cash:
    • 2014: $560 million unrestricted cash
    • 2015: $445 million cash, add the $377 million from Seaport District Assemblage sold 3/16/2016 = $822 million cash
  • $781 million additional debt needed in next 2 years for development, $541 million is for short term debt for Waiea and Anaha condos in Ward Village (repaid in full by end of 2017)

  • South Street Seaport:
    • Jean-Georges and David Change announced restaurants in Pier 17 building
    • Renovation of Historic District completed by late 2016
    • Not announced expected cash flows yet due to complexity and plans
    • Still working on concept for “Project Two” (700,00 SF additional) 

New Projects (not mentioned in 2014 AR or 2015 Q3 10-Q)
  • One Merriweather (199k office, 49% preleased to Medstar) in downtown Columbia, MD
  • The Constellation (124 unit luxury apartments/ Joint Venture) in downtown Summerlin, Las Vegas
  • Begun process of master planning remaining 184 acres in Summerlin, NV. Envision over 5 million square feet of density
  • One Constellation (mentioned above) is first multifamily development in Summerlin
  • Plan for Columbia, MD, approved in 2015 by Howard County, for:
    • 2,300 residential units
    • 1.5 million square feet office
    • 314,000 million SF retail
    • 250 hotel rooms
    • 4.9 million SF density on 35 acres surrounding Merriweather Post Pavilion 

New Comments:
  • Estimated MPC gross valuations (not yet done, that I’ve seen) = $4.749 billion undiscounted
  • Weinreb shares his belief that most land is discounted at 15% - 20% for raw undiscounted law; should not be the case for HHC land, as located in established MPCs
  • The Woodlands: sell-out date is certain and soon, “single digit” discount rate should be used
  • HHC provided estimated pro-forma “average price per acre” for The Woodlands Hills (~$253k per residential)
  • The Summit (JV with Discovery Land) is selling lots from $2 mil - $8 mil, will hold 270 residences by end 2023. “Sales well ahead of schedule”. Project has 39 lots under contract for $119 million, collected $45 million in deposits from this already. This land was contributed at book value of $13.4 million.


The Woodlands:
  • Commercial land in The Woodlands – 785 acres – should be valued at undiscounted amount of $737 million due to values increasing from $10 per sq./ft. in 2010 to $22 per sq./ft. currently. (Note: I had $485.7 million undiscounted)
  • The Woodlands MPC cash margin = over 90% as infrastructure built = $237m undiscounted (note: I had $193.6 million undiscounted)
  • The Woodlands  = owner and developer of virtually all of the remaining commercial land in The Woodlands, do not have competitive pressures to quickly lease or monetize properties
  • Slowdown in Houston helped HHC because competitors have retreated and HHC continues to strengthen their dominant position in the market
  • 48% of occupied office space leased to investment grade companies
  • Retail portfolio has average remaining lease term of 8.5 years
  • Office portfolio has average remaining lease term of 7.8 years
  • No tenants carrying significant balances more than 30 days past due

 Taxes:
  • Do not expect to pay taxes over next few years due to $255 million of NOLs
  • Higher NOI from commercial properties would incur taxes, but they are burdened in short-term by mortgage debt, depreciation, interest, and thus taxable income from these properties should be “near zero” in next several years
  • HHC holds non-core assets that, if sold, could provide more than $340 million of additional tax deductions 

Valuation Notes:
  • My MPC valuations had a $5.775 billion undiscounted value (although I used 12% - 15% discount rates), yet HHC used $4.749 billion undiscounted.
  • Adjusting my MPC valuation based on:
    • The Woodlands at 9.0% discounted
    • Lowering the price/acre of Summerlin
    • Using 13.0% discount rates for all other MPCs
    • Adjusting The Woodlands Commercial Land to be somewhat closer (but still $50m + off undiscounted), using 13.0% discount rate
  • All in, adjustments to MPC values lowered my MPC “NAV” by ~$2.00/share, from ~ $30/share to $28.00/share



26 comments:

  1. Thanks for your thoughts on the 2015 letter. Having over $800M in cash is quite significant for HHC but so are capital intensive projects making their way through development. There are plenty of reinvestment opportunities on existing assets for the foreseeable future 3-5 years out.

    At these prices I'm curious about your thoughts on instituting a sizable buyback program? (100-200M in place) Management has never made mention or has even insinuated thoughts on buying back stock, but I'm having trouble understanding the rationale of future development vs allocating capital via share buybacks at prices in the mid 90s or below. Am I missing something?

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    1. You're not missing anything, and my talks with them don't insinuate that a buyback is off the table at reasonable prices; however, I think they would rather deploy money in their current assets, build market share, control supply, and reduce competition, which will also build long-term value. Remember that SSS/Pier 17 will will cost $514m but they don't have any financing for that project. I just think the runway is pretty large, and if The Woodlands stays strong or Houston-area recovers, they will begin that ~8.0m of commercial development, which I think they will do in the next 2 years unless things get worse (which could happen). However, they have a lot in the pipeline in Ward Village commercial + Columbia, MD commercial + Summerlin commercial. Plenty of money to be spend if they can continue to earn > 8% yield to cost. As much as I would like a buyback personally, I would rather them reinvest the capital and build higher earnings power, as well as be opportunistic if things become available (especially in The Woodlands).

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  2. Thanks for the comment. You made me realize that I'm being too static in my thinking regarding project development. There are plenty of benefits beyond the returns on the specific projects but more broadly increased value on existing assets in the portfolio that I was neglecting.

    "as well as be opportunistic if things become available (especially in The Woodlands)."

    This is one area which I had a lot of thought about. Although HHC will certainly have competition they do have right of first refusal on many properties there. Also considering David Weinreb's past foray in commercial acquisitions, the type of environment being experienced currently in the Woodlands is right in his wheelhouse for finding value-added deals.

    http://www.bizjournals.com/houston/morning_call/2015/10/behind-thewoodlands-development-co-s-strategy-for.html
    http://www.wsj.com/articles/SB922231882393479178

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  3. Hi Value Seeker,

    Just wondering if you have any thoughts on the CFO's departure?

    Thanks for everything you put out on this blog.

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    1. It's disappointing, especially considering he made a financial contribution to join HHC in 2011. Without having any inside information, I can think that it is plausible that the environment could be quite stressful, considering the projects that are still in the works and how "driven" the other executives are (maybe they have high expectations?). Another is, looking at Andrew Richardson's history, he tends to change jobs every 4-5 years. He was a CPA in EY for 5 years, VP of Investment Banking at Morgan Stanley for 5 years, Executive VP at iStar Financial for 6 years, CFO of NorthStar Realty for 5 years, and CFO of HHC for 5 years. Interestingly, he departs each position in March around 5 years, and he just announced his departure from HHC. Besides just getting an itch to do something else, I'm not sure. I still think the BOD and management in place is strong, and I would be much more worried if Weinreb left.

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  4. Thank you. Agree the most likely reason is simply a personal decision as you suggested. Although I also wonder a little about what Ackman said on his call that HHC has no bulge bracket coverage and made no effort so far to tell its story. While not focusing on story telling was likely a company decision, normally the responsibility of investor relations falls to the CFO. So to the extent that the new guy becomes a bit more active in IR, perhaps a change isn't all bad.

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    1. Some of my initial conversations with them were never with an "IR" individual. In fact, the current "IR professional" doesn't do IR full-time, it's only when needed. He is on the capital markets side. However, I don't see any of this as a bad thing. Why would I want them to tell their story right now? Instead, I would rather it remain more hidden until it absolutely becomes too large and needs more capital. For now, the lack of quarterly calls and the once/twice a year webcast is fine with me. The disclosures in the reports have improved a lot, likely to help investors value HHC better.

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    2. I agree. Sounds like you are not done adding? In the case of Ackman, he's probably content with his 24% stake. With his fund having done horribly, he perhaps wouldn't mind any of his positions go up relatively quickly. Hence his statement on the call. Also, management will be able to realize some of their paper wealth starting this Nov, so a higher price will be useful.

      What do you think are the major catalysts that may come up in the coming year or so? Presumably any agreement on the Seaport phase 2 would help. Anything else in this time frame that you think is important?

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    3. The single most important things are: (1) get part 1 of South Street Seaport finished with solid occupancy and leasing rates, and (2) to show stability in The Woodlands commercial projects. All eyes are on both of those, in my opinion. There were some setbacks for SSS (Storm Sandy, etc.) and the hopes are high for this project. Let's hope they complete it 2016-2017 and it comes in better than expected. As for The Woodlands, everyone is waiting for the shoe to drop. I stay on top of The Woodlands CRE market and there have been some SF come up for sub-lease, non yet in any HHC buildings that I am aware of. I believe Layne Christensen in Hughes Landing may be looking for sublease. The opening of 1725/25 HL and 3 Hughes Landing with open SF was a large red flag, but if the remainder of the properties can stay strong through 2016/7 then I would imagine HHC valuation would creep higher. The vacancy rate is low for the other HHC buildings in The Woodlands and investors are worried that there is some lag and eventually there will be cracks. We shall see. I think it will hold up better than expected.

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    4. Thanks. Are you aware of any other CRE firms that have large exposure to Houston? Just curious how much those may have come off.

      While people generally point to the situation in Houston as the main cause for the weakness in HHC shares, I wonder what other factors might also be at play. At its worst level, the stock was off almost 50% from peak, even though it's obvious Houston certainly accounts less than half of the total value and the assets will be worth something even if oil goes to zero.

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  5. Value Seeker,

    I know you may already be aware of this article already, but does this seem as concerning to you as it is for me in regards to Seaport Leasing? We certainly don't know what the actual contract says but this seems troubling that the company would allow this much power for a tenant in such an important location.

    http://nypost.com/2016/04/11/jean-georges-south-street-agreement-came-with-a-sweet-side-deal/

    "Vongerichten and his business partner, Phil Suarez, can veto any other restaurant or food tenant at the complex if they don’t feel they’re the right fit for the new Seaport’s less touristy, locally oriented approach or compete too directly with their own planned places — and they’ve nixed a bunch of Seaport suitors already.

    “They get to pick and choose who goes into the complex,” said Eastern Consolidated co-principal and senior retail leasing director James Famularo.

    He should know: “We had 10 or 12 operators interested in going there and they killed them,” Famularo said. He wouldn’t name names, but said they included a beer garden, a moderately priced seafood chain and burger and ice cream spots"

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    1. The article is wrong/incorrect about the power they have.

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  6. I invested a pretty big chunk of my net worth in HHC on the first day of trading in Nov. 2010. It's been a rocky ride! At first, it was easy to say that it traded at a good discount to BV, with properties stated on the books at ridiculously outdated values (e.g. Seaport at $3 million in initial Form 10). I still hold most of my position, and see it's undervalued after taking the time to compile a NAV table. However, I keep wondering if management will reorganize the company somehow to make it easier to value? In its present form, it will defy a back of envelope valuation (NOI/cap rate) given the plethora of property types.

    Perhaps the upshot here is that management will someday capitalize on the discount via repurchases? The Citi initiation report from May '16 estimates that core EPS will be $10.84 in 2018. I think more street coverage with CF/share estimates like that will help investors ball-park a value.

    Another interesting dynamic is the management warrants that activate in Nov.'16 and expire in Nov.'17. If I'm interpreting it correctly, they are net settlement swaps, meaning Weinreb/Herlitz/Richardson don't actually need to fork cash out-of-pocket to settle them. The higher the share price on settlement, the more shares they will receive. Given that, I wouldn't be surprised if management becomes more promotional over the next year to get the stock price up. For now, they're probably quite focused on Phase I of the Seaport (e.g. completion and filling with tenants) as executing on that is critical.

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  7. Very surprised that Herlitz chose to exercise his warrants and sell his shares now... At a depressed price and before Seaport Phase I opened.

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  8. Does anyone know if he sold all or part of his warrants? Thanks.

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  9. Looks like he's kept some. Although everyone wants the stock price to be higher, realistically there're many reasons the executives may need money and hence sell now. For Herlitz, even though the shares are way off the highs, he still made a lot of money via the warrants so his view of stock price could be a bit different from ordinary stockholders.

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    1. That is a good point JB - my back of envelope shows he made more than 10x before taxes on his original $2 million warrant purchase. It's also possible that some kind of life event caused a forced sale.

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    2. Just trying to be rational in assessing the facts - since last year, tea leaf reading of management behavior is probably neutral to somewhat negative, considering the CFO departure and Herlitz share sale. On the business side though, most seem to be progressing well. I am personally not too worried about Houston and tend to think it will do well over time due to its many inherent advantages outside of oil. LV and Hawaii are doing well. The only large uncertainty is Seaport - 1) how well will it perform post Pier 17 opening? and 2) what kind of a deal will HHC get for Phase two?

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    4. JB, I think that's good tea leaf reading... is there something going on behind the scenes? Ideally, this is all part of Pershing's plan to flip management into the next seven year warrant deal, but given Herlitz and Weinreb didn't sell out of their warrants at the same time, I doubt that's the case.

      As the passive investor, I expected the next quarters to be catalysts (cash from Hawaii condos flowing in, opening of Seaport Phase I). The last thing I would've expected is for any of them to sell out now with the price at a good discount to NAV and the high of $160 a few years ago. (I shoulda took some off the table!!!) It's kind of strange. I mean, they've been very quiet in terms of investor exposure...minimal webcasts, no conference calls - though the first investor day will take place this year as I understand.

      I remember the stock shooting up in 2012/2013 every time Weinreb gave a presentation. But essentially it's been radio silence for the past two years. I have the exact same questions regarding Seaport. My bet would be that the ramp up of Seaport will take some time, meaning the $75M NOI estimate doesn't get reached for a few years.

      I drew lots of confidence from those 7-year warrants. Let's hope ValueSeeker hears back from the company and shares his findings.

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    5. A follow-up. Grant had 315,731 warrants from 11/22/2010 that were able to be exercised between 11/22/2016 and 11/22/2017. He elected to exercise 308,881 on 1/03/2017 and he gifted the remaining 6,850 to a Bank of America charitable fund, leaving him zero warrants remaining. The only remaining stake he has are his 39,203 restricted stock from his compensation plan. They vest in increments based on original earned date. The first stock of 9,097 shares vests on 12/31/2017. So, all of the stock he can sell, he has sold.

      What to imply from this? It looks negative, of course. But he would have had to exercise them this year by 11/2017 anyways. Second, he has a very expensive piece of land in Dallas, TX, and is rumored to be building a sizable home currently. Maybe he needs the cash? Maybe the combination of needing to exercise them this year with his need for the cash for his home led him exercise. Recall, he will pay sizable taxes on those gains as well.

      We don't know for sure, but I would imagine it could look more of a red flag than actually is. Add that the Andrew Richardson departure in 2016 didn't give any explanation. Time will tell on this.

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    6. Thanks a lot Value Seeker. I saw on Form 4 Grant had 127,387 shares left - is that not correct?

      If he sold all he could, that's a very bad signal to me. First, the expiration is 10 months away. Second, He could have exercised his warrants but kept some shares. Looks like he's in a big hurry.

      I presume the former CFO has also sold out - do you have any idea?

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    7. Well let's just hope Weinreb stays in, or at least he is rolled into the next long-term warrant deal concurrently with exercising his warrants.

      This must be a monstrous home that Herlitz is building. Thank you ValueSeeker for the intel... I think it is a reasonable explanation if the construction requires cash now (how big is this frickin' house?) as I bet most of his capital was tied up in those warrants. Recall that he committed 'only' $2 million into the warrants vs. $15 million from Weinreb, so it's safe to assume his resources compared to Weinreb are not as plentiful.

      But without further information, it's hard to take all this as anything but a negative. This has been a frustrating stock to own for a few years... the opening of Seaport Phase I is a possible catalyst, but I'm not sure whether it'll be positive or negative. I hear the leasing environment has become tougher over the past year, so initial tenant inducements may be higher than thought. At Downtown Summerlin, most tenants were given a year of free rent.

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