Variant Perceptions

Category: Ackman

Buffett on the imperfect turnaround

Can you think of an example of a retailer that was successfully turned around?

Broadcasting is easy; retailing is the other extreme. If you had a network television station 50 years ago, you didn’t really have to invent or being a good salesman. The network paid you; car dealers paid you, and you made money.

But in retail you have to be smarter than Wal-Mart. Every day retailers are constantly thinking about ways to get ahead of what they were doing the previous day.

We would rather look for easier things to do. The Buffett grocery stores started in Omaha in 1869 and lasted for 100 years. There were two competitors. In 1950, one competitor went out of business. In 1960 the other closed. We had the whole town to ourselves and still didn’t make any money.

How many retailers have really sunk, and then come back? Not many. I can’t think of any. Don’t bet against the best. Costco is working on a 10-11% gross margin that is better than the Wal-Mart’s and Sams’. In comparison, department stores have 35% gross margins.

It’s tough to compete against the best deal for customers. Department stores will keep their old customers that have a habit of shopping there, but they won’t pick up new ones. Wal-Mart is also a tough competitor because others can’t compete at their margins. It’s very efficient.

Warren Buffett, student visit 2005

Another addition to the turnaround toolbox so that I don’t forget the obvious and known even in tempting circumstances.

And these are tempting circumstances. There are two retailers that I like their owner operators and I like their prices. Is there a need to mention their names?

Running the risk of being repetitive, my opinion is that in comeback stories the balance sheet is better used to estimate the runway of a business rather than its value. Both of these retailers have decent runways but the problem is that neither is turning.

These were some thoughts from an old previous post on players facing external threats.

The prospects do not look so bright when you consider that for most of these companies, failure means their core business declines into oblivion. Also many of them may not have clients, hidden capabilities, or platforms to leverage.

A good financial position, like Dell’s or Yahoo’s,  can give them time to experiment and look for alternatives. But from the point of view of an investor even if the plan is successful the company will probably be a follower in the new industry, product, segment, business model: a shadow of its former self.

So the downside is not that well protected, the probabilities of success are not that good, and the upside will probably be limited: does not look like the recipe for successful investing. This is an area where I think value investors have to be careful.

I’m still curious about Dell and Yahoo. I’m still curious about these two retailers. Actually, at the moment there are dozens of interesting situations. However, my preferred style is to jump on businesses that are turning or have already turned at the risk of missing some… and there are some good ones out there.

Now, if they decide to liquidate abruptly or in willful steps … well, that’s not a turnaround.

Position: none.


A friend suggests me to read Mauboussin’s More Than You Know, Chapter 21 and I do. Retail and technology are not the best sectors to look for comebacks.

Exhibit 21.2 shows what happens to companies that realize a downturn. The sample includes almost 1,200 companies from the technology and retail sectors.

The data for the two industries are strikingly similar, and not particularly encouraging: Only about 30 percent of the sample companies were able to engineer a sustained recovery. (Credit Suisse defined a sustained recovery as three years of above-average returns following two years of below-cost-of- capital results.) Roughly one-quarter of the companies produced a nonsustained recovery. The balance—just under half the population—either saw no turnaround or disappeared. Companies can disappear gracefully (get acquired) or disgracefully (go bankrupt).

This analysis also shows how long companies experienced downturns. For both retailers and technology companies, roughly 27 percent of downturns lasted only two years, and for both sectors over 60 percent of downturns lasted for less than five years. In other words, the destiny of most firms that live through a downturn is determined rather quickly.

These mean-reversion and turnaround data underscore how strong and consistent competitive forces are. Most stocks that are cheap are cheap for a reason, and the likelihood that a business earning poor returns resumes a long-term, above-cost-of-capital profile is slim.


Pershing Square on the mortgage market

The health of  the banking and housing sectors are critical for a sustained recovery and both could be interesting sources for ideas given the distress and forced selling. Most interesting, both sectors are interrelated especially with the Big 4’s high percentage of their loan portfolio in mortgages.

Though, I am of the opinion that it is still possible to have a banking recovery without a complete housing recovery so most of the blogging efforts have gone in that direction… but how to ignore a data-packed presentation on the housing and mortgage issues especially when prepared by Ackman/Pershing Square.  That saves a lot of time. (Source: Dealbreaker)


Maguire Properties, Liabilities (Part II)

Good liabilities are an asset – Bill Ackman

Note: this article was written for the Complete Growth Investor a couple of weeks ago. The preferreds and common had a fantastic ride since it was written. So I would recommend some caution with the margin of safety of both the common and the preferreds and please adjust the reference prices and target returns. Note also the intro written two weeks ago.

The thesis has two parts. First, to prove that MPG has a margin of safety and its liability structure will protect it from Chapter 11. If that is true, it will come perfectly clear that the unencumbered and non recourse properties should provide plenty of assets and cash flow to pay the cumulative preferreds in a year or two.

The preferreds have accumulated already $1.9 per share and will keep accumulating $1.9 per year. And there are only 10 million preferred shares with a $25 liquidation preference trading at $9 per share. I think it is safe to say we are looking to a potential 3x in two years with a clear catalyst (dividend reestablishment) and downside protection (properties with non recourse mortgages and unencumbered assets). And every quarter we wait at least we are accruing more dividends.

The second part is trickier because it is no only about showing that the common is undervalued. But more important, that it has more upside than our opportunity cost: the potential 3x of the preferreds and its higher preference in the capital structure. And there is a real possibility that I may fail to convince you given that an important part of the value in the equity is intangible optionality.

So let’s start. “Good liabilities are an asset” is a very counterintuitive thought. However, when credit is limited long term maturities and non recourse gives management options in his negotiation with lenders:

The post is dry, so I hope this chart will make things easier. The top right quadrant (Type 1) is the type of debt that you want to have, the type of debt that gives you options. In particular, if you have to refinance an unprofitable mortgage it will be in your terms because you have time (LT maturities) and you carry a stick (non recourse). It is much more difficult if you are in the bottom left corner (Type 4). The obligatory maturity payment gives the lender the upper hand. Even a profitable property in this situation, like Lantana, could be a problem. And that is the reason that its sale for a profit is such good news.

For the most part, MPG has good liabilities (Type 1 in green). However, even some of these good mortgages, the ones highlighted in red, have some recourse obligations. One is Lantana that was sold in November last year, so problem solved, and the other one is Griffin Towers recently mentioned in a WSJ article, with a $23 million recourse repo facility.

Also from the good mortgages (type 1) you have probably noticed that several are in default. Those are the ones jingled mailed (OC strategy) that I mentioned in Part 1 of the series:

I’d like to begin my comments this morning with a brief background on the assets involved in our plan announced today. All seven of these assets were acquired by the company after the initial public offering of Maguire in June 2003.Four were part of the acquisition of 24 EOP/Blackstone assets in April 2007. One was part of the acquisition of the common wealth portfolio in March of 2005 and Park Place I and Park Place II were acquired in 2004. The borrower for each of these loans secured by these assets is a special purpose entity formed for the purpose of owning and operating and individual property. Prior short falls in monthly debt service and leasing costs have been mostly satisfied through property level reserves. These reserves were funded at acquisitions with mortgage proceeds. As these reserves are exhausted, capital of contributions to these special purpose entities will be required.

Six of these assets included in the plan are encumbered by CMBS mortgage loans. The master servicers of the mortgage loans in cumber in these properties have been advised that the future operating and debt service requirements for the property will rely only on property generated revenues and as a result, the borrower expects an imminent default under the loan. (CC Q3 2009)

And what is the beauty of this? Well all these properties have a combination of large vacancies, high interest rate, or both. In other words, they were burning needed cash.

Projected cash flow savings for the next 18 months from the disposition of these seven assets are anticipated to be approximately $30 million. Then in addition for this group of asset, the cash burn associated with this group of assets during the quarter was approximately $6 million so as you can see once these assets are dispose we’re still slightly negative primarily due to capital expenditure but again we are still utilizing restricted cash on our balance to fund the majority of our leasing cost, those are funds that will be defeated overtime and need to replace but from a near term liquidity perspective , that’s a major source of cash that we have to lease of our portfolio. (CC Q3 2009)

Cash Flow Savings = $30 million / 18 * 12 = $20 million per year

Reduced Cash Burn = $6 million * 4 = $24 million per year

Increased Cash Flow = $44 million per year

For MPG, that has only recently achieved cash flow breakeven, this is nothing to sneeze about and should help the company navigate the recourse debt left. And also, it could easily sustain the dividends for the preferreds if the core Los Angeles CBD properties do not deteriorate.

But that is not the end of the story, since they are carrying a big stick and there is no incentive for the lenders to foreclose. I do not want push this point too far given that to renegotiate commercial mortgage-backed securities (CMBS) is difficult given the fragmented nature of its ownership (ie: Stuveysant). But, if MPG, that does this for a living, is not able to lease these properties up to profitable levels, who else?

Regarding the recourse short maturity portfolio (type 4), most of it is related to constructions loans

Each of our construction loans is subject to a partial or total guarantee by our Operating Partnership. The amounts guaranteed at any point in time are based on the stage of the development cycle that the project is in and are subject to reduction if and when certain financial ratios have been met. These repayment guarantees expire if and when the underlying loans have been fully repaid.

The terms of our Lantana Media Campus construction loan and Plaza Las Fuentes mortgage require our Operating Partnership to comply with financial ratios relating to minimum amounts of tangible net worth, interest coverage, fixed charge coverage and liquidity. Certain of our other construction loans require our Operating Partnership to comply with minimum amounts of tangible net worth and liquidity. We were in compliance with such covenants as of September 30, 2009.

So selling Lantana, that was a $176 million combined debt, solved a large part of the remaining recourse issues. The rest are substantially smaller and the way they are dealing with it is through a lease up strategy to eliminate some of the recourse obligations:

If you were to look at the portfolio, basically in Orange Country, probably an asset that has got the largest cash burn would be an asset called Griffin towers. It also has associated with it a repurchase facility that is recourse to the company. So there’s a $23.2 million, I believe recourse facility. Though upon Karman Campus, which is 151,000 square foot building in Irvine, it’s a building that we constructed that’s currently empty, that’s obviously has cash burn from interest expense. Again it has a recourse obligation associated with it approximately $7 million.

Then in Central Orange, we also having that, it’s called 3800 Chapman. It’s about 63% vacant, so it is not covering debt service. However, it has a debt service guarantee until maturity for 100% of the debt service. So, our focus there is to lease-up that asset if we can achieve a one-one debt service coverage ratio for two consecutive quarters we can eliminate the recourse and that has been our strategy for that assets.

Then in San Diego, we have an asset called 2385 Northside, which was a construction asset, was 52% leased. That tenant will start paying rent later on in the year. So, it’ll make a debt into the short fall. Currently, we have no rent coming in and we are very close to signing another lease that will take that asset to 72% occupied. Our strategy there has been to focus on leasing because again, that asset has a repayment guarantee that can be eliminated, as you achieve certain debt service coverage ratio. (CC Q3 2009)

If the lease up does not work, plan B is to sell the property and pay the difference. A strategy similar to the sale of 3161 Michelson in the second quarter of 2009.

Gordon Watson – Ore Hill Partners On the construction loans you’re selling, are you anticipating at this time making any payments from unrestricted cash to get rid of those construction loans?

Nelson Rising It’s conceivable there will be some, but it’s our hope that it will be minimal. The Northside property is on the market. It’s 75% leased. It’s a good property that’s part of a four-building complex, and we are marketing all four buildings and just the newly constructed building separately if someone wants that.

And so I think that will be successful in not having any payment. The offer that we have in bottom of that for in common stock will require some payment to bring that loan to the balance. The purchase price is being offered to us under a letter of intent, not a binding agreement yet, on the 207 Goode would be the loan balance number. These are all transactions in the works. Nothing is closed, and I just don’t have an answer as to the amount that we would be forced to pay. Those loans do have guarantees.

In the case of the Glendale property we have just received a Certificate of Occupancy and as is the case of most construction loans, until you have Certificate of Occupancy 100% of the loan is guaranteed. Once the lender approves the Certificate of Occupancy, the Glendale number will be $9 million. Von Karman is about $7 million, and Northside is about $4 million. But it’s our hope that our sales prices will come close to giving us break even on this.(CC Q3 2009)

So $20 million from the construction projects plus $23 million for Griffin Towers in recourse obligations should not be the end of the world. And there are no really big short term non-recourse issues (Type 3). KPMG Tower comes due only in 2012 and it is 93% leased so it should not have a problem to renegotiate or sell. The only other issue could be Brea Corporate Place that is only 56.3% leased.

So lets consider that are some assets besides the profitable LA CBD core: cash, unencumbered land, a 20% participation in a profitable JV and a net operating loss carry forward. First cash:

$62 million in unrestricted cash and it seems that items 2, 3 and 4 are just conservative accounting. And when properties are sold some of these reserves will be released. Regarding land, I went through the 10K (Note 22), $151.6M in the books is unencumbered (Note 4 in the 10Q)

We also own undeveloped land that we believe can support up to approximately 4 million square feet of office and mixed-use development and approximately 5 million square feet of structured parking, excluding development sites that are encumbered by the mortgage loans on our Stadium Towers Plaza, 2600 Michelson and Pacific Arts Plaza properties, which are in default.

Note 4—Land Held for Development and Construction in Progress

Land held for development and construction in progress includes the following (in thousands):

MPG also owns a 20% interest and is responsible for day-to-day operations of the properties of a joint venture withan Australian firm, Macquarie Office Trust (do not confuse them). Given that they use the equity method the cash flow statement only records distributions, undervaluing the earnings power of the JV. It also receives fees for asset management, property management, leasing, construction management, acquisitions, dispositions and financing. In this JV, Quintana defaulted but all the other properties are very profitable. One California Plaza is in a bind given its short term maturity. But its equity is substantial and generates good cash flow so it is in a good position for a sell

With respect to One Cal Plaza, that’s a process that is being basically driven by Macquire. There has been a significant interest in the asset. Again, it’s under contract, and the person who has it under contract with the entity is in the process of raising, trying to put together a final financing on that property. (CC Q3 2009)

And finally, As of December 31, 2008, MPG had a net operating loss carry forward of approximately $270 million that should shield the profits when the recovery comes.

So the equation is easy: not much in recourse obligations left, the OC strategy should restart cash flow generation, and there is cash, unencumbered land, a 20% participation in a profitable JV and large NOLs to carry them through the turnaround. The preferreds must be an easy kill, is there more value left for the common?

Long MPG