Category: Equity

REITs and leverage

It was announced today that Dundee REIT (TSX: D.UN) and H&R Reit (TSX: HR.UN) will be purchasing 2/3rds and 1/3rd, respectively, the Scotiabank headquqarters in Toronto, for a price of $1.266 billion. This was a classic sale-and-leaseback transaction by Scotiabank.

The salient press release is here. Specifically, this line caught my attention:

Highlights:

Going-in capitalization rate of 5.2% – The $1.266 billion purchase price reflects a 5.2% going-in cap rate.

$650.0 million of 7-year first mortgage bonds, provisional A (high) rating, to be issued – To provide partial funding of the purchase price, $650.0 million of first mortgage bonds (100% interest) will be issued with a 7-year term at an effective interest rate that will not exceed 3.45%. Dundee REIT and H&R REIT have entered into an underwriting agreement with Scotia Capital Inc. and TD Securities Inc.

…

The current weighted average in-place office rent is approximately $31.45 per square foot, more than 10% below estimated current market rates of $34.49 per square foot.

The company is also issuing $300M in equity at $35.90/unit. Their annualized yield at that price is 6.12%.

A cap rate of 5.2% basically means you invest $100 to get $5.20/year back. The income figure is usually net operating income, which excludes the depreciation and interest expense associated with owning the property. The figure also implies that it is calculated with the present occupancy rate (99.5%).

So Dundee is receiving a fairly slim return. Let’s just assume that they exclusively purchase this building with debt financing and ignore the more expensive equity. Also, let’s generously assume they can flick a switch and charge the “market rate” for their leaseholders (which is unlikely since Scotiabank is their majority tenant in the building and presumably negotiated a bulk discount associated with the sale of the building!). Their cost of debt is 3.45%, and they anticipate receiving 5.7%, so a spread of 2.25%.

When you do factor in the other attributes (e.g. the true cap rate of the building, depreciation, real estate pricing risk, state of the Toronto economy, occupancy, cost of equity) there is not a heck of a lot when it comes to a margin of error. One predominant question is what happens when interest rates rise to the point where you are paying 200 basis points more on everything? A lot of the higher levered REITs are going to get killed on two fronts – financing expenses and balance sheet write-downs when others are trying to liquidate exactly the same assets. Your compensation as an equity investor is amazingly small.

My conclusion here is that the Bank of Nova Scotia (TSX: BNS) made one hell of a deal.

Facebook IPO and social media

All of the financial journalism out there is directed toward Facebook’s IPO and the fact that the price dropped after offering. Here’s a cool chart after the $38 IPO:

There is no requirement for IPOs to rise in price after they go public. In fact, the huge price spikes seen in IPOs (especially during the internet stock era) simply represents a mispricing in the IPO price – in the usual case where a hot IPO spikes up on the first day of trading, the difference between the market price and the IPO price is cash that went into IPO purchasers’ wallets instead of the underlying company.

In Facebook’s case, however, the offering was for new equity and also selling stockholders – Facebook itself sold 180 million shares of stock (raising $6.76 billion net), and insiders sold 241 million shares (liquidating $9.07 billion net for themselves).

Notably, a week ago, the insiders were slated to sell 157 million shares. This was bloated up by another 84 million shares and raised a cool $3.157 billion net for those insiders. They had a vested interest in the IPO price being high and not low, so in classic form, Wall Street of course fleeced investors once again. I don’t sympathize whatsoever with the investors of the IPO simply because they were trying to make exactly the same dollar that the selling shareholders made off of them.

I’m not going to offer any critique on valuation, but an investor in Facebook shares is investing mostly for the ride and not for control – insiders control most of the Class B shares, which has 10 votes, while the offering is for Class A shares, which has 1 vote per share. Thus, CEO and founder Mark Zuckerberg will have 58% voting rights and 44% economic rights after the offering. This will shift over time as insiders cash out their Class B shares (they will convert into Class A and then be liquidated into the market).

The top of the tech IPO market in the last decade was the IPO of Palm, which went for nearly a hundred dollars per share when it went public in March 2000 before crashing to earth during the tech wreck. Is this broken IPO a sign of what’s about to happen in the social media space? Companies like LinkedIn (Nasdaq: LNKD) and Yelp (Nasdaq: YELP) and Groupon (Nasdaq: GRPN) come to mind. I will make a concession that Groupon is not exactly a “social media” company but I will lump them in that space.

Fundamentally, Facebook reminds me of what AOL or Compuserve was back in the 90’s. After acquiring Compuserve, AOL managed to sport a huge market capitalization before crumbling into obsolescence and I suspect that Facebook will follow the same trajectory. The question is whether there is still any growth left in Facebook, or whether the business at this point is strictly about monetization and nothing else – before it manages to get rid of all of its customers with relentless spamming and other useless features which will degrade the product.

Perhaps I am biased since I do not have a Facebook account.

Converting crap to cash

I think everybody has a lot of spare junk that they wish they could click a button and just sell. It is also cumbersome to list items on Craigslist since there is a lot of filtration required. Likewise, Ebay is no longer a good place to get rid of unnecessary garbage since competitive forces have rendered markets full of supplies of garbage that nobody needs.

Scale this problem up by a factor of a thousand and you have companies with warehouses full of garbage they don’t need. So insert in a company like Liquidity Services (NYSE: LQDT) and take a look at what they’ve done since the economic crisis:

Suffice to say, the horse is completely out of the barn now and the company will be facing the law of large numbers soon (i.e. growth percentages are going to slow down), but I just found this interesting. Companies finding profitable ways of getting rid of junk assets (either through re-selling them or otherwise trashing or recycling them) should continue to do well.

JP Morgan and large financial companies

One reason why I don’t own companies like JP Morgan (NYSE: JPM) is because you truly don’t have a clue what’s going on inside these companies. Even top management (such as Jamie Dimon) has to find out through a relatively roundabout way that some of his employees have blown away $2 billion in equity making trades they presumably thought were hedging some other risk but turned out not to be.

Can anybody with a straight face look at their 10-K and make heads or tails of it?

In essence, when you invest in these types of companies you are really taking a leap of faith that the assets they claim to have are real and collectible, and that the liabilities aren’t misstated in such a way that causes them to pay out more than what you see on the books. You are also taking a leap of faith that their loan portfolio takes in more income than they pay out to depositors.

On paper, you are paying $37/share for a company that analysts (before this 50 cent per share trading loss) believe will make $4.97/share this year and $5.60/share next year. Let’s pretend this is true. Sound cheap? Sounds like it, but ultimately do you really know what you are purchasing?

You are buying an implicit guarantee that JPM will crank up its dividend yield over a period of time and hopefully rack up some capital appreciation since its earnings are significantly higher than its dividend payout. The question is – will the company blow up? JP Morgan blowing up doesn’t seem all that likely right now, but just ask people that invested in Bear Stearns, Merrill Lynch, Wachovia, or Washington Mutual five years ago, where an implosion equally seemed unlikely. Who knows? I don’t, and that’s why I’m staying away from these true leap of faiths like JP Morgan equity.

This type of thinking applies to most large cap financial companies, including the large Canadian Banks (specifically, TD, RY, CM, BMO, BNS and to a lesser degree NA and CWB).

That said, you can also invest in these large capital financial firms as a variety of a Pascal Wager where if companies like JPM collapse (or one of the big five Canadian banks) that there is going to be so much collateral damage that subsequently earning a return on investment is not going to make much difference since you’ll be hiding in your underground bunker while civilization collapses around you.

Rosetta Stone

My first equity purchase in 2012 was Rosetta Stone (NYSE: RST) at a basis of approximately $8.50. I had started accumulating shares at the $7.50 to $7 range and was hoping to obtain more of a position, but unfortunately the stock slipped away and the last pieces I acquired was at the $9-$10 level. My original wish was that their stock would decline down to $6.50-ish where I would have obtained a full position, but instead I got about half of my desired position, at a higher than desired basis – c’est la vie!

The company was compelling for a few reasons:

1. They had a well known, existing franchise in a sector (language learning) that clearly would benefit from globalization and not be whittled away by other companies’ offerings (which exist and are relevant competition);
2. Their balance sheet was very clean, having (assuming the $7.50 price point) about $100 million in the bank and a market cap of about $160 million; this means an investor was paying for very little to own the underlying franchise;
3. And speaking of the franchise, it is a $250M/year business selling software. Similar to selling pharmaceuticals, software tends to be a very capital-intense up-front business, and the main operating expenses tend to be sales and marketing. So for the princely sum of about $60 million, you could buy into a business at a P/R of about a quarter, fairly cheap if you assume that the software asset is actually worth anything (and indeed, it is, you just can’t see it on the balance sheet since R&D expenses are mostly expensed away and not capitalized).
4. Google Translator and other such “free” services (such as speaking into your iPhone) doesn’t really intersect too much with the language learning software market. If anything, these free services are a compliment.

There were some negatives, including:

1. The previous history of the company being an LBO target and then going public again; there were significant shareholders in the corporation that are actively divesting their interest. Correspondingly, management doesn’t have too much of an ownership stake in the firm – the new CEO has about a 1.5% stake in the company, while the former CEO has about 5%;
2. The profitability of the company has been low, but this is primarily due to marketing expenses;
3. Penetration into international markets has been less successful than originally desired by management;
4. Pressures dealing with US markets (specifically those somewhat exposed to government funding such as education);
5. Management changes – the CEO at the top recently stepped down and they have internally promoted their CFO to CEO and recently hired a new CFO.

I’ll leave out the hard-core quantitative metrics. I’ll condense it by saying the company appeared cheap at their single-digit valuation. Since I’m no longer interested in accumulating shares, I’m holding it in my portfolio since my price target has not been reached yet even with the past week’s action where a relatively rosy quarterly report took them up 30% and I am revealing this holding to the world.

All I have to do now is find 6 or 7 of them and start using the cash balances and who knows, 2012 might turn out to be profitable compared to the (relative) disaster I had in 2011.