Thesis
At the current price, common stock of real estate developer The Howard Hughes Corporation (HHC) provides investors with a margin of safety against permanent capital loss and genuine option value. The stock's most recent close as I write this was at $47.98, about 86% of tangible book value. This is despite the fact that the firm's high quality real estate assets have been written down to levels that reflect the depressed real estate market of recent years. The sponsors of the firm have assembled a very strong board and management team with outstanding records in the real estate industry and have provided strong incentives for them to perform. Possible reasons for why the stock is undervalued include myopia (the firm is unlikely to show impressive financial results in the short term), the lack of analyst coverage, the difficulty in valuing the firm, and general market volatility.
Business Description
The Howard Hughes Corporation was spun-off from General Growth Properties as General Growth emerged from bankruptcy in November of 2010. HHC was organized for the purpose of exploiting a portfolio of real estate assets that did not meet the yield criteria sought by REIT investors or that would benefit from redevelopment activity that might temporarily depress yields. HHC is organized as a C corporation to allow for maximum flexibility in financing and investment decisions (one relatively small consolidated entity, Victoria Ward Limited, is still operated as a REIT). The firm operates in three segments: Master Planned Communities (MPCs), Operating Assets, and Strategic Developments. All assets are located in the United States. The firm is named for the old Howard Hughes Corp. that owned the Las Vegas land that is now the Sutherlin MPC. General Growth bought the 50% of the unsold land in Sutherlin still held by the Hughes heirs for $230 million in September of 2010. HHC also recently bought out Morgan Stanley's 47.5% economic interest in the Woodlands MPC near Houston for $117.5 million, giving the firm 100% ownership in all four of the Master Planned Communities. The firm's strategy is to sell off the land in the MPCs and to redevelop or reposition the operating assets and strategic developments to maximize long-term shareholder value. The operating assets consist of retail and office properties that are currently generating income, though management is looking to redevelop or reposition most of them. The strategic developments segment consists of properties and rights that are not generating revenues and will require "substantial future development to achieve their highest and best use." One example of the firm's strategic developments is the right to build above the Fashion Show Mall in Las Vegas.
My Argument
My thesis on HHC is that the stock represents a free option on the development of currently depressed high quality real estate by a highly capable and well incentivized management team. To demonstrate why I believe the development options are free, I need to convince you that the value of the firm’s current net assets per share are at least equal to the current stock price. To do this I will make two arguments. First, I will argue that the firm’s current book value less the carrying value of the MPCs is a conservative estimate of the market value of those net assets. Second, I will show that a very conservative discounted cash flow (DCF) valuation of the MPCs yields a value above their carrying value. With the stock trading below book value, these conclusions demonstrate that there is a margin of safety in the stock, even with zero value attributed to strategic developments and options to redevelop the operating assets. Lastly, I will argue that the growth options are extremely valuable.
Why Operating Assets are Worth at Least Book Value
The firm’s operating assets were written down substantially in preparation for General Growth’s emergence from bankruptcy and the HHC spin-off. Bankruptcy courts are known for demanding conservative valuations designed to be of more use to bondholders than equity investors. I believe that HHC’s assets have been written down to a level that assumes that the current depressed conditions are a “new normal” in the real estate market. General Growth recorded $630 million in impairments on HHC assets in 2009 and $80.4 million were recorded on HHC operating assets alone in 2010. Riverwalk Marketplace in New Orleans accounted for $56 million of these impairments and Landmark in Alexandria Virginia accounted for the other $24.4 million.
Landmark, located just outside of Washington, DC, still represents an attractive development opportunity. Riverwalk was just starting to recover from Katrina when the recession hit, but it is still well rented and has a great location overlooking the Mississippi river. The property comes with both unique challenges and unique potential. Riverwalk is one of the properties in which HHC is keeping lease terms short to keep redevelopment options open (management admits this in their recent 10Q), which is generally unattractive to major tenants. This provides a second reason to believe that the operating assets are worth at least book value: the assets have significant untapped pricing power.
Valuing the MPCs
The biggest challenge in valuing HHC is valuing the MPCs. The land can’t be sold all at once, and small changes in assumptions about timing of sales, realized prices, discount rates, and the effects of inflation can result in large differences in valuations. Since I am most interested in estimating the low-end case, I performed a DCF valuation using very conservative assumptions. The results of this valuation appears below. I estimate a total value of $1,479,647,491 for the four MPCs. In order to avoid complications arising from inflation, I use real values for cash flows and discount rates. I conservatively assume that real land prices remain constant at today's depressed levels. While I have done my best to use reasonable, conservative values, in some cases my estimates are likely to well off. This is particularly true of my estimates for some of my land price estimates. See the appendix for a more complete description of my valuation assumptions.
| HHC MPC Values | ||||
| Summerlin | Bridgeland | Woodlands | Maryland | |
| Price/Acre Res. | $400,000 | $273,000 | $357,000 | $400,000 |
| Price/Acre Com. | $400,000 | $273,000 | $455,000 | $400,000 |
| Residential acres: | 5,934 | 3,831 | 917 | 8 |
| Commercial acres: | 890 | 1,226 | 936 | 200 |
| Total saleable acres: | 6,824 | 5,057 | 1,853 | 208 |
| Years to sell out: | 27 | 24 | 10 | 8 |
| Com. Acres Sold Per Year: | 33 | 51 | 94 | 25 |
| Res. Acres Sold Per Year: | 220 | 160 | 92 | 1 |
| Proceeds Comm. Sales/yr: | $13,185,185 | $13,945,750 | $42,606,200 | $10,000,000 |
| Proceeds Resi. Sales/yr: | $87,905,185 | $43,578,763 | $32,726,190 | $380,000 |
| Total Land Proceeds/yr: | $101,090,370 | $57,524,513 | $75,332,390 | $10,380,000 |
| % Cost of Sales Land: | 27.25% | 27.25% | 27.25% | 27.25% |
| Cost of Land Sales/yr: | $27,552,156 | $15,678,292 | $20,531,825 | $2,829,066 |
| Share of MPC Expenses: | 48.94% | 36.27% | 13.29% | 1.49% |
| MPC Expenses Per Year: | $10,562,303 | $7,827,924 | $2,868,428 | $321,346 |
| Pre-tax Income Per Year: | $62,975,912 | $34,018,297 | $51,932,138 | $7,229,588 |
| Tax Rate: | 35.00% | 35.00% | 35.00% | 35.00% |
| Taxes: | $22,041,569 | $11,906,404 | $18,176,248 | $2,530,356 |
| After-tax Income/yr.: | $40,934,343 | $22,111,893 | $33,755,889 | $4,699,232 |
| After-tax CF/yr.: | $68,486,499 | $37,790,185 | $54,287,714 | $7,528,299 |
| Real RF Rate: | 1.02% | 1.02% | 1.02% | 1.02% |
| Risk Premium: | 7.64% | 7.64% | 7.64% | 7.64% |
| Discount Rate: | 8.66% | 8.66% | 8.66% | 8.66% |
| Value of MPC: | $706,851,503 | $376,921,278 | $353,675,166 | $42,199,543 |
Completing the Valuation
Next, I compute the value of common equity by adding the adjusted book value of common equity from the Q2 balance sheet (less the carrying value of the MPCs) to the estimated DCF value of the MPCs and subtracting the $117,500,000 that HHC invested near the beginning of Q3 to buy out Morgan Stanley's interest in the Woodland's MPC. With the completion of that transaction, the share of equity attributable to non-controlling interests on the balance sheet is immaterial. I add outstanding stock options to shares outstanding to get diluted shares, but I do not add warrants, as a warrant liability of $298,493,000 already appears on the balance sheet. This value for the outstanding warrants exceeds the estimate that I obtained using an asset pricing model, so I retained the balance sheet value. Dividing the estimated total equity value of $2,144,928,491 by the 38,621,447 diluted shares results in what I believe to be a very conservative estimated value of $55.47 per common share, which is comfortably above the current stock price. Again, this valuation attributes no value to development options.
Total PV of MPC CFs: | $1,479,647,491 |
Book Value Equity End Q2: | $2,130,919,000 |
Less BV of MPCs: | $1,348,138,000 |
Less Q3 Woodland's Purchase: | $117,500,000 |
Total Value: | $2,144,928,491 |
Diluted Shares: | 38,621,447 |
Per Share Value: | $55.47 |
Upside
HHC's real estate portfolio consists of high quality properties in desirable locations such as the South Street Seaport in Manhattan, Ward Centers in Honolulu, and multiple desirable properties in the Washington D.C. metro area, Las Vegas, and the Houston area. I encourage you to read the 2010 10-K for a complete descriptions of the properties. It is important to note that the HHC's chairman Bill Ackman led the group that sponsored the plan for General Growth to emerge from bankruptcy and simultaneously spin-off HHC. This is important because it eliminates the possibility that General Growth might have loaded HHC with inferior properties. Ackman's Pershing Square Capital, along with Brookfield Asset Management and M.B. Capital Partners all hold large blocks of stock and warrants in HHC.
This write-up is long enough already, so I am not going to attempt to quantify the option value that HHC is likely to realize from its strategic developments and its options to redevelop its operating assets, except to say that I believe that it could be multiples of the current stock price. Some financial analysts use the term "option value" loosely to refer to the possibility that something good might happen in a firm's business at some point in the future. However, in order to profitably take advantage of an option to increase capacity in an industry, a firm must have some way of protecting itself from competition. HHC has a clear competitive advantage in the form of unique assets, namely the contractual rights to develop some very desirable locations. HHC also has the ability to lever up to take advantage of these opportunities. Typically, failure on one project, no matter how disastrous, will not destroy the option value of other projects because most of the debt used in HHC's developments will be non-recourse debt secured only by the assets of the project or joint venture entity. Almost all of HHC's current debt is non-recourse.
HHC's experienced and accomplished management is extremely well incentivized with warrants and stock holdings. The company's CEO, President, and CFO even took the unusual step of purchasing warrants with their own funds, and the warrants are not exercisable until 2016 or 2017. Strike prices for the warrants range from $42.23 to $54.40. The further in the money the warrants get, the more the interests of the warrant holders resemble those of long-term shareholders.
Risks
-The housing market fails to turn around in the next few years (current depressed conditions are in fact a "new normal" in the real estate market).
-Management fails to execute. I have no reason to believe that this will happen, but it can never be ruled out.
Catalysts
-Increased analyst coverage.
-High profile profitable projects capture the attention of investors.
-Inflation fears or actual inflation lead to a run on quality real estate.
-"The big one" hits California; Summerlin West becomes oceanfront property.
(kidding about that last one of course).
Appendix: Why My MPC Valuation is Conservative
Most land prices are based on recent sales recorded in HHC's SEC filings, but some are estimated based on similar listed properties. When possible, the low end of the price range is used. I used management's estimates of the number of years for each MPC to sell out from HHC’s 2010 10K and subtracted one year from each. I then simply assumed that the available commercial and residential acreage will sell out uniformly. That is, I divided remaining residential acreage, accounting for sales through June 30th, 2011, by the number of years to sell out for each MPC. I then did the same for the commercial acreage. This results in projections of 472 residential acres and 203 commercial acres sold per year for the first eight years, before the first MPC sells out. If one only considers projected sales in the first year, this assumption could be classified as mildly aggressive. HHC sold 192 residential acres and 36.6 commercial acres in the six months ended June 30th, 2011. This annualizes to 384 residential and 73.2 commercial acres. However, given the state of the real estate market and the fact that HHC has only recently put its full sales team in place, it is not unrealistic to believe that HHC will reach the projected sales level in a year or two. More importantly, in most scenarios it would be assumed that sales will be heavily front-loaded. Using a front loaded pattern of sales with sales decreasing by 10% per year with otherwise identical assumptions (not shown on this write-up, but I can provide the spreadsheet) results in a total estimated value of $1,866,344,496 for the MPCs, versus the $1,479,647,491 estimated in the table. Cost of sales as a percentage of land sale revenues is estimated by dividing the carrying value of the MPCs by the total nominal amount of projected revenues from land sales. Estimated MPC expenses are taken from the 10Q. The share of MPC expenses for each MPC is based on the pro-rated share of acreage. The statutory tax rate of 35% for U.S. corporations is assumed. The real discount rate is estimated as the real return on 30-year treasury bonds plus the implied risk premium on the stock market estimated on October 1st, 2011 by professor Aswath Damodaran. This last figure should be used with caution, especially when stock prices are high, but in this case I believe that the result is reasonable, though conservative. HHC used a nominal discount rate of 8.5% to estimate the value of the Riverwalk asset for impairment purposes.
Disclosure: I am long the common stock of the Howard Hughes Corporation (HHC).
