Why Hovde is Wrong About General Growth Properties
[See original version of article with better looking charts at Seeking Alpha.]
General Growth Properties (GGWPQ.PK) has been in bankruptcy protection since April, after being unable to refinance maturing debts. While General Growth’s record of profitability had been strong, their massive debt load still came back to bite them during the credit crunch. As of their March 31st 10-Q filing, their debt-to-equity ratio was an astounding 13.8!
General Growth started attracting investor attention in May, however, after hedge fund manager Bill Ackman made the case for buying into the company. Essentially, he believed that in spite of GGWPQ’s bankruptcy filing, equity investors would come out unscathed because the value of their assets was greater than the value of the debts.
Shares of General Growth Properties plummeted Tuesday morning after news that hedge fund manager Eric Hovde was shorting the company. Hovde’s basic thesis is that the company's equity is worth $0 based on a valuation analysis using capitalization rates over 8.5%. Hovde directly challenges Ackman’s analysis and believes that the cap rates make the company worth nil.
Why Hovde Might Be Wrong
Hovde’s analysis has been critiqued already by a few authors including Todd Sullivan and Whitney Tilson. Sullivan attacks Hovde’s use of an 8.5% cap rate, which he views as unrealistic given the current realities. Tilson also critiques the cap rate, but further states that a cash flow analysis should yield a much higher valuation.
I would further press the case that using cap rates, while completely ignoring cash flows, is an extremely flawed methodology to value General Growth. The end result, in this case, is an almost nonsensical analysis where one must conclude that certain properties have no value even when there is direct evidence that they are highly profitable. All in all, General Growth’s net property values and cash flows suggest that it may be undervalued by the market.
A Balance Sheet Analysis
First off, let’s take a look at the balance sheet. My abbreviated version of it can be found below:
The first thing that jumps out to me is that absurdly highly amount of leverage that General Growth took on. Simply going by that, General Growth looks like it could be a rotten investment since any minor declines in value in their property account could make their equity fall into the red. But to end our analysis there would be foolhardy.
The second thing I’ve started looking at on the balance sheet of REITs is the accumulated depreciation account. In particular, I like to analyze the ratio of Accumulated Depreciation to Gross Property and Equipment [AD/GPPE]. This might seem like an odd statistic to gauge, but the reason I look at it is because the inherent contradiction with real estate book values. Real estate properties are carried at cost on the balance sheet and they take depreciation charges over time. However, real estate generally appreciates in value over time; the past two years are a rare exception to the rule.
General Growth has one of the highest AD/GPPE ratios I have seen at 19.3%. If one were to scan through their most recent 10-K filing and search for their accumulated depreciation schedule, one would see that many of their properties were purchased pre-2004, with a sizable number of purchases in the 1990s. This is important because (a) these properties were not purchased at the height of the bubble and may be undervalued on the balance sheet and (b) they have taken more significant depreciation charges than most recently purchased properties in 2006 or 2007. Hence, there's a greater likelihood that they are undervalued based on book values. While GGWPQ does have a few notable post-2004 purchases and they had a slew of developments after 2006, which were in no small part a cause in their bankruptcy filing, these properties do not dominate their overall portfolio.
There is a caveat here, however, and that’s my personal belief that mall REIT properties are the most difficult to ascertain valuation projections for. This is because, unlike office, industrial, or residential properties, mall REIT properties’ values are highly dependent on foot traffic and foot traffic seems to be highly dependent on the general aesthetics and appeal of the mall environment. What this means is that mall REIT properties don’t automatically retain their value as well as other commercial or residential properties. Rather, a mall REIT must make significant capital contributions to a given property to “retain its value.”
However, this is one thing that General Growth has been very good at. In fact, you could say of General Growth that they are one of the world’s best managed mall property firms, but that they have terrible financial management skills. It’s easy to see why they went bankrupt once one takes a look at their capital expenditures (which I do further below), but they’ve actually been very successful at their bread and butter of managing mall properties.
The real value in General Growth is in the cash flows their properties generate. While GAAP earnings have been poor recently, those are largely irrelevant to any meaningful analysis both because of the deprecation factor and because of other non-cash charges. In order to try to gauge General Growth’s “real profitability”, I have attempted to devise some measures that would analyze “sustainable earnings”, which is sort of my own hybrid between “earnings” and “cash flows.”
The best measure in my opinion would be “EBDTA + Impairments.” Notice I excluded interest, which is traditionally used in EBITDA. It makes little sense to ignore interest when that’s precisely the thing that might be weighting a company down. I also added “impairments” back since they are non-cash charges.
I also attempted to come up with another similar measure “Sustainable Real Income.” It should theoretically be more accurate than my first measure, but the problem is that it’s really difficult to conclude what General Growth’s real tax rate might be based on this calculation. As a result, it ends up being flawed.
In any case, here are the results:
Notice that for the current fiscal year, we end up with an annualized “EBDTA + Impairments” profitability of $1.56 per share. Given that the fourth quarter would most often be the best quarter for a mall REIT, this probably understates the actual profitability.
Since my Sustainable Real Income (“SRI”) measure doesn’t work very well here, it might be more meaningful to tack on a tax rate to “EBDTA + I”. However, in reality, since General Growth’s depreciation charges will probably exceed this number for the foreseeable future, it’s completely possible that they will have a 0% real tax rate for the next few years.
The next thing I want to do is find out what General Growth’s earnings would be in the event that revenues continued to decline. I create a pro-forma chart of my previous chart in order to accomplish this. I decide to try to annualize the first three quarters of this year to get a FY 2009 estimate. My belief is that I am lowballing this estimate based on expense numbers in previous Q4s, but this should be reasonably close.
For the subsequent columns, I look at a certain percentage (e.g. 5%, 10%) drop in revenues. Then, I offset that by a drop in expenses equivalent to half the drop in revenues. For instance, if revenues drop 10%, I drop expenses 5%. Is this realistic? It may or may not be. It’s completely possible that I am underestimating a drop in expenses, but then again, this might be about right.
Here are the results of the pro-forma real profitability measures:
Notice that revenues have to drop more than 20% before we finally hit negative territory. That’s a pretty steep drop considering how far we’ve fallen already.
Finally, let’s take a quick look at cash flows. The following chart lays out three measures:
Cash Flows from OperationsCash Flows from Operations excluding Working Capital changesFree Cash Flows
Just as above, I divide it into fiscal year results and the results for the first three quarters of ’09 and ’08:
The first thing that really stands out to me is the CapEx from 2006 to 2008 (which I highlighted in bright yellow). You want to know why General Growth went bankrupt --- that measure explains it better than anything else! This company seems to have placed no realistic limits on their capital expenditures, so in spite of the fact that they were doing very well in their operations and very profitable, they went on a complete debt binge in the belief that they could never grow fast enough. Once you limit the absurdly high capital expenditures, General Growth’s cash flows actually look pretty good.
The most important measure to me from the above chart would be Cash Flows from Operations excluding Working Capital changes. For the first three quarters of FY ’09, General Growth’s CFOs – WC was at $1.45 which is pretty good. While I didn’t do it on the chart, it might even be more useful to look at that measure and subtract capital expenditures, which gives one a result of about $300 million or roughly 95 cents per share. If you annualize that and assume a slight uptick for Q4, it’s about $1.30 per share. Which isn’t bad and certainly suggests that the company’s true value is not $0.
While the earnings and cash flow analysis are relatively straightforward for General Growth, other variables are much less so. It is my belief that their properties are slightly undervalued on the balance sheet, but this is based, in no small part, on the cash flows those properties are producing. Given General Growth’s heavy leverage, it’s pointless to assign any value to their assets (due to an equity interest) aside from the cash flows.
As such, I would value General Growth based on a “real profitability” estimate between $1.00 – 1.50 per share. My best guess is $1.20 per share, which would yield a valuation of around $15 - $20 per share.
Once again, however, the heavy leverage and the fact that they are in bankruptcy protection creates a lot of variables that are difficult to compensate for. As such, I would not choose to go long on this at the current price, which is near $9 per share. This is not only because of the uncertainty, but also because I believe there are other mall REITs that are more attractively priced right now (and not in bankruptcy protection).
If I had conducted my analysis when the shares were selling for $1, though, I would’ve gone long in a heartbeat. Too bad I am late to the game, but I chose to buy into other REITs instead and have done fairly well on those. Of course, if I could turn back time, obviously, I’d take GGWPQ at $1 instead. At this point, I probably wouldn’t consider jumping into GGWPQ unless it fell below $5 again.
The Final Say
When I took my first equity analysis course at UNC, I remember the first assignment my professor gave us that involved creating a Discounted Cash Flow (DCF) analysis. He put us into groups and we were all completely clueless. The test company was Starbucks (SBUX). We plugged some numbers into his model and he went around the class the next day asking about our results. Most of the groups (including my own) had absurd answers that seem to be easily refuted by much simpler measures. Some groups came up with values over $100 (this was in Spring ’08, mind you) and I believe my group came up with a value of around $65.
The basic point I am driving at here is that you can’t simply arbitrarily plug numbers into a model and come up with a realistic valuation. You have to understand what those numbers are doing, why you are using them, and then you have to compare them to the reality that you do know in order to see if the two are in sync with one another.
Hovde’s analysis seems to fail on this front. You can talk about cap rates all you want, but when the cash flows are staring at you right in the face and directly contradict that analysis, then one must consider that there are significant flaws in their methodology. Todd Sullivan lays out the case as to why the 8.5% cap rate is not realistic to begin with, but a simple glance at the cash flow statement should tell one as much.
Due to the uncertainties associated with bankruptcy, I would not say with 100% certainty that General Growth has a true valuation over $0, but I believe the cash flows suggest that it’s more likely than not that it does. Moreover, it is probably worth more than $10 per share and possibly worth over $25 per share. As such, even if there are good reasons to be skeptical of the long case, I view it as a completely terrible short opportunity. Hovde may get burned badly on this one. Disclosure:
Author has no position in GGWPQ.PK. Author is long on several other REITs.