Iron Men

The richest man in the world pondered the unfinished business of his life. Hoping to mend their rift, Andrew Carnegie penned a letter to his former partner. He requested a meeting with Henry Clay Frick, whose towering palace loomed only blocks away from Carnegie’s own Fifth Avenue mansion. The irascible Frick was in no mood to satisfy the old man’s ego. He received the hand-delivered note, wadded the paper and tossed it back to the messenger. “Yes, you can tell Carnegie I’ll meet him. Tell him I’ll see him in Hell, where we are both going.”

Steel is an alloy forged by fire from iron and carbon. Nothing generated more heat and pure carbon than the coking coal of Western Pennsylvania, and nobody made more coke than Henry Clay Frick. Their business alliance provided Carnegie Steel with a ready supply of inexpensive coking coal. Steel from Carnegie’s Pittsburgh empire would form the backbone of America’s industrial revolution.

Carnegie so greatly admired Frick’s relentless pursuit of cost reductions that he proposed that the coke baron should become the boss of his steel business. Carnegie awarded Frick shares in the company. Frick could be tyrannical, but his methods proved successful. Carnegie Steel’s production and profits soared.

But relations between the two industrial titans became testy. Frick’s involvement in the dam failure that caused the catastrophic Johnstown Flood of 1889 killing more than 2,000 set Carnegie on edge. His violent repression of the 1892 Homestead strike tarnished Carnegie’s reputation. They argued endlessly over the price increases for Frick’s coke. Finally, Carnegie invoked the “Iron Clad Agreement”, a long-dormant business clause which provided a mechanism for a partner’s removal from the business. By January of 1900, Frick was out.

Iron has always been synonymous with strength. Herman Knaust chose the name Iron Mountain for his record-storage business in upstate New York during the 1950’s. As corporations produced millions of paper documents, their safe preservation became paramount. Knaust saw the need to store them in a secure facility where they could not be damaged by fire, theft, or even atomic blasts.

Iron Mountain (IRM) has grown to become one of the world’s leading document and data storage companies with over $6 billion in revenues over the trailing twelve month reporting period ending September 2024 (TTM3Q). Storage generates 62% of revenues, and the remainder comes from services, including document processing as well as the de-commissioning and disposal of used IT equipment. Despite the high concentration of service revenue, Iron Mountain trades as a real estate investment trust. The company has over 7,400 facilities in 60 countries, with 98 million square feet of floor space and 731.5 cubic feet of storage volume.

The main attraction for Iron Mountain during the past four years, and its most likely source of growth for many years ahead, is the construction and operation of data storage facilities. These are the buildings that house IT servers and cloud storage infrastructure. The demands for robust computing power for artificial intelligence has set off a race to develop data centers. Iron Mountain aims to be at the leading edge of the AI infrastructure boom.

The current data center portfolio has 26 locations with 918 megawatts of storage capacity. 327 megawatts is leased or under contract, 184 megawatts is pre-leased, leaving 357 megawatts yet to be leased. The company expects 130 megawatts to be leased for the year 2024. At the end of 2023, Iron Mountain had $1.6 billion of development in progress.

Data center construction requires immense amounts of capital. Cushman and Wakefield, a leading real estate advisory and brokerage firm, recently released a 2025 Data Center Development Cost Guide. The average cost to develop one megawatt of “critical load” (building and IT equipment) averaged $11.7 million in the US. In other words, the cost to double Iron Mountain’s data center capacity would be $10.7 billion.

It will be difficult for Iron Mountain to grow its data center portfolio without issuing more stock. The company’s status as a REIT requires it to distribute most of its income, so retained earnings are minimal. Operating cash flow over the TTM3Q summed to $836 million, and $769 million was paid to shareholders.

Iron Mountain equity trades at a market capitalization of $31 billion and debt and leases account for $17.1 billion, giving the enterprise a value of $48 billion. The company is rated below investment grade by Standard and Poor’s at the BB- level. The current weighted average cost of the company’s debt is 5.67%, but additional debt in today’s current rate environment would cost IRM 6.7%. Additional leverage is not a prudent source of capital unless it is paired with the issuance of new stock.

At today’s market price of $105.73 per share, Iron Mountain trades at a 45% premium to its intrinsic value.

I’ve taken a two-step approach to arrive at a value of Iron Mountain’s equity closer to $73 per share. Using the earnings power valuation (EPV) method, I took the free cash flow for the business and discounted it at the weighted average cost of capital of 7.6%. The aforementioned 6.7% cost of debt (5.53% after taxes) account for 34.8% of capital, and 8.7% was used as the cost of equity. I simply priced equity 2% over the market cost of debt. Unlevered free cash flow of $1.7 billion capitalized at 7.6% is $22.5 billion. Subtract the market value of debt and leases ($13.59 billion and $2.91 billion, respectively), and the net EPV is $7.84 biilion.

Next, I went fishing for the simplest possible explanation for the gap between the market value of the business and the intrinsic value of its current assets – the unknown future development pipeline. I created the most basic discounted cash flow projection possible. I assumed that IRM placed a development pipeline into service that started with $1.6 billion in Year 1 and grows by 10% annually over five years. I assumed the data centers earn an 8% yield on cost. The terminal value of the business reflects perpetual growth at the current Treasury 10-year yield. The present value of future cash flows, discounted at 7.6% amounts to $13.5 billion. The net value of these two figures, after adjusting for noncontrolling interests is $21.3 billion, or $72.57 per share.

Readers may say that my discount rate is too high. After all, institutional quality real estate continues to trade at capitalization rates between 5% and 6%. I would argue against a lower discount rate for two reasons: One, the faster that the world embraces digital data, the more IRM’s legacy businesses of document processing, storage and destruction diminishes in value. Two, the discounted cash flow model, while laughably over-simplistic, is also generous. Few institutional real estate developers earn much more than a 6% yield on their costs in the current environment. More importantly, my model makes no allowance for the rapid depreciation of the equipment and possible obsolescence of the facilities as more sophisticated ones are built.

Frankly, my earnings power valuation is also quite generous. I add back restructuring charges, despite their seemingly recurrent nature. The company has incurred nearly $670 million in restructuring charges since 2019. I make a deduction for the ongoing capital needs for the facilities, but no deduction is made to unlevered free cash flow for the “customer inducements” and “contract costs” that exceed $100 million annually. These charges appear among capital items rather than on the income statement where they probably belong.

More conventional metrics also point to Iron Mountain’s inflated valuation. The company offers a 2.7% dividend yield – thin gruel in a market where 10-year TIPS can be bought with a 2.23% handle. Meanwhile, IRM trades at 23.5 times adjusted funds from operations (AFFO) projected to be $4.50 per share for 2024.

Iron Mountain will be forced to raise equity in large amounts to fund the data center program. The additional shares will be highly dilutive if the investments can’t yield more than the cost of capital.

Iron, carbon, steel, silicon…the future beckons.

Until next time.

Note: Meet You in Hell is an entertaining book by Les Standiford, published in 2005, that chronicles the formation and dissolution of the relationship between Carnegie and Frick. Chapter One colorfully describes the “letter incident”.

DISCLAIMER

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.

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Don’t know much biology

Alexandria Real Estate Equities is the leading landlord for the pharmaceutical and biotechnology industries. The Pasadena-based firm boasts 41.8 million square feet of office and laboratory space, with a further 5.3 million square feet under construction. Shares of the real estate investment trust with the ticker ARE closed at $102.66 on Friday. Total market capitalization of $18 billion represents a slight discount to the book value of equity on the balance sheet.

Alexandria focuses on campus “clusters” where it has been proven that the proximity of multiple science innovators stimulates creativity. These clusters have been developed in locations with robust university ecosystems such as Boston, the Bay Area, San Diego, New York, the DC metro, Seattle, and the “Research Triangle” of North Carolina. Most recently, the company announced a 260,000 square foot lease with the bacterial disease biotech firm Vaxcyte at the San Carlos, CA campus.

Occupancy is a healthy 94.7% across the portfolio. Alexandria’s balance sheet shows $33 billion of real estate assets (undepreciated) and $12 billion of debt. Standard & Poor’s regards the debt as investment grade with a BBB+ rating.

Despite the good metrics, Alexandria stock has been pummeled over the past three years, falling by more than half from the $223 peak at the end of 2021. The biotech industry boomed during the early stages of the pandemic, but the subsequent collapse has been brutal. Deals in the pharmaceutical industry have fallen to their lowest level in a decade. This is a far cry from the halcyon days of 2020 and 2021, when over 183 firms raised more than $30 billion from initial public offerings. Today, most trade below their IPO price, and many are cash-burning zombies.

Over the years, Alexandria has invested in many of its tenants with it’s own venture capital arm. Between 2018 and 2021, Alexandria booked over $1 billion in investment gains on its portfolio.

Unfortunately, as the market turned hostile, investment losses in 2022 and 2023 exceeded $527 million. At the end of September. Alexandria carried $1.5 billion of investments among its assets. Some are publicly-traded and marked-to-market on a consistent basis, but most are illiquid and the value is highly subjective.

Trouble in the biotech industry also led to losses of rental income. Between 2020 and 2023, ARE faced lease impairments in excess of $750 million.

Is Alexandria’s stock now a bargain? Not quite. I consider a stock trading 25% or more below its intrinsic value to signal an investment green light. Based on my calculations, the stock trades at a 7% discount to the value of its underlying assets.

Intrinsic value calculation:

By my estimates, 2025 free cash flow will be approximately $1.7 billion. Capitalizing this amount at 6.59% leads to a value of $25.7 billion for the operating real estate. Adding development in progress and the company’s investment portfolio, both at book value, leads to a total asset value of $34.9 billion. Subtracting the market value of debt results in a net value of $24.5 billion. Many of the company’s assets are held in joint ventures with developers, so about 18% of the value is attributable to these partners, leaving a net asset value of $20 billion.

There are some important caveats to consider:

  1. I’ve mentioned the risky nature of the venture-backed tenants. They sow the seeds of major upside for Alexandria, but they could also prove to be a source of future impairments.
  2. Interest expense is mostly capitalized. The company reported about $162 million of interest over the trailing twelve months. In reality, this figure is much higher. In 2023, about $364 million of interest was capitalized because it was related to debt on new developments. This is entirely appropriate, but the failure to lease pending space could lead to a drag on results if this interest must be deducted from operating profits
  3. New developments are significantly more costly. Although ARE is only expanding its portfolio by 13% with its current development pipeline, the cost of new projects equate to more than 28% of undepreciated book real estate assets. Construction costs suffered massive inflation since 2020, and it will be difficult to obtain future rents that need to be 30-40% higher than current market levels to drive adequate returns.
  4. Returns on capital have never been much better than 6%. Taking a look at cash operating income as a percentage of undepreciated operating assets shows a company that has earned returns that aren’t exactly eye-popping. This is institutional-quality real estate with very low debt costs, so the 6% neighborhood may be respectable, but its not the kind of number that will drive exceptional growth.

Which brings me to my final issue with all REITs in an environment of sustained higher interest rates: the prospect of equity dilution.

REITs, by virtue of their tax-exempt status, must distribute most of their profits. Retained earnings are a limited source of growth capital. External capital and the reinvestment of gains from property sales provide the funding for growth. In the low-rate era between 2009 and 2021, earning a 6.5% return on capital drove returns on equity to the low double digits when borrowing costs were in the 3-4% range. Indeed, as share count rose by 65% over the past six years, assets on the balance sheet increased by 170%. This positive leverage is the key to building real estate wealth.

In the current rate environment, the math isn’t so hot. If Alexandria finds itself unable to grow with low-cost debt, incremental shares must be offered to the public in ever-increasing quantities. When capital is expensive, REIT shareholders face dilution.

So where does this leave us?

Alexandria has a solid business renting space to big pharma companies. Most of its debt is financed at 3.8% for another 13 years. The stock trades at a slight discount and offers a nice dividend in excess of 5%. However, ARE also relies on the ability of many cash-burning high-risk ventures to continue paying rent.

Many firms will fail. Some may become blockbusters. Alexandria doesn’t have to bet on one horse, it owns the thoroughbred farm. They know which smaller tenants are growing and making progress on their drug pipelines. In fact, their venture business gives the firm upside when a tenant wins the derby.

If you have a favorable outlook on the biotechnology industry, Alexandria shares seem like a decent way to receive a nice dividend while a recovery forms. Indeed, there are signs of a thaw. Several new funds have found traction. Venture money may be flowing to the industry once again.

As for me, I would prefer to wait for a further decline in the share price to make an acquisition. The company has $9.3 billion of development in progress that may struggle to find tenants willing to pay top dollar for lab space. The new paradigm for inflation-adjusted rents has not been “battle-tested” in a market where firms are looking to preserve cash. Splashing out big dollars on fancy office space probably won’t sit well with venture capital investors who have seen much of their pandemic era gains evaporate. Corporate austerity may be the new watchword for the biotech industry.

Until next time.

DISCLAIMER

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.

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Control

Louis XIV was a control freak. The “Sun King” reigned from 1643 to 1715. The king’s day was timed to the minute to allow the officers in his service to plan their own work accordingly. From morning to evening his day ran like clockwork, to a schedule that was just as strictly ordered as life in the Court. “With an almanach and a watch, one could, from 300 leagues away, say with accuracy what he was doing”, wrote the Duke of Saint-Simon.

When it came to rigorous discipline, the King’s finance minister was equal to his master. The legendary Jean-Baptiste Colbert brought fiscal responsibility to a kingdom that was nearly bankrupt at the start of the 1650’s. Colbert, a relentless workaholic, introduced a system of government accounting that was the first of its kind. Spending was brought to heel and tax collections were enforced.

Colbert is often credited with laying the foundations of the modern French state. He centralized government power and introduced mercantilist policies which included investments in infrastructure and academies for the sciences, engineering and arts. Colbert raised tariffs on manufactured imports like Venetian glass and Dutch textiles and promoted French industry.

Although modern France recognizes Colbert’s fiscal innovations, few mourned his passing in 1683. The French taxation system was notoriously regressive, with nobles and clergy being exempt. Peasants, laborers and business owners were taxed heavily. Even many noblemen despaired at Colbert’s reforms. Oral testimony was no longer allowed for verification of one’s noble status. The rolls of noblemen were purged as those of the highest caste were required to provide documentary evidence dating back more than 100 years.

In modern finance, the lack of control can lead to all sorts of complications. Take Live Nation (LYV), for instance. Live Nation owns Ticketmaster and produces over 44,000 live music and events around the world each year. Yet, during the first nine months of 2024, only 60% of earnings were attributed to shareholders. The company owns and operates venues through a series of joint ventures with local promoters and facilities owners. These noncontrolling interests have a claim on 28% of net income.

There are also redeemable noncontrolling interests that have a claim on company earnings. These are opaque arrangements with promoters that have the ability to sell their interests back to the parent company using a put option. The problem with these put options is that their costs are variable in nature – the more the company earns, the larger the option premium gets.

These redeemable noncontrolling interests are shown on the balance sheet as a liability, but because they can increase in value over time, this “accretion” is also deducted from earnings per share. For the nine-month period ending September 30, 2024, earnings amounted to $849.2 million. Subtract the share for noncontrolling interests, and $695.3 million was left. Or was it? Earnings per share should have been $2.95, but the accretion of redeemable noncontrolling interests for the period meant that only $2.18 was attributable to shareholders. This means that LYV is trading at 160 times earnings for the trailing 12-month period.

Live Nation seems to be overvalued by as much as 54% once deductions are made for noncontrolling interests. I am not even factoring in the possibility of anti-trust litigation for monopolizing the ticket industry. While such enforcement seems less likely under the Trump administration, much risk remains.

Live Nation posted $23.3 billion in revenues over the trailing twelve-month period. There are massive margins in tickets. Ticketing accounts for about 12% of revenues, and 37% of operating income. The venue operations, on the other hand, are capital intensive and only generate 5% margins. To make matters worse, growth seems to have peaked. With the conclusion of the Taylor Swift tour and the post-pandemic surge fading from view, revenues declined by over 6% in the third quarter. Aside from the excitement around the Sphere (SPHR) and a few major tours, many concerts have struggled over the past year.

Below is my earnings power valuation for Live Nation. I calculated an equity value of $12.7 billion versus the current market capitalization of $31.3 billion. I applied a weighted average cost of capital of 8.22%. This factor includes $6.3 billion of debt with an S&P rating of BB, or an imputed debt cost of 5.85% under current yields and spreads.

Is my discount rate too high? Perhaps. But even if you use 6%, the equity value sums to $18.8 billion. Should I factor in something for growth? Maybe. But there doesn’t seem to be much near-term growth. In the long-term, growth will come from more venue developments and leases – a business which generates poor yields on capital. There’s a reason why most venues are built with taxpayer funds: the economics rarely work. No amount of U2 and Adele concerts can save The Sphere from an eventual bankruptcy filing.

I am also being pretty fair with how I treat the redeemable noncontrolling interests. I do not deduct anything from earnings. Instead, I have deducted the $1 billion book value shown on the balance sheet after operating income has been capitalized. Finally, I only make a deduction for maintenance capital expenditures of $188 million. In reality, the future capital commitments for the firm are much greater.

It was said that between 3,000 and 10,000 courtiers visited Versailles on a daily basis for a chance to mingle with the Sun King. If only Colbert had Ticketmaster in his day.

Until next time.

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Rock Paper Scissors

The Seven Years’ War was the first global war. Battles were fought on three continents as European conflicts spread to colonial territories between 1754 and 1763. Great Britain and Prussia fought an alliance of France, Austria, Russia and Spain. In North America, Britain and France battled on the frontier. Iroquois warriors joined British soldiers against French forces allied with Algonquin and Huron tribes. In defeat, France ceded control of the Great Lakes and Canada.

The Seven Years’ War laid important foundations for the American Revolution. First, the war left Britain with heavy debts. Taxes were levied against the British colonies to replenish King George III’s treasury, sowing bitterness and resentment. Second, the war militarized the colonists. Militias were armed and George Washington and his officer peers trained under British high command. Third, France was eager to avenge her losses, and an alliance with the rebellious colonists would form in the following decade.

In the late days of the American Revolution, with Washington’s ragged army badly in need of a victory, France raised the game. Comte de Rochambeau marched 5,500 troops from Rhode Island to New York where the French Expédition Particulière joined the Continental Army. As French ships prevented a British escape from Chesapeake Bay, forces led by Washington, Lafayette and Rochambeau routed the redcoats at Yorktown, Virginia. The victory was decisive, and independence soon followed.

“Rochambeau” is instantly familiar to many because it is a name frequently given to the game more commonly known as “rock-paper-scissors”. You’ve never heard it called “Rochambeau” before? Me neither. But my friend from Colorado swears by it as does my native-Minnesotan wife.

Why Rochambeau? Was Lafayette the winner who laid some smooth paper on his compatriot’s rock, thus forcing Rochambeau to take command of a grueling march through the mid-Atlantic during the blistering humidity of a colonial summer? Paper always seems to be the sneakiest move. It’s counter-intuitive to win with paper, so light by nature, and it’s just the sort of play a sly bâtard like Lafayette would lay down. Touché.

It turns out there is no proof that Rochambeau ever played rock-paper-scissors, and drawing any connection with the French general is pure speculation. According to the authority on such matters, the World Rock-Paper-Scissors Association, the first mention of a game called Rochambeau appeared in the 1930’s.

Rochambeau is an easy game. Usually, the loser is required to complete some unpleasant obligations like take out the trash, change a diaper, follow Scooby into a haunted cave, or march to Yorktown through swamps and marshes. Government-sponored lotteries are also pretty simple. The winning number is drawn at random. Huge jackpots, microscopic odds. Our governments have been in the gambling business for a long time.

Governments sponsor and benefit from lotteries but they outsource the operations to businesses. The largest publicly traded provider of lottery services is a company called International Game Technology (IGT). Based in London, IGT has substantial operations in Italy and Rochambeau’s old stomping ground of Rhode Island. De Agostini, an Italian conglomerate, controls 42% of the company. IGT runs lotteries, and it also produces gambling technology and equipment. Earlier this year, private equity giant Apollo agreed to pay IGT $4.05 billion for the gaming division with plans to merge it with Everi – another game-tech business. The sale will be completed in the second half of 2025 and will leave IGT as purely a lottery service provider.

Unfortunately, there is no free lottery ticket lying on the ground for buyers of IGT. The price of IGT stock appears to offer no upside to those waiting for the check from Apollo to arrive. In fact, after adjusting for the Apollo transaction, the equity of the combined entity is trading at a 3% premium to the intrinsic value of the lottery business.

The lottery business may be appealing to some because it carries long-term contracts and largely predictable revenue streams. Although point-of-sale equipment is needed, the business doesn’t require a huge capital investment as more of it migrates online. But there lies part of the rub: as more moves online, the gambler’s options widen. Lotteries are a crude game of chance. Why not take a few hits at those wagers which involve “skill” – sports betting and casino games? Certainly, staid old lotteries will lose in the ever-increasing world of online gambling choices.

There are two other problems with IGT: One, the company provides a huge windfall for governments, so naturally it is taxed as such. Tax rates for the company approach 50%. Two, quite a lot of the profits go out the back door through a series of joint ventures. Non-controlling interests grab about 47% of the value.

So, what’s left for the shareholders? You’ve got a lottery business with $2.5 billion in revenues. Operating margins are about 27%, but the taxman taketh 50%. There is about $600 million of free cash flow remaining which can be capitalized at a rate of 7.2%*. Adding $4.05 billion of cash to the net debt of $5.16 billion, results in an equity value of $7.17 billion. Noncontrolling interests have a claim on 47%, so the lottery business is worth about $3.8 billion to shareholders. Meanwhile, the market cap of IGT equity is about $3.9 billion today.

Note: Between the time this article was drafted last week and published today, IGT dropped 6%.

IGT may be worth keeping an eye on. If the market continues to trade the business lower, a discount could emerge. Right now, the odds favor the house.

Until next time.

DISCLAIMER

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.

*Weighted average cost of capital was determined with the assumption that the company’s optimal capitalization is 35% debt and 65% equity. IGT carries a BB+ S&P Rating and therefore has an approximate 6% cost of debt. The figure of 9.06% was calculated as the cost of equity.

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Mauna Loa

Mauna Loa is Earth’s largest active volcano. The Hawaiian mountain is also the world’s tallest. Mauna Loa rises 30,085 feet from base to summit which is higher than Mount Everest measured from sea level to peak (29,029 feet). To say that much lies below the surface is an understatement. The weight of millions of years of volcanic eruptions has actually caused the Earth’s crust to sink by five miles. Therefore, the total height of Mauna Loa from the start of its eruptive history is an astounding 56,000 feet.

The 45,000 residents of Hilo, Hawaii, while living among some of the most beautiful surroundings in America, also face the possibility of extinction. Mauna Loa last erupted in 2022, but lava flows were minimal. Eruptions damaged small villages in 1926 and 1950. The most recent serious threat occurred in 1984, when massive rivers of molten rock stopped just a short distance from Hilo Bay. The threat to Hilo is not an apocalypse of Pompeian proportions. No, the real danger is a slow and painful demise. If Hilo Bay fills with lava, cargo ships can’t dock. The Big Island would cease to be habitable.

Now if you think I’m about to use my newfound knowledge of volcanic peril as some kind of metaphor for the current state of financial markets, you would be absolutely correct. It’s coming down Fifth Avenue. About as subtle as Captain Kirk wearing a Bill Cosby sweater.

In my metaphor, Warren Buffett is the Pacific Ocean near Hawaii. Vast, deep, and refreshingly cool with about $325 billion of cash on hand after selling more Apple stock, according to Saturday’s 3rd quarter report. Yes, he’s got some risk from storms but mostly it’s smooth sailing. Mauna Loa is the AI bubble. As lava keeps building up, the peak gets higher. It’s thrilling… and dangerous.

Technology companies will spend $200 billion this year on capital improvements related to artificial intelligence. This technology will require the addition of 14 gigawatts of additional power by 2030. To put that in perspective, Berkshire Hathaway Energy’s coal plant in Council Bluffs produces 1,600 megawatts of electricity.

Do you think nuclear is the solution? Well, Georgia just opened our country’s latest nuclear facility. The Alvin W. Vogtle Electrical Generating Plant sits along the Savannah River in Waynesboro. This marvel took 15 years to build and cost a mere $35 billion. Its generating capacity is 4,500 megawatts.

Technology has a history of delivering miracles, but it also bears witness to a poor track record of capital allocation. Look no further than Lumen Technologies (LUMN), the offspring of the fiber optic cable bubble of 1999-2001. Lumen holds the fiber assets of CenturyLink, Qwest and Level 3. If those names sound familiar, there was nothing like the Level 3 bubble for Omahans of a certain vintage who rode the Kiewit spinoff to dizzying heights and painful lows. And we all remember the Qwest Center. Despite a debt restructuring earlier this year, LUMN remains safely in junk territory and will be fortunate to stave off bankruptcy.

You didn’t come here for macro-economic observations or a mini-course in geography. There’s investment ideas to be had.

Welltower

My contention that Welltower remains 40% overpriced relative to the underlying value of its assets took a step back after the company raised annual per share FFO guidance to $4.33 from $4.20. In my estimation, this upgraded forecast is worth $1.3 billion of additional net asset value and raises the total to $50 billion. A nice boost, indeed. Shares rose accordingly.

Despite the improved performance, my bearish outlook for Welltower remains firmly intact. If you’re scoring at home, you’ve got a REIT with a market cap of $80 billion yielding less than 2% and trading at 30 times FFO. The company also announced a $5 billion equity offering. REITs like Welltower that invest capital at modest yields are forced to turn to equity for growth when the debt gets too expensive. They become dilution machines.

CK Hutchison

There are times when value traps are like a Siren’s song. It’s like watching Lethal Weapon when nothing else is on. You know that there is no plausible reason why Gary Busey’s henchmen can’t kill Danny Glover in the middle of the desert, but you’re damn well going to watch anyway because you need proof that this cinematic muddle was deserving of three sequels. But thank God they kept going! Lethal Weapon 2 has that fantastic moment when Joe Pesci brings Danny Glover to the South African consulate and tells them he wants to emigrate to the land of Apartheid.

Anyway, CK Hutchison is the descendant of the Hutchison Whampoa conglomerate built over decades by Li Ka-Shing in Hong Kong. I wish there was an updated biography of Li who is now in his mid-nineties and has passed the reigns to his son. He certainly belongs in the business hall of fame. CK Hutchison has a market capitalization of about $20 billion and holds some of the world’s largest port infrastructure assets and telecom businesses. The stock trades at 29% of book value and offers a dividend yield of about 6%.

I ran a few back of the envelope numbers, and CK Hutchison pencils to roughly $60 billion of value. Yet, the stock has been “cheap” for many years. Why decide to invest now? It seems like the second generation of Li’s family (now in their 60’s) has figured out that something needs to be done for long-suffering investors. The company listed its infrastructure assets on the London exchange in August as “CK Infrastructure”. They have also contributed their European mobile networks to a joint venture with Vodafone.

The appeal of CK Hutchison is that its port infrastructure is irreplaceable. Unlike auto manufacturers and steel companies which deservedly trade below book value due to brutal competition, ports are generally impervious to competition. Nature only created so many locations around the globe where massive cargoes can dock. Globalization may be taking a step back, but it’s not stopping. I’m going to dig more deeply into CK Hutchison.

Until next time.

DISCLAIMER

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.

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Strange

In 1990, Jeremy Irons won an Oscar for his portrayal of the mercurial and debonair Claus Von Bülow in Reversal of Fortune. Von Bülow captured tabloid headlines for the attempted murder of his Newport socialite wife, Sunny (Glenn Close). The case seemed hopeless. Only Claus had access to the insulin that left Sunny in a diabetic coma. Evidence was only part of the problem. Claus was not exactly a warm and fuzzy guy. With his angular chin and vaguely European accent, the ascot-wearing Von Bülow was aloof and arrogant. Against the odds, the young professor Alan Dershowitz (Ron Silver) and his earnest team of Harvard Law students delivered a stunning acquittal. 

At the end of the movie, Claus sits in the back of his chauffeur-driven Jaguar as Dershowitz bids him farewell, saying: “You know, it’s very hard to trust someone you don’t understand. You’re a very strange man.” As the door closes, Von Bülow deadpans, “You have no idea.” 

“Strange” is subjective, of course, and context matters. Claus was probably a normal guy if your scene was 1970s ski chalets in Gstaad. To a working class jury in 1980s Rhode Island, he was eccentric. 

If you’re on the artificial intelligence bandwagon, everything might seem pretty normal right now. Short term interest rates are coming down and we may be on the cusp of a new information technology miracle. In this exuberant era where the NASDAQ sets new records nearly every day, Omaha’s Warren Von Büffett seems strange. After all, he’s sitting on $240 billion of T-bills. Imagine selling all that Apple stock right when this AI thing is just starting to take off!

What’s strange? What’s normal? I like Jodi Picoult’s thoughts on the matter: “I personally subscribe to the belief that normal is just a setting on the dryer.” Ms. Picoult usually digs deep into matters of the heart, but she could just as easily be opining on the current state of financial markets.

The value of corporate equities as a percentage of GDP has only been this high two other times. While most of us mortals must pay our debts by forking over cold hard cash to the lender, huge numbers of heavily indebted firms are paying their interest bills by issuing IOUs. You need to squint to see the spreads on corporate bond yields. It turns out that nearly losing one presidential candidate to assassination, and the other to dementia doesn’t have much of an effect on markets. Did I mention there are two wars with nuclear implications going on? How about the collapse of the world’s second largest housing market? Nope, hold my beer because the QQQs keep ripping higher. 

I remember the Three Mile Island meltdown. It was not an auspicious moment in American history. We had kind of a Jimmy Carter-malaise thing going down, and our status on the world stage was being put out to pasture by Ayatollah Khomeini. We couldn’t even manage nuclear power plants very well. When they said we’re re-starting Three Mile Island again because we need so much power to run these AI chips, my bullshit detector issued an alert. 🚩

Welltower (WELL) is a company that Claus Von Bülow might prefer: Very strange, indeed.  Welltower stock behaves like it belongs among the exalted world of artificial intelligence  – surging ahead by 45% over the past six months alone. Given the levitating stock price, it probably shouldn’t come as a surprise that Welltower’s CEO quoted Jensen Huang in his last shareholder letter. The excitement fades pretty fast when you realize that Welltower operates in the staid world of housing elderly folks.

While other senior living companies trade within a justifiable range of the value of the underlying assets, Welltower seems divorced from reality. By my reckoning, the company trades at a premium of over 40% to its underlying bricks and mortar. Welltower is a Toledo-based owner of senior living facilities that trades at a market capitalization of over $80 billion, or $132 per share. However, a reasonable valuation of the real estate indicates that the stock should trade closer to a level of $50 billion. That computes to a share price near $80.

As a real estate investment trust (REIT), Welltower is required to pay out most of its earnings as shareholder distributions. Yet the yield on offer is a paltry 2%. Growth can only be achieved by adding external capital, and Welltower has issued billions of dollars in new stock since the debt markets became less hospitable. In December 2022, the company also gained the dubious distinction of a write-up by Hindenburg, the famed short-seller, for questionable dealings with the mysterious Integra Health Properties.

Moreover, Welltower is not a simple business. WELL has a complex collection of disparate facilities throughout the country operated by a diverse set of managers. Many facilities are net-leased to other operators leaving Welltower the simple role of cashing rent checks as a landlord. Many others are operated hands-on by the company. Looking after the elderly is a tough business. You need skilled medical staff to run these properties in addition to a legion of cleaners and minders. The government is constantly looking over your shoulder (especially after the whole Covid fiasco), and Medicare money comes with strings attached.

Welltower also acts as sort of a bank for senior housing developers, with over $1.7 billion of notes receivable on the books. To complicate matters further, WELL also owns a collection of outpatient medical clinics.

There are certainly many reasons to praise Welltower. The company disposed of $5 billion of struggling assets during the dark times of Covid, and rebounded with a $10 billion acquisition frenzy over the past three years. Welltower added another $2 billion of development during that time. In 2023, operating income (including depreciation) increased by over 30%. 

Hindenburg’s questions aside, I don’t see anything nefarious about Welltower. It is just really expensive. Welltower is a business which earns returns on capital around 6% and returns on equity around 7-8%. This won’t set your nanna’s pulse racing. Through 6 months of 2024 reporting, operating income has only risen 5%. Meanwhile, notes receivable from operators have doubled since 2022. Who’s borrowing from Welltower at 10% interest rates? Probably not the most seaworthy. The firm racked up $36 million of impairments in 2023 and $68 million for the TTM period to June 2024. These aren’t horrible figures, but they show that not everything comes up smelling like roses in the senior living business. 

Management recently guided for $4.20 per share in funds from operations (FFO) for 2024. This preferred metric for real estate investment trusts adds back depreciation and other non-cash items. I reverse-engineered the guidance for FFO to arrive at a pro forma net operating income (NOI) for 2024 of $3.3 billion. This NOI calculation takes FFO a step further by removing debt service costs and the administrative costs of running the company to arrive at an unleveraged, asset-level value for the business. 

In fairness to Welltower, the increase in NOI is substantial compared with the $2.7 billion generated in 2023. The company has certainly improved operations, pruned underperforming assets, and had much stronger occupancy levels as the post-Covid senior market has recovered. A 22% increase in NOI is impressive for any business, especially a real estate company with slow-moving assets. 

How does $3.3 billion of net operating income translate into asset values? I capitalized the income using 5.97% to arrive at a gross asset value of $55 billion. 

The 5.97% “cap rate” was derived using the following logic: I simply applied the spread for Welltower’s Standard & Poor’s BBB credit rating to the “risk-free” 10-Year Treasury yield of 4.07% to arrive at a current debt cost of 5.15%. I assumed that the company earns an equity yield just 1% higher than this cost of debt (6.15%) and weighted the equity percentage at 85%. One could argue that this 5.97% cap rate is slightly high. Perhaps I could impute a bigger weighting to the less-expensive cost of debt. After all, Welltower has been able to raise debt at much lower rates in the past.

My counter-argument would be that a lower cap rate would be too aggressive for a business that has a mixture of assets, ongoing charge-offs for underperforming notes receivable, and a collection of diverse and unpredictable operators assigned to the facilities. Finally, I am not making any allowances for capital improvements at existing properties. These assets require nearly $600 million per year in upkeep that is not reflected in NOI. They are, however, certainly an ongoing cash obligation for Welltower. I am being very generous by excluding them in the value computation.

To arrive at a net asset value, I added cash of $2.6 billion as well as construction in progress at book value, and unconsolidated equity interests at 1.5x book value. After subtracting debt of $14 billion, Welltower’s net asset value pencils slightly above $48 billion.

You may say that I’m not appropriately valuing the future. There’s more upside at Welltower, says you. Yes, there is more upside. Unfortunately, as a REIT which is required to distribute its earnings to shareholders, incremental growth can only come from external capital: Sell more stock or raise more debt. When you’re earning returns on capital in the 6% range and you’re borrowing at 5%, you don’t have tremendous opportunities for upside. 

I am short Welltower. It’s a $132 stock that should be priced to yield in the mid 3% range around $80-85. 

I could leave you with some Jim Morrison lyrics. Instead I will give you something special by Wire. Or you may prefer REM’s 1987 cover version:

“There’s something strange going on tonight.

There’s something going on that’s not quite right

Joey’s nervous and the lights are bright

There’s something going on that’s not quite right.”

Until next time.

Disclaimer:

The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.

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Find me in the club with a bottle full of bub

I was in a couple of clubs this past week. Let’s start with the fun club. The Irish band Fontaines DC played a sold-out Slowdown on Saturday night. The band went on at 9 and I almost missed the opener. Maybe they saw the prevalence of white males over the age of 40 and reckoned it would need to be an early bedtime. This is a Grammy-nominated group of guys in their 20’s touring in support of their fourth album, so we’re not talking Van Morrison here. Where were all the kids? It made me think of the recent article with the hypothesis that rock and roll died with Kurt Cobain. This is a pretty dramatic take on the music industry, but I think a lot of youngsters are gravitating towards hip-hop and EDM where most of the sonic barriers are being broken.

You could hear the appeal to an older set: Carlos O’Connor has the guitar stylings of a Jonny Greenwood, and listeners of a certain vintage surely hear echoes of Nirvana, The Pixies, The Church, The Cure and even Weezer in the mix. Grian Chatten has an impressive vocal range and his cadence can sound almost like a Dublinesque Eminem at times. Maybe it’s the cyncial nature of the songs. After all, the band’s most powerful track “I Love You” has a chorus of “Say it to the man who profits, and the bastard walks by.” Jaded stuff. Excellent music, nonetheless.

Dublin rockers would sneer at the other club I visited last week. Jim Grant held his annual conference in New York, and I decided I wanted to see some different rock stars: Stan Druckenmiller on slide guitar and Bill Ackman on drums. Druckenmiller got the most headlines when he said that his old boss, George Soros, would be a little disappointed that he hadn’t committed more capital to his high-conviction trade: Short the long end of the yield curve. In a country running peacetime deficits of roughly 7-8% of GDP where neither presidential candidate has made a peep about a balanced budget, a long duration Treasury has much to blush at. Toss in a recession and war, and you have real downside risk holding anything longer than two-year paper. He was also firm is his belief that no foreigners were safe investing in a China controlled by Xi Jinping, despite David Tepper’s recent optimism.

I was most intrigued by Boaz Weinstein’s presentation. This chess prodigy was a Deutsche Bank managing director at 27. His firm, Saba Capital, has targeted the closed-end fund universe where wide discounts to underlying net asset values can persist for a long time. Saba has pressured some managers to narrow the discounts by taking large positions in the funds and gaining sufficient board control to advocate buying back shares or liquidating altogether.

Weinstein was particularly vocal about his legal brushes with BlackRock. The battles with the asset management behemoth have been contentious (and expensive), and it was slightly appalling to hear about the lengths BlackRock would go to suppress actions that could benefit widows and orphans trapped in underperforming closed-end vehicles. Saba’s Closed-End Funds ETF trades a with the ticker CEFS and has a current distribution rate of 7.62%. There’s limited downside, and you get to earn a nice yield while you let Mr. Weinstein work his craft. Seems like a good club.

Michael Green’s presentation on the distortion of passive vehicles in the market was compelling, but I couldn’t help but think he was preaching to the choir. I invite you to read his thought-provoking pieces. His point has validity: The concentration of market capitalization in the biggest stocks is increasingly reinforced by the automated passive funds which allocate towards a market-cap weighted index. Passive funds have made a mockery of most performances of the managers in the audience, however, and I had a feeling that Larry Fink was sitting down at Hudson Yards watching the proceedings remotely with a smile on his face.

I can tell you who is not in the club: Warren Buffett. The man is sitting on nearly $300 billion of cash. Sure, he could be hedging the likely increase in capital gains taxes should the Democrats take control. He could be getting his “affairs in order,” as they say. But for a guy who famously says you shouldn’t time the market, it feels an awful lot like market timing to me. I offer the chart from Jennifer Nash at Advisor Perspectives:

Corporate equities as a percentage of GDP have rarely been so high. The Fed is cutting rates into an environment of very loose financial conditions. What could go wrong?

So where are the clubs that I want to hang? I mentioned Saba’s ETF above. A few weeks ago, I talked about relative value at Peakstone Realty Trust (PKST) and the ethanol producer REX American Resources (REX). Sam Zell’s (RIP) Equity Commonwealth has a no-brainer preferred yielding north of 6%. I’m supposed to hang out in the real estate club, but developing apartments at a 6.5% return on cost with a looming oversupply of units at rents that need to be 30% higher than pandemic era prices seems like an unfriendly wager.

I’d rather hang out with Barry Sternlicht. He can often be found on CNBC lately crying the blues and talking his book, but the guy is a legend. Starwood will probably have some messes to clean up, but they will also seize opportunities to profit from distress. Meanwhile you can hold STWD at a 9.5% dividend yield with the best capital allocators in the business. It makes illiquid and highly leveraged suburban Omaha apartments seem like a visit to the yearbook club after school. Anchored to old memories, the club is far too optimistic that the good times will return. Go to the reunion in 30 years and see what decades of high leverage and “equity” subordinated to a 9% preference can do to a guy. It ain’t pretty.

I tried to get interested in Heartland Express trucking (HTLD) recently. The company’s stock has seen a lot of insider buying in recent months. I can make an argument that HTLD is selling at a discount to its intrinsic value. It trades at an EBITDA multiple of about 7x. If you figure free cash flow can hit $115 million in 2024 during a freight recession, then there should be a lot of upside. The recent market cap is around $900 million for a company that could be worth $1.2 billion.

My enthusiasm waned quite a bit when I noticed that much of the aforementioned cash flow came from a lack of investment in trucks. Heartland depreciated nearly $100 million of its vehicles in the first six months of 2024, but only invested about $3 million (net) in new trucks. By comparison, local company Werner Enterprises depreciated $146 million of vehicles during the first six months of 2024 and reinvested a net $118 million in new equipment. The freight market is probably recovering, but it will take a lot of capital for Heartland to modernize its fleet. This one’s a pass for me.

I’m working on a write up for Welltower (WELL). I mentioned it several weeks ago as a very expensive stock with slightly dubious amounts of asset churn. There is a lack of a clear strategy with medical office buildings paired with B-quality senior living assets. The company is a REIT and yields a sub-par 2.2%. The stock has risen 54% over the past 12 months and trades hands at a $76 billion market cap. It strikes me as absurdly overvalued and is my strongest candidate for a short position. You can talk all you want about favorable demographics, but the earnings are weak and the operating costs are not improving as more states impose minimum staffing requirements. Medicare reimbursements are dropping and the company is highly levered.

Until next time.

Appendix: Heartland Trucking income statement and return on capital.

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It just doesn’t matter

I had a thesis: The pandemic boom in camping and water sports is over. Find a stock that didn’t get the memo and sell it short in the hopes of making a profit on the decline. I thought I had found such an overpriced nugget in the form of Patrick Industries (PATK), an Elkhart, Indiana maker of a lot of stuff that goes into recreational vehicles, recreational boats, and recreational powersports. It’s fairly, um, recreational, and therefore totally discretionary. They also have a division that makes parts for the housing industry.

The days of social distancing are over. Camping and water sports had an incredible two-year run. Remember “glamping”? That seemed to pass from our lexicon faster than ayahuasca at a sweat lodge. Thor Industries (THO), one of the biggest RV makers, saw sales increase from $8 billion in 2020 to over $16 billion in 2022. Thor will do well to exceed $10 billion in 2024. Meanwhile, Patrick’s stock price put the hammer down on Thor. PATK is up 273% over five years and 90% over the past twelve months. Is Patrick a stock that I would sell short? No.

Patrick will have sales of about $3.6 billion in 2024. It trades at about 21 times earnings with a market capitalization of $3.2 billion. The enterprise value to EBITDA multiple for PATK is 11 and the company generates over $350 million in free cash flow per year. Most importantly, Patrick seems to be pretty good at acquisitions, spending about $1.8 billion over the past six years. Take Sportech, for example. Patrick acquired the company in January for $315 million from a private equity firm.

Sportech, of Elk River, Minnesota generated revenue of $255 million in 2023. Based on the pro forma numbers in the Patrick 10-Q, it looks like Sportech generated about $26 million of EBITDA during the first six months of 2024, so it seems like Patrick paid a multiple of around 6 times EBITDA. The public markets give Patrick a multiple above 10 times EBITDA, so presto-chango you have a nice return on the investment without doing any heavy lifting.

Now, if you take out Sportech, the results at Patrick for the first half of 2024 were flat-to-down. Net sales excluding the acquisition would have been $1.8 billion for the first six months of 2024 which is slightly below the levels of 2023. The acquisition machine needs to keep rolling at Patrick in order to keep the shares elevated. This seems possible – Patrick may offer a sanctuary for beleaguered suppliers to the RV and marine industry. If the boom is over, Patrick may be able to swoop up some more acquisitions at bargain prices.

Just for grins, I decided to conduct a rough valuation of Patrick using steady-state income and capitalizing the free cash flow by the weighted average cost of capital. Bruce Greenwald would call this an “earnings power valuation”. I employed a weighted average cost of capital of 7.63% on free cash flow of $373 million to arrive at a value of $4.9 billion. Subtracting debt of $1.5 billion and adding cash of $43 million results in an EPV of $3.4 billion – roughly in-line with the current market cap.

Shorting a stock requires a steely certainty that the company is either a. An unsustainable bubble, or b. Engaging in some kind of accounting deception. Patrick meets neither criteria. Do, I think Patrick could be heading down the road of making unwise acquisitions simply to paper over underlying weakness in the core business? It’s possible. Returns on capital have dwindled (see appendix) to the high single-digit levels. Is that the result of overpaying for some businesses, or simply the cyclical trough the industry faces? Hard to say, but I wouldn’t try to bet against management.

Right on cue, the RV industry received a jolt this morning with the release of a report by Hunterbrook Media accusing Winnebago (WGO) of selling defective RVs and a looming warranty crisis. PATK dropped about 3.5% on the news. It may be something. Or not.

Tripper: Important announcement – Some hunters have been seen in the woods near Piney Ridge trail and the fish and game commission has raised the legal kill limit on campers to three. So, if you’re hiking today, please wear something bright and keep low.

Appendix: Patrick Industries operating results 2017-2024 TTM to June 30 with associated returns on capital.

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It takes a soul to love the prairie

Are the Cornhuskers back? They seemed unstoppable in the first half. Fun times. The stadium was electric. The second half was a little underwhelming. I’m not so sure about the post-game field invasion by the students. Let’s hold off the pandemonium until we get some bigger wins under our belt. Despite all the flashy antics from the Sanders family, Colorado probably just wasn’t that good.

I rushed the field on a freezing November afternoon in 1991. We came from behind to beat Oklahoma. It was a Big 8 championship. In a testament to just how good our offensive lines were during the Osborne era, our quarterback on that day was neither Gill, Frazier, Crouch, nor Frost. Not even Gdowski. It was none other than the merely adequate Keithen McCant. Of course, he was backed in the I-formation by the Omaha Central grad, Calvin Jones. The future All-American 200-lb machine was only in his sophomore year.

Looking around Memorial Stadium, it is readily apparent that Nebraska is truly dependent upon agriculture. You can’t miss all those seed and insecticide banners among the flashing Dororthy Lynch signs. We tend to forget this in Omaha. We’re an ag state, but lately the state of ag isn’t so great. Corn at $4 a bushel won’t buy you much name, image and likeness recognition.

You might think that the ethanol business would be a good place right now. Reasonable gasoline prices and lower corn input costs should help the ethanol producers improve their margins. Unfortunately, Omaha’s Green Plains (GPRE) doesn’t seem to be heading in the right direction. The company is losing money and they are the subject of an activist investor campaign seeking to liquidate the business.

GPRE trades around book value; they’ve got some debt but it is mostly in the form of low-rate convertible notes. I think someone with better industry knowledge can decipher whether or not the stock is bargain at it’s nearly 52-week lows. It would have to be someone who can conduct a sum-of-the-parts valuation. I decided to not hurt my brain too much and search for a profitable ethanol producer instead.

REX American Resouces (REX) seems to be the kind of ethanol investment that makes sense. The Dayton, Ohio company has a market cap near $750 million and zero debt. They had nearly $350 million of cash on hand at the end of July, and they are currently plowing profits into a plant expansion. Sales run about $800 milion per year with gross profits approaching $100 million last year. Operating margins for the fiscal year ending Janaury 2024 were above 8%. I generally dislike businesses that rely on government mandates to sustain their operations, but with nearly 40% of all corn being grown for ethanol it seems unlikely that the program will ever be ended.

REX plans to spend $150 million to expand its One Earth facility in Illinois. At the end of January 2024, entities affiliated with REX shipped approximately 716 million gallons of ethanol over the preceding 12 month period, of which 290 million gallons can be attributed to the parent company. Most imporantly, REX is generating returns on capital in excess of 30%. The strong balance sheet allows the company a wide berth to weather another cyclical turn in the corn and energy markets. The stock is trading well below it’s highs from earlier this year. REX looks like an attractive investment.

Peakstone Realty Trust

I’m still gnawing away at my Peakstone Realty Trust (PKST) analysis. The company has a market cap of $500 million and currently yields slightly less than 7%. They have a marquis client roster with a focus on industrial warehouses, and (gasp) office space. Peakstone has about $1.4 billion of debt to go with $2.5 billion of (undepreciated) real estate, but most of the interest rates are capped in the 4.5% range. The weighted average life of remaining lease terms exceeds seven years, so there is a long runway here. The company has sold off some troubled office. This one’s not for the faint of heart, but if you had to make a bet on babies being thrown out with bathwater, you should consider PKST.

Total net operating income for the trailing twelve months was $191.8 million. I capitalized these amounts by sector using 6.5% for industrial, 7.5% for “other,” and 20% for office and arrived at an asset value of $1.73 billion. Subtract the debt and add the ample cash balance of $461 million, and the net asset value is nearly $800 million. The stock is selling for $13.70 and the assets seem to pencil at $21 a share. You might even call this a margin of safety.

These aren’t self-storage facilities in Hastings, people. We’re talking Amazon warehouses here. The office? You’ve got the Freeport McMoRan HQ building in Phoenix, for example. Class A stuff. Is there more downside in office? Maybe. Is a 20% cap rate something I just pulled out of the air? A little bit. Certainly, the next step is to evaluate the office portfolio on a building-by-building basis and decide what is a zero and what is valuable. There’s also this troubling notion of the market being fairly efficient most of the time, and 25 cents aren’t just lying around waiting to be picked up. But sometimes that quarter on the ground really is there for the taking.

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No country for old men

At the risk of sounding like Jimmy Carter, I felt a sense of malaise at this year’s commercial real estate summit. Last week, the Omaha conference reached its 35-year milestone under the guidance and creativity of the indefatigable attorney and developer, Jerry Slusky. Maybe it was the panel discussion that devolved into career counseling for young brokers by a grizzled veteran. Perhaps it was the lack of statistics on rental trends and square footage absorption, leading a developer to wanly muse about seeking out markets where “demand exceeds supply.” This revelation produced solemn nods and much chin-stroking from the pilgrims.

Lenders assured me that none of their loan books had the faintest whiff of distress, yet a panel on the subject implied otherwise. One general contractor told me that many of his clients in the southwestern portion of the US are going ahead with apartment projects “even though the numbers don’t work” because they know they are locking in today’s cost basis for the future. I had no response to this business plan. Using such logic, one could have made this justification to move forward on a real estate development at virtually any moment in the past 75 years.

It was the irascible Creighton economist Ernie Goss who brought out the wet blanket. I love an economist who is one-handed. There aren’t many. Dr. Goss gamely mixed John Maynard Keynes with Warren Zevon, befitting a professor who could pass for Bob Dylan’s cousin. Goss talked about the agricultural sector in gloomy tones. Corn at $4 a bushel is no bueno for Nebraska. His most sobering reminder was the chart showing that interest on the national debt now exceeds spending on national defense. No empires have survived this inflection point. All that Aztec bullion filled Spain’s coffers for two centuries before an overextended domain began to unravel in the late 1800’s. France sold its New World colonies to pay for Napoleon’s conquests. Lest one thinks such fate can’t befall the holder of the world’s reserve currency, it was Britain with her once-invincible pound sterling that was hobbled by two world wars and went cap-in-hand for an IMF bailout in 1976. George Soros heaped further ignominy on the beleaguered pound in 1992.

I can be prone to cynicism. It’s a blind spot, and an especially poor trait in a real estate developer where one’s raison d’etre is the rosy future. But I can’t help but feel there is a bit of the “end-of-the-Roman-Empire” feeling around. There’s bacchanalia galore with stock indexes hitting all time highs, private jets whisking families on vacation, the return of the Hummer, liquor lockers at private clubs, multiple country club memberships, CNBC masquerading as due diligence, billions of dollars in NIL money for college athletes, the de-facto legalization of THC and sports gambling, and Nebraska finally going all-in on it’s own casino gambling. Meanwhile, the low end of the income spectrum faces insurmountable home-ownership costs and pain in the grocery aisle. There are two wars being waged on the doorstep of NATO, a former president was nearly assassinated, and the current president all-but-admitted he was too senile to serve another term. And yet! And yet. What’s the VIX at? 100? Nope, try a benign 15.79. Credit continues to flow. Jerome Powell just declared victory. Game on.

You’re starting to ramble. Are you turning into an old man? Well, I don’t think of myself that way, but in actuarial terms the answer is unfortunately, “yes”. But there’s a place for old men. I’m not talking about ending up like Sheldon Levene in Glengarry Glen Ross. I’m envisioning Clint Eastwood here. Cigar and a Smith & Wesson. Let’s take another wise old Omaha guy I like – Warren Buffett. Berkshire Hathaway owns $235 billion of Treasury bills after significantly reducing holdings of Apple. Buffett may be old, but he’s not cynical. I can’t recall an annual meeting where the words “America’s best days lie ahead” weren’t uttered. However, in this instance, I prefer to watch what the man does, not what he says.

Dude, this is bumming me out, and your Hollywood references are beta. Let’s move along to that book you’re reading.

Ok. I’m about halfway through Nate Silver’s On the Edge: The Art of Risking Everything. It’s a fun read, but I think Silver could have used a better editor (pot, meet kettle). We follow his poker exploits, head down his sports betting rabbit-hole, take a tour of the venture capital industry, and then make an off-road excursion into the bizarre downfall of Sam Bankman-Fried. These are members of “The River,” Silver’s term for those who think in terms of probabilities and make wagers using their best estimates of positive expected value (EV). Yet, so much of what passes for rigorous evaluation of odds based on massive amounts of data often coalesces into little more than well-informed gut instincts. Silver seems to recognize this despite his continued attempts to explain most decisions in probabilistic terms. Take bluffing, for instance. Poker players smoke out a weak hand with a massive bet. Brute intimidation can often work better than the best statistical calculator. Venture capitalists are guilty of herd mentality and they have been conned by the likes of Adam Naumann and Elizabeth Holmes more often than they care to admit.

I am not a mathematician, and my knowledge of statistics is only good enough to read a Nassim Taleb book without a thesaurus. Nor am I a gambler. However, one character seems to be missing from Silver’s book – the 18th century Swiss mathematician Daniel Bernoulli. Silver relegates him to the footnotes. It was Bernoulli who first started to ask why people didn’t take certain bets, even though the probability might yield a positive expected value. Bernoulli figured out that the value of a bet was in direct proportion to the utility of the additional wealth to be gained. A rich man probably wouldn’t take long odds if it meant a major loss of capital, but a poor man has little to lose on a longshot. If you want a great discussion of Bernoulli and his role in finance, pick up The Missing Billionaires by Victor Haghani and James White.

Silver brushes right past Bernoulli’s revolutionary discovery. In a parenthetical aside, he writes “If you had a net worth of $1 million, would you gamble it all on a one-in-50 chance of winning $200 million and a 98 percent chance of having to start over from scratch? The EV of the bet is $3 million, but I probably wouldn’t.” Probably wouldn’t?!?! How about “no way”! Unless you are very young and have immense confidence that you can re-earn your million-dollar nest-egg, you’re not going to take that bet.

The marginal utility of wealth is critical to understanding the business wagers called “investments.” A venture capitalist on Sand Hill Road with $200 billion of assets under management will not agonize over staking $20 million on an AI-powered start-up that automates logistics in warehouses if it has a chance for asymmetrical upside returns. A solo investor with a net worth of $20 million would never take on such a venture alone, despite his or her immense personal wealth. Kahnemann and Tversky famously uncovered the psychology behind such thinking. Humans are risk averse. Most of the time expected pain of loss is greater than the appeal of a gain.

All of this talk of Bernoulli and wagering based on one’s wealth rather than simply the expected value of a bet reminds me of another Warren Buffett gem: When discussing the failure of Long-Term Capital Management which was headed by Nobel laureates and nearly brought markets to a standstill in 1998, Buffett remarked:

But to make money they didn’t have and didn’t need, they risked what they did have and did need. That is foolish. That is just plain foolish. It doesn’t make any difference what your IQ is. If you risk something that is important to you for something that is unimportant to you it just does not make any sense. I don’t care whether the odds are 100 to 1 that you succeed or 1000 to 1 that you succeed. If you hand me a gun with a million chambers in it, and there’s one bullet in a chamber and you said, “Put it up to your temple. How much do want to be paid to pull it once,” I’m not going to pull it. You can name any sum you want, but it doesn’t do anything for me on the upside and I think the downside is fairly clear. So I’m not interested in that kind of a game. Yet people do it financially without thinking about it very much.

I think we’ll leave it here for now. Coming soon… I have crunched some more numbers on Peakstone Realty Trust (PKST), and I think it trades at a 30% discount to it’s net asset value. You also get a 6% dividend while you wait. Elsewhere, Iron Mountain (IRM) seems to be infected with the same kind of data center hype that is artificially buoying the legacy data center stocks Digital Realty Trust (DLR) and Equinix (EQX) – companies that inflate their earnings by minimizing their depreciation and distorting operating cash flow by attributing far too much weight of capital expenditures to “growth” vs “maintenance”. Finally, I ran some numbers on Carnival Cruises (CCL) with the thesis that it would make a good short. It’s leveraged to the hilt. There were no COVID bailouts for cruise operators who are domiciled in tax-havens. Sorry, you can’t have it both ways. It seems I am wrong about CCL. Barring a major consumer slowdown (not entirely out of the question), the stock seems fairly valued. Until next time.

/by