Goon Squad

Everyone wants to be unique. Elvis Costello made a career out of it. Costello’s biting sarcasm stood in stark contrast to the wave of conservatism that swept Britain in the late 1970’s and brought Margaret Thatcher to power. He might have been talking about the military, or he could have meant the anonymous office drones, or maybe he was thinking of the formulaic record company hit makers. Whomever it was – probably all the above – he knew he couldn’t be one of them.

You can be a non-conformist investor. The romantics believe that you will be paid quite handsomely like John Paulson or Michael Burry. Most of the time you end up underperforming. In the worst cases, you finish lonely and broke like Jesse Livermore.

I had aspirations of finding that iconoclastic piece of investing research when I sought to understand Brookfield Infrastructure Partners (BIP). Just as I was about to hit send, I found a major bust in my numbers. To quote the legendary bassist Mike Watt:

After correcting the error, my valuation exercise resulted in a number that was pretty close to the current market price. There’s nothing particularly wrong with this conclusion. Most of the time, markets are efficient. However, I was convinced that Brookfield Infrastructure Partners was wildly overvalued. Confirmation bias can be a hell of a drug, apparently. So, here’s my story. If you stick around until the end, you just might find some loose threads to pull that may yet prove to be BIP’s Achilles heel.

When most people discuss Brookfield, they are either referring to the giant Canadian asset fund known as Brookfield Corporation (BN), with a market cap of $91 billion, or its cousin Brookfield Asset Management (BAM), with a market cap of $22.8 billion. I’m writing about another head of the hydra: Brookfield Infrastructure Partners (BIP), the publicly traded limited partnership with a market capitalization of $13.64 billion at the recent price of $29.54 per unit.

Brookfield Infrastructure Partners posted consolidated revenues of $21 billion in 2024 among four segments: utilities, transport, midstream and data. Utilities include 2,900 km of transmission lines in Brazil and 3,900 km of natural gas pipelines in North America, Brazil, and India. There’s also smaller distribution and metering businesses in the UK and ANZ. Transport includes the Triton intermodal container business, minor railroads in North America, Europe and Western Autralia, and toll roads in Brazil. Midstream is largely focused on gas pipelines and gas liquids processing facilities in North America (primarily operated by Inter Pipeline of Canada). The data business includes fiber optic networks in North America, Brazil, and Australia, 300,000 cell towers in Europe and India, and 140 data centers. There are no synergies between these businesses. It is largely a collection of assets gathered by Brookfield Corporation (BN), and Brookfield Asset Management (BAM) which generate significant management fees.

Deciphering BIP requires a compass and flashlight. The company is structured as a limited partnership with the controlling general partner (GP) interests held by a variety of Brookfield entities. Many entities are based offshore. Certain GP interests are also owned by the publicly traded Brookfield infrastructure Corporation (BIPC). The limited partnership units trade with the ticker BIP.

Consolidated assets of the holding company amounted to nearly $104.6 billion at the end of 2024. Debt totaled $54 billion. Book equity summed to $29.85 billion. Yet, the publicly traded limited partnership units have balance sheet equity of little more than $4.7 billion. Over $20.5 billion of book equity is attributable to joint venture partners and the balance of $4.6 billion is held by general partners and preferred interests.

BIP is proud of its distributions to its limited partners. The dividend yield on offer for today’s unit purchasers is nearly 6%. According to BIP, this payout ratio is well-covered using the company’s preferred metric of distributions as a percentage of funds from operations (FFO), and as a percentage of adjusted funds from operations (AFFO). FFO is a proxy for operating cash flow. The measure adds non-cash items, mainly depreciation, back to net income. AFFO takes funds from operations and subtracts maintenance capital expenditures. According to BIP, 88% of AFFO is paid to partners. The dividend is a key component of BIPs investment appeal, and any doubt in the ability of the company to pay unitholders their quarterly stipend would surely send the share price plummeting.

The most important conclusion to draw from the financial reports is just how little is owned by the limited partners. Publicly traded units of BIP only have a claim on 15.76% of the balance sheet equity. Funds from operations tell a similar story. Consolidated revenues of $21 billion emerge as $5.67 billion of FFO. Approximately $3.2 billion of FFO is attributable to the joint venture partners, leaving $2.47 billion of funds from operations attributable to the partnership. Next, BIP deducts maintenance capital expenditures of $606 million. This leaves $1.86 billion of adjusted funds from operations (AFFO). Limited partners received 77.9% of the distributions in 2024 and general partner and preferred interests received 22.1%.

Valuation

As noted above, BIP limited partners have a claim on approximately 15.76% of the company’s equity, so I adjusted balance sheet items to reflect this percentage. AFFO for 2024 was $1.86 billion. I added the proportional interest expense attributable to the partnership to arrive at an “unlevered AFFO” of $2.4 billion. Distributions were split between general partners and limited partners, with the LP’s receiving about 78% of the total. Therefore, I assigned $1.87 billion to the limited partners. This “unlevered AFFO to limited partners” was capitalized with by dividing the amount by 8.22%, the weighted average cost of capital for BIP.

Where does that 8.22% discount rate come from? At $8.5 billion, debt accounted for 39% of capital. Interest as a percentage of total financial liabilities cost BIP 6.28% in 2024, or 4.96% after tax deductibility is factored in. Equity costs take into account the geographic diversity of BIP’s revenues. The breakdown follows: 67% North America, 11% India, 12% South America, and 10% “Other”. I used the 10-year US Treasury rate of 4.31% for the risk-free rate assumption across all regions, but I did adjust the equity risk premiums. Therefore, the North American cost of equity is approximately 8.6%, India is 14.5% and Brazil is 15.3% the balance was weighted to a cost of equity of 10.2%. The total cost of equity amounted to 10.23%.

The total capitalized value to limited partners is $22.77 billion. After subtracting $8.3 billion of proportional net debt, the net value to the limited partner unitholders is $14.5 billion, or $31.41 per share. Based on this calculation, BIP is fairly valued.

It didn’t start out this way. I thought I would crunch enough numbers to show that Brookfield Infrastructure Partners is significantly overvalued.

My run down the rabbit hole started with an article which appeared in the Financial Times on March 5th. The article questioned the opaque financials of Brookfield Corporation (BN). In a series of transactions, Brookfield appeared to utilize reserves from its insurance subsidiaries to disguise losses on Manhattan office buildings. Casting doubt upon the integrity of one of the world’s largest asset managers is a tall order, so it raised a few eyebrows when the name Dan McCrum appeared in the byline. McCrum famously exposed the $24 billion Wirecard fraud in 2018. I’ve not read McCrum’s book about “Europe’s Enron”, but I highly recommend the documentary Skandal! in which he features prominently.

The FT article from March 5 quotes a few sources who share their skepticism about the Canadian asset management behemoth and its various holding companies and subsidiaries. One, Keith Dalrymple, has written several comprehensive pieces about Brookfield Infrastructure Partners (BIP).

Dalrymple argues forcefully that the limited partnership units should trade for roughly net asset value. In his view, the market misunderstands the partnership to be a conglomerate with aggregated cash flows. In his view, BIP is merely an investment holding company which should be valued at the net value of its balance sheet. Dalrymple contends that BIP’s market value is overstated by as much as 300%.

There is no doubt that BIP’s use of consolidated financials allows the company to create the illusion of a unified conglomerate. Moreover, the liberal use of the non-GAAP accounting terms “FFO” and “AFFO” make the company sound like a real estate investment trust. The reality is far different. The web of joint ventures is a loose confederation of companies.

One of the most enlightening parts of Dalrymple’s research was his reference to Edper, a Canadian holding company that collapsed in 1995 under mountains of debt. At one point, Edper held assets of over $100 billion and employed over 100,000 Canadiens in its many subsidiaries. Its market capitalization once amounted to 15% of the Toronto Stock Exchange. Edper was the brainchild of Edward and Peter Bronfman. Exiled from the main Seagram’s Bronfman clan, Peter and Edward formed Edper in 1959. They controlled Trizec-Hahn, one of north America’s largest real estate developers, Brascan, the huge Canadian metals and mining giant, and Labatt Brewing. Control reached dozens of companies.

The brothers perfected the art of acquiring a business with borrowed money, taking most of it public while maintaining control, and using leverage to repeat the process over and over through a vast web of subsidiaries. Ultimately, excessive debt caused the empire to collapse. But the professional management at Edper didn’t disappear. In fact, EdperBrascan emerged from the ashes and changed its name to Brascan in 2000. It transformed itself into none other than Brookfield Asset Management in 2005.

Dalrymple contends that the modern Brookfield companies are using the same playbook. Looking at Brookfield Infrastructure Partners through the Edper lens changes one’s understanding of the limited partners: Although they are technically participants in the equity structure of the business, they have no voting authority. As long as BIP can pay the distributions, the units trade for a price that is three times as high as the value of its underlying assets. This expensive currency a useful tool for adding future joint ventures to the BIP umbrella.

In a sense, Brookfield is borrowing money at 6% interest under the guise of “equity”. It’s an especially good deal to be the general partner in this structure. After all, thanks to incentive payouts, general partners collected 22% of the distributions despite having a claim on less than 1% of book equity. Then there are the management fees. Brookfield earns 1.25% of the market value of all classes of partnership units plus recourse debt at the holding company level. Management fees were nearly $400 million in 2024. Add the $363 million of general partner distributions and you have proceeds to the parent companies that exceed 4% of revenues. This is a lucrative arrangement for BAM.

The area that bears further scrutiny is the use of maintenance capital expenditures to manage adjusted funds from operations. BIP reports that AFFO taken as a percentage of invested capital results in a return on capital between 14% and 15% over the past two years. I wanted to know if the overall company had equally stellar returns on capital. I decided to reverse engineer an FFO for the entire company. I took FFO attributable to the limited partnership and added back the FFO attributable to non-controlling interests. Let’s call this “global FFO”. Next, I took the percentage of limited partner FFO to global FFO for each year. Then I divided the maintenance capital expenditures attributed to the partnership by this percentage to come up with a “global maintenance capital expenditure” amount. Finally, I subtracted the global maintenance capital expenditures from the company wide consolidated FFO amount to calculate a “global AFFO” number. The return on capital was less than 10% on this company-wide basis.

I may be way out over my skis on this hypothesis, but one can envision a scenario where BIP maintains the illusion of strong performance by adjusting the maintenance capital expenditures in such a way to increase AFFO to the LP’s. The maintenance capital expenditure gray area could be rather fuzzy. How many accountants are questioning the useful life of a toll road in Minas Gerais, a cell tower in Kolkata, or a pipeline valve in Thunder Bay?

Finally, I would also highlight the growing weight of debt at the company. Leverage now exceeds 180% of book equity. Interest coverage defined as FFO-to-interest expense has steadily declined from over 5x in 2017 and 2018 to 2.75x last year. There’s plenty of coverage, but the margins are shrinking. Once again, the Edper playbook is at work. Not only is non-recourse debt present at the joint venture level, BIP has added $4.5 billion of corporate debt with no assets to back it up.

So where do we stand? Capitalizing unlevered AFFO gets you to a valuation in line with the current market price. This is reasonable, but its also the game that BIP management wants you to play. They want you to value the steady dividend and take their estimation of cash flows attributable to limited partners. A more cynical view is that the holding company is an illusion. The unified financial statements are possible because of intricate partnership control mechanisms. The company exists only on paper. The confederation of assets pay lucrative management fees, and as long as the dividend remains intact, few will question whether the company deserves to trade for three times its net book value.

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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No Regrets

I decided I needed a soundtrack for this week’s article. The theme is regret – the feeling that you wish you could change something that’s already happened. Edith Piaf laid the mark down. She had no regrets at all. Defiantly, she announced:

Je repars á zéro. Non, rien de rien. Non, je ne regrette rien!

Non, je ne regrette rien (No, I Regret Nothing) topped French charts for seven weeks in 1960 and became more famous for its use in countless movies since. Edith is musical tonic for the gin of regret. Still feeling guilty about that nice guy you ghosted after you found out he owned six cats? Edith at full blast will fix that.

Need a song that shows a little remorse, but still basically says “f*ck ’em”? Leave it to Ol’ Blue Eyes. In 1969, Frank Sinatra crooned with feigned modesty:

 Regrets, I’ve had a few. But then again, too few to mention… And more, much more than this, I did it my way.

Artists were more introspective in the post-Vietnam era. Regret began to fill the airwaves. Take the easy-going beach classic Margaritaville by Jimmy Buffett. The 1977 ballad seems innocuous on the surface. Tequila, salt, sand and sun. But don’t let those steel drums fool you. Margaritaville, the anthem for an entire cult following, is all about regret. Jimmy Buffett is basically drowning his sorrows because he knows he blew his chance at true love.

I know it’s my own damn fault.

By the 1990’s, Regret was on full display. All Apologies by Nirvana immediately comes to mind, but I prefer Pearl Jam’s Black for its gut-wrenching agony.

I know someday you’ll have a beautiful life. I know you’ll be a star in somebody else’s sky. But why, why can’t it be. Oh, can’t it be mine?

Need more? Johnny Cash covered Trent Reznor’s Hurt:

If I could start again. A million miles away. I would keep myself. I would find a way.

That’s some painful regret right there. If you’re reaching for the tissues, let’s close our little musical journey on a lighter note. Taylor Swift’s, Back to December:

It turns out freedom ain’t nothing but missing you.

Ah, that’s better.

Regret is a dish served cold in Leverkusen, Germany. If you call Bayer headquarters and get placed on hold, you probably have to listen to Radiohead. The regret of which I speak is the 2018 purchase of Monsanto for $63 billion. It has been nothing short of a disaster for the venerable aspirin-maker which dates its founding to 1863.

Bayer operates in three segments: Crop Science (2024 revenues, €22.3 billion), Pharmaceuticals (€18.1 billion), and Consumer Health (€5.9 billion). Crop Science features the RoundUp herbicide franchise and DeKalb seeds. Pharmaceuticals offer a wide range of treatments with success in cardiology and women’s health. Consumer Health includes the famous Aspirin brand as well as Aleve, Claritin, MiraLax, and AlkaSeltzer.

The Crop Science business presents the largest challenge. Between 2019 and 2024, Bayer has taken over $13 billion in goodwill impairment charges. The company has accumulated over $19 billion for litigation expenses. The problem has been claims that RoundUp, the indispensable weed-killer, causes cancer. Monsanto has reached settlement agreements on nearly 100,000 lawsuits for approximately $11 billion and estimates that 58,000 cases remain. However, Bayer won a significant victory last August when the US Circuit Court of Appeals ruled that Federal law shields the company from claims at the state level. The court rejected a plaintiff’s claim that Monsanto placed farmers in danger by failing to place a cancer warning label on the product. The ruling conflicts with other decisions and leads to a belief that the commerce-friendly US Supreme Court could soon weigh in and reduce Bayer’s liabilities.

The Pharmaceutical division faces an urgent need to replenish its drug pipeline. Xarelto is Bayer’s bestselling drug, but its patent expired in 2024. Generics have started to cut into sales of the anti-coagulant. Xarelto sales topped $4 billion in 2023 and declined to $3.5 billion in 2024. The top 15 medicines accounted for $15.3 billion of sales, or 85% of the pharmaceutical segment. The next best performer is Eylea at $3.3 billion and 1% annual growth, and Nubeqa at $1.5 billion and 73% annual growth. The drugs are for retinal diseases and cancer treatment, respectively. Only a German company could withstand the irony of producing medicines to cure cancer while simultaneously making a herbicide that is a carcinogen. Somewhere, Friedrich Nietzsche is having a laugh.

Bayer has two missions: clean up the Monsanto litigation and create a more robust pipeline of pharmaceuticals. Bill Anderson, a native Texan, was hired in 2023 to lead Bayer. Anderson is a drug industry veteran, having previously run Genentech’s oncology, immunology and opthamology divisions. He later served as CEO of Genentech, a subsidiary of the Swiss drug-giant Roche, and ultimately ran Roche’s entire pharmaceuticals division. Given Anderson’s background expertise, there is speculation that once the RoundUp litigation has been arrested, the crop sciences business could be sold.

What we need to know is whether or not Bayer has the makings of a good value investment. For all of Bayer’s problems, this is still a multinational company that generated $4.5 billion of free cash flow in 2024. If you can handle the rocky ride ahead, Bayer could prove to be a very lucrative investment with a great deal of upside.

Shares trade on the DAX for about €23, giving the company a market capitalization of €22.6 billion, or $24.5 billion. American investors can buy ADRs with the BAYRY ticker for about $6.30 apiece. The company recently closed the books for 2024 and posted €46.6 billion of revenues, a decline of 9% from 2023. Operating income was €3.5 billion, with operating margins collapsing from 17.2% in 2023 to just below 7.5% in 2024. Mr. Anderson faces a stiff test.

Leverage is a concern. Over €40.8 billion of debt and leases weigh heavily. The board responded to the threat of losing Bayer’s BBB rating by eliminating the company’s hefty dividend which preserved about $2.4 billion last year. Debt was reduced from 2023’s level of $45 billion and is now on par with 2018 levels. Management is keen to reduce the debt further.

I decided to value Bayer using the preferred tool in Bruce Greenwald’s kit – a calculation of earnings power value (EPV) by taking normalized and unlevered free cash flow and dividing it by a percentage rate which reflects the company’s cost of capital. Using 2024 numbers, I calculated Bayer’s intrinsic value to be approximately €68 per share, or nearly three times its current trading price.

There are three items of note: First, I capitalized Bayer’s annual R&D spending which has hovered between €5 and €7 billion per year. The adjustment adds about €250 million to the annual income. Second, I made the computation of the weighted average cost of capital with a sledgehammer rather than a scalpel. Debt is fairly straightforward. As a BBB rated company, Bayer can borrow at 5.7% in the US market. I chose the US risk-free rate rather than the German bund rate that is about 150 basis points lower. For the equity (35% weight), I employed a 10% risk premium over our 10-Year rate, for 14.3%. The WACC, therefore, computes to 7.55%. Third, I deducted €8 billion from the value as a litigation reserve for future RoundUp claims.

Unlevered free cash flow of €8.7 billion is thus capitalized to €115 billion. Subtract net debt of €36.6 billion, pension obligations of €3.3 billion and the aforementioned litigation reserve, and the net value sums to €66.9 billion after a small adjustment for noncontrolling interests. The resulting share price of €68 gives an investor a very wide margin of safety.

Next, I made an assumption that Anderson and Co. can improve margins. Even if they rise to just 12%, still well below the recent past, it produces an additional €2.2 billion of operating cash. This boosts the share price above €96. One may quickly rebut my thesis by pointing out that the company very well may need every scrap of operating leverage if the Xarelto decline is more precipitous than expected, or the drug pipeline runneth dry.

The next exercise is to break down what a split-up Bayer might look like. Here’s a preview: The Crop Science business had an adjusted EBITDA of $4.3 billion in 2024. Corteva, spun off from DuPont in 2019 has a market cap of $41.5 billion and an EV/EBITDA multiple of 15. Even a 12 multiple would value Bayer’s agriculture division at €51.6 billion. Something to ponder.

Litigation is no way to run a business. If an investment thesis relies on a favorable ruling from the Supreme Court, you’re already on shaky ground. But Monsanto’s RoundUp isn’t like tobacco. It’s not a leisure product. RoundUp is an essential tool for the farming industry. Glyphosate is so effective, many farmers fear that it may disappear from the market and lead to replacement by cheap knock-offs from China which are likely to be unregulated and riskier to one’s health. RoundUp is not going away.

Things are looking better in Leverkusen. Even their fußball team, Bayer Leverkusen won the Bundesliga in 2024. It’s the first time a team other than Bayern Munich or Dortmund won since 2008. So, they’ve got that going for them, which is nice.

Hat tip to my friend Guillermo who hails from Vigo, Spain and put me onto the Bayer value story. 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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Craftsmanship

Boston real estate was feeling pretty sore in the early 1990’s. Many state-chartered banks in New England had collapsed under the weight of so many bad commercial real estate loans, just like their savings and loan brethren throughout the southwest. I first stepped into this troubled market by briefly working for a small real estate brokerage office in Boston.

We got a call from a man who was interested in selling his retail condominium. Wearing my coat and tie, I went with Peter, whom I considered a grizzled veteran even though he was probably only around 35. I didn’t even know about the existence of commercial condominiums. It was a first-floor space in a 1920’s brick building with large glass display windows. Despite the architectural charms, we didn’t think there was much of a market for a 2,500 square foot storefront with on-street parking.

The door opened with a jingle. Wood floors, high tin ceilings, and old brass lamp fixtures illuminated the room. The smell hit you right away. A sharp odor. Turpentine. Acetone. Oil. But it slowly faded into warm woodiness. Like an old church reassuringly scrubbed by parish ladies bearing buckets of Murphy’s oil soap and tins of carnuba wax.

We were met by the owner – a man who was probably in his early fifties, slim and athletic. He had wiry gray hair, sharp blue eyes and the kind of wrinkles you see on runners who have spent a lot of time in the sun. We reached out to shake hands and were clumsily met by his left which he cupped around the knuckles of our outstretched rights. I tried not to look too closely, but his right hand hung limply at his side.

After the awkward introduction, we soon realized we had entered the man’s cathedral. Before us stood row after row of heavy wooden desks – maybe 20 in all. Each one was a masterpiece of carved rosettes, scrolls, leaves, vines and columns. Mahogany pantheons stood among castles of walnut and majestic oak temples. Weighing hundreds of pounds, and much more expensive than any commission check that we stood to earn from a sale, these furnishings were destined for Back Bay mansions and State Street banks.

We learned the owner had suffered an accident on his bike that caused paralysis in his right arm. His career as a carpenter and craftsman was over. He had no partner or apprentice, and his children had moved on. He answered our real estate questions with grim stoicism, but his eyes sparkled once we asked him to show us his inventory. Was he at peace with his tragic misfortune? We took down his information, made some measurements and told him we would call with a proposal to list the space for sale.

I remember buckling the seatbelt when we got in Peter’s car. A small voice inside of me told me to go back and ask the man to teach me to continue his business. I could be his apprentice. This urge came despite my entire woodworking experience consisting of a single semester of shop class in seventh grade. He may have been flattered by my offer, but he would surely know his craft was more than a skill to be taught. It was art. Was I an artist?

As you grow older, you begin to wonder how different your life might have been if you had chosen different forks in the road. The furniture would have been magnificent. The finished product something to behold. Maybe I’d be the one looking for a woodworking apprentice today. Someone to carry on my craft.

Then you realize that every path is painful. How many desks could I have sold, really? All those hours sanding, carving, chiseling, and finishing. The dust, fumes, and bloodied fingers. The greedy lumber mill, the client’s bounced check, the revival of midcentury modern and Restoration Hardware. There’s no easy path, as fanciful as it may seem. Yet it was art. Something tangible. Not just numbers on a spreadsheet.

Ah well, off to the spreadsheets we go.

Elliott Management has received much notoriety for its activist shareholder campaigns. In recent weeks Paul Singer’s fund has taken large stakes in BP, Phillips 66, Honeywell, and Southwest Airlines (LUV). Although the firm chalked up a big win at Starbucks last year, two campaigns were less successful: A 2023 shake-up at Goodyear yielded no investment gains. Meanwhile, shares of Sensata (ST) have fallen 12% after an initial surge during May 2024’s announcement of a cooperation agreement between management and the fearsome investment firm. Elliott gained a board seat and pressed for the replacement of the CEO after a series of acquisitions that failed to deliver positive results.

I enjoyed some investment success several years ago when Elliott pressured Cabela’s to sell to Bass Pro Shops, so I am always tempted to follow Singer’s moves. Sensata trades 32% below its 52-week high, and it caught my eye. Goodyear turned out to be a rare blemish for the Elliott team. The tire business is plagued by shrinking margins and brutal competition from Asian manufacturers. Sensata is different. Sensata produces sensors and electrical protection components that have unique technological sophistication. Moreover, the adoption of hybrid and electric vehicles has increased demand for Sensata’s products.

How will Elliott’s scheme play out? For my valuation exercise, I’m purely focused on the possibility of improved operating margins. This is Elliott’s playbook for Southwest. Last week, Southwest announced that they would conduct the first major layoff in the company’s history. They expect to cut salaries, primarily in the corporate offices, by 15%. This is part of an effort to save $500 million annually by 2027. Comparing salary margins at Southwest versus Delta Airlines, it’s not hard to see where value can be created.

Looking back to the peak of Southwest’s market capitalization in 2018, salaries accounted for 37% of passenger revenues. Meanwhile, salaries at Delta amounted to 27% of passenger revenues. Six years later, Delta’s wage bill has risen to 32% and Southwest’s surged to 49%. There’s no argument to be made that Southwest can match Delta. But can they cut salaries back to 46% of passenger revenues? That seems very likely. Such a reduction would boost profits at Southwest by $625 million. Assuming a post-tax multiple of 7.9x translates into $5 billion of market capitalization for LUV, or just about 27% above current levels.

How about Sensata? What kind of value creation can margin improvement deliver?

Revenue for the Attleboro, Massachusetts firm has plateaued at $4 billion over the past three years. Operating margins have declined from 17-18% levels prior to Covid, to around 13% today. Tracking the trailing twelve-month period ending in September of 2024, unlevered free cash flow at Sensata was about $500 million. Using a weighted average cost of capital of 7.69% for the business leads to an earnings power value of $3.95 billion after accounting for about $2.6 billion of net debt. On a per share basis, this is around $26, or slightly below last week’s $29 level.

If Sensata can just lift margins by a couple of percentage points (easier said than done) from 12.25% to 14%, free cash flow would increase to $573 million, and translate into over $900 million of shareholder value. This puts the stock in the $32 range. That’s only about 7% above the current price, but the exercise shows the direction management may be headed. Others have noted that some business lines may be sold.

There’s danger in blindly following a fund manager’s latest 13D or 13F filings. People tend to focus on one or two names rather than seeing the big picture. Elliott’s latest filings include a diverse array of holdings. They also disclose many hedges – put options on many sector ETF’s rank among the firm’s many positions. Filings are historical. Elliott could have sold Sensata shares last week. We won’t know for a couple of months.

I will say that in a market that continues to trade on price-to-sales hopium, it is refreshing to actually find a US company selling near it’s intrinsic value using the straightforward earnings power value methodology. Sensata is reasonably priced. The downside appears to be protected. In the case of both Southwest and Sensata, Elliott’s investment thesis of operating margin improvements will translate into tangible business performance and shareholder value.

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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No Show

Many years ago, when I was in high school, my Dad gave me some scholarly advice that paid dividends in subsequent years. He said that if I was stumped on an essay question, then the best thing to do was to “show what I know”. I may not have all the facts about the Battle of Antietam, but I might be able to muster some pretty decent paragrpahs about why Abraham Lincoln demoted General George McClellan. “Show what you know” snatched mediocrity from the flames of academic despair on several occasions.

That’s where I’m at this week. I don’t have any new conclusions, but I can tell you a few of my thoughts and observations. Here’s to showing what (little) I know…

Peakstone Realty Trust (PKST)

Oh Peakstone, you broke my heart. Last fall, I thought I found the ideal REIT trading at an enormous discount. Peakstone was priced in the $14 range and had a market cap of $480 million. The office and industrial REIT owns some prime property like the Freeport McMoRan tower in downtown Phoenix, Amazon distribution centers, and the McKesson office complex in Scottsdale.

I threw a ludicrous cap rate at the office space and figured the real estate was still worth about $1.7 billion. After subtracting net debt of $936 million, I thought the stock was worth $18. Plus it had a 6% yield.

We’re now 40% lower, and that stings. A lot. All management really had to do was buy back stock, sell assets and pay down debt. When your dividend is yielding 6%, it’s a no-brainer. Instead, deal junkies do what deal junkies gotta do. Deals, y’all. In November, they went out and re-levered the balance sheet in to buy a $490 million portfolio of outdoor storage real estate at a cap rate of… 5.2%.

I did not have buying B industrial assets with negative leverage on my bingo card, but there you go. The website photos on Peakstone’s portfolio page now look like the opening credits from Sopranos.

Barry-Callebaut (BRRLY)

The Zurich-based refiner and seller of chocolate has taken an absolute beating as the price of cocoa has skyrocketed. Shares are down 50% over the past year. I’ve never seen anything quite like the price chart for cocoa. Parabolic is an understatement. It’s actually mind-boggling.

Crop failures in Ivory Coast and Ghana have led to a shortage. But is it really that bad? There’s got to be an opportunity here somewhere. Surely futures markets are way over their skis?

Barry-Callebaut is one of the leading suppliers to confectioners, and they have a dynamic new CEO who has begun an efficiency drive. The problem is that Barry-Callebaut had to purchase inventories of cocoa at massive discounts to the contracted sales prices to their customers.

Working capital looks like an absolute trainwreck. The company spent over 2.6 billion CHF on cococa inventory over the past year. In order to cover the loss, BRRLY turned to the debt markets and raised about 3 billion CHF. Eventually, the cocoa market’s gotta rebalance, right?

Digital Realty Trust (DLR)

The sector is so hot right now. An Australian fund manager, Nate Koppikar, is shorting data centers in the belief that supply of will outstrip demand as this whole AI-thing bursts its bubble. I have looked at Digital Realty in some depth. I don’t have much of a smoking gun here, but I do agree that the market is way ahead of itself.

Digital Realty trades at 24 times projected funds from operations and carries an enterprise value of $70.4 billion. I produced a cocktail napkin set of numbers and my conclusion is that the stock trades at a 40% premium to its intrinsic value.

I took the most recent unlevered free cash flow of $1.9 billion and applied a cap rate of 5.5%. This results in an asset value of $35 billion. I subtracted debt, redeemable noncontrolling interests, preferred stock and added joint venture investments at 2 times book value. Next, I ran a very basic discounted cash flow on a future investment pipeline that essentially doubles the company’s real estate footprint in five years. I assumed 25% leverage for the new properties. The present value of future development amounts to $17.4 billion. The sum of these pieces is an estimate of net asset value of $39.7 billion.

Obviously, this is a work in progress, but here are my general observations thus far: REITs must distribute 90% of their taxable income. Therefore, it is very difficult to achieve growth through the reinvestment of profits. DLR pays a dividend yield near 3%, and this leaves virtually zero cash to deploy into new data centers. DLR must, therefore, raise external capital in order to grow. I assumed that they continue to borrow 25% of their future investment requirements. The rest needs to come from the issuance of new stock. Indeed, during the first three quarters of 2024, Digital Realty raised $2.7 billion by issuing new shares.

Raising cash through the sale of stock to deploy into profitable real estate developments works just fine as long as the return on capital exceeds the cost of capital. In this regard, DLR’s recent track record has been unexceptional. Returns on capital have hovered near 6.5%. In my future development scenario, I assumed returns of 10%. This is what their major competitor Equinix has been able to achieve. DLR has been able to produce shareholder value despite unremarkable asset performance because they loaded up with debt at the absolute bottom of the COVID-era interest rate bonanza. The weighted average cost of the $17.1 billion of loans outstanding is a puny 2.9%. Unfortunately, the incremental debt for the development program will have an interest rate in the 5% range.

At this point, I don’t have a strong conviction about the value of Digital Realty. My projections are too simplistic to be relied upon. But I do believe that the stock reflects a future development pipeline that must be executed flawlessly and at returns much higher than the company has a achieved in recent years. REITs that can issue stock, and deploy the cash at returns in excess of the cost of capital work very well. When they don’t deliver those returns, they become shareholder dilution machines. I’m going to leave it here for now.

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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Five O’Clock Charlie

MASH was always full of laughs, but those CBS writers never let you forget about the senseless brutality of war. One minute the affable Colonel Henry Blake is on his way back from Korea to his wife and kids, the next minute he’s gone. Radar runs into the triage tent to tell everyone the news. Gut punch.

So goes Hollywood. Blake’s actor, McLean Stevenson, wanted more screen time. Fed up, he asked to be released from his contract in 1975. CBS obliged. I’m sure McLean Stevenson appeared in other roles. I can’t tell you what those were.

We don’t like to admit so much in life comes down to luck. It has to be skill, knowledge, expertise or “God’s plan”, right? There must be an explanation.

But sometimes luck really is the answer. Henry Blake lands in Tokyo. McLean Stevenson gets cast as Mr. Rourke on Fantasy Island.

Sure, you can put yourself into a lucky positions. Sam Zell’s father knew the Nazis were coming for his family. He prepared. He moved assets. He fled Poland. He also just happened to catch the last train out before the Luftwaffe bombed the tracks.

America has had a lot of lucky breaks. In the War of 1812, England was on the verge of reclaiming her colonies. Washington, DC was under siege by the British army. After the White House burned to the ground, a great tornado struck the Potomac valley. The British fled.

But we’ve gone too far. We’ve turned into a nation of degenerate gamblers. It’s not enough to go to a casino down the street or have an online sports betting app on your phone. You can trade memecoins! Just buy stock in quantum computing companies with no viable way to profitability. Or, you can roll your entire net worth into triple-levered Nasadq QQQ ETF’s. You’ll be fine. Stop-loss orders always get filled in a market panic.

That’s why value investing appeals to me. There is so much luck, chance and uncertainty involved in business. You can’t know the future. But you can hope to find companies that are selling at a price with a margin of safety – they appear to have some protection from downside; from bad luck and all of its cousins.

The most unlikely place to find good companies selling for reasonable prices is Hong Kong. As unbelievable as that sentence may read, it was not generated by Co-Pilot. Two weeks ago, I wrote about the bargain price for Johnson Electric (JEHLY), and briefly mentioned Budweiser APAC (BDWBY) and Sinopec Kantons (SPKOY). This week I am recommending WH Group (WHGLY).

WH Group is the world’s largest producer of pork. The stock trades on the Hong Kong bourse and can also be bought over the counter at about $15.90 per share. The company had revenues of $26.2 billion in 2023 and $25.4 billion over the last twelve months’ reporting period through June of 2024. China and Europe accounted for 39% of WH Group’s 1H2024 revenues, and 46% of operating profits. The company was unfazed by the pandemic, instead it suffered it’s worst financial results during 2023 when pork prices in North America collapsed causing major inventory write-downs at the Smithfield division.

WH Group purchased the Virginia-based Smithfield for $4.7 billion in 2013. Now, WH Group plans to-relist Smithfield in a share offering. The projected value of the Smithfield operation is $10.7 billion. As part of the IPO, WH Group will reap about $540 billion in cash and reduce its ownership stake from 100% to 89.9%.

WH Group trades with a trailing PE of 10.4 times earnings and pays a substantial 5.6% dividend yield. The company is rated BBB by Standard & Poor’s, carrying a modest $3.8 billion of debt and operating leases with a weighted average interest rate of 4.4%. Gross margins are in the 19% range, with net margins above 8.5%. Returns on capital have been between 13% and 15% in recent years which seems noteworthy for a food processor.

By my calculations, WH Group has more than 23% upside. Unlevered free cash flow for the company exceeded $1.8 billion over the trailing-twelve month reporting period. Employing a weighted average cost of capital of 9.77%, gives WHGLY a value of $18.9 billion. Adding $800 million of cash but subtracting the debt and about $400 million of pension obligations leaves  an earnings power valuation of $15.6 billion. Adjusting for non-controlling interests, WH Group is worth about $13.4 billion, or $21 per American share. The effect of the Smithfield IPO is also presented below.

There are plenty of caveats. WH Group is listing its Smithfield operations because they have an opportunity to raise some cash, but the political optics are important. Distancing China from the US food chain is probably a well-caulculated move to insulate the company from US criticism. Second, WH Group has already run up by about 30% over the past 12 months. The really low-hanging fruit has been plucked. Finally, the Chinese economy is suffering a dramatic downturn as the property market hangover sets in. Consumers are in a frugal mood. Eating less pork may be a way for Chinese households to economize.

The Smithfield IPO will be a landmark moment for WH Group. If the North American operations receive a $10.7 billion stamp of approval by American investors, it could lead investors to ascribe a higher multiple to the Chinese and European businesses.

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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Pseudo-Analysis

My sister and I always knew it was a big deal when Dr. Sidney Freedman showed up on MASH. The psychiatrist wasn’t there to join the wise-cracking banter in the triage tent. And he sure wasn’t going to put on dresses with Klinger or pull pranks on Dr. Winchester. Somebody was about to get their psychological puzzle dis-assembled right there on national television.

In the final seasons of the comedy show’s 11-year run, MASH explored some dark territory. Even though MASH was set during the Korean War, just about everyone knew it was really about Vietnam. As the series went into its last few years, CBS seemed to stop pretending. Alan Alda’s hair grew pretty long, and so did his dramatic scenes.

Not only was it ground-breaking to put a psychiatrist on television in the 1970s, the writers gave him the rank of major. Dr. Freedman outranked the surgeons, BJ and Hawkeye. CBS seemed to be asking a generation of Americans burdened by the Vietnam era the ultimate question: What good is fixing a broken body if you can’t heal the soul?

It was actually our mother who clued us in to Dr. Freedman. Mom took a keen interest in Sid, just like she preferred the wit and charm of John Chancellor to the gruff Walter Cronkite. Mom had a master’s degree in social work, so Sid was her kind of people. Yep, when Dr. Sidney Freedman came to the camp, we knew it was time to go deep.

Having a mother with an MSW was like having Dr. Sidney Freedman right in our home. Well, in Mom’s case, it was more like a combination of Sid plus a mixture of Helen Reddy and Maria from Sesame Street. The childhood distress of silent treatments from girls in the classroom, peer pressure, embarrassment about acne – Mom was always ready with the right words. “Maybe they’re being mean because of their own insecurities”. Thanks, Mom!

They could make a modern spin-off of MASH with Dr. Sidney Freedman as the lead character. Only this time he wouldn’t be a shrink in a military hospital unit, he’d be running a private credit firm. Preferably one named for a Greek or Roman god. “Welcome to my office. Make yourself comfortable. Some of my clients sit, but most prefer to lie on the SOFR.” This script practically writes itself. It would be like having Dr. Wendy Rhoades on Billions, only better.

You need to have a degree in psychology to understand today’s markets. The keen ability to diagnose and treat delusional thinking is a prerequisite. Consider this: an electronic token generated by a computer algorithm has reached a price of $100,000. The “currency”, invented by Satoshi Nakamoto in 2008, is backed by no government and has few nodes of exchange except for illicit activities. Who is Satoshi Nakamoto? To quote Nate Bargatze, “Nobody knows.”

Let’s take it a step further. There is a company called MicroStrategy (MSTR). It is nominally a software business, but it really has only one purpose. It issues shares in the company to the public for which it receives old fashioned United States dollars. These dollars are backed by the world’s most powerful military, the largest economy, and is recognized around the globe as “legal tender for all debts public and private”. But instead of putting these dollars to work as investable capital for economic production, what does MicroStrategy do? It simply turns around and uses the real dollars to purchase electronic “crypto currency”.

MicroStrategy now owns $43.4 billion of this digital currency. Logic would tell you that the value of this company should be in the neighborhood of, say, and I’m just guessing here… $43.4 billion? Nope. The company trades with a market cap of $80 billion. “Investing” in MicroStrategy means that you are paying $2 to receive $1. And that $1 may not even actually be $1 because its digital money invented by some random guy with a computer in 2008.

There is a paragraph that I came across recently that seemed to leap from the page. Looking back from their perch in 1940, Benjamin Graham and David Dodd made this observation in Security Analysis: “The advance of security analysis proceeded uninterruptedly until about 1927, covering a long period in which increasing attention was paid on all sides to financial reports and statistical data. But the “new era” commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period.”

Pseudo-analysis? Here’s another head-scratcher. Let’s see if we can understand the concept called “Yield Farming”. Yield farming is a high-risk investment strategy in which the investor provides liquidity, stakes, lends, or borrows cryptocurrency assets on a DeFi platform to earn a higher return. Investors may receive payment in additional cryptocurrency.

Got it?

Yield farming sounds very sophisticated. It also sounds an awful lot like something Charles Ponzi would have invented were he alive in 2025 instead of 1925. If you prefer time traveling to 1635 Amsterdam, you could easily replace the word “cryptocurrency” with “tulip bulb”. For those of you earning such a high return, I wish you well. When the music stops, someone will be holding an empty bag.

The hunt for rational market prices has led me to Hong Kong. Don’t laugh. The Hang Seng index is down by about 17.5% since its October-2024 peak. Fears of a Chinese debt-deflation spiral have begun to make the headlines as 10-Year Chinese bond yields have tumbled to 1.65%. China has too much real estate, not enough population growth, and massive levels of government debt at the local levels where municipalities became far too dependent upon the real estate market.

Amid the gloom, there are bargains to be found. Earlier, I wrote about the major discount to book value on offer at CK Hutchison (CKHUY). Meanwhile, Budweiser APAC (BDWBY) trades for 14 times earnings and pays a 6% dividend yield. The oil refiner, Sinopec Kantons (SPKOY) can be bought for a PE of 7.6 yielding 6.58%. But Johnson Electric is the biggest bargain of them all.

Johnson Electric (JEHLY) shares are valued at $1.2 billion by the market, trading hands at a price-to-earnings ratio below 5x for the trailing twelve-month period ending September 2024. The Hong Kong-based maker of small electrical motors racked up sales of $3.8 billion for the fiscal year which ended in March of 2024. Sales declined over the most recent 6-month period compared with 2023, but gross margins expanded from 22.2% to 23.6% resulting in gross profits over the trailing twelve months at $859 million. Net margins are in the 7.5% range, and operating income for the 12-month period amounted to $292 million.

Johnson Electric makes small motors which are an integral part of the automotive, factory automation, life sciences, and HVAC sectors. The automotive sector accounts for 84% of sales and therein lies the rub. Peter Lynch often warned about buying cyclical companies with low-PEs, and the current cycle may not be favorable for autos. Interest rates in much of the West have placed auto affordability beyond the reach of most consumers, and China faces a possible oversupply problem in its domestic EV market.

Johnson Electric can weather a cyclical downturn. The company was started by Mr. & Mrs. Wang Seng Liang in 1959, so this won’t be their first rodeo. The balance sheet is strong. Nearly $700 million of cash offsets the $425 million of debt. The company is rated BBB by Standard & Poor’s. PricewaterhouseCoopers is the auditor. Johnson Electric has over 1,600 customers with sales split roughly by thirds between Asia, North America, and EMEA. Over 30,000 employees manufacture more than 4 million products per year in factories across the globe.

The stock is exceptionally cheap. Unlevered free cash flow over the most recent 12-month period was approximately $283 million. Using a weighted average cost of capital of 9%, the earnings power value exceeds $3.1 billion. Deduct net debt and some pension obligations, and the intrinsic value of the equity is $3.3 billion or $35.65 per ADR. The current market price represents a 64% discount. The market value is a whopping 50% discount to book value. Meanwhile, the 5.7% dividend yield seems well-covered.

Johnson Electric may be in the early days of a difficult downturn for the global auto sector. The saber-rattling between China and Washington certainly isn’t helpful. Despite these concerns, a 60% discount represents a massive margin of safety. I will be adding Johnson Electric to my portfolio.

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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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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