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.
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.
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.