Reflections on Howard Hughes
Updated: Oct 23, 2019
Yesterday, Howard Hughes released its much-anticipated review of strategic alternatives. With the shares down 18%, I suppose it is safe to say the market doesn’t like it.
Below, I’ll run you through my thinking. To give away the ending, I am not selling a share. (I may buy more). Howard Hughes is – or rather was – the largest position in the Woodlock House portfolio, at an average cost of $102. (It's number 3 now).
Needless to say, today’s drop is some serious short-term pain. But I created Woodlock House to be a long-term vehicle and owner of publicly traded businesses. I’m not going to get overly worked up after ten months of ownership. (We started in January).
I think the story at Howard Hughes is compelling here for a number of (simple) reasons, which I will get to below. [Apologies for any typos, as I wrote this rather quickly. Should you find any, please send me a kind e-mail and I’ll make the change: email@example.com].
First, a little background…
In June, when Howard Hughes announced they were going to do a strategic review, the stock jumped 40% to about $130. “Strategic alternatives” is Wall Street babble for an eventual sale of the company, in whole or in part. And with most net asset value (NAV) estimates ranging from $170-ish and higher, people thought the review would result in a sale that would close some part of that gap between NAV and the stock price.
That did not happen here. There is no sale.
I have to say I am surprised they did not announce a sale of some kind. I had doubts, which I expressed here, that they would sell the whole company. But I thought the odds were high they’d sell something.
After reaching out to 35 investors, 14 did deep due diligence on the company.... and no one came back with an offer. (There is one investor who has yet to weigh in, but it sounds like the odds are low they make an offer). With all the cheap money sloshing around today, I am, again, surprised there were no bidders.
Instead, Howard Hughes unveiled a plan to transform the company. Yesterday, management held a conference call to discuss it. Bill Ackman, the chairman of Howard Hughes, presided over the call. (Ackman, through his firm Pershing Square, owns a 13% economic interest in the company.)
The basic outline of the plan is in the release, which you can read here.
I don’t want to just repeat what’s there. Instead, I’ll get into what I think are the most compelling reasons to own Howard Hughes and what are some of the downsides.
So, today we own a real estate company with a number of compelling attributes, in no particular order of importance:
It is self-funding. This is big. Most real estate companies, in particular REITs, have to go back to the market to raise capital for development activities and growth. Not so here.
Track record of net operating income (NOI) growth. Howard Hughes has an impressive track record of NOI growth. Take a look at this chart of NOI since 2010:
We’re at $215 million in NOI on annualized numbers through Q2. Again, that’s without raising any capital. In fact, Howard Hughes bought back a small amount of stock around $120 per share. This growth should continue, though they will lose some NOI on assets sales. (Discussed below).
G&A will drop by about 1/3rd by 2021. Howard Hughes will cut $45 million to $50 million in annual expenses. At a 5% cap rate, that’s $900 million in present value on the low side. Use whatever cap rate you want, but this alone creates a lot of value.
$2 billion in asset sales in the next 12-18 months. The company expects net proceeds after debt repayment of $600 million. A substantial portion of this will go toward buybacks. The assets they are selling, we won’t miss. As Ackman said on the call: “We will lose $44 million of annualized NOI or $66 million on a stabilized basis. But even on a stabilized basis, it's a 3% return on the $2 billion of sales.” So, we free up a lot of capital that is stuck in low-earning assets. And we have substantial capital for buybacks.
Reducing share count. As Ackman said on the call, one of the most frustrating things about owning Howard Hughes is when the stock price gets low they can’t do anything about it. But now they can. I love that buybacks are going to be part of the arsenal here. And over time a reduction in shares outstanding should be very accretive to remaining investors.
$60m in free cash flow at stabilization (and growing). The company provided the following chart during the call:
Important to point out, Seaport is left out of the rental income side of things, but all the expenses are included. So, there is quite a bit of upside here if/when Seaport is a success.
Anyway, this is $60 million in free cash flow – and growing. I like this and I believe it will be easier to follow and value as this cash flow stream grows. Look at their track record of NOI growth again. It is impressive. This should continue and, in fact, should accelerate under the new plan.
NAV of $170 at least. On the call someone asked Ackman about the various NAV estimates out there that seem to start around $170. Ackman said these NAVs were "conservative." However, after a failed attempt to sell, the NAV becomes more academic I’d argue. (What’s an NAV if no one will buy it?) The focus should now be on NOI and free cash flow and more traditional metrics like return on capital (plus, of course, keeping an eye on condo and lot sales, which will still be important). While I like having a large NAV – and one that should continue to grow on a per share basis – it’s not my focus. Over a longer period of time, the share price should gravitate toward NAV, especially as cash-spinning properties make up more and more of that NAV.
Insiders will be increasing their commitment. As I mentioned, Ackman owns 13% of the company and said he would increase his stake when he can (after earnings). The new CEO also expressed a desire to purchase shares (namely, a similar warrant deal that Weinreb had). So, he’ll have skin in the game.
A word about the CEO: I was surprised to see Weinreb out. Perhaps he did not approve of the new plan. Or perhaps there was more internal criticism of his management to date. We don’t know. Paul Layne is the new CEO. I have not met him yet. But he did a great job with Woodlands. I have no issue here.
Huge development potential. Howard Hughes has at least a decade of raw material to work with. And it is in very desirable MPCs, where there are enormous synergies. This last point was something I came to appreciate again listening to the call yesterday. Ackman said they were selling 110 North Wacker, which is a new property they developed in Chicago. It's a beautiful building and is quickly leasing up. It will generate solid free cash flow. And it will raise the value of everything around it.
But that's the problem. And that’s why they are selling it. As Ackman said, it would be better if they had built a Wacker in, say, Woodlands, where they own everything around it and thereby capture the appreciation for themselves. So, the focus on MPCs creates synergy and is clearly where their dollars are better spent.
All of the above are factors I really like and give me comfort that this is a position I can hold in size and own for a long time.
There are some downsides, of course:
Seaport is still here and it will be a drag on the stock until they complete it. A lot of investors don’t like Seaport. It’s cost more to develop than initially thought and is taking longer. It is their riskiest project by a long shot. As mentioned, they do not include any contribution from Seaport in their pro-forma NOI, but they do include all expenses. So, lotta upside here when/if they get it done... at that point, they'll likely get an equity partner and Howard Hughes will be able to take out a good bit of capital. But again, this is going to take time. (Ackman said the upside was "upper hundreds of millions of dollars.")
Failed auction overhang. The fact is that Howard Hughes contacted 35 investors, 14 of which did extensive due diligence and.... got no offers. That will hang over the stock for quite some time. But I think the cash flow that HHC will generate over the next 18 months will reward patient investors.
Still an Orphan. Some investors will fret that Howard Hughes is not a pure-play office or retail or homebuilder. It is a mix of different property types. It is not a REIT. It does not pay a dividend. So, some will argue the stock has no "natural" shareholder base among real estate investors who like single-property stories, dividends and a clean REIT structures... Well, we'll have to wait and see. I think HHC has a compelling story to tell as a focused MPC company and I think more investors will want to own it as it proves itself and the new plan over the next year to 18 months.
Overall the positives outweigh the concerns in my view.
Reflections on Process
Naturally, when something like this happens, it makes you reflect deeply on your own process and decision-making.
Some may wonder if I regret not selling some at $130. This is also a question I asked myself. My answer is no, for a few reasons.
Least important, I would have incurred a large short-term capital gain, which obviously makes the gain quite a bit smaller.
Second, there is reinvestment risk. Meaning, what do I do with the money? I could’ve rolled it into something worse.
But the most important reason: such a strategy is a long-term loser. You can’t bank on a formula that requires you to buy at $100, sell at $130, buy back at $100, etc., and to do it again and again over many years. That’s an incredibly difficult and narrow road to investment success. Besides it's also a crappy way to live.
Besides, I was one of those who had the NAV at $170 and growing. I bought the stock with the idea that I would own it for a long time. So why sell at ~$130?
My due diligence on Howard Hughes exceeded anything I’ve done for any other name in the portfolio. I have visited all of Howard Hughes major properties.
I’ve met with David Striph (then head of Ward Village in Hawaii), Kevin Orrock (Summerlin, in Las Vegas), Tim Welbes (Woodlands, Houston) and other Howard Hughes executives. I have owned the company personally and in my newsletter portfolios for more than 9 years. (I have nearly all my liquid net worth invested in my fund. And I still have a very large position sitting in my IRA.)
I felt like I knew the company well. I had confidence in its assets and people. I have always been impressed with the people I’ve met at Howard Hughes. All of this allowed me to make it a big position.
Such work is important not necessarily because it will lead to some insight that no one else knows about. (That is rare). It’s important because it gives you the mental ballast to stick to a position when times get tough. It gives you the knowledge to sort through problems.
I think investors sometimes underestimate the psychological difficulties in owning stocks. It’s brutal to watch a big position drop like this – if you’re not prepared for it. You have to think going in, that no matter what the stock, you will suffer a big decline at some point. It is just a matter of time before the market tests you. Even Berkshire Hathaway has been cut in half (or nearly so) at least a few times.
If you haven’t done the work, you’ll likely sell out at a bad time. You’ll be heavily influenced by what some guy says on Twitter or CNBC or whatever – because you won’t know enough to have your own expert opinion. You won’t know enough to call BS. Opinions are cheap. And lots of people opine on stocks they know next to nothing about.
One other thought on this: I have often wondered why Seth Klarman and some other great investors I admire are so reluctant to talk about names. What’s the harm? Don’t they want people to know the story and bid up the stock? Don’t they want to invite feedback and criticism to learn from others?
Well, after running Woodlock House for ten months, I understand more why they don’t. The problem with talking about your positions publicly is entirely psychological. Because, people will want to come back to you after every bump and dip and want to ask you “what do you think now?” And then there are people who will want you to do their work for them. “Well, what about this? And what about that?”
All of which shortens your own time horizon. It makes months seem like years. The best way to run a tax efficient, low-cost stock portfolio over the long-term is to detach yourself a bit from the day-to-day and quarter-to-quarter narrative.
Fortunately, I have 15-years of experience running newsletter portfolios, which are very public. I’m more immune than most to the meaningless chatter, criticisms, etc. Even still, I have been disengaging from Twitter, investment conferences, requests from reporters, podcasts, etc.
I still Tweet some things from time to time. And I enjoy writing the blog. But it’s important to manage these distractions. You have to sort through the pros and cons of public engagement yourself. But I would urge you to at least think about how much time you give to Twitter, TV, podcasts, message boards and the like. The benefits of technology do not come without a price.
Anyway, back to Howard Hughes: As I say, I am not selling any shares. If things get really nutty and it goes to $90 or something like that, I may step in and buy a little more, but we're pretty full on this position in my eyes.
Again, one of the reasons I created Woodlock House was that I wanted to have a (near) permanent capital vehicle to own (publicly traded) businesses over the long haul. My capital base gives me the great luxury of really thinking in terms of years, not months. (There is also plenty of skin in the game here. More than 60% of the fund’s assets come from the principals: Bill Bonner and myself).
As usual, I could change my mind about everything above. So, please do your own work and be sure to read my disclaimers.
Thank you for reading. As always I wish you the best of success in the markets!
Published October 22, 2019
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