Murray Stahl Third-Quarter Stock Commentary: LCAPA, LUK, HHC
Liberty Starz group, a tracking stock of Liberty Media Corporation (LCAPA) , is a major producer, developer and distributor of television and movie programming, operating 16 premium subscription channels, such as the Starz and Encore channels; these aggregate 51.9 million subscribers3 and continued the recent subscriber growth into 2011. At the helm is owner-operator John Malone, who controls 4.9% of the shares and 31.2%4 of the voting power. Mr. Malone has a track record of repurchasing shares at opportune moments and making shrewd, accretive deals. The current cash balance and cash flow levels will allow him to do both, while still providing a wide margin of safety for investors. Mr. Malone recently walked away from contract renewal negotiations with Netflix to exclusively stream Starz content via the Internet, despite an offer from Netflix that is likely to have been over 10 fold greater than the legacy contract from 2008. As evidenced by recent deals struck by other content owners, the Starz content is deeply undervalued in Liberty Starz’ current stock price. As of June 30, 2011, Liberty Starz had net cash of $1.2 billion, equal to about one-third of the market capitalization, and sustainable, stable operating cash flows of over $300 million, allowing Mr. Malone the flexibility to continue to act opportunistically to sustain high returns on capital. Yet the stock trades at not much above book value – which is to say that for some reason, little is being paid for the plentiful future earnings – and less than 9x estimated 2011 earnings (when adjusted for the cash balance). However, even this valuation is misrepresentative, as it is based upon trailing earnings that include roughly $25-$30 million per year from the soon to expire legacy Netflix contract, whereas the renewal price that Mr. Malone rejected some weeks ago was reportedly on the order of $300 million. Incorporating an allowance for the renewal value of this content, Liberty Starz shares trade at perhaps less than 6x earnings. Even the direst forecasts for consumer spending and cable subscriber growth can hardly justify the current valuation of Liberty Starz given the cash “safety net,” reliable cash flows, attractive contract renewal schedule and vested, long-term oriented owner-operator management.
Leucadia National (LUK)
Leucadia National epitomizes the “owner-operated” business by focusing on long-term growth in book value and opportunistic asset purchases. Ian Cumming (Chairman) and Joseph Steinberg (President and CEO) collectively oversee the operations and investments and own slightly less than 20% of the shares outstanding (~$1 billion market value). Their curriculum vitae are best described by the history of Leucadia’s book value per share expansion: 13.6% per year for the 10.5 years since year-end 2000, and 14.6% per year for the 20.5 years since year-end 1990. Leucadia presently has a variety of associated companies and investments in multiple industries including investment banking, commercial mortgages, metals and mining and industrial manufacturing. This is an active portfolio and subject to change, although historically the investments have been long-term and met disciplined value criteria. A key principle of the investment methodology at Leucadia is consideration of purchase price (i.e., margin of safety). This is a different sense of safety (and opportunity), though, than that practiced by conventional agent-operator CEOs. For instance, a not insubstantial addition to earnings and book value was born of the purchase, in 2007 and 2008, well into the unfolding twinned crises of the auto industry and lending sector, of Americredit Financial for $418 million. Americredit is a sub-prime auto loan provider. Outcome? Leucadia sold Americredit to General Motors in July 2010, for $3.5 billion in cash, Leucadia’s share being $875 million. The previously mentioned agent-operator CEOs conversely view margin of safety as hoarding cash that ultimately returns negligible amounts to shareholders. As of June 30, 2011, the company had $9.2 billion in assets, $2.4 billion in liabilities and $6.8 billion of equity. During 2009 and 2010 (consistent with the past 20 or 30 years), Leucadia earned returns on equity of 15.6% and 34.3%, respectively, yet as of this writing trades at over a 10% discount to book value. In overly simplified terms, a multiple of book value can be interpreted as an expectation of return on equity. By this price measure, investors not only do not expect a high return on equity from Leucadia, they expect no return. Furthermore, the company has a conservatively positioned balance sheet with ample liquidity to weather any tumults associated with economic hardship, yet also maintains flexibility to initiate investments should the opportunity present itself. Of course, it is possible that Leucadia will trade at a further discount to book value. However, management might well take advantage of this, should it come to pass. The company has traded at a premium to book value for much of the past decade. Accordingly, we view the current valuation as an anomaly – one can acquire an interest in one of the most successful private investment portfolios of the past three decades, not only without fee or introduction, but at a material discount. If shares of Leucadia are to trade at book value – a valuation that we still consider a sizeable discount – the return as of the writing will be slightly less than 20%.
Howard Hughes Corporation (HHC)
The Howard Hughes Corporation is a real estate holding company created by various firms that committed capital to facilitate the reorganization of General Growth Properties (“GGP”). GGP was forced into bankruptcy due to the inability to refinance debt obligations, despite remaining quite profitable throughout the credit crisis. As such, substantial equity value remained when it came time to restructure. The sponsor firms, including William Ackman, founder of Pershing Square Capital, and well-regarded Brookfield Asset Management chose not to include all of the assets previously held by GGP, and to spin off the properties that did not fit the cash flow and leasing parameters desired by conventional retail REIT investors, thus creating a second company: the Howard Hughes Corporation. Mr. Ackman elected to become Chairman and remains very active in the management decisions.
As of this writing, the bankruptcy recapitalization leaders, Brookfield Asset Management and William Ackman, control 15.8% of the shares outstanding. This figure fails to incorporate the warrants also held by these companies, which when exercised will increase the ownership to over 26.9%. Mr. Ackman elected 3 executives to run Howard Hughes on a day-to-day basis. Given the modest salaries they earn, their primary compensation will be through 7-year warrants that cannot be hedged for 6 years. The executives paid a combined $19 million for these warrants, which will be worthless if the common shares do not exceed the exercise price. It is both uncommon and remarkable for a management team to accept to expend cash as part of a compensation package. As of this writing, both warrants issues sold to the executives are well below the exercise price. This compensation structure ensures that every member of the management not only shares a long-term outlook, but also a vested interest aligned with shareholders.
As of June 30, 2011, Howard Hughes had approximately $3 billion in assets, $894 million in liabilities and $2.1 billion in shareholders’ equity. As of this writing, the company was priced at $43.58 per share, which is less than .80 times book value. This can be interpreted as investors believing that Howard Hughes will sustain negative earnings and/or ultimately be unable to realize the balance sheet values of the assets in liquidation. The discount to stated book value does not even reflect the actual markdown. One should make allowance for the conservative valuation of the assets, as is typically the case with stated asset values post reorganization (bankruptcy courts commonly value assets conservatively to provide additional flexibility post-bankruptcy). For instance, consider the South Street Seaport property in lower Manhattan on Pier 17. This tourist destination is held at merely $3.1 million book value. This may be compared to operating income of over $5.0 million in 2010. Even this operating income figure is misleading due to the economic climate under which the legacy leases and tenants were negotiated. It certainly fails to reflect any redevelopment plans for the site, which could include hotels, residential units and the like. Further, many of the other properties are on the books at costs that were established decades ago. The land for the enormous Summerlin master planned community in Las Vegas, for instance, was acquired in the 1950s.
The assets of Howard Hughes will take time to develop and monetize, however, management has been careful to limit asset sales at current depressed levels and to find strong strategic partners for the future property development. Due to the quality of assets, long-term vested management team and substantial discount to current market value, we believe that Howard Hughes Corporation represents an attractive long term opportunity with a more than adequate margin of safety.