I think this is a good time to revisit this idea, which was originally written up by Adanah in October 2001. Since that time, APO has generated a very nice IRR of about 30%. However, the stock might be due for further appreciation if my expectations about free cash flow are correct.
The lack of free cash flow has been the main factor that has held this stock back. As Adanah and Chapman Capital (a large shareholder; see 13D filings on Edgar) have noted, there is substantial asset value which they estimated at $20-30 per share. But while cash from operations has risen nicely from $13 million in 2000 to $17 million in 2002 ($3.28 per share!), nearly all of that cash has been used either to fund additional land development or to pay down recourse debt.
At least two factors suggest that much more of APO’s operating cash flow may be available to shareholders going forward, however:
1. A key component of recourse debt, net of unrestricted cash, has been reduced from a challenging $39 million at 12/98 to a very manageable $19 million at 9/03.
2. APO has reached agreements with U.S. Home, a division of Lennar, to develop two important parcels in St. Charles, Maryland with relatively limited capital required from APO.
Before delving into more details on the issues above, I’ll mention that APO has shown fairly steady earnings, ranging from $0.60 to $0.71 per fully diluted share in the three years through 2002. However, diluted earnings jumped nicely to $0.66 in the first nine months of 2003 and operating cash flow was even stronger at $2.53 per share.
Focusing on APO’s leverage, I believe the key factor is the level of the company’s recourse community development debt. This is the toughest type of debt to obtain and service because it is secured by land and improvements that are not immediately income producing. APO also has debt (mostly non-recourse) on apartment projects and construction debt related to homebuilding. These categories are not especially problematic, however, because the first is supported by rental cash flows and the second is self-liquidating.
When APO was spun off in 1998, it brought with it a relatively high level of recourse community development debt. The $39 million net figure mentioned above equaled about 67% of the book value of APO’s 12/98 community development assets. At that point, APO was still recovering from the tough real estate environment of the early 1990’s and land financing was expensive and hard to come by.
At 9/03, the $19 million of net recourse community development debt equaled only about 35% of the book value of community development assets. While APO may well bring this debt level down further, I believe it’s at a level that is sustainable for the company and comfortable for its lenders. As a result, APO is not facing the same pressures to direct operating cash flows to debt reduction.
The U.S. Home agreement announced earlier this month is significant in several ways. With respect to cash flow, U.S. Home/Lennar has agreed to use its balance sheet to back municipal bonds that will complete major infrastructure improvements for at least 2,000 single family lots as well as commercial and apartment land. APO will still need to pay for the “on-site” work of grading the lots, bringing in utilities, etc., but these costs are smaller and are staged in more manageable phases than are the major “backbone” improvements of arterial roads, sewers, etc. Through the agreement with U.S. Home, APO offloaded the requirement of providing $20 million of financial support for backbone improvements.
APO is now very closely tied with U.S. Home as the two companies had previously entered into a joint venture to develop 400 homes in an active adult community adjacent to the golf course in St. Charles’ Fairway Village. That project should begin to generate cash flow for APO in 2004.
I expect that these developments will allow APO to begin directing future operating cash flows towards its longstanding objective of enhancing shareholder value. Management has talked for many years of wanting to pay dividends as high as $1.00 per share and possibly initiating stock buybacks. The $0.10 per share dividend declared in January may have been the first step in this direction. There was no indication as to whether dividends will be recurring, but it would be very positive if this dividend is made permanent and, over time, increased. Dividends of $0.40 per share would provide an attractive 4.7% yield on the current share price and the yield would rise to nearly 12% if APO is ultimately able to pay $1.00 per share.
One question investors always need to ask with sleepy micro caps like APO is “Why now?” APO is trading well below its probable asset value, but that’s been the case for many years. Similarly, even though the stock has performed reasonably well in the last couple of years, what would make an investor think that will continue?
I’m optimistic because of the factors cited above and because I think visibility is reasonably good for 2004 and 2005. In particular, the Parque Escorial project in Puerto Rico is performing very well and is driving overall profits for APO. Net income from Puerto Rico was only $1.6 million in 2002 but was $2.8 million for the first nine months of 2003. The homebuilding activities at Parque Escorial should continue their strong contributions at least through 2005 and this project is entering the final years when profits – and especially cash flows – are often strongest. The 500-acre Canovanas property provides long term opportunity in Puerto Rico and this project will be enhanced by a new highway that is currently being completed, connecting that area with metropolitan San Juan.
In St. Charles, agreements with the county government and with U.S. Home have created an opportunity for APO to develop and sell perhaps 150 to 200 lots per year with relatively steady profits and cash flows. Additionally, APO has been building up its rental property income to the point that cash flows from the apartment portfolio cover most of the company’s G&A costs, leaving cash flows from property development relatively unencumbered. For example, in the first nine months of 2003, rental property revenue less rental property operating expense and interest equaled $4.1 million while G&A expense was $5.0 million.
While I don’t 100% agree with everything Adanah said, I recommend his write-up for an overview of APO’s assets and possible asset values. As a supplemental example, I will note that rental property revenues less operating expenses for the first nine months of 2003 equaled $6.6 million. Annualizing this figure and using a rough cap rate of 10% suggests the apartment portfolio could be worth $88 million, a $36 million (nearly $7 per share) premium over the $52 million net book value. Given the length of time that APO has held its St. Charles and Puerto Rico land, I think there is little question that the tangible equity value is far above the current trading price, as Adanah and Chapman have indicated.
1. Increased free cash flow resulting from lower development and debt service requirements.
2. Sustained dividends and/or stock buybacks.