|Shares Out. (in M):||272||P/E||0||0|
|Market Cap (in $M):||5,600||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
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Summary and Thesis:
At current levels, we believe that FCE.A represents a highly attractive risk / reward profile and presently offers a more compelling opportunity that at any time over the recent years. In early December, FCE announced that it would collapse its dual class share structure, a move which sets up the stock to trade to fair value over the next 12 months. Using appropriate hedges, we believe downside is minimal. Assuming FCE trades to or is acquired at fair value, upside is ≈50%.
Forest City is an owner of real estate assets concentrated in urban markets such as New York City, Boston, Washington DC, and Los Angeles, and San Francisco. At current levels, FCE trades at a ≈6.75% cash cap-rate. High quality real estate in gateway markets does not trade at those cap-rates even in significantly higher interest rate environments. Public peers and private market values are in the low-5% to sub-5% cap-rate range.
This write-up will be fairly brief and focus on the current opportunity. For further background on the situation, we’d refer to previous VIC write-ups from 2013 and 2015. For thorough information on FCE’s properties we’d refer to the Company’s SEC filings and investor presentations. We are happy to address any specific questions in the Q&A section.
On December 6, 2016 FCE announced that it would eliminate its dual class share structure (http://ir.forestcity.net/phoenix.zhtml?c=88464&p=irol-newsArticle&ID=2227911). The dual class structure collapse will be formally implemented following the 2017 AGM.
Under the dual class structure, the founding families (most notably the Ratner family) controlled the board of directors. In our view, the dual class structure represented a severe overhang on the stock and precluded shares from trading at fair value. REITs should trade at fair market value only insofar as two conditions are met:
1) The Company can be sold at fair market value – FCE’s dual class structure and the resulting board control had the effect of strongly dissuading potential suitors from approaching the Company because of the (accurate) perception that the family was not interested in selling.
2) Investors have confidence that management/BOD will not destroy shareholder value through poor capital allocation – in the years prior to the financial crisis, FCE management/board made certain poor decisions which destroyed significant amounts of shareholder capital and which created ripple effects that have continued to the present (further referenced below). The dual class structure rendered traditional (proxy contest, etc.) activism impotent, disabling shareholders from dislodging existing management/BOD [that said, management has performed admirably over the last few years and has taken a series of demonstrably shareholder friendly actions such as the divestment of non-core assets, conversion to a REIT, substantial pullback from development activity, and implementation of cost reduction initiatives].
In our view, therefore, the significance of the dual class structure collapse cannot be overstated. With the dual class structure in place, there were identifiable reasons for why FCE deserved to trade at a discount to fair value. Those reasons no longer exist.
It is important to highlight that the dual class structure collapse came on the heels of a highly negative reaction to 3Q16 earnings. With 3Q16 earnings, FCE announced a $307mm write-down of its long troubled Pacific Park (formerly Atlantic Yards) project. On a YTD basis prior to the dual class structure collapse, FCE had underperformed the RMZ by ≈1500 bps. Based on current trading levels – i.e. inclusive of the bump shares received from the dual class structure collapse – FCE has underperformed the RMZ by ≈950 bps YTD. The recent general decline in REIT shares has contributed further to FCE’s absolute declines.
The Pacific Park write-down was frustrating and further underscored the need for corporate governance reform at the FCE. But from a fundamental standpoint, it is important to recognize the following: 1) the write-down relates to a project that commenced more than a decade ago and was spearheaded by Bruce Ratner (who has now stepped down from the board); 2) the write-down is entirely non-cash; 3) zero balance sheet value remains for Pacific Park (so no risk of further write-downs); 4) future cash obligations associated with Pacific Park are de-minimis (≈$.20/share).
In our view, the selling stemming from the 3Q16 release was the result of acute investor frustration/fatigue and explain why – despite the dual class structure collapse – FCE offers such a compelling opportunity.
In our view, the thesis / event path from here is straightforward: following the dual class structure collapse, FCE ought to be treated by the public markets as any other REIT. We anticipate, therefore, that over the course of the next year shares will trade at levels much closer to fair value. And if that doesn’t happen, we anticipate that the Company will be acquired at a price that reflects fair value. We believe there are numerous parties – many with very low costs of capital – that would be interested in acquiring FCE.
In addition, there are two additional specific catalyst which should facilitate shares trading closer to fair value:
Sale of retail portfolio: in August 2016, FCE announced that it would explore strategic alternatives for its retail portfolio (http://ir.forestcity.net/phoenix.zhtml?c=88464&p=irol-newsArticle&ID=2196704) with conclusion of the process expected by the end 1Q17. FCE’s retail portfolio represents ≈24.5% of NOI and is split into two pieces: 1) Regional Malls; 2) Specialty Retail – (mostly) street retail and retail centers across the five boroughs of New York City.
Both the Regional Malls and Specialty Retail portfolios have JV partners (owning 49%) in place for the vast majority of the assets [Regional Malls – QIC, an Australian RE fund associated with the Queensland SWF; Specialty Retail – Madison Realty, a RE focused PE fund]. FCE has expressed confidence that the JV partners are keenly interested in acquiring the remaining controlling stakes in their respective assets. Helpfully, transaction data points exist for the assets:
- Specialty Retail – in January 2016, Madison sold a 14% interest (i.e. 28% of Madison’s 49% interest) to JLL for a 5.3% forward cap-rate (http://www.jllipt.com/content/pdf/JLLIPT_Investment_Profiles_2015-2016_with_Point_Loma.pdf p. 9-10).
- Regional Malls – QIC has entered the JVs with FCE over the last 3 years, with the most recent transactions having closed in April 2016. The purchases have consistently been in the mid-5% cap-rate range.
Our view of the potential transaction cap-rate is informed by those data points, discussions with industry participants, and comments from management.
In our view, the sale of the retail portfolio accomplishes two very important items:
1) Highlights undervaluation – the assets are likely to sell at a cap-rate significantly below where the consolidated FCE entity trades, despite retail being the highest cap-rate asset category in FCE’s portfolio.
2) Simplifies portfolio – following the sale, FCE’s assets will be limited to multi-family and office properties, and the significant majority of JV assets will have been shed. We believe this will make FCE easier to analyze as a public company and also make it more attractive to potential acquirers.
Dividend increase: FCE reinitiated its dividend after conversion to a REIT in January 2016, but established the dividend at the nominal level of $.24/share. Management, however, has made it clear that the dividend will increase to a steady-state / normalized level in accelerated fashion. We expect substantial progress on that front over the next 12 months.
In summary: on top of the dual class structure collapse, we believe the combination of the retail portfolio sale and dividend increase will further spur shares to trade closer in line with FCE’s underlying value. And again, to the extent that does not happen, we anticipate that interested parties will approach the Company.
FCE trades at a ≈6.75% cash cap-rate. High quality real estate in gateway markets does not trade at those cap-rates even in significantly higher interest rate environments. Public peers and private market values are in the low-5% to sub-5% cash cap-rate range.
As the analysis below presents, even if we apply highly punitive valuations to the Company’s assets, downside is extremely limited. And in the case that cap-rates for such high quality assets rise to those levels, a hedged position should still work out very well. Prior to the dual class structure collapse, FCE possessed idiosyncratic factors which made hedging difficult. At this point, we believe FCE’s fortunes are much more closely correlated to those of other REITs and therefore FCE can be hedged very effectively using the right combination of substantially higher valued peers (and all of which lack the identifiable reason for mispricing and forward catalysts which FCE possesses).
Note: in return for relinquishing control, the Class B shareholders will receive 1.31 Class A shares for each Class B share they own. The impact of that transaction is fully accounted for in our valuation model.
Additional notes on valuation:
- NOI figures are all on a cash basis (i.e. GAAP recognized straight line rent is excluded)
- All values are presented on a net basis – i.e. gross value (NOI / cap-rate) less debt. FCE has no corporate leverage (other than a small amount of convertible debt which we have converted to equity for valuation purposes) – all debt is asset recourse mortgage debt
- Our bull case is really a market base case insofar as it reflects current market value of the assets based on a slew of transaction data points, discussions with brokers, public market valuations, etc.
- Our scenarios are based on run-rate stabilized NOI, and therefore give FCE no credit for further NOI growth
- Our scenarios give FCE no benefit for achieving the meaningful property level cost reductions the Company is targeting
Provided below is detail on how we value FCE’s non-operating assets. Significantly, in all cases we write off to zero the remaining ≈$96mm in development assets and ascribes no value to the significant land rights FCE possesses in Baltimore / Washington DC and San Francisco.
- General risks REITs are exposed to (rising interest rates, widening cap-rates, etc.) – hedgeable
- Specific issues in FCE’s asset categories and markets – largely hedgeable
- Failure to sell retail portfolio – unlikely but possible
In summary, we believe that FCE.A is: 1) cheap on an absolute basis; 2) very cheap on a relative basis (with appropriate hedges liquid and easily borrowable); 3) possesses identifiable catalysts that should result in a rerating of the shares.
We believe an appropriately hedged position features minimal downside and ≈50% upside over a 12 month period.
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