|Shares Out. (in M):||2||P/E||0.0x||0.0x|
|Market Cap (in $M):||96||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||18||EBIT||0||0|
|TEV (in $M):||115||TEV/EBIT||0.0x||0.0x|
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I am going to try to keep this short and sweet, because the basic analysis is simple. Unfortunately this is an illiquid stock, but if it weren't illiquid there wouldn't be a relatively quick 123% upside available. Gyrodyne has a market cap of $96m (at $65 per share) and, with 90% certainty, is about to receive $153m ($103 per share) in cash from a lawsuit that it won at trial in June 2010 and whose appeal was argued yesterday. If it loses the appeal, the underlying business should still be worth at least the $62m ($42 per share) that it was trading at before Gyrodyne’s trial victory in June 2010. It is probably worth more because it owns a valuable hidden asset, which I discuss below. If it wins as expected, its value should be the $42/share starting amount plus the $103/share cash from litigation, or $145/share. That is 123% upside and 35% downside. Using a 90% probability weighting for winning the lawsuit, the expected return is 107%. The company intends to liquidate and distribute all of this value to shareholders.
I am a Harvard-Law-trained former litigator with extensive trial and appellate experience. I have read all the trial transcripts, trial briefs, expert witness reports, the trial court’s decision, and the appellate briefs, all of which the company helpfully puts on its web site’s home page at www.gyrodyne.com. Yesterday I flew to New York to watch the oral arguments in the appellate court. Nothing is ever certain in litigation, but this case is as close as it gets. On the merits, it is a slam dunk. Before the oral argument, I used an 80% chance of winning in my valuation calculations, simply because 20% is the minimum I would leave to allow for judicial bias, incompetence, corruption, or pressure to get reelected or reappointed. I attended the oral argument specifically to assess which way the judges were leaning. (I have sometimes completely changed my opinion of who was going to win an appeal based on the judges’ questions during an oral argument.) These judges’ questions made it clear that they are leaning heavily towards Gyrodyne. After oral argument I have raised the odds of winning to 90%; ten minutes into the argument I sat in court with my laptop and broadband card buying the last shares that are ever likely to change hands at $61.
UPDATED SHARE COUNT AND MARKET CAP
The last quarter’s financials statements show 1,290,039 shares outstanding ($84m market cap), $1.2m cash on hand, and $17.7m debt. In September the company completed a rights offering in which it sold 192,641 shares at $53 per share for $10.2m, which brings the new share count to 1,482,680, market cap to $96m, and cash on hand to $11.5m. Although the company was running low on cash and will need more to pay for its planned real estate activity, it could have easily added another $10m of debt, and it expects to get its $153m judgment paid soon. The only plausible reason for choosing a rights offering was to allow knowledgeable shareholders to increase their percentage ownership at a discount, at the expense of other shareholders who failed to exercise. We’re not complaining; we fully exercised our subscription rights, including the overallotment option. Bulldog Investors (a prominent activist investor) owns 18% of Gyrodyne; as part of the rights offering, Gyrodyne entered a stand-still agreement with Bulldog and amended its poison pill plan so that Bulldog could go over the 20% ownership threshold without triggering the poison pill.
A VERY BRIEF BACKGROUND ON THE BUSINESS
Gyrodyne was founded in 1946 to design and build specialized helicopters. That business is long gone. What is left is the land the company used for its helicopter business – 314 acres in north central Long Island, located 50 miles from Manhattan, right next to SUNY (State University of New York) Stonybrook, and now mostly a higher-end residential area. You can view the location on Google Maps using "1 Flowerfield, 11780."
Today Gyrodyne operates as a REIT owning medical office buildings. The business is currently running at break-even but owns a number of buildings with high occupancy rates and stable cash flows. The company is explicitly in liquidation mode, seeking to distribute its assets to shareholders (after it finally collects on its lawsuit) in the most tax-efficient manner.
THE EMINANT DOMAIN LAWSUIT
In 2005 when SUNY Stonybrook wanted to expand, it used eminent domain to take 245.5 acres of Gyrodyne’s land and paid Gyrodyne $26.3m. Gyrodyne elected, under eminent domain law, to accept that amount as an advance payment while it pursued a court claim for a higher award. (It used the $26m to buy medical office buildings to keep the proceeds tax-free under REIT law.) The trial involved two basic issues. The first was what the “highest and best use” for the land would have been had the state not taken it. The state argued that, because the land was currently zoned for light industrial use, light industrial was its highest and best use. This argument was, to put it bluntly, ridiculous. The land is surrounded by residences. The evidence was clear that Gyrodyne’s neighbors would have strongly preferred residential to industrial development and that the two towns encompassing the land would likely have approved applications to rezone it for residential use.
The second issue was how much the land would have been worth under its alternative uses. Gyrodyne put in extensive evidence and expert opinion on the odds of rezoning, likely densities (how many residential units per acre), costs, and comparable valuations. My original, objective (pre-stock-purchase) reading was that Gyrodyne’s expert witnesses had done a good job identifying the relevant variables and probabilities, assigning reasonable value ranges for them, and selecting reasonable mid-points within the ranges for valuation purposes (rather than stretching for a higher valuation). The state put in no evidence on the land’s value if developed for residential use, instead offering only an industrial-use valuation and cross-examining (in a bullying manner) Gyrodyne’s witnesses on their residential valuations. In his written opinion, the trial judge went out of his way to criticize the state’s attorney by name and describe what a terrible job he had done at trial, both strategically and tactically -- so terrible that he turned an already-weak case into a total loser for the state.
The trial judge accepted Gyrodyne’s valuation of $125m. After deducting the $26m already paid, that left $99m still owed. Statutory interest of 9%, or $9m per year, accrues from the date of the eminent domain taking in November 2005; thus the interest owed is now $53m. Add another $1.5m awarded for fees and costs, and the total owed is now $153m and growing at a rate of $24,300 per day.
There is little that need be said about the appellate arguments. The state’s briefs largely raise issues that were not raised at trial (which is largely a no-no on appeal), some of which are deeply flawed as a matter of pure logic. (If you read the briefs, I’m referring to its arguments about the time value of money.) Gyrodyne’s brief does a better job than the trial court’s opinion did in explaining how the record evidence supported the valuation amount. The trial court’s findings of fact cannot be overturned unless “clearly erroneous,” and it is difficult to conceive of what ruling of law the appellate court would overturn unless it is actively looking for some way, any way, to save the state some cash. That outcome seems unlikely given how hostile the judges were towards the state’s arguments during oral argument yesterday. As one example, a judge asked the state’s appellate lawyer, “what are you seeking on this appeal?” The lawyer said “a new trial,” and a second judge responded dismissively, “you think you can do it better the second time.”
THE HIDDEN ASSET AND VALUATION OF THE NON-LITIGATION BUSINESS
Gyrodyne’s original piece of land on Long Island is called Flowerfield and still houses its small headquarters. After the 245.5-acre taking, Gyrodyne is left with 68 acres. The company already has a completed plan to turn it into 309 luxury residential units (townhomes, condos, and single-family detached). You can view the plan at http://www.flowerfieldhomes.com/images/MASTERPLANSKETCH12-22-0607-50.pdf. The company has owned Flowerfield since the 1951, and its book value on the balance sheet is only $1.9m – $558k for the land and $1.3m for zoning and environmental costs. My overly simplistic and conservative estimate of the land’s true value is to take the same per-unit value for a raw-land sale to a developer that Gyrodyne’s experts used at trial: $130,000 per unit, or $40m in total.
In speaking with Gyrodyne’s CEO, I learned the following about Flowerfield:
Recall that I valued the entity apart from the litigation award at $62m, simply using the company’s stock price prior to the trial decision. We now have another way to get to the same number:
Those amounts magically total $62m. I swear it is a coincidence. I am excluding both a discount for the time and expense of getting to a Flowerfield sale, but I am also ignoring the upside from other land whose book value is too low due to land price appreciation. $62m is close enough for our purposes.
SHAREHOLDERS WILL GET THE CASH (OR MARKETABLE SECURITIES)
As I reconfirmed today with Gyrodyne’s CEO, the company “is in liquidation mode” (his words); they fully intend to distribute all of its value to shareholders in either cash or marketable securities.
The starting point is this language in Gyrodyne’s 10K:
"On December 9, 2005, the Company presented at its 2005 annual shareholders meeting a strategic plan for the future direction of the Company. The objective of the plan is to position the Company so that it is best able to achieve one or more shareholder liquidity events in a reasonable period of time that would put the maximum amount of cash or marketable securities in the hands of the Company’s shareholders in a tax efficient manner. The plan calls for achieving this objective by: A. pursuing a conversion to a real estate investment trust (REIT), B. disposition and redeployment of the assets of the Company in a tax efficient manner, C. maximization of the value for the remaining 68 acres at Flowerfield, D. and vigorous pursuit of maximum value from the State of New York for the 245.5 acres of Flowerfield taken by eminent domain." The company converted to a REIT on May 1, 2006.
Under REIT law and an IRS private-letter ruling that Gyrodyne received on March 1, 2011, the condemnation award and interest will not cause Gyrodyne to lose its tax-free REIT status. However, the two pieces of cash are treated separately under the law and will have different dispositions. The $53m interest payment must be distributed to shareholders to avoid taxation. The $99m judgment cannot be distributed to shareholders tax-free. The company has two basic options for using the judgment payment tax-free. The first is to reinvest the proceeds into new income-producing real estate, which is what the company did with the original $26m payment. The second option is to pursue a “section 1031 exchange”: a larger REIT with more liquid stock could acquire Gyrodyne for stock. The acquirer could take the $110m in cash, lever it up with cheap debt (thanks, Ben!), and buy a whole lot of real estate. Gyrodyne shareholders could keep the acquiror’s shares – even a year’s holding period would cut the capital gains tax bill in half – or sell them for a quick flip.
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