Description

2018.10.14 EQC Long Thesis ($28.68)

I believe EQC is an attractive long today.  The prior writeup by dman976 was very well done and remains highly valid today.  While a very similar thesis holds today, I believe the risk-reward to be even better now.  I believe the risk today is even lower and the end game (liquidation or distressed acquisition) even closer.  

Going asset by asset, I estimate NAV at ~$34.50 / share and more like ~$36 / share if I ascribe value to the Bellevue and Austin development opportunities.  While 20% or 25% upside may not sound terribly exciting, I believe the fundamental risk to be extremely low. In fact, I think that fundamental risk today is lower than ever before in EQC (as more of the portfolio today has been converted to cash and as the remaining assets have seen their values lifted to higher levels than ever before given continued successful repositioning and lease-up).  While it is difficult to peg the precise timing of the “transformational event” (i.e. final liquidation in all likelihood, but possibly distressed acquisition), we are by definition ~8 months closer to that end point today than in February when dman976 wrote up EQC.

In the very immediate past, EQC shares have traded down over 4% in last 3 trading days. The IYR REIT index ETF is down a comparable amount over that short period.  That doesn’t sound like much, but EQC has over 60% of its market cap in net cash (i.e. net of debt and preferreds, meaning its TEV is less than 40% of its market cap) while the IYR index ETF is closer to 40% net debt to TEV (meaning its TEV is more like 170% of its market cap).  So that >4% share price decline in 3 days implies that EQC’s CRE portfolio (or TEV) has traded down ~4.5 times as much as that of its peers (i.e. EQC TEV down over 11% while IYR TEV down more like 2.5%).

At very long last, EQC has burned through its NOLs and announced its first (special) dividend since Sam Zell’s team at Equity took over.    This means that future asset sales should trigger further special dividends.

Q3 earnings will be reported in a week and a half, but it seems that Q3 was quite productive.  The final asset in the Chicago market near O’Hare airport was sold (EQC has recently leased the previously under-leased building back up by bringing in Komatsu for its US headquarters).  EQC indicated they sold it for a low 7% cap rate if you give full credit for the free rent, etc, it sold for closer to a 3.7% cap rate on current cash NOI. They also sold the final Ann Arbor asset for $29.5mm despite it generating LQA negative cash NOI of ~$0.76mm annualized.

EQC’s biggest outstanding lease roll risk had for a long time been Expedia’s Bellevue headquarters.  Expedia’s lease ends 12/31/2019 and EXPE is vacating. But in August, EQC signed a new lease with AMZN that expires in 2036.  While the AMZN lease represents a slight roll down from EXPE’s ending cash rent, it represents a roll upwards on a GAAP basis (i.e. over the term of the lease).  So what had been amongst EQC’s very biggest risks now appears to be its second most valuable remaining asset that presumably should attract many bidders. AMZN 20 year debt is trading a hair over 4% YTM.  So this asset is somewhat similar to a 20 year AMZN bond but here the principal at maturity is the land and building instead of bond principal payment from AMZN. I would guess this is now a <<6% cap rate asset and probably closer to 5% cap rate asset.  Let’s call it 5.5%. That would translate to ~$577 / SF which doesn’t seem crazy for the high barrier, high cost market with current CBD vacancy rates at only ~6%. If we hold rent and NOI margin constant with EXPE historical levels, then assuming a 5.5% cap rate on this single asset instead of the ~8.3% implied cap rate at which EQC trades today, that drives an incremental $0.70 / share of value from that one asset alone.

Last Wednesday afternoon, a press report stated that EQC’s single biggest remaining asset (1735 Market Street in Philadelphia) had been put up for sale.  The article cites a expecting it to sell for the ~$500mm range. I estimate annualized rent of ~$40mm at that asset. Annualized rental revenue reported for Q2 was $36.6mm, and implied $34.11 of annualized rent per leased SF.  Assuming that same rental rate would imply incremental rent of $3.3mm and take revenues to $40mm given the newly signed August lease for 97k SF (subsequent to end of Q2). If I were to assume a 62% NOI margin, that would imply $24.8mm of annual NOI.  Applying a 5% cap rate would imply a $496mm valuation, or $385 / SF. That all seems in the ball park. So that one asset could sell for ~$200mm more than its valuation currently being implied by the stock’s 8.3% implied cap rate. An incremental $200mm for that asset would be $1.63 / share of incremental value from that asset alone.

With EQC shares overall now trading at ~8.3% implied cap rate (ascribing no value to the development rights), the math gets even more compelling assuming that the Philly asset and AMZN asset can both be sold in the relatively near future at the previously mentioned price ranges.  If the Philly asset trades for ~$500mm range and the Bellevue AMZN / EXPE building trades at ~$250mm, then the remaining portfolio on today’s share price would be trading at an implied 13% cap rate (again assuming no value to the Austin or Bellevue development rights). So we’d be getting the remaining assets in Denver, Austin, Bellevue, Boston, and DC (and a tiny asset in East Windsor, CT) at that valuation, along with the development upside thrown in for free.

It is not a stretch to say that Bellevue and Austin are two of the hottest markets in the country today.  But I haven’t done a deep dive to precisely estimate the value of the development opportunities. So in most of the analysis, I ignore it altogether, assume no value, and just view it qualitatively as additional potential upside.  If I try to put some numbers on the development rights in the interim, I can come up with ~$180mm or $1.47 / share as a rough place holder / swag. I get there by theoretically assuming ~$110mm, or $100 of value per SF, for EQC’s ~1.1mm SF of entitlements at its 600 E 108th Ave NE in Bellevue.  Similarly, I can assume ~$70mm, or $1mm per acre, for the 70 acres at Research Park.  This is a vacant and separate tax parcel from the other 107 acres on the site where Flextronics has its long term triple net lease with EQC.

Today, 62% of EQC’s market cap is net cash and its TEV therefore is only 38% of its market cap.    Pro forma for the hypothetical sale of the Philly and AMZN buildings, those figures would change to 83% of market cap in net cash and TEV equal to only 17% of market cap.

Again, from an asset perspective, it’s hard to see much of any fundamental downside today.  Going back to giving no credit for the development rights, and assuming the Philly and AMZN buildings are NOT sold, I calculate ~3% downside in the stock price to get to a 9% implied cap rate and ~5% downside to arrive at a 9.5% implied cap rate.  But assets like these in these markets didn’t even trade at cap rates that wide in the GFC! And as mentioned earlier, giving no credit for the development rights but assuming Philly and AMZN buildings ARE sold for my expected valuations, then the current stock price would imply a 13% cap rate for the remaining assets.  Therefore, I suspect that if/when the Philly and AMZN assets are sold, the share price will have moved higher.

Of course, saying there appears to be minimal fundamental downside can be little consolation -- there’s always the potential for MTM downside in the public markets.  And certainly there is real opportunity cost if Zell and his team just sit tight for far, far longer than they’ve indicated, hoarding cash and never doing anything with it.  While I can never be sure, I have great confidence in Zell’s stewardship and management has been exceptionally clear that they will not sit by idly for much longer if they cannot find a transformational acquisition opportunity.  There are many management teams whose statements I discount tremendously, but for now, I believe this management team and believe that everything they have done to date has been consistent with my understanding of their prior indications.  

I suspect the market disagrees with me.  I think there were a number of other investors who expected the end game to occur sooner than I did, and who grew fatigued with EQC and moved on.  Relatedly, there is near term theoretical share price downside to EQC if the market assumes no transformational deal ever gets done, the cash doesn’t get returned to shareholders for another several years, and the market discounts back the future cash return at a high discount rate.  But running through some hypothetical figures seems to me to make a stronger case for near term share price upside, not downside.

For instance, if my asset by asset valuations are accurate and we give no value to development rights, then the current share price is implicitly assuming you don’t get any cash back for 2 years (it’s all back-end loaded, no special dividends before then), and using a 9.75% discount rate (despite the fact that the majority of the future cash proceeds are already cash, and despite the high quality nature and attractive markets of the remaining buildings).  If we assume the weighted average timing of the cash return is 1 year from now, then a 20.4% discount rate and no value to development rights would yield today’s share price. If we assume the same weighted average timing of the cash return from liquidation is 1 year from today, but instead discount that back at a rate 7%, then that would imply 12.5% share price upside today. If we attribute some value to the development rights, then discounting back at 7% for 1 year implies 17% upside today.

Of course, there is also the risk that Zell’s team does announce a mega acquisition, but that the market uncharacteristically decides to hate it and the stock trades down instead of up on the news.  First, it seems quite unlikely they will find an acquisition meeting their criteria barring some exogenous shock or immediate severe recession. They’ve made it abundantly clear that asset values are high, it is a seller’s market, they look to acquire at deep discounts to replacement cost, etc.  It seems significantly more likely that instead the company is liquidated. Second, if by some good fortune they do uncover such an opportunity, it seems quite unlikely given Zell’s track record that the market would immediately decide to hate it rather than celebrate it. (EQC shares actually popped a while back on just the rumor that it had been looking at Forest City.)  Third, it is likely any such deal takes additional time to uncover given the starting point today of rich valuations and a seller’s market. I believe it is therefore highly likely that incremental assets will be sold and converted to cash in the interim even if a transformational acquisition ultimately materializes. In that case, as more assets are sold and converted to cash, more special dividends should be paid in the interim, and the implied cap rate at today’s share price would further widen (from the accretion of selling assets at cap rates inside of the current implied cap rate).  I’d expect the share price to move up just to keep the pro forma implied cap rate as wide as today’s current implied cap rate. It’s also possible that the discount shrinks as more and more of portfolio gets converted to cash, especially as a portion of that cash (the taxable gain portion) needs to be paid out to shareholders as dividends anyway. So even if ultimately EQC does a deal and the market hates it, it is plausible the share price will have moved up in the interim.

I wouldn’t be surprised to see EQC embark on a significant share repurchase after Q3 earnings are announced.  Most recently, EQC bought back 3mm shares of stock in Q1 at an ASP of $29.67 / share, of which 1.7mm shares were bought back in March 2018 at an ASP of $29.88 / share.  That would imply a share price of $27.38 / share after adjusting for the recent $2.50 special dividend. But that needs to be adjusted higher in order to keep the discount to intrinsic value constant given that $2.50 / share of net cash was distributed at a 0% discount, meaning a higher adjusted share price is need to hold the discount to intrinsic value constant.  Given the magnitude of the heavy lifting and execution that has taken place since then March, the stock is significantly more attractive and de-risked today than it was back then. Plus by definition we’re 7 months closer now to the end game of ultimate liquidation or big acquisition. The $130.9mm remaining authorization would likely take at least November and December to use up, as it would likely represent ~20% of total trading volume over that period based on ADTV.  

I view EQC as an assymetric and attractive “short disguised as a long”.  Similar to a CRE short, an EQC long position should do much better over time if CRE gets hammered.  Also similar to a short, EQC should do worse over time if CRE stays strong or gets stronger and the company simply liquidates.  However, that should generate a gain, rather than a traditional CRE short generating a loss under that CRE backdrop. I also don’t have to worry about a short squeeze, losing borrow, etc.

In summary, it is very difficult to see fundamental downside from here in EQC, aside from opportunity cost.  It doesn’t seem hard to find ~20% upside here (~$34-35 / share), before any development rights, or ~25% upside (~$36 / share) with some value ascribed for the development rights.  There could be greater upside if we hit a sudden distressed cycle or air pocket in CRE that enables an attractive, game-changing acquisition to be consummated. Assuming just a simple liquidation, we could end up with a better than expected IRR to the extent asset sales get consummated relatively quickly and cash distributions occur in advance of the final liquidation date.

Given the risk profile, I think EQC at today’s prices can be owned in large size outright / unhedged.  Situations where so much of the asset value is net cash suggest a range of potential future values that can seem incredibly narrow and limited – not just limited downside, but also limited upside.   But the thing about such situations is that relatively small changes in stock price can dramatically impact that upside/downside ratio. I believe that the most recent moves amidst last week’s volatility have created an especially favorable opportunity in that regard.  

In short, I think the risk/reward from today is particularly attractive for EQC shares. I think the share price decline in recent days has created higher upside than we’ve had in a long time, at the same time that I believe that the downside has been curtailed.  I think the shares are mispriced today and that one can prudently make it a large position given the curtailed left tail. So despite relatively limited absolute upside relative to most upside cases in other investments, I think an EQC position can be prudently sized up enough so that it can nevertheless contribute some real attribution as the likely liquidation unfolds.

Catalysts

Asset sales

Further special dividends

Likely liquidation and return of all cash

Potential distressed acquisition by one of the very best cyclical CRE investment teams of all time

Catalyst

Asset sales

Further special dividends

Likely liquidation and return of all cash

Potential distressed acquisition by one of the very best cyclical CRE investment teams of all time