Description

Thesis.  HomeFed Corporation provides a leveraged vehicle for participating in rising Southern California and Virginia home prices, provides an effective call option on the development of two early stage Southern California master-planned communities, and provides the opportunity to partner with a proven value creator, the company’s Chairman, Joseph Steinberg.  HOFD is debt free, currently generates positive cash flow, and holds cash and short term investment equal to over 20% of its NAV, giving the company staying power in a volatile business. 

A caveat:  HOFD trades over-the-counter.  Over 65% of the outstanding shares are held by insiders and major holders, and the stock is thinly traded.  Consequently, the stock is suitable primarily for smaller funds and personal accounts. 

Business and Background.  HomeFed Corporation engages in the development of (primarily) residential real estate projects.  HOFD is not a homebuilder; rather, it acquires, entitles, and develops raw land and then sells the finished lots to homebuilders or other developers.  HOFD's current development projects consist of three master-planned communities in varying stages of development:  San Elijo Hills located in San Marcos, California (North County San Diego); a portion of the larger Otay Ranch planning area located in Chula Vista, California (southern San Diego County); and Ashville Park located in Virginia Beach, Virginia.  HOFD also owns the Rampage Vineyard, a 1,544 acre grape vineyard located in southern Madera County, California (near Fresno), which is not currently entitled for commercial or residential development, and the Fanita Ranch property, a 2,600 acre parcel of vacant land located in Santee, California (East County, San Diego).

Leucadia National Corporation owns 31.4% of HOFD's outstanding shares.  In addition, Joseph Steinberg, Leucadia's Chairman, owns, together with affiliates, over 10% of the outstanding shares, and Ian Cumming, Leucadia's former Chairman, owns, together with affiliates, nearly 10% of the outstanding shares.  Steinberg has served as HOFD's Chairman since 1999, and Cumming has been a director for a like period.  Although Cumming is stepping down from Leucadia's board, he is standing for re-election to HOFD's board.

HOFD's history is intertwined with Leucadia.  In 1995, in connection with the chapter 11 reorganization of HOFD, Leucadia acquired 41.2% of HOFD's common stock.  In 1998, as one component of several transactions with HOFD, Leucadia entered into agreements to purchase additional shares of HOFD common stock that, if consummated, would increase its ownership of HOFD to 89.6%.  In a series of transactions in 1998 and 1999 (1) Leucadia assigned its HOFD shares and the stock purchase agreements to a trust formed for the benefit of Leucadia's shareholders, (2) the trust acquired the shares under the stock purchase agreements, and (3) the trust distributed to Leucadia's shareholders shares representing 89.6% of HOFD's outstanding shares.

As a result of these transactions, Leucadia no longer owned any HOFD shares.  Leucadia acquired its current interest in HOFD in 2002 in a transaction described later in this write-up.

Transcripts of Joseph Steinberg's prepared remarks at HOFD's annual shareholders' meetings are available on EDGAR for every meeting from 2003 on.  I encourage readers to review the transcripts - not only do they provide a good overview of the company's assets and business, but they also provide a real time account of the housing bubble and bust through the eyes of an interested and intelligent observer.

Assets.  HOFD's real estate assets (San Elijo Hills, Otay Ranch, Rampage Vineyard, Ashville Park, and Fanita Ranch) are discussed below.

            San Elijo Hills.  San Elijo Hills is a fully entitled master-planned community located in San Marcos,California.  When completed, San Elijo Hills will be a community of over 3,400 homes and apartments, as well as a commercial and residential town center.

            Leucadia originally acquired the San Elijo Hills project out of bankruptcy in 1995.  In connection with Leucadia's distribution of its HOFD shares in 1998, HOFD was appointed the development manager for the project, with responsibility for the overall management of the project.  In 2002, HOFD purchased Leucadia's interest in the San Elijo Hills project (consisting of an effective 68% indirect equity interest) for $1,000,000 in cash and shares of HOFD common stock which today represent 31.4% of HOFD's outstanding shares.  In December 2012, HOFD purchased one of the noncontrolling interests in the project, increasing its interest in the project from 68% to 85%.

            HOFD has substantially completed development of all remaining residential single family lots at the San Elijo Hills project.  As of March 31, 2013, 2,118 of the available 2,382 single family lots have been sold, and land entitled for 1,070 multi-family units (out of 1,081 total) have been sold.

            HOFD has remaining for sale 264 single family lots, land entitled for 11 multi-family units, and land entitled for 37,800 square feet of commercial space.  In addition, HOFD owns town center property consisting of 11,000 square feet of retail space and one unsold residential condominium.

            Otay Ranch.  In 1998, HOFD and Leucadia formed a joint venture (Otay Land Company, LLC) to purchase approximately 4,850 non-adjoining acres of land located within the larger 22,900 acre Otay Ranch master-planned community in Chula Vista, California.  The joint venture acquired the land for $19,500,000, with Leucadia contributing $10,000,000 for a preferred equity interest.  In 2003, the joint venture redeemed Leucadia's preferred equity interest, leaving HOFD as the 100% owner of the project.

            Subsequent to acquisition, HOFD disposed of part of its land in several sales transactions and an eminent domain proceeding, and now owns approximately 2,800 acres.  Of this, the total developable area is approximately 700 acres, including approximately 170 acres of land designated as "Limited Development Area and Common Use Area."  The remaining approximately 2,100 acres are designated as non-developable open space mitigation land.

            The SR 125 toll road, which was completed in 2007, runs along the western border of one of HOFD’s parcels and is a quarter mile east of another.  The toll road was designed with one or more interchanges (yet to be built) on or adjacent to parcels owned by HOFD.

            In 1993, the City of Chula Vista and the County of San Diego approved a General Development Plan (GDP) for the larger Otay Ranch planning area.  Since acquiring the property in 1998, HOFD has been working with the City to obtain entitlements consistent with the GDP.  HOFD has agreed with the City to (1) dedicate 50 acres of development land in the Otay Ranch project and 160 acres of open space land in the unincorporated area of San Diego County and (2) pay an endowment of $2,000,000 (of which $1,000,000 has been paid) to fund costs associated with establishing a higher education facility on the property.  In return, the City conditionally committed to allocate a maximum of 6,050 residential units and 1.8 million square feet of commercial development space to the project.  In February 2103, the City Council approved an amendment to the dedication agreement, and HOFD hoped to receive final discretionary approvals of its development applications this year.  However, the applications have not yet been approved.  If the applications are not approved and implemented, the City must return the endowment funds and the dedicated land to HOFD.

            Under the GDP, 1.188 acres of open space mitigation land project must be dedicated to the government for each 1.0 acre of land that is developed, excluding land designated as Limited Development Area and Common Use Area.  After giving effect to this requirement and the pending dedication of land to the City, HOFD's holdings can be summarized as follows: 

             Rampage Vineyard.  In 2003, HOFD paid $6,000,000 for a 2,159 acre grape vineyard located north of Fresno in Madera County, California.  Pursuant to options exercised by a neighboring land owner, and to settle litigation with another party, HOFD subsequently disposed of 615 acres, leaving 1,544 acres.

            The property is not entitled for residential or commercial development.  HOFD purchased the land intending to obtain the necessary entitlements to develop the property as a master-planned community.  Numerous approvals were required; among other things, obtaining entitlements required HOFD to procure a 20 year firm supply of water for up to 10,000 homes.

            While evaluating its development options and working to obtain water rights, HOFD also rejuvenated the vineyard, and began conducting farming activities at the property, growing commodity grapes sold to wineries making low-priced wines.  Beginning in 2010, HOFD has been generating positive cash flows from its farming activities.

            In 2011, HOFD listed the vineyard for sale for $25,000,000 but found no takers.  HOFD continues to conduct farming activities while it explores possible development as a master-planned community.

            Ashville Park.  In 2012, HOFD acquired Ashville Park, a 450 acre master-planned community located in Virginia Beach, Virginia.  HOFD acquired the property from Wells Fargo, which foreclosed on the previous developer in 2010.  HOFD paid $17,350,000 for the property.

            HOFD acquired 450 entitled single family lots, plus a visitor center.  The project is being developed in phases, as follows:

• Wilshire Village:  Development of this phase was completed, and several finished lots sold, before HOFD purchased the project.  HOFD acquired 91 finished lots plus a visitor center in Wilshire Village.
• Ranier Village:  Ranier Village consists of 164 lots to be developed and sold by HOFD.
• Remaining Phases:  The remaining phases are unimproved and are entitled for 195 lots.  HOFD has not announced a timetable for the development and sale of these phases.

            Through April 25, 2013, HOFD has sold 59 Wilshire Village lots and has developed and sold 90 Ranier Village lots.  Thus, as of April 25, 2013, HOFD owned 32 finished lots plus a visitor center in Wilshire Village, 74 lots to be developed and sold in Ranier Village, and land entitled for 195 lots in the remainder of Ashville Park.  HOFD expects that the completion and ultimate sale of the Ashville Park community will take five to six years.

            Fanita Ranch.  In 2011 HOFD paid $11,000,000 to purchase a promissory note secured by the Fanita Ranch property, a 2,600 acre parcel of vacant land located in Santee, California (twenty miles east of downtown San Diego).  HOFD immediately foreclosed and took ownership of the project.

            Fanita Ranch is a master-planned community that was entitled for approximately 1,400 residential units.  The project’s Environmental Impact Report and development agreement with the City of Santee were approved in 2007.  However, the project entitlements are being challenged under the California Environmental Quality Act related to purported issues with the EIR, and some of these challenges have been successful, resulting in at least one court order directing the City of Santee to decertify the EIR and set aside all project approvals.  HOFD acquired the property intending to complete the necessary entitlements to develop the property as a master-planned community.  The process will take many years to resolve and, in light of the legal challenges, may result in substantial modifications to the original development plan.

Valuation.  I value HOFD on a sum-of-the-parts basis, valuing each of its real estate assets separately on an after tax basis.  HOFD has significant net operating loss carryforwards and alternative minimum tax credit carryovers.  HOFD's NOLs are not available to offset alternative minimum taxable income; however, after HOFD has used all of its NOLs, the minimum tax credit carryovers can be used to reduce HOFD's future regular income tax (but not AMT).  The practical effect of these attributes is that HOFD's federal income tax rate will be limited to 20% for the next approximately $240,000,000 of taxable income.

            San Elijo Hills Land.  The development of the San Elijo Hills project is substantially complete.  Accordingly, I value the project on a per-lot basis, assigning a value of $275,000 per lot using recent sales transactions as a reference.  I believe this is conservative for two reasons.  First, HOFD sold 52 lots for an average price of $314,000 in 2010, 93 lots for an average price of $275,000 in 2011, and 54 lots for an average price of $325,000 in 2012.  Second, management has consistently maintained that the remaining unsold lots in San Elijo Hills are mostly its best, most expensive lots and that HOFD will exercise patience to realize maximum value for these lots. 

            San Elijo Hills Town Center.  I value the 11,000 square feet of (mostly leased) town center retail space at $200 per square foot, and the unsold residential condominium at its listing price of $725,000, less sales costs.

            Otay Ranch Project.  I value the Otay Ranch development land and mitigation land separately.

            The Otay Ranch development land is the most difficult of HOFD's assets to value.  In general, residential land in southern San Diego County is less desirable than residential land in North County.  Nonetheless, San Diego County is one of the most attractive areas in the country to live, and given the advanced stage of the entitlement process, and the completion of significant portions of required infrastructure, I believe the Otay Ranch land has value.  I have arbitrarily assigned a value of $12,500 per entitled lot and $10 per square foot of entitled commercial property.  I believe it is best to look at the Otay Ranch project as an option.  Under the not unreasonable assumption that HOFD's ultimate profit on the project is $40,000 per lot, there is the potential for significant value creation.  However, this requires not only the final granting of entitlements, but significant capital expenditures as well, and in any event will take years to realize. 

            HOFD owns 1,370 of excess mitigation land at Otay Ranch, meaning land that HOFD is not required to dedicate to the government to offset its development activities.  Some owners of development land within the larger Otay Ranch development lack sufficient mitigation land to cover their inventory of development land; HOFD's excess mitigation land may have value to these developers.  Developers outside the Otay Ranch planning area may also be prospective buyers of HOFD's excess mitigation land.

            In two separate sales of mitigation land, one completed in 2004, and the other completed in 2006, HOFD received $13,000 per acre.  I value HOFD's excess mitigation land at $5,000 per acre, or $6,848,800, which I believe is conservative given historic sales comps.

            The total project value for Otay Ranch is as follows: 

            Rampage Vineyard.  I value the Rampage Vineyard by capitalizing the average of the last three years farming income at a 10% rate, yielding a value of $26,000,000.  HOFD unsuccessfully attempted to sell the vineyard for $25,000,000 in 2011.  Nevertheless, I believe a $26,000,000 value is supportable, given the increased farm income since 2011 and the market in general placing a higher value on cash-yielding assets. 

            Ashville Park.  I value the Ashville Park project at book value.  I believe it is actually worth significantly more than book value; however, based on the limited sales activity to date and the even more limited availability of development cost information, estimating the project's value would be speculative at this point.  I am hopeful that reported results for 2013 will shed more light on the prospective value of this project.

            Fanita Ranch.  I also value the Fanita Ranch project at book value.  Like Otay Ranch, it is best to look at the Fanita Ranch project as an option.  HOFD likes the location and quality of the project, and envisions developing a community similar to San Elijo Hills.  If HOFD is able to complete the project, and assuming an ultimate profit in the range of $50,000 to $100,000 per lot, there is the prospect for substantial value creation.  However, as with Otay Ranch, this would require significant capital expenditures and will take years to realize.  Further, given the challenges to the project's entitlements, there are significant legal risks as well.

            Aggregate Valuation.  Adding HOFD's substantial cash and short term investments to its real estate assets, and subtracting liabilities, yields the following NAV: 

Investment Case.  HOFD’s stock currently trades at a slight premium to conservatively stated NAV, i.e., it is not obviously cheap.  The investment case for HOFD, notwithstanding the premium, is as follows: 

• The San Elijo Hills and Ashville Park projects, in which finished lots are currently, or in the near future will be, available for sale, provide a leveraged vehicle for participating in rising home prices.  A 10% increase in home prices should result in a roughly 15% to 20% increase in finished lot prices.

• The Otay Ranch and Fanita Ranch developments are call options on the substantial value that can be created by transforming raw land into master-planned communities.

• HOFD is debt free, and holds cash and short term investment equal to over 20% of its NAV.  The cash and investments allow HOFD to capitalize on opportunities (evidenced by the Ashville Park and Fanita Ranch investments), allow HOFD to fund significant lot development expenditures without borrowing, and give HOFD staying power in a volatile business.  As Joseph Steinberg put it, the company is built to survive in bad times and thrive in good times.

• HOFD provides the opportunity to partner with Joseph Steinberg, a proven value creator, on terms roughly equivalent to a direct investment in the company, with confidence that management will act as excellent stewards of shareholder capital.

• For those so inclined, HOFD’s land assets may provide an inflation hedge.

Risks. 

• Failure to obtain final entitlements for Otay Ranch
• Permanent revocation of Fanita Ranch entitlements
• Housing recovery stalls or reverses
• Risks inherent in an illiquid, thinly traded stock

Catalyst