Description

IRSA/CRESY

(Note this was written when IRSA was $16.50 or 13% higher than 14.60 current; I believe it’s now cheaper and more attractive after trading off with EM sentiment.)

IRSA is a real estate company in Argentina that trades at less than 50% of its sum-of-the-parts value and owns high-quality, irreplaceable, urban malls, offices, and hotels. IRSA’s inflation-linked hard assets provide downside protection and have 100%+ upside with a near-term catalyst to re-rate the stock in the October presidential election when the unpopular Kirchner administration will be necessarily replaced. All presidential candidates have indicated they plan to adopt more orthodox economic policies. In particular, the removal of capital controls will allow capital to flow into Argentina and benefit the market. Though I prefer to stay in the United States to find value investments, in this case I believe investing in the NYSE-traded ADRs of an Argentine company is worth venturing abroad for the most attractive public real estate investment I’ve found in the world today:

• My sum of the parts valuation gives fair value of $36 per share or 120% above $16.50/share current

• High-quality, constantly fully-occupied, trophy assets available at a discount to regional comps, replacement value, and realized private-market transaction values

• Aligned with management who own 26% of the company and have a proven track-record as smart capital allocators, having turned a small investment by Soros in 1990 into the largest real estate and agriculture business in Argentina

• A major near-term catalyst in the post-election removal of capital controls, fiscal reform, index inclusion, export tariff reform, etc.

• Additional upside in assets beyond the core real estate, including an equity stake in an Argentine bank, a significant plot of undeveloped Buenos Aires land, and a stake in the Lipstick building in Manhattan

• Buying alongside smart value investors like Centerbridge and Finepoint

CRESUD is IRSA’s parent company which owns 65% of IRSA in addition to agricultural farmland. At today’s price the IRSA stake is worth most of CRESUD’s total value. The implied value of CRESUD's agricultural holdings is significantly lower than the $5k+ per hectare at which CRESUD has recently sold farmland privately and as low as 2-3x my calculation of normalized EBITDA from the productive cropland. I advise purchasing both securities. IRSA and CRESUD both publish complete, English-language financial statements which are filed on EDGAR and available on their investor relations websites. IRSA’s most recent annual reports, quarterly financial statements, and earnings presentations are available here: annual report, interim financials, and earnings presentation.

1. Valuation

• IRSA valuation:

• IRSA primarily generates net operating income from its mall, office, and hotel portfolio.  For purposes of this valuation financials are quoted in millions of U.S. dollars to match the U.S. dollar ADRs, as of LTM 1Q15, and converted at the period average “blue dollar” exchange rate which is currently 13.4 ARS/USD. A quick note on currency: the “official” exchange rate of 9.2 ARS/USD is much more favorable to the company and would make its earnings more valuable in dollars and its valuation more attractive, however using the “blue dollar” unofficial rate is more conservative and more realistic. You can calculate the capital markets blue dollar rate using the conversion ratio on equivalent sovereign bonds or equivalent ADRs and locally listed stocks, or find the “street” blue dollar rate daily at http://www.dolarblue.net/. Though the ultimate exchange rate once currency controls are lifted after the election is hard or impossible to know, most market participants think the rate will be somewhere between the official rate and the blue dollar rate. IRSA’s leases are denominated in USD, so the dollar cash flow from tenant contracts has kept up well over the last 15 years despite high peso inflation.

• Applying a 10% cap rate to the mall NOI of USD 121M, an 8% cap rate to the office NOI of 27M, and 12% cap rate to the 19M of hotel NOI is worth 1.7B gross value from the real estate asset portfolio. These cap rates are conservative relative to comps and relative to private market valuations in Argentina:

• Private market cap rates are very tight in Argentina. Per latest CBRE data, the private market for office properties trade at an average 6.0% cap rate. Our discussions with local RE investors confirmed that RE has remained an in-demand asset class for investors with pesos through the high-inflation period since 2008 and the private market for prime commercial and residential RE is extremely tight. We also take comfort in the fact that IRSA has sold assets at cap rates that are significantly lower than the public market valuations. (I would encourage them to sell even more to take advantage of the current, wide public/private valuation arbitrage opportunity in Argentine real estate, which we are confident will close over time.) For example, May 5 2015 IRSA announced it had sold 8,470 sqm of office space plus parking at the Intercontinental Plaza Building, a 100% occupied class-A office building in central B.A. which I found impressive when I visited, for an implied 5.8% cap rate. Management told me that they were motivated to sell due to a newly constructed building on the adjacent block coming onto the market unoccupied, pressuring rates in the submarket; if not for the other property, they would have realized an even tighter cap rate on the sale. In a similar sale, IRSA sold the Bouchard Plaza Building in B.A. over multiple transactions between October and November 2014 for an average 6.0% cap rate.

• There are no private market transaction examples for malls but there are public comps in the region. In Brazil, a significantly troubled economy in which almost every public mall REIT exhibited negative SSS in the latest quarter, the malls trade at an average 8.6% cap rate on 2015 NOI and 9.5% cap rate on 2016 NOI (using comps Aliansce Shopping, Sonae Sierra, BR Malls, Multiplan, and Iguatemi and consensus sell-side NOI estimates).  These comps represent mid- to high-end malls, but not higher-end than IRSA’s portfolio (except potentially Iguatemi).

• In my opinion, the rest of the sum of the parts value includes conservative valuations for other assets (described in detail below in section 2, “Assets”): 201M for the Banco Hipotecario stake, 350M for Solares de Santa Maria, 188M for IDB, and 105M for other assets including the rest of the land bank for development, the US REIT stakes, and the Lipstick building, taken at book value or conservative cap rates. Subtracting 456M of net debt gets to 2,096M of equity value or $36.23/share, 120% above current price. If you applied a 10% or 15% “holding company” discount to the equity, you would have $32.60 or $30.79 value per share or 98% or 87% above current price.  

• I believe there is additional upside in “other assets,” which takes the land bank outside of SSM at book value, though historically land and developed projects have been realized significantly above book value. Though I primarily view IRSA as a value investment where you create high quality stabilized assets at a discount to intrinsic value, IRSA does grow its portfolio through developing new malls. Management has told me they underwrite development projects to an 20% unlevered, dollar return and will target opening 1-2 malls per year which implies expanding GLA ~5% per year. IRSA’s near-term pipeline is an opening of a new mall in San Martin (2016), an expansion of the mall at San Rosario (2016), and adding a 3rd floor to the Alta Palerma (2017). The expansions are higher-return than ground-up development and management plans to add +25% to the GLA of Alta Palerma with the additional floor in a project that underwrites to a 30%+ IRR.

• CRESUD valuation:   

• CRESUD is IRSA’s parent company which holds 65% of IRSA and Argentine farmland. CRESUD is a cheap way to buy IRSA, with the market currently valuing the land “stub” at $150M, less than half of its conservative fair value of 320M and significantly less per hectare than where CRESUD has sold its farms recently. CRESUD is primarily a land developer, buying raw land to develop into cattle land, cropland, or even real estate for residential development, a business in which they have successfully realized USD IRRs averaging 18%. The productive cropland, grazing and cattle land, and marginal reserve land is being created extremely cheaply at current market prices. Very conservatively assigning 0 value to the reserve land and giving $500 per hectare to the cattle land and $3,000 per hectare for the cropland – the lowest end of the valuation range for farmland in conversations I had with public and private agricultural management teams (AdecoAgro, SLC Agricola, Vanguarda, and MSU) – gives 320M value to CRESUD’s land. In 2014 they sold 2k hectares of the San Cayetano and Araucaria farms for $7k/ha at the blue dollar FX or $10k/ha at the official FX, and some sales of prime corn-belt farmland occur at >$20k/ha.
  
  Another way to look at CRESUD’s stub value is on a multiple of normalized EBITDA. Agricultural production in Argentina under Kirchner has been significantly distorted by three policies: high tariffs, export restrictions, and FX convertibility. Both candidates have voiced support for lowering the tariffs applied to soybeans, wheat, and corn (35%, 25%, and 22%) and would probably eliminate altogether the tariff on wheat and corn (domestically consumed crops and extremely unpopular tarrifs). Second, export restrictions force farmers to seek export permits that are limited in quantity and sometimes denied; this has artificially limited the amount of corn planted in recent harvests, and has proven extremely unpopular with farmers. This policy will likely be eliminated as well post-Kirchner. Finally, perhaps the first and easiest benefit for farmers, is that they have suffered the penalty of the dual exchange system: they earn revenue from export sales at the official exchange rate but must pay approximately 50% of their costs (e.g. seeds, fertilizer, and machinery; most costs other than labor) at the unofficial rate. When the exchange rates converge, exporters like farmers will be the first to benefit.
  
  Adjusting for these three distortions CRESUD would earn 50-70M USD EBITDA, meaning its stub at current market valuation is 2-3x normalized EBITDA, and even my target fair value of 320M would be 4.5-6.5x normalized EBITDA, a conservative multiple relative to 10x normalized EBITDA for agricultural peers. The sum of the parts of CRESUD with its IRSA stake at current market value ($16.50/share) implies $14.97 stock price or 31% upside from current $11.35/share:

• Valuing its IRSA stake at fair value of $36.23/share, CRESUD would be worth $30.06 or 164% upside from current:

• After a 15% or 20% “holding company” discount, the stock would be worth $24.54 or $23.10 per share, or 116% or 103% upside from $11.35. There could be additional upside in other assets. For example, I’m valuing a non-consolidated JV farm called AgroUranga in prime corn belt acreage at $5k/ha vs. $10k+ estimate for private market value, and valuing the very small businesses FyO (FutorosyOptiones.com, a grain brokerage business) and Cactus Argentina (feedlot business) at zero. You can view all of CRESUD’s farmland in Google Earth here.

2. Assets

IRSA has four lines of business: Shopping Centers, Office, Hotels, and Development – commercial, office, and residential. Most of the business is in shopping centers, which represents 73% of net operating income.  All the properties are viewable in Google Earth using the KML file located here.

• Malls

• Currently 98.5% occupied, IRSA owns many top quality, irreplaceable shopping center assets and its mall portfolio represents a dominant position in the shopping malls in Argentina and Buenos Aires. IRSA owns 18% of the total gross leasable area and 23% of the total stores in shopping centers in Argentina as a whole, and in the city of Buenos Aires, more than 47% of the available GLA.  IRSA believes that it is difficult to add additional GLA in Buenos Aires due to zoning restrictions and market experts confirm that the number of new shopping mall additions in B.A. is extremely small. At least one of the shopping centers IRSA has developed was actually a redevelopment of a run-down and closed shopping center. The complete list of malls with GLA and occupancy is on page 19 of the annual report.
  
  One mall I visited was the Alta Palermo mall in the upscale neighborhood of Palermo, which is a trophy asset for IRSA. It’s a 19k square meter mall located in an irreplaceable location in the heart of B.A. at the intersection of two major streets (Avenida Santa Fe and Avenida Coronel Diaz) and literally on top of a public transportation stop (Subte D, Bulnes). Anecdotally when I visited recently on a weekday, the mall was packed, more crowded than malls I’ve visited in the United States, every storefront appeared to be occupied, and the quality of stores, displays, merchandise, and mall infrastructure all felt extremely “first world.” Alto Palermo’s location on the border of Palermo and Recoletta is considered one of the fanciest locations in Buenos Aires. The sales per square meter in Alto Palermo of $1,200 make it one of the highest sales/sqm of any mall in Latin America.   

• Offices and hotels
  
  

• Currently 98.4% occupied, IRSA’s office buildings are all in central Buenos Aires and represent 16% of NOI. Office leases are typically 3 years in length (the minimum allowed by law).  Leases are dollar denominated but paid in pesos at the official exchange rate.  Leases have built in fixed inflators.  Given the divergence between the blue dollar exchange rate and the official exchange rate, and marking all amounts to the average blue dollar rate, the $/sqm office rent started to fall in 2011, then between 2013 and 2014 it held flat.  Prior to 2011 office rents were climbing (rapidly between 2005 and 2010).  Some of the prior increase in rents related to recovery from pessification in the 2001/2002 crisis.
  
  

• Other Assets
  
  

• Solares Santa Maria (formerly Santa Maria del Plata): SSM is a very large waterfront property abutting a park/ecological reserve in the City of Buenos Aires.  The property was purchased in July 1997.  It is located 10 minutes from down Buenos Aires and walking distance from Puerto Madero, the waterfront neighborhood that has been developed over the last 10 years into today one of the most expensive neighborhoods of Buenos Aires with high end residential and office real estate (the most popular destination for ex pats).  IRSA intends to develop its property for mixed purposes including residential complexes, offices, stores, hotels, supermarkets, etc. I toured the property and was taken aback by how large the amount of undeveloped land is given how close it is to Puerto Madero and highly developed neighborhood. In September 2010, IRSA sold a 10% stake to Israel Sutton Dabbah.  The value of IRSA’s interest in the property implied by the Sutton Group transaction (which was closed in USD) is $53 mm.  Based on the average price for raw land in the Puerto Madero region, where both SMP and Puerto Retiro (a second but much smaller water front property - which I value at book value) are located, IRSA’s SMP interest could now be worth as much as $430 mm assuming that 40% of the acreage is surrendered to the government at no cost for public park. Realizing the value will depend on successfully getting the property permitted for development, which management is optimistic will happen under a new administration. I assume $350m value.
  
  

• Other assets in the development portfolio are mostly very small, including a 9.5% stake in the high-end Argentine residential developer TGLT, a 27% stake in the U.S. hospitality REIT Supertel, and a 50% stake of the prime class A office building 885 Third Avenue (Lipstick Building). Elzstain made the U.S. real estate investments during the crisis and they have all proven successful.
  
  

• Material public stakes:
  
  

• Banco Hipotecario: IRSA owns 30.0% of the business alongside the Argentine government which owns 64%. Banco Hipotecario is a mortgage bank in Argentina which historically had a high market share of mortgage lending in Argentina. It was selected in 2012 to administer ANSES’s mortgage program, essentially a subsidized low rate loan for rural, low income borrowers to buy land and build homes. Their administration of this program will help the bank recapture its historical market share of mortgage lending in a normalized lending environment. The mortgage and lending markets have been extremely distorted by the high interest rate / high inflation environment and government requirements to make uneconomic loans to SMEs, minimum deposit interest rates, consumer loans rate caps, etc. The Kirchner administration has essentially frozen private sector banking. In Argentina, banking penetration as measured by loans/GDP and deposits/GDP is significantly lower than in many peer countries including Chile, Brazil, Colombia, and Peru (and that ratio is using a depressed, post-Kirchner GDP).
  
  Reflecting optimism, many Argentine banks trade as high multiples of book despite low current RoEs given the expectation that the Argentine banking sector will grow 2-4x over the medium term.  Banco Hipotecario trades at 1.8x book value, below comps Banco Galicia, Banco Macro, and BBVA, which trade at 2.9x, 2.6x, and 3.2x or an average of 2.9x despite a similar RoE profile to Hipo. I'm valuing Hipotecario at its current public market value, or $201M assuming the blue dollar FX.
  
  

• IDB: IDB Development is a restructuring play in which IRSA owns a 49% equity investment. I am not assuming any upside from the investment working and just value IDB at its current market capitalization. IDB owns interests primarily in Israeli multi-line insurance, cellular telecom, grocery markets, real estate, and agro chemicals. Many of their companies are among the largest in their respective industries in Israel.
  
  The most valuable asset is a 55% ownership stake in Clal Insurance, a multi-line insurer (life, health, P&C, long-term savings products, etc.) which is publicly traded as CLIS IT and trades at 83% of book value. Clal is the second largest insurer in Israel and is not over-levered, but the 2012 bankruptcy at IDB, operating permit, change in leadership, and lack of clarity regarding the IDB stake and operating permit of ownership of the IDB stake has created an overhang on the stock. Currently return on equity at Clal is 7-8% and sell-side estimates have it growing to 11%+ in two years, so trading at under 85% of book value is a low valuation. IDB is in the process of selling its stake in Clal. In a very similar transaction in June 2015, another Israeli conglomerate Delek agreed to sell its 52% stake in the fourth largest insurer Phoenix to the Chinese investment firm Fosun for 1x book value. People familiar with the sales process in Israel believe there are bids from financial sponsors including a Chinese group and strategics including US and European insurers. If IDB successfully sells Clal by the end of 2015 at 1x book value, they will be able to significantly de-lever and teh sale will be positive for IDB's stock. Outside of Clal, the stakes in public companies are all at Discount Investment Corporation, another holding company with public and private operating companies beneath it. Under DISI are public companies Shufersal, Cellcom, Property and Building, and the private company Adama, along with other private assets including land and a development project in Las Vegas. I see upside in IDB if Elsztain is successful in reorganizing and de-levering the business, but I am currently just valuing the stake at market value. Managemetn has indicated that long-term they will not put more than 10% of the business into international ivnestments.
  

3. Argentina Context

• Cristina Kirchner will be replaced in the October 2015 election: she is constitutionally prohibited from running for president again. Also she recently chose not to run for a seat in congress, surprising those who expected her to try to remain in power politically. The Argentine consensus is that her populist, interventionist economic policies have failed Argentina and each of the possible presidential candidates have acknowledged the need to pursue reform.
  
  

• Economy: The failed, populist economic policies of Cristina Kirchner have led to dissatisfaction in her and her party. After Argentina defaulted on its debt obligations in 2001 and the ensuing chaotic devaluation of the peso, Nestor Kirchner was elected president in 2003. When Cristina Kirchner succeeded her husband in 2007, her policies were more populist, protectionist, and market unfriendly. Cristina Kirchner raised agricultural taxes, subsidized electricity costs, instituted currency controls, intervened in the private banking system, appropriated YPF from Repsol, and has refused to settle with the holdout creditors, all of which has undermined Argentina’s credibility in international markets and led to a deterioration of investment and economic conditions and very high inflation. Beginning in 2008 the inflation rate reported by INDEC (7.2%) diverged from the true inflation estimated by private economic consultants and reported to congress by opposition parties (23.8%). In 2015 INDEC estimates inflation of 15.3%, vs. 30% estimated by independent consultants, down from 40% the year prior. The decline in Cristina’s and the FvP’s popularity has also been hastened by scandals including the murder of federal prosecutor Alberto Nisman and more recently reports tying Anibal Fernandez to a 2008 triple murder.
  
  

• Election outcomes: The election will probably proceed to a second round between Scioli and Macri in November. Although Scioli is currently leading, the final results are too close to call based on latest polls. The two credible candidates are Daniel Scioli of the Frente para la Victoria (FvP), Cristina’s party, and Mauricio Macri of PRO/Frente Cambiemos, the main opposition coalition. Though both candidates have expressed support for reform policies, Macri’s commentary is more anti-Kirchnerist and market-friendly and he would enact reforms like eliminating capital controls and settling with holdout creditors to access international debt markets almost immediately, whereas Scioli would take a more moderate timeline for reform and might face more pressure from Kirchnirist influences. The economists on Scioli’s advisory team are market-friendly in commentary, and particularly in conversations with business leaders, leading many to believe that Scioli’s more populist speeches are electioneering to shore up support; ultimately, he is committed to “returning Argentina to its place on the world stage” and feels personally responsible for doing so, though he wants to win the election. Therefore, Scioli himself rarely addresses holdout settlement or currency controls, but his aides and economic advisors have indicated they would be priorities for the administration.
  
  

• The latest polls from the most credible pollster, Management and Fit, shows 35.3% support for Scioli and 26.5% for Macri. The third candidate, Sergio Masa, with 11.8% support, is also an opposition candidate and many of his supporters would vote for Macri in a 2-candidate runoff. Either 45% support or 40% with a lead of 10 points on the next candidate is sufficient to win outright in the first round without a run-off. It will be difficult for Scioli to win in the first round, and the distribution of Masa’s supporters and undecided voters mean the outcome of the run-off is still too close to call.
  
  

• The important dates are the primary on August 9, the formal beginning of campaigning on September 20, the general election on October 25, and the potential second round on November 22.
  
  

• Index inclusion: Many factors point toward reform policies leading to capital inflow to Argentina in the medium term which will lift values of local equities. Inflows should be especially beneficial for IRSA and the small number of companies with US-listed ADRs. The MSCI downgraded Argentina from an “emerging” to a “frontier” market in 2009 due to capital controls, which will be eliminated under a new administration. Additionally, IRSA is large enough by market capitalization to be included in the MERVAL index, but got excluded when CRESUD bought in a larger stake and the stock’s liquidity fell below the threshold. If the stock price recovered closer to fair value, management would float more of CRESUD’s stake and IRSA could rejoin the index. More broadly, settling with the holdout creditors and eliminating capital controls will allow Argentina to tap debt markets and attract foreign capital. Early evidence of this includes the raising of new Argentina-focused funds like Bienville created to buy stocks including IRSA in advance of the regime change and economic reform, and an RE investment fund launch managed by an established local residential real estate sponsor being marketed by bulge bracket investment banks to U.S. investors to buy and develop commercial office and logistics properties in Buenos Aires, to take advantage of the scarcity of class A properties and Argentina’s 3-5 year growth trajectory.

Disclaimer:
The author is presenting the views of an investment firm that has a material long position in the securities of the company discussed herein. The author is not otherwise affiliated with such company, including as an employee, director or consultant. The views expressed herein are provided solely for informational purposes and do not constitute an offer to sell, or the solicitation of an offer to buy, any security. The information provided herein is not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision. The contents of this message should not be construed as legal, tax, accounting, investment or other advice. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained herein by the author or its affiliates and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions. The information and opinions contained herein are provided as of the date this message is originally posted. The author has not independently verified all information contained herein and has no obligation to update any of the information provided. The views expressed herein are subject to change without notice at any time and the author and its affiliates may trade in any manner in the company’s securities, whether consistent or inconsistent with the information provided herein, as they deem appropriate. Past performance of a security is neither indicative nor a guarantee of future results of such security. There can be no assurance that an investment in the company will be profitable or that the assumptions regarding future events and situations will materialize or prove correct.

Catalyst

 October 2015 election: