Description

Description

ProLogis(PLD) operates as a real estate investment trust in the United States. It owns, operates, and develops industrial distribution properties in North America, Europe, and Asia. The company operates in three segments: Property Operations, Fund Management, and Corporate Distribution Facilities Services (CDFS). The Property Operations segment engages in the ownership, management, and leasing of industrial distribution and retail properties. The Fund Management segment provides investment management services for unconsolidated property funds and other properties. The CDFS segment primarily develops properties that are contributed to a property fund or sold to third parties.

Bull Story

• Logistic demand is uncorrelated to economic conditions, but rather driven by global trade, and the need to replace obsolete properties.  Globalization is indeed an undeniable trend.

• Increased complexity in supply chain designs leads to demand for higher quality properties.

• PLD's global presence is their competitive edge.  PLD can work together with global companies such as DHL or Walmart on projects that are impossible for local, smaller operators.

• Strong growth in revenue, net income and FFO. CAGR is 30% and 20% from 2003 – 2007.

My Thesis

PLD has completely changed its business model since 1999. It has become a house of cards and is a strong short idea at $50/share.

I initially viewed PLD as a long idea. It has outperformed the Bloomberg US REIT index in the last 5 years by 5% annually. It has strong growth rate. The bull story is good and the company is generally viewed as a blue-chip name. However, the Macquarie Prologis Trust transaction (Australia listed, ticker MPR) in July 2007 caught my attention and leads me to focus on its CDFS business in which my short thesis is based on.

CDFS business

“By early 1999, the public equity capital markets were an increasingly costly method of raising capital. To secure private equity capital, ProLogis changed the primary focus of its overall development activities — from the development of distribution properties to hold in the property operations segment on a long-term basis — to the development of distribution properties in the CDFS business segment that, upon completion, are generally contributed to property funds formed by ProLogis. Accordingly, the primary focus of the CDFS business segment became that of developing properties to be contributed to property funds rather than properties that are sold to third parties. “

“The property fund strategy: (i) allows ProLogis to realize, for financial reporting purposes, a portion of the development profits attendant to its CDFS business activities by contributing its developed properties to a property fund; (ii) provides a source of private capital to ProLogis; and (iii) allows ProLogis, as the manager of the property fund, to maintain its market presence and customer relationships that are the key drivers of its operating system. ProLogis realizes a portion of the development profits from the properties contributed to property funds to the extent of the third party investment in the property fund acquiring the property. The proceeds received by ProLogis from the contribution of properties to the property funds are recycled into ProLogis’ CDFS business segment thus, providing a private funding source for its future development activities and continued growth. To supplement the private equity investments in each property fund, the property funds obtain secured debt financing using their properties as security such that the leverage ratios in the property funds range from 30 to 75%.”

Source: 2002 company 10K.

These property funds are accounted for under the equity method. The nice thing about this method is that it allows the reporting company to keep assets and liabilities off balance sheet. The accounting is somewhat similar to the way investments banks record their subprime exposure under the infamous SPE/VIE/conduits entities.

	FY1 2003	FY1 2004	FY1 2005	FY1 2006	FY1 2007
Sales/Revenue/Turnover	1473.289	1874.931	1851.228	2463.122	6212.73
CDFS disposition	900.978	1294.39	1140.46	1286.841	5005.41
% of sales	61.15%	69.04%	61.61%	52.24%	80.57%

Source: Bloomberg

The CDFS business has become the most significant source of revenue for PLD. It is more suitable to view PLD as a real estate developer rather than as a real estate operator. The operator business model is simple. They collect rents and payout dividends after all expenses are paid. All the investor has to do is to estimate the present value of the cash flow.  However, PLD is not an operator.

Problems with CDFS business model

• Properties are sold to property funds, which is usually set up as a Joint Venture (JV) with an institutional investor such as a bank or pension fund, where PLD usually maintain 20%+ interest. It is hard to determine if these transactions are arm’s length.

• Disposition prices are determined by an independent firm such as CB Richard Ellis and Jones Lang Lasalle. PLD has obvious incentives to inflate the price. Not only can they book a huge gain at the time of transaction, a high price also means higher management fees and incentive fees going forward.

• I believe CB and Lasalle have conflict of interest similar to the way S&P and Moody’s had with structured finance. The 3^rd parties are paid per deal.  Imagine if CB used higher cap rates and assign lower property values. Would PLD go back to CB in the next deal?

	2003	2004	2005	2006	2007
PLD acquisition ($/sf)	31.67	40.99	50.4	60.86	51.96
PLD disposition to property funds ($/sf)	63.20	69.87	87.43	88.66	80.50
disposition/ acquisition	1.996	1.705	1.735	1.457	1.549

Source: company reports

• There is huge difference in terms of the price shown in the above table and I do not believe the discrepancies can be explained as differences in asset quality. I suspect either PLD is underpaying for their acquisitions or the property funds are overpaying for PLD’s CDFS assets. I believe in the latter.

• Each fund relies on leverage to enhance returns. The true leverage ratio is much higher than reported.

• Property prices have come down by 10 -15% in 2007.

PLD's JV	2003	2004	2005	2006	2007
avg ownership	24.80%	21.60%	22.10%	23.00%	25.50%
JV assets total	5,782.51	9,582.40	10,068.70	13,235.00	19,371.60
3rd party debt	3,066.53	4,886.70	5,217.00	6,633.60	10,650.90
JV leverage	2.13	2.04	2.08	2.00	2.22

Source: company reports

• Although the debt of the property funds are non-recoursed, PLD enters into Special Limited Contribution Agreements (SLCA) with certain of its property funds. A decline of 95% to 35% of fund value will trigger the SLCA liability.

SLCA exposure	2003	2004	2005	2006	2007
assets subject to provisions	5200.00	6500.00	7000.00	9100.00	6300.00
obligations by PLD	357.80	407.40	518.70	663.60	1200.00
reserve on balance sheet	0	0	0	0	1.3
reseve as % of total obligation	0.00%	0.00%	0.00%	0.00%	0.11%

Source: company reports

• PLD has booked zero reserve for its SLCA liability except in 2007 when they book a $1.3 million reserve against liability of $1.2 billion.

Earnings Quality

% of sales	FY1 2003	FY1 2004	FY1 2005	FY1 2006	FY1 2007
CDFS disposition	61.15%	69.04%	61.61%	52.24%	80.57%
Rental Income	35.69%	28.11%	32.46%	36.95%	17.19%
Property Management Income	3.16%	2.85%	4.99%	10.12%	2.11%

1. CDFS = low quality earnings. Not a single property transaction has ever gone through normal bidding process. All transactions are priced by 3^rd parties which have conflict of interest. Moreover, PLD is involved in several problematic transaction with its property funds discussed later.

2. Rental Income = high quality earnings.

3. Management income consists of 2 parts. The first part is the management fee and incentive fee from managing the property funds. These income will be recurring only if the house of cards doesn’t fall. The second part is the earnings realized from partial ownerships in these funds. The recognized earnings are consistently higher than the cash dividends received. I made adjustments for my calculation

Cash flow Analysis

Cash flow in millions	2003	2004	2005	2006	2007
adjusted cash flow from operation	(108.60)	204.60	(573.35)	(1,040.11)	(516.60)
net cash borrowings	168.59	313.97	1,993.08	1,719.96	3,237.63
cash borrowing/equity		0.10	0.51	0.33	0.58

Source: company report

Adjusted cash flow include prefer dividends, and the disposition/proceeds from real estate transactions. I made this adjustment because the buying/selling of properties to JV is PLD’s core business.

• As you can see, PLD has a chronic addiction to leverage because they need to fund their development pipe to keep the CDFS business going. And that in turn drives PLD’s own growth rate.

Problematic Transaction

2007

Bought MPR from Macquarie for $2B in July 2007 and later sold the same assets for $2.139 B in August Prologis NA Industrial II partnered with Citi.

• During conversations with management, they indicate that the gain of $139 million is due to decreased in cap rates.

• They also said Citi intended to securitize the assets but was unable due to current credit crisis.

• MPR was a publicly traded fund in Australia with trading volume in the millions. After 4 weeks of the buyout, the asset increase just because some analysts changed their cap rate assumptions. I think the $2.139 B price tag is ridiculous.

2006

Bought NA properties fund II – IV from Arcaptia for $695 m, then sold the same properties to NA industrial fund for $750 m one month later.

• Once again the pricing of this deal amazes me. An 8% increase in asset values in 4 weeks.

When the music stops

In the past 5 years, cheap and available credit drives up property prices. Coupled with strong trade demand, industrial properties value has continue to rise. The increased value of assets in turn frees up more credit because the collateral is deemed safer. With a favorable macro environment, high growth rates and hidden leverage, PLD became the darling for investors.

In some way, the CDFS business is similar to the current credit crisis. The ownership interest that PLD holds in the JVs is equivalent to the “senior tranche” of a CDO. (protected by the SLCA). Problem: PLD, as the sponser of these JVs (CDO), has incentive to write up the value of the assets to generate huge gain upfront (fees), even if the value of the deal is questionable (no liquid market to price these things). The property appraisers, eager to earn fees, play along (very much like the credit rating agencies).

1. A sudden shortage of credit would break PLD’s model as it relies on financing to fund its CDFS pipeline.

2. Decrease in properties value will hurt because of the leverage PLD employs.

   • The above 2 factors are correlated and are in full effect.  Judging from PLD real estate transactions in 2007, prices have fallen 10 - 15%. (refer to the acquisition/dispostion table)

   
   

Best case scenario

PLD will suffer lower earnings and growth rates because real estate is cyclical and the CDFS business is a house of cards that will fall someday. They might have to take on some assets in their pipeline onto their balance sheets. They also will have to write down their investments in the JVs. Currently CDFS represents over 70% of earnings, so I am forecasting a 30-40% decrease in normalized earnings.

Worst case scenario

PLD refuses to deleveraged even when asset values go down believing the downturn is only temproraily. However, once the SLCA liability is triggered, it can lead to a domino effect. Further declines in asset values will trigger more obligations. The property funds will lower their dividend payments towards PLD. PLD will be forced to sell assets at distressed prices to pay creditors (look at Harry Macklowe), face writedowns on JV assets, repay the short term loans used to fund pipelines.

	2003	2004	2005	2006	2007
True Leverage (asset/equity)	2.75	3.23	3.27	3.39	4.44

*include consolidation of off balance sheet assets and liabilities

*use undepreciated real estate asset value as it is closer to economic reality.

• 16% decline in properties values of the property funds will trigger SLCA.

• 23% decline in overall properties assets (include JV) value will wiped out current equity.

Recommendation

Best case scenario: Target price $26. Assigned 13x multiple to normalized earning power.

Worst case scenario: Target price $ 5. Assumed a 20% decline in property values.

Catalyst

Cataylst

*

credit crisis has lead to slowdown in economic activities
*

a decline in industrial property price that began in 2007. (down 10% already).
*

Quarterly earning announcements with negative suprises.
*

Issuance of new equity to deleverage.