Description

“On the rare occasions that a rights offering is used to effect a spinoff, it is worthwhile to pay extra close attention”
-You Can Be A Stock Market Genius, p. 109 of the kindle version

Tl; dr: net of cash and some other assets, investors are effectively paying nothing for Seaport District at SEG. Seaport is an entire controlled neighborhood in Manhattan with a >billion of cost in the ground. Yes, it’s been troubled (to put it lightly)…. but the optionality is too large to ignore, and the technical around the backstopped rights offering present interesting optionality in the short term.

And one quick note: I’m going to use $25/share as SEG’s share price through this write up; that’s a bit below where it’s trading as I post this, but I think $25 is a fair number to use given that’s where the rights offering is priced and the rights offering will provide the opportunity to by ~1.25 shares (or more) for every one share you own. Either way, it’s a small difference in price / I don’t think changes the large upside potential here. I've also used the post-rights offering share count and cash balance in the description, before the rights offering, they have ~5.6m shares out with just ~$10m of net cash.

I realize I’m playing to the crowd / professor here, but I’ve long considered You Can Be A Stock Market Genius the best book for modern stock investing. If I had to simplify the book down to one core concept, it would be spin offs can be lucrative (actually it would be incentives matter, but that’s so trite I figured I’d go with something a little more bespoke… plus it’s the main thing almost everyone takes from the book anyway!). Why? For four main (and somewhat interconnected) reasons:

1. Forced selling from noneconomic shareholders (i.e. dividend paying fortune 500 company spins off a small non-dividend paying company worth a fraction of its overall value; shareholders can’t own the new spin for a variety of reasons)
2. Companies that have previously languished receive new focus (i.e. maybe a company was treated as a cash cow inside of their old structure, but once spun out it can invest the cash into profitable growth opportunities the prior parent had neglected).
3. Previously non-incentivized insiders suddenly have a lot of reasons to care about the company creating value (i.e. the top brass may have gotten stock in a larger conglomerate they were a small piece of before…. but, post spin, they get options struck in their company. Under a conglomerate, finding another 10 bps in cost cuts might not be worth the effort / headache / internal disruption given it barely moves the needle…. but when it can send the stock up 10% and capture management millions of dollars in wealth, suddenly the incentives are really aligned!).
4. This touches on all the prior three reasons… but management may be incentivized to keep the share price low out of the gate in order to maximize their economic exposure to the stock (i.e. options might be struck at the spin price, or at the price of the spin 30 days after the spin…. so management may intentionally try to tank the spin to maximize their upside!). So by paying attention early, you may be able to buy at a cheap price.
   1. This is mainly why rights are so interesting alongside a spin; management can design rights offerings to maximize their participation and exposure to equity upside.

Earlier this month, Howard Hughes (HHH) completed their spin off of Seaport Entertainment (SEG); this is the first spin-off I can remember that is coming with a rights offering (though this is coming with a backstopped rights offering, not a rights offering for the whole spin, which is what I believe Greenblatt refers to in his quote… I haven’t seen one of those in a long time either!). I believe SEG fits all of the criteria for a severely mispriced spin, and, while not without risks, I think SEG presents a hugely skewed risk / reward.

Seaport Entertainment consists of variety of assets, with the headliner being the aptly named Seaport District in lower Manhattan:

For those who’ve followed HHH, the reason for the spin is clear: once considered a potential crown jewel (For example, PSH’s 2017 AR Notes “The Seaport District, one of HHC’s most valuable assets, is on track for its opening in the summer”), the Seaport has been an abject disaster. All in, HHH had invested well over $1B into Seaport thinking that it would turn into a trophy property as it scaled up / developed. Here’s what HHH’s 2017 AR had this to say about Seaport: “Our total construction costs for the Seaport District… equal $785m ($731m net of insurance)…. We are targeting a stabilized annual return of between 6% and 8% on our net costs…. As an irreplaceable part of Manhattan, you cannot assign a value on owning a district like this in New York. There is no true comparable to the Seaport District. Therefore, we believe that if we ever did decide to sell, the property would realize a historically low cap rate with a significant spread relative to our return on cost yields.”

Instead of a trophy asset, the Seaport has turned into a cash inferno; the Seaport lost ~$50m in NOI in both 2023 and 2022, and somehow those losses seemed to be accelerating as they lost ~$32m in the first half of 2024:

Given a variety of spinoff costs and some funkiness with their JVs, that NOI number might slightly overstate how bad things are at Seaport… but it does not change the fact that Seaport has (again) been an abject disaster, with HHH taking a ~$710m impairment on it in 2023 (see p. 89 of 2023 10-K) and choosing to spin the company off so HHH investors could focus on the cash generation of their core business rather than continue to fund nonstop losses at Seaport. Of particular note, given SEG’s continued cash inferno, HHH chose to spin SEG off with a rights offering (backstopped by Pershing) rather than park a ton of cash on SEG’s balance sheet.

Almost immediately after completing the SEG spin off from HHH, Ackman / Pershing Square filed a 13-D noting they were considering taking HHH private. With the benefit of hindsight / knowing about that bid, I think it’s clear that Ackman / Pershing needed SEG to be spun out of HHH before they could attempt a take private…. but I think you could come up with two completely different reasons for needing that spin:

• Reason #1: Seaport is a never ending inferno of cash burn with enormous negative value. Ackman couldn’t take HHH private with SEG inside because it would hang like an anchor around his / the company’s neck forever. Ackman was willing to backstop a rights offering and light ~$175m on fire in order to contain / limit the losses at HHH and take it private.
  • If you were taking this example to its absolute nightmare conclusion, the rights offering is basically designed to cover SEG’s cash burn for multiple years so that, in an absolute worst case scenario, SEG can cover losses long enough to get past the fraudulent conveyance look back to HHH.
• Reason #2: despite the negative results to date, the upside of Seaport is enormous, and both Ackman and the board know it. Seaport has ~$1B of cost sunk into and will certainly burn more cash in the near term, while HHH currently (post spin and with a little take private premium post the 13-D) sports a ~$3.5B market cap; there’s simply no way to take HHH private if it still has SEG in it because the range of values given that upside / cost basis are too wide and trying to negotiate a price for Seaport would effectively overwhelm everything else in negotiations (as well as making financing much more difficult).
  • To make this simple: let’s say the board is asking Ackman to pay $4.5B for HHH post spin, and Ackman is trying to pay $3.5b. There’s room to meet in the middle there…. but if SEG is inside and Ackman is arguing it’s worth zero or $500m while the board is pushing for $1b or $1.5b, then the negotiations for SEG basically overwhelm the negotiations for all of the rest of HHH!

I could believe either side of those arguments… however, at current prices, SEG is one of the most mispriced options I’ve ever seen. You don’t have to believe there’s much of a chance of reason #2 playing out for SEG to offer a completely skewed risk reward.

Let’s start with the most important reason I think SEG is so interesting: valuation. SEG spun off with ~5.58m shares and will pursue a rights offering backstopped by Pershing that will see them issue another 7m shares at $25/share (see p. 29 for share counts), so the market cap looks like this:

SEG has no recourse debt, though they do have a small preferred and some mortgage like debt on their Las Vegas Ballpark and 250 Water Street….

Those mortgages are non-recourse (see P. F-17 of the spin docs), so I think the proper way to think about them is to ignore them when calculating the EV, which means at current prices and on a post-rights offering basis, we’re paying $130m for all of Seaport’s assets ($315m market cap less ~$185m of cash less preferred post rights offering).

That seems crazy to me. Again, the Seaport is a disaster, but if you scroll to p. F-62 of their spin docs you can see they’ve spent over $1B at the Seaport…