Thursday, November 22, 2007

Crisis Looming at Maguire Properties?

Continuing my series on looking for stocks likely to suffer from macro themes, I've recently been doing some work on REITs. I have been short RWR since early in 2007, a play that has finally started to pay off, but was hesitant to choose individual companies due to my lack of ability to distinguish one REIT from another. As I write this now, I still am far from an expert, but believe I have a better understanding of the underlying REIT dynamics due to work I've done educating myself these last couple months, and am confident enough that I plan to begin to make some specific REIT bets. With that disclaimer out of the way, lets dig in.

In my search for potential shorts, I have focused on two main qualities:

1) High leverage (Debt/Equity)
2) Exposure to local economies most likely to be hard hit due to recent macro issues (e.g. Florida, Southern California)

REIT companies with exposure to hard hit aspects of the economy are likely to struggle with lower rents, high vacancy rates, and other issues that should reduce their NOI (Net operating Income). The more a REIT is leveraged, the more macro issues are unlikely to affect their bottom line and the quality of their balance sheet. In some cases, such as Maguire (MPG), it seems as though these issues could very well affect their solvency.

Maguire Properties Overview
Maguire Properties is a highly-levered commercial real estate REIT with properties concentrated in Southern California. The general thesis here is that it is looking increasingly likely that MPG will either be forced to cut their dividend, to continue to liquidate existing properties, issue a dilutitive equity offering (if they can get anyone to buy it), or sell the company. The company needs a friendly debt market to continue operating as it is, paying a dividend and continuing developement of its projects. I believe the most likely outcome is sale of the company, either by choice if they do it soon, or by mandate if they don't. At these prices, I think the downside of a short is limited at NAV, and the upside could be 30-80% depending on how quickly and how much the MPG's assets erode in value.

MPG has some serious balance sheet issues. Let's take an abbreviated look at some key numbers for MPG (numbers in million):
Market Cap: $1,212
Net Debt: $4,817
Enterprise Value: $6,029

Total Equity (including Depreciation): $6,353
Total Debt: $5,492
Debt/Equity: 86%

The big issue here--outside of the enormous interest payments and consistent reliance on borrowings to fund the dividend and operations--is that a relatively small impairment of the equity (in this case, about 14% at book) would entirely wipe out the equity.

The above is a proxy value for the equity based at book (cost). But in reality the value of the equity is always shifting. Here's where things get interesting--analysts are mostly sour on the stock, due to macro issues, poor operating performance, and leverage. Most analysts, however, still see downside protection in the NAV, which most peg at ~$30/share. Management rejected an offer in late 2006 at between $42-44/share, and reportedly tried to engineer a buyout of the company at $60. Though there are several ways to value NAV, the most accepted analysis is the Net Operating Income of the properties divided by the cap rate, which is the discount rate applied to the operating income to get a total value of the cash flows. Then you subtract the debt, and divide by the total outstanding shares to get the NAV/share of the equity. Let's take a look at historical cap rates:

Keep in mind that lower cap rates mean a higher implied NAV value. Cap rates were recently at historical lows, due to higher expectations for underlying asset appreciation, lower cost of borrowing, and the availability of more leverage, all of which made the actual performance of the property as an income producing asset relatively less important. These conditions, which existed as recently as a few weeks ago, are gone, and it does not look like they are coming back. In an increasing cap rate environment, that equity cushion is easily wiped out. What happens if cap rates rise to anything approaching historical levels? Below is an analysis of what happens to NAV when you change the cap rate assumptions (assuming NOI of $324M & value of other assets of $1,602M):
Cap Rate NAV/share
5% $44.54
5.25% $38.89
5.50% $33.75
5.75% $29.06
6.00% $24.76
6.25% $20.81
6.50% $17.15
6.75% $13.77
7.00% $10.63
7.25% $7.71
7.50% $4.98
7.75% $2.43
8.00% $0.04

At a cap rate of about 8% (well within historical norms, especially in tough real estate markets), the equity gets wiped out. Perhaps noticing these trends, several activist investors have recently gotten involved to try to force a sale of the company while cap rates are still somewhat favorable. It remains to be seen to what degree they will be successful, and what cap rate they can negotiate on a transaction. With the uncertainty in the market right now, California's poor economic outlook, and MPG's poor capital position, I would peg the odds of a deal as relatively small.

I value the upside potential in a short by taking a look at four scenarios, which basically involved valuing the company at 4 different cap rates and assuming an eventual sale of the company @ NAV.

Scenario Activist successful Forced Sale Forced Sale Forced Sale
Probability 20% 30% 30% 20%
Cap Rate 5.75% 6.5% 7.0% 8.0%
NAV @ sale $29.06 $17.15 $10.63 $0.04
Dividends 0 $1.60 $2.40 $3.20
Total Return $29.06 $18.75 $13.03 $3.24
Current Price $25.68 $25.68 $25.68 $25.68
Return -13% 27% 49% 87%
Prob Weighted 5.81 5.63 3.91 0.65

Probability Weighted Return: 38%

With minimal downside risk and strong potential upside, I think the risk/reward here looks rather favorable. Catalysts include increasing cap rates, commercial real estate turmoil, increasing credit spreads and risk aversion, dividend suspension, and decreasing occupancy rates and thus NOI.

Note: Author is not currently short MPG, but likely will be soon. Not a recommendation to buy or sell shares. Numbers herein are accurate to the best of my abilities, but should be double checked. Do you own DD.

Saturday, November 17, 2007

Shorting Staffing Stocks Part 2: MNST

In my prior post, I outlined the logic behind a short in Korn Ferry and how it is likely to see its value erode as unemployment rises and demand for its permanent placement services decline.

In looking for shorts that benefit this macro theme, I have tried to focus on pure-play permanent search companies, notably HSII and KFY, with strong US exposure, as I believe these are the stocks most likely to be punished by an oncoming downturn in hiring.

Another interesting way to play this macro theme is via Monster Worldwide (MNST). Monster faces supply/demand economics as the permanent staffing companies. They derive the bulk of their revenues based on the volume of job listing posted to their site, which very neatly follows generally higher patterns. In the prior downturn, MNST suffered a revenue decline despite us being relatively early in the online medium as a primary channel for hiring. Flash forward to today, and a MNST short heading into the next staffing downturn appears even more attractive--with the online hiring market having matured in the US, it is likely we will see a more magnified downturn in this next cycle.

MNST Overview:
MNST has organized itself in 3 business segments: North American MNST, Internation MNST, and Internet & Ad fees. Below is a breakdown of revenue and operating income as a % of total:

Revenue Breakdown:
2007 YTD
Monster NA 54%
Monster Int 35%
Int & Ad Fees 12%

Operating Income Breakdown:
2007 YTD
Monster NA 81%
Monster Int 13%
Int & Ad Fees 6%

Though MNST has generated 54% of its revenue from its US Monster operations, it generated a whopping 81% of its operating income from its US operations before corporate expenses. Without income from its US operations, it would be running at a loss after account for corporate expenses. Though Monster International and the internet content business may be more meaningful contributors to profit in the long term, they are unlikely to generate substantial profits in the near term, as MNST has made it clear that they are investing heavily in these businesses long-term growth potential at the expense of short term profitability. While this is good for shareholders long term, its impact in the years to come, as the US operations profitability declines, will likely not help the stock's short term performance. These divisions are also eventually likely to suffer from a downturn in the US market.

So, what kind of impact might we see in a difficult hiring environment? In the last downturn, Monster was part of TMP, which has since been spun off. I've done my best to compile the income statement for monster only (for WW):

2001 2002 2003 2004 2005 2006
Revenue $533,830 $402,543 $412,796 $516,371 $708,718 $964,331
Operating Inc $152,623 $24,550 $52,891 $101,936 $163,612 $244,625

Ouch. Operating leverage is great when it's working for you (as seen in the great run Monster has had since the bottoming out of the latest employment market), but it can be awfully painful when things turn sour, as all that revenue that was previously flowing to the bottom line suddenly dries up. It's worth noting that Monster took big restructuring charges in 2002 and 2003 which would make their earnings look prettier on a non-gap basis, but doesn't hide the fact that when the employment market swoons, Monster gets creamed.

I could go ahead and run numbers to try and get a downside estimate, but bottom line is that its much lower than what Monster is learning today. Analysts once again allude broadly to macroeconomic fears but still project increasing EPS and EBIDTA numbers off into perpetuity. When the ugliness once again reveals itself, Monster will get creamed.

Like KFY, Monster has generated some impressive free cashflow over the past couple years, which they, like KFY, are wasting on stock buybacks. Monster trades at about 26x FY07 earnings, which I believe should represent peak earnings for this cycle. As those earnings and multiples contract, the stock should see huge declines similar to what it experienced in 2002. I'd peg trough earnings her as sometime in 2009, when I think the stock will really take it on the chin. The $20 Jan 10' puts could be interesting as a small speculative position as well.

Disclaimer: Author is short MNST. Not a recommendation to buy or sell shares. Do your own due diligence.

Shorting Staffing Stocks Part 1: KFY

My apology for the delay in updates. I hope to do a much better job updating more regularly in the future.

With the recent market turmoil in the financials, I have closed out many of my short positions in the space: most notably ABK and MBI, and have been looking to other, more overvalued sectors to hedge my long positions.

The staffing sector has already taken a hit, but if history is any indication, there could be a lot more room to fall. If you believe we are at the onset of a recession that will eventually manifest itself in a considerably weaker jobs market, then several staffing companies look particularly attractive as a way to profit off the upcoming job market turmoil.

Market Overview:
Not all staffing companies are created equal. There are two primary different types of staffing companies:

1) Permanent search: these companies typically hired on a fee basis to find and screen employees for permanent hire on behalf of other companies. They are typically paid a non-recurring fee based on their success in finding a suitable applicant.
2) Temporary Staffing companies: these companies find and screen employees for temporary jobs, which can range anywhere from weeks to months. The temporary business model is different than the permanent placement model, in that staffing companies usually employ the worker themselves, paying them an hourly rate and billing out the employee at a higher rate to another company. These companies make their money on the spread between what they pay the employees and what they bill them out at.

Staffing is a cyclical industry. When economic times are good, companies do more hiring. Not only do they do more hiring, but they usually have a more difficult time finding quality employees, since unemployment rates are low and demand for qualified employees may outstrip supply. Permanent staffing companies are in particular demand when economic times are good--companies like Korn Ferry are often retained to help companies poach talent from other companies because the supply for qualified employees is so low. In bustling economic times, companies are generally also willing to pay more for these kind of services then in poor economic times. Temporary staffing is cyclical but not as much: in good economic times they benefit from increased staffing needs, but they also tend to hold up moderately well in poor economic times as companies shy away from full-time hires and look more to temporary employees to complete a specific task or project.

In bad economic times, the permanent staffing companies in particular face difficulties. Not only do companies hire less, but the supply/demand dynamic shifts strongly in favor of companies hiring. There are more likely to be more qualified workers, making it easier for the company to hire themselves, or to justify lower fees to the permanent staffing company. This can often result in both lower absolute number of permanent hires, plus lower fees/placement.

Why Korn Ferry
Korn Ferry specializes in high level permanent placement. Their earnings have historically been cyclically tied to trends in hiring and unemployment rate, and there is no reason to believe that this will not continue into the future. In addition to the aforementioned negative impact of a poor hiring environment, staffing companies like Korn Ferry further suffer due to their high fixed cost based on recruiters. Productivity/recruiter usually suffers, making relatively small moves in revenue devastating to the bottom line.

Though apparently reasonably valued, Korn Ferry is trading at peak earnings. A quick glance at the companies stock price between 1999-now will give you a good look at the sort of downside potential inherent when the hiring environment turns. Korn Ferry is a slightly different company than they were previously: they have more international exposure, a stronger balance sheet (becoming less so with share buybacks), and a more favorable cost structure than at the last turn in the cycle. SG&A expenses as a percent of total sales are much less than they were in past cycles, making the risk of big losses as the cycle turns less likely. Let's take a look at KFY in 2001 (peak earnings form last cycle) v. KFY's lastest FY ending April 2007.

FY2001 FY2007
Revenue 651.6 689.2
Gross Profit 231.6 196.8
SG&A 149.7 105.3
D&A 26.9 9.3
EBIT 55.0 82.2

Revenue 100% 100%
GM % 35.5% 28.6%
SG&A % 23.0% 15.3%
D&A % 4.1% 1.3%
EBIT % 8.4% 11.9%

I focus on EBIT rather than Net income to remove the affect of Interest Income and one time gains/losses, and focus on the profitability of the underlying business. Though KFY's SG&A expenses are down, their GM % is also down, mostly likely from increasing competitive pressures in the staffing business. If you adjust for differences in D&A, EBIT margins are only 70 basis points (.7%) from their prior peak. Not too impressive of a structural improvement in the business.

Despite talks of cyclical fears in KFY, analysts are still projecting healthy YoY increases in profits and revenue for the foreseeable future, which I think will be unlikely to materialize. Permanent staffing is, and always will be economically cyclical, and although KFY has made strides in reducing its fixed cost structure and global footprint, subsequent downturns are still inevitable. So, assuming we are once again at peak earnings, what is the downside as KFY transitions to trough earnings over the next couple years? Let's compare FY2001 with FY2003:

FY2000 FY2003 Change
Revenue 651.6 338.5 -48%
Gross Profit 231.6 92.2 -60%
SG&A 149.7 73.1 -51%
D&A 26.9 16.2 -40%
EBIT 55.0 2.9 -95%

Revenue 100% 100% 0%
GM % 35.5% 27.2% -23%
SG&A % 23.0% 21.6% -6%
D&A % 4.1% 4.8% 16%
EBIT % 8.4% 0.9% -90%

Not very pretty, is it? So, assuming we are once again at a cyclical peak, what does the future hold? This time, I'm going to use Last twelve month financials and see what trough earnings might come out to, assuming similar declines:

LTM FY2010 (?)
724.3 434.6
209.0 96.1
112.6 78.2
9.3 9.0
87.1 8.9

100.0% 100.0%
28.9% 22.1%
15.5% 18.0%
1.3% 2.1%
12.0% 2.0%

The above assumes a relatively conservative 40% drop in revenues from peak revenues, a 23% gross margin decline (consistent with that experienced in the last downturn), SG&A expenses rising to 18% (keep in mind company become much more lean during last downturn, and they are unlikely to be able to cut expenses again as much this time around). Under this model, EBIT would drop considerably. On a net income basis, it is likely the company would be flat to slightly positive or negative, depending on interest income and write-downs.

In times of trough earnings, it seems most reasonable to value KFY on a EV/Sales basis given the depressed state of earnings. In the past economic cycle, KFY traded at several points in trough periods at .5 EV/sales ratio. Assuming the same valuation on our hypothetical projection of trough earnings, KFY's enterprise value would be approximately $220M. If recent corporate activities are any indication, KFY is likely to buy its stock on the way down, eroding some the value of its cash. If we assume a 25% erosion to current Cash & ST investments of about $245M, that would leave KFY with a a TEV of $220M+ $200M of Cash and equivalents, yielding a market cap of $420M. With a market cap of $832M currently, that gives us an upside of about 50% in two years on our short.

If you think our economy is headed down the drain, this is a relatively low risk trade. KFY's international exposure in emerging economies is still small, and though their international exposure may lessen the blow some, a huge chunk of their business is still US based. In poor economic times with rising unemployment, it's tough to see KFY's stock performing well, even if it holds up better than expected, given all the negative macro fears and dearth of catalyst likely to be present.

Disclosure: Author is short KFY. Not a recommendation to buy or sell shares. Do your own due diligence.