Las Vegas Sands–a bounceback in 2Q11

the results

In 2Q11, LVS had unusually bad luck in its gambling operations in Singapore and in Las Vegas.  That happens occasionally.  Give a properly run casino enough time, however, and the odds even out.  2Q11 was a more normal quarter for the company from an odds point of view.  Combine that with stunning growth in Singapore, and the result was revenue for LVS during 2Q11 of $2.35 billion, up 47% year on year.  Eps of $.54 weere more than triple the net during the comparable period of 2010, and 25% ahead of the Wall Street consensus.

the details

To my mind, the biggest story is Singapore, where EBITDA (earnings before interest, taxes, depreciation and amortization–I’m not a fan of this metric, but it’s the one this industry uses) was $405.4 million, up 42% quarter on quarter (up “only” 30% if you adjust 1Q11 results up to reflect normal “luck”)July may turn out to be the best month ever for the Marina Bay complex–which, strictly speaking, isn’t even finished.  Singapore is now by far the most valuable part of LVS.

I wasn’t floored by the Macau results, which–at EBITDA of $391.6 million–were up 27.5% year on year and about 4% quarter on quarter (market growth rates were 40%+ and 12%+, respectively, during those periods).  The issues are new capacity that opened recently right next to some of LVS’s operations, and the time it tales to recover from the actions of an inept CEO (since fired; he’s suing).  The Hong Kong stock market, however, regards the earnings report as very good news.  Sands China was up 10% in overnight in a flat market.

Las Vegas continues its slow recovery.  LVS posted EBITDA of $92 million in 2Q11 for Nevada operations. The lion’s share of the $30+ million quarter on quarter gain is a return of casino “luck” to normal.

$10 billion in debt no longer looks like such a big problem

Roughly speaking, $4 billion of that amount is borrowed against Singapore operations, $3 billion against Macau and $3 billion against the US.  LVS has just renegotiated the Macau debt to extend maturities and lower interest expense by close to $100 million yearly.  LVS will likely refinance Singapore soon, as well.

My back-of-the-envelope guess is that the LVS empire will generate $2.5 billion-$3 billion in cash flow over the coming 12 months.  Call it $2.8 billion.  Assume calls on that cash of $1 billion for capital expenditure plus $300 million for interest expense and $200 million for extra working capital.  That leaves $1.3 billion to go to debt repayment.  If LVS could manage twelve months without major capital outlays, borrowings would be more than cut in half in under three years.

Also, were LVS to sell 15% of Marina Bay in an IPO, I think it would raise enough to wipe out all its US debt.  I doubt this will happen until the property is more mature, but the possibility has to make lenders–and investors–feel more comfortable about LVS’ debt level.

And, of course, LVS has $3 billion or so in cash on its balance sheet.

the stock

A sum of the parts calculation is probably the most reasonable.

At yesterday’s closing price, LVS had a market capitalization of $33.8 billion.  The company’s share of publicly traded Sands China is worth $17 billion.  If we assume that Marina Bay would trade on the same valuation as Sands China–which could prove much too low–then that 100%-owned property is worth $24 billion.

This means Wall Street is valuing LVS’ US operations at -$7 billion.  This compares with a +$7 billion implied valuation for WYNN’s US operations and +$3.3 billion for those of heavily indebted MGM.

LVS shares (which I own–I may sell some today, though) would have to rise by about 30%, just for the implied valuation of its US properties to match those of MGM.  It would take a 20% rise just to get the value up to zero.

Why the disconnect?  I don’t know.  The former CEO of Sands China is suing, and claiming all sorts of improprieties by LVS management.  It’s also possible that some investors are uncomfortable with LVS’s debt–I know I have been–or don’t understand that the earnings disappointment in 1Q11 is just one of those things that happen in the gambling business.

the Flatotel and the Alex Hotel: a cautionary tale for investors

a free Wall Street Journal

I’m not a particular fan of News Corp, even though I will admit I was one of the first US-based holders of the stock–and a large one at that–in the mid-Eighties.  The Wall Street Journal is being delivered to my door every day this week as part of a campaign to gain new subscribers, however.  Yes, there’s a lot of fluff and it’s very US-centric.  But the paper is better than I remember.  To my surprise, I may end up subscribing.

That’s not my point today, though.

the underbelly of finance

The “Greater New York” section of yesterday’s paper has an interesting article in it that gives a glimpse at a part of the usually-hidden underbelly of finance.  It also shows some of the obstacles that investors in “deep value” or “distressed” assets routinely face.

Titled “Hotel Developer Must Check Out,” the article describes a recent foreclosure action in which a New York judge put two Manhattan hotels, the Flatotel and the Alex, into receivership.

Alexico

The back story is about a former gold trader and a hotel developer who met in the gym and formed a hotel management company, Alexico.  Borrowing heavily from Anglo Irish Bank (the institution, incidentally, that played the pivotal role in crashing the entire Irish economy), the two started a number of high-end hotel and condominium projects. Then the great recession came.

Anglo Irish has since been nationalized.  As part of its restructuring, it sold the loans it made Flatotel and Alex–a face value of $258 million–to a consortium of US real estate management groups for maybe half that.  They went to court to force Alexico to turn over control of the two hotels.

That’s not the interesting part.

the interesting part

This is:

–the two hotels are losing money   They haven’t made payments on their debt, nor have they paid real estate taxes, for two years.  But they did manage to pay Alexico $570,000 in management fees during that period.

–in addition, the ailing hotels scraped together enough cash to lend $5.3 million to other parts of the (now crumbling) Alexico empire.

–why didn’t Alexico extract even more money from the two failing hotels, you may ask?  A cynic, meaning someone who’s seen this movie before, would say that what Alexico took was all the cash the hotels were generating.

–besides this, the plaintiffs in the case say the hotels’ financial records are a mess (what a surprise!). No elaboration, but I don’t think the issue is that the accountants spilled coffee on the books or that the entries are all mixed up and in the wrong places.  I interpret this as meaning there’s no way of knowing how much money came in the hotels’ doors or tracing where it went.  If so, there may be more money missing than the loans.

All of this is pretty standard fare.  But there’s typically more:

–were the hotels larger, we’d probably also be talking about their employee pension plan–who manages it?  did it too lend money to other parts of Alexico?

–if Alexico built the hotels instead of buying them, we’d likely also be asking about whether the structures are up to code, or if the construction company used lower-quality materials than specified in the contracts.

when the burden of proof shifts…

As a general rule, it’s a mistake in a situation like this to think either  1) that this is the first time the people involved have done something like this, or 2) that what you’ve discovered to date is everything they’ve done to the asset in question.

This is why it takes a certain mindset to navigate through the potential minefield of a distressed asset.  All in all, I’m happier being a growth stock investor and leaving this sort of analysis to someone else.

Capital intensive companies (II): pros and cons

on the plus side…

1.  The high cost of entry into a capital-intensive business can act as a barrier to competition.  For example, almost anyone can come up with the money to open a restaurant.  But if a big semi-submersible offshore drilling rig costs $100 million, the number of new parties that can give the industry a try is very limited.

2.  First mover advantage can be considerable.  Site location can be important, for example, for proximity to raw materials, customers or transportation of the final product.  A beachfront or a spectacular view can make a difference to a hotel.

Just as important, if a market is only big enough to support one entrant, an intelligent competitor will realize that his entry may create chronic overcapacity and eliminate the possibility of profits for either.  So he’ll look elsewhere.  If he can’t figure this out, his bankers or potential equity investors may withhold the funds he needs.

3.  Lead times for new capacity can be long.  This is not a question of the time it takes to raise capital.  But permitting for new construction may be arduous–a locality may not want another new chemical plant.  Actual construction may take a year or two.  Therefore, even if booming demand justifies adding new capacity, it can be several years before it arrives on the market.

4.  High operating and financial leverage means profits in good times can be enormous.  A hotel, for example, may have to run at about 50% of capacity to cover its cash operating costs, and at about 60% to break even if we include depreciation of the plant and equipment.  But, since the out-of-pocket cost of renting a room is, say, $12 (cleaning, and replacing the soap) the income from selling one more room is high.  And, when occupancy rises high enough, the hotel can hike the price of all the rooms it rents–raising profits exponentially.  There have been times in Manhattan, for example, when, in a strong economy, hotel rooms have rented for over $800 a night.

…and the minus

It’s a characteristic of capital-intensive businesses that the owners take the risk of buying the long-lived assets that will drive the profits of the firm at the outset.  So they may not have a lot of control or flexibility in what happens afterward.  They may be price takers.  They have fixed capacity and demand rises and falls with the business cycle.

From an investor’s point of view, this is perfectly acceptable.  These companies can be very rewarding investments.  You just have to keep in mind that they may be highly cyclical and you can’t fall in love with them and forget this.  There’s a time to sell as well as a time to buy.

There are two big worries for the capital-intensive company, though, other than the fickleness of stockholders:  overcapacity and technological change.

overcapacity

Overcapacity is not just the cyclical ebb and flow of demand.  Say you operate a mid-range hotel located at the intersection of two highways and catering to traveling businessmen.  You have 200 rooms, which are occupied 80% of the time during the work week, and you’ve almost completed construction of a new wing with another 75.

One day, a competitor chain starts to build a 250 room hotel right across the street.  This makes no sense.  There isn’t enough business for two hotels of any type, let alone two targeting exactly the same audience.

When the new hotel is open, occupancy for both you and the other guy will probably max out at 40%–not enough to cover out-of-pocket costs.  Even worse, a price war will inevitably break out as you both vie to capture what traffic there is.

When the competitor realizes he’s made a horrible mistake, his goal shifts from making a profit to extracting as much of his capital from the location as possible.  This is bad.

Even worse (for you and the overall market), suppose you “win” the price war and the other guy goes into bankruptcy.  The physical assets will still be there.  They’ll be sold at auction, probably at a bargain price, to a new competitor who will probably have a lower cost of ownership than you do.

That’s overcapacity.

technological change

I’ll write about the internet in another post.  It’s the mother of all technological change.

The more traditional example of the effects of technological change on an industry is the advent of the electric arc furnace in the steel mini-mill.

Up until the mini-mill, steel had been produced in blast furnace mills.  These plants can cost several billion dollars, take years to build, have mammoth capacity and must run 24 hours a day.  Location is invariably a compromise among access to raw materials and the need to transport end products to many different customers.  None of this mattered, because for a long time it was the only game in town.

Then in the 1980s, a better mousetrap in the form of the electric arc furnace came along.  A plant cost about 20% of what a blast furnace did and used cheaper inputs and labor.  It could be located closer to a customer, lowering transportation costs.  And it didn’t need to run continuously.  It very quickly took a third of the steel market in the US away from the blast furnaces.

The advent of the mini-mill caused a twenty-year slump in the traditional steel industry, one it only came out of at the beginning of the new century.

More tomorrow.

How expensive is US housing?

residential real estate

Many observers (including myself) think that the housing market in the US began to bottom a little more than a year ago, as savvy property buyers began to return to key markets to pick up prime properties at prices they (correctly) thought would not go much lower.

Soon after midyear, overall housing-related indices began to bottom and then to rise.

Recently, signs of stabilization have emerged even in the worst-hit markets, like Miami, which suffered from wild speculation, massive overbuilding and heavy reliance on large multi-unit residential structures.  (In south Florida, unlike the case in most of the US, projects take longer to complete and when they’re done you don’t just have one unsalable detached house. You have maybe 100 unsalable condominium units.)

Despite all this good news, the question still arises whether this is simply an elaborate technical movement–sidewise price action based mostly on the market needing time to absorb the stunning depth of the declines of the past three years, but to be followed again by another fall off the table.

the Economist analysis

In a recent issue, the Economist observes these phenomena and addresses the valuation question.  For a variety of countries, it calculates the historical relationship between rental income and house prices.  It then uses this figure to figure what home prices should be, given today’s rents.  The results?

the US

1.  For the US, the magazine does three calculations.

Using the Case-Shiller ten-city index, house prices are 3.9% overvalued.

On on the Case-Shiller national index, house prices are 3.7% undervalued.

Taking the Federal Housing Finance Agency index, which eliminates anything financed with a sub-prime loan–in other words, is really biased to the upside–house prices are 13.1% overvalued.

If this simple measurement is close to correct, then the US housing market is on relatively firm footing.  It may not go up, but the floor is unlikely to disappear from beneath us.

undervalued markets

2.  Other fairly-/undervalued markets?

Japan, 33.7% undervalued

Germany, 14.6% undervalued

Switzerland, 7.1% undervalued

China, 2.7% overvalued.

I’m not sure where the data come for China.  This certainly cuts against the conventional wisdom, though, and lines up with the brave few who are arguing that the rise in property prices in the Middle Kingdom are just keeping pace with its rip-roaring economic growth.

overvalued markets

3.  Overvalued markets?

Australia,  56.1% overvalued

Spain,  53.4% overvalued

Hong Kong,  49.1% overvalued

France, Sweden, Britain and Belgium, all 30%+ overvalued.

Of  these, prices in Hong Kong, Australia, Britain and Sweden are rising.

what to make of this

The US, the first place where housing troubles emerged, appears to be most of the way back out of the woods.  This doesn’t mean that prices will be going back up much from here.  Who knows?  But it suggests that housing is not going to provide more negative economic surprises.

The undervalued markets are by and large in moribund economies.  China is an outlier.  It’s hard to know what to say about it.

The overvalued markets are split between fast-growing areas in the Pacific and the euro-zone.  Sounds like more potential trouble brewing in Euroland–as if they needed more.