Saturday, October 16, 2010

Don't Mess with Old St. Joe

Growing up in the Florida citrus industry is great training for a value investor.  Farming is a wonderful classroom.  There are superior businesses and inferior ones.  Some businesses are inherently profitable, while others (including family farms) are not.  Steady positive cash flow is a beautiful thing.  And you don't need a textbook to define free cash flow once you go without it.  

I also learned to be wary of asset valuations, especially when someone else (or even the market) is providing the number.  The 1980's are memorable for this reason.  Many in the citrus industry borrowed heavily to buy/plant more citrus acreage at ever-rising costs.  After all, citrus prices were only going higher, thanks to overseas demand.  Land values would certainly follow.  For a time, it was a self-fulfilling prophecy.  Higher prices provided confirmation of the thesis and it continued. 
Until it stopped.   

Let's just say that when the underlying assumptions died, they died hard.  There were more than a few bankruptcies and (amazingly) not one bailout.  There are consequences to hubris and faulty assumptions. When it comes to real estate, these miscalculations seem to happen more often than not.  Florida real estate seems particularly vulnerable.

Value investors frequently invest in "land bank"-type companies from Consolidated Tomoka Land (CTO) - owned by Third Avenue and Wintergreen - to The St Joe Company (JOE) - owned by Fairholme, Royce, and Third Avenue.  Moths to a flame?

No question, the attraction to these companies is the underlying asset value and the perception of a margin of safety.  Given my history, I've never been comfortable with the risks.  There have always seemed to be superior companies available at comparable prices.  With the benefit of hindsight, I'm content with the decision.

This week, David Einhorn of Greenlight Capital made a presentation at the Value Investing Congress about his short position in The St Joe Company.  139 pages of pain for the Panhandle Chamber of Commerce and anyone long JOE shares.  Long, painful... and compelling to someone with the biases explained above.  But, true or not, I couldn't help but feel sorry for St. Joe and about the portrayal of my home state by Einhorn.  You'd think the whole state was prison and shanty towns. 

Einhorn's reputation is such that merely mentioning his position can result in success.  Einhorn announces his short position and a bunch of lemmings follow suit.  His words alone are all the due diligence they needed apparently.  Einhorn knows the power of his words.  He even joked that conference attendees might want to leave during his presentation to "call (their) brokers".  Talk about a self-fulfilling prophesy!  And perhaps a bit of hubris?

Nonetheless, JOE fell 20% in 2 days.  One assumes Greenlight is still short, hoping their $7 to $10 per share target price becomes reality. 

But David Einhorn isn't the only investor who has the ear of Wall Street.  Bruce Berkowitz of the Fairholme Funds is on the other side of the trade as JOE's largest shareholder.  The recent dust-up over JOE  seems to have everyone's attention with two of the world's best investors on opposite sides.  Both men are very public proponents of their respective positions.
But this isn't just a divergence of opinion.  It's pretty clear that these two teams don't like each other.  Articles like Berkowitz to Einhorn: 'Thank you.' show this dimension.  Einhorn says St. Joe has accounting issues (massive write-downs that need to be realized) and accused management of "Imagineering".  Berkowitz accuses Einhorn of "ad hominem attacks" and an attempt to "crush" St. Joe.  In addition to an investment disagreement, this is starting to look like a pissing contest with poor old JOE caught in the middle.

Choosing sides could be hazardous to your portfolio.  While I naturally side with Einhorn's skepticism, I won't be shorting the St. Joe Company.

Bruce Berkowitz openly talks about buying St. Joe in its entirety.  And idol threat?  Fairholme already owns a third of the company.  Moreover, the current market value of $2 billion means any respectably sized firm could do the deal. With debt so cheap, currencies being debased, and investors looking for hard assets, one can imagine a disappointing outcome for Einhorn regardless of the merits of his argument.

St. Joe Company doesn't have massive debts and it has access to the capital markets.  The cash crunch argument may, therefore, be overstated.

JOE shares have already dropped precipitously, following the trajectory of Florida real estate.  Einhorn argues that they have further to go, but does that warrant shorting?  Is there a margin of safety?  I can confidently say that the company was more risky in 2005 when the sun was shining brightly.  That year, the company booked $120 million in profits and sported a $6 billion+ market value.  Neither level has been seen again. 

Florida real estate doesn't lend itself to pie-in-the-sky thinking these days.  Any mention of Florida real estate conjures images of empty condos, creeping swamps, and alligator-infested golf courses.  One doubts that the shareholders of St. Joe are suffering from hubris.  Most, like Berkowitz, simply think the future for St. Joe isn't as horrible as the recent past.

Berkowitz can force the issue.  If he and JOE management make a deal, Einhorn losses.  Einhorn, on the other hand, must get other investors to agree with his point of view.  But this doesn't make St. Joe a bargain that should be bought either.

Mention the Gulf Coast and people think hurricanes and oil spills, not pristine beaches and retirement bliss!  Einhorn's presentation would (at the very least) cause me to wonder about St. Joe's asset values, capital allocation, accounting policies, and management team.

Strange as it sounds, Bruce Berkowitz and David Einhorn could BOTH be correct.  It's a question of time.  Berkowitz can afford to be very patient and very long term.  As a hedge fund manager, Einhorn probably doesn't have the same luxuries.  It's conceivable that Einhorn makes money today (and has) and that Berkowitz wins tomorrow.

With that level of conviction, I'll be watching this fight from the cheap seats.

Pass the OJ, please!

Disclosure:  No positions.

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