Wednesday, March 16, 2011

Genesis Land: Still Doing Your Work For you

It's important to remember that what a company is worth is not based on its future earnings, but rather its future cash flow. Earnings are often a decent, smoothed-out version of cash flow, and therefore valuations based on estimates of earnings are usually the way to go, but not always. With that in mind, consider Genesis Land Development Corp (GDC), a real-estate development company with operations in Calgary.

Earnings for this company will be choppy; some quarters it will unload big chunks of land, others it will lose money as it services land for future development. So trying to take past earnings and extrapolate what future earnings might look like is likely to lead an investor down the wrong road.

On the other hand, the future cash flows to this company might best be estimated by the property values of its land holdings. As the company sells down its land holdings (for the purposes of paying down debt, which has been the company's stated goal for many quarters), it is monetizing its assets and generating rather strong levels of cash flow (relative to enterprise value).

Recognizing that investors may want to know the appraised values of its holdings, the company actually hired a third party to estimate the value of its land, for the second time this year. Last week, the report suggested that the firm's net assets are worth $8/share (even after accounting for hypothetical taxes), which was almost a 100% premium to the company's share price that day! Shares reacted by appreciating all of 3%, suggesting the market either doesn't buy the results, or doesn't think net asset value is important.

Of course, such an assessment is rife with conflicts of interest. The third party firm is being paid by the company, and so to claim future business with the firm (rather than lose it), there is an implicit inducement to inflate the numbers a little bit. The good news for shareholders, however, is that this third party appraiser is not a one-man shop operating out of his parents' basement (not that there's anything wrong with that...I have nothing against my primary reader demographic!). Cushman & Wakefield is a global firm servicing 58 countries with 13,000 employees, so they are unlikely to toy with their reputation for a couple hundred grand (or whatever it is they got paid for this appraisal project).

However, anything is possible; the fact that a third party has appraised the company does not mean shareholders should go in blindly. Nevertheless, the evidence here suggests there may be a wide disparity between what the company trades for and what the value of its land holdings appear to be. Some shareholders who choose to investigate further may feel that GDC shows minimal downside relative to upside potential.

Disclosure: Author has a long position in shares of GDC


Unknown said...

Hey Saj,

Great blog as always!

It seems like the company is changing its auditor every 2 years. Does it raise a flag or is it a common practice? What do you think?

Alex P.

Zachary said...

Imagine valuing a cable company based on earnings. There's a laugh.

Taylor said...

The price to value gap on this one is enticing. I'll definitely look further into this company.

By the way, I love the blog. Very educational.

Saj Karsan said...

Thanks Alex and Taylor! I agree the past accounting/ethical issues are a potential risk, which is probably why the discount is so large.

Taylor said...

Since I wasn't familiar with Genesis' primary place of business operations (Calgary), I decided to head over to wikipedia to do a little research. Since it's a RE company, location is of obvious importance:

-Ranked 5th Best place to live in
-The city has received high rankings for cleanliness
-As of 2006, Calgary was the most expensive city in Canada for commercial real estate, and 2nd most expensive city for residential. Granted, this was during an unsustainable boom period.
-Calgary is also home to substantial employers such as BP, Shell Canada, Shaw Communications, Dow Chemical. Apparently, Imperial Oil moved its operations to Calgary because favorable tax rates.
-The city is home to 87% of Canada's oil and natural gas producers and 66% of coal producers. The city's dependence on oil is decreasing, however.

I think its safe to say that any deterioration of the margin of safety will not be due to the location of the properties.