Porter on JOE

Let's get right to the heart of the matter... Our subscribers are irate one of Steve Sjuggerud's latest recommendations is the target of famed short-seller David Einhorn. They're mad the stock fell 20% in two days. They're mad we admire Einhorn. And most of all, they're mad no one at Stansberry told them what to do about it all yet...

Says one paid-up subscriber:

You know I can't be the only subscriber that is really miffed at the St Joe situation. Dr Sjuggerud, who has some great advice for his True Wealth subscribers, but to not say a word or an e-mail... I'm aghast of the situation, and Wednesday and Thursday's Digest, all you talk about is Einhorn's magnificent 139-slide show detailing his marvelous research, in the meantime we small-time investor's watched in horror as Joe drops 20% in two days.

Luckily you taught me to watch position size and watch your stops and I can consider myself one of the lucky ones that used my own due diligence and got out yesterday, after my own research and held my loss to 10%. Just another example of the "big guy" eating us little guys for lunch. I'm so miffed at your glorification of Einhorn, it is a little disheartening that you glorified him, while you always seem to try and watch out for us little guys and talk about out smarting "Mr Market." I'll bet you get an earful from a lot of us on this one and I look forward to Porter addressing this on Friday. – Steve R.

Let's start with David Einhorn – one of the world's best investors. The hallmark of his investment style is extraordinary fundamental research, which we greatly admire. We also like his brash, outspoken style, which, like us, has gotten him in trouble with the SEC. (We're constantly amazed by the public's aversion to seeing the emperor has no clothes. We simply can't understand it.) We see Einhorn as the best of Wall Street's new generation, one we're a part of, too.

We think getting angry or emotional about Einhorn is childish. He is a smart guy, who does good research. He has as much to lose as anyone in this situation. Finally... we like it when someone we respect takes the time to study an asset we know well. Getting Einhorn's perspective on one of our recommendations is helpful to us. And if we're right, having the opportunity to buy shares at $20 instead of $25 could significantly increase our returns.

Einhorn spoke around noon on Wednesday. I was in New York, in the room when he spoke. I got back home late Wednesday night. First thing Thursday morning, I studied his presentation and read all of St. Joe's SEC filings. I went to bed last night after making up my mind around 2 a.m. Yes, I took time to eat dinner with my family and put my three-year-old son to bed. But I didn't go to bed until I'd finished my work and made up my mind.

It is now Friday, and I'm writing to you about this matter. That is as quickly as I could do a thorough job. Despite the implied claims of our marketing, we are not omniscient. I actually had to read the SEC filings and think about what the information meant. I knew whatever I said about this would matter to our subscribers. I know tens of millions (if not hundreds of millions) of dollars are at stake. And so you'll know for next time, I will never give in to pressure to speak before I am confident enough in my work to say something intelligent. I'm sure Dan and Steve were in the same boat. I know they're both sending something shortly to their respective subscribers.

I can't imagine you'd want me (or them) to do anything other than this... but I do think many people falsely believe our jobs are easy... that we use some crystal ball to come up with our work. It's not that way.

And keep in mind, Einhorn has the luxury of a nearly unlimited research budget, thanks to the billions he manages. He can hire as many analysts as he needs. He can take as long as necessary to prepare his report. (If you want to see all 139 pages, you can get a copy here: http://rghost.net/2914658?r=1367.)

My research team? I had my dog, Ruby, sitting next to me. I also had a warm fire going to ward off the cold rain outside. And a nice glass of cabernet to keep my mind focused. So... maybe Einhorn has a bit of an edge on me, but this isn't my first rodeo, and when it comes to financial statements, I'm no pansy.

What's my conclusion? I agree with Einhorn's core allegation about the company. St. Joe hasn't written down the value of its investments far enough, yet. Two things tell me Einhorn is right. First, when St. Joe sold an entire development in central Florida last year, it took a $60 million charge at the close of the sale. All of the other writedowns it took were less than $10 million – even on much larger developments in much worse condition in terms of their outlooks (aka ghost towns). Once you've sold a property, you have no choice about whether or not to report the money you've lost on the development.

Second, in the spring of 2008, St. Joe sold more than $500 million in new stock. That's a huge amount of new shares for a company the size of St. Joe. Why on earth would a Florida development company need to raise $500 million in new stock (all of which was used to pay off debts) at the end of a 15-year Florida land boom...? The only explanation for this was its development efforts failed. The fact is, development is a very capital-intensive business, something that wasn't reflected in the company's earnings and hasn't been reflected (yet) in its balance sheet.

So in this specific and narrow way, I think Einhorn is likely to be right. I believe St. Joe will take a big write off of its assets. But so what? It isn't news Florida land values are down between 50% and 75% from their peak. When it comes to landholding companies, investors already know the accounting is spurious. After all, St. Joe is holding almost 600,000 acres of land on its books at their acquisition costs of around $15 million. That's what accounting rules require.

Likewise, impairments in St. Joe's real estate investments are done according to accounting rules. Sure, management would probably prefer to avoid these writedowns, but just giving the numbers a quick glance, it's clear it can't.

Nevertheless, none of this is important to investors because the write-offs wouldn't involve any cash losses and wouldn't surprise anyone. The questions that matter now are: What's a fair and safe price to pay for this stock, and how much money is the company likely to earn for shareholders over any reasonable length of time? Accounting is designed to help investors discover these values, but it doesn't dictate them. Reasonable investors – like Sjug, Ferris, Berkowitz and Einhorn – can have reasonable disagreements about these matters. Who will be right? That really depends...

Here are the relevant facts: St. Joe owns 577,000 acres of land in Florida. Most of it (405,000 acres) is within 15 miles of the Gulf of Mexico. Based on actual land sales over the last three years, I would estimate this land today is worth roughly $2,000 an acre. Most of it is raw timberland. Some of it (41,000 acres) has been approved for development. And some of it is highly valuable beachfront property.

Based on my estimates, the land is worth $1.15 billion. Joe's total liabilities add up to around $200 million. So its net asset value (NAV) is roughly $1 billion. St. Joe has 92 million shares outstanding. That makes NAV per share $12.54. That's what I'd estimate you could liquidate St. Joe for today, if you merely took the land and sold it to a private investor. That's a bigger number than Einhorn says the stock is worth ($7). But it's a much smaller number than Berkowitz has recently been paying (more than $20 per share). Why would two wealthy and knowledgeable investors have such a big discrepancy between what they both obviously believe the stock is worth?

The answer lies in the option value of the land. Today's NAV is unlikely to remain depressed for long. The new airport now serving the St. Joe area is likely to make this part of Florida much more attractive to retirees and vacationers. That will increase land sales and land prices. You can see the same pattern happen time and time again in Florida land development. Likewise, it's not hard to believe the Fed's money printing will increase land values, in general... and the price of productive land (like timberland), substantially.

For comparison, consider the stock market value of other major timber companies has risen substantially this year. Plum Creek, the biggest, is up about 20%. Potlatch is up about 25%. I think Einhorn is making a mistake when he bets against these trends, especially when it comes to St. Joe. You see, St. Joe has two things that greatly enhance the option value of its portfolio...

First, it has essentially no net debt. The company has $165 million in cash, held against less than $40 million in long-term debt. And thanks to its timber operations, St. Joe has positive cash flow. Over the last two full years ('08 and '09), the company earned almost $100 million in cash. There's no way this company is going bankrupt or will experience any financial strain whatsoever, barring a complete collapse of the entire state of Florida's economy.

Second, St. Joe has invested an enormous amount of money in its existing developments. The scale of these investments is almost laughable – which was one reason Einhorn's presentation was so impressive. The former head of St. Joe, Peter Rummel, came from the Walt Disney Co., where he was head of "Imagineering." It's clear his imagination got the better of him when he decided to pile billions of dollars into developing what, in many cases, was marginal land.

You can think about it this way. In 1999, the first year Rummel took over St. Joe, the company earned $124 million (net income), after spending $298 million on development in 1998. But from 1999 forward, the company spent enormous sums of money, more almost every year as Rummel tried to build his vision of a beautiful new world.

In addition to these huge operating expenses, Rummel was also investing heavily in things like building community centers, golf courses, roads, etc. In total from 1999 through 2008, when he left the company, he spent $1.2 billion on capital expenses. Putting the operating costs (which includes the value of the land being sold) together with the capital projects, you find Rummel spent almost $7 billion on St. Joe's transformation from a paper company to a real estate firm.

How much money did St. Joe generate from all this effort? Very little. Cumulative positive cash flow from 1999 until spending was largely halted in 2007 totaled a measly $216 million. I wouldn't be surprised if Rummel personally made more money than the entire company during his tenure. In fact, I estimate the total return rate on Rummel's St. Joe investments was less than 3%.

These are the things that made Einhorn's presentation so memorable: The streets leading to nowhere. The sewage systems sitting empty. The golf courses with no one on them, etc.

But the fact is, all these problems have long been priced into the stock. They pose no threat to current investors. Rummel has long since left the company. But the value of many of his investments remains to be unlocked.

That's what Berkowitz, Sjuggerud, and Ferris see in the company. What's the future value of this development potential? A lot, because most of the expensive work – like building the roads and the infrastructure – are complete. And since there's no risk of bankruptcy, the option value of this potential remains safe.

How much could St. Joe be worth in the next five years? That's hard to say. But there's the potential for enormous gains if the 41,000 acres it has permitted for development end up being worth anything like current developed land prices. Assume $100,000 for each acre, on average – that's $4.1 billion.

What do I think is going to happen? I expect St. Joe will soon take a big write-off of its impaired real estate. That will help it lower lot prices and begin to recover. I also expect it will spin off its timberland into a new timber REIT, a move that could generate maybe $1 billion for existing shareholders.

Also, if these things don't happen quickly enough, I'd expect to see Berkowitz take over the company. He has agreed not to purchase more than 30% of the stock – but that promise expires in 2014. If the current management of St. Joe doesn't unlock the value that's clearly in these assets, Berkowitz will.

What do I think you should do? I personally like Sjug's approach, as he explained to his readers in last month's True Wealth. This is simply a buy-hold-and-be-patient situation. There's really nothing more to it. And nothing to get so excited about, no matter what Mr. Fancy Pants says in New York.

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Short mailbag today, considering most of the e-mails were about St. Joe. Anything else on your mind... feedback@stansberryresearch.com.

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Porter comment: You're right! Great call, Curzio.

Regards,

Porter Stansberry
Baltimore, Maryland
October 15, 2010