The Seven Years’ War was the first global war. Battles were fought on three continents as European conflicts spread to colonial territories between 1754 and 1763. Great Britain and Prussia fought an alliance of France, Austria, Russia and Spain. In North America, Britain and France battled on the frontier. Iroquois warriors joined British soldiers against French forces allied with Algonquin and Huron tribes. In defeat, France ceded control of the Great Lakes and Canada.
The Seven Years’ War laid important foundations for the American Revolution. First, the war left Britain with heavy debts. Taxes were levied against the British colonies to replenish King George III’s treasury, sowing bitterness and resentment. Second, the war militarized the colonists. Militias were armed and George Washington and his officer peers trained under British high command. Third, France was eager to avenge her losses, and an alliance with the rebellious colonists would form in the following decade.
In the late days of the American Revolution, with Washington’s ragged army badly in need of a victory, France raised the game. Comte de Rochambeau marched 5,500 troops from Rhode Island to New York where the French Expédition Particulière joined the Continental Army. As French ships prevented a British escape from Chesapeake Bay, forces led by Washington, Lafayette and Rochambeau routed the redcoats at Yorktown, Virginia. The victory was decisive, and independence soon followed.
“Rochambeau” is instantly familiar to many because it is a name frequently given to the game more commonly known as “rock-paper-scissors”. You’ve never heard it called “Rochambeau” before? Me neither. But my friend from Colorado swears by it as does my native-Minnesotan wife.
Why Rochambeau? Was Lafayette the winner who laid some smooth paper on his compatriot’s rock, thus forcing Rochambeau to take command of a grueling march through the mid-Atlantic during the blistering humidity of a colonial summer? Paper always seems to be the sneakiest move. It’s counter-intuitive to win with paper, so light by nature, and it’s just the sort of play a sly bâtard like Lafayette would lay down. Touché.
It turns out there is no proof that Rochambeau ever played rock-paper-scissors, and drawing any connection with the French general is pure speculation. According to the authority on such matters, the World Rock-Paper-Scissors Association, the first mention of a game called Rochambeau appeared in the 1930’s.
Rochambeau is an easy game. Usually, the loser is required to complete some unpleasant obligations like take out the trash, change a diaper, follow Scooby into a haunted cave, or march to Yorktown through swamps and marshes. Government-sponored lotteries are also pretty simple. The winning number is drawn at random. Huge jackpots, microscopic odds. Our governments have been in the gambling business for a long time.
Governments sponsor and benefit from lotteries but they outsource the operations to businesses. The largest publicly traded provider of lottery services is a company called International Game Technology (IGT). Based in London, IGT has substantial operations in Italy and Rochambeau’s old stomping ground of Rhode Island. De Agostini, an Italian conglomerate, controls 42% of the company. IGT runs lotteries, and it also produces gambling technology and equipment. Earlier this year, private equity giant Apollo agreed to pay IGT $4.05 billion for the gaming division with plans to merge it with Everi – another game-tech business. The sale will be completed in the second half of 2025 and will leave IGT as purely a lottery service provider.
Unfortunately, there is no free lottery ticket lying on the ground for buyers of IGT. The price of IGT stock appears to offer no upside to those waiting for the check from Apollo to arrive. In fact, after adjusting for the Apollo transaction, the equity of the combined entity is trading at a 3% premium to the intrinsic value of the lottery business.
The lottery business may be appealing to some because it carries long-term contracts and largely predictable revenue streams. Although point-of-sale equipment is needed, the business doesn’t require a huge capital investment as more of it migrates online. But there lies part of the rub: as more moves online, the gambler’s options widen. Lotteries are a crude game of chance. Why not take a few hits at those wagers which involve “skill” – sports betting and casino games? Certainly, staid old lotteries will lose in the ever-increasing world of online gambling choices.
There are two other problems with IGT: One, the company provides a huge windfall for governments, so naturally it is taxed as such. Tax rates for the company approach 50%. Two, quite a lot of the profits go out the back door through a series of joint ventures. Non-controlling interests grab about 47% of the value.
So, what’s left for the shareholders? You’ve got a lottery business with $2.5 billion in revenues. Operating margins are about 27%, but the taxman taketh 50%. There is about $600 million of free cash flow remaining which can be capitalized at a rate of 7.2%*. Adding $4.05 billion of cash to the net debt of $5.16 billion, results in an equity value of $7.17 billion. Noncontrolling interests have a claim on 47%, so the lottery business is worth about $3.8 billion to shareholders. Meanwhile, the market cap of IGT equity is about $3.9 billion today.
Note: Between the time this article was drafted last week and published today, IGT dropped 6%.
IGT may be worth keeping an eye on. If the market continues to trade the business lower, a discount could emerge. Right now, the odds favor the house.
Until next time.
DISCLAIMER
The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.
*Weighted average cost of capital was determined with the assumption that the company’s optimal capitalization is 35% debt and 65% equity. IGT carries a BB+ S&P Rating and therefore has an approximate 6% cost of debt. The figure of 9.06% was calculated as the cost of equity.
Mauna Loa is Earth’s largest active volcano. The Hawaiian mountain is also the world’s tallest. Mauna Loa rises 30,085 feet from base to summit which is higher than Mount Everest measured from sea level to peak (29,029 feet). To say that much lies below the surface is an understatement. The weight of millions of years of volcanic eruptions has actually caused the Earth’s crust to sink by five miles. Therefore, the total height of Mauna Loa from the start of its eruptive history is an astounding 56,000 feet.
The 45,000 residents of Hilo, Hawaii, while living among some of the most beautiful surroundings in America, also face the possibility of extinction. Mauna Loa last erupted in 2022, but lava flows were minimal. Eruptions damaged small villages in 1926 and 1950. The most recent serious threat occurred in 1984, when massive rivers of molten rock stopped just a short distance from Hilo Bay. The threat to Hilo is not an apocalypse of Pompeian proportions. No, the real danger is a slow and painful demise. If Hilo Bay fills with lava, cargo ships can’t dock. The Big Island would cease to be habitable.
Now if you think I’m about to use my newfound knowledge of volcanic peril as some kind of metaphor for the current state of financial markets, you would be absolutely correct. It’s coming down Fifth Avenue. About as subtle as Captain Kirk wearing a Bill Cosby sweater.
In my metaphor, Warren Buffett is the Pacific Ocean near Hawaii. Vast, deep, and refreshingly cool with about $325 billion of cash on hand after selling more Apple stock, according to Saturday’s 3rd quarter report. Yes, he’s got some risk from storms but mostly it’s smooth sailing. Mauna Loa is the AI bubble. As lava keeps building up, the peak gets higher. It’s thrilling… and dangerous.
Technology companies will spend $200 billion this year on capital improvements related to artificial intelligence. This technology will require the addition of 14 gigawatts of additional power by 2030. To put that in perspective, Berkshire Hathaway Energy’s coal plant in Council Bluffs produces 1,600 megawatts of electricity.
Do you think nuclear is the solution? Well, Georgia just opened our country’s latest nuclear facility. The Alvin W. Vogtle Electrical Generating Plant sits along the Savannah River in Waynesboro. This marvel took 15 years to build and cost a mere $35 billion. Its generating capacity is 4,500 megawatts.
Technology has a history of delivering miracles, but it also bears witness to a poor track record of capital allocation. Look no further than Lumen Technologies (LUMN), the offspring of the fiber optic cable bubble of 1999-2001. Lumen holds the fiber assets of CenturyLink, Qwest and Level 3. If those names sound familiar, there was nothing like the Level 3 bubble for Omahans of a certain vintage who rode the Kiewit spinoff to dizzying heights and painful lows. And we all remember the Qwest Center. Despite a debt restructuring earlier this year, LUMN remains safely in junk territory and will be fortunate to stave off bankruptcy.
You didn’t come here for macro-economic observations or a mini-course in geography. There’s investment ideas to be had.
Welltower
My contention that Welltower remains 40% overpriced relative to the underlying value of its assets took a step back after the company raised annual per share FFO guidance to $4.33 from $4.20. In my estimation, this upgraded forecast is worth $1.3 billion of additional net asset value and raises the total to $50 billion. A nice boost, indeed. Shares rose accordingly.
Despite the improved performance, my bearish outlook for Welltower remains firmly intact. If you’re scoring at home, you’ve got a REIT with a market cap of $80 billion yielding less than 2% and trading at 30 times FFO. The company also announced a $5 billion equity offering. REITs like Welltower that invest capital at modest yields are forced to turn to equity for growth when the debt gets too expensive. They become dilution machines.
CK Hutchison
There are times when value traps are like a Siren’s song. It’s like watching Lethal Weapon when nothing else is on. You know that there is no plausible reason why Gary Busey’s henchmen can’t kill Danny Glover in the middle of the desert, but you’re damn well going to watch anyway because you need proof that this cinematic muddle was deserving of three sequels. But thank God they kept going! Lethal Weapon 2 has that fantastic moment when Joe Pesci brings Danny Glover to the South African consulate and tells them he wants to emigrate to the land of Apartheid.
Anyway, CK Hutchison is the descendant of the Hutchison Whampoa conglomerate built over decades by Li Ka-Shing in Hong Kong. I wish there was an updated biography of Li who is now in his mid-nineties and has passed the reigns to his son. He certainly belongs in the business hall of fame. CK Hutchison has a market capitalization of about $20 billion and holds some of the world’s largest port infrastructure assets and telecom businesses. The stock trades at 29% of book value and offers a dividend yield of about 6%.
I ran a few back of the envelope numbers, and CK Hutchison pencils to roughly $60 billion of value. Yet, the stock has been “cheap” for many years. Why decide to invest now? It seems like the second generation of Li’s family (now in their 60’s) has figured out that something needs to be done for long-suffering investors. The company listed its infrastructure assets on the London exchange in August as “CK Infrastructure”. They have also contributed their European mobile networks to a joint venture with Vodafone.
The appeal of CK Hutchison is that its port infrastructure is irreplaceable. Unlike auto manufacturers and steel companies which deservedly trade below book value due to brutal competition, ports are generally impervious to competition. Nature only created so many locations around the globe where massive cargoes can dock. Globalization may be taking a step back, but it’s not stopping. I’m going to dig more deeply into CK Hutchison.
Until next time.
DISCLAIMER
The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.
In 1990, Jeremy Irons won an Oscar for his portrayal of the mercurial and debonair Claus Von Bülow in Reversal of Fortune. Von Bülow captured tabloid headlines for the attempted murder of his Newport socialite wife, Sunny (Glenn Close). The case seemed hopeless. Only Claus had access to the insulin that left Sunny in a diabetic coma. Evidence was only part of the problem. Claus was not exactly a warm and fuzzy guy. With his angular chin and vaguely European accent, the ascot-wearing Von Bülow was aloof and arrogant. Against the odds, the young professor Alan Dershowitz (Ron Silver) and his earnest team of Harvard Law students delivered a stunning acquittal.
At the end of the movie, Claus sits in the back of his chauffeur-driven Jaguar as Dershowitz bids him farewell, saying: “You know, it’s very hard to trust someone you don’t understand. You’re a very strange man.” As the door closes, Von Bülow deadpans, “You have no idea.”
“Strange” is subjective, of course, and context matters. Claus was probably a normal guy if your scene was 1970s ski chalets in Gstaad. To a working class jury in 1980s Rhode Island, he was eccentric.
If you’re on the artificial intelligence bandwagon, everything might seem pretty normal right now. Short term interest rates are coming down and we may be on the cusp of a new information technology miracle. In this exuberant era where the NASDAQ sets new records nearly every day, Omaha’s Warren Von Büffett seems strange. After all, he’s sitting on $240 billion of T-bills. Imagine selling all that Apple stock right when this AI thing is just starting to take off!
What’s strange? What’s normal? I like Jodi Picoult’s thoughts on the matter: “I personally subscribe to the belief that normal is just a setting on the dryer.” Ms. Picoult usually digs deep into matters of the heart, but she could just as easily be opining on the current state of financial markets.
The value of corporate equities as a percentage of GDP has only been this high two other times. While most of us mortals must pay our debts by forking over cold hard cash to the lender, huge numbers of heavily indebted firms are paying their interest bills by issuing IOUs. You need to squint to see the spreads on corporate bond yields. It turns out that nearly losing one presidential candidate to assassination, and the other to dementia doesn’t have much of an effect on markets. Did I mention there are two wars with nuclear implications going on? How about the collapse of the world’s second largest housing market? Nope, hold my beer because the QQQs keep ripping higher.
I remember the Three Mile Island meltdown. It was not an auspicious moment in American history. We had kind of a Jimmy Carter-malaise thing going down, and our status on the world stage was being put out to pasture by Ayatollah Khomeini. We couldn’t even manage nuclear power plants very well. When they said we’re re-starting Three Mile Island again because we need so much power to run these AI chips, my bullshit detector issued an alert. 🚩
Welltower (WELL) is a company that Claus Von Bülow might prefer: Very strange, indeed. Welltower stock behaves like it belongs among the exalted world of artificial intelligence – surging ahead by 45% over the past six months alone. Given the levitating stock price, it probably shouldn’t come as a surprise that Welltower’s CEO quoted Jensen Huang in his last shareholder letter. The excitement fades pretty fast when you realize that Welltower operates in the staid world of housing elderly folks.
While other senior living companies trade within a justifiable range of the value of the underlying assets, Welltower seems divorced from reality. By my reckoning, the company trades at a premium of over 40% to its underlying bricks and mortar. Welltower is a Toledo-based owner of senior living facilities that trades at a market capitalization of over $80 billion, or $132 per share. However, a reasonable valuation of the real estate indicates that the stock should trade closer to a level of $50 billion. That computes to a share price near $80.
As a real estate investment trust (REIT), Welltower is required to pay out most of its earnings as shareholder distributions. Yet the yield on offer is a paltry 2%. Growth can only be achieved by adding external capital, and Welltower has issued billions of dollars in new stock since the debt markets became less hospitable. In December 2022, the company also gained the dubious distinction of a write-up by Hindenburg, the famed short-seller, for questionable dealings with the mysterious Integra Health Properties.
Moreover, Welltower is not a simple business. WELL has a complex collection of disparate facilities throughout the country operated by a diverse set of managers. Many facilities are net-leased to other operators leaving Welltower the simple role of cashing rent checks as a landlord. Many others are operated hands-on by the company. Looking after the elderly is a tough business. You need skilled medical staff to run these properties in addition to a legion of cleaners and minders. The government is constantly looking over your shoulder (especially after the whole Covid fiasco), and Medicare money comes with strings attached.
Welltower also acts as sort of a bank for senior housing developers, with over $1.7 billion of notes receivable on the books. To complicate matters further, WELL also owns a collection of outpatient medical clinics.
There are certainly many reasons to praise Welltower. The company disposed of $5 billion of struggling assets during the dark times of Covid, and rebounded with a $10 billion acquisition frenzy over the past three years. Welltower added another $2 billion of development during that time. In 2023, operating income (including depreciation) increased by over 30%.
Hindenburg’s questions aside, I don’t see anything nefarious about Welltower. It is just really expensive. Welltower is a business which earns returns on capital around 6% and returns on equity around 7-8%. This won’t set your nanna’s pulse racing. Through 6 months of 2024 reporting, operating income has only risen 5%. Meanwhile, notes receivable from operators have doubled since 2022. Who’s borrowing from Welltower at 10% interest rates? Probably not the most seaworthy. The firm racked up $36 million of impairments in 2023 and $68 million for the TTM period to June 2024. These aren’t horrible figures, but they show that not everything comes up smelling like roses in the senior living business.
Management recently guided for $4.20 per share in funds from operations (FFO) for 2024. This preferred metric for real estate investment trusts adds back depreciation and other non-cash items. I reverse-engineered the guidance for FFO to arrive at a pro forma net operating income (NOI) for 2024 of $3.3 billion. This NOI calculation takes FFO a step further by removing debt service costs and the administrative costs of running the company to arrive at an unleveraged, asset-level value for the business.
In fairness to Welltower, the increase in NOI is substantial compared with the $2.7 billion generated in 2023. The company has certainly improved operations, pruned underperforming assets, and had much stronger occupancy levels as the post-Covid senior market has recovered. A 22% increase in NOI is impressive for any business, especially a real estate company with slow-moving assets.
How does $3.3 billion of net operating income translate into asset values? I capitalized the income using 5.97% to arrive at a gross asset value of $55 billion.
The 5.97% “cap rate” was derived using the following logic: I simply applied the spread for Welltower’s Standard & Poor’s BBB credit rating to the “risk-free” 10-Year Treasury yield of 4.07% to arrive at a current debt cost of 5.15%. I assumed that the company earns an equity yield just 1% higher than this cost of debt (6.15%) and weighted the equity percentage at 85%. One could argue that this 5.97% cap rate is slightly high. Perhaps I could impute a bigger weighting to the less-expensive cost of debt. After all, Welltower has been able to raise debt at much lower rates in the past.
My counter-argument would be that a lower cap rate would be too aggressive for a business that has a mixture of assets, ongoing charge-offs for underperforming notes receivable, and a collection of diverse and unpredictable operators assigned to the facilities. Finally, I am not making any allowances for capital improvements at existing properties. These assets require nearly $600 million per year in upkeep that is not reflected in NOI. They are, however, certainly an ongoing cash obligation for Welltower. I am being very generous by excluding them in the value computation.
To arrive at a net asset value, I added cash of $2.6 billion as well as construction in progress at book value, and unconsolidated equity interests at 1.5x book value. After subtracting debt of $14 billion, Welltower’s net asset value pencils slightly above $48 billion.
You may say that I’m not appropriately valuing the future. There’s more upside at Welltower, says you. Yes, there is more upside. Unfortunately, as a REIT which is required to distribute its earnings to shareholders, incremental growth can only come from external capital: Sell more stock or raise more debt. When you’re earning returns on capital in the 6% range and you’re borrowing at 5%, you don’t have tremendous opportunities for upside.
I am short Welltower. It’s a $132 stock that should be priced to yield in the mid 3% range around $80-85.
I could leave you with some Jim Morrison lyrics. Instead I will give you something special by Wire. Or you may prefer REM’s 1987 cover version:
“There’s something strange going on tonight.
There’s something going on that’s not quite right
Joey’s nervous and the lights are bright
There’s something going on that’s not quite right.”
Until next time.
Disclaimer:
The information provided in this article is based on the opinions of the author after reviewing publicly available press reports and SEC filings. The author makes no representations or warranties as to accuracy of the content provided. This is not investment advice. You should perform your own due diligence before making any investments.