Playing Inflation Part 2

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Warren Buffett famously told investors that if they wanted to prosper during periods of inflation, then they needed to buy companies with high returns on capital and pricing power. As a result, it should be no secret why a company like Coca-Cola (KO – USA) trades so richly—it’s being priced as an inflation resistant Treasury, and investors are crowding into it. As with most things related to Buffett, everyone listens, but then the critical thinking stops.

Sure, if you want to survive during inflation, then you should buy businesses with inflationary pricing power. But what if you want to dramatically outperform during a period of inflation? What do you want to own?

In my mind, I want to own hard assets that are trading at a dramatic discount to their replacement costs. However, I do not want any random assets. I want high quality and scarce assets where the cash flows will eventually justify the replacement cost. Importantly, I want to own assets with minimal recurring costs of maintenance. Along the way, I want cash flow, preferably lots of it. Finally, if I can do this on a slightly levered balance sheet, that should dramatically improve my returns—though excessive leverage could be deadly.

If you follow this thought exercise through to its logical conclusion, I believe you’ll end up owning lots of companies like St. Joe (JOE – USA) and Valaris (VAL – USA). I should know, as I did this exercise and ended up with those two being the largest equity positions in my fund.

Let’s examine how this works in practice. VAL owns one of the largest offshore fleets globally. I am estimating that the replacement cost of this fleet, based on industry sources, is approximately $25 billion (16 floaters at $1 billion each, 33 modern jackups at $250 million each and 50% of the ARO JV with 7 additional jackups), which admittedly is a very abstract number and may be directionally correct, though likely to be incorrect with any order of precision .

At $76 a share (August 4th, 2023), VAL has an enterprise value (EV) of approximately $5.5 billion. Let’s stick with round numbers here and call it a $5 billion EV. Using the above estimations, the company’s EV is 20% of replacement cost. Now, let’s assume that the replacement cost of the fleet increases by 10% due to hypothetical inflation of structural steel, labor and all sorts of assembly costs. As a result, replacement cost would now be $27.5 billion. Interestingly, that increase of $2.5 billion would be 50% of the EV. If inflation accelerated to a hypothetical 20%, then you’d have a $5 billion increase or 100% of the EV.

As you can see, there’s huge leverage to inflation here given how low the EV is when compared to replacement cost. The leverage to inflation certainly appears to be much greater than if Coca-Cola simply raises its pricing by the inflation rate each year.

Of course, the rigs are not currently worth replacement cost, so this is an abstract exercise. Furthermore, you wouldn’t want to replace the current rigs, when there are newer designs available. That said, I’m taking a certain leap of faith that at some point in this cycle, dayrates will increase to the point that the existing rigs will actually be worth their estimated replacement cost, and potentially even a premium to replacement cost. Otherwise, how will new rigs enter the fleet and satiate the rapidly increasing demand?? Of course, a wave of newbuildings may obsolete the current fleet. However, in the unlikely case that excessive dayrates spur a round of newbuildings, and eventually obsolete VAL’s fleet, this whole exercise has been more than worthwhile as the company will have likely earned at least the replacement cost in free cash flow, and potentially multiples on the replacement cost, before that happened. Meanwhile, on my thin sliver of EV, in our thought experiment I’m making theoretical returns of 50% a year assuming 10% annual inflation in newbuild costs while I await this dream scenario.

I believe that VAL will spew cashflow. Looking at recent industry press releases, dayrates are approaching $500,000 for a floater and $200,000 for a benign jackup. Assuming those dayrates and current utilization rates for the fleet I believe VAL will produce slightly less than $3 billion in pre-tax cash flow annually after maintenance expenses. That’s 55% of the current EV of $5.5 billion. More importantly, I suspect that a good chunk of that cash will get returned to me as a shareholder, given that it’s highly unlikely for the company to build new rigs, at least not until current values exceed replacement costs. Until then, they’ll likely buy back shares at what I think is a massively accretive discount to replacement cost, and potentially pay me a dividend. Eventually, I believe that the shares will accrete to replacement cost, by which time I will have picked up my 5-fold accretion, plus whatever the impact of inflation is on my replacement cost, plus some healthy cashflow too.

This seems like a much better way to play inflation than a consumer product name. Sure, Coca-Cola is a much higher quality business, but everything is relative as an investor, and the goal of this exercise is to get leverage to inflation.

Let’s chat about JOE, as it’s the largest equity position in my fund. As opposed to VAL where the assets are worth well less than replacement cost today, JOE’s land is actually worth current land values. Naturally, I believe this dramatically reduces the risk of owning JOE when compared to VAL.

While precision is difficult when valuing land assets, I believe rather strongly that JOE’s current Net Asset Value (NAV) is between $200 and $300 a share. This is calculated using a range of $100,000 to $150,000 of value per acre (our own internal model) and applying it to the approximately 120,000 buildable acres that JOE owns, and then adding in approximately $1.5 billion of cash flow producing real estate, net of debt and cash, divided by the approximately 58.3 million shares outstanding. I realize that $200 to $300 a share is an incredibly broad range of values, but it is simply impossible to fully calculate the value of the assets with any better precision because of the variability in acreage relative to the size of JOE’s holdings. Could the NAV be demonstrably higher? Of course. Could it be materially lower? I’d say it’s highly unlikely based on where recent transactions have been occurring, but it would be unfair not to remind you of the difficulty in being precise here.

What’s far more interesting, is that JOE’s landbank appears to be appreciating at somewhere between 10% and 15% a year. This is calculated simply by adding the population growth of their two core counties (Walton at 10.6% and Bay at 5.7% according to company presentations) and the 12-month average of YoY CPI. Of course, it doesn’t hurt that every time JOE builds something of value, the land surrounding it also appreciates, as adding population, infrastructure and amenities naturally makes the surrounding land more valuable.

If you use the lower bounds here of $200 a share and 10% growth, you accrete $20 a share from land appreciation. At the higher bound of $300 and 15% growth, you’re accreting $45 a share. What’s fascinating is that this value creation is all tax free, until a realization even happens for the company. In a strictly numerical sense, based on the current share price of $60 (August 4th, 2023), you’re earning between 33.3% and 75.0% annually assuming the same levels of population growth and inflation. As a believer in structural inflation, it’s important to note that, every 1% increase in the inflation rate will add somewhere between $2 and $3 a share to the growth of value or 333-500 basis points of annual value appreciation, using the NAV bands calculated above. See how the multiplier works on an asset that is trading at a huge discount to NAV??

This business earns a few dollars a share in annual cash flow from operations, before adjustments for new property start-up expenses. More importantly, JOE invests to develop commercial real estate. During 2022, it spent $251.8 million on development activities. Assuming a mid-teens stabilized yield on development activities and a capitalization rate in the high single digits, I believe it’s unlikely that JOE didn’t at least double its money on these activities, representing at least $6 a share in additional value creation. In total, JOE is likely producing approximately $10 a share of additional annual internal value creation before the land appreciation, assuming that 2x return on development activities and a constant level of reinvestment. Put it all together, and I believe that JOE is creating between $30 and $55 a share in NAV accretion currently, or between 50% and 91.7% annually, based on the $60 share price. For me as an investor, what’s fascinating about this scenario is that this NAV accretion is occurring at a company with minimal financial leverage. If anything, I’d prefer that they took on more debt and used it retire stock at a discount to NAV.

This is where the math gets quite fascinating. While buying stock at somewhere between 20% and 30% of my estimated NAV is amazingly accretive, I believe other activities are even more accretive. JOE recently broke ground on a new medical facility. As retirees are a major demographic buying homes from JOE, this is very likely going to increase the value of the landbank. The exact value of any particular improvement to the region is hard to calculate so I’ll use round numbers for illustration. What if it adds $10,000 per acre to the 120,000 acres that they own? That would be approximately $20 a share in accretion, while $25,000 an acre would add $50 a share to NAV. That’s far more accretive than simply buying back shares.

It’s my opinion that almost every time JOE does something, whether it’s building a medical facility or simply adding a new shopping amenity or marina, it adds value to all of its other land. There’s a flywheel here and I think it keeps spinning faster and faster each year, as evidenced by the rapid growth in the population of the two counties where JOE is so dominant.

Ultimately, if the business can continue to increase NAV by 15-20% or more a year (the net of land value accretion + cash flow + value creation from development outlined above), I suspect that the shares will eventually trade at a premium to NAV. Why couldn’t the shares trade at 1.5 times NAV once the market understands the myriad ways that NAV can expand at rates far faster than simple land appreciation??

Returning to the inflation narrative, I’m of the view that inflation is now structural. The rate of inflation will wax and wane over time, but higher levels of inflation are now permanent and likely to be higher in the future. If that’s the case, then I want to own assets that not only give me inflation protection, but a whole lot of torque to future levels of inflation.

Despite recent appreciations at both JOE and VAL, they seem to offer tremendous upside still. I feel that most investors are still too focused on cash flow as opposed to NAV when analyzing these assets and are missing the inherent value available in their asset intensive balance sheets. In an inflationary environment, it is my view that NAV is a second and potentially more torqued lever to drive appreciation, while earning cash flow along the way.

Most investors are wed to prior models, models that came of age during the past few decades of declining interest rates and inflation. As a result, they don’t recognize many of the prior rules are now inverted.

These rules should be obvious to those who have studied inflation. However, I believe very few have truly studied inflation. If they did, they would know that there are better ways to play it, especially early in the cycle when most investors are still focused on cash flow. That cash flow will come, but for now, asset appreciation is what matters to me.

Disclosure: Entities that I control are long JOE and VAL.

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