iStar Inc (STAR) 2003 Q2 法說會逐字稿

Good day. And welcome to the iStar Financial Incorporated Second Quarter Earnings Conference Call. Today's conference is being recorded. At this time, for opening remarks and introduction, I would like to turn the conference over to iStar Financial's Executive Vice President of Capital Markets, Mr. Andrew Richardson. Please go ahead, sir.

Thank you operator and good morning everyone. Joining us today are Jay Sugarman, Chairman and Chief Executive Officer; Katy Rice, Chief Financial Officer; Tim O'Connor, Executive Vice President and Chief Operating Officer, and Colette Tretola, Senior Vice President and Controller.

Before I turn the call over to Jay, I want to inform you that the call is being simultaneously cast on our website. We also have a replay number, 1-800-475-6701 with a confirmation code of 690985. Before we begin, I need to inform you that statements in this earnings call, which are not historical facts, may be deemed forward-looking statements. Factors that could cause actual results to differ materially from iStar Financial Inc. expectations are detailed in our SEC report. Now, I would like to turn the call over to iStar Financial Chairman and Chief Executive Officer, Jay Sugarman. Jay.

Thanks, Andy. Welcome -- thank you all for joining us today. The second quarter 2003 was another strong one for iStar. We continue to expand our market leading position in the high-end real estate finance role. Earnings reached another all-time record and our shareholders benefited as we began expanding our shareholder base. Conclude a much broader range of institutional investors and that's an activity at net interest margins continue to be strong, offset somewhat however by lower interest rates and increased repayment activity.

I think by far the most interesting dynamic in our market right now, involved the various aspect of what continue to be historically low interest rate. So let me quickly walk you through what we are seeing on that front. Here's our conclusions about how ultra-low interest rates impact iStar.

One, origination volumes go up. Demand for our customer focus financing has increased pretty materially, in fact through the first six months of this year, we have closed almost the same number of transactions we closed in all of 2001. Two, repayments go up. Borrowers are pursuing opportunities to lower their cost of capital, often times to below the rates at which we can meet their needs given our current ratings and cost of capital. Three, spreads go up. Impacts of rate floors and the stickiness of cap rates allowed some incremental room for spread to expand. Although increased competition will generally drive those spreads back down over time. Four, total absolute yield fall. Since we are in a spread business, when base rate fall, the total yield recharge borrowers fall, as well. Five, leverage is important for us.

We try to take advantage of the same spread compression and low overall base rates as our borrowers are, in an environment like this. And given the high percentage of first mortgage activity at iStar, leverage levels will edge up. Six, returns on equity edge down. This is a function of low base rates again. We are still earning the same or higher net return on equity spread, but those spreads are now on top of base rate that are hundreds of bases points lower. And seven and finally, the value of that return on equity goes up. A company that can earn 18% returns on equity in a 4% charging market is a fundamentally more valuable company. So while earnings grow this difficult to increase beyond our plan in this environment, generating strong, steady increment dividends with higher returns on equity have made existing earnings and earnings growth all the more valuable.

The net effect of all this appears to be something of a neutral at least on our earning. Activity certainly rises, earnings will continue to grow near expectations and variations will still be driven primarily by two things; timing of transactions and a share-count dilution created by changes in our stock price. So net net the interest rate picture hasn't really changed our business fundamental that much, although, it has perhaps changed the relative value of our business in the capital market.

We'll turn now to the real estate collateral picture. We're still waiting to see a pickup in the supply demand equation that will improve market condition.

Obviously, as the finance company making loans at moderate loans of value level, we are much less impacted by the weak real estate market conditions out there. But we did see the equity owners of most property types and some of our borrowers still feeling the effects of the bottoming market. Based on our most recent risk ratings; however, the quality of our portfolio continues to be very strong and very stable. We do have a few loans on our watch list, or all of these are still fully performing. We added one new office loan to that list, which lost the tenant and so occupancy fell to 80% as a result.

On the other hand, we will likely be removing an existing watch list loan in the near future. So, the total should be relatively constant on the loan side. On the corporate credit side, we still have just a handful watch list credit, totaling 3 out of the nearly 120 credits in our corporate tenant lease portfolio with the latest addition being another telecom credit we inherited as part of the Trinet transaction. With good property flow back in those few watch list corporate credits, we still feel quite comfortable with our asset positions there. One other note on the corporate tenant lease side in the last quarter, we did see most of our corporate tenant lease activity last quarter to take longer to close than expected. But we think most of those transactions will now close in the third quarter bringing our annual corporate tenant lease volume back in line with our earlier projections. The bottom line, as there is still a lot of money shaping our particular line of business and good opportunities are taking longer to get closed. Now, lets cover some specifics, let me turn it over to Katy. Katy.

Thanks, Jay. Good morning, everyone. I'd like to cover three topics. First, I'll summarize our results of the second quarter then talk about our earnings guidance. Then I'll talk about risk management and credit quality, and finally, I'll review our capital markets activities and balance sheet position. Let's start with our results. As Jay mentioned, we had another strong quarter, particularly in light of this continued softness in the economy.

Our adjusted earnings came in at 80 cents per diluted common share, right inline with consensus. Our net investment income rose to 87 million. Our return on assets was 6.1% and our return on equity for the quarter was 18.7%. Our leverage increased slightly to 1.8 times book equity. Second quarter interest coverage was 2.7 times, and our fixed charge coverage was 2.3 times. Our payout ratio for the second quarter was 81%, and our unencumbered asset to unsecured debt ratio was just over 2 times. Lets turn to new business, our investment team had another busy quarter. We originated 13 new transactions with total capital commitment of 487 million.

As expected, repayments were up this quarter. They totaled 329 million. Approximately, 58% of the dollar volume of this quarter commitments was made through repeat customers. This is just a statistic that we track closely. More and more of our customers are recognizing that we provide a unique level of service and flexibility, and they are willing to pay a premium for this service. Repeat customers are our best source of new transactions and are our real validation of our business model. This quarter, we continue to originate assets with an emphasis on security and credit, with first mortgages and participations in first mortgages accounting for over 86% of our volume. 83% of our new loan volume this quarter was floating rate and 17% was fixed rate.

Geographically, we continue to diversify our asset base with 35% of our new commitments located in the western region, 19% in the Northeast, 16% in the South and Southeast and 16% in the central region. Our in-place net interest margin at the end of the quarter was down slightly to 393 basis points, primarily due to the higher volume of floating rate loan origination. This is still a relatively high number, as we generally think of net interest margins in this 350 to 400 basis point range, as very good. Currently, over 60% of our floating rate loans have LIBOR floors, which average about 2.3% with LIBOR's historic lows currently at 1.1%. These LIBOR floors are providing an additional boost to our net interest margin.

In the prior two quarters earnings releases, we issued 2003 adjusted earnings guidance of $3.22 to $3.28, per diluted common share, based on net asset growth of 800 million to 1 billion. With interest rates remaining low, we're expecting repayments to be higher than forecast nine months ago and are currently estimating repayments in the $900 million range for the year. Our origination volumes are also exceeding our original projection. We're expecting originations of approximately 1.8 billion this year. So, we're still comfortable with our net asset growth assumptions of 800 million to 1 billion.

However, historically low interest rates result in lower full dollar earnings generation, even with continued strong net interest margins and origination volume. The impact of lower rates is difficult to accurately calculate given the mix of our originations and repayments and the size of our asset base. At this point in the year, we believe that our strong origination volume is generally offsetting the impact of lower rates.

However, we continue to monitor this important dynamic and the impact it may have on our future earnings. As most of you are aware, our stock prices increased to around $28 at the beginning of the year to a little over $37 today, a 32% increase. Our earnings model assumed share price growth later in the year, and therefore, we did not anticipate a level of increased diluted shares that we're expecting today. At today's share price, the dilutions from in the money stock-based compensation, stock options and warrants is expected to be in the 3 cents to 5 cents per share range.

So, with respect to our 2003 earnings guidance, we are issuing revised adjusted earnings per diluted common share guidance of $3.20 to $3.25 for the year or about 2 cents to 3 cents lower than our previous guidance. We're also revising our annual GAAP EPS guidance by a similar amount to $2.34 to $2.44 per share. As you know, the principal difference between GAAP earnings and adjusted earnings is non-cash depreciation and amortization. Because we're required to depreciate our own corporate tenant lease assets changes in the mix of our origination volume between loans and leases, which otherwise does not have a significant impact on adjusted earnings could result in more GAAP earnings volatility.

For these reasons, we will generally issue quarterly and annual GAAP EPS guidance with a wider range than our adjusted earnings guidance. With respect to the third quarter, we expect to generate adjusted earnings per diluted common share of 81 cents to 82 cents. We expect GAAP EPS of 62 cents to 64 cents. We've provided a reconciliation of GAAP EPS and adjusted earnings on page 11 of the press release. Now, lets turn to risk management and credit quality. As you know, our risk ratings are the result of our quarterly credit review, which is a two-day bottom of review of each asset. Last quarter, we refined our risk rating system for loans in order to better reflect two statistics that were implicit in our prior ratings system.

The first is our assessment of the risk of principle loss and the second is how the collateral is performing compared to our original underwriting. We continue to use a scale of one to five in rating each asset, with one being the best rating and a five indicating a problem asset. We have included both of these loan rate risk ratings in our earnings release. We believe that breaking out those statistics will enable you better understand how the risk to recovery of our principle is relatively insensitive to fluctuations in underline real estate markets conditions and changes in collateral performance.

In this quarter, despite of challenging economic environment, our overall asset quality remained strong. With respect to our loans, the weighted average rating for risk of principal loss was 2.52 and for performance compared to original underwriting, the average increased slightly to 3. The average of these two ratings was 2.76, up slightly from last quarter's rating of 2.75. For our structured finance portfolio, the in place debt service coverage at the end of the quarter remained a very strong 2.2 times. This is based on actual cash flow or trailing 12 months cash flow and current interest rates. Our last dollar loan-to-value was 68.7%. So, overall, our borrowers continue to have significant equity investments to support our loans.

Now lets move to the CTL portfolio. Our CTL risk ratings continue to reflect our assessment of the quality and longevity of the cash flow yield from the assets. The average risk rating of our CTL assets at the end of the second quarter was 2.79, an increase from the prior quarter's rating of 2.76. Our CTL portfolio remains well leased at 94.9% with the weighted average remaining least terms of 9.2 years. Lease exploration for the remainder of the year represents just 1.8% of our annualized total revenue for the second quarter of 2003.

A part of our risk management process, we monitor the credit profile of the performance of our corporate tenants. At the end of the quarter, over 87% of our corporate tenants lease customers were public companies or subsidiaries of public companies and 54 % were investment grade or implied investment grade. This gives us good visibility, which reflects you the credits underlying our leases. In addition to reviewing our risk ratings each quarter, we also determine whether assets should be added to our watch list or put on non-accrual.

At the end of the quarter, we added two loans to the watch list. The first loan which has a book value of 30 million, is collateralized by an office building that is experiencing near-term tenant rollover in a fairly soft market. The second loan which has a book value of 3 million is collateralized by a retail property, which is also experiencing operational weakness. We added one corporate tenant lease with a book value of 41 million to our watch list due to the tenants credit deterioration. The watch list now includes seven loans and three CTLs with a total book value of 189 million.

This quarter, we put two assets on non-accrual. The first is a $13 million loan secured by a hotel asset that continues to experience weak operating performance. The second is a $7 million loan secured by an office property that is experiencing increasing vacancy. While both these loans are current, we believe that placing them on non-accrual is appropriate. We also removed two loans from our non-accrual list this quarter. The first we paid in full and the second was moved from non-accrual to our watch list because the underlying collateral is generating sufficient cash flow to adequately cover debt service. We now have three assets with an aggregate book value of 24 million or 0.4% of our total book value on non-accrual.

We continue to monitor our watch list in non-accrual assets very closely. As we give each quarter, we continue to build loss reserves. While we continue to maintain one of the strongest credit track records in the industry, we want to be sure that we are well protected in the event that credit issues arise. Our general loss reserves and asset-specific cash reserves total 202 million or 586 basis points at the end of the second quarter. With respect to our corporate tenant leases, our cash deposits letters of credit and accumulated deprecation, total 250 million or 984 basis points of book value as of June 30.

Based on the size and diversity of our asset base and the reserve levels that we have built, we are comfortable that the extent were to suffer a credit loss, it would not have a material impact on our overall results.

Finally, let me walk you through our recent capital markets activities in our balance sheets In May, we completed the third successful offering under our proprietary iStar Asset Receivables or STARs' program, which match funds' assets and liabilities with on-balance sheet debt. We issued 646 million of investment grade bonds backed by approximately 739 million of our structured finance and corporate tenant lease assets. Our STARs investors once again acknowledged the high quality of our collateral and the value of iStar sponsorship. The transaction was well oversubscribed and we were able to price the bonds at very attractive spreads. We used the proceeds to repay outstanding borrowings under our credit facilities.

Also, during May, SOFI-IV, formally our largest shareholder, contributed 15.9 of the 20.1 million iSTARS shares that the funds held for the limited and general partners of the fund. Some of the holders then sold 6.9 million of the shares distributed to them in an underwritten public offering. After the offering, SOFI-IV held 4.2 million shares, which is less then 5% of our common shares outstanding. This distribution was the successful conclusion to SOFI-IV's quarterly liquidation of their position in iSTAR. Since October of 2001, we've generated over 50 million shares of demand for our stock for SOFI-IV. And we are hopeful that the recent distribution eliminates any perceived overhang on our stock.

In July, we completed an underwritten public offering of 5.6 million shares or approximately 140 million of 7 7/8% Series E Cumulative Redeemable Preferred Stock. The Series E Preferred was issued in exchange for 140 million of our 9.5% Series A Preferred. We did not receive any proceeds from the offering, however, the transaction results in over 2.2 million of annual savings on our Preferred dividends. In addition to reducing the companies overall cost of debt, our financing activities this quarter enables us to introduce our story to a variety of new investors.

One of our goals in 2003 is to continue to expand our shareholder base by proactively targeting potential new investors and increasing their awareness of our company and its track records. This year, we also remained highly focused on achieving investment grade ratings from Moody's and S&P. We've scheduled our annual update meetings with each of the agencies this fall and believe that we will be able to provide them with a compelling case for an upgrade. We continue to have plenty of financing capacity from their pipeline. Currently, we have five credit facilities with the total committed capacity of 2.7 billion and just 1.1 billion drawn at the end of the quarter. We have no meaningful debt maturities until 2005, but we continue to have plenty of liquidity to fund our growth for the remainder of 2003. And with that let me turn it back to Jay.

Thanks, Katy. A lot of information. There're really just two things I want to follow up on, Katy talked about repeat customer business and about the company's rating. Obviously, those two things do go hand-in-hand, nothing is more important to us than being able to meet all our customer needs quickly and efficiently.

Right now, we are blocked out of a certain percentage of our customers business simply because of our cost to capital, which is the result of our rating. I think if we look at the strength of our balance sheet, the strength of our franchise, how we stack up on a relative basis, the companies that are rated significantly higher than us, I think we look forward to being granted access to the same cost of funds, the same ease of capital raising that many of our larger competitors who are much higher levered and frankly are in much tougher business environment than we are -- if we can get that same advantage, I think that customer retention number will stay very high. So, as we head into what look like an unusually busy third quarter for us, I think we'll just go ahead and open it up for question. Operator.

Thank you. Ladies and gentlemen, if you would like to ask a question please press "*" then "1" on touchtone phone. You will hear tone indicating you've been placed in queue. You may remove yourself and queue at anytime by pressing the "#" key. If you are using a speakerphone, please pick up your handset before dialing. Our first question comes from Michael Hodes with Goldman Sachs. Please go ahead.

Hi, good morning. Three quick questions for you. Jay, in your comments you mentioned that on the commercial lease side that there was a fairly decent size pipeline again in the quarter and I also noticed that there were no corporate channel lease assets originated in the quarter. So I bet you what you were saying is that a lot of that stuff slipped into July in that -- it doesn't represent current change in outlook for that part of the business?

Yes, that's exactly, right Michael. This is a timing issue but I will tell you that business has gotten very competitive, so the lead-time, try for actually closing deals and look like they are lengthening at the static [inaudible] shift. But for the second quarter, it's simply a matter of deals we felt we could get closed, did not close. And obviously, we don't set the time frame for our closings -- we are a customer focused business. They tell us when they want to close, we show up.

Okay and then the second question pertains to other income. I noticed that it jumped up a little bit versus the first quarter. I'm wondering if that's a function of the pickup in refunding activity?

No question. I should have mentioned that one of the seven impacts of ultra low interest rates are repayments go up. When repayments go up, other income goes up. They do, kind of, go hand-in-hand.

Okay. And then lastly, in a press release there was a comment about your decision not to pursue of the new business initiatives that's been -- that you guys have been evaluating since the beginning of the year. May be you can elaborate on that a little bit?

Yes, we have a regular review of what's going on in the world and the market. We actually set up a formal process headed by Spencer Haber at the beginning of the year to explore some of the businesses that look like they would fit inside our universe. I will tell you we are going great guns in our core business and really still like the risk return there better than almost anything else.

We did find some attractive businesses, particularly on securities side of the world, where we think we have a relatively good, strong understanding of the risk return dynamic. I don't think any of those businesses necessarily fit in a publicly traded company that qualifies as a REIT. There are things that while they are attractive they are not things we're going to pursue at this time inside the company. Yes, we'll continue to look at those areas down the road, but I would tell you for the next 6 months, 12 months, we feel very good about the core business, and that's where we are going to spend our time.

Great. Thanks a lot.

Thank you. Our next question comes from Don Destino with JMP Securities. Please go ahead.

Hey guys, a couple of questions. First Jay, last quarter you mentioned that I think the pricing and fundamentals for some of the products outside of your CTL and first mortgage businesses were looking more attractive and you made a little bit of mention of it in the press release. I was hoping that you could may be elaborate a little bit on which of those businesses look attractive, and if its just the pricing that is making it more tempting or if that is also a commentary that you think that fundamentals have troughed, and you are willing to maybe go a little bit higher in the capital structure or do some more of your corporate finances and that, kind of, thing.

Yes, Don, I guess two things I would tell you. One, we had hoped that we'd see a little more uptick pressure in the market literally across every product -- property type. We still see kind of bumpy bottom forming, but we haven't seen any signs - we've seen a little bit more activity, but we haven't seen any real change in the supply demand fundamentals out there. And I think before we start going a little deeper in the capital structure, we want to have a pretty good viewpoint that supply demand is fundamentally turning a corner.

You saw, again, a very heavy concentration on relatively safe positions in the capital structure this quarter. We certainly have the capability and the fingertip feel for the market to shift into higher return opportunities when they present themselves. I think on the corporate side, we'll probably see those opportunities first. We are consciously still turning away higher return business until we see something on the supply-demand side that makes us a little more comfortable.

We are actively engaged in a number of transactions that need our expertise, and I guess that's the second part of your question. It's not just the function of price and risk of war. It's also a function of where do we bring something special to that borrower that he is going to value and pay a premium for. And I would tell you on the corporate side may be more so than the junior side right now we think we can bring a competitive advantage to balance sheets that are trying to take advantage of that uptick when and if it happens, we want to be standing right there for them with any type of capital they need. And again, I think it's one of the reasons why ratings are actually very important to us because we want to be thoughtful about how we respond to customer requests as opposed to right now. They're essentially just [a clip]. Below a certain return, we can't make ROE, we have to tell them go somewhere else. I think with a more appropriate cost of capital, you will see us to be able to play a larger role in our customers' capital raising.

Okay. Well, that's actually a good bridge into my next question, which is that it looks like you are at least starting to get close to bumping your head against where you want to be from a leverage basis. Would it -- first of all, is it reasonable to think that you'd want to bring some more capital in some time relatively soon. And secondly, would it make sense just to make the ratings process more of a slam dunk to do the capital raise and bring the leverage down before you go to the rating agencies for the review.

Yes, I know Katy's shaking her head. Remember Don, we do not believe we are anywhere close to a leverage level that should impact our ratings. In fact, at two to one, we think we are still under levered relative to what we feel is the product mix right now. Remember, first mortgage loans, high-grade investment grade CTLs should be levered differently than the rest of the product mix. Given that we just came off of literally eight quarters where we have concentrated on relatively safe stock that should and will be levered more highly than stuff that lowered down on the capital structure. We don't feel like 1.8 times is even close to a point where the agency should have qualms about giving us a ratings upgrade.

So I want to caution all of our listeners. We do not think this upgrade is based on any set leverage level or any additional equity capital coming in the business. We think when they go through the scenarios there's just literally no scenario where our creditors could ever have an issue. That seems to us to justify investment grade credit ratings. I think the product mix, the underlying quality of cash flow should determine whether we run at 1.7, 1.9 or 2.0, and I think over the last eight quarters, we have done nothing but lean on the safer higher quality cash flow stream.

So I feel surprised that if there is any push back on, jeez you're at the higher end of your range because naturally as we push towards first mortgages and investment grade detail, you do need to take advantage of the fact that those are safe cash flows and lever them effectively and appropriately. Based on our last capital adequacy, we are still way over-equitized relative to single A finance world. I just don't see any pressure coming from that quarter. Should we or will we raise equity capital when it's appropriate? Absolutely. I think Katy can probably answer when we think that is but it's not in a near-term timeframe.

Got it. Let me ask you actually one more quick question about the repeat customers. Can you give us a sense of -- was most of that refinancing of your own loans out to those customers or are those customers also coming for new financings?

Yes, it's mostly brand new transactions. Sometimes an asset will trade from an existing owner to a new owner and we will provide the financing to the new owner, because we know everything about the asset. You know, that's a, it's not a refinancing per se, but it is the same asset being financed again. In many of our deals we put the borrower's name and then we have roman I, II, III, IV, V, or VI. It's literally the sixth time we've done a deal with them.

Right.

New asset, new opportunity, new transaction: they come back to us and say, "Look, you know everything about me. We've already done documents five times." It's just a heck of a lot easier for them to do business with us again.

Got it. Thank you very much.

Thank you, we now have a question from Jack Micenko with Lehman Brothers. Please go ahead.

Hi, good morning. I was wondering if you could drill down a little bit more on the 3 to 5 cent differential in guidance from this quarter versus last in terms of how much of it is rate and how much of it is dilution. If I run the dilutions to the model I'm getting about 3 cents. And you said 3 to 5, and I am wondering because of lower rates is that incremental 2 cents or rate driven function. And if it is, what is the, sort of, move in the 10 year yield backup north of 4%. Does that, maybe, potentially lessen the chance of that 2 pennies coming in this year or -- could you just talk around that a little bit if you could?

Sure. Hi Jack, this is Cathy. Really, the reduction to our guidance of 2 to 3 cents is really right now driven by the dilutive effect of our increased stock price. We're not taking into account. It's actually fairly difficult in our portfolio to calculate the impact right now of the lower interest rates. As volumes of origination have increased, we do think we're offsetting that at this point, but obviously the dilutive effect of our increased stock price is about 3 to 5 cents annually, which we can calculate, and so we are reducing the overall guidance by 2 to 3 cents.

Okay. Great. Thanks a lot.

Thank you. And once again, if you have a question or a comment please press "*" then "1." We'll move on to Anne Maysit of Deutsche Bank. Please go ahead.

Good morning. My leverage question was answered. The other question I had was with respect to a comment that you made in when you look at assets and make a determination whether they go on non-accrual or under the watch list. What is the determining factor that decides which option the company selects and then the second question is to confirm that the two loans were placed on non-accrual were previously on your watch list?

Yes, Hi -- as we talked about the watch list is really more of a management tool, we get together quarterly on a formal basis and review each asset, but we also talk about our assets weekly at our Monday morning meeting. And assets that we see that may be having deterioration in the collateral, maybe having coverage problems, we do put on our watch list, so that's really more of a management tool. The non-accrual loans, well there is an accounting definition, which we do review in our Q's and K's. We frequently will put something on non-accrual despite the fact that it is still paying and we are still booking the interest and principal payments when they do come in. But we typically note something and generally they have been on the watch list before they are put on non-accrual but we see something that is, either continued deterioration or changes in a posture that from a - in a conservative perspective and really wanting to guide you all, we don't feel its appropriate to book the income if we are not certain it's going to come in.

Thank you. And the two loans?

Yes, both of the loans that we have put on non-accrual this quarter were on our watch list.

Thanks. Thanks so much.

Thank you. And we have no further questions at this time. Please go ahead with your closing remarks.

Again I want to thank all of those who have joining us on the phone and on the web today. Again, we think this is a very interesting market, lots of new forces that work for us, its actually a good opportunity to continue to expand our franchise, as I mentioned, the origination activity does that mean we're in front of more customers getting more chances to demonstrate how iStar is different than other capital providers, long-term as a very powerful positive force and we look forward to taking an advantage of that in the third quarter and will talk to you then. Thank you.