iStar Inc (STAR) 2003 Q4 法說會逐字稿

Good day, and welcome to the iStar Financial Inc. fourth-quarter and fiscal-year 2003 earnings conference call. Today's conference is being recorded.

At this time, for opening remarks and introductions, 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 an access code of 718879.

Before we begin, I need to inform you that statements in this earnings call which are not historical fact may be deemed forward-looking statements. Factors that could cause actual results to differ materially from iStar Financial's expectations are detailed in our SEC reports.

Now, I'd like to turn the call over to iStar Financial's Chairman and Chief Executive Officer, Jay Sugarman. Jay?

Thanks Andy, and welcome. And thank you all for joining us today. This morning, we reported earnings for the fourth quarter and full year 2003, completing another year of strong growth and exceptional performance for our shareholders. iStar has continued to serve the high end of the commercial real estate finance markets with innovative strategies and a truly single-minded focus on delivering the best custom tailored capital solutions for our customers. What we're seeing is as our customer base has grown and our cost of capital has been reduced, we're finding ourselves well positioned to provide a wide range of capital to repeat customers on a noncompetitive basis. We expect this dynamic to continue to drive our business and our growth throughout the coming year.

Turning to full-year 2003 results, we finished the last year with significant achievements in a number of areas. Let me just tick those off. First, earnings reached an all-time high of $338 million, or $3.25 per share on an AEPS basis. Second, new originations reached a record $2.2 billion during the year, a 20% increase from 2002. Third, return on equity finished at over 19% despite running at average leverage levels that are still well below our conservative stabilized leverage targets and significantly below other commercial finance companies. Fourth, we continued to strengthen our already strong balance sheet with additional equity capital, giving us almost $2.5 billion of tangible book value and began our transition to unsecured debt capital through a series of transactions that Katy will outline in a minute. Fifth and finally, total shareholder return was just under 50% for the year, completing a four-year period in which iStar shareholders have enjoyed returns that have dramatically outperformed all major market indices.

That's 2003 on the whole. Let me turn now to the fourth quarter in particular. As I've mentioned in prior calls, the velocity of our business continues to increase, with iStar closing 16 separate transactions this quarter. With 75% of that transaction volume coming from first mortgages and corporate tenant leases, and an average investment size of less than $30 million per transaction, we continue to increase both the quality and the diversification of the portfolio. Interestingly, over two-thirds of the deals represented repeat customer business, and we continue to work closely with our existing customer base to avoid some of the overheated conditions we see playing out in the more competitive areas of our business.

As you saw in our release, earnings came a penny above guidance at 85 cents per share on an AEPS basis. That represents a 10% increase from the fourth quarter of 2002. And returns on equity and net interest margins remained strong and slightly above our expectations.

We have mentioned in various forms over the past year that hotel lending represented one of the most attractive areas to generate strong risk-adjusted returns throughout most of 2003. Not surprisingly, we made significant investments in that sector up to and including the fourth quarter of the past year. However, I will tell you we believe the winds have shifted again and in our minds, the number of opportunities in that sector appear to be diminishing. We have identified a few interesting situations still in that sector going forward, but we would expect hospitality lending to decline unless market conditions change again.

I want to talk more about the market and our investment strategies in a minute, but let's have Katy fill you in on the specifics of the fourth quarter. Katy?

Thanks, Jay. Good morning everyone. I'd like to cover three topics. First, I will summarize our results for the fourth quarter and the fiscal year ended 2003. Next I'll talk about risk management and credit quality and finally, I will review our capital markets activities and balance sheet position.

Let's start with our results. As Jay mentioned, we had another strong quarter. Our adjusted earnings came in at 85 cents per diluted share, one cent above consensus. Our net investment income rose to $90.5 million, which is a record for us. Our return on equity for the quarter was 19.5%. Our leverage decreased to 1.7x book equity. Fourth quarter interest coverage was 2.8x, and our fixed charge coverage was 2.3x.

In terms of new business, our investment team had a busy quarter. We originated 16 new transactions with total capital commitments of $456 million. We had repayments this quarter of $252 million.

Let me give you a little more color on our new commitments this quarter. With respect to underlying collateral, about 43% was hotel, 21% was mixed-use, and 15% was office. We're continuing to originate assets with an emphasis on security - with first mortgages accounting for 58% of this quarter's volume. 63% of our volume was floating rate, and 37% was fixed rate. Geographically, 39% of our new commitments this quarter were located in the Northeast, 18% in the Southeast, and 12% in the West.

Now let's move onto the full-year results. For the fiscal year 2003, we had another record year in a number of areas. Revenues grew over 16% from the prior year, reaching $607 million. Our AEPS the year came in at $3.25, at the top end of our guidance and right in line with consensus.

We had a record year with respect to our new origination volume, with 60 transactions totaling $2.2 billion committed dollars, the largest gross origination volume that we've ever had.

Our volume was, however, slightly lower than our guidance as a few transactions that we thought would close in the fourth quarter were delayed until the first quarter of 2004. In addition, our CTL business grew more slowly in 2003, as this business remains very competitive, with significant capital chasing transactions that we believe are fundamentally mispriced on a risk-reward basis. We also had slightly higher than expected repayments and prepayments in 2003 totaling about $1.2 billion, bringing our net asset growth to just under a billion for the full year.

Our in-place net interest margins at the end of the year were 386 basis points, right in the middle of our expected 350 to 400 basis point range. We generated a return on equity of 18.9% for the full year.

Our credit statistics remain strong. At the end of the year, our leverage was 1.7x. From a coverage perspective, we continue to post consistently strong results. For the year, our interest coverage was 2.7x and our fixed charge coverage was 2.3x. Our dividend payout ratio was 78.7% for the year.

Now let's move onto our 2004 earnings guidance. I'd like to spend a few minutes reviewing the first quarter compensation charges that we discussed on our last earnings call.

In early October, our CEO, Jay Sugarman, contingently vested the remaining 400,000 incentive shares out of a total of 2 million now earned by him under the Company's Long Term Incentive Plan. We expect that these shares will become fully vested on March 30, 2004. At that time, the Company will record a one-time charge in the line item, "General and Administrative Stock-Based Compensation." The charge will be equal to our stock price on March 30th multiplied by 2 million shares. So, as an example, assuming our stock price closed at $40 on March 30th, the charge to earnings would be $80 million.

Most of you are familiar with our CEO's compensation arrangement under our Long Term Incentive Plan. It's described in detail in our last three annual proxy statements, and in each of our quarterly financial statements since 2001. But let me quickly summarize some of the key points.

Three years ago, the Board structured our CEO's employment agreement with four tranches of incentive shares that vested once certain stock price hurdles were met. The agreement was structured such that he would receive no incentive shares if the company generated less than a 20% average annual total rate of return to its shareholders during the period beginning January 2001 and ending March of 2004. In order to earn the maximum number of shares, or 2 million, the company had to generate an average annual total rate of return of more than 35% during the same period. As of February 6th of this year, the Company generated through dividends and stock price appreciation a 37.4% average annual total rate of return for its shareholders.

Now to put this performance in perspective, our average annual total rate of return of over 37% has solidly outperformed most of the indexes, including the S&P 500, which had an average annual total rate of return over the same period of negative 3%; the Russell 1000 financials, which had an average return of negative 0.4%; and the Morgan Stanley REIT Index, which had an average return of 18.5% over the same period.

In total, since January 2001, our shareholder returns assuming the dividends were reinvested were approximately 168%, and over $2.7 billion of shareholder value has been created.

Earlier this quarter, our CEO entered into a new three-year employment agreement which has three components. First, an annual salary and cash bonus which is based upon meeting various performance targets set by the compensation committee of the Board of Directors. Second, an approximately 250,000-share common stock grant which will vest at the end of the first quarter but is restricted from sale for five years. The third component is his participation in the 2006 CEO and Directors HPU program which was approved by shareholders last year. The HPU program, which is described in detail in our proxy statement, is a performance-based compensation plan that requires participants to purchase units in the plan three years prior to any potential vesting, and only has material value to the participants if the company provides excess returns to it shareholders.

In addition to the CEO shares, as we discussed last quarter, two other incentive share awards will vest in the first quarter of 2004. The first is a 100,000 incentive share award that I received when I joined the Company. It vested at the end of January based on achieving certain total rate of return targets. The second is a 155,000 share award that was issued to the principles of the former ACRE Partners. This represents the final contingent consideration related to our acquisition of their company in 2000.

So we expect the aggregate first quarter 2004 compensation charge to be 2,505,000 shares multiplied by the then current stock price. Assuming a $40 stock price on the respective vesting dates of the incentive shares, the total first quarter charge related to compensation will be approximately $100 million.

In January, we announced that we are redeeming the 2 million outstanding shares of our 9?% series B Preferred Stock and the 1.3 million shares of our 9.2% Series C Preferred Stock. We assumed these securities as part of our acquisition of TriNet, the net lease company we acquired in 1999. GAAP required that the Series B and Series C Preferred Stocks be marked to their fair market values at the time of the acquisition, which resulted in iStar Financial recording a $9 million discount to the $82.5 million face value, even though the original issuer actually received the $82.5 million of cash when the securities were originally sold. Upon completing the redemption of the Series B and Series C Preferred Stock on February 23rd, we will recognize the $9 million discount as additional preferred dividends, thereby reducing AEPS and GAAP earnings by $9 million.

Now let's talk about our 2004 earnings guidance before giving effect to the compensation and preferred stock redemption charges that we just discussed. We expect diluted adjusted earnings for 2004 of $3.40 to $3.48 per diluted common share, and diluted GAAP EPS of $2.43 to $2.53. For the first quarter, we expect diluted AEPS of 85 to 86 cents and GAAP EPS of 61 to 64 cents.

Our first quarter and full year 2004 earnings will be reduced by the compensation and preferred stock redemption charges that we just reviewed. While we cannot predict the actual amount of the compensation charges because they are dependent on our stock price at the time, if we assume a $40 stock price, the aggregate amount of both the compensation and preferred stock redemption charges would total approximately $109 million.

After giving effect to these charges, we expect a first quarter diluted AEPS loss of 8 to 9 cents and a GAAP EPS loss of 30 to 33 cents. For the full year, after taking into account the charges, we expect diluted AEPS of $2.46 to $2.54, and GAAP EPS of $1.49 to $1.59.

Our guidance continues to assume net asset growth in 2004 of approximately $1.6 to $1.8 billion. Our guidance incorporates our expectations that certain loans may repay in advance of their actual maturity dates during the year. So if these borrowers repay early, then we would expect net asset growth at the lower end of our range.

Yesterday, we announced a 5.3% quarterly dividend increase - from 661/4 cents to 693/4 quarter cents, or $2.79 on an annualized basis. We review our dividend annually, and target a 5% annual dividend growth rate and a 78% to 82% payout ratio. We are committed to providing shareholders with a rock solid dividend that has a substantial earnings cushion.

Now, let's turn to risk management and credit quality. For those of you who have followed us for a while, you know that our risk ratings are a result of our quarterly credit review, which is a two-day, bottom-up review of each asset. Every professional at iStar attends this meeting. We continue to use the scale of 1 to 5 in rating each asset, with 1 being the best rating and a 5 indicating a problem asset.

This quarter, our overall asset quality remained steady. With respect to our loans, the weighted average risk rating was 2.67 for risk of principal loss compared with 2.65 last quarter, and 3.15 for performance versus original underwriting compared to last quarter's ratings 3.11. In-place debt service coverage at the end of the quarter remained a very strong 2.2x, based on 2003 actual cash flows and current interest rates. Our last dollar loan-to-value for the entire portfolio was 67.5% so our borrowers continue to have significant equity investments to support our loans and cushion us from realizing the continued effects of softer commercial real estate markets.

Now, let's move to the CTL portfolio. The average risk rating of our CTL assets at the end of the fourth quarter improved slightly to 2.62 versus 2.69 in the prior quarter. Despite a challenging leasing environment, Tim O'Connor and our risk management team continued to do a great job of extending our lease maturities. Anecdotally, Tim and his team are beginning to see a stabilization in many real estate markets across the country, with tenants beginning to reassess their space needs in anticipation of an improving economy.

Our CTL portfolio remains well-leased at 93.1%, with a weighted average remaining lease term of 9.9 years. Lease expirations in 2004 represent just 3% of our annualized total revenue for the fourth quarter of 2003. So we continue to have little exposure to near-term real estate market conditions.

As part of our risk management process, we monitor the credit profiles and performance of our corporate tenants. At the end of the year, 86% of our corporate CTL customers were public companies or subsidiaries of public companies, and 57% were investment grade or implied investment grade. This gives us good visibility with respect to the credits underlying our leases. In addition, our CTL portfolio remains well-diversified from an industry concentrations perspective, with over 38 SIC codes represented.

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 fourth quarter, we had five assets on the watch list with an aggregate book value of $103 million. With respect to our non-accruals, we took one loan off non-accrual at the end of the fourth quarter, so we now have three loans totaling $40 million on non-accrual status. This is down from $51 million at the end of the last quarter and represents just 0.61% of our total asset base.

Two of the three loans on non-accrual continue to pay interest currently, and the third loan, which has a principal balance of approximately $27 million, is now more than 60 days delinquent. We discussed this loan in greater detail last quarter, but to quickly review, the loan is a 90% interest in a mezzanine loan that we acquired as part of the Lazard Freres structured portfolio in 1998. It is secured by a Class A office building. We placed the loan on non-accrual last quarter, when the borrower stopped making its debt service payments due to insufficient cash flow at the property level. While the structure of the loan precludes us from foreclosing, we continue to believe that the underlying collateral value supports our basis in the outstanding unpaid principal balance. Consistent with our proactive risk management discipline, we continue to monitor all of these assets very closely.

As we do each quarter, we continue to build loss reserves to ensure that we are well protected when credit issues arise. Our general loss reserves and asset-specific cash reserves totaled $252 million, and represented approximately 6.73% of our gross book value at the end of the fourth quarter. With respect to our corporate tenant leases, our cash deposits, letters of credit, allowances for doubtful accounts, and accumulated depreciation totaled $275 million and represented 9.87% of the gross book value of our CTL assets.

Finally, let me walk you through our recent capital markets activities on our balance sheet. As most of you know, it is our objective to transition from being a primarily secured borrower to becoming a primarily unsecured borrower, when and if it is cost effective for us to do so. We expect this transition to take several quarters. However, based on the recent strength of the capital markets, particularly the bond markets, we were able to make significant progress towards this goal over the past several months.

So we had a very busy quarter from the capital markets perspective.

In December, we completed a $500 million senior unsecured bond offering comprised of a $350 million seven year tranche with a coupon of 6.0% priced at a slight discount to yield 6.10%, and $150 million ten year tranche with a coupon of 6.50%, also priced at a slight discount to yield 6.60%. Subsequent to year end, we issued an additional $350 million five-year tranche with a coupon of 4?% priced to yield a 4.90%.

We were pleased with the number of new fixed-income investors that participated in the offerings and with the market's overall recognition of our credit momentum. Over 45% of our new investors were high-grade buyers. We used the $850 million aggregate proceeds of these offerings to repay borrowings under our secured credit facilities.

Also in December, we completed an underwritten public offering of 3.2 million shares, or $80 million, of new 7.65% Series G Preferred Stock. We issued it in exchange for the $80 million of our remaining outstanding 9.5% Series A Preferred Stock. Going forward, this will result in a positive annual adjusted earnings impact of approximately $1.5 million.

In January, we also called for the redemption of all of the outstanding 9?% Series B and 9.2% Series C Preferred Stock, with a combined liquidation preference of $82.5 million. As we've already discussed, there will be a $9 million charge associated with the redemption of the Series B and C Preferreds, as we must now reverse the discount ascribed to these securities as part of our acquisition of TriNet. Both series are currently callable and we believe that the dividend rates are approximately 165 to 180 basis points higher than where we could issue preferred today. We will continue to look for ways to reduce our cost of capital.

Early in 2003, we began a more rigorous and defined investor relations program that was designed to broaden our shareholder base. We spent a considerable amount of time educating and updating investors and introducing the iStar story to new investors. We are pleased that several leading money management firms became new shareholders in 2003. We expect to continue our efforts in this important area in 2004.

In December of last year, we successfully completed a 5 million share offering of our common stock. We now have over $2.4 billion of tangible book equity to support our growth. We used the $191 million net proceeds from the offering to repay existing secured indebtedness.

Late last year, we also began working with several leading financial institutions to arrange a new unsecured credit facility. We expect the new facility to be much larger than our existing $300 million unsecured facility. We also expect that it will replace our existing facility prior to its maturity in July of this year.

A new, larger unsecured facility will be an important part of transitioning our balance sheet toward unsecured debt. Once the new facility is in place, we intend to use it as our primary source of working capital for funding new investments prior to match funding them with a mixture of longer-term debt and equity.

In terms of match funding, we try to minimize the impact of changing interest rates on our business. We are committed to operating our business such that a 100 basis point move in interest rates has a minimal impact on our earnings. We define minimal as a range of plus or minus 2.5%. We are currently operating well within our policy, with a 100 basis point move in interest rates impacting earnings by only about 1%, or less than a penny a share per quarter.

Lastly, we believe that we have plenty of liquidity to fund our business through 2004. Our recent capital markets activities have however, decreased our shelf capacity. So you will probably see us increase the size of our universal shelf up to the $1.75 billion level in order to accommodate our projected net asset growth for the next 12 to 18 months.

And with that, let me turn it back to Jay.

Thanks, Katy, for all that detail. I just wanted to finish up by talking very briefly about the market conditions we see going forward in 2004. The most obvious change we see in our markets is the large amount of capital that's now trying to figure out how to participate in the real estate finance market that has been delivering exceptional returns over the past ten years. And while we do see new competition coming into the market, we have been very successful in avoiding that new money by working closely with our repeat customers -- targeting transactions with a combination of real estate, capital markets, and corporate credit makes it difficult for unsophisticated capital to compete -- and delivering for our customers with the speed and reliability that has become a hallmark of iStar over the last decade.

Overall, we start 2004 with a very attractive pipeline, several large transactions that are great examples of iStar's competitive advantage, and a firm belief that we can deliver better solutions to our high-end customers than any other capital source out there. And we'll look forward to sharing some more information on some of those deals next quarter. But for now, we'll open it up for questions. Operator?

(OPERATOR INSTRUCTIONS) Don Destino, JMP Securities.

Two questions about the environment you're operating in. First, specifically relating to hotels, you've been talking all year about the opportunities in hotels. And then, Jay, you mentioned that the opportunities are diminishing. Is it that the supply of opportunities is diminishing? Or the fundamentals are diminishing and you're not as interested in that market? And would that have any implications for what you did so far this or last year?

Yes, Don, this is Jay. The capital vacuum in that sector that really started post-9/11 and continued all the way out almost through the end of last year created some of the best risk-return we've seen in hospitality lending since the early to mid-'90s. What we're seeing now is a lot of new capital coming into that market with no real competitive advantage. The only way they can win deals is to bid lower spreads and more proceeds. And I would say that dynamic took hold pretty strongly towards the end of last year, and we see continuing into the new year. So on an open field macro basis, I don't think you'll see nearly as many opportunities as we thought were available over the last two years.

That said, we still see, because of our enormous information flow in that sector, one-off yields that the market is not aware of or that we have some specific knowledge around that still represent great risk/return. But the contrarian play beginning after 9/11 that worked so well for us has probably played out. And I think we got the last few really good open market deals out there last quarter. And we're not expecting to see those going forward.

Got it. So you're still comfortable with the fundamentals of the hotel?

Oh, yes -- this is a capital flow issue.

Second question -- you mentioned in the press release that real estate fundamentals are stabilizing to the point where you're getting more interested in some of your higher margin product -- your corporate lending and your subordinate lending. Can you speak specifically about what you're seeing in the commercial real estate markets that's giving you that comfort or that interest?

Well, not surprisingly, the cycle repeats itself every five to ten years in real estate. And we're coming out of some very difficult fundamentals. The economy is starting slowly to recover. And the first sign you see is an increase in activity. Rates, rental rates, ADRs, apartment rates are all still weak. And concessions are still high. But it's usually the first sign that when activity picks up, even without dragging back pricing power -- shortly thereafter, call it 12 to 18 months later, pricing power starts to come back in markets. So I wouldn't say we're going to aggressively exploit a recovery. We will tell you as opposed to the last couple of times we've talked, we don't see kind of the quietness out there that is probably a lot more scary than activity at low rates. That usually is a precursor to stronger activity at stronger rates. Usually it's just a question of how fast the macro market recovers. But for the first time we're hearing pretty much across the board -- activity that represents a significant increase. We are not hearing rental rates, ADRs or anything like that moving with a lot of alacrity. But usually, it's a good sign to at least see the activity picking up.

Michael Hodes, Goldman Sachs.

Just a quick follow-up to that last question. Regarding opportunities in the corporate and junior lending arena. Do you think this time next year we'll have seen a notable shift in your mix? Or this is kind of just a slight shift at the margin?

I think the good news is our cost of capital is going down. We are working with a lot of our repeat customers on just a wide range of stuff, anywhere from the most senior pieces of their capital structure down through potential spin-offs and corporate-tenant lease type opportunities. As I said in my closing remarks, we're staying away from a lot of the new capital in transactions where it actually takes very sophisticated real estate corporate credit and capital market expertise to meet their needs. And you'll see a couple of, we think, fairly large transactions in the new year that will be perfect examples of what we do well and what the rest of the market probably doesn't even see. And I think you'll see the returns on those are pretty exceptional. Some are going to be senior, some are going to be junior, and some are going to be corporate type CTL transactions. But this is the dynamic that we see developing our business, which is the big, macro vacuum of capital that we saw in various sectors is probably not available. The good news is our cost of capital going down and the increase in our repeat customer base is allowing us to continue to find opportunities that we think are as good or better than what we saw over the last two years.

And then I guess this is more for Katy -- this facility that you're working on -- other than being bigger, is it going to be more flexible in terms of covenants? I think your pre-existing facility had a debt-to-equity covenant of 2-to-1. Is this going to be more flexible there?

Yes, we are working on a larger facility, probably in the $750 million range. Again, as we start shifting our activities to being primarily unsecured, we're kind of in a transition period, and until we get the line set up, we are continuing to have a little excess liquidity on our secured facilities. The new line of credit -- we're in the process of working on it. But we are hopeful that the covenants will allow us a lot more flexibility in our existing facility. And we'll actually have leverage covenants in excess of two times.

And then just lastly -- pro forma for the recent unsecured borrowing -- how much of your borrowings are unsecured right now? Is it close to 40%?

Actually, on an asset basis, if you think about secured assets, which is what the bondholders are looking at -- as of June 30, 2003, about 24% of our assets were unencumbered. And as of 12/31, about 46% of the assets were unencumbered. This is a little understated as of today, because we did a $350 million unsecured bond offering in January. So we haven't factored that in. We're also planning to repay the corporate tenant lease financing that is coming due that is about $193 million. So if you look at it pro forma for those transactions, we have about 2.7 -- almost $2.8 billion of unencumbered assets.

Okay. And is that the metric that you were referring to in terms of getting over 50%?

Getting over 50....

I mean, you said your mix of unsecured versus secured - is that relative to assets, or just relative to liabilities?

Yes, I mean you can look at either way. We're sort of looking at it right now in terms of assets. But obviously, they're complementary.

(OPERATOR INSTRUCTIONS) And allowing a few moments, Mr. Sugarman and our host panel, we have no further questions. Please continue.

Well, again, I want to thank you all. We're obviously trying to give you as much detail as we can in these calls. But if you do have any follow-up questions, feel free to give Katy, Andy, or myself a quick holler. We're looking forward to 2004 as a very interesting year for iStar as we do transition into what we think is a lower cost of capital and a much more effective platform using unsecured debt. So we'll look forward to talking to you about three months from now. Thanks again.

And ladies and gentlemen, that does conclude our fourth quarter and year end conference call for today. Thank you very much for your participation, as well as for using AT&T's Executive Teleconference Service. You may now disconnect.