iStar Inc (STAR) 2004 Q2 法說會逐字稿

Good day and welcome to the iStar Financial second quarter 2004 earnings conference call. 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, and Katy Rice, Chief Financial Officer.

Before I turn the call over to Jay, I want to inform you that the call is being simultaneously cast on our Web site. We also have a replay number, 1-800-475-6701, with a confirmation code of 736778.

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 would like to turn the call over to iStar Financial's Chairman and CEO, Jay Sugarman. Jay?

Welcome, and thank you for joining us today. As you saw in our press release this morning, I am happy to report iStar had another very strong quarter and we have enjoyed an excellent first six months of the year. We met or exceeded most of our key goals for this quarter providing custom tailored capital to a wide range of high quality real estate owners around the country. Our total funded and committed investments were well north of $600 million and our returns on equity and most earnings measures continued at or near historical highs.

Our strategy during the past quarter was premised mainly on our belief that many parts of the investment and capital markets have reached a point where risk-adjusted returns are no longer interesting. We have successfully steered around most of those markets in generating new investment opportunities and we have been actively engaged in harvesting investments where we feel the imbalances have gone well past equilibrium. Looking forward over the next quarter or two, this strategy might lead to slower net asset growth, but it will enable us to take advantage of the more compelling opportunities that inevitably follow such periods of rapid capital flows.

Let me turn quickly to the highlights of this quarter. Earnings, strong originations during the first half of the year drove our adjusted earnings to record levels reaching almost $100 million in the quarter and representing a new record on a per-share basis.

On the originations side, we closed 17 separate transactions and committed over $700 million in new and follow-on commitments this quarter. Net interest margins on what continued to be relatively safe investments remains strong due to the most part to our actively avoiding many of the areas where competition is driving down spreads.

On a return on equity and leverage front, we again saw return on equity finishing just below 20%, and there is no doubt we are still running with leverage that is below even our normally conservative targets. With $2.5 billion in tangible book equity and a portfolio heavily weighted towards high quality first mortgages and long-term credit tenant leases, I think we will be able to move that leverage number up to more appropriate levels when needed.

On the credit quality side, the portfolio continues to be strong and well-positioned. Few assets in our portfolio give us concern and key portfolio credit scores again improved during the quarter. I am going to come back in a minute and talk about our strategy on the repayment front but let's get the quarter summary from Katy first. Katy?

Thanks, Jay. Good morning everyone. I would like to cover three topics this morning. First, I will summarize our results for the second quarter and review our earnings guidance. Next, I will 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. We had another strong quarter with Adjusted Earnings coming in at $0.87 per diluted common share, which was at the top end of our previous guidance. Our net investment income rose to a record $105.4 million up 23% from the second quarter of 2003. Our Return On Equity for the quarter was 19.9% and our leverage at the end of the second quarter was 1.8x debt-to-book equity plus accumulated depreciation and loan loss reserves. Second-quarter interest coverage was 2.7x, and our fixed charge coverage was 2.3x. In terms of new business this quarter, we generated $742 million in new financing commitments in 17 separate transactions and we had repayments of $394 million. With respect to the underlying collateral about 22% was in the hotel sector, 20% was industrial, another 20% was retail, and 16% was office. We are continuing to originate assets with an emphasis on security with first mortgages and participations in first mortgages accounting for 75% of this quarter's volume. 88% of our loan volume was floating-rate and 12 percent was fixed-rate. Our in-place net interest margin at the end of the quarter was 419 basis points, a few basis points higher than our typical range of 350 to 400 basis points.

Geographically, 30% of our new commitments this quarter were located in the mid-Atlantic region, 18% in the West, where we continue to believe there are some good value propositions and 18% in the Southeast.

Despite a very competitive environment, we had record new commitments totaling $1.7 billion in the first half of the year bringing our cumulative repeat customer transactions up to $6.1 billion. We believe that the repeat customer metric is a real validation of our business model and demonstrates both the growth and the strength of our franchise.

Now, let's move on to our earnings guidance. As Jay mentioned, there continues to be a tremendous amount of inexpensive capital in both the public and private commercial real estate markets many of our borrowers anticipate prepaying loans with the proceeds from initial public offerings, asset sales and refinancings. As a consequence, we expect a higher level of prepayments for the remainder of the year assuming the capital markets environment remains strong. As you know, most of our loans have some form of call protection so many of these prepayments will generate significant prepayment penalties. Increased prepayment penalties will result in higher other income, which will be offset by a reduction of the interest income generated from the repaid loans going forward.

Our earnings guidance incorporates both the robust net asset growth totaling almost $869 million that we experienced in the first and second quarters and our current expectation that prepayments in the third and fourth quarters will be higher than we anticipated at the beginning of the year. We are currently forecasting minimal to no net asset growth for the third quarter. Fourth quarter net asset growth will be dependent on the strength of the capital markets and the tone of the investment environment in the latter half of the year. We expect the favorable timing of the investment volume in the first and second quarters, as well as the higher other income from prepayment penalties to mitigate most of the earnings impact of increased prepayments this year.

With respect to our corporate tenant lease portfolio, as we have done in the past, we are taking advantage of the strong commercial real estate sales environment to selectively market certain non-core sale/leaseback assets. We expect that any such sales would be completed in the latter part of the year and would total no more than $200 to $300 million representing only a small percentage of our $3 billion-plus corporate tenant lease portfolio.

So, with that as a backdrop, let's talk about our 2004 earnings guidance. For the third quarter we expect diluted AEPS of $0.86 to $0.88 and GAAP EPS of $0.63 to $0.66. For the full year before giving effect to the first quarter compensation and preferred stock and bond redemption charges, we continue to expect Adjusted Earnings of $3.40 to $3.48 per diluted common share and diluted EPS of $2.50 to $2.60. After giving effect to the first quarter charges we expect diluted adjusted earnings of $2.30 to $2.38 and GAAP EPS of $1.40 to $1.50.

Now, let's turn to risk management and credit quality. This quarter our overall asset quality improved. With respect to our loans the weighted average risk rating was 2.59 for risk of principal loss, compared with 2.62 last quarter and 3.15 for performance compared to original underwriting, compared to last quarter's rating of 3.16.

In-place debt service coverage at the end of the quarter remained a very strong 2x based on trailing 12 months cash flows through March 31, 2004 and current interest rates. Our last dollar loan-to-value for the entire structured finance portfolio was just 67.3 %, 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 second quarter improved slightly to 2.50 versus 2.52 in the prior quarter. Tim O'Connor and our risk management team continue to see stabilization and improved leasing activity in many real estate markets across the country. Our CTL portfolio remains well leased at 95.3% with a weighted average remaining lease term of 10.9 years. Lease expirations in 2004 represent just 1.4% of our annualized total revenue for the second quarter of 2004, 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 second quarter, 77% of our corporate tenant customers were public companies or subsidiaries of public companies. This gives us good visibility with respect to the credit's underlying our leases. In addition, our CTL portfolio remains well diversified from an industry concentration 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 second quarter, watch list assets represented just 1% of total assets, a decrease from 1.59% in the prior quarter. Non-accrual assets represented just 0.36% of total assets as compared to 0.55% at the end of the first quarter.

As we do each quarter we continue to build loan loss reserves to ensure that we are well protected when credit issues arise. Our general loan loss reserves and asset-specific cash reserves total $265 million and represented approximately 6.18% of the gross book value of our loans at the end of the second quarter.

With respect to our corporate tenant leases, our cash deposits, letters of credit, allowances for doubtful accounts and accumulated depreciation totaled $311 million and represented 9.81% of the gross book value of our CTL assets.

Now, let me walk you through our recent capital markets activities and our balance sheet. This month we reduced the capacity available under one of our secured credit facilities from $500 to $350 million and extended its maturity. It is our objective to continue our transition from being a primarily secured borrower to becoming a primarily unsecured borrower. As part of this shift we expect to reduce the capacity of our secured credit facilities over time while still maintaining a prudent level of availability in the event there are disruptions in the unsecured corporate credit market.

We are now funding the majority of our investments with our new $850 million unsecured line of credit. As we accumulate balances on the line we expect to term them out or match fund them with longer-term, unsecured debt. As I mentioned earlier we are anticipating fairly significant prepayment volume in the third quarter, which will lower outstandings on the line as the loans repay. Based on our current expectations with respect to net asset growth, we do not anticipate the need to issue longer-term unsecured debt in the third quarter. Any bond issuance in the fourth quarter will be dependent on new origination and repayment activity.

At the end of the second quarter the majority of our asset base was unencumbered. Our unencumbered assets now total approximately $4.6 billion which is nearly three times larger than our unencumbered asset base at the beginning of the fourth quarter of 2003 when we began our transition from secured to unsecured debt funding.

We get a lot of questions about where we are with the rating agencies, so let me give you a quick update on timing. As we have discussed on prior calls, we are planning to hold our annual update meeting with Moody's sometime after our second quarter financials are filed. We are currently working with our new lead analyst at S&P to bring him up to speed on the Company in preparation for our annual update meeting. Typically, our annual meeting with S&P is held mid to late third quarter. Fitch recently affirmed our BBB- minus investment grade rating, so we do not anticipate a formal review with Fitch at this juncture.

The recent increase in interest rates has also prompted many questions about what happens to our business if rates continue to rise as most economists predict. Our objective is to deliver stable earnings and strong risk-adjusted returns to our shareholders and to insulate our earnings as much as possible from changes in short and long-term interest rates. We match fund fixed-rate assets with fixed-rate debt and floating-rate assets with floating-rate debt. 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 increase in rates decreasing adjusted earnings by only about 1.25% or just about a penny a share per quarter. So, while we expect that rising rates may create some opportunities on the origination front they will have a relatively small impact on the right side of the balance sheet.

We also take a conservative approach with respect to our asset and liability management. We fund ourselves so that the maturity of our liabilities closely matches the maturity of our assets. Currently, the weighted average maturity of our assets is 6.4 years and the weighted average maturity of our liabilities is 5.3 years. We have almost no debt maturing this year and very little debt maturing in the next 3 years. Our asset maturities are well in excess of our liability maturities over the same period. We believe that we have plenty of liquidity to fund our business through 2004, particularly with our new credit facility in place.

From an equity perspective, we review our dividend annually and target a 5 percent annual dividend growth rate and a 78% to 82% percent payout ratio. A 100 basis point increase in interest rates would only increase our dividend payout ratio from 79% to 80%. We are committed to providing shareholders with a strong dividend that has a solid earnings cushion.

With that, let me turn it back to Jay.

Thanks, Katy. Let me take a moment to describe a part of our loan repayment strategy. Even when loans in our portfolio are performing very well we often actively work with our borrowers to modify prepayment penalties and this often encourages prepayment when we believe it is appropriate. While we obviously forego some economic benefit for doing so it does gives us the ability to shape our portfolio and serve our customers in a way that has benefits that generally outweigh the costs. We do expect several situations in the coming quarters where our proactive reduction of prepayment fees will encourage a repayment that we believe makes sense in the current environment and in our portfolio. It is one more way we can differentiate our approach to providing capital from the securitized world where a performing loan can almost never be modified even when it makes sense for all parties.

With that, let me open it up now for questions. Operator?

Thank you. Today's question-and-answer session will be conducted electronically. Don Destino with JMP.

I apologize if you hit on this, I missed the first part of the call. Jay, I am just not quite clear, is it just for customer service reasons that you would encourage repayments of loans that probably have higher than market rates, given what you are saying about the increased inflows and the very competitive pricing out there?

This is a debate we have had internally several times. We have a number of transactions right now where borrowers want to repay us. Frankly, we would rather leave the loan out and just earn the interest for a long period of time. The economics are fairly compelling because the prepayment penalties are attractive, but if you gave us our druthers all things being equal, we would stick to the documents and say, "You owe us an enormous prepayment penalty." In most cases where it is a repeat customer and somebody we want to continue to do business with we have been willing and are right now willing to cut them a break. It is still an attractive proposition for us. The IRRs are spectacular, but if you told me, in the absence of a customer service component would I change that document? Would I give back some of the economics to a borrower? The answer would be no. So, clearly underlying a lot of those decisions -- some are portfolio-driven but in many cases, it is a customer where we say, "Look, if we don't do this, it may either preclude them from a great transaction or it will leave a very bitter taste in their mouth, because our IRRs will be, in many cases, better than theirs."

The prudent course of action when we are absolutely certain we are right on is to cut a fair deal. That has been our reputation for years it is how we want people to see us. It is a major differentiating factor from almost any other capital provider we know of in this market. We have done it before when we wanted to massage the portfolio and get out of tough assets. I would say in today's environment we are doing it for people who are doing great so it is not really a let's get out of problem assets, it is a let's continue to build relationships with high quality sponsors who we know will come back.

So generally, it is just that relationship; it is not necessarily contingent on some other transaction that they are going to send iStar's way in the relatively near future?

Rarely is there that direct quid pro quo. I wish I could point to $1.00 given up generated $2.00 in earnings but this is the way we run our business since the day we started. It has paid enormous dividends in building our franchise. Again, look at the long-term success of our business and know this is the right move.

Just as a follow-up, as you are looking at the capital inflows, is it having more of an effect on your kind of deeper down in the capital structure products, or is it having an effect across the board?

I would say it's across the board, Don. Maybe we are getting a little more conservative. We have always had a viewpoint here that around September financial excesses start to get wrung out of the system. If you look at the last six or seven years, the flashpoint often occurs in the third or fourth quarter. We clearly see the dynamic building in the marketplace where capital is being I would say overly aggressive in closing sides and hoping for the best. That scenario scares us. Generally, we will dance around markets where we see that kind of capital activity and spend our money somewhere else. As you saw in the second quarter, there were plenty of places to put our money, I think it is going to be less of a question about our investment philosophy, it is much more of a viewpoint as to where do we want to take money off the table. As Katy said, more likely than not, we are actually going to be selling some assets. Normally, I would tell you we would not do that but we think in this environment that is the right way to create shareholder value. We are going to be less concerned about net asset growth in the third quarter and more opportunistic in trying to create value. I think you will see us do some things over the next two to three quarters that will protect the high returns we get on the capital we invest. I am not too worried about the capital impacting that strategy.

I think, on the repayment side we are just going to have to wait and see. Going into the third or fourth quarter we tend to get even more conservative about how we want to position the portfolio. Right now, despite a normal very healthy return of capital coming in just by flow of business, we are actually proactively taking in more money. Some may disagree with this strategy, it served us extremely well in 2000 and 2001 and it served us extremely well in San Francisco and Silicon Valley. When everything gets overheated we are going to take money out of those markets and we are going to place it elsewhere. We are not going to be short-term focused we are going to look at the long-term benefits we can generate for shareholders and deep down we all know this is the right strategy so that is what we are going to do.

That is very helpful. Thanks a lot.

Michael Hodes with Goldman Sachs.

One question and one clarification, I guess. In terms of the outlook that you are providing, I am curious, as you are thinking about share count it sounds like you are taking the prudent course here you are looking to be more careful in growth given the environment. That obviously requires less demand on the balance sheet and we normally think about you guys issuing equity in the latter part of the year. I am assuming that you guys are going to calibrate that to the asset growth.

Then secondly, in terms of Moody's revisiting the rating, are you saying it is when the Q comes out that they are going to revisit it or today's release is what will get them going in terms of thinking about the quarter?

With respect to equity, I think you actually answered the question, which is I think we will calibrate that to the asset growth. We do not currently have plans but depending upon the net asset growth that we do achieve in the third and fourth quarters, we will look at that equation at that time. But right now, given what we see on the horizon we do not have plans for equity throughout the remainder of 2004.

With respect to Moody's, they do like to wait for the Q to come out. Obviously, there is a little bit more depth of information and what-not. Typically, we have had our update meetings with them in September, so they did agree to move that up and we are calendaring that meeting right now.

Don Fandetti is on the line with Wachovia.

Good morning everyone. Jay, a quick question -- would you describe the excess capital flows as continuing to increase, or are you seeing some signs of sort of a flat lining?

I would say they are continuing to increase, Don. If I think about the different market segments, the unsophisticated capital can only go a few places and that is clearly a place where we are seeing the capital continue to flow heavily. I think, in the places that really require some level of expertise, some level of reputation and credibility, it has flattened out. I think those markets have stabilized and those are some of the markets we are playing in pretty heavily. But if you just talk about close your eyes, do not have to do much due diligence, don't really have to understand capital markets, don't really need to underwrite credit materially, there is more money coming into those markets chasing yield, and we have not seen that flow abate yet. I am not sure what is going to stop that money coming in, because as we have said over the last 10 years, risk-adjusted returns in real estate finance are very attractive. It is why we like this business. But I think, as some of those players try to find those returns, they are all gravitating to a couple of key sectors and swamping those sectors. I think we are seeing the life companies, the foreign capital, the syndicate retail capital all starting to clog up the pipeline in the same key core markets. We are just not spending a lot of time there any more. We are using our skills and our knowledge and our information flow to figure out where they are not and go and spend our time there.

Thank you.

Susan Berliner with Bear Stearns.

Great. I have three questions, if you guys don't mind. One is I was wondering if you could break down the origination volume. I know 75% was in first mortgages, I was wondering what the balance was in?

Sure. Let me grab that while you ask your next question.

Sure. The second question was in regards to the unencumbered portfolio. I think the press release said you had 4.6 billion of assets right now that were unencumbered. I was wondering, I actually thought that was a little bit higher than I was expecting. I wondered what you thought that number would look like at the end of the year.

Yes, Sue, on that question, the unencumbered pool has grown fairly dramatically because of our activities on the unsecured bond side and obviously repaying our secured facilities. But also, now going forward, we would expect it to grow with our net asset growth if we continue to fund everything on an unsecured basis.

The interesting thing this quarter as well is the composition of the unencumbered asset pool is becoming closer and closer to the Company’s overall, which I know is something that some bondholders originally were concerned about. Obviously, when you do secured financings you do tend to take your "best assets" but as we continue to grow the quality and the composition of the unencumbered asset pool is starting to get a lot closer and closing in on the same metrics as the overall company.

Okay. The third question was if you could just repeat -- I think, if I heard you correctly, you said, in regards to issuance, you would not be issuing in the third quarter and would revisit in the fourth quarter, perhaps?

On the bond side, that is correct. The fourth quarter will be very dependent on how our net asset growth and pipeline look and really dependent on the prepayments that we receive. Some of the prepayments, as I mentioned, are dependent upon companies or our borrowers either going public, refinancing with a different firm, or selling assets. So, there are some things that are blowing out there that may or may not happen with respect to prepayment. Prepayments in the third quarter would just be used to pay down our line of credit, so we wouldn't need to issue longer-term debt.

Back to your first question, in terms of new originations this quarter, in the second quarter, we mentioned about 75% of first mortgages. We did not originate any corporate tenants lease assets this quarter. I think that is representative of two things. One, that market has been very competitive, but I think it is probably a little bit of a quarter-to-quarter fluke that we actually did not have a closing this quarter in the corporate tenant lease world. But about the remaining 25% were partnership and corporate loans, 18% partnership loans and 7% were corporate-related loans in the real estate segment.

Great. Thanks very much.

Bruce Harting with Lehman Brothers.

There is a little bit of a possibility that you covered this, I came on a little bit late. What are some of the geographies where you are particularly keen and not keen right now and asset classes that you are finding to be most attractive? Can you talk a little bit more specifically about pricing as rates are going up and competitive pressures there? Thanks.

We did touch on it a little bit. We think it is more driven right now not as much by geography but by product type. We always classify it as the main food groups where the underwriting is perhaps less intensive, the understanding of the capital marketplace is less intensive. Those markets are, in our words, over-bid. There is too much money all looking at the same deals; people are getting 15 and 20 financing bids for assets. That is just uninteresting for us and frankly I am not sure it can continue but we are not even spending a lot of time looking there.

Geographically, as Katy said, we do think on the West Coast, particularly in some of the markets that got beaten down after the 2000/2001 problems, have become interesting. We have done quite a bit of investing out there, but I would not target the geography as much as the product type the things where high quality sponsors are finding opportunities that are not trampled by the massive capital out there and working one-on-one or maybe inviting us and one other player to work with them. They are trying to keep their knowledge base under the radar. They need someone who has got the reputation for being quite; they do not want to show it to the securitized world and they do not want to show it to a bunch of bidding finance companies. That is the kind of deal we are targeting and winning.

Our view, in terms of interest rates, is it just does not impact our business at all. We actually would invite the yield curve to start flattening. We think that will take some of the steam out of the unsophisticated capital sales.

So our hope right now is that the measured increase in interest rates will actually be a positive for our business, not a negative. There is a diminutive impact on earnings but we think it changes the investment environment in our favor, so we are actually happy to see that again.

Then lastly, in terms of the capital coming in, it is a yield market right now. People are looking for places that they can earn safe risk-adjusted yields. We have seen spreads get compressed anywhere that money can go, whether it is real estate, whether it is the syndicate market, whether it is the high-yield market. Spreads have come in around the world and around investment types. Real estate is no different. We continue to think we are in a niche expert business and that capital will have a hard time finding the types of deals and the types of sponsors we like to target. But we are not immune from it, and again, you will see it more on the repayment side. If our borrowers have done a great job and have an opportunity to capitalize or monetize on it, either through a sale or an IPO, there is nothing we can do about that. Hooray for them, they have done a great job. They are going to reap the benefits, so will we. We will then go out and redeploy that capital in an attractive space, but that money is out there. Not kidding ourselves, the liquidity in the capital markets is as high as we have seen since 1998. In many cases, we think that is unsustainable, and we are going to be very cautious because we have seen this story before and generally the opportunities get a lot better on the other side of scenarios like this than they do right in the middle of it.

Thank you.

At this time, I would like to turn the conference back over to the management team for any closing comments.

Well, thank you again. We look forward to seeing you in about 90 days. I think our challenge, over the next quarter, is really to continue finding those opportunities that we specialize in. We will have a better sense when we come back of where we think those opportunities are and we will share those with you in the third quarter. Thanks again and goodbye.

Ladies and gentlemen, that does conclude our conference for today. Thanks for your participation and for using AT&T's executive teleconference. You may now disconnect.