Download Cost of Capital - North Carolina Petroleum & Convenience Marketers

Enhancing Petroleum Marketer Performance: Value
Driven Analysis and Practice
I. How do we know how we are performing in the context of our environment? What are the
best indicators of our condition? What indeed are our objectives? II. Where are we headed?
Can we rely on economic forecasts? Our own firm’s? What techniques are useful? Are there
aids to optimizing our value creating abilities? Big picture vs focused picture: EconomyIndustry-Firm-Family ? II. Where are we headed? Can we forecast these forces are headed?
Economically? Industry-wise? Firm-wise?
George A. Overstreet, Jr.
Walker Professor of Growth Enterprises
Associate Dean of Research and Centers
MhcIntire School of Commerce
University of Virginia
Charlottesville, VA 22903
[email protected]
434 242 7063 mobile/UVa
434 985 4188 farm
Key Private Firm Managerial “Must-do’s”
• Private Firms are different than public firms!
Unfortunately, most managerial research has
addressed public firms—family firms are more
complex than partnerships!
• Lacking market based value signals, private
firms can use value based management
signals or metrics to substitute for market
based signals (daily equity price changes).
• This, however, requires a disciplined &
knowledgeable path. Also, serious study and
what Geoff Colvin refers to as “deliberate
practice”. It is not in the domain knowledge
sphere of most accountants and CEOs but
requires their buy-in!
Key Private Firm Managerial “Must-do’s”
I. Adopt value based management practices and
systems based on the following principles:
a. Establish accountability at each strategic
value unit based on the value added principle
that it must contribute positively to the firm’s
value (yield a return on capital greater than its
cost of capital (EBIT*(1-tax rate/(Debt +
Equity) less Weighted Average Cost of Capital
(% Debt*Cost of Debt*(1-tax rate) + (%
Equity*Risk Adjusted Opportunity Cost of
Equity)—naturally, this goes for new
investments as well as existing ones.
Key Managerial “Must-do’s”
II.
Develop a Business Council and Family Council—
Study Groups can serve the former role if used
appropriately. Study Generation to Generation.
III. Develop a living competitive market derived--value
based–plan designed to identify, establish, and
sustain competitive advantage for each Strategic
Value Unit in your portfolio. Why competitive
advantage? Returns on capital greater than the cost
of capital are very rare without competitive
advantages in highly competitive market
economies. Discuss!
Key Managerial “Must-do’s”
IV. Establish a Value Coach to get over the learning
curve and “Firm Council” or Small Advisory Board of
Wise, Experienced, Proven, Diverse Advisors to
serve as a Sounding Board
V. With your team, develop a living strategic,
competitive market derived--value based–plan
designed to identify, establish, and sustain
competitive advantages for each Strategic Value
Unit in your portfolio. Why competitive advantage?
It is the source of returns on capital greater than the
cost of capital in competitive markets. Make sure it
is considers your family’s life cycle and the need for
diversification! And the need for appropriate
incentives.
Key Managerial “Must-do’s”
VI. Establish Separate SVUs for Real Estate and
Operations for Company Ops and Dealer Ops, Etc. If
you don’t have balance sheet for each, develop
market based valuation alternatives to establish
your opportunity costs and capital allocations
VII. Treat the business as a business and the family as a
family with a council for each. Devote time to
making sure each is “healthy” and “value” oriented
Suggested Readings/Study: Talent is Overrated: What really Separates WorldClass Performers from Everybody Else, Geoff Colvin, 2008, 2010, Portfolio.
Competition Demystified: A Radically Simplified Approach to Business
Strategy, Bruce Greenwald and Judd Kahn, 2005, Portfolio. Valuation:
Measuring and Managing the Value of Companies, Tim Koller, et al, McKinsey
and Company, 2010, University Edition, Wiley; Generation to Generation: Life
Cycles of the Family Business, Kelin E. Gersick, et al, Harvard Business School
Press, 1997.
Strategic Value Management: A BALANCED APPROACH
II. STRATEGIC VALUE ASSESSMENT
•SOURCES OF COMPETITIVE ADVANTAGE
•ECONOMIC PROFIT/LOSS DYNAMICS
•FINANCIAL METRICS AND PERFORMANCE
•Strengths, Weaknesses, Opportunites, Threats (Swot)
•STATUS QUO VALUATION
Value
Based
Management
IV. EXECUTION OF STRATEGIC
INITIATIVES AND ESTABLISH
MONITORING/INCENTIVE SYSTEMS
•ESTABLISH OWNERSHIP PROGRAMS AND OPTIMAL FIRM
STRUCTURE
•DETERMINE BEST PRACTICES AND STRETCH
GOALS/MEASURES
•CREATE AND IMPLEMENT VALUE SCORECARD AND
INCENTIVE SYSTEM
III. FORMULATION AND Strategic Value Mgt.
(SVM) RANKING OF STRATEGIES/TACTICS
•FORMULATE VALUE ADDED STRATEGIES
•ASSESS CORPORATE VALUE ADDED (NET PRESENT
VALUE) AND SENSITIVITY TO KEY VALUE DRIVERS
•PRIORITIZE CAPITAL INVESTMENTS
Questionaire on Performance Monitoring & Planning, Page 1
1.
2.
1.
2.
3.
4.
5.
6.
7.
Name: _____________________________________________________________
Firm: _____________________________________________________________
Does your firm formally engage in planning that should impact performance on a regular
basis? Yes/no If yes, how often? Man/woman hours last two years?
_______________________
Has it been successful? Very 5………3 fair…….1 not at all
Do you follow national economic trends? Yes/No If yes, what sources do you use?
_________________________________________________________
_____________________________________________________________
Regional and local economic trends? Yes/No If yes, what sources do you use?
______________________________________________________________
Do you analyze competitive trends in your marketplaces? Yes/No If yes, do you collect
data? Yes/No If yes, what types?
________________________________________________________________
Do you feel that your firm has a competitive advantage? Yes/No If yes,
describe___________________________________________________________________
_______________________________________________________
If your firm has a competitive advantage, will it manifest itself in terms of performance?
Yes/No If yes, describe how so?
_______________________________________________________________
Questionaire on Performance Monitoring & Planning, Page 2
8.
Do you periodically value your firm? Yes/No If yes, do you use an outside
source or do it internally? Outside/internal/Both? Do you measure the value of
the firm’s profit centers or parts? Yes/no? If yes, how do you assess value?
A. Market comparables? Yes/No If yes, market “comps”, what “comparable”
benchmark/s do you use?
________________________________________________. B. Discounted cash
flow valuation Yes/No C. Liquidation Value of Assets and Liabilities Yes/no
9. What key financial measures does your firm formally use to assess how your
firm is performing?
A.__________________________B._____________________
C.__________________________ D. _______________________________
E.___________________________F. _______________________________
10. Were they used as an integral part of your valuation assessment? Yes/No
11. What key operating performance metrics do you use to assess unit
performance?
A.__________________________B._____________________
C.__________________________ D. _______________________________
E.___________________________F. _______________________________
Questionaire on Performance Monitoring & Planning, Page 3
12. Let’s test your overall firm marketplace for competitive advantages: Does it
exhibit market share stability? Yes/No/Unknown Does it exhibit low entries
and exits? Yes/No/Unknown Does it exhibit high profitability? (return on
capital employed over 10 percent after tax?) Yes/no/ unknown
13. Let’s test for competitive advantages? Does your firm have proprietary
technology, supply contracts, or advantaged locations? Yes/no/unknown
Does your firm have customer captivity? Yes/no/unknown Does your firm have
economies of scale and hence is a low cost producer? Yes/No/Unknown
Strategic Value
Management
II. STRATEGIC VALUE ASSESSMENT
•SOURCES OF COMPETITIVE ADVANTAGE
•ECONOMIC PROFIT/LOSS DYNAMICS
•SWOT
•LIFE CYCLE (PORTFOLIO ANALSIS)--MATRIX
•STATUS QUO VALUATION
Value
Based
Management
IV. EXECUTION OF STRATEGIC
INITIATIVES AND ESTABLISH
MONITORING/INCENTIVE SYSTEMS
•ESTABLISH OWNERSHIP PROGRAMS AND OPTIMAL FIRM
STRUCTURE
•DETERMINE BEST PRACTICES AND STRETCH
GOALS/MEASURES
•CREATE AND IMPLEMENT VALUE SCORECARD AND
INCENTIVE SYSTEM
III. FORMULATION AND SVM
RANKING OF STRATEGIES/TACTICS
•FORMULATE VALUE ADDED STRATEGIES
•ASSESS CORPORATE VALUE ADDED (NET PRESENT
VALUE) AND SENSITIVITY TO KEY VALUE DRIVERS
•PRIORITIZE CAPITAL INVESTMENTS, NTI,
DEMOLISH/REBUILD, DIVESTMENTS
I. The Playing Field
• How tough is the competitive state of our industry?
Relative to “pure competition”?
• What does that suggest for our industry and its
individual firm performances?
Ia. The Playing Field: How Tough is the Industry?
PORTER’S FORCES GOVERNING COMPETITIVE POSITION
GOVERNMENT
REGULATIONS
II. BARGAINING
POWER OF
SUPPLIERS
Exit Barriers
MARKET’S
COMPETITIVE
POSITION & PROFITABLITY
III. BARGAINING
POWER OF
BUYERS
I. CURRENT
COMPETITORS
Entry Barriers
POTENTIAL
COMPETITORS
IV. THREAT OF NEW
ENTRANTS
V. INDUSTRIES WITH
PRODUCT
SUBSTITUTES
Ib. Porters Five Forces Model: C-Store Industry
Fragmented Nature With Each Neighborhood Market Differing
Market fragmented with each being
unique; consolidating with highly
efficient price competitive chains on
top of huge number of single store
operators
Low to Moderate barriers to entry
 Capital costs rising ($2.5 to $4 m.) new
to industry units plus OH
 Low urban land availability with sprawl
showing signs of slowing
Potential Entrants
Relevant Buyer Power
 Low switching costs due
to public posting of gas
prices leading to low
switching costs; tired iron
having hard time competing
Industry Competitors
Buyer Power
Supplier Power
Rivalry/Existing Firms
Very High Supplier Power
 Limited number of refineries hold
lots of pricing power.
 Rising global demand & fixed Supply
suggests potential long term price
increases
Substitutes
Substitute Products
 Hyper marts & gas
Drug store chains; grocery
fresh movement
Electric/hybrid vehicles
Moderate
High
Ic. Porters Five Forces Model Inputs
Resulting Competitive Score
(3.5 being oligopoly and 5 being pure competition)
Supplier
Power
Buyer
Power
C-Stores
High
High
High
High
High
4.75
Dealer
High
High
High
Mod
High
4.50
Space Heat
Mod
Mod
High
High
Mod
4.25
Card locks
High
High
High
Mod
Mod
4.25
Terminals
Mod
Low
High
Low
Low
4.25
Transports
Low
High
High
Low
High
4.75
* Force Level
High
Mod.
Competitors
Substitutes
Potential
Entrants
Competitive
Score 3 to 5
Assessing Competitive Advantage? Are Incumbent Advantages
Identical to Barriers to Entry? Source: Competition Demystified, p. 56.
1. Develop industry map
Identify strategic value units having individual
market segments
Identify competitors in each segment
2. Test for existence of competitive advantages
•Mkt-share stability, dominant firm, low entries & exits
•Sustained high profitability
3. Look for sources of competitive advantage
•Proprietary technology
•Advantaged resources (locations)
•Customer Captivity (Switching Costs)
•Economies of Scale
•Government Intervention
• If no, pursue
operational
efficiencies! If
you are an ant,
consider
exiting!
• If yes, identify
and manage
competitive
advantages.
Id. Barriers to Entry Model: Steps to Assessing the Competitive State of a Firm’s
Markets—Generic Strategy Implications
• Step 1: Develop an Industry Map with segments and
competitors for Each Value Center
• Step 2: Test for Existence of Competitive Advantage
(Mkt. Share Stability, Dominant Firm, Low Entries
and Exits, Sustained High Profitability)
• IF No, Pursue Operational Efficiency
• IF No & Vulnerable, consider exiting to save assets
• IF Yes, Identify and Manage Sources of Competitive
Advantage (Proprietary Technology, Cheap
Resources, Economies of Scale, Barriers to Entry,
Customer Captivity)
Ie. Barrier to Entry Model and Strategy Implications:
Case Example
Market
Share
Stable?
Dom.
Firm?
Low entry
Exit?
Roic > Wacc?
Pursue ?
C-Stores
no
no
no
no
Op.Eff.
Dealer
no
no
no
no
Op.Eff.
Space Heat
yes
yes
yes
yes
CAdv
Card Locks
yes
no
yes
???
CAdv
Terminals
yes
no
yes
yes
CAdv
Transports
no
no
no
no
Op Eff
Operational Efficiency = (Op. Eff.)
Identify and pursue Competitive Advantage = (CAdv)
Notes
Implications of Structural Analysis
Within the Petroleum Marketing
Industry
Analyzing the Competitive Landscape
What Return on Invested Capital Should
We Expect for the Industry Given Its
Competitive Structure?
Ij. Long Term Industry Comparisons for ROIC After Tax
40 Year Average through 2004, Koller, Valuation:
Measurement and Management, Wylie, 2005, 141.
Pharmaceuticals & Biotechnology
Household and Personal products
Software and Services
Media
High Performing PM 01-07
Top Quartile, CSX Data 93-06
Semiconductors and Equipment
Health Care Equipment and Services
Food, Beverage and Tobacco
Technology Hardware and Equip.
Automobiles and Components
Consumer Durables and Apparel
Total Sample
Retailing
Materials
Energy
CSX Data 93- 06
Transportation
Telecommunications Services
Utilities
15.2
15.0
14.7
14.1
12.0
11.9
11.3
11.0
10.3
9.9
9.5
9.0
9.0
8.4
7.7
7.0
6.9
6.5
6.2
CSX Entire Corp. Sample ROIC averaged 6 percent from 1993 to 2006 and 7% (including owner’s salary) and 6 %
(excluding owner’s salary)—note this is not the same sample of firms for each year. Top quartile ROIC averaged
12%.
18.4
If. The Playing Field
• How tough is our industry? Relative to “pure
competition”? Close to pure competition; keep in
mind there are huge differences market by market.
• What does that suggest for our industry and its
individual firms’ performance? Low Return on
Invested Capital versus Cost of Capital
• If so, how did we dodge the recession bullet?
Strategic Value Management (SVM) Has Three
Key Functions

Enhancing firm value is the ultimate financial
objective

Key Question: Will the proposal raise the firm’s
market value? Is its return on capital greater than
its cost of capital? Does it have positive Economic
Profit and NPV?

Firms and their Strategic Value Units (SVUs) must
identify and focus on the key drivers of value.

The firm’s management options (SVM) must
integrate strategy, action plans, targets,
performance measurement and incentives across
the organization.
ROIC less Cost of Captial (EP) integrates performance measurement across
key decisions
Operating
Decisions
EBIT(1-t)
EP ($) or (%) = EBIT(1-t) - (Capital x Cost of Capital (%)
Ec. Profit = Return on Invested Capital – Weighted Average Cost of Capital
Investment
Decisions
(Capital)
Financing
Decisions
(Cost of Capital)
Ec. Profit (Value) Basics: What must management do to increase EP and
create firm value? Also, Minimize Cost of Capital – Optimal Use of Leverage
[
NOPLAT
EP ($) =
Capital
Cost of
Capital
]
X
Capital ($)
Operate - Improve the return
earned on existing Capital
Build - Invest as long as
returns exceed the cost
of capital
Harvest - Divest capital when returns
fail to achieve the cost of capital
A Typical Financial Management System
Acquisition
Analysis
Performance
Measurement
Performance
Benchmarking
Incentive
Compensation
Earnings
Returns
?
Growth
Cash Flow
Margins
Budgets
Operational
Initiatives
Capital
Budgeting
Communicate
Results
Strategic
Planning
Goal
Setting
The Financial Management System and Economic Profit
Acquisition
Analysis
Performance
Measurement
Performance
Benchmarking
ROIC less WACC
= Ec. Profit
Operational
Initiatives
Incentive
Compensation
Capital
Budgeting
Communicate
Results
Strategic
Planning
Goal
Setting
Return on Invested Capital less the Cost of Capital or Economic Profit is the
key metric to for alignment and consistency in the organizational architecture
Decisionmaking
(planning &
resource
allocation)
Accountability
&
Rewards
Performance
Measurement
Case #1: Looks are deceiving—Growth
in Invested Capital
$140,000,000
$120,000,000
What Stage is the
Firm?
$100,000,000
$80,000,000
$60,000,000
$40,000,000
$20,000,000
$0
2001 2002 2003 2004 2005 2006 2007 2008
Fixed Assets
Cap Rents
Working Cap
28
Invested Capital Per Gallon
Total Company: Implications?
0.7000
0.6000
0.5000
0.4000
0.3000
0.2000
0.1000
0.0000
2001
2002
2003
2004
2005
2006
2007
2008
Working Cap 0.048 0.045 0.063 0.072 0.091 0.091 0.121 0.125
0.204 0.256 0.24 0.219 0.207 0.208 0.211 0.241
Cap Rents
Fixed Assets 0.142
0.18
0.168 0.148 0.169 0.196 0.225 0.222
29
Income and Expense Growth
Total Company
$60,000,000
$55,000,000
$50,000,000
$45,000,000
$40,000,000
$35,000,000
$30,000,000
$25,000,000
2001 2002 2003 2004 2005 2006 2007 2008
Income
Expense
Return on Invested Capital: Another
Story
16.00%
14.00%
Return %
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
2001
C1
2002
2003
Ind Avg
2004
Top Qrt
2005
2006
2007
2008
CP 8 Yr Avg
31
Return %
Return on Invested Capital
Strategic Value Unit (SVU No. 1)
16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
2001
2002
SVU
2003
2004
Ind Avg
2005 2006
Top Qrt
2007
2008
Return %
Return on Invested Capital
SVU No. 1 and Comparable Companies
Discuss Recent Value Enhancing Moves
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
2001
Case Firm
2002
2003
2004
Firm B
2005
2006
Firm C
2007
2008
Firm D
Case # 2. Composite, High Performing Segment
Again Note Growth in Capital Invested for Composite, High Performing Case Here we
also see its blended cost of capital (WACC)?
$600
11.0%
$543
10.0%
9.0%
8.0%
$400
$400
7.0%
6.0%
$281
$300
5.0%
$215
$200
$162
4.0%
$174
3.0%
2.0%
$100
1.0%
$0
0.0%
2001
2002
Equity
2003
Debt
2004
Total Capital
2005
2006
WACC
WACC
Capital (in Millions)
$500
Case #2: Wealth Creation & Composite High Performing Firm EVA Trend
Now, for the quiz: What does this suggest for its Return on Invested Capital? Greater
than or Less than its Cost of Capital (WACC)?
12%
11%
$50
What about the
firm’s matrix
position?
10%
9%
$38
8%
$30
7%
$30
6%
5%
$20
4%
$13
$10
3%
2%
$7
$3
1%
$0
0%
2001
2002
2003
EVA $'s
2004
2005
EVA %
2006
EVA %
$40
EVA $'s
(in millions)
$46
Case # 2. EVA Market Value Assuming Same Future Performance
What is the EVA Based Value of Our Composite, High Performing Case Sector?
Moral: Growth plus Returns equal Huge Value Gains
(Note: Enterprise Value equals Invested Capital & PV of EVA, with no growth)
Supported by market “comps”? Implication?
$1,200
$800
$600
Total Value
(in Millions)
$1,000
$508
$463
$381
$288
$400
$175
$200
$34
$0
$136
$108
$125
$57
$66
$90
2001
2002
2003
$105
$201
$91
Equity
Debt
$145
$199
2004
2005
EVA
$254
2006
In summary,
•We can profit from the financial discipline
that value based analysis and planning
provides—it is a form of deliberate practice
similar to what Geoff Colvin describes in
Talent is Overrated?
Let’s not forget we need to monitor our
environment or “it’s all about the economy”
Now for the Big Picture—A. Economic
Monitoring on the Cheap for Best Results—
Two Free, Proven Monitoring Sources B.
Where are the Commercial Real Estate
Markets Headed?
What do both suggest for our industry?
Business planning esp CRE is all about the Economy--Chicago Fed National Activity
Index (3 Mo. Moving Average) Shows U.S. Economy Went into Recession in Q4 2007
Above
Inflationary
Level
+0.7
Below
Rec.
Level
So where are we now in the economic cycle?
The Chicago Fed National Activity Index
(CFNAI) is a monthly index designed to gauge
overall economic activity and related
inflationary pressure.
So where are we now in the economic cycle? CFNA-M3
CFNAI recently in a state of flux
• The index’s three-month moving average, CFNAI-MA3, increased to .11
in February from .05 in January 2011. February 2011’s CFNAI-3 month
moving average suggests that growth in national economic activity is
approximately equal to its historical trend. With regard to inflation, the
amount of economic slack reflected in the CFNAI-MA3 suggests subdued
inflationary pressure from economic activity over the coming year.
• The index’s three-month moving average, CFAI-MA3 declined to -0.19
from -0.15 in April suggesting that the economy is below its historical
trend. It remained negative for the second month reaching its lowest
point since November 2010. Keep in mind it also suggests low inflation
despite all the market pundits!
•
•
On September 20, 2010, the National Bureau of Economic Research (NBER) determined that June 2009 marked the end of the recent
recession. By comparison, the CFNAI indicated that the recession had ended in its October 26, 2009, release—almost a year earlier.
Stay tuned to the Chicago Fed’s email alerts on the Chicago Fed’s National Activity Index! Best “free” economic condition data
available at any price. Know where you are before establishing where headed! Note: To compare the success of the CFNAI in tracking
the dating of recessions established by the NBER, see
www.chicagofed.org/digital_assets/publications/cfnai/background/cfnai_background.pdf.
At Long Last, Trucking Data Utilized! Important!
About the Ceridian-UCLA Pulse of Commerce Index™
In conjunction with economists at UCLA Anderson School of Management and Charles
River Associates, Ceridian has launched the groundbreaking Ceridian-UCLA Pulse of
Commerce Index™ by UCLA Anderson School of Management. It is a first of its kind
indicator of the state and possible future direction of the U.S. economy. The index is
issued monthly and has been proven to track closely to the Federal Reserve’s Industrial
Production number.
The Ceridian-UCLA Pulse of Commerce Index (PCI) is based on real-time fuel consumption
data for over the road trucking. By tracking the volume and location of diesel fuel being
purchased, the index closely monitors the over the road movement of raw materials,
goods-in-process and finished goods to U.S. factories, retailers and consumers.
Compiling and Analyzing the Data
Every day across the United States, over the road trucks are fueling up with diesel as they
move goods across the country, delivering everything from produce to raw materials to
finished goods. Through Ceridian’s electronic card payment services for the
transportation industry, Ceridian has been able to track this data and analyze the volume
of fuel being used by these vehicles on a yearly, monthly, weekly and daily basis. Ceridian
processes millions of these fuel transactions each year, and the data provides a
compelling story about the status and direction of the U.S. economy.
New Ceridian-UCLA Index: Trucking Based Ec. Index
Ceridian-UCLA Commerce Index and Industrial Production
Stalled Out?
Ceridian-UCLA Index: Longer View
Higher Fuel Prices Slowing the Economy?
Unfortunately, economic forecasts are notoriously deficit so the best we know is where we are at a point in
time. Thus, it pays to know the long term history. How bad was the credit crisis relative to other rough
times?
“Below the Banking, Currency, Default, and Inflation Index (Rhinehart & Rhinehart, After the Fall,” 2010)
Rhinehart and Rhinehart, “After the Fall,” 2010
• More than ample evidence that the decade of
relative prosperity prior to the fall was fueled by an
expansion in credit and rising leverage spanning
approximately a decade;
• This is followed, in turn, by a lengthy period of
retrenchment that most often only begins after the
crisis and lasts almost as long as the credit surge.
• Clearly, not what one wants to hear on the morning
news!
Rhinehart and Rhinehart, “After the Fall,” 2010
• Paper examines 66 countries from 1900-2010 for 15 post WWII
financial crises as well as the great depression, the 1973 oil shock
and the current crisis;
• "After the Fall" predicts likely scenarios a decade after the crisis
year of 2007;
• Their findings suggest a 90% probability that real house prices will
be below 2006 prices in 2018;
• The chart illustrates that the “great recession” was not up to WWI
hyperinflation, the great depression and WWII. So, things could be
worse. Still, according to Peter Linneman’s comparative analysis—
clearly the worst post WW II recession to date.
Rhinehart and Rhinehart, Findings
• Rhinehart and Rhinehart go on to demonstrate that
real per capita GDP growth rates are significantly
lower during the decade that follows severe
financial crises, particularly those characterized by
synchronous world-wide shocks.
• Importantly, the median post-financial crisis GDP
increased growth decline in advanced economies is
approximately one percent.
• So, if the normal growth of the economy was 4—
then 3; if 3.5—then 2.5 etc.
Rhinehart and Rhinehart, Findings
• And, as we would also expect, during the decade following severe
financial crises, unemployment rates are significantly higher than
in the decade that preceded the crisis.
• The rise in unemployment is most marked for the five advanced
economies studied, where the median unemployment rate was
about five percent higher.
• In ten of the fifteen post-crisis episodes studied, unemployment
never fell back to its pre-crisis level within the following decade.
• Clear implication—the recession has run true to form and will
have a longer impact than a “normal” one with higher
unemployment and lower economic growth! So, why is the press
so surprised?
Summary of Economy Concerns: Jim Clayton, Cornerstone Real
Estate Advisors, Feb. 13, 2001
U.S. Debt Shrinking Slowly
1x. Toward a More Balanced Global Economy
Challenge
for China
and Other
Asian
Nations:
Re-orient
Growth
Away
from
Exports to
Domestic
Demand
The Coming Decade – Macro Outlook
US recovery from “Great Recession” is in flux, but its impact will be evident throughout
the forecast period with slower growth & higher unemployment:
– US & Europe’s weak economies threaten global recovery
– Robust private sector growth is not yet occurring
– Structural changes are occurring in the federal budget; mandatory and interest
expenses are increasing faster than revenue
 Congressional Budget Office (CBO) projects deficits never under $700B
through FY20
– FY11 deficit is 9% of GDP & in 5% range through FY20
– Deficits decline till FY14, then rise to $1.25 trillion by FY20
– Public debt will reach 90% of GDP by 2020
– Persistently high debt will constrain discretionary spending
 CBO estimates interest expense, $200B in FY10, reaches $900B by FY20,
becoming an additional major budget driver
The Federal budget is on an unsustainable path – US Comptroller General
56
Growing Budget Competition from Mandatory & Interest
Chart Sizes are proportional to total dollars
FY 2011 Request
$3.8 Trillion
Interest
7%
$254B
Outlays in Current Dollars
FY 2020 Projection
$5.7 Trillion
Interest
15%
$845B
Security
23%
$895B
Non-security
14%
Social Security $520B
19%
$730B
Security
17%
$955B
Non-security
9%
$529B
Social Security
21%
$1,201B
Note: New “Security” category groups DoD, DoE Nuclear Wpns, DHS, VA, some of DoS and other security assistance programs
Source: OMB, Budget of the U.S. Government, Fiscal Year 2011
Structural changes to interest and mandatory spending squeeze discretionary
57
Public Debt Increasing Far Above Normal
1958 – 2008 Average= 38%
Note: FY10 – FY20 per CBO March 2010 Estimate of FY11 PB
Sources: OMB, Congressional Budget Office, March 2010
Future debt rises to levels not seen since the end of World War II
58
US General Government Gross Debt Projected To Exceed GDP by
2015
General Government Gross
Debt as a Percent of GDP
US General Government Gross Debt
is Projected to:
 Double between 2000 and 2015,
exceeding 100% of GDP
 Surpass European countries such as UK,
France, and Germany, and rival that of
Greece and Italy
 Large public debt is slowing GDP
growth in Japan and Euro-zone;
could slow growth in US
 Japan’s GDP growth slowed in the ‘90s,
averaging only 1.7%
 IMF reports GDP in Euro-zone countries
will grow ~ 1% in 2010-2011
 UK to cut defense by up to 20%
General Government Gross Debt Source: IMF Fiscal Monitor,
“Navigating the Fiscal Challenges Ahead”, May 14, 2010,
Statistical Table 6, p. 85
Chronic federal deficits are putting US on a path to reach
European–style debt levels and slower economic growth
59
Fiscal Restraint Already Evident in Non-Defense Discretionary Outlays
Non-Defense Discretionary Spending
FY 1962 – FY 2015
Historical Actuals
FY11-15 Plan
Real CAGRs:
700
Spike due to
FY09 Stimulus
300
60’s:
70’s:
80’s:
90’s:
00-08:
09-10:
11-15:
4.6%
6.1%
-1.6%
1.5%
2.9%
18.1%
-3.5%
200
62-15:
2.5%
600
500
400
100
0
Source: OMB Historical Tables, FY 2011 Budget, Table 8-8. Non-defense is all discretionary except budget function 050.
After decades long growth, expect a contraction in non-defense spending
60
DoD Budget 1945-2015: Threat Driven, but Debt Constrained
Public Debt
% of GDP
120
100
80
60
40
20
0
800
Historic Budget Constraint Zone: Public Debt > 40% GDP
Afghanistan and Iraq
Wars
WW II
DoD Budget
in Constant FY11 $B
Korean War
Reagan Build-up
Vietnam War
600
400
Missile Gap
Cuban Missile Crisis
200
19% Decline
31% Decline
44% Decline
0
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Large debt levels will impair future US ability to increase
defense spending as quickly as in the past
2010
2015
61
Deficit Forecast: Bleak Without Major Entitlement Reforms or
Revenue Growth
Percent of GDP
OMB February ’09
Actual FY10 deficit is approximately 10% of GDP. CBO
projects $1.3T deficit, $20.3T debt in 2020.
OMB February ’10
CBO Mar ’10 Assessment of
FY11 Budget
TechAmerica Forecast
Changes from Mar 10 CBO:
• Adjustments for DoD base
budget and OCO forecasts
• Higher assumption for health
care reform costs
• Reduced international affairs
spending
• Risk of higher interest rates
Fiscal Year
Deficits stay above 4% through the forecast period;
the trend is toward larger, not smaller, deficits from FY14 through FY21
62
External Environment Summary
• Long-term growth of Social Security, Medicare and Medicaid has put the
country on an “unsustainable fiscal path”
– Rapidly growing health care costs are the most significant problem
• Huge deficits, growing national debt and an uncertain global economy will
constrain the discretionary budget
– Deficits of historic proportions projected for foreseeable future
– Annual interest on debt projected to exceed DoD base budget by 2017;
and earlier if interest rates rise
• The only practical way to reduce deficits & debt is via a combination of
strong economic growth, increased revenues, and reduced spending
– President froze non-security discretionary spending for FY11-13
– Subsequently OMB directed non-security agencies to cut 5% in FY12
– Presidential Commission reported recommendations in December 2010;
but Congress must ultimately make the decisions—now in deadlock!
“The biggest threat we have to our national security is our debt.”
Adm. Michael Mullen, Chairman of the JCS, June632010
New World, Old Rules?
As Financial Markets Rallied & Global Economy Moved into
Recovery
Credit Crisis Revealed Many Mistaken Assumptions on How the
World Operates
Economies Cannot Grow Beyond Their Means in Perpetuity
Reasonable Probability of Reorienting Global Growth Away from
US Consumer to Emerging Market Demand
Uncertainty focused on two key factors:
1. Fortunately, Developed World Growth Did Not Collapse
2. Developing Nations Must Not Rely on Growing US Consumption
CRE Cycle Roller Derby: Development, Space, and Capital
Source: RCA
Aug. 07
Trends + to Sept. 08,
space mkts.
turn negative
Here We Show “Core” CRE Price Changes Broken Out Between Income
(Space Markets) and Cap Rate (Capital Markets) Effects
Capital Markets: The Big Picture
• Transaction activity has only recently revived
• Prices starting to firm as credit crunch eases, but improvements selective
Quarterly Commercial Real Estate Investment
CRE Sales
$160
CRE Prices
$140
$120
CRE Prices
Down 42%
Peak to Trough
$100
$80
$60
$40
$20
$0
'01
'02
'03
'04
'05
'06
'07
'08
'09
'10
sources:
CRE Sales: Real Capital Analytics, office, industrial, retail, multi-family properties $5mil+
CRE Prices: Moody's/REAL CPPI National Aggregate Index
Private CRE Appreciation Decomposed—Two Market Downturns
Last Year’s Overstreet Scenario Going Forward (2009-2010)
•
•
•
•
1991—1993
NCREIF Price Index -23.5%
NOI Effect
- 3.2%
Cap Rate Effect
-21.0%
Interaction Effect
+ 0.7%
•
•
•
•
2002—2004
NCREIF Price Index
12.4%
NOI Effect
-16.4%
Cap Rate Effect
+34.4%
Interaction Effect
-5.6%
2007/2010
2007/2010 C-Store Ostreet SWAG
• NCREIF Price Index
-- 40.0%
•NOI Effect
-- 15.0%
•Cap Rate Effect
-- 25.0%
•Interaction Effect Ignore
• Pet Mkt. Price Index
-- 20.0%
•NOI Effect
+5.0%
•Cap Rate Effect
-- 25.0%
•Interaction Effect Ignore
Not over the Maturing CRE Mortgage
Debt “hump” Yet!
Vacancy Trends, 1991 to 2010—Office, Industrial
Retail Historically Weak, Apt. solid
REITs: A Leading Indicator--Good Omen?
Key Take-away
Monitor REITs in general
and industry examples
Getty (gty) (hpt) (nnn)
Core Property and Bond Pricing Relationship Linked
10 Year Treasury
Baa Corporate Bond
Real Estate (Cap Rate )
10%
Recently, Cap Rate Decline Has
Lagged Bond Market Rally
9%
8%
7%
4Q10
6%
Feb.
2011
5%
4%
Feb.
2011
3%
2%
2002.01
2003.01
2004.01
2005.01
2006.01
2007.01
2008.01
2009.01
2010:1
Treasury and corporate bond yields are monthly through February 2011. Real estate
cap rate is quarterly through 4Q10 and represents equally weighted average cap
rates from institutional core property transactions.
73
Sources: Cornerstone Research, NCREIF, and Federal Reserve Board.
Reading the Cap Rate “Tea Leaves”
1. Cap rates on core real estate tend to be highly
correlated with Baa corporate bond rates
2. Cap rates on core real estate tend to be slightly
higher than Baa corporate bond rates Why? Less
Liquid? Riskier?
3. Relationship “flipped” in 2006 as property prices
hit new highs—then back to “normal” in 2009-but with a too robust a spread (back to chart)
4. Suggests future drop in cap rates and rise in
property prices—which has been in process the
past two quarters
But…..make sure we look at all the evidence
• Yes, at the aggregate level, cap rates spreads to corporate
bond and treasury rates remain relatively high by historical
standards;
• Yet “spreads” for high quality properties in select markets
(DC, SF, and NYC for example) are much skinnier!
• Indeed, fierce competition for core properties in such
markets has led to 6 percent and below cap rates on a
number of transactions—a bifurcated to trifurcated market
situation! It is the old “flight to quality” routine!
Com. Mortgage Interest Rates and Difference
(Spread) to Risk Free Rate Has Normalized!
7.5%
**Interest rate data based on properties and portfolios valued at $2.5 million or greater and on loans with terms
between 7 and 13 years.
7.0%
* CRE Industrial, Office, and Retail - 6 month
average
6.5%
6.0%
5.5%
5.0%
4.5%
4.0%
3.5%
Commercial (CRE)
Multifamily
10-Year Treasury
3.0%
2.5%
'01
'02
'03
'04
'05
'06
'07
'08
'09
'10
'11
Post Bubble Cap Rate Spread Expansion
Conclusion: Highly likely that CRE has bottomed out! But each local market
is different which presents a Demand/supply puzzle. Analyze!
• Spreads to treasuries remain high which coincides
with continued economic and property sector
weakness—hence, risk and higher cap rate spreads
• Yet, historically, these same metric conditions have
coincided with property value rises over a three to
five year period.
• Chances are good that our “cap rate tea leaves” are
pointing to a similar outcome this time around.
Time to buy—Time to Sell?
Robert White (CEO, Real Capital Analytics)
recently put forward the following thesis?
Core asset (office, retail, industrial, apt.) prices in
major markets up strongly in 2010 (approximately 30
percent);
Distressed assets still priced relatively well with
lenders ready to deal;
If you own stabilized properties or can manage to
stabilize one quickly—arbitrage opportunity exists to
sell high and buy low;
Buyers are paying up for high quality, well leased
properties while the vast majority are discounted
significantly;
Risk takers will rarely have a better situation.
Bob White, RCA CEO, Market CRE Thesis
Continued
• Time is NOW as distressed opportunities will
evaporate within next two years
• Spike in major markets and assets driven by buyer
demand as much as the return of debt markets;
• As CMBS conduits continue to expand and buyer
pool deepens, they will be forced to expand into
other markets—driving the markets up;
• Fundamentals improvement also factors in—with
example of apartments last year up 30 percent.
Looking Back: Rich Rewards for Early Movers
Change in Investment Orientation, ’10 – ‘11
Bob White, RCA CEO, Market CRE Thesis
Continued—Concerns and Comforts?
• Rising interest rates? Oil prices? Japanese Disaster?
Tax increases (capital gain or real estate specific)?
• Commercial real estate is still a relatively new asset
class for institutional investors and allocations are
not optimal from a percentage basis and, hence,
should rise;
• Sell high—buy low or buy low and sell high—it
appears to be a great time to do either!
• What do you think? How does the Convenience
store product fit into this thesis? Discussion?
Other Pundits:
Prudential Real Estate Advisors positive at turn of year
•After a long period of fits and starts, conditions now
seem ripe for an extended recovery in CRE;
•Firmly established in multi-family and hotel;
•Office, retail, and industrial starting to turn after
hitting near-record vacancies;
•Caution required given that the turn is dependent on
what they view as a still “fragile” recovery
RREEF’s Take on Retail—note for smaller and high growth
metros—extreme selectivity! Does it apply to C-stores?
•Capital slow to return—distressed situation! Changing now as
surviving retailers stronger with store closings, etc.
•Consumers modestly increasing their wayward ways!
•Investors returning! Yields compressing here also;
•Prefer top quality although older properties with exceptional
locations if low-rent anchors are nearing the end of lease
renewal options
•Top investable properties found in a broad array of metro
situations but beware of smaller and high-growth, low barrier
metros!
Time to buy—Time to Sell? C’stores?
Here We Show “Core” CRE Price Changes Broken Out Between Income
(Space Markets) and Cap Rate (Capital Markets) Effects
Industrial Still Struggling
Office Also Struggling
Multi-Family On a Different Track
Retail Still Struggling But Down Less than Office
CRE All About S&D and Retail Has an Issue!
Retail Demand (Constant-Liquidity) & Supply Indexes
Demand
250
Supply
200
150
100
50
yyyyq
20101
20091
20081
20071
20061
20051
20041
20031
20021
20011
20001
19991
19981
19971
19961
19951
0
19941
Dem 1994Q1=100, Sup set to = avg level
300
Good Case Example: Appraisal vs. Mgr. Est. & Tax Assess.
Values
Description
2010 Tax Ass.
Mgr. Est. Value
Appraisal
App. Vs Ass.
App. Vs. Mgr. Est.
App./Ass
App/Est
%
%
Car Wash
$410,700
$600,000
$460,000
$49,300
-$140,000
112%
77%
Service Station
$575,000
$750,000
$551,000
-$24,000
-$199,000
96%
73%
Office
$154,100
$250,000
$210,000
$55,900
-$40,000
136%
84%
Warehouse
$159,600
$200,000
$206,000
$46,400
$6,000
129%
103%
C-store
$378,776
$450,000
$419,500
$40,724
-$30,500
111%
93%
C-store
$409,900
$300,000
$499,000
$89,100
$199,000
122%
166%
C-store
$300,000
$250,000
$325,000
$25,000
$75,000
108%
130%
Service Station
$336,364
$350,000
$438,000
$101,636
$88,000
130%
125%
C-Store
$362,903
$350,000
$521,500
$158,597
$171,500
144%
149%
C-store and Garage
$653,968
$1,000,000
$750,000
$96,032
-$250,000
115%
75%
$25,700
$50,000
$53,000
$27,300
$3,000
206%
106%
C-store
$987,037
$1,050,000
$817,000
-$170,037
-$233,000
83%
78%
C-store
$1,582,090
$2,250,000
$930,000
-$652,090
-$1,320,000
59%
41%
Total
$6,336,138
$7,850,000
$6,180,000
-$156,138
-$1,670,000
98%
79%
Building Lot
Lessons Implied for Petroleum Distribution CRE
•
•
•
•
Nourishing traditional banking relationships will pay large dividends in tough
periods but should require keen assessment of the bank’s risk posture, etc.
Securitization and CMBS are not dead and they are beginning to recover—it has
not been rapid—does continued scarce and pricier debt suggest liquidity buildup for petroleum marketing firms? What are the long term implications?
Discuss!
Alignment with equity & debt sources crucial to success during and post crisis;
a great moment for creative partnering.
Operational excellence necessary for turnaround opportunities! Operational
excellence is Rare! It is worth the price! Buy or lease A properties with
B performance and turn into A properties.
95
Lessons Implied for Petroleum Distribution CRE
•
•
•
•
•
Study history! These real estate banking crisis cycles are predictable although
history repeats but never the same way. Banks are key element not because
they create credit but because fractional reserves and mortgage based
lending—a violent combination!
History suggests strongly that these banking based expansions and subsequent
real estate (asset) bubble crashes are slightly less than two decades in duration
(14 +/- years of build-up with a mid-term slow down followed by 4 +/- years of
tough sledding)—Avoid the winner’s curse period (last 2+/- years of upturn);
Don’t try to pick the top—be conservative! Sell in the 13th if you don’t ride it
out! Never buy early in a falling market at the end of the cycle—they last years!
Value based strategic plans for real estate intensive firms should be based on
this long cycle reality—fractional reserve banking systems and land inflation
over a cycle lead to severe corrections!
Optimal long-term value route requires identifying the economic turning
points—extreme points in the long term real estate cycle—and doing the
opposite of the “herd” at these key points!
Extremes take years to develop & new technology will not alter this!
96
Lessons relative to BEST PRACTICES
Essential Elements of Great CRE Investor/Managers have not
changed: Confront the Brutal Facts; Get the right people on the bus
and the wrong ones off; run the business as a business & the family as a
family
1. Know Yourself, Your Firm, Its Parts, and Its Risk Tolerance
Moreover, How Each Relates to Owner/s Personal Risk
Tolerances and Financial Objectives—Analyze Deeply
2. Determine Whether Each Unit is Adding Value: Analyze your firm’s
portfolio of products, units, and strategic value parts with the best
techniques available—Economic Value Added/Life Cycle Analysis (BCG
matrix)
2. Know Your Real Estate Markets—Establish a Information Network that
Assures Your Team of Asymmetric Information
Treat this as a necessary CRE business activity
Lessons relative to BEST PRACTICES Cont.
3. Understand subtleties of unit & firm value drivers-formally analyze the market demand and supply
characteristics and build these assumptions into your
financial projections and discounted cash flow analyses
• If you don’t practice DCF, review a value based analysis and see why not?
Warren Buffet’s academic mentor can’t be wrong!
4. Understand the benefit/costs of leverage and build this
into your modeling efforts
ROE = ROIC + (ROIC less Cost of Debt) X D/E
Moral: Unless you are making solid returns on invested
capital (Debt + Equity), financial leverage won’t help
& it can HURT
Manage toward ROIC for each Value Center
Lessons relative to Best Practices Cont.
5. Structure your real estate portfolio separately from your
operating business and account and manage it optimally using
best practice techniques to cull, revitalize, and add new to
industry units! Strategically establish fortress CRE positions!
6. Realize that managerial time and talent is your most critical
resource; capital can be creatively raised even in credit
constrained environments .
7. Management requires the focus achieved through applying
value based principles—unfortunately still not well understood
and used where needed most—in our private firm
environments. Return on Invested Capital less the Weighted
Average Cost of Capital =s Economic Profit ; Present Value of
Economic Profit =s Corporate Value Added! Grow Accordingly!
Lessons Confirmed by Credit Crisis
•
•
•
•
Debt contains a largely ignored risk (refinancing)
20 plus percent IRRs far easier to generate in spread sheets
than in reality
Worst-case analyses rarely come close to potential worse
cases and normally are too extreme—thanks to the
limitations of our ability to forecast complex outcomes
Cheap and easy money portends expensive and scarce
money in the future!