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Are San Francisco tech companies disclosing real estate risks adequately? October 15, 2013

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Twitter HQ - big enough?

Twitter HQ – big enough?

Tech companies in San Francisco ought to all know that one of the main growth constraints they face is the availability of office space to house workers.  Availability of the highly-sought-after so-called “creative space” is near zero.  Even if a company is willing to forego exposed timber, high ceilings, skylights and other cool features and settle for more conventional space, according to Colliers research, only 9.7% of the downtown San Francisco office space is vacant, and that percentage is declining fast.  The amount of space being sought by tenants currently in the market represents about half of the limited vacancies.  Undoubtedly, some companies are not going to be able to find the right space in the right location at the right price to meet their needs.

Boilerplate 10k disclosures

Yet, while San Francisco-based companies disclose in their 10K’s a seemingly endless list of risks, I don’t know of any who have cited availability of real estate as a risk to the growth of their business.  Almost all tack on a boilerplate nothing like the following at the end of Item #2 regarding Properties in their 10-K’s: “We believe that our facilities are adequate for our current needs.”  If any mention is made of future needs, it’s usually a statement like this one from a well known tech company headquartered in downtown San Francisco:  “If we require additional space, we believe that we will be able to obtain such space on acceptable, commercially reasonable terms”.

Really?   With downtown San Francisco vacancy possibly approaching 5%?

Maybe it’s time for disclosures about real estate to be taken more seriously.  After all, the value proposition to prospective shareholders of most tech companies is not based on their current level of profitability, but rather projections of much greater profitability in the future.  In our “new economy”, where office space to house knowledge workers needs to be considered a factor of production, the availability of this resource cannot be treated so cavalierly.

The issue of real estate as a constraint looms particularly large, one would think, for companies filing for IPO’s, but it’s unclear whether disclosures are taken much more seriously there.

Twitter’s IPO

Take the case of Twitter which has recently filed its IPO registration statement.  The statement reveals that Twitter currently has negative net income, so clearly the value proposition is all about growth.  The statement lists 28 pages of “Risk Factors” many focused on constraints to growth, but the only reference to real estate as a constraint is about data centers: “we cannot be assured that we will be able to expand our data center infrastructure to meet user demand in a timely manner, or on favorable economic terms”.  There’s no mention of real estate to house all the folks doing software coding, administering data systems, selling advertising, and generally managing the enterprise.

Now, Twitter, to its credit, may have its non-data-center real estate needs under control more than most companies.  In April of 2011 it made a bold, visionary move when it leased space in a giant building on Market Street in a prominent, easy-to-reach location, but one that is adjacent to a red light district.  After amendments, Twitter now has about 300,000 square feet under lease until November of 2021.  In moving to a less-established office location, Twitter was able to grab a lot of contiguous space at a price that, presumably, allowed it to bank space for the future.

Apparently, though, it wasn’t enough.  There are reports that Twitter is currently in negotiations for another 320,000 square feet.  What happens if its negotiations are not successful?  Will growth be limited?  I’m sure enquiring investors would like to know.  It would have been nice if the IPO registration statement had explicitly addressed the question of availability of real estate to grow.  As it is, we don’t know if the omission of listing real estate availability as a risk to growth is because Twitter actually has its needs covered for the foreseeable future or because it was simply following bad industry practice of not taking real estate availability seriously enough to disclose it as a risk if, indeed, unavailability might be a problem.

Is availability of real estate a material risk?

Some observers might say that availability of real estate is not material enough a risk to list in financial disclosures.  Any real estate executive, however, who has been ordered “don’t let real estate limit our growth” is keenly aware of how real this risk can be, particularly in San Francisco.  And while there are workarounds for San Francisco companies, like hiring people elsewhere or letting them work from home, companies are in San Francisco because that’s where they think the talent is or at least to where it can be recruited.  That’s where they think there’s a unique tech vibe that energizes their companies.  And that’s where they go to great lengths to make their workplaces cool so they can attract the best talent.  They wouldn’t be paying the premium to do business in San Francisco if having workplaces in the city were not so important. So … if they can’t find that space to create cool workplaces to house the workers they want to hire, isn’t that a material issue?   And shouldn’t the risk that they might not be able to get the space be disclosed to investors?

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“We’ve come up with a design that puts 12,000 people in one building” June 9, 2011

Posted by Bob Cook in Company Case Studies, Corporate HQ, Green Initiatives, Profession of Corporate Real Estate, Silicon Valley.
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It’s not often that a CEO of a major company makes a presentation to City Council on company plans for a new headquarters building.  But Apple is no ordinary company, and Steve Jobs certainly is no ordinary CEO.  He’s not afraid of being accused of having an “ediface complex” — a concern that afflicts most other CEO’s and which is responsible for the declining quality of architecture as it relates to corporate headquarters buildings, IMHO.  No, no one is going to challenge Mr Black Turtleneck, Mr Cool, himself, on this one.

It’ll be interesting to see if Jobs’ new Apple HQ announcement spurs imatators … just as has been the case with the iPod, iPhone, and iPad.  Will it become ok, again, to build iconic HQ’s? 

See Jobs’ presentation to Cupertino’s City Council here:  http://www.youtube.com/user/cupertinocitychannel#p/u/0/gtuz5OmOh_M

Facebook taking Sun headquarters? Schumpeter’s creative destruction at work. January 5, 2011

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, Silicon Valley.
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Economist, 1883 - 1950

Joseph Schumpeter, Economist, 1883 - 1950

The Mercury News reported yesterday that Facebook is close to buying the former Sun Microsystems headquarters in Menlo Park CA for its own.

It’s all part of economist Schumpeter’s “creative destruction”.  With innovation, there are those who rise and those who slide.  Over the last decade, Facebook has risen, Sun has slid.

Sun built its million-square-foot Menlo Park campus during the dot-com boom of the late 1990’s (remember that?), back when its Unix-based servers sizzled and allowed Sun’s boastful advertising slogan: “We’re the dot in dot.com”.   Sun even built a couple more million-square-foot campuses in Silicon Valley and made one its official headquarters address.  The Menlo Park campus, though, was never displaced as home of executive management, and it continued to be the “real” headquarters until “the end”. 

“The end” began when the internet boom busted and, as the IT market moved away from Unix, Sun’s revenues busted even more.  Last year, the remnant of the once-proud company was bought by Oracle for $7.4 billion, a paltry sum given Sun’s much-loftier market capitalization ten years earlier.   Sun’s management is largely gone.   When Oracle closed the purchase, Sun’s last CEO Jonathan Schwartz famously haiku’d: “Financial crisis/Stalled too many customers/CEO no more“.  Oracle whose headquarters campus is down “the 101” about 10 miles, apparently, figures it can do without the old Sun headquarters.

As Sun has slid into the tech horizon, Facebook has risen towards the tech heavens.  Founded only a few years ago, in 2004, with a handful of employees, the company now has about 2,000 workers … still small compared to the nearly 40,000 that Sun had at one time, but other stats are superlative:  Its market cap is estimated to be about $50 billion … a staggering amount for a company that is still privately-held … and it claims to have 500 million users!  It even has a movie made about it.  Facebook’s trajectory is strongly upward, and undoubtedly it feels it will fill the former Sun headquarters, which can probably house at least 3,000 workers, in no time.  It’s earned the right to have everyone under one roof … to have its own campus.

A loser, a winner:  It’s the Schumpeter Way.

Is Employee Housing Far-Fetched? What is Google up to now? November 22, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Ask virtually any corporate real estate exec whether it makes sense for his company to provide housing for its employees, and you’ll get a dismissive “we don’t do that”.  So sums up conventional wisdom on the subject.

Now, it is true that some companies have provided housing for manufacturing employees in China where workers expect to receive it, but most U.S. companies now tap Chinese labor through contract manufacturers like Foxconn (infamous for its worker housing), so few provide housing themselves. 

And while it’s true that companies have in the distant past provided worker housing domestically, for example in Pullman which was built by the Pullman Sleeping Car Company way back in 19th Century Chicago, few companies provide employee housing today.   The exceptions are lumbering and mining operations and resorts, remote from existing housing.  Most companies, though, are located in urban areas with plenty of housing available, and in most cases, it makes sense for companies to rely on the “the invisible hand of the market” to provide housing for workers.   This is the conventional wisdom.

But, what kind of unconventional situation would make this conventional wisdom not wise?

And what is secretive Google planning for the Googleplex, its headquarters complex in Mountain View CA, where it has been reported it may build housing?

And are the two questions related?

Last week, the San Jose Mercury News reported on how “Google’s growth online [is] reflected by [its] expansion in Mountain View”.  The Merc revealed that Google may be building housing as part of its 1.2-million-square-foot expansion of its present four-million-square-feet of real estate holdings in Mountain View.  Previously TechCrunch and others had reported that Google was pushing the City of Mountain View to allow more residential and retail development in the vicinity of its campus … evoking visions of a “Googletopia” … so news of Google building housing is not surprising.

What exactly is Google up to, though?  One of the Merc’s sources says that as much as 120,000 square feet of residential could be built in the new campus development Google is planning … and “that would be the rough equivalent of 60 homes of 2,000 square feet”.   My thoughts on the math:  while the arithmetic is technically correct, it just doesn’t add up.

What on earth would Google want with 60 homes?  It’s not a number that would make a dent in Google’s ability to house its local employees … which the Merc estimates to be around 17,000 … and why would Google want the headache of deciding who should be allowed into such plum housing?  (A 2,000-square-foot house might not sound like much, but in Silicon Valley, that’s actually a pretty big home.)

Here’s what might make sense, though:  Google builds dormitories.  Google could squeeze as much as 400 dorm units (think small “nerd capsules”) in that 120,000 square feet.  While not enough to house a large percentage of its workers, it’s big enough to be noticed and plenty large enough to serve as a pilot to see if building and owning more dorms might make sense.  This is why it might …

Each month, Google hires a raft of twenty-somethings … many straight from university life, many from overseas … and many don’t want to live in the houses or two bedroom apartments that the market provides.  Why should they?   They don’t need kitchens; Google feeds them for free.   They don’t need space; they spend most of their waking hours at a desk.  They don’t need family rooms; they don’t have families … they’re nerds (which, BTW, today, is a complement … at least in Silicon Valley).  And they certainly don’t need to spend a lot on rent; it’ll be a while before their stock grants and options vest. 

Furthermore, these are not, of course, conventional people Google is hiring.  These are the cream of the crop.  They’re the people other companies oogle, and competition for them is the reason Google just announced it is raising salaries 10% across the board.  Providing these people with dorms on campus would be a great recruitment and retention tool.  With dorms, maybe the next salary increase would only have to be 5%.

So, if the demand for dorms is there, why can’t “the market” provide? Where is the “invisible hand”?   Zoning is the problem.  Two reasons.  The first has to do with geography.  The zoning in Mountain View has heretofore envisioned non-residential uses on the Google side of “the 101”, the U.S. highway that separates recreational, commercial, and aviation uses from the more residential, neighborhoody part of Mountain View.  A private developer would not be able to build a dormitory near Google’s campus… let alone right on it.   The second reason is that zoning in Mountain View and all the surrounding communities tends to limit the number of dwelling units that can be built on a site, either explicitly as a “DU per acre” limit or implicitly because of the physical and economic practicalities of providing the required parking.  Developers, therefore, being dictated how many units they can build, develop large and luxurious units which allow them to more easily recoup their high-Silicon-Valley land costs.  While some cities force developers to build some affordable housing as a condition of gaining their entitlements, the zoning still applies such that dorms are not in anyone’s product line.

So, the “invisible hand” isn’t working:  Googlers want dorms (or so one would think), but developers can’t get the zoning and, even if they could, couldn’t afford to build dorms.  Google wants to make the Googlers happy, but can’t rely on the market.  Google does, though, have influence over zoning (by virtue of being Mountain View’s biggest employer), and so could  act on its own if it wants dorms for its employees.  It certainly hasn’t been shy about providing Googlers with the good life on campus … from free gormet food to massages to pool tables to swimming pools.  Will it build housing?  The situation is unconventional enough to make conventional wisdom unwise.

Now … to be clear … there has been no announcement, as far as I know, that Google is going to build a dorm, and I have no insider knowledge to that effect.  But … putting two and two together … what do you think?

And if Google is not going to build dorms, maybe some of those other companies who are oogling the Googlers should think about doing so.

McKesson to Buy US Oncology; takes over $600 M of lease obligations November 1, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting, M & A Integration, Silicon Valley.
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Today, San Francisco-based McKesson, a medical supplies distributor, announced that it will buy Houston-based US Oncology, a provider of cancer drugs and administrative services to doctors.  The reported value of the transaction is $2.2 B , comprised of the purchase of the company stock for $560 M and an assumption of US Oncology’s debt obligations of $1.6 B.  The amount of debt is particularly relevant in understanding how much McKesson is “paying” (a slightly ambiguous term) for the company.  US Oncology has a huge amount of debt, and according to McKesson’s press release, “it is anticipated that substantially all of US Oncology’s debt will be repaid or refinanced”.

$2.2 B or $2.8 B?

Looks to me, though, that value-of-the-deal should be more like $2.8 B.  You need to include the $600 M of future operating lease obligations that US Oncology has … much of it related to space that will probably not be needed after a post-close consolidation of real estate portfolios.  A more accurate estimate of how much McKesson is “paying” (there’s that pesky, ambiguous word again) would include those obligations.  That would push the price up by 25% to $2.8 B.

Undoubtedly, McKesson knows US Oncology has $600 M of future minimum operating lease obligations; those obligations show up in the notes to US Oncology’s latest 10-K.  These minimum operating lease obligations are not, however, among the $1.6 B of long-term obligations referred to in press reports and which show up on the company’s balance sheet.  Yet, these operating lease obligations are as real as are the balance sheet obligations (or at least they are if you ignore the fact that McKesson might be able to disavow leases in a bankruptcy). 

If the lease obligations were on the balance sheet (as they will be once the new lease accounting standards are in effect; see below), then the reported value of the transaction would probably have been this more accurate number of $2.8 B.

Savings from consolidations

McKesson’s task will be to see how much of that $600 M obligation it can whittle down.  In its press release, the company said that “there is already an overlap between the goods and services provided by the two companies, and the combination will allow for cost-savings from shared operations”.  A large portion of those savings might come from consolidating the real estate portfolios of the two companies with the savings eventually realized either through the natural expiration of unneeded leases or through subletting or buying out of lease obligations.

The opportunity to find savings is large.  US Oncology has 5 M square feet of real estate or so it was reported a year ago when it awarded CBRE an exclusive right to provide real estate services.  McKesson, according to a report in 2007 that announced CBRE being appointed to provide services to McKesson, had 17.5 M square feet.   (Neither company discloses the square footage of their portfolios in their 10-K’s., something that will change significantly when the new lease accounting standard, with its required disclosures, is put in place.)

Millions of dollars of operating expenses are probably possible to be eliminated from the combined companies by reducing their combined real estate footprint.  Twenty-million-some square feet of space is a lot to work with and provides ample scope to find savings. 

And McKesson really should try to reduce that $600 M of lease obligation before the new lease accounting proposed by FASB and IASB comes into effect.

New Lease Accounting will put obligations on McKesson’s balance sheet

Those lease obligations that McKesson is taking on will not remain “off-balance sheet” forever.  When the new lease accounting being proposed by FASB and IASB comes into effect, probably in 2013 or 2014, whatever is left of those obligations will show up on McKesson’s balance sheet because there will be no grandfathering of existing leases.  A considerable amount might still be left because … even if all the leases expiring prior to 2014 were not renewed … according to the 10-K,  there would still be over $300 M of obligations due in 2014 and beyond.

In fact, the amount going on the balance sheet might even be considerably higher than the $600 M of obligations that existed at the end of last fiscal year.  That’s becauase the accounting boards are proposing that the amount of balance sheet obligations be based on the “longest possible lease term that is more likely than not to occur”.   That means McKesson would have to include, not just the minimum lease obligations on its balance sheet, but also the obligations related to extension periods related to options-to-renew that are likely to be exercised.  Who knows, if many of the leases expiring from 2010 to 2013 are renewed (perhaps because McKesson needs more time to implement a consoldiation plan) and if a lot of the leases have options-to-renew that are likely to be exercised, then the number going on the balance sheet could end up pushing $1 B.

A final note on lease accounting:  Reportage of the McKesson / US Oncology transaction is just another example of how the absence of lease obligations on balance sheets is problematic … particularly as more and more companies have more and more of their financial obligations in the form of operating leases.   And while we can probably assume that McKesson and its advisors fully understood that they were really “paying” $2.8 B for the company, not $2.2 B (even though its own press release used the latter figure), when others use the transaction as a benchmark for company valuations, they’re probably unlikely to adjust the price for the operating lease obligations. Balance sheets without operating leases, as now called for by GAAP, are way too imperfect.   Balance sheets are no longer meaningful.   Leases need to go on them … as they shortly will if FASB and IASB have their way.

To learn more about the new lease accounting, click here.

Google Buying New York Building? October 27, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, Lease Accounting, Silicon Valley.
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Follow-up regarding story below:  On December 3, 2010 it was reported by the WSJ and others  that Google has, in fact, contracted to buy the building at 111 8th Avenue Building.  An interesting post on how this tech-laden building is emblematic of New York’s important role in the geography of the internet age was published by Globe St and you can see it here
 
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In a previous post I laid out the reasons why it makes sense for companies to buy their headquarters:  low prices in today’s market, low corporate borrowing costs, large amounts of cash on hand, and the forthcoming new lease accounting which will take away some of the financial-statement advantages presently enjoyed by leasing versus owning.  I had referred to recent HQ-acquisitions by Northrop Grumman and others and concluded the post with “more are yet to come”.  That logic applies not just to headquarters buildings, but to any large, strategically important building in a company’s real estate portfolio. 
 

111 Eighth Avenue

$2 Billion Purchase

Today, the New York Post announced that “Google appears close to buying the trophy 111 Eighth Ave. building, one of the largest buildings in Manhattan.”  The 2.9 million-square-foot building is rumored to have a price tag of close to $ 2 billion.  A big number, but well within the capability of Google, which is a cash-generating money machine.   Lately, it’s been generating more than $2 billion quarterly in free cash flow … so it could pay for this building with the cash generated in just three months.

Google needs New York

While this isn’t Google’s headquarters, it is one of its largest engineering centers outside of the Googleplex in Silicon Valley.   In 2006, the New York Times reported that it was the largest and … if that is still not the case … it undoubtedly is the most important Google site outside of Silicon Valley.   New York is the center of the world’s advertising industry, and that’s the industry that makes Google rich.  Google needs to be in New York to access that industry and, equally importantly, to feed off the energetic frenzy of the Big Apple.  It’s likely to need a large New York presence for a long time… an imperative in deciding to buy versus lease.

So… the purchase of 111 Eighth Avenue, if it is to be, appears to be the result of the perfect storm:  Manhattan office prices are at historic lows, Google’s got oodles of cash, and the property is strategically important.  The purchase is of interest, though, for other reasons, also.  It exemplifies bold strategic planning moves on both the part of a tenant, i.e. Google, and a landlord.

Perfect building for Google

The 111 Eighth Avenue Building is so big it actually has multiple addresses … one on each side of the building, which covers an entire city block.  Those big floor plates … greater than 200,000 square feet … make the building perfect for Google.  The bigger the floor, the more room there is for scootering around, literally.  The big floors allow Google to recreate the office environment and culture it has in California.  Also making the building a good match for Google is the fact that, according to DataCenterKnowldege.com, it “is also one of the most wired carrier hotel properties in New York, and a key intersection for the Internet’s largest networks”.  One wonders if some game-changing utilization of this capability is in Google’s plans. 

A Prescient Building Owner

One also wonders if Taconic Investment Partners, owner (and presumably seller) of the building was  particularly prescient or just lucky.  Back in 1998 when it bought the building, conventional thinking had it that big, deep floors with space far from the window line are undesirable to office tenants.  Lawyers, investment bankers, advertising account execs… they all want window offices.  Did Taconic know when it “implemented a complete repositioning plan including vacating the printing and warehouse tenants to assemble large blocks of space” that companies like Google would come along for whom the large floors were ideal?  Remember, Google was just founded in 1998.

Google’s Ambitions

Google’s ambitions for the building are unknown.  Presumably, though, it envisions expanding in the building bit-by-bit as it expands its New York office.  Google’s website today lists about 140 positions available in New York.  They’d need 30 K to 40 K square feet to accommodate those folks.  Back in January, it leased an additional 57,000 square feet to add to the 270,000 square feet it initially leased in 2005; one report puts Google’s present occupancy at 500,000 square feet  … still just a fraction of this huge building.  No one knows how much space Google might eventually occupy.  The company’s ambitions, though, seem limitless.  Making such a large investment might portend more than a desire to secure office space in Manhattan.  DataCenterKnowledge.com reports that the building “houses major data center operations for Digital Realty Trust, Equinix, Telx and many other providers and networks”.  Could the building become the center of the “parallel internet” some think Google wants to build?  The potential building purchase is sure to provide fuel for the conspiracy theorists and makes for great “Google watching”.

What happens to Adobe’s HQ (and good citizenship) if Microsoft buys the company? October 12, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Silicon Valley.
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Rumors are still floating that Redmund-WA-based Microsoft might buy San-Jose-CA-based Adobe.  Rumors were set off by a New York Times blog last Thursday revealing a meeting between company CEO’s.   Adobe’s stock price soared more than 11% the day the rumor started.  It’s settled back a bit since then, but still lies above the pre-rumor price.

The purchase of Adobe would be huge.   First, the price … likely to be more than $15 B …  would make it one of the most expensive tech acquisitions ever … more than Oracle’s$10.3 B purchase of PeopleSoft, its $8.5 B purchase of BEA or its $7.4 B purchase of Sun Microsystems, more than Intel’s $7.7 B purchase of McAfee, and more than Cisco’s $6.9 B purchase of Scientific-Atlanta.   It would also be the most expensive acquisition ever by Microsoft, bettering its $6.3 B purchase of aQuantive. 

More importantly, though, from a Silicon-Valley perspective, a Microsoft purchase of Adobe would be the first purchase of a sizeable Silicon Valley company by an “outsider”.   How would an out-of-town Microsoft handle Adobe?  Would it treat it as a semi-autonomous subsidiary, getting the benefits of teaming up against Apple and Google but letting Adobe manage its own way operationally?  Or would it subsume Adobe into its folds, use the Adobe operation as a foothold to tap the Silicon Valley talent pool and just merge it into other business units … so that eventually the only remaining vestige of the company we-know-as-Adobe would be the .pdf  file extension?     (Not to overdramatize, but maybe this is what Scott McNealy, former Sun Microsystem CEO, was talking about when he said “it really is mankind against Microsoft … this is why I don’t quit … I don’t want to leave my children to a Microsoft-only world.”)

As for Adobe’s HQ real estate, it would be a shame if Microsoft … or any other out-of-town buyer .,. did not let the Adobe folks run independently and call the shots vis a vis the Silicon Valley real estate strategy.  For in this regard, Adobe has been a particularly good citizen … for San Jose, in particular, and, more generally, for the “green movement”.  It would be good to keep that good citizenship going.

So what has Adobe done to be a good citizen?  First, Adobe alone, among large Silicon Valley companies, has had the nerve to locate its headquarters in downtown San Jose … and in, of all things, a group of high-rise buildings!   A million-square-feet worth!  This seems to be anathema to other Silicon Valley companies where the de rigueur is to locate in low-slung, big-footprint buildings where it’s easy to roller skate from department to department.  Sure, these buildings have lots of roof space for solar collectors, but nothing compares, from an energy perspective, to being downtown.  High-density downtowns are much easier to serve with energy-efficient public transportation than are the Googleplex’s and the Googleplex-wanna-be’s that sprawl across the Silicon Valley landscape.  (Although, to be fair, Silicon Valley is much less sprawling than are business landscapes elsewhere; some might even call Silicon Valley “urban”.)  Downtown San Jose has light rail, good bus service, might eventually get an extension of the BART subway, and probably will even get a stop on the high-speed rail line going from S.F. to L.A., if it ever gets built.  Adobe deserves kudos for being downtown.

Adobe also deserves kudos for its efforts to “green” its HQ buildings.  Back in 2006 Adobe was one of the first companies to get its headquarters a LEED (Leadership in Energy and Environmental Design) Platinum certification from the U.S. Green Building Council.  A host of environmental-friendly measures were implemented from water-use efficiency to energy-saving lighting systems to avoidance of hazardous chemicals in building maintenance.  Adobe has even installed vertical wind turbines on its buildings to generate electricity … not a lot of it … but every bit helps.

And Adobe’s good citizenship extends beyond energy-savings and the environment;  it has also had its impact on San Jose’s art scene and the scenery of downtown’s skyline.  A few years ago it installed, at the top of one of its buildings, the Semaphore, an enigmatic art piece visible from miles away that emits a secret code (which has been cracked and turns out to be the full text of Thomas Pynchon’s novel The Crying of Lot 49.)  

How would things change with a distant owner whose performance metrics for its business units would  probably not include measures of good citizenship?  Would the Semaphore remain on San Jose’s skyline?  Would the vertical windmills be maintained so they generate electricity properly?  Would the Adobe operation be eventually moved to some low-rise buildings in a misguided effort to improve expense metrics?

It’s always sad when a hometown company gets bought by an outsider.  We’ll see if the purchase happens or not.   Outsiders have tried before to buy into Silicon Valley.  There was the failed attempt by Microsoft to buy Yahoo back in 2008 and an unconsummated deal for IBM to buy Sun Microsystems in 2009.  Even if the Microsoft deal does go through, though, Adobe might be too big for even Microsoft to swallow.   Microsoft might have to leave Adobe to operate on its own.  Whatever … let’s hope the Adobe windmills keep turning.

For-Profit Education and the Need for Leases on Balance Sheets September 12, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting.
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September’s here, school is starting, out-of-work workers need retraining … and the for-profit education industry should be partying. Shareholders and managers of companies running places like University of Phoenix (APOL), Argosy University (EDMC) , Corinthian College (COCO), DeVry University (DV), Strayer University (STRA), and others should be having back-to-school beer busts. Events of this past summer, though, have dampened the industry’s prospects, and a sobering time is ahead.

Until recently, the industry had been on an expansion tear, as the unemployed and underemployed attempt to upgrade their credentials in a challenging job market. Fortune’s “100 Fastest-Growing Companies” lists DeVry (#46), Strayer Education (#74) and Corinthian Colleges (#79). This summer, though, the U.S. Department of Education announced that it wants to curtail access to federal funds for any for-profit education company where too many of its students don’t repay their college loans … particularly if the non-repayment is due to the fact that there’s no way their students can earn enough after graduation to make payments. As you might guess, the DOE action was prompted by its discovery that, in fact, this is the case for many companies in the sector. As a result, the future of these companies is suddenly in jeopardy. If their students can’t get government-supported student loans, enrollment will fall because many prospective students won’t be able to pay tuition. Fewer students will mean, of course, less revenue.

How will these companies fare? If you look at just their financial statements, you’d get the impression that the companies are so under-leveraged that they will easily be able to survive reduced revenue. The Apollo Group, owner of the ubiquitous University of Phoenix, with annual revenues of $4.8 billion and net income of $600 million, has only $350 million of long-term obligations. Another example: DeVry has annual revenue of $1.9 billion, net income of $280 million, and long-term obligations of only $106 million. A third example, particularly eye-catching: Strayer has annual revenue of $579 million, net income of $120 million and a measly $12 million of long-term obligations. All of these companies could pay off their long-term obligations, as shown on balance sheets, with only a portion of one year’s earnings.  Across the industry, financial statements make companies look strong.

Undoubtedly, some investors have bought the stock of for-profit companies thinking the companies offered a great combination of fast growth and strong financial structure … a combination that they could have known was too-good-to-be-true if only they had read the notes in the companies’ financial statements filed with SEC.

They would have, though, had to have read those notes very carefully … and thoughtfully … and knowledgeably … and not have overlooked the section on operating leases. The operating lease section is just one of many in the “Notes to Consolidated Financial Statements” included in 10-K submissions. These notes are generally intended to provide detailed information on the line items shown on the balance sheet and other financial statements. In the case of the operating lease section, however, information is about obligations that don’t appear as line items on the financial statements. Anyone without an accounting background could easily overlook the import of the section. And many probably have.

The truth is these for-profit education companies have hundreds of millions of dollars of operating lease obligations which are all “off-balance sheet” even though are as real as obligations like the bond debts which are “on-balance sheet”. In the case of Apollo, there are $757 million of future lease obligations … more than twice the amount of long-term obligations now shown on the balance sheet. At DeVry, future lease obligations total $579 million … more than five times the amount of long-term obligations shown. And at Strayer, future operating lease obligations total $218 million, which is … OMG! … more than 18 times (yes, that’s eighteen times, no decimal point is missing!) more than the amount of long-term obligations shown on the balance sheet.  (See Table A.)

Table A: Stats for Selected For-Profit Education Companies   (in $ millions unless otherwise noted, rounded to simplify presentation)

  APOL CECO COCO DV EDMC ESI STRA
Annual Revenue (1) 4,800 2,000 1,800 1,900 2,500 1,500 580
Annual Net Income (1) 600 210 150 280 170 350 120
Long-Term Liabilities (2) 350 200 400 100 1,930 175 12
Future Operating Lease Obligations (2) 760 725 635 580 1,140 185 220
Lease Obligations As % of Long-Term Liabilities 217% 362% 159% 580% 59% 106% 1833%

Note 1:  Last twelve reported months.   Note 2: Last annual 10-k report.

If these operating lease obligations were included on balance sheets, investors would get a much better idea of the financial structure of the companies. They would understand how these companies have funded their operations with operating leases, which is not necessarily bad, but it does mean that these companies are not as financially secure as financial statements would lead one to believe.  These leases represent high fixed expenses that put these companies at solvency risk should their revenue decline. If all leases were on the balance sheet, investors would understand that these companies are, in fact, highly-leveraged … via operating leases.

And while it is true that, in the case of a bankruptcy filing, a company may have the right to cancel leases such that, theoretically, operating leases are less set in concrete than are obligations like bonds, from a practical point-of-view, how can a company actually cancel leases and improve its situation?  Any wholesale canceling of leases would be tantamount to going out of business.  So while leases might, legally-speaking, be canceled, this is a mute point, practically-speaking.

And so we have a situation where the largest obligations of these for-profit education companies do not appear on their balance sheets even though balance sheets are supposed to provide a snapshot of a company’s financial situation, showing what it owns and what it owes. Balance sheets aren’t doing what they’re supposed to do. And while savvy stock analysts understand that lease obligations are not on the balance sheet but can be seen in the notes to the financial statements, even some of them probably don’t fully account for these obligations when evaluating companies.  And they probably don’t go out of their way to bring these obligations to the attention of investors when things are booming and they have a “buy” recommendation out.  For many reasons, obligations noted in footnotes just don’t carry the same weight as those seen on balance sheets. Out-of-site, out-of-mind.

So what should be done?

Well, what should be done is being done… albeit, belatedly. The FASB and the IASB are working together to create a new accounting standard for leases. The proposed standard is outlined in the Exposure Draft on Leases issued by the two accounting bodies in mid-August. The thrust of the new standard is that leases will go onto the balance sheet … as both a right-to-use asset and a lease liability … in an amount equal to the present value of likely lease payments. This proposal is open for comments until December 15, 2010, and the accounting boards plan on issuing the new standard by June 2011.

Many people aren’t enamored with the proposed new accounting. It is going to cause a lot of pain to companies in terms of the effort required to comply and has many implications that reach far beyond accounting, per se.  

The case of the for-profit education industry, though, shows how important lease-accounting change is if financial statements are to serve their function. This will become all the more clear if revenues of these for-profit companies decline, and one or more of them file for bankruptcy protection.  If this happens, the for-profit education sector will serve as “Exhibit A” in the argument for why leases should go on balance sheets.

Click here to read more posts about the new lease accounting.

3Par’s lease cancellation option and the HP vs Dell bidding war August 24, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, M & A Integration, Silicon Valley.
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3 comments

Update 9/3/2010:  It appears that the bidding war for 3Par did happen.  After a number of volleys, it looks like HP is the winner.  Yesterday, 3Par accepted its latest offer, and Dell said it is withdrawing from the bidding.

According to the San Jose Mercury News, here’s how the bidding went:

Aug 16:  Dell and 3Par announce they have an agreement for Dell to acquire 3Par at $18 a share.

Aug 23:  Before the stock market opens, HP announces competing offer to acquire 3Par at $24 a share.

Aug 26:  3Par announces in the morning that Dell has countered at $24.30; HP raises to $27 after the market closes in the afternoon.

Aug 27:  3Par announces before the market opens that Dell has raised its bid to $27 and HP goes to $30 two hours later.

Sept 2:  3Par announces before the market opens that Dell has raised to $32 and that HP has countered at $33. Dell announces it’s withdrawing from the bidding an hour later.

Update 8/26/2010:  Yesterday, Dell matched HP’s offer for 3Par and 3Par has accepted it.  This does not preclude HP from making another bid, but reportedly there is a $72-million termination penalty that 3Par would have to pay if it didn’t close with Dell.  

It’s good entertainment watching the bidding for 3Par.  Dell offered $1.1 billion .. a full 87% premium over 3Par’s pre-offer market cap … and it looked like a “go” … until HP, yesterday, offered $1.6 billion.  Dell, reportedly, is preparing another offer.  It has quite a deficit to overcome … $400 million … but if it matches or betters HP’s offer, we might see an exciting bidding war. 

How the two companies perceive the overall value of 3Par is, of course, based on how 3Par’s product lines, technology, and talent could add value to their respective companies. When, however,  it comes down to the short strokes… when the increments between the bids are in the neighborhood of $100 million, $50 million, or even $10 million or less … that’s when those leading the acquisition teams will be looking for the not-so-obvious elements of value hidden in 3Par.  

When they look at the real estate … and they need look no further than 3Par’s 10-k … they’ll find a nugget.  3Par’s annual operating lease expense is about $2.5 milliion, but mostly from its 263,000-square-foot headquarters in Fremont CA (in Silicon Valley) for which it has the right to cancel the lease as of May 2011, albeit with a $1 million cancellation fee.  If the acquirer can move the 3Par operation to property they already have (and which is difficult to dispose given the depressed real estate markets), there’s hidden value in that right to cancel.

It looks like 3Par … when it amended the lease to include the cancellation provision … may have already been thinking about how it might look to a potential purchaser.  And it had good reason to think that a suitor might be from nearby …  with the acquisition-minded likes of  HP, Intel, Oracle, and Cisco all headquartered in Silicon Valley.

So, could the presence of this cancellation provision determine who wins the bidding war?  Maybe.  It depends on how short are the short strokes.

While it is difficult to estimate the extra value that could be garnered from eliminating some of 3Par’s real estate overhead, it is clear that the cancellation option most likely has more value to HP, which has lots of real estate in Silicon Valley where it is headquartered, than to Dell which is headquartered in Texas. 

As to how much value could be gained.. here’s my stab at quantifying it:  The annual expense that could be saved by eliminating the lease looks to  be on the order of $2 million.  There would be other savings to be had, though, from consolidating 3Par operations into the acquirer’s operations. Using a (very imperfect) rule-of-thumb for the  cost of housing an employee of around $10,000 per year … and assuming that most of 3Par’s 668 employees are at headquarters, the potential savings could be close to $6 million per year.  That savings would be eroded away by the costs of retrofitting space to accommodate 3Par and by the migration of some expenses (such as utillities) with the people, but a reasonable estimate of the annual savings possible from integrating 3Par into the acquirer’s facilities might be about $3 million, on a pre-tax basis.. That’s about $2 million, after-tax, virtually all of which would flow to the bottom line.  At a p/e ratio of, say, 10, that savings would be worth $20 million to shareholders.  Not a big number relative to the overall offer price of $1.5 billion, but maybe enough on-the-margin to help win the bid.  Depends on how short are the short strokes.

Addendum 8/26/2010:  Maybe the short stroke is the $72-million cancellation penalty.

Amazon earnings off another 1% due to real estate …. or so they would be if the new lease accounting was already in effect July 28, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting.
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3 comments

Earlier this week, I posted about Amazon’s disappointing results… about how the market reacted negatively to its increasing operating expenses and how real estate expenses likely are contributing to its higher-than-desired cost structure.  Let’s take a look, though, at how expenses would have been even worse if the new lease accounting standard, being created by FASB and IASB, was in effect now.

(For a good review of the new accounting standard and its implications, see my webinar series which is available on-demand on TRIRIGA’s website.)

As I’ve posted previously, in the year that the new lease accounting is adopted, a company is going to see its lease-related expenses increase by 5% to 10% or even more where the remaining terms of leases are exceptionally long.  We can use the operating lease obligation amounts shown in Amazon’s latest 10-K to estimate what the effect on Amazon will be. 

The 10-K shows minimum operating lease obligation to be $162 M (2010), $146M (2011), $130 M (2012), $122 M (2013), $115 M (2014), and $317 M (2015+).  Assume the last amount is actually distributed evenly over the years 2015 through 2019.  For simplicity, we will ignore the fact that there may have been free rent periods or fixed rent increases that may make acrued expenses differ from cash flow.  Let’s also assume that Amazon’s applicable incremental borrowing expense, which would be used to discount the obligations to determine how much lease obligation goes on the balance sheet, is 3.5%.

Under current accounting, none of the operating leases would be on the P&L, and the P&L expense for these operating leases would be $162 M for 2010. 

Under the new accounting, though, Amazon would record an $850 M right-to-use asset on the asset-side of its balance sheet and an equivalent amount as a lease liability on the liablity-side.  This will set in motion P&L accounting for the leases.  There, if the new standard were in effect, Amazon would record expense of $174 M … an increase of $12 M over the expense under current accounting … or an increase of 7.5%.  See chart, below.

The impact will be even more if Amazon’s leases have options to renew that are likely to be exercised.    The obligations related to the renewal periods would also go onto Amazon’s balance sheet and, due to the way the accounting arithmetic works, result in an even higher expense in the first year of adoption of the accounting standard.

How would this $12 M affect Amazon’s bottom line?   Let’s use, for illustration, the company’s Net Income for FY2009 of $902 M.  This $12 M of additional expense, adjusting for taxes, would decrease net income by about 1% … not an insignificant number.  To put the number in perspective, if the market were, therefore, to cut Amazon’s valuation by 1%, approximately $500 M of share value would be lost.

Whether one agrees with the logic of the new accounting or not, the financial effect is going to be something that cannot be ignored.

 

Current vs New Accounting for Amazon’s Existing Operating Lease Portfolio  Clarification:  The  information in this chart shows the P&L impact of operating leases that existed as of 12.31.2009.  It does not assume any renewal of those leases, nor does it make any assumptions regarding the signing of new leases.

  2010 2011 2012 2013 2014 2015
Current Accounting            
Rent 162 146 130 122 115 63
  Total 162 146 130 122 115 63
             
New Accounting            
Depreciation 144 128 113 106 99 53
Interest 30 25 21 17 14 10
  Total 174 153 134 123 113 63
   % Increase 7.5%