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2011: Year of the Rabbit …. and Decade of the Corporate Real Estate Exec February 13, 2011

Posted by Bob Cook in Alternative Workplace Strategies, Corporate HQ, Financial Planning & Analysis, Green Initiatives, Lease Accounting, M & A Integration, Profession of Corporate Real Estate.

This Thursday ends the 15-day Chinese New Year Celebration.  According to the Chinese Zodiac, we’re entering the “Year of the Rabbit”.   We may also, though, be entering the “Decade of the Corporate Real Estate Exec”, the decade in which corporate real estate execs rise to truly strategic roles in their organizations.

The year 2011 will usher in an era of increased responsibility for corporate real estate professionals.  Events playing out this year will put corporate real estate executives, their staffs, and their advisors front and center.  The spotlight will be hot, but rewarding … for those ready to perform.

Leaving the oughts behind

With a name like that … “the oughts” … we should have known the decade from 2001 through 2010 was going to be tough.  Slashing budgets, laying-off people, constantly explaining why the company still has too much space:  it was not the best of times for corporate real estate folks. 

To be fair, the oughts did have their fun moments:  implementing alternative workplaces, expanding into China and India, building solar-power arrays, planning next-generation data centers.  But while these activities were sometimes high-profile (in the sense of “gee-whiz”, isn’t this cool), for the most part they tended to be tactical activities in service to specific divisions or functions … away from the central concerns of headquarters.  They did, however, help raise the self-image of corporate real estate professionals who no longer are satisfied with a backstage, custodial role.  Most are ready to perform on stage.

The good and the bad

So, if you’re in corporate real estate, how will 2011 differ from the past?

Good News:  You won’t be tasked to slash your budgets; corporate profits are doing just fine and executive management is now focused on growth rather than contraction.   You won’t be consolidating (unless your company buys another company to integrate); you’ve already done your consolidations.  And you won’t have to lay off any more of your staff; thank God, that’s over … or at least it is if you avoid being on the “losing end” of a Merger.

Bad News:  Some of you may lament, though, that some of the things that were fun in the past won’t be on the agenda in 2011:  You won’t be constructing many new buildings; we have enough of those for a while.  You also won’t be building out much space inside your buildings because you probably have built space you’re still not using.  You won’t be flying across oceans looking for new space; globalization is taking a breather while companies wait for worldwide demand to catch up with worldwide capacity.  And you probably won’t be doing a big outsourcing; where outsourcing makes sense, you probably already have.

The shape of 2011 and the decade to come

The Year of the Rabbit, CY2011, and the coming decade will bring a new world shaped by these forces: 

  • cash hoards at leading companies in a “winner-takes-all” economy
  • attractive real estate markets  from an occupier’s perspective, for at least a few more years in most locales and indefinitely in some
  • new advances in “green technologies” and lowering prices due to competition
  • the establishment of a new lease accounting standard
  • strained budgets at all levels of government

The New Agenda

This world will bring those corporate real estate professionals who are ready for the stage closer to the core of their companies’ businesses.  The new corporate real estate agenda for the “Year of the Rabbit” and beyond:

  • Acquisition Integration
  • Balance sheet Management
  • Corporate Citizenship
  • Design & Management of Processes
  • Employee Retention and Recruitment


Acquisition Integration.  Most leading companies are sitting on cash hoards and have large borrowing capacity, setting the stage to make the year 2011 record-breaking in terms of M&A activity.  Corporate real estate execs will play key roles in integrating acquired companies, as they have been, but those, savvy enough to grab the opportunity, will engage beyond managing cost-saving consolidations.  They will take a leadership role in managing the “soft art” of cultural integration. Corporate real estate execs have an opportunity to address a vexing problem: most M&A’s are unsuccessful.  Most experts think the obstacle to success is cultural incompatibilities.  By simply extending corporate real estate’s responsibilities from the physical environment to the social environment and thinking of themselves, not as “facility engineers” but, as “social engineers”, corporate real estate execs can … and should … take on the challenge of successfully merging cultures to achieve M&A success.

Balance Sheet Management.  All that cash and borrowing capacity at leading companies are going to make real estate central to discussions about financial structure.  Companies need to decide whether they should continue to retain all that cash (something that stockholders don’t like), pay down debt (something that has probably already been done if the company has a lot of cash), give cash to shareholders via stock buybacks or dividends (something that company managers don’t like because they want to keep money for a “rainy day”) or spend it (something that certainly cannot be done foolishly.)    It turns out that spending cash to buy company facilities bridges these concerns: it keeps wealth in the company in a way that can be turned into cash if needed, earns more than cash-equivalent investments, and can often support business operations better than can leasing property.  Real estate is, thus, destined to become important in discussions about a company’s financial structure, particularly over the next few years while an “occupier’s market” reigns and purchases can be made cheaply.  Also entering the discussion will be the new lease accounting standard that will transform the balance sheets of many companies and bring real estate strategy (own vs lease, lease duration, utilization) even further into discussions about company financial structure.

Corporate Citizenship.  Our governments are broke (to use an imprecise but, I think, meaningful term.)  Corporates will be called upon to pick up the slack … either forcefullly by regulation or voluntarily… and they will have to get serious about social and environmental responsibilities.   Federal and state governments can’t afford tax breaks for energy-savings and environmental-protection so companies will be expected to beef up their sustainability programs.  While technological advances may improve the ROI on energy-saving and environmental-protection investments, companies will be expected to make these investments even where there’s no payback.  As for local governments, they can’t afford redevelopment programs so companies will be expected to participate in urban revitalization projects, even when no subsidies are available.  There may even be a return to the civic-mindedness of the 1960’s when corporations built their headquarters with plazas to serve as centers of their communities.  Corporate real estate professionals will be managing much of this good corporate citizenship.

Design & Management of Processes.  As the role of corporate real estate execs migrates towards the center of the company, execs will find themselves spending less time on implementation and more time designing and managing processes to lead, coordinate and govern the implementers, who will increasingly be outsourced providers.  Acquisition integration, for example, requires processes to plan consolidations, account for them, and track implementation status.  Another example: the new lease accounting will require SOX-compliant processes to record leases in a timely fashion, abstract them accurately, and (if the present proposal holds) make quarterly assumptions about their likely lengths, contingent rents, and service components.  All these processes will have to be integrated with processes of other functions … HR, IT, Finance … intertwining corporate real estate with other key functions and making it integral to how the company works.

Employee Retention and Recruitment.  Despite the fact that unemployment is still stubbornly high, competition for top talent is severe.  As product design, marketing, supply chains, financing, and the art of management, itself, becomes more sophisticated, the winning of the competition for sophisticated talent is becoming more and more important to company success.  If you have the best talent, you can create the best products, the best marketing, the best cost structure, etc. … the things that allow you to easily win the competition for customers.  And what attracts talent?  Money helps, but ultimately, it’s about the work environment.  Here again, corporate real estate execs can play an important role by using their command over the physical work environment to help mold the social work environment that will determine how successful their company is in retaining and recruiting talent.

It is a new year:  “Year of the Rabbit”. 

Will it be a new decade:  “Decade of the Corporate Real Estate Exec”?

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.

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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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.

Preparing the company for sale: Palm did it right! May 17, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, M & A Integration, Silicon Valley.
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Real estate tends to be one of the last things evaluated during M & A due diligence by the acquiring company, and it’s not surprising that – surprise! – surprises are found there. Lengthy lease commitments, owned property worth less than net book value, contaminated sites, mission critical infrastructure that’s prohibitively expensive to move to the acquiring company’s site: these are just some of the surprises found by acquiring companies when they finally take a look.

Rarely, if ever, do these surprises derail an acquisition, but they do sometimes lead to re-pricing of the deal. And while the price cut might not be much as a percentage of the overall deal price, it can be a significant percentage of the amount had by the acquired company’s equity investors once they’ve paid off creditors and preferred-return equity holders. It’s at that point that the acquired company managers kick themselves for not more carefully managing their real estate portfolio.

You may ask: if they had managed their portfolio carefully, what would have they tried to achieve? What would have been the home run, the hole-in-one, the three-pointer at the buzzer? It would have been this: having real estate commitments (such as leases) and exposures (such as owned properties) that extended into the future no further than the date on which the acquiring company will be able to move the acquired company into its own facilities in an orderly fashion. “Not achievable!” you say? Think again.

Palm, which is being bought by HP for $1.2 billion, may have done it. According to its 10-K’s (see Table 1, below), Palm does not own any property and has done a masterful job over the last few years of decreasing its lease obligations. At the end of FY2007, the value of its minimum future lease obligations was $49.2 million; by end of FY2009, this had been cut in half to only $24.5 million.

Looking at the minimum future lease obligations net of sublease obligations from subtenants shows similar results – $34.7 million at end of FY2007 that were cut in half to $15.3 million at end of FY2009.

Making the story even better: if Palm has been able to avoid committing to any additional leases since the end of FY2009 in May of 2009, then as of the end of FY2010 which ends this month, it’s lease obligations should amount to no more than $13.2 million. After accounting for commitments from subtenants, its net lease commitment would be only $8.0 million. What an incredibly light burden for HP to have to take on! Miniscule in comparison to the value of the deal. It easily sets the stage for HP to be able to move Palm into HP facilities without HP having to bear much of an economic burden to pay rent on the unneeded property.

But wait! There’s more! By time the acquisition is closed and plans can be made and implemented to relocate Palm, it will probably be near the end of Palm’s FY2011 at which time only $2.4 million of lease obligations will remain and, incredibly, only $1.1 million of obligations net of obligations from its subtenants will remain. Can you believe it? Only a $1.1 million overhang of real estate obligation on a $1.2 billion M & A deal. That’s like driving the ball off the tee and coming to within an inch of a cup 700 yards away.

This light burden should make it economically feasible for HP to relocate the Palm operations to HP facilities. There should be plenty of space to accommodate Palm in HP’s 77-million-square-foot real estate portfolio, of which 7 million square feet was vacant and not sublet as of the end of HP’s last fiscal year in October 2009. For comparison, Palm’s Silicon Valley operation occupied only 347,000 square feet.

Yes, Palm did it right. From outside the company, it’s hard to know if it was from careful planning, from restrictions put on Palm by the real estate market or from just dumb luck. I’d like to think it was from the first of these possibilities – that there was an understanding of the need for careful real estate portfolio planning, that the planning was carried out consciously and that it paid off. A clear planning success story if ever there was one.

TAble 1: Palm’s Minimum Lease Obligations as Reported in 10K’s

Year in which rent was projected to be due FY2007 10K FY2008 10K FY2009 10K
2008 11.9 0.0 0.0
2009 11.7 11.5 0.0
2010 11.5 11.3 11.3
2011 11.2 10.7 10.8
2012+ 2.8 2.4 2.4
Total Min Lse Obligation 49.2 35.9 24.5
Less: Subtenant Income 14.5 13.0 9.2
Total “Net” Minimum Lease Obligation 34.7 22.9 15.3