Key Points
Bill Ackman's Pershing Square bought a controlling stake of Howard Hughes last year at a premium price.
Investors are heavily discounting that price today.
There are good reasons to remain on the sidelines for now.
Last year, Bill Ackman and his fund, Pershing Square (NYSE: PS), purchased 9 million shares of Howard Hughes Holdings (NYSE: HHH) at $100 per share, acquiring a controlling stake in the business. Today, those shares are worth about $72 each. At the end of September, Ackman laid out his case that they could be worth much more. He believes Howard Hughes could be a "compounding machine" and that the value of the business over the next 50 years could easily surpass $1 trillion.
Not everyone is buying what Ackman's selling, though. Here's why the market might be underpricing Ackman's bet.
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Bill Ackman, chief executive of Pershing Square. Image source: Getty Images.
Transforming Howard Hughes
Howard Hughes is seen as a real estate company. Right now, that's exactly what it is. The bulk of its assets is tied to land and developments for the master-planned communities it builds.
Ackman is aiming to transform the business. He bought Vantage Group, an insurance company, for $2.1 billion. He immediately liquidated the fixed-income holdings in the insurer's portfolio, using the excess capital on Vantage's balance sheet to invest in common stocks. That's about $1.3 billion today.
Ackman plans to free up more capital by liquidating Howard Hughes' real estate holdings, positioning it more as a real estate manager than an acquirer and developer. Meanwhile, the operating assets and finished condos on its balance sheet will start producing cash. Management expects between $2.5 billion and $3 billion in cash generated by the real estate holding by 2030. That extra capital will go into the insurance business, expanding its capacity to underwrite risk and invest more capital.
He expects Vantage, under the leadership of former Arch Capital Group CEO Marc Grandisson, to deliver above-average underwriting results. Meanwhile, the equity portfolio, managed by Pershing Square, could produce returns in line with the fund company's historical average of 15% to 20%. The combined result is a return on equity between 16% and 22%.
There are some significant risks to the plan. First, Howard Hughes might not get as much value from its real estate assets as Ackman suggests, as interest rates have skyrocketed in recent months (lowering the value of non-income-producing real estate like land). Second, Pershing Square takes a significant fee for managing Vantage's portfolio, which will cut into Ackman's optimistic return projections.
Management estimates Howard Hughes' intrinsic value at $104 per share, which could grow to $211 by 2030. Investors are rightfully discounting those assessments based on the optimistic numbers management provided in arriving at its estimates.
However, at about $70 per share, the stock could be interesting. If it can successfully liquidate its real estate assets and show improvements in its underwriting under new management, the stock could move higher. But investors may want to wait on the sidelines to see the start of a successful transformation first.
Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Howard Hughes. The Motley Fool has a disclosure policy.