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Cogdell Spencer Inc. (NYSE:CSA)

Q4 2008 Earnings Call Transcript

February 26, 2009 4:00 pm ET

Executives

Dana Crothers – IR

Jim Cogdell – Chairman

Frank Spencer – President and CEO

Chuck Handy – SVP and CFO

Scott Ransom – President and CEO of Erdman

Analysts

Rich Anderson – BMO Capital Markets

Karin Ford – KeyBanc Capital Markets

Buck Horne – Raymond James

David Cody – Citi

Stephanie Krewson – Janney Montgomery Scott

Operator

Hello and welcome to the Cogdell Spencer Inc. fourth quarter and year-end 2008 earnings conference call. All participants will be in a listen-only mode. There will be an opportunity for you to ask questions at the end of today’s presentation. (Operator instructions) Please note, this conference is being recorded. Now, I would like to turn the conference over Ms. Dana Crothers. Ms. Crothers, you may begin.

Dana Crothers

Thank you so much. Welcome to Cogdell Spencer’s fourth quarter and year-end 2008 conference call. The press release and supplemental disclosure package were distributed yesterday as well as furnished on Form 8-K to provide access to the widest possible audience.

In the supplemental disclosure package, the Company has reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Reg G requirements. If you did not receive a copy, these documents are available on the Company’s website at www.cogdellspencer.com in the Investor Relations section. Additionally, we are hosting a live webcast of today’s call, which you can access in the same section.

At this time, we would like to inform you that certain statements made during this conference call, which are not historical, may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although Cogdell Spencer believes the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that its expectations will be attained.

Factors and risks that could cause actual results to differ materially from those expressed or implied by forward-looking statements are detailed in yesterday’s press release and from time to time, in the Company’s filings with the SEC. The Company does not undertake a duty to update any forward-looking statements. With that, we’d like to begin the call with Jim Cogdell, our Founder and Chairman of the Board, Jim.

Jim Cogdell

Good afternoon. Welcome to our first quarter and year-end ’08 earnings call. Joining me in Charlotte are Frank Spencer, Chuck Handy, and Scott Ransom. After our update, we will be available to answer any questions you might have. We are here today to take a look back at ’08, a very successful year for our Company. We are in the midst of one of the most economically challenging times that this country has ever– has seen in many decades. Obviously, our Company and our clients are not immune to the difficulties this environment presents. In December, we announced a cost saving plan and reduction in force that will generate approximately $17 million in annual saving in ’09. We also reduced our dividend in the fourth quarter to $0.225.

Everyone has been affected by the recent change, but by implementing this business strategy, we feel that we are in much better position to serve our client, our shareholders, our business partners, as we navigate the troubled waters ahead.

Now, I would like to turn the call over to Frank Spencer for the review of ’08. Frank?

Frank Spencer

Thanks, Jim. Good afternoon and thank you for joining us today. I am very proud of what our Company has accomplished during 2008. We successfully completed our merger with Erdman and now have completed our integration process. This partnership of industry leaders has been transformative for our Company, creating the nation’s most fully integrated healthcare facilities company with more employees serving end users than any other competitor.

The $247 million transaction was financed through a $100 million term loan arranged by KeyBanc, an $85 million rollover in equity held by Erdman’s principal shareholders and members of its management team, and a new $150 million secured line of credit arranged by Banc of America. Then Company also placed approximately 53.7 million in common equity in January and in September we raised another 37.5 million in equity.

We were able to meet 2008 FFOM per share guidance despite raising over 175 million in equity during the year while also taking a $0.06 per share charge related to severance and restructuring. We successfully brought approximately $40 million in project investments online with the acquisitions in Richmond, Virginia, and Chattanooga, Tennessee, and with the completion of Alamance Regional Mebane Outpatient Center.

In August, we formed a joint venture partnership for acquisitions with Northwestern Mutual and broke ground on our first synergy project in September. The integration process with Erdman is now complete and features several restructuring initiatives. Over the past few weeks, we have announced the promotion of several executives in our regions and the recruitment of top talent in our national offices, including seven Regional Presidents and a senior Vice President of In-patient Delivery. Scott Ransom will talk a little later about some of the exciting changed that are taking place across the regions where we have a strong emphasis on client relationships and creating value throughout our portfolio.

But first, I’d like to take a few minutes to walk through the first fully integrated project in Pensacola, Florida to highlight our project delivery model. The Woodlands Center for Specialize Medicine project is an excellent example of our integrated delivery model at work. Our strategic planning team worked with the client to develop a comprehensive strategy to meet their healthcare delivery needs. The Hope Medical Group is a physician group that has partnered with us to offer multi-specialty services to its community. Our capital team worked with the client to determine the optimum ownership and financing strategy to feet their needs. The end structure was a joint venture with Cogdell Spencer owning 40% of the project and the physician group owning the majority 60%. The delivery team collaborated with the Hope Group to determine a design that speaks to the emotional needs of their patients and families while supporting the safety, security, and efficiency of the physicians and staff.

Our incoming property management staff works closely with the physicians and their administrators prior to completion. We will begin integrating our property management team this summer to ensure a smooth transition. The Pensacola, Florida project is on budget and on schedule for completion in December, 2009, and is 100% pre-leased.

This is the kind of direct capital investment that our integrated delivery model can produce with minimal market risk. Our business model is inherently different from commercial real estate companies as we build to suit and ensure adequate lease-up before a project can begin.

Our occupancy rate in the core portfolio at year-end was 92.4%, reflecting a stable trend. We expect to see a small decline in the first quarter followed by a move upward during the balance of the year. The recent projects such as the Woodlands and the Cancer Center in Mebane, North Carolina, are examples of fully pre-leased projects that will produce future increases in net operating income. We expect overall portfolio results in 2009 to exceed our 2008 results.

Now that we’ve looked over the success our Company has had during the year, I would be remiss to overlook the obvious effect that the financial crisis has had on our business and that of our clients. As the recession became imminent during the fourth quarter, we began to see delays in our pipeline. This, along with the frozen credit markets led us to make some very tough decisions.

In December, we announced a business plan that will lead to a cost savings of approximately $17 million in 2009. We cut our dividend to $0.35 per share to $0.225 per share, resulting in annual payment of $0.90 per share, down from $1.40 per share.

We eliminated approximately 115 positions to right-size the Erdman subsidiary. We have eliminated incentive payouts and have instituted a Company-wide salary freeze in 2009. We have now experienced some pipeline cancellation during the first quarter as clients are choosing a conservative approach while they weather the storm. Why we continue to see a delay in certain healthcare projects as client systems look to shore up their balance sheet in the face of financial crisis.

We feel that we are well-positioned to rebound once the credit maturities loosen and liquidity for healthcare projects is restored. During the week of January 22nd through the 29th we saw four hospital bond offerings ranging from $120 million to $214 million with all-in pricing from 5.73% to 7.32%. This is a very encouraging sign and suggests a move towards more liquidity in the tax exempt markets.

As for our own capital, we are choosing to make investment only when risk-adjusted returns warrant it. We are committing capital to projects when they drive our design-build platform, when we have obtained construction financing, and they are substantially pre-leases.

Our FFOM guidance for 2009 is for a range of $1.10 to $1.22 per share. To give us more – a more in-depth look at our financials for the year, I’d like turn now to Chuck Handy, our Chief Financial Officer.

Chuck Handy

Thanks, Frank, and good afternoon everyone. Let me begin by providing you with an update on our capital activity during the past few months. In the fourth quarter, we placed secured financing on the East Jefferson Medical Plaza in Metairie, Louisiana. This building was acquired during the first quarter of 2008, and was previously unencumbered by debt. This $11.6 million mortgage requires interest-only payments through its maturity in January, 2012. We’ve entered into a swap arrangement that has effectively fixed the interest rate on this mortgage at 5.55% through maturity.

Also, during the fourth quarter, we refinanced the mortgage for River Hills Medical Associates office building in Little River, South Carolina. The new mortgage note payable requires monthly payments of principal and interest through its maturity in December, 2001, based on a 25-year amortization schedule. The interest rate on the mortgage has been swapped to provide an effective fixed rate of 5.53%. As a result of the refinancing, the principal balance was increased by $1.1 million to $4 million.

In October, we repaid the remaining $7.4 million principal balance on the mortgage note payable for Birkdale Medical Village with funds from our revolving line of credit.

In January, we announced the ground-breaking of a $21 million medical office building and ambulatory surgery center in Jackson, Tennessee. This 75% pre-leased, 106,000-square foot project marks our first project with West Tennessee Healthcare Inc. and is located on the campus of Jackson-Madison County General Hospital. Ultimately, this project is expected to be owned 50% by Cogdell Spencer and 50% by a combination of local physicians and West Tennessee Healthcare.

Last week, we closed on $14.77 million of long term financing for this project, providing for a total term of 10 years, which includes a construction period of 18 months. The loan requires interest-only payments of LIBOR plus 2.5% during the construction period and converts to a permanent loan requiring monthly principal and interest payments based on a 25-year amortization schedule.

We entered into a forward-starting interest rate swap that fixes the interest rate at 6.19% from the end of construction to maturity. The structure of this project demonstrates our discipline of starting only development projects that produce the desired return, possess a significant level of pre-leasing and when acceptable construction financing is in place.

Of the $48 million in mortgage debt that we have maturing in 2009, $30 million has extension options of two years at our option. The remaining 2009 maturities are related to well-leased properties that have very manageable loan to value ratios. In addition, we have unrestricted cash balances totaling $34.7 million at December 31st.

Now, let me review our performance for the fourth quarter. As noted in our earnings release, FFO Modified, or FFOM, for the quarter was $8.1 million compared to $5.1 million for the fourth quarter of 2007, representing an increase of 59%. FFOM per share for the current quarter was $0.30 compared to $0.31 per share for the fourth quarter of 2007.

Net loss for the quarter was $1 million or $0.06 per share. Revenue for the fourth quarter totaled $100 million. Rental revenue for the quarter totaled $20.1 million, while revenue related to design-build contracts totaled $78.7 million. Fee revenue, including property management, leasing, and development fees as well as expense reimbursements totaled $1.1 million for the quarter.

Selling, general, and administrative expenses for the fourth quarter totaled $9.8 million, which included $2.2 million of corporate G&A. Included in fourth quarter expenses was a non-recurring charge of approximately $1.5 million pre-tax or $900,000 after tax related to a reduction in force of approximately 115 positions that was announced in December, 2008.

At December 31st, approximately 7% of our debt was at fixed rates and our average interest rate on real estate mortgages was approximately 5.7%. Our total debt had a weighted average remaining term of approximately 3.3 years and we had $124.5 million outstanding on our $150 million revolving line of credit at quarter-end.

For the fourth quarter, our interest coverage was 2.5 times and our fixed charge coverage was 2.2 times. On January 30th, we paid a dividend for the fourth quarter of $0.225 per share to shareholders of record on January 14th.

At December 31st, we had approximately 671 leases at our consolidated properties with an overall occupancy of 92.4%. No single tenant accounted for more than 7.5% of annualized rental revenue.

Recurring capital expenditures for the fourth quarter totaled $822,000 or approximately $0.25 per square foot across our consolidated portfolio. Tenant improvements related to second generation leases totaled $422,000 or approximately $0.129 per share across our consolidated portfolio for the quarter.

Now, let me discuss guidance for 2009. We expect 2009 FFOM to be in the range of $1.10 per share and $1.22 per fully diluted share and unit for 2009. As a reminder, we believe FFOM to be an important supplemental measure of operating performance because it adds back to traditionally defined FFO the non-cash amortization of non-real estate related intangible assets associated with purchase accounting for the Erdman merger.

Our 2009 guidance reflects the 2009 business plan that we announced in December that includes the implementation of a cost savings plan, which when combined with our reduction in force will generate approximately $17 million in annual savings. Included in this plan is the elimination of all incentive compensation for 2009 fiscal year unless budgeted benchmarks are substantially exceeded. Also reflected in the 2009 plan is the reduction of our dividend to a rate of $0.225 per share and unit.

While these decisions were difficult to make, we believe the result will be to enhance our operating and capital flexibility and put us in a better position to server our clients and provide us with added capital to meet our ongoing financial obligations.

At this time, I would like to turn things over to Scott Ransom, President and CEO of Erdman to further discuss the recent restructuring within the regional offices and what that means for our clients. Scott?

Scott Ransom

Thanks, Chuck, and before I get started I’d like to just say we are very pleased with the overall operating results at Erdman this year that essentially met the pre-merger expectations and reflected in the 2008 FFOM.

I am excited to share some news on our recent regional office business strategy. We have named seven Regional Presidents, a new leadership position in the Company. The Regional Presidents will focus on client relationships, market strategy, increasing business volume, and deploying capital through new project development. We have welcomed three new executive as Regional Presidents this past month – Paul Aigner in the Seattle office, Bill Dagar in the Dallas office, and Tim Schlichting in the Denver office.

We also promoted four of our business leaders to Regional Presidents including Susan Dorr in the Atlanta office, Roger Herritz in the Madison office, Jeff Nicholas in the D.C. office, and Matt Nurkin in the newly created Charlotte Urban office. This new organization structure positions us to better serve our clients with the highest level of leadership commitment.

As we look to the future, we recognize of sustainability in our built environment. In 2008, we saw a dramatic rise in the interest of our clients in implementing sustainable practices in their healthcare facilities. We are embracing sustainability not only to address market demand, but more importantly to instill into the fabric of our business. It’s easy to make grand statements about commitments to being green; it’s far more challenging to operate with a triple bottom line mentality through a commitment to economic, social, and environmental leadership.

Achieving this level of sustainability requires intense focus and dedication to best practices from planning through design, construction, and operations. We are maximizing the return on our healthcare facilities investments through the greening of our own portfolio to preserve its long term value. This involves the incremental repositioning of individual properties to align with the Company’s new performance standards while embracing the sustainability goals of our healthcare clients. Sustainability is a true partnership with every stakeholder sharing in the benefits of economic, social, and environmental quality.

We also continue to apply advanced technology in every aspect of our business. For example, we are aggressively advancing the use of building information modeling, or BIM, in our design process with multi-disciplined teams, using innovative digitalization and modeling technology. BIM enables our project teams to work collaboratively with our clients to achieve better outcomes. It requires participation from the entire team from conception to completion to effectively respond to all of the projects special and geometric challenges. BIM allows us to proceed confidently into construction, having identified and addressed project issues, potential additional cost and opportunities that would often go undetected using traditional delivery models.

Our new leadership focus, regional restructure, advancement of sustainability, and incorporation of leading-edge technology are key strategic initiatives in our 2009 business strategy. Amidst the challenges of the current economic climate, we are investing in the future of our Company through our people, our process, and our priorities. And I look forward to answering any questions you may have. Frank?

Frank Spencer

Thanks, Scott, and thank you all for joining us this afternoon. With that I would like to open it up for questions. So operator, if you could open the phone lines?

Question-and-Answer Session

Operator

Thank you very much. (Operator instructions) our first question will come from Rich Anderson from BMO Capital Markets. Please go ahead.

Rich Anderson – BMO Capital Markets

Thanks, and good afternoon everybody.

Frank Spencer

Hey, Rich.

Rich Anderson – BMO Capital Markets

Frank, maybe could you just expand upon the comment where you said 2009 will exceed 2008 results. I assume you are talking about the core business of Cogdell Spencer, correct?

Frank Spencer

Yes, that reference was to the core portfolio.

Rich Anderson – BMO Capital Markets

Okay. And could you give any parameters that sort of – or support that statement like what are you expecting, are you expecting X amount of same-store growth or – you mentioned that – you referred to occupancy, but what is it about the year that you said – makes you think it’s going to be a better year?

Frank Spencer

Well, several things. One is, as is usually the case, we are in very close communication with our tenants on all levels of the portfolio. And so what we are projecting is essentially stable occupancy with a modest increase in rents and therefore NOI at sort of the same that we’ve gotten out of the core portfolio year-over-year.

Rich Anderson – BMO Capital Markets

Okay. But you are not seeing doctors consolidating their space or any sort of lack of usage of space that might test the same store results during the year?

Frank Spencer

Actually, we are seeing some of the inverse, which is we had some in-place renewals that we were very pleased about, but I think what you are seeing in the external environment unless new projects were already underway physicians are very reluctant to make a change in this kind of capital environment. And I think some physicians who might have been thinking about retirement in a year or two, six or eight months ago, are now assuming they are going to be practicing for another five year at least. And so we’ve actually seen a pickup in some of the smaller renewals that we actually had pegged for retirement. So, overall occupancy is stable and as we’ve talked about in the past we don’t view 50 basis points one way or the other as dramatic moves, but quarter-over-quarter we run in that 92% to 94% band.

Rich Anderson – BMO Capital Markets

Okay, that’s very interesting. You mentioned adding people or few new people and promoting others for new positions within Erdman. And I guess the question is was this new position a response to these conditions or was this something you would have done otherwise. I mean what was – explain the thought process of bringing in this Regional Presidents concept.

Frank Spencer

Yes. This is something that would have – we were in the process of doing this as part of our integration plan. Part of the excitement and the synergy of bringing Cogdell Spencer and Erdman together was the ability to offer a much more complete and (inaudible) complex a value proposition to our clients. And part of our process all along was to recruit and/or promote leaders within our regional offices who could be the face of the Company and deliver that more sophisticated product offering. And so I actually think we would say that we are being bold and moving forward with the implementation of that plan in spite of a challenging environment, but I think the worst time to back off of customer interaction and customer service is when the environment is difficult.

And so the thought process was something we’ve been working on as a team for months. You don’t just recruit those people overnight. All of those who have been either recruited or promoted internally, all have broad backgrounds in both healthcare facilities and finance. Now they don’t each come from exactly the same point, but they each bring a very robust set of skills to the leadership of the regional offices.

Rich Anderson – BMO Capital Markets

And so that’s contemplated in the $17 million savings or the $17 million is a net of all that?

Frank Spencer

Correct.

Rich Anderson – BMO Capital Markets

Okay.

Frank Spencer

That’s correct.

Rich Anderson – BMO Capital Markets

Chuck, for you, the credit facility almost entirely drawn as of the end of the year, and I guess it matures in 2011. Can you comment on what the pricing of that might be when it comes time to renegotiating that?

Chuck Handy

I mean – one thing that we do have a one-year extension option on that, so that it gets it out to one year beyond the stated maturity. The one thing that I also will point that I alluded to in my earlier comments was we do have a lot of the line drawn right now, but we are also sitting on substantial cash at year-end as well that we just chose to sit on the cash and not pay the line down. So, I think you got to look at those two pieces of information in tandem. But, at this point, once we have to renew the revolver at maturity, we – I think there is just too much uncertainty right now for us to be able to say what our expectations would be at that time.

Rich Anderson – BMO Capital Markets

That was the longest non-answer [ph] I’ve ever heard.

Chuck Handy

Well, thank you.

Rich Anderson – BMO Capital Markets

And then finally I guess on the urban sites a question about the survivability of the business. I know that’s an extreme way of putting it, but if we were looking at three or four years of just turning off projects, client after client, putting it off, putting it off, I mean how survivable is the business? Can it withstand something that long or is there a point where it just – the weight of the delays becomes too much and you just sort of have to really consider stopping?

Frank Spencer

Well, I think, Rich, the way we look at that, if you say there will be no construction in healthcare in America for the next four years, then that’s probably a pretty bad scenario for us. On the other hand, we don’t think that’s really realistic. I think a couple of things to keep in mind, one is we’ve done the restructuring and the cost savings not because Erdman was anywhere close to loosing money, but rather to retain the profitability we enjoyed this year. And so, we are going to make money in the Erdman enterprise, we are going to make substantial money in 2009 even though we are prepared for lower revenues. That’s number one. Number two is I think even if you assume that there is a slowdown I think it’s pretty hard to pro forma know future healthcare construction over the next three or four years and so that is not a scenario we are preparing for. And we think we are very well positioned with both our existing clients and clients – we are winning new business still today, and signing new agreements even in this environment. So, Scott, you want to tag onto that?

Scott Ransom

Yes, Rich, I would say there is all kinds of different projections for the next two years you can look under. AIA, American Institute of Architects just projected healthcare construction spending for this year (inaudible) I mean they are somewhere probably in the dropping 5% or so to upwards to 10% or maybe a little bit more. But there is not a dramatic fall off like you might see in some other segments of the building industry. I think what you are saying will be probably more prevalent to the marginal players in our market. As you know, we have a 60-year history. We built over 5000 medical facilities, and we expect to retain the Number One ranking for size and volume of design-build firms in healthcare. So I think although it is – we are weathering the storm like everyone else, as Frank said, we are – part of our tough actions we had to take was to essentially keep our revenues in line or maybe a slight tick up from our 2008 numbers

Frank Spencer

(inaudible).

Scott Ransom

(inaudible) estimate, yes. So, although you’ve got a good point, I mean we are not – like we said, planning to just shut the thing down for three or four years, because we do think again, as we – as this thing turns around and – Chuck mentioned or Frank mentioned some of the recent bond offerings. They were very encouraging in that 5.5% to 7.5% where in October non one was issuing bonds. It was basically shutdown and if they were they were north of 10%. So, we are seeing some improvement and we think this is going to get on track whether it’s going to be at 90 days or the next years or so, we are not certain.

Rich Anderson – BMO Capital Markets

Okay. Thank you very much.

Operator

The next question will come from Karin Ford from KeyBanc Capital Markets. Please go ahead.

Karin Ford – KeyBanc Capital Markets

Hi, good afternoon. Just following up on that last thought, Scott, has any of – I guess that bond activity is encouraging – have you seen any of Erdman’s clients choosing to go ahead with projects that you guys are working on in the last, say, two to three months.

Scott Ransom

Yes.

Karin Ford – KeyBanc Capital Markets

Okay. And what percentage would you say that is versus the percentage of people choosing to either delay or cancel?

Frank Spencer

That’s hard, Karin, that’s hard to put a percentage on in that we are continuing to design for clients although a project may have slowed in its speed toward the design-build contract conversion

Scott Ransom

Yes.

Frank Spencer

So, I think what we are seeing is clients testing the waters for pricing and availability and we know they are doing that.

Karin Ford – KeyBanc Capital Markets

Right. Okay. And I guess a question for Chuck. What is the Erdman fee level, the range of fees and/or margins that’s assumed in the guidance range?

Chuck Handy

Talking about revenues, the fees that we’ve assumed in the guidance, I mean we have projected contracted fees, but I guess the way I will sort of approach that is that just based on cost savings play [ph] we’ve implemented that we’ve already discussed I mean we are really projecting flat year-over-year profitability for Erdman. So, I think that’s probably a better way to look at it. And as far as margins on a run rate basis, Scott, that’s probably – what percentage do you think on a run rate set? Probably –

Scott Ransom

Probably, a little bit north of what we’re at this year. That was 17%, you’re looking at a gross profit percentage.

Frank Spencer

Yes, gross margin.

Chuck Handy

Gross margin should be probably around 17% just for your – just for projection purposes.

Karin Ford – KeyBanc Capital Markets

Got it, okay. And also, what type of G&A assumptions is in your range?

Chuck Handy

We actually – as a – as far as corporate G&A goes, we’ve actually – we’re looking at that as flat to actually decreasing as a percent of revenue. I mean, one thing, obviously, that’s running through there for 2009 that you got to take into account is the elimination of incentive compensation, and so forth, so that certainly will impact and reduce corporate G&A for 2009.

Karin Ford – KeyBanc Capital Markets

Okay, that’s helpful. And just a couple of questions on the new developments. I know – you said you got the construction loan on the one project. Did you also get construction financing on the smaller North Carolina deal as well?

Frank Spencer

That one’s very small and we are just funding that out of cash at the moment, although we may choose to modify the current mortgage and recover that cash, but it’s less than $2 million total.

Karin Ford – KeyBanc Capital Markets

Got it. And it looks like the loan-to-cost on that loan – that construction loan you got is roughly 70%. Is that roughly what lenders are sort of looking to do with 100% pre-lease deals?

Chuck Handy

That’s right. On a loan-to-cost basis, yes, roughly 70%.

Karin Ford – KeyBanc Capital Markets

Got it. And what’s the expected yields on those developments?

Frank Spencer

The nominal yields that – and then, this is where, as you know, Karin, having followed us, it really depends on whether or not we’re the design builder. So, the nominal yields are anywhere from nine to a little north of ten, but if we’re the design builder then we’re capturing that whole value chain for our shareholders and depending on how the job buys out, our yields are always better than the nominal yield.

Karin Ford – KeyBanc Capital Markets

Got it. Okay. And just one last one, are you planning any new starts on your – for your account on your balance sheet for 2009?

Frank Spencer

We will do some new projects. And whether or not they are all on our balance sheet or joint ventured with physicians or we may actually even bring in some third-party deal equity to keep the engine humming and not deploy as much capital, but yes, we plan to continue to do capital deployment deals where we are the design-build firm and we’ll look at all three strategies, balance sheet, end-user equity, and third-party deal equity.

Karin Ford – KeyBanc Capital Markets

Great. Thanks very much.

Operator

The next question will come from Buck Horne from Raymond James. Please go ahead.

Buck Horne – Raymond James

Hi, good afternoon. Just wondering if you’d be willing to put some dollar number on the design-build revenues that are currently under contract, and maybe what that number would look like relative to where you were last year at this time?

Frank Spencer

Well, we gave some broad ranges last year and we have admittedly had fewer conversions since then, and so the number is down on two fronts. One is we’ve completed some of our backlog, and so we’ve probably, in terms of completions, Scott, come down another $40 million or $50 million total net.

Scott Ransom

Yes.

Frank Spencer

And then we’ve lost a few out of the top, so, whereas we were at a backlog of round numbers three times revenues, we’re probably down in the two-and-a-half times range right now. So, we’ve got a very substantial backlog and that’s part of what gives us confidence in positioning ourselves for when liquidity is fully restored.

Buck Horne – Raymond James

Is there a way to think about how that’s split between 2009 revenue and 2010 revenues?

Frank Spencer

Not unless you can tell me exactly when the credit markets are going to open up. I mean, I don’t mean to be glib, but it’s an uncertain period and we just don’t know exactly what that timing looks like.

Buck Horne – Raymond James

Okay. And could you describe, maybe, the magnitude of the contract cancellations that you mentioned in the first quarter? Had any ground been broken on any of those deals or any break-up fees or charges that we might expect to see with those cancellations?

Frank Spencer

The answer to the second half of the question is no, absolutely not, none at all.

Buck Horne – Raymond James

Okay.

Frank Spencer

When we say a cancellation, it would have been a project that was in the project-design-analysis phase. That’s our internal lingo. The feasibility pencil on paper, not – we haven’t had anything that’s had a spade in the ground cancelled or failed to pay.

Scott Ransom

No.

Buck Horne – Raymond James

Okay, okay. And just one more, if I could. Could you give us an idea what the retention rate on the leases that expired recently with the recent retention rate on renewals is?

Frank Spencer

The fourth quarter was low 90s, Chuck, and overall for the year was lower than that, but we continue to run in that high 70s to mid 80s. But as you guys know, it’s a little bit lumpy. We had one big hit during the year in ’08, which was the 32,000-square-foot Mecklenburg Medical Group in our Randolph project, but that project has now been redeveloped and we are re-leased with the exception of about 14,000 feet at this point. So, that was a big hit to the retention statistics, but generally across the board, as I’ve said earlier, as we moved into the fourth quarter, retentions went up dramatically as clients renewed in place.

Buck Horne – Raymond James

Thanks, gentlemen.

Operator

The next question will come from Michael Bilerman from Citi. Please go ahead.

David Cody – Citi

Hi, good afternoon, guys. This is David Cody here on the line.

Chuck Handy

Hey, David.

David Cody – Citi

Question, given the resizing of the development platform, can you describe what sort of dollar volumes you accommodated on the new platform in sort of a minimum and maximum in terms of project scope?

Frank Spencer

No, not really. And the reason we can’t is that the manpower, or the number of person hours is probably a better way to say it, that it takes to do a $50-million job is not a linear relationship to a $6-million job. The $6-million job is inherently less efficient to put through the process. And so, it really becomes a function of project size and the order in which they sign up. So I would say, Scott, with the right mix of products, we could do as much today as we could before the reduction in force. On the other hand, if you had the wrong mix of projects, we probably had – have to add headcount.

Scott Ransom

Yes. I mean, I think we’re staffed now, I mean, based on the stage of where our projects are. There is – sometimes between a nine-month and, maybe, north of 12-month gestation period during the – from you were hired to do some conceptual analysis feasibility all the way through you’re getting the schematic design of the project done into the working drawings. You have a time there, David that you can actually hire up as needed. But right now, we think we still have capacity for growth.

David Cody – Citi

Got it. I guess what I’m trying to angle at is if you see a significant reduction in volumes from where you are now, I mean, and this is probably more of a 2010 issue, do you feel that the platform has been sized more towards the downside or that you’re still assuming high volumes?

Frank Spencer

Well, we definitely sized towards the downside and would stretch to grow, but I think what Scott’s saying is that the ability of our architectural and design and engineering groups to draw exceeds the pace of staffing up in the field to construct. And as everybody knows, unfortunately, that there is lots of field talent available in the market right now, so we really don’t think we’ve cut where we can’t grow, but we think we’ve cut to where we expect volumes to be.

David Cody – Citi

Okay. And then, just moving over to some of your guidance assumptions. If you could just touch on your expectations for expense growth in 2009 and, specifically, with regard to taxes and how you will control some of that growth relative to matching NOI growth from last year.

Frank Spencer

Well, as I’m sure you know, but I’ll share for other folks who may not have followed us as closely, almost all of our leases pass through operating expenses of the buildings to the tenants. So we’re not operating on a gross lease basis but rather what we call a full service lease with an operating expense stop. So the expense side of the equation for us, in terms of the per square foot cost of energy, taxes, insurance, all – janitorial, all of those normal things in a running an office building, those are all tenant expenses in our portfolio. And so, while we watch them like a hawk because we think that’s part of what our reputation and brand is built on, and we want to ensure that our clients always have the lowest cost of occupancy that’s available to them; it is not a risk for us in the P&L.

David Cody – Citi

Where would you peg that percentage at, at the end of the year?

Frank Spencer

Which percentage?

David Cody – Citi

In terms of the pass-through of total expenses.

Frank Spencer

No, not the adjustment – I mean, almost all.

David Cody – Citi

Okay. So high 90s, okay.

Jim Cogdell

Yes. Probably operating. Yes.

David Cody – Citi

Okay, great. And then, do you have any land holdings on the balance sheet?

Frank Spencer

We have one.

Chuck Handy

One, yes.

David Cody – Citi

Just one? Okay.

Frank Spencer

We have one very small deal, the carrying cost of which is under $250,000, I think.

Chuck Handy

Yes.

David Cody – Citi

Okay. And then just lastly, any thoughts on the dividends? There’s been a lot of discussions around cash versus stock. You guys discussed that internally? Anything you can share with us?

Frank Spencer

Yes, I think it’s clearly the Board’s intention to pay in cash as it did in our January dividends. Part of the reason the dividend number is where it is that we fully cover that on a cash flow basis. We’re not borrowing under the line of credit to pay dividend, nor are we borrowing under the line of credit to fund CapEx. And so, we’re fully covering and see no reason not to pay it in cash. That said as I have to do, the SEC tells me this every time. The Board of Directors is going to look every quarter at what’s the best policy is and will make a prudent decision relative to that. But our desire and our intention is to continue paying a cash dividend.

David Cody – Citi

Okay. Thank you for the detail.

Operator

(Operator instructions) We have a follow up question from Rich Anderson from BMO Capital Markets. Please go ahead.

Rich Anderson – BMO Capital Market

I figured I’d ask you, I was going to you, but I’ll ask you since we have time. What’s your expense stop per square foot on average, that’s, I guess, the number I’m interested in?

Frank Spencer

Actually, Rich, it’s – the average expense stop is not a meaningful number and here’s why. I mean, we’re happy to go through the details with you on this. But it really relates to each building and each lease, so you could have a building – as long as 100% of your expenses are covered in that expense stop, then what you’re really looking for is on an individual building are all my expenses covered? And so, you could have a building that the tenant has been there for 15 years and they might have a $5.50 expense stop, and you might have somebody who moved in last year, and they have a $7.50 expense stop; and the total expenses for the building are projected this year to be $7.80. And so, we’re getting 100% of that $7.80 back from the tenants, because what the stop does is it says, “If it goes above this, you pay any increases; and if we’re halfway intelligent managers, we set the stop where the expenses are.”

Rich Anderson – BMO Capital Market

Right. Okay. That’s pretty smart. Thanks.

Operator

The question will come from Karin Ford from KeyBanc Capital Market. Please go ahead.

Karin Ford – KeyBanc Capital Market

Hi. I just wanted to follow up with one quick one as well. One of your competitors yesterday said that in their portfolio they were expecting – they were seeing market rents come down slightly in 2009 in their medical office portfolio. I know you guys said you’re expecting rents to be up modestly in 2009. Do you think that – is it sort of a difference between on-campus and off-campus, is it particular markets? Are you seeing market rents come down in any of your markets?

Frank Spencer

Karin, I really – I don’t know what the details of the competitor’s portfolio are, so I certainly couldn’t compare us to that. I just know that on average, we’re seeing a modest increase. And I think this gets back to our whole theory of how we run the business, which is we don’t try to push the rents dramatically when the market is tight, and we have very consistent small year-over-year increases, and that makes it easier for the clients to accept when the markets are not as tight. And I think our tenants are so accustomed to our pattern that we’re not really seeing any pushback on that.

Karin Ford – KeyBanc Capital Market

Great, thank you very much.

Operator

The next question will come from Stephanie Krewson from Janney Montgomery Scott. Please go ahead.

Stephanie Krewson – Janney Montgomery Scott

Hey guys. I’m going to ask Rich’s follow-up question in a different way because it’s the same question, one of the few questions that we had.

Frank Spencer

Okay.

Stephanie Krewson – Janney Montgomery Scott

If you were to experience vacancy, what expense on average per square foot would you no longer be able to pass through?

Chuck Handy

Different question.

Stephanie Krewson – Janney Montgomery Scott

I think that’s where he was going with it, if I maybe so bold.

Frank Spencer

Okay. I’ll let you and Rich get together later and figure that out. But –

Stephanie Krewson – Janney Montgomery Scott

He’s a smart guy. I know he’s asking the right stuff.

Frank Spencer

So what you’re really asking is what percentage of costs are fixed versus variable, right?

Stephanie Krewson – Janney Montgomery Scott

Well, let’s just make it even easier. We know what your average – what’s your average annualized base rents are, and we can divide that by your average occupied square feet.

Frank Spencer

Yes.

Stephanie Krewson – Janney Montgomery Scott

So that implies a based rent for occupied square foot?

Frank Spencer

Okay.

Stephanie Krewson – Janney Montgomery Scott

And maybe that number is around $24.

Frank Spencer

Okay.

Stephanie Krewson – Janney Montgomery Scott

What do we have to subtract from the $24 to get to a net effective rent across your portfolio?

Frank Spencer

Well, I mean, that – all you have to do for that is to take NOI and divide by the same denominator.

Stephanie Krewson – Janney Montgomery Scott

Right. I did that.

Frank Spencer

So what did you get?

Stephanie Krewson – Janney Montgomery Scott

I am just double checking.

Jim Cogdell

That’s it. Be careful with that computer stepping.

Stephanie Krewson – Janney Montgomery Scott

Jim. We’re estimating that your average expenses – that your cost to carry that you’d have to pick up if you have some incremental vacancy or conversely if you lease up space what you did to that pass-through is between $7 and $8?

Frank Spencer

All right, and your math is correct. And the number is, I think – I’m not sure I’ve seen ’09, but around $7.80 is correct. But now this is what I was talking about. A lot of that is variable.

Stephanie Krewson – Janney Montgomery Scott

Right.

Frank Spencer

So the vacancy does not necessarily mean that you suffer the whole $7.

Stephanie Krewson – Janney Montgomery Scott

Correct.

Frank Spencer

So – yes, you’re correct that if you do have some vacancy you lose the ability to pick up some of it, but not all of it; and the split those two is about 40% variable and 60% fixed.

Stephanie Krewson – Janney Montgomery Scott

Excellent. Thank you much.

Operator

We show no further questions at this time. I would like to turn the conference back over to Frank Spencer for any closing remarks.

Frank Spencer

Okay. We appreciate everybody’s interest and as always are available to any of you who have specific questions and would encourage you to review the material, go to our website. It’s all available under Investor Relations. And as we look forward with caution, but optimism, we’re excited about 2009 because we think it’s going to be an opportunity to really take an expanded platform, a more sophisticated service offering and really provide additional value-add to our clients. And we think the long-term results of that is that we’re going to pick up market share and opportunity as others pull back. Thank you and we will talk to you again soon.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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Source: Cogdell Spencer Inc. Q4 2008 Earnings Call Transcript
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