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Alexander & Baldwin, Inc., (NYSE:ALEX)

Q2 2010 Earnings Call

July 29, 2010 5:00 p.m. ET

Executives

Stanley Kuriyama – President and Chief Executive Officer

Christopher Benjamin – Senior Vice President, Chief Financial Officer and Treasurer, Director, Hawaiian Commercial & Sugar Company

Norbert Buelsing – President, A&B Properties, Inc.

Matthew Cox – President, Matson Navigation Company, Inc.

Suzy Hollinger – Director, Investor Relations

Analysts

Sloan Boland – Goldman Sachs

George Pickral – Stephens

Brendan Maiorana – Wells Fargo

Sheila McGrath – KBW

DeForest Hinman – Walthausen & Co

Operator

Good day ladies and gentlemen, and welcome to the Q2 2010 Alexander & Baldwin earnings conference call. (Operator instructions.) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to Ms. Suzy Hollinger, Director of Investor Relations. Please proceed.

Suzy Hollinger

Thank you, Derrick. Aloha and welcome to Alexander & Baldwin’s Q2 2010 earnings call. On the call with me today from Honolulu are Stan Kuriyama, A&B President and CEO; Chris Benjamin, A&B CFO and also General Manager of HC&S; and Norb Buelsing, President, A&B Properties. And joining us from Matson headquarters in Oakland, Matt Cox, President of Matson.

Before we begin please note that statements in this call and presentation that set forth expectations or predictions are based on facts and situations that are known to us as of today, July 29, 2010. Actual results mat differ materially due to risks and uncertainties such as those described on pages 17 through 26 of our 2009 Form 10-K and other subsequent filings with the SEC. Statements in this call and presentation are not guarantees of future performance.

Slides from this presentation are available for download at our website, www.alexanderbaldwin.com. You will see an icon at the top of the website to direct you to the appropriate session for download.

This slide provides an agenda for our presentation, after which we will take your questions. We’ll start with Stan who will comment on performance for the quarter.

Stanley Kuriyama

Thank you, Suzy. As you may have noted from the earnings release we issued this afternoon, net income for the Q2 was $29 million, or $0.70 a share, more than double the earnings for the same quarter last year of $13 million or $0.31 a share. These results were driven primarily by a 75% increase in ocean transportation operating profit and significant improvements in agribusiness performance. Real estate sales of improved properties remained favorable in the quarter, while real estate leasing continues to be pressured by lower renewal rents, the timing of sales and acquisitions, and the impact of expired 1031 exchange proceeds.

A strong Q2 performance resulted in first half operating profit of $99 million, compared to $49 million compared to the first half of 2009, and earnings per share of $1.12, compared to $0.38 at this time last year.

Let me now brief you on Q2 highlights. The China trade lane performed exceptionally well this quarter, with very strong volumes and rates. Demand has increased significantly, resulting in full sailings and rates in the Q2 are 50% above a-year-ago levels. As a result of our positive long-term outlook for China, we have decided to initiate a second string between China and Long Beach. This service will allow us to capitalize on the tremendous operating experience, infrastructures, and customer base Matson has developed in China over the past four years. Matt will have more details about our new China service and the performance of our Hawaii and Guam trade lanes in just a few minutes.

I’m also pleased to report that we continued to build traction in our project x investment efforts in Hawaii. In June we acquired two fee-simple parcels in a well-allocated urban area of Honolulu that are approved for residential and commercial uses. The timing of this investment positions the company to take advantage of the next upswing in the urban residential market, which has seen growth in sales and median prices over the last six months.

Demand for quality real estate assets continues, and we were able to achieve a good price on the sale of an industrial property in Kent, Washington, during the quarter. Our 1031 reinvestment efforts also remain active despite a challenging market. We reinvested $23 million of proceeds from previous property sales in the acquisition of a prime neighborhood shopping center in Kona on the island of Hawaii. And last week we announced the purchase of a fully-zoned 35 acre industrial complex on Oahu, which utilized $38 million of 1031 proceeds.

As usual, we’ve included in the appendix information, sorry. Finally, to continue with the good news for the quarter, excuse me, a 67% increase in tons of sugar produced together with higher sugar prices helped drive significant improvement in agribusiness performance. Based on our first half production results and the sugar prices we have locked in for the balance of the year, we are on track to perform better in 2010 than we had originally projected.

All in all, we had a good quarter as we realized the benefits of the company’s diversified earnings base. But just as important we have begun to lay the foundation for the future growth of this company as well.

As I started to mention earlier, we’ve included in the appendix information on Hawaii’s economic performance. Noteworthy for this quarter has been the continued improvement in tourism. Visitor arrivals for the quarter were up 7.5% compared to last year, principally driven by increases in visitors from the western United States, Japan, and Canada; and visitor expenditures increased more than 8% over the same timeframe.

Statewide hotel occupancies have shown positive year-over-year growth in eight of the last nine months, and occupancy was at 82% for the week ending July 17th, a 7% improvement from a year ago. The outlook for tourism remains positive as the airlines have announced a 6.5% increases in seats to Hawaii from June through August 2010.

Now at this time I’d like to turn the program over to Matt for a discussion of Matson’s performance.

Matthew Cox

Thanks, Stan, and good afternoon. As Stan mentioned, ocean transportation’s operating profit improved dramatically in the quarter, primarily from the strong performance in our China service. Overall strength in this trade lane also drove income from our SSAT joint venture hire. We experienced relatively stable performance in Hawaii and noted some signs of growth in Guam.

China performance is driven primarily by the higher levels of market demand and tightened shipping capacity that better matches current demand. We also benefit from our premium expedited service. Our ships are operating at effectively full capacity and rates have increased 50% in the Q2 compared to rates for the same quarter a year ago, and by 30% sequentially from the Q1. We expect that the strength in China’s rates and volumes experienced in the Q2 will continue through the balance of 2010 and into 2011, subject to normal seasonality.

As Stan mentioned, to build upon our hard-earned experience and customer base Matson has developed over the last four years in our China service. We’re expanding our presence with a second weekly service, the China/Long Beach Express 2. CLX2 will provide round trip service between Hong Kong, Xi’an, Shanghai in China and Long Beach using five time chartered ships that are sized at approximately 3500 TEUs. CLX2 will maintain Matson’s niche customer and transit approach while expanding our geographic coverage to the very important Pearl River Delta manufacturing hub, further defining Matson as a China specialist now culling five of the largest ports in that country.

We will continue to provide premium service that includes speed, reliability, next-day cargo available, and eye-touch customer service. Our operations will begin mid-August and be in full deployment by early October. Matson will spend roughly $50 million to $60 million to purchase containers and other equipment for this new service. Losses generated fro the startup days of the new service are expected to reduce our 2010 ocean transportation operating profit by $10 million to $15 million, with the majority of these losses recognized in the Q4 of 2010. We are of course really excited by this new venture and the opportunity to expand our presence in one of the world’s most powerful economic engines, China.

Let me now turn to Hawaii. Q2 performance in our Hawaii trade lane aws relatively consistent with the performance for the same quarter in 2009. Container volumes were down slightly and auto volumes were lower by 22%, primarily due to the timing of automotive rental fleet replacements. However, ongoing benefits of our cost reduction initiatives offset the effects of these lower volumes. We continue to expect relatively flat performance in the Hawaii trade lane for 2010 but are well positioned to benefit when growth in the Hawaii economy strengthens.

It is important to note, however, that with utilization it he low 90% range that we have our fleet well-sized for the current volumes in this trade lane and are able to bring reserve ships back into service as demand improves.

Operating performance in Guam improved in the Q2 compared with last year. We’re beginning to see signs of increased construction mobilization on the island, some of which is related to the pending US military troop movement from Okinawa to Guam. Volumes and rates were both up in the quarter and we expect modest volume growth for the remainder of 2010 with further improvements in 2011.

Our logistics segment’s operating profit was $1.5 million, compared to $1.8 million a year earlier. The impact of lower warehouse volumes and downward pressure on intermodal yield from competition and available capacity in the quarter were only partly offset by increased highway and intermodal volumes and highway yields. While modest industry improvement is anticipated in 2010, full-year results for this segment are expected to be similar to the 2009 result.

At this point, the company remains focused on organic growth opportunities and improving operating efficiencies, while seeking to expand into new markets through personnel recruiting initiatives. I now would like to turn the call over to Norb Buelsing, President of A&B Properties.

Norbert Buelsing

I’d like to start with real estate sales. In the Q2 we earned $8 million in operating profit, $1.6 million lower than the Q2 of 2009 due to the timing and types of properties sold. As we said in the past year-over-year comparisons do not provide a consistent barometer of future performance as these sales are episodic by nature. In the quarter we sold Valle Freeway Corporate Park in Kent, Washington, and several vacant parcels on Maui. We continued to see demand and favorable pricing for quality properties.

As you may recall, early in the quarter we acquired the 88,300 sq ft Lanihau Marketplace in Kailua-Kona on the island of Hawaii for $23 million. The center is a grocery-anchored shopping center with strong, stable tenants and is 99% occupied. And just last week we announced the acquisition of Komohana Industrial Park, a 35-acre, fully zoned industrial complex in West Oahu for $38 million. The property is located in Kapolei, one of the fastest-growing cities on Oahu. Both properties were purchased with 1031 proceeds from earlier dispositions.

While our 1031 exchange program remains active, during the first half of the year $8 million of exchange proceeds expired. At quarter end, approximately $76 million of qualified 1031 proceeds were available for reinvestment, which was subsequently reduced by the $38 million invested in the aforementioned Komohana property. Of the remaining proceeds, $16 million is expected to expire without the investment. While disappointing, the expiration of these proceeds is a reflection of our strong discipline and investing only in quality properties that meet our underwriting criteria.

As Stan mentioned, we also continue to seek development opportunities in Hawaii and we are pleased with the purchase of two development sites in Honolulu. This slide shows an aerial view of the sites and you can see that they’re in a prime location, close to Ahuimano and Ward shopping centers and Ahuimano Beach Park. In our existing development pipeline we continue to push forward projects on Maui and Kauai. Construction plans have been submitted for our 179 acre Maui Business Park II industrial subdivision on Maui and at Kukui’ula, construction of the golf course is near completion and we’re expecting substantial completion of the resort’s core amenities by year end.

Let me now turn to real estate leasing. Although portfolio occupancy remains stable, lower minimum lease renewal rates and the impact from the timing of 1031 sales and acquisitions, and the expiration of 1031 proceeds lowered our leasing operating profit by $2.5 million in the quarter compared with the Q2 of 2009. Mainland rates appear to have stabilized in the quarter, however, and we noted increased leasing activity at our mainland industrial and office properties. Occupancies for our Hawaii properties remained relatively steady at 93% and are expected to remain stable. However we are experiencing modest declines in Hawaii renewal rates.

Due to the continuing impact of lower lease renewal rates, the timing of 1031 sales and acquisitions, and the expiration of 1031 sales proceeds the company expects leasing operating profit for the balance of the year to be consistent with Q2 results. I’d now like to turn the call over to Chris Benjamin to discuss agribusiness.

Christopher Benjamin

Thanks, Norb. Q2 agribusiness performance improved significantly compared to 2009. As Stan mentioned, the recovery was mainly a result of the 67% increase in sugar production during the quarter thanks to improved growing conditions that increased our yields and factory enhancements that enabled us to process much higher volumes of sugar cane. Higher sugar prices also helped, with realized prices roughly 30% higher than year-ago levels. Through quarter end we had forward priced over 80% of the 2010 crop at attractive levels, and current market price remains strong.

Based on production levels for the first half of the year and the favorable pricing environment, agribusiness could approach break even profit levels in 2010. This is better than we originally had projected. However, with only 40% of the expected crop harvested as of quarter end, full year results can’t be projected with certainty.

While improved performance enhances the segment’s near-term prospects, the company’s sugar operation continues to face external challenges. Two water rulings in the Q2 have reduced HC&S’ prospective access to irrigation water. While the resulting loss of water doesn't immediately threaten sugar production it will result in a future suppression of yields and will have an impact on the company that will only be quantifiable over time.

The company continues its exploration of the potential to produce biofuels from sugar or other crops. These efforts are ramping up as we approach the October kickoff of extensive federally-funded research projects. We also are undertaking both research and pilot projects with private entities. The higher sugar prices we’re enjoying could help provide a bridge to a new energy model.

That concludes our operational updates, so now I will comment briefly on financial matters. Our balance sheet remains strong with solid assets, relatively low debt levels and as you can see at the bottom of this slide, ample liquidity. Our total debt has increased $55 million since year-end, due primarily to real estate development investments. Despite the increase in leverage, our debt to total capital remains low at 32%.

Slide 27 shows our high-level cash flows for the year-to-date versus prior year. The largest swings are related to net investment into our business – again, the real estate development investments – and the resulting increase in debt. The bottom of the page reconciles our $24 million of GAAP CAPEX to the $145 million of gross CAPEX I’ll discuss on the next slide.

Slide 28 shows are year-to-date capital spending and our capital outlook for the balance of the year. As you can see, we’ve raised our full-year capital forecast by nearly $50 million to include anticipated capital expenditures for the new China service. The revised capital budget for 2010 is now $370 million, but this includes $105 million of self-funded 1031 exchanges and a placeholder of $25 million for yet-to-be-identified real estate development and investments. While our pipeline remains active the timing of this type of investment is always difficult to predict.

I’d now like to turn the call back to Stan for closing remarks.

Stanley Kuriyama

Thank you, Chris. To summarize our comments on this call, the remainder of the year we believe Matson will perform similarly to its Q2, subject to normal seasonality and reduced by the $10 million to $15 million of startup losses expected from the new China service. Our leasing portfolio, for the reasons described earlier, will not achieve last year’s results although performance is expected to stabilize over the balance of the year at Q2 levels. We had a good first half in property sales, but these sales are episodic and opportunistic by nature, and second half results are expected to moderate from first half levels. Finally, as Chris mentioned, agribusiness should beat our original projections and could approach break even levels for the year.

Of course our outlook for the company is based on results for the first six months of the year, and could differ if current conditions change materially. Overall we’re pleased not only with our operating performance but with key investments made to support future growth. The extension of our shipping service in the world’s fastest-growing economy will continue to strengthen the diversification of our earnings, and our recent relate estate acquisitions, together with other projects in the pipeline, will position us well for the eventual recovery of our real estate markets.

As always, we will continue to focus on growth opportunities in the company’s core businesses that will create long-term shareholder value. That concludes our presentation today. I’ll be happy to answer your questions. Thank you.

Question-and-Answer Session

Operator

(Operator instructions.) The first question is coming from the line of Sloane Boland with Goldman Sachs. Please proceed.

Sloan Boland – Goldman Sachs

Thank you. Good afternoon. Just maybe a start on the new China route, just sort of thinking about underwriting of the CAPEX spend that you’re looking to put to use and how that return ramps over time. And then I know Chris, you talked about timing kind of being difficult but maybe if you could frame some numbers around that.

Matthew Cox

Sure. Hi Sloan, this is Matt. I guess the way we’re looking at this now is we targeted an investment of $50 million ro $60 million, and to your first question about how we’re planning on financing that – between the improved operating results we’re seeing an the cash available from that, together with borrowings under Matson’s committed lines we should, that’s how we’ll plan to finance the acquisition of equipment necessary for the startup.

As for the second part of our question, related to what are our earnings prospects and so on, we did mention that during this startup period we’re going to be incurring between $10 million and $15 million in operating losses, and that’s largely because we’ll be building our book of business starting with very little cargo and as we get to our targeted vessel utilization there’ll be a period of losses. We do expect in 2011 for this investment to earn a positive return, although probably in the first part, first half of the year or the first quarter at least we do expect some operating losses. And most of the profits that we’ll be earning will be in the second half of 2011.

I mean as to our long-term prospects for this, we do believe that the, at maturity that the operating earnings from the CLX2 could plus or minus comprise 10% to 15% of the total operating earnings of Matson Navigation. That’s kind of our thinking at this point.

Sloan Boland – Goldman Sachs

Okay. And maybe just to frame it in terms of return on capital invested, how that was thought about in the underwriting process. And then even just you know, basic details about when would the route commence, those types of kind of just general details.

Matthew Cox

Yeah, okay. As to the general details we have, we believe we’ll be starting the transition of this new service beginning mid-August, so the first vessels will be sailing x Xiamen, Ningbo and Shanghai beginning the middle of August, and then we’ll begin our new service from south China around mid-September and be into our full deployment the first week of October as we bring on these charter vessels and put them into their starting rotations. So that’s basically the way that the service will be put together. We’ll also be timing for the manufacture and leasing of new equipment in order to be able to provide the container capacity necessary to fund the ship.

As to your question about long-term earning and targeted returns, I would ask Chris to comment on that.

Christopher Benjamin

Sure. I’d be happy to. Yeah, with respect to you know, the underwriting of the project, it was very typical of any project that we underwrite. We did very extensive modeling of not only a set of baseline assumptions but also a range of scenarios. Obviously the nature of this trade is very different from the core trades that we operate in but we know it pretty well from the last several years and we felt pretty good about the assumptions that we were able to model, both again baseline and sensitivities. I guess the only thing I could really say, Sloan, is that we felt very good about the risk adjusted retunes in the trade. We did utilize kind of an international shipping adjusted cost of capital to reflect the risk inherent in that trade lane, and felt good about the return results.

Sloan Boland – Goldman Sachs

Okay. And there’s just one last question. I guess on the rate growth, maybe Matt if you could offer a little color there. I guess a lot of it’s come from supply in the international market coming in, just because demand has. How quickly could some of that shipping supply come back? I guess it’s an ultimate question of how variable could those rates be going forward? And maybe tie that in with the thought process on the investment.

Matthew Cox

Sure, I’d be happy to do that. I think what’s happened here, if you take a bit of a longer context here is there has been a rapid increase in transpacific eastbound freight rates. But if you look at it in a larger context it’s largely a recovery of freight rates from a very significant collapse in freight rates as the world economy went into recession last year and there was a significant surplus of ship tonnage that was made idle by the reduced levels of shipment.

We’ve seen a dramatic increase in the demand. It hasn't just been a constriction of supply, and so the trade dynamics are such that a lot of the idle capacity that was somewhere over 10% of the world’s supply in January of this year has largely been redeployed into the Asia/Europe, intra-Asia and transpacific trades. So as of this moment there is very little idle tonnage to be absorbed.

And so our views of the market really are there's been a dramatic recovery of freight rates in the eastbound trade and what we’re seeing after a period of significant volatility that we’re going to be entering a period of relative stability. And that was one of the factors that went into our thinking.

Sloan Boland – Goldman Sachs

Okay, great. Thanks for that, Matt and Chris.

Operator

The next question comes from the line of George Pickral with Stephens. Please proceed.

George Pickral - Stephens

Good morning, everybody. Stan, just to clarify the comments you made in your closing remarks. You said expect transport to be flat with Q2 levels? Is that correct?

Stanley Kuriyama

Right. Q2 levels subject to seasonality, so typically the Q4 is a little softer than the other quarters; and then subject to the expected startup losses that we mentioned on the new China service.

George Pickral - Stephens

Okay, so okay. So I guess the number you gave I guess excluded that, so then we have to take out the losses on top of that, mostly in Q4. I just wanted to make sure that your initial comment didn’t include those losses.

Stanley Kuriyama

Right.

George Pickral - Stephens

And then maybe Stan or Matt, kind of sticking with the new service offering here, can you maybe talk about what prompted the decision? Was it you all seeing the market opportunity? Was it your customers coming to you? And then along those lines it seems like a pretty quick startup here. Do you have any customers in place already and can you talk about utilization levels you need to get to? I know I just asked about four questions but…

Matthew Cox

Okay, and I’ll answer six of the four questions you asked me. But no, George, basically Matson, since it had its initial success when it started its service four years ago has long had an interest in expanding this high-service carved out niche market as the international trades have become more homogenous, as larger vessels operating through carrier alliances and so on have become the norm in the transpacific. And so our original idea was to carve out this high-service niche. And what we’re effectively doing is taking this service that we’ve built over the past four years that’s focused primarily on central China – Xiamen, Ningbo, Shanghai – into south China.

And so while it seems sudden the market conditions have now presented over a period, as I said of remarkable instability, it allows us to we think profitably enter the south China market which is as you know the largest market in China, in Xi’an Pearl River Delta. As to your question about customer and demand and what drove this, certainly there was the strategy but there was also a significant amount of turmoil caused by the other international carriers, decisions unilaterally to lay off capacity, their unilateral decisions to slow steam; and lots of longstanding relationships between international carriers and the customers have been significantly frayed by this economic cycle.

And so there was a significant interest in both expanding our premium niche service out of south China and the damage that’s been done based on the very significant economic cycle that we’ve gotten our way through. But more specifically Matson has about 300 contracts, George, in our CLX1 service and about 200 of those 300 customers have cargo needs out of south China, so there’s significant overlap there in terms of customer base. Of course we talked to most of our customers about their interest levels.

The other thing that it does for us is it provides us a second sailing from Shanghai. So we can offer a mid-week and end-week sailing out of our core Shanghai market which allows us to, instead of just getting a part of a customer’s production to get all of it. So we feel like we’re, from a cargo standpoint, extremely well positioned based on the factors I just talked about.

George Pickral - Stephens

Okay, and then one more question on this. You mentioned rates have gone up on a recovery and you could argue that it was right of the international steamship lines to withhold capacity to get rates back to around break even. A lot of it’s come back into the market. What is your concern that they aren’t disciplined with capacity in 2011, if we see a little bit of a slow down and the potential for rates to crater again? Or do you think that they’ll be good with their capacity, take it back offline as they seasonally do or should?

Matthew Cox

Yeah, I mean my personal opinion is the international carriers as a group reportedly lost almost $20 billion and I think they have been so traumatized by this near-death experience that they are going to be very disciplined in their approach to adding and subtracting capacity in the market as demand dictates. That’s our personal view.

George Pickral - Stephens

Okay, last question and then I’ll turn it over. You mentioned, one of you mentioned the sequential increase in China rates. Any other sequential increases in your Hawaii or Guam rates?

Matthew Cox

Well George, on the Hawaii rates and Guam rates, Matson has long taken the approach that it will take an annual rate increase around the 1st of the year. And it’s done so in 2010 as it’s done in previous years and we’ve been pleased by the retained increases from our annual increase. And as you know our approach is to take small annual increases reflecting generally the increases in underlying cost structures. And that has gone on meeting our expectation.

George Pickral - Stephens

Okay. I didn’t know if there was any spot business that would come in above contract rates or not.

Matthew Cox

No, not in the Hawaii or Guam trades.

George Pickral - Stephens

Okay, thank you.

Stanley Kuriyama

George, maybe I might just add a point on your question on rates. You know, if you look back at the inflation-adjusted cargo rates in this trade lane, current rates are actually fairly low in comparison. On an inflation-adjusted basis over the last ten to 20 years, rates actually have been fairly higher than what we see today. But in our underwriting we of course did not assume this type of accelerated increase of rates; we actually had fairly, very modest increases in rates over time. We also understand that there could be some volatility in this trade lane as it has experienced over the last ten years. So those factors are understood by us and I think reflected and incorporated into our underwriting for his investment.

George Pickral - Stephens

Okay. Thanks, Stan.

Operator

Your next question comes from the line of Brendan Maiorana with Wells Fargo. Please proceed.

Brendan Maiorana – Wells Fargo

Thanks. Good afternoon. Just I guess maybe first with Stan and on the new trade lane, the new service – you know, if I look at kind of the visuals of the quarter you’ve got some 1031 money that you’re allowing to elapse because you’re not getting investments there. And you’re allocating a reasonable amount of capital to this new trade lane but it’s beyond the capital that’s being invested. It seems like it’s a little bit of a bigger investment than that just with the leasing of the ships and starting a new service. So it seems like you’re moving more in the direction of the transportation side of the business than the real estate side of the business. Is that a fair assessment? And is that how you view growth in the company as you look out over the next few years?

Stanley Kuriyama

Brendan, no, that’s not I think our perception. I think we’re still pretty equally weighted in terms of, you know, future expectations between transport and real estate. And if you look at current capital budget as far as our own future projections of our use of capital there is you know, I would say an equal amount of capital going into both businesses. You know, real estate remains opportunistic. We have, as you know we are pretty well focused on Hawaii real estate opportunities. You know, as we mentioned we’re beginning to see some traction there but you know we still remain disciplined on that as well in terms of seeking only good investment opportunities that meet our criteria.

China, you know, is growth in our core business. So we just, you know, there are a lot of companies wanting to do business in China now. We feel fortunate that we already have four years as Matt said of very hard-earned, very successful experience in that trade lane that we can capitalize. So we feel good that this is part of our core business for transportation. I think this is a right move for Matson and we’ll continue to emphasize real estate going forward as well.

Brendan Maiorana – Wells Fargo

How much, I think historically you’ve targeted return on capital in your transportation business as lower than in the real estate business, and maybe even lower, not in the development side of the business but in the owned, the commercial portfolio. Is that a fair assessment of how you’re looking at the returns of this new China service relative to the amount of capital you’re allocating to the business?

Christopher Benjamin

No, this is Chris, Brendan. No, I don’t think so. I think that if your characterization is right about historically looking at returns in transportation lower than real estate it’s only really reflective of the relative risk profile of the two businesses. When we’re doing commercial property acquisitions, you know, we’re looking at returns and cap rates very consistent with what’s out there in the market. And as you know those returns you know, are not in the 20+ IRR range. It’s in the real estate development side of the business that we’re looking at those kinds of returns because of the higher risks associated with it.

Similarly, when we’re looking at investments into our core Hawaii trade lane, which is of course a much more, traditionally a much more stable trade environment, we may be looking at returns that are well below our real estate development returns. But I can assure you that as we look to get into the international trade here, both with our initial investment several years ago and with this investment we are looking at risk adjusted returns as I said that are really more consistent with what we might look at with a real estate development return because of the nature of the trade.

Brendan Maiorana – Wells Fargo

Okay, fair enough. And then for Matt, what needs to happen I guess or what… If you look at your existing China service you’ve got kind of the filled ships on the back haul so it seems like it’s a lower-risk type of service. What things do you need to do in the new China service that maybe you’re not doing in the existing service to make sure you’re successful in that trade lane?

Matthew Cox

Yeah, it’s a good question and your observation is a good one. Our CLX1 service as we’re now calling it does benefit from a head haul in both directions, and so implicitly has a lower break even than the CLX2 service. I would say however, the fact that these are foreign flag time charter and our operating cost structure will be lower on the CLX2 service by the nature of this trade – it won’t go through Hawaii or Guam, won’t seek to. But it is just as important that we fill the ship full in the head haul direction or nearly full, and it’s also important that Matson gain an foothold in the transpacific west-bound market which is predominantly characterized by wastepaper, scrap metal, chemicals, resins and so on, which would be a new market for us. But fortunately there are a number of us on the Matson management team who have international experience and know those markets and know how to operate them.

So I think that the secret of our success in this trade will be the same a CLX1 in many respects, which is get the ships there on time, get them there fast to leverage this high-service brand that we’ve established in central China into south China; and then operate the ships relatively full. So in some ways it’s very similar.

Brendan Maiorana – Wells Fargo

Thank you.

Operator

Your next question comes from the line of Sheila McGrath with KBW. Please proceed.

Sheila McGrath - KBW

Yes, good afternoon. I also had a question on the new service. Can you just remind us, this service is going to take about $50 million of capital you indicated. Can you remind us how much the original China service startup costs were?

Christopher Benjamin

Do you want me to take that, Matt?

Matthew Cox

Yeah.

Christopher Benjamin

Well, the project in its entirety was about $365 million but remember, that was, included the purchase of two ships which effectively allowed us to take three ships that were already in the Hawaii service and add two ships to extend the service on to Guam and Hawaii. So that was part of that capital expenditure. In this case we’re going to be time chartering the vessels so the capital investment is much lower.

Sheila McGrath - KBW

Okay. And a question for Norb. I was wondering if you could give us a little bit more detail on some of the valuation metrics on the pricing of, cap rates on the sales and acquisitions, and also on the residential land acquisition.

Norbert Buelsing

Sure, Sheila. On the sales, as Stan mentioned we were, we felt we were fortunate in getting good prices on the sales, and the most recent being the Valley Freeway Corporate Park. And that sale on a cap rate basis was approximately 8%. There was some rollover exposure but generally we’ve got very favorable pricing and good demand for a quality product. On the development side, in that regard, you know, we target IRRs on our developments in the range of 18% to 20%. Certainly each project is unique so that return expectation can change both up and down. But that’s generally you know, our target.

Sheila McGrath - KBW

Okay. And then on the acquisition of the industrial in Hawaii, the industrial park – what was the cap rate on that one?

Norbert Buelsing

That acquisition was about an 8% return on the existing income.

Sheila McGrath - KBW

Okay. Okay, and last question. When we look at the different segments, ocean transportation was up, agriculture was up. And you did give us a little bit of insight on the transportation outlook, but on the agricultural, this was a surprise to us that it was up, the profitability. Do you expect that to continue for the balance of the year?

Christopher Benjamin

Well Sheila, as I indicated, at this point we’re comfortable saying that we should be able to approach break even in the business. You know, we’re, as I said at the end of the quarter we’re 40% through the harvest and so you know, there’s still a long ways to go but the signs so far are positive that we should be, we hope very close to break even.

Sheila McGrath - KBW

Okay, thank you.

Operator

(Operator instructions.) Your next question comes from the line of DeForest Hinman with Walthausen and Company. Please proceed.

DeForest Hinman – Walthausen & Co

Hi. I have a question or a couple questions on the decision on water resource management made, I guess it was in late May. You know, and I’m going off the article that was written in the Maui News. It sounds like there was a pretty substantial loss in the amount of gallons that the agriculture segment will be able to receive. I guess the first part of the question is when does that start? And secondly, if we’re unable to get this decision reversed and it’s going to be in placed on a go forward basis, is that business viable as a farming operation?

Christopher Benjamin

This is Chris; I’ll take, those are good questions. The first part of the answer is we are losing prospectively about 30 million gallons of water in the wintertime, or I think it’s from November to May, no, November to April each year; and then about 20 million gallons in the other six-month period. Now, if you look at our aggregate water deliveries over the course of the year on average they’re about 200 million gallons, and so that can appear to be a relatively small percentage. The problem is that in the summer months when water is most needed and most valuable our water deliveries fall dramatically, and that could make up in some months the majority of the water that we would have otherwise received.

So it is a significant impact to us. Exactly how much of a financial impact it’ll have going forward is hard to predict and we’re just going to have to do our best to manage with the lower amount of water. One of the things about sugar cane is that it doesn’t necessarily die when it doesn’t get water; it just doesn’t grow as well. So the impact is really going to be on lower yields going forward and we’ll just have to see how effectively we can manage it.

The question about when does it get implemented – actually, the first 10 million gallons of the 30 was actually, it was a decision that came down in the fall of 2008 and so that was already implemented about a year and a half ago. So that water we have already put back into the streams. The remaining decisions, the two that were made in May, maybe May and early June, were, are to be implemented relatively soon. We’re working with the Water Commission staff to determine exactly when and how to implement them. But they will kick in fairly soon.

You know, at this point it’s very difficult to say because as I said before we don’t know what the long-term impact will be. It certainly could have been a much more dramatic reduction in water and that was what we were fearing. So in some ways this was good news because it doesn’t lead to an immediate you know, decision to shut down the plantation. But at the same time it is going to have a long-term impact and we’re just going to have to monitor it and see how significant it is. But there’s so many variables that will determine the profitability of the business including sugar pricing and other things that drive production that it’s hard to say exactly what the impact of this decision will be.

DeForest Hinman – Walthausen & Co

Now in terms of the decision from the Water Resource Management Group or the Commission, is this something that we’re going to contest or are we kind of content with this? And also the opposition group, are they kind of content or do they want even more water? I mean how does this issue stand? Is it still in flux?

Christopher Benjamin

Yeah, there are two separate processes but the short answer is that in both the east and west Maui processes the original petitioners have taken the steps available to them to appeal these decisions. So they, this will go on for some time, certainly on the west Maui side where there is a formal appeal process that is assured, the petitioner is assured of an appeal. That certainly will go on. On the east Maui side, it’s not certain whether the contested case hearing that the petitioner has requested will be granted but suffice it to say that this will probably go on for quite awhile, at least on the west Maui side where appeals have been filed.

DeForest Hinman – Walthausen & Co

So are we appealing as well or just the petitioners are?

Christopher Benjamin

We are not appealing, no.

DeForest Hinman – Walthausen & Co

Alright. Thank you.

Christopher Benjamin

Thank you.

Operator

I have a follow up question coming from the line of George Pickral with Stephens. Please proceed.

George Pickral - Stephens

Hi, two more quick ones. Matt, I think you mentioned, or maybe Stan, you mentioned about the Hawaiian auto volumes down due to the timing of the rental fleet replacement. Should we expect to see a ramp up in those volumes in the back half of the year?

Matthew Cox

Hey, George, this is Matt. I think our view is that if you look historically there are two cycles per year of auto replenishments so I would think… And the timing of those, as we’ve said before is always based on when the auto rental companies decide to re-fleet. So typically we’ll expect a second surge of cars sometime in the second half of the year. But what I would expect is that year-over-year you wouldn’t see any dramatic swings.

George Pickral - Stephens

Okay, good to know. And then Norb, a quick one for you if I can. The two fee simple parcels you bought in Oahu, is the plan right now to develop them as condos or are there other options on the table that we’re exploring?

Norbert Buelsing

No, George. In respect to development plans, certainly the properties Stan mentioned are entitled both for residential and commercial use, but ideally they would be developed as residential condominiums with maybe a small commercial component. The properties are both entitled. Potentially on a combined basis those two parcels could have up to 500 units developed on them. That’s not to say that’s what our final plans would be. Presently we’re in a pre-development phase, we’re doing preliminary design work and market studies. So you know, I think through those development, that development work we’ll be able to better define what the best opportunities are.

George Pickral - Stephens

Okay, sounds good. Thank you.

Operator

At this time I’m showing no further questions in queue. I’d like to turn the call back over to Ms. Suzy Hollinger for any final remarks.

Suzy Hollinger

Thanks, everybody, for being on the call. As Stan mentioned earlier in the appendix to the slides is some information about the Hawaii economy. If you have any further questions regarding anything that was presented please call me at 808-525-8422. Thanks again.

Operator

Ladies and gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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Source: Alexander & Baldwin, Inc., Q2 2010 Earnings Call Transcript
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