There are several reasons for our bearish view on Blackstone (NYSE:BX).
1) The GSO deal may be dilutive to book value. BX recently announced the purchase of a hedge fund, GSO. We believe this deal may be dilutive to Blackstone’s book value. In the absence of public information, the following analysis is theoretical, but we think worthwhile. Using Och Ziff as a comparable for GSO, Och Ziff’s price/assets under management was recently about 25%. GSO was bought for about 10% of assets under management. Och Ziff has a price/ book value of 12X. Assuming GSO’s book value stands in the same proportion to its assets under management as do Och Ziff’s that would male BX’s purchase of GSO at 5X book, though probably the purchase price was more at Och Ziff’s multiple.
Even assuming the lower multiple of 5X, this would make the acquisition dilutive to BX’s book value, and mean that BX would now be trading at a book value of 2.6X tangible book (proforma for the GSO acquisition) , as compared to Goldman Sachs’ 2.3X tangible book, and our estimate of Merrill Lynch’s 1.9X price/tangible book. Goldman Sach's revenue streams, and even Merrill Lynch’s for that matter, are far more diversified than are BX’s. BX is leveraged to hedge fund performance and private equity performance, which are in turn dependent on cooperative debt markets. Of late, debt markets have been anything but cooperative. The If BX were valued at Merrill Lynch’s (MER) valuation, it would be trading for about $13.5 per share. We believe that the investment banks constitute better comparables for BX than do the traditional asset management firms, given the risk of BX’s investments, which are more akin to the risk found in investment banks’ businesses.
2) The $500 million announced buyback also might not be a positive. The GSO deal was also combined with the announcement that there would be a $500 million buyback for 20% of BX’s outstanding stock. Doing a buyback and then issuing a like amount of shares for GSO amounts to no reduction in shares outstanding, and in addition entails a potential outlay of some $400 million in cash. If GSO is purchased for 5X book that means that BX’s balance sheet may be weakened as under this scenario goodwill would be increased by 715 million ($900 mn-$185 million of GSO’s theoretical book value), and there is a potential cash outlay from BX of $400 million. Under this scenario, tangible book value would go down.
3) Additional potential for substantial shareholder dilution. Shareholders may suffer substantial dilution going forward. According to Blackstone’s 10Q, some 440 million partnership units may be exchanged for common units on a 1:1 basis. These partnership units will vest over 2- 8 years. Even with a presumed 8% forfeiture rate, shareholders could be diluted to the tune of some 60% over these years. It should be stressed that these partnership units are not options which may or may not be exercised. Rather, they are more like restricted stock, which almost certainly will be converted to partnership units.
If we take the present value of 400 million partnership units discounted at 10% over 8 years, this amounts to about 185 more common stock units than are now listed as outstanding common units. If we were to adjust BX’s current book value, proforma for the theoretical analysis of the GSO acquisition, for these 185 million units, BX’s tangible book value would be about $4.00 per share, and it would be trading at about 4X book value. Again, using Merrill Lynch’s valuation as a benchmark, if BX were valued comparably to Merrill, it could be valued at about $8.00 per share. The argument could be made that BX should be compared to traditional asset management firms such as Franklin Resources.
Even so, Frankin Resources is trading recently at about 3X tangible book value, as compared to BX’s 5X tangible book, proforma for the theoretical shareholder dilution outlined above. Were BX awarded Franklin Resource’s valuation, it could be trading at $12.00 per share.
4) Non-Cash Compensation is an Expense. On a GAAP basis, BX’s loss in Q3 2007 was $.44 per share. However, according to an earnings release by BX it had “economic net income after taxes” in Q3 3007 of $234 million. “Economic net income after taxes” excludes that amount of 440 million of Blackstone Holding Partnership units, which vested during the quarter.. BX argues that this compensation expense as non-cash, and thus not an economic cost. However, the vesting of these partnership units is dilutive to shareholders, and has a real economic impact. Many companies we look at have issued options to the tune of about 5% of shares outstanding. In BX’s case, unvested partnership units, which will vest on a 1:1 basis into common units, represent over 150% of common units now outstanding. This constitutes a huge dilutive overhand going forward.
5) Potential for Additional Writedowns. We do not believe the fallout from leveraged buyouts has yet been seen in the markets, and BX could very well suffer writedowns on the value of its private equity investments, again to the detriment of book value. There is a deferred tax asset on BX’s balance sheet of some $793 million. Should BX become unprofitable, which could happen in the event of LBO writedowns, this deferred tax asset may need to be written down, which would reduce book value by some $3.00 per share. It’s also true that BX’s net income benefits from unrealized gains on investments. As per the 10Q, BX has significant leeway in determining the fair value of its investments. We have seen how many of the major investment banks carried risky assets at far greater than their fair value on their balance sheets. The same could occur in BX’s case.
6) BX on an operating basis. According to BX’s Q3 2007 10Q, it has some $98 bn in assets under management. Let’s assume a flat year so that BX earns a 2% management fee and no performance fees. Let’s not even assume any investment writedowns. Let’s assume those assets grow 10% yr/yr to $110 bn. Let’s assume BX earns a management fee of 2% of those assets, which would be $2.2 bn. Let’s also assume BX’s comp expense is 50% of revenues, in line with investment banks, and let’s also assume its SG&A is 20% of revenue. Its pre-tax income would then be $660 mn, and its net income (given its current tax rte of 5%, which may not hold) would be $625 mn. If we allow for the dilution of 185 additional common units mentioned in 2) above, its proforma market cap would be some $8bn.
On that basis BX is trading at about 13X forward earnings. Goldman Sachs (NYSE:GS) is currently trading at about 9X its estimated November 2008 FY earnings. So BX is trading at roughly a 40% premium to Goldman Sachs on forward earning. Let’s remember though that the banks have already had their day of reckoning vis a vis asset writedowns. BX’s day of reckoning may be yet to come. If only 10% of BX’s $6.7 bn in investments were written down, all of the $625 mn in net income outlined above would be wiped out, and BX would likely have a value of less than $10.00 per share. Even without asset writedowns, if BX was valued at GS’s 9X forward earnings as outlined above, it could be valued at about $13. 00 per share.
Even when Blackstone went public, the glitter was wearing off of the public’s infatuation with private equity. So why did Blackstone go public? It could well be that Blackstone recognized it’s stock might fall after the IPO, but it felt that even in such a scenario BX would still be valued more dearly than if Blackstone were to wait, at which time the public markets might have been completely closed to them. If this was management’s assessment, they were probably correct. But what is good for management and even the overall company is not necessarily good for shareholders. We view this stock as an excellent short sale candidate.
We have considered the possibility that BX might buy an investment bank, in view of their recent declines. This is a risk to our short thesis. However, given the still tenuous state of various bank balance sheets vis a vis CDO exposures, for example, we think BX is less likely to pursue such a path. An acquisition of an investment bank would only heighten BX's exposure to risky assets, in our view.