Stratus Properties Is Undervalued With A Significant Near-Term Catalyst

| About: Stratus Properties, (STRS)
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Stratus Properties (NASDAQ:STRS) is a low-risk way to benefit from the booming Texas real estate market given its undervalued real estate assets, high free cash flow and significant debt reduction. The sale of the W Hotel & Residences and Austin City Limits Studio Theatre should act as a catalyst for significant price appreciation.

Company overview

STRS is a diversified real estate company focused in Austin, Texas with four operating segments:

Real estate segment includes properties in the Barton Creek and Circle C communities, Lantana as well as condominium units at the W Austin Hotel & Residences. STRS owns 112 residential lots and 2,356 potential lots.

Hotel segment includes the W Austin Hotel.

Entertainment segment includes Austin City Limits Studio Theatre.

Commercial leasing segment includes office and retail space at the W Austin Hotel & Residences, a retail and bank building in Barton Creek Village, 5700 Slaughter and the Parkside Village project in the Circle C community. STRS owns 186,480 square feet of developed commercial real estate, 12,000 square feet under development and 2,921,000 square feet of potential development.

Source: SEC filings

Investment thesis

STRS is undervalued given the following positive factors:

  • Strong real estate market
  • Undervalued real estate assets
  • High free cash flow
  • Significant debt reduction

Strong real estate market

Austin is one of the strongest and fastest growing real estate markets in the country with the following growth drivers:

  • Growing high tech, healthcare and tourism industries
  • State and federal government jobs (state capitol in Austin)
  • University of Texas-Austin
  • 4.9% unemployment rate
  • New Circuit of the Americas racetrack

Source: CB Richard Ellis, Austin MarketView, Marcus & Millichap Research Services, CoStar Group, Inc.

Source: SEC filings

Furthermore, the difficulty in obtaining approvals and entitlements provides a competitive advantage to incumbent developers (such as STRS).

Undervalued real estate assets

The low P/B ratio of 0.89x significantly undervalues the premium real estate assets carried at cost on the balance sheet and not current market value. STRS continues to eliminate this discount through asset sales. For example, STRS sold properties at its Lantana project for ~$100 million with a cost of ~$46.1 million.

Source: SEC filings

High free cash flow driven by strong operating performance.

FCF yield of 21% (ttm FCF of ~$23 million).

In mrq, real estate revenue increased 32% due to increased sales at Barton Creek and the sale of higher priced condos at the W Austin Hotel & Residences.

In mrq, hotel revenue increased 12% due to higher revenue per available room led by higher average occupancy and room rates.

Source: SEC filings

In mrq, entertainment revenue dropped slightly by 2%.

In mrq, rental revenue increased 41% due to increased occupancy for office and retail space at W Austin Hotel and Residences and Parkside Village. For 2012, no single commercial leasing property exceeded 10% of total assets or revenue.

Significant debt reduction

Reduced 2013 year-end debt maturity from ~$70 million on 6/30/12 to ~$10 million on 12/31/12.

Source: SEC filings

In March 2013 obtained modification to loan agreement with Beal Bank to reduce the minimum stockholders' equity balance required by $10 million.

In December 2012, restructured loan agreement with Comerica that reduced interest rates, extended maturities and increased total borrowing capacity by $3 million to $48 million ($20.2 million outstanding borrowing).

In September 2012 modified loan agreements with American Strategic Income Portfolio and paid off two of seven unsecured term loans totaling $9 million and reduced the interest rates from 8.75% to 7.25% and extended the maturity dates and modified the prepayment provisions of the remaining five unsecured term loans.

Sale of Block 21 is significant near term catalyst

Block 21 is a mixed-use development within the popular 2nd Street district in downtown Austin surrounded by six blocks of shopping, dining and entertainment. Assets include the following properties:

W Hotel & Residences, a LEED-certified luxury hotel (managed by Starwood Hotels & Resorts) with 251 rooms and 159 residential condos. The hotel opened in December 2010 and condo closings began in January 2011.

~40,000 square feet of Class A office space (84% leased at average gross rental rate of ~$45 per square foot, among highest office rents in Austin)

~18,500 square feet of street level retail space (86% leased at average triple-net rental rate of ~$32 per square foot, among highest retail rents in Austin).

Austin City Limits Studio Theatre (home of Austin City Limits television show - longest running music series in history). It hosted 193 events in 2012 with estimated attendance of 219,800, up from 151 events in 2011 with estimated attendance of 187,500. Awarded "Best New Major Concert Venue," by Pollstar in 2012 and features a state-of-the-art recording studio.

The growing interest in Austin commercial real estate provides a valuation floor for STRS. Jones Lang LaSalle is currently marketing Block 21 to potential buyers. The sale should realize a premium (given its unique features mentioned above) and lead to significant debt reduction.

Risks

Despite previously mentioned debt reduction/loan modifications, STRS still has $130 million in debt which is required to be repaid through asset sales.

High competition from competing properties (residential communities, hotel, entertainment). However this risk is mitigated given the unique competitive advantages mentioned above.

Conclusion

STRS is attractive after the recent ~13% correction. A stop should be placed below $12.5 (can always re-enter if stopped out) and a minimum target of $16.5 for a return of ~23%. The time frame is three to six months given the previously mentioned short term catalyst.

Note: there is a significant opportunity to capture alpha in illiquid, microcap stocks - especially during periods of high volatility. Superior order management and execution on both sides of the trade (entry and exit) can easily add several hundred basis points of performance.

Traders with greater resources (e.g. access to algos, superior order management software), flexibility (e.g. ability to watch market all day rather than place order at inopportune times) and experience (e.g. no market orders!) should be able to minimize market impact. While a transaction cost analysis is important irrespective of the asset class or category, it is absolutely critical for improving performance when trading microcap stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.