What's New at Korn Ferry & Maguire Properties?

Includes: HSII, KFY, MPG-OLD
by: Eric Wolff

Given that both these stocks have moved against me in recent weeks, I thought I would post an update. I previously gave arguments for a short position on both stocks, and each has rallied on short term positive news: Korn Ferry (NYSE:KFY) had an excellent quarter, and maintained better then expected guidance. Maguire Properties (NYSE:MPG-OLD) announced it is looking to put itself up for sale (again), which was one of the main risks I'd mentioned in my short thesis. So, what does this news mean for each company? See my prior write-ups on KFY and MPG.

In KFY's case, I consider short term earnings to be largely irrelevant, except that they generate a bit more cash for a quarter or two. My thesis remains clear: if hiring in the US slows down, KFY's business will deteriorate, as it has in the past. That said, I should note that there are reasons to believe that this downturn may not be quite as bad as in years past. KFY's sector exposure is buoyed by a healthy basic materials and other significant non-cyclical focus, which could potentially help them weather a storm a bit more.

In retrospect, I likely should maybe have focused more on Heidrick & Struggles Int'l (NASDAQ:HSII), which has over 50% of it's business attributable to Financial services and consumer cyclical industries. I'll be taking a look at them more in the coming weeks. That said, though my KFY thesis has been taking longer to play out then expected, I still believe we will see their earnings erode meaningfully from current levels over the coming quarters as the credit mess spreads to other parts of the economy.

MPG ran up significantly on news that it may be acquired. When they went through a similar process in late 2006, the company had multiple offers in the $35-40 range which they turned down. Fast forward one year, and the market for selling is noticeably worse. MPG has been unable to sell two of their smaller properties that they have hoped to divest due to volatility in the capital markets (read: no buyers offering a price they like). Analysts have continued to use go-go cap rates in the 5-5.5% range, vs. historical rates of 7-8%.

With the credit market having fallen apart, recessions beginning in both LA and Orange County, declining occupancy rates, and a distressed seller with some serious balance sheet issues, how favorable can we really expect the sales process to be for MPG? Some analysts, as well as MPG management, claim they are cheap on a square foot basis; though that may be true, they are going to have a mess of a time unlocking value by raising rents or improving occupancy for the foreseeable future given market conditions. With almost everyone predicting lower prices next year as cap rates rise and occupancy continues to decline, what buyer would be willing to buy now? Why not wait?

We're also talking about a significant amount of capital here, depending on how the deal is structured: a buyer would need to put up over a billion in capital and, given how much debt MPG already has (too much), I doubt there is any way you could lever this transaction more than it already is levered. And what kind of REIT is going to want to add anothert $5 billion in debt to their balance sheet? And whose jittery investors will want to learn that their company just purchased a large vat of commercial real estate in two of the worst markets?

MPG is essentially a levered play on southern California commercial real estate. Who on earth wants to own the equity portion of that deal? Given market conditions, I just don't see MPG being taken out and, if they are taken out, I can't imagine anyone paying much north of $30/share, which limits downside at these levels in a short to about 10%. On the upside to a short, if MPG is unable to sell they would likely get hit hard, as this would suggest that the market is valuing their assets significantly below analysts' and the own companies NAV assumptions. You'd also see a lot of hot money that has been holding out for a sale flee once again.

As the commercial real estate market continues to decline and cap rates return to more normalized historical levels, it is also entirely possible that MPG's NAV is totally wiped out, as total equity value dips below total debt. The only way MPG will sell is if they can find a greater fool. And, unfortunately for them, many of the greater fools are going out of business, or quickly wising up. If MPG is left holding the bag on this one, the debt holders may very well own this company.

Disclosure: Author is short KFY and MPG.