St Joe Company

Portfolio manager’s Letter May – June 2012

The St Joe Company has a long history in Florida. It was started by Alfred Irenee Dupont and his bother-in-law Ed Ball in the early 1930’s to benefit from the havoc created by the great depression. Together they purchased many distressed assets, including an interest in Florida National Bank, a number of corrugated cardboard box plants, a sugar company, a controlling interest in the Florida East Coast Railway Company, and an enormous amount of land. In a single purchase in 1933 he purchased 240,000 acres in northwest Florida, several phone companies, two railroads, a port terminal, a sawmill, and almost the entire gulf town of Port St. Joe.

After Dupont’s death in 1935 the business was run by the very conservative Ed Ball, and its primary business was using the companies enormous land resource to grow southern pine that could be sold to timber mills and pulp mills. After Ball died the company continued in the paper business until 1997 when shareholders decided that their best interested required a more aggressive approach.

They brought in Peter Rummell as CEO. Rummell had extensive experience in land development including time at Avrida Co (the company that developed Boca Raton) and the Disney Development Company. Rummell converted St Joe from stagnant paper company into aggressive real estate development company, In Northwest Florida this development was focused on prime beachfront Property east of Destin Florida.

Peter Rummell

Possibly misunderstanding his market Rummell developed St Joe’s land into a very up scale and sophisticated beach communities “Water Color” and “Watersound beach” were geared to downplay the role of the automobile, and focus on small commercial centers that you could walk to or ride a bicycle around, and he produced what is unquestionably one on the nicest beach communities anywhere in Florida.

Just 50 miles south of the Alabama border this part of the Florida panhandle had long been known as the “Redneck Riviera”. The fine white sand and wide beaches make for some of the prettiest beaches in Florida, the catch being that cool winters give the area a different season that south Florida, and different class of tourist than areas further south. Since the area is a comfortable one day drive from large population centers in the Midwest. The season is the summer and the tourists more likely to be families and arrive by car rather than by airplane.

Rummell did not like the nickname Redneck Riviera, and was determined to build developments that would retire the label. His theory apparently being that he could spend enough money to change the character of his market – “build it and they will come”.

Nice as “Water Color and Watersound” have turned out to be, it was an expensive way to develop land. St Joe Company took on $600 million in debt in addition to several hundred million in profits to pay for utilities and improvements in its various developments. The Florida land boom was able to extend this expensive development for a few years, and the bubble was able to produce a nice run-up in St Joe Company’s stock for a while with the price reaching $83 in 2005, but it has never produced the sort of profit than would justify the capital expenditure required.

In 2007 with the stock at $60 per share, with shareholders firmly on the hook for Rummell’s grand vision and with the real estate bubble about to pop Hedge Fund Owner David Einhorn published a negative report on the stock. It was a great call, and profitable one for him. In 2010 he published a follow up report showing that what profit the St Joe Company had produced in the decade Rummell was in power came from the sales of raw land from the St Joe Company’s massive holdings rather than as a result of a profit on the money that had been spent on its expensive beach developments.

In 2007 the St Joe Company clearly felt the softening in the real estate sold its portfolio of office buildings for $377 million. In 2008 the St Joe Company raised $570 million with offering of common stock. These actions allowed the St Joe Company to lower its net debt to about $25 million and raise its cash position to $188 million. For this the old management clearly deserves a lot of credit because it put St Joe Company in a much better financial position that most of the real estate companies and financial institutions in this country. Looking back it is clear that if it were not for this foresight the St Joe Company would not have survived.

Berkowitz bought St Joe Company

In addition to the price correction, the nature of the St Joe Company has under gone a fundamental change in character. The St Joe Company today bears no resemblance to the company Rummell created. Beginning in February 2008 mutual investment manager Bruce Berkowitz used his Fairholme Fund to buy into St Joe Company. Currently Fairholme holds 27% of St Joe Company’s common stock.

Berkowitz has used that stock position first to gain two seats on the St Joe Company’s board and then in March of 2011 to take control of the board and have himself named CEO. With his average cost of $26 per share Berkowitz clearly feels the St Joe Company’s real estate is worth more than current market price would indicate, but much more interesting is the question is what Berkowitz plans to do with St Joe Company. Last year at the annual meeting he was asked that question and said that he wanted to generate more recurring income.

An example of this would be the lease the company signed with ITT to build a 100,000 square foot multipurpose building on St. Joe property at the new Beaches International Airport. Expanding his answer to the question of St. Joe’s future, he said that he would use St Joe Company to hold positions that he could not hold in Fairholme. This would include a large category that might cover anything from its present real estate business to the outright purchase existing business.

But what we do know with reasonable certainty is St Joe Company today bears no relation to the company of the same name in 2007. What we can say about the company is:

1. Management has been changed (several times).
2. Present management is likely to pursue the best interests of shareholders, because it is controlled by largest shareholder.
3. Therefore it is likely (knowing what we do about Berkowitz’s history) that management will pursue a long term shareholder’s interests at the expense of quarter to earnings comparisons.
4. St Joe will become more of an operating company and will deemphasize the business of developing real estate, and concentrate on commercial development of its 71,000 acres surrounding the Beaches International Airport.
5. Since Berkowitz took over last year, the emphasis has been on lowering operating costs, and the St Joe Company now claims that it will be cash flow positive in 2012.

The Leucadia Connection

In March 2011 Berkowitz brought in Park Brady to run St Joe Company. Brady had been CEO of ResortQuest a subsidiary of Leucadia Corporation. Then later in 2011 the St Joe Company brought in other alumni of Leucadia when Patrick Bienvenue was made CFO. He had been president of Leucadia Financial Corporation and Leucadia Development Corporation.

In February 2012 Leucadia closed on contract to purchase the old Panama City Airport (the airport replaced by the new Beaches International). The purchase was for 708 acres in Midtown Panama City, the purchase was for $51.9 Million or $73,264 per acre. It is of note that this real estate is about 12 miles as the crow flies from the new beaches international, and that most of the area between the two airports that is not under water in West Bay is owned by St. Joe.

St Joe Company’ 2011 Impairment

On January 25, 2012 the company announced that it chose to include an impairment charge in its 2011 earnings. The $374.8 million impairment was a non-cash charge to reduce the book value of improvements made to development properties. A large part of Einhorn’s short recommendation was based on the argument that these assets were overvalued, and there can be no question that the present value of this real estate was not worth as much as it had been in 2007.

St Joe Company included in the announcement a discussion of the change in management policy that essentially made the impairment meaningless. With the company’s cash flow under control there is no pressing need to raise cash. With no need to raise cash the current market value of similar property sold in the area is irrelevant. The day of the announcement St. Joe was up $.25, and remains at a higher price today.

Berkowitz is smart enough to know that you do not maximize shareholder value by selling assets in a distressed market. The best way for him to maximize the company’s value is to sit on his hands for a few years, and historically he has been a patient value investor. This should be a long term positive for St. Joe holders.

First Quarter 2012

The 10Q for the first quarter shows that the company is well on its way to living up to its promise to be cash flow positive in 2012. Although the income statement showed a small loss, the St Joe Company’s cash position increased from $162.4 million on 12/31/2011 to $165.7 million at the end of the first quarter. Operating expenses decreased from $52.1 million in the first quarter of 2011 to $32.1 million this year, evidence that Berkowitz was serious when he promised to reduce operating expenses to the point that distress sales of real estate would no longer be necessary.

There is some evidence of recovery real estate with real estate sales at $14.0 million for the quarter compared to $5.2 million last year. Most of the increase came from a couple big sales in commercial real estate but both the resort and primary residential sectors showed substantial price increases with the resort lots up 53% over the first quarter of last year and the primary residence lots up 43%. The rate of sales is still slow and the price increases may have more to do with St Joe Company’s resolution to hold on to property until it gets a good price than it is an indication of a broad recovery in the local real estate market.

The Annual Meeting

For the annual meeting I flew into the new Panama City Airport, and it looked to me like there was more activity than last year. I stayed in Panama City Beach which is a large tourist community right in the middle of much of the real estate owned by St Joe Company. There was no sign of recession there, the hotels were busy and shopping centers and restaurants were packed even though they are not yet into their peak season.

I drove down to St Joe Company which is at the eastern end of St Joe Company’s properties, and is a much smaller city the Panama City. WindMark which was the main focus of Einhorn’s call for the Impairment charge is located just west of St Joe Company. It is a very nice property with a three mile beach front walk, and lots of vacant property.

St Joe Company spent a lot of money trying to make this as upscale as Watercolor, but it is a long 15 mile drive through Tyndall Air Force Base to get there from Panama City and probably an hour east of Watercolor and Seaside the closest upscale areas. In between is Panama City Beach which is a nice Florida tourist destination, but definitely not targeting the same customer as Water Color. It hindsight it appears the decision to go ultra-high-end with a development in this location was questionable.

Panama City Beach is nice and apparently very popular resort destination. There is a brand new shopping center that is as nice as anything in Orlando or South Florida except for the luxury properties, but the primary dialectic is still redneck Riviera.

At the meeting it was announced that the company has applied to change the zoning on the St Joe Company’s property in the town of St Joe Company from residential back into industrial which it was originally, and focus in commercial development around the port. The Port of St. Joe is a deep water port and would handle bigger ships than the port at Panama City. It would be the closest of any of the Florida ports to the Panama Canal, but management does not anticipate that it could ever handle large container ships.

There not presently facilities to handle large ships of any kind, so what they have in mind is not entirely clear and it will be a long time before this business would generate any serious cash flow. There might be a tie in to the new airport so maybe this is what they have in mind.

This is an indication that company under Berkowitz is more interested commercial real estate and less interested in the luxury resort business. Also it was pointed out at the meeting that they are interested in more primary home developments (as opposed second homes and resort business). They have one subdivision in Panama City Beach for primary home and the lots there as selling well.

Valuation

Make no mistake this will be a slow blooming rose. The only reason the investor should not wait to invest, is a big short position (17 million shares), and the fact that 74% of the stock is held by 5 large institutional investors. The second largest holder of the stock is Blackrock Inc. which owns 19.1%, and has increased its position by 1.2 million shares in the 12 months ending on December 31, 2011. So now that the Impairment has been recorded what the shorts were waiting for is history, so short covering may be important to the stock’s pricing over the next 12 months.

Since there are two large shareholders that together hold almost 50% of companies stock it would be easy from them to agree to a sell out if the terms where agreeable to both. So there is a possibility the company could be acquired, but I think it much more likely that Berkowitz is in for the long term. If the buyout opportunity did present itself it would have to be at a premium to Fairholme’s cost of about $26.00 per share.

At $17 per share you are buying St Joe Company’s 573,000 acres for $2,737 per acre which looks cheap when you consider what St Joe Company is selling property for today, but it not just a question of the current price of little pieces of this land as it is a question how long it will take them to realize a fair price for their assets.

For the 31,000 acres that is currently entitled or land that has been rezoned (this is only 5.4% of the St Joe Company’s total property), first quarter prices which include two parcels for commercial property, would value that land at about $87,000 per acre or $2.7 billion, but at the rate the land is selling it will take a long time to realize this value.

Much of the St Joe Company’s remaining 540,000 acres is located where it has the potential to eventually be zoned for commercial or industrial use. Particularly the 70,000 acres around the new Panama City Airport, in addition there is many miles of land fronting on Hwy 98 between Destin and Panama City Beach, and eventually the land around the port of St. Joe.

St Joe Company’s value is more a question of when that how much. The three counties where most of the St Joe Company’s land is located have historically shown slow growth compared to similar coastal counties further south on the Gulf, but the area is very nice and may not be able to remain growth free now that the rest of the state has become so overcrowded. Finally real estate may not be liquid but it is a good hedge against inflation, and while inflation is currently not our main concern the day may come when this is an important issue.