Blackstone Group (BX) – Too Good to be True?

[This is the first part of a series of posts on BX. Make sure u read the second post because my analysis has been updated with some important changes]

Overview

Blackstone Group is a recently listed American company that is active in the private equity business. Private equity companies are in the business of buying businesses and selling them later at a profit. Often, the acquisition targets of private equity companies are underperforming public companies. For instance, Cerberus Capital Management recently acquired struggling automaker Chrysler from Daimler Chrysler, in a bid to turn the business around and later sell it at a profit.

Blackstone was recently in the news as one of the first US private equity IPOs and also because the Chinese government took a substantial financial stake in the company.

A friend of mine recently gave me a call to ask what my opinion of the stock was. Blackstone’s stock has recently fallen from its post-IPO high of around $35 and is currently trading at around $23. The most recent half-year results indicate that Blackstone’s earnings grew at a tremendous rate: HY07 earnings are 2.67x that of HY06 earnings. Furthermore, if we double HY07 earnings for a full year estimate, the current stock price gives a FY07 P/E of only 1.6! Indeed, at first glance, Blackstone may appear to be a value investor’s dream.

A deeper examination of the situation, however, may shed light on why the market is pessimistically valuing a company with such stellar results.

Lumpy Business Model - Blackstone’s corporate private equity and real estate businesses have benefited from high levels of activity in the last few years. These activity levels may continue, but could decline at any time because of factors out of management’s control. While the long-term growth trends in Blackstone’s businesses are favorable, there may be significant fluctuations in our financial results from quarter to quarter.

Use of Leverage to Enhance Returns - In order to generate enhanced returns on equity, Blackstone has historically employed significant leverage on its balance sheet. As a public company, Blackstone intends to continue using leverage to create the most efficient capital structure for Blackstone and its public common unitholders. Blackstone anticipates that its debt-to-equity ratio will eventually rise to levels in the range of 3:1 to 4:1 as it attempts to increase its return on equity for the benefit of common unitholders. This strategy will expose Blackstone to the typical risks associated with the use of substantial leverage, including affecting the credit ratings that may be assigned to Blackstone’s debt by rating agencies. Blackstone’s use of leverage to finance its business will expose us to substantial risks, which are exacerbated by our funds' use of leverage to finance investments".

Volatile Activity According to Economic Conditions - Blackstone focuses closely on actual and expected changes in the economic conditions and conditions in the debt and equity capital markets in all of the geographic regions in which it conducts business, and the company tries to accelerate or reduce (or on occasion suspend entirely) the rate of its investment—or disposition—activities in response to changing economic and market conditions. In the past, changing economic and market conditions and Blackstone’s investment actions in response to those changes have led to swings in investment activity from year to year. Blackstone expects these swings to occur in future years as well, which is one of the reasons why there may be significant volatility in revenue, net income and cash flow.

Impact of Tightening credit

Decreased Liquidity and Higher Cost of Credit - Widening credit spreads as precipitated by the subprime correction mean that the easy credit that fueled leveraged buyouts and private equity acquisitions is no longer as freely available as it was. This means that in the months ahead, Blackstone will find it more challenging that in to find the financing to pursue its deals than it did in previous years where liquidity was easily available at a low cost of debt. At the same time, the higher cost of credit will mean that Blackstone will probably have to pay higher interest rates on its financing. This narrows the field of acquisition candidates because hurdle rates have risen and the standard of cash flows that acquisitions generate will have to be higher than before.

Higher interest costs on existing acquisitions – Existing deals may be subject to higher debt servicing costs and this will eat into the profitability of the firms of which Blackstone has taken private. This in turn will have an impact on the investment returns of the private equity investments and the fees and revenues due to the firm. Furthermore, the higher cost of debt increases the probability default. This risk is especially pertinent since private equity firms tend to take on significant leverage at high yields in order to fund their acquisitions.

Decreased deal flow – Blackstone gets a significant amount of revenues from deal advisory fees. The impact of higher credit spreads on a lower deal flow will see a decline in advisory revenues and fees.

High Fixed Costs & Operating Leverage – As the financial statements show, Blackstone has a cost structure with significant fixed costs and operating leverage. This is a double-edged sword. In the past couple of years, times have been good and this has translated into significant gains in profit. However, the same cost structure will cause a rapid drop in profits during a period of economic uncertainty or downturn. Furthermore, an aggressive capital structure means interest costs will rise substantially as credit spreads widen.

Valuation

At a valuation of 1.6 P/E, probably indicates that the market thinks that HY07’s earnings are at a cyclical peak and that earnings will fall in the periods ahead. The question is, how much will the earnings fall by and is the current valuation overly pessimistic?

A proper valuation will probably have to involve a DCF/NPV valuation projecting the financials taking into consideration current conditions in the credit markets and the possibility of a U.S. economic downturn. However we will probably need the 2H07 results to gauge the impact of the slowing economy on BX’s profitability.

If we just take the current earnings and assume that it will fall to 1/5^th of current numbers next year then BX is trading at 8x forward earnings. I think this is still quite a conservative valuation and my guess is that BX is somewhat undervalued by the market. If you are optimistic that the current credit correction is a temporary malaise for the market then I think BX looks conservatively valued. If however you think we might have a broader slowdown in the economy then it may be better to stay on the sidelines for BX.

At 10x guesstimated forward earnings, this gives BX a fair value of about $30, which is near IPO price and what the Chinese government paid for their stake.

Appended below are extracts from Blackstone’s prospectus particularly pertinent to the valuation problem at hand.

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Difficult market conditions can adversely affect our business in many ways, including by reducing the value or performance of the investments made by our investment funds, reducing the ability of our investment funds to raise or deploy capital and reducing the volume of the transactions involving our financial advisory business, each of which could materially reduce our revenue and cash flow and adversely affect our financial condition.

Our business is materially affected by conditions in the global financial markets and economic conditions throughout the world that are outside our control, such as interest rates, availability of credit, inflation rates, economic uncertainty, changes in laws (including laws relating to taxation), trade barriers, commodity prices, currency exchange rates and controls and national and international political circumstances (including wars, terrorist acts or security operations). These factors may affect the level and volatility of securities prices and the liquidity and the value of investments, and we may not be able to or may choose not to manage our exposure to these market conditions. The market conditions surrounding each of our businesses, and in particular our corporate private equity and real estate segments, have been quite favorable for a number of years. Future market conditions may not continue to be as favorable. In the event of a market downturn, each of our businesses could be affected in different ways. Our profitability may also be adversely affected by our fixed costs and the possibility that we would be unable to scale back other costs within a time frame sufficient to match any decreases in revenue relating to changes in market and economic conditions.

Our investment funds may be affected by reduced opportunities to exit and realize value from their investments and by the fact that we may not be able to find suitable investments for the investment funds to effectively deploy capital, which could adversely affect our ability to raise new funds. During periods of difficult market conditions or slowdowns in a particular sector, companies in which we invest may experience decreased revenues, financial losses, difficulty in obtaining access to financing and increased funding costs. During such periods, these companies may also have difficulty in expanding their businesses and operations and be unable to meet their debt service obligations or other expenses as they become due, including expenses payable to us. In addition, during periods of adverse economic conditions, we may have difficulty accessing financial markets, which could make it more difficult or impossible for us to obtain funding for additional investments and harm our assets under management and operating results. A general market downturn, or a specific market dislocation, may result in lower investment returns for our investment funds, which would adversely affect our revenues. Furthermore, such conditions would also increase the risk of default with respect to investments held by our investment funds that have significant debt investments, such as our mezzanine funds, senior debt vehicles and distressed securities hedge fund.

In addition, our financial advisory business would be materially affected by conditions in the global financial markets and economic conditions throughout the world. For example, revenue generated by our financial advisory business is directly related to the volume and value of the transactions in which we are involved. During periods of unfavorable market or economic conditions, the volume and value of mergers and acquisitions transactions may decrease, thereby reducing the demand for our financial advisory services and increasing price competition among financial services companies seeking such engagements.

Our revenue, net income and cash flow are all highly variable, which may make it difficult for us to achieve steady earnings growth on a quarterly basis and may cause the price of our common units to decline.

Our revenue, net income and cash flow are all highly variable, primarily due to the fact that we receive carried interest from our carry funds only when investments are realized and transaction fees received by our carry funds and fees received by our advisory business can vary significantly from quarter to quarter. In addition, the investment return profiles of most of our investment funds are volatile. We may also experience fluctuations in our results from quarter to quarter due to a number of other factors, including changes in the values of our funds' investments, changes in the amount of distributions, dividends or interest paid in respect of investments, changes in our operating expenses, the degree to which we encounter competition and general economic and market conditions. Such variability may lead to volatility in the trading price of our common units and cause our results for a particular period not to be indicative of our performance in a future period. It may be difficult for us to achieve steady growth in net income and cash flow on a quarterly basis, which could in turn lead to large adverse movements in the price of our common units or increased volatility in our common unit price generally.

The timing and receipt of carried interest generated by our carry funds is uncertain and will contribute to the volatility of our results. Carried interest depends on our carry funds' performance and opportunities for realizing gains, which may be limited. It takes a substantial period of time to identify attractive investment opportunities, to raise all the funds needed to make an investment and then to realize the cash value (or other proceeds) of an investment through a sale, public offering, recapitalization or other exit. Even if an investment proves to be profitable, it may be several years before any profits can be realized in cash (or other proceeds). We cannot predict when, or if, any realization of investments will occur. If we were to have a realization event in a particular quarter, it may have a significant impact on our results for that particular quarter which may not be replicated in subsequent quarters. We recognize revenue on investments in our investment funds based on our allocable share of realized and unrealized gains (or losses) reported by such investment funds, and a decline in realized or unrealized gains, or an increase in realized or unrealized losses, would adversely affect our revenue, which could further increase the volatility of our quarterly results.

With respect to our proprietary hedge funds and many of our funds of hedge funds, our incentive fees are paid annually, semi-annually or quarterly if the net asset value of a fund has increased. Our hedge funds also have "high water marks" whereby we do not earn incentive fees during a particular period even though the fund had positive returns in such period as a result of losses in prior periods. If a hedge fund experiences losses, we will not be able to earn incentive fees from the fund until it surpasses the previous high water mark. The incentive fees we earn are therefore dependent on the net asset value of the hedge fund, which could lead to significant volatility in our quarterly results.

We also earn a portion of our revenue from financial advisory engagements, and in many cases we are not paid until the successful consummation of the underlying transaction, restructuring or closing of the fund. As a result, our financial advisory revenue is highly dependent on market conditions and the decisions and actions of our clients, interested third parties and governmental authorities. If a transaction, restructuring or funding is not consummated, we often do not receive any financial advisory fees other than the reimbursement of certain out-of-pocket expenses, despite the fact that we may have devoted considerable resources to these transactions.