Monday, September 17, 2007

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

A few days ago I wrote a research note on the Blackstone Group, wondering if it might be an investment opportunity too good to be true. At that time, it seemed like it was trading at a mere 1.6x P/E, and for a company like Blackstone, that would be a steal.

I certainly hope nobody bought the stock based on my calculation of 1.6x P/E, since it turns out that Blackstone is not trading at 1.6x P/E, but instead is trading at something very different. This goes to show you can't just follow other people's opinions, you need to do your own research. Check, check and double check. I can be and am wrong from time to time.

So, why the confusion?

Confusing Pattern of Disclosure

Below the reported income statement of Blackstone’s latest 10-Q, there is an indication of a weighted-average common units of 256m. This was the number used in the calculation of the firm’s P/E to give 1.6

This number, however, is rather misleading.

In order to get to the real number of units that you need to divide the earnings by, you need to look deep into the notes. The following extract was found on page 23 of the same 10-Q. Click for full image.

As we can see, there are another 827m units which will effectively vest themselves over time and which will have an equal claim on Blackstone’s earnings over the next few years. This brings the total effective number of units to 827m + 256m = 1084m which is 4.22x the number of common units.

For more on the same, the analyst will find information in the prospectus, as shown below:

This total of 1084m effective units gives BX an estimated P/E of 6.82, if the profits of the first six months of 07 are replicated in the 2nd half of the same year. This is very different from a P/E of 1.6 based on the 256m common units.

But, even though the company does actually disclose all the number of units actually outstanding, one must ask, why isn’t it more transparent? The number that should effectively be used is the 1b in units, not the 256m. The company could jolly well just state this number up front as it is the important number to be used in calculations. It should be disclosed in the main financial statements and not be left to the footnotes where users of the financial statements have to dig and delve. I can't help but feel a little suspicious over BX's attitude towards disclosure.

Economic Net Income: Superior Measure?

Blackstone in its prospectus and 10-Q, frequently refers to an accounting measure which they call Economic Net Income. ENI represents Net Income excluding the impact of income taxes, non-cash charges related to the amortization of intangibles and the non-cash charges related to vesting of equity-based compensation.

A recent Merrill Lynch research report on BX from Wall Street based analyst Guy Moszkowski (who is supposed to be part of the All-America analyst team) claims, "GAAP earnings will be of very limited usefulness in evaluating BX performance given the massive non-cash Goodwill and compensation amortization costs GAAP will be saddled with for many years. The relevant question is, which of the adjusted figures is the "right" one for valuation of the company? In our view, ENI is best, since it captures the best-available view of the true value of the portfolio and the earnings it will yield over time"

The analyst also uses another measure which he calls distributable cash earnings, and claims the market can 'default' to cash: "Economic Net Income vs. Distributable Cash Earnings: conceptually, this adjusts ENI for non-cash earnings; ENI is conceptually, in our opinion, a better foundation for valuing the company than cash distributions, but for the time being we think the market will default to cash"

I personally have problems with these statements:
a. using a conceptually sound valuation model like the Residual Income model or the Abnormal Earnings Growth model will deal with the amortisation and compensation costs in the valuation
b. the cash based valuation and the accrual based valuation should theoretically converge in the long run, so i don't see how a market can 'default to cash'

In my opinion, ENI is not necessarily a superior measure of value. It is definitely a useful measure of performance, but not a suitable substitute for valuing the company. The prospectus does not go so far to claim that ENI is a superior measure of value for the company. Instead, it makes a sensible disclaimer that “ENI should not be considered in isolation or as an alternative to income before taxes in accordance with GAAP.”

Whither the Credit Crunch?

Disregarding the confusion over the disclosure and the accounting issues surrounding the company, Blackstone still remains a strong business. It has made impressive returns and has an established track record, earning upwards of 30% IRR on its private equity deals before fees. Interestingly, a credit crunch would be a good thing for Blackstone. The IPO will give Blackstone billions of its own capital to finance its deals -- and it could even use its stock. This would certainly give the firm a big competitive advantage over other private equity firms which have chased and closed deals on poorer terms.

However, investors should note that the CEO of Blackstone, Steven Schwarzmann, cashed out on $800m during the IPO. As with any company, the price might be too high; initial investors in Blackstone’s IPO have discovered this to their detriment.

Blackstone will make a sensible investment, but only at a reasonable price. The current price of around $24 does not look too bad, but then again I think it could be cheaper. I’ll keep tabs on this company and write more when I can clarify the meaning of Economic Net Income and other accounting matters later.