Q2 2023 Letter - Along For The Ride

Inflation is dropping, interest rate hikes are near an end, and stocks are loving it.

Quarterly Performance

2023 second quarter results continued to build on the themes we witnessed in Q1 with large cap tech stocks accounting for most of the markets gains this year. In fact roughly 75% of the 16.89% YTD returns for the S&P 500 came from just 7 stocks (AKA "The Magnificent Seven") - Facebook (NASDAQ: META), Apple (NASDAQ: AAPL), Nvidia (NASDAQ: NVDA), Google (NASDAQ: GOOG), Tesla (NASDAQ: TSLA), Microsoft (NASDAQ: MSFT) and Amazon (NASDAQ: AMZN). The rest of the market was essentially flat. If your portfolio didn't include those 7 names then it would have been pretty tough to beat the S&P500 Index through the first 6 months of the year. Seaside Private Capital (SPC) made incremental gains during the quarter and is now up 9.77% YTD vs. 7.46% YTD during our Q1 Update. The S&P 500, as previously mentioned, is at 16.89% YTD gains vs. 7.50% YTD in Q1. We are happy with these results as all of our holdings are still trading at reasonable valuations vs. the Magnificent Seven trading at nosebleed multiples, which is simply not sustainable. SPC does own META and GOOG, however, both stocks are trading at ~23x forward P/E while I think a reasonable multiple would be ~30x for such high quality businesses. That's a big divergence versus Nvidia and TSLA which are trading at 57x and 73x forward P/E, respectively.

Along For The Ride

Over the past 18 months the various macroeconomic headwinds that lead to a bear market in 2022 have largely reversed. After the most recent FED interest rate hike in July, we're most likely near the top on interest rates if not there already. Inflation is clearly continuing a downward trend. We may be range bound with 3-4% inflation versus the FED's goal of 2%, but that isn't really a bad thing. At the same time the labor market continues to show strength and Investors have started to realize that maybe things aren't so bad after-all. Although I have no crystal ball, I have a positive outlook for market performance through the remainder of the year. According to FactSet, as of August 4, 2023 of the 84% of companies that have released earnings, 79% beat their earnings expectations (10 year average earnings surprise is 73%). Analysts and the investor community more broadly have been overly negative and there is still ongoing chatter about a potential recession, which I mentioned back in my 2022 Annual Letter. It's exactly in these instances where we should be looking to go against the herd and play offense. I don't think the market is necessarily cheap, but I don't see valuations being stretched at the moment either. I think REITs are still very attractively priced at the moment and fundamentals remain strong among our holdings.

Portfolio Update

SPC was not very active during Q2. We are currently invested in 14 portfolio companies and have a cash position of roughly 8%, which is enough dry powder to add one more core position if the right opportunity arises. We are currently focused on monitoring portfolio company performances and will opportunistically exit positions if our estimates of fair value are reached. Otherwise we are comfortable siting on our hands and doing nothing. Below we will provide a general update on our portfolio companies.

Macerich (NYSE: MAC)

MAC released Q2 earnings on August 8 and reported pretty healthy results. Occupancy continues to improve and is now at 92.6%. Leasing activity also remains very robust, significantly outpacing 2022 leasing (21% higher than Q2 2022), which was already at highs not seen in over a decade. This has pushed leasing spreads to a very strong 11.3% vs. 6.6% reported in March. Given the current leasing trends and higher occupancy, leasing spreads and base rents should continue to increase over the next few years. CRE is a slow moving asset but the fundamentals in the mall space are solid. MAC stock continues to languish around $13, which we think is far too cheap. The largest overhang is the balance sheet and mall refinancing activity, but as stated on their Q2 earnings call, debt markets seem to be opening back up for mall assets. As MAC's occupancy continues to improve I expect strong dividend increases to follow as their payout ratio is only at ~37%.

Simon Property Group (NYSE: SPG)

SPG posted fundamental results similar to MAC. The business continues to power along with occupancy climbing to 94.7% as of 6/30/23, which is an 80 basis point improvement YoY. As usual, SPG raised guidance throughout the remainder of the year and they also raised the dividend again by 2.7% to $1.90 per share (8 dividend increases since 2020). The stock has rebounded a little bit and is trading at ~$118 per share with a current dividend yield of 6.4%. This is a strong core position at SPC and we are comfortable holding for the long-term. We also still believe the stock is heavily undervalued.

As a side note to mall transactions, Westfield has sold two Class B malls in the past few months, one at a 10% cap rate and the other at an 8.5% cap rate. As I have noted in the Q1 Update, it seems these valuations are pretty consistent and in-line with the private market transactions I have been tracking over the past 12-24 months. This has reinforced my view that Class A malls can range between sub 4% to sub 6% cap rates while Class B can range from 7%-12%.

Global Payments Inc. (NYSE: GPN)

GPN reported strong results for Q2. There's some noise in the numbers due to dispositions and acquisition activity, but overall revenue was up 7% YoY (up 15% excluding dispositions), the merchant acquiring business was up 9% YoY, and the issuer segment was up 5% YoY. Very strong revenue growth across the board. Margins also improved by 100 basis points YoY to 44.8%. GPN's new CEO, Cameron Bready (previously GPN's COO) is off to a strong start and we look forward to Mr. Bready leading the business into its next chapter of growth.

Armada Hoffler Properties (NYSE: AHH)

AHH's share price, similar to most REITS, has been treading water as of late, currently around $12 per share. However, the underlying performance has been nothing short of spectacular, which was reinforced with Q2 results. AHH recently announced a $50MM stock repurchase program, which will primarily focus on retiring preferred shares (thereby reducing leverage, which we like). The company maintained guidance and occupancy remains very strong at 96% or higher across retail, office, and multifamily. Same store NOI increased 4.8% and releasing spreads are now 8.9% on a GAAP basis. AHH also raised its dividend by 3% in May to $0.195 per share. I think the stock is worth at least $20 today and worth nearly $30 per share by 2025 as their current development projects stabilize.

Kilroy Realty (NYSE: KRC) - KRC stock has been getting hammered among fears that office properties are obsolete. This is the same theme that has taken down Class A malls and we can see in the fundamentals that mall assets are performing very well, but it takes time for the sentiment to change in CRE. KRC owns best in class office buildings that are still holding up very well. During Q2 the company updated its guidance range from 0%-2.0% NOI growth to 1.5%-2.5% NOI growth. The midpoint for FFO guidance is $4.48/share on ~88% occupancy. We think KRC is doing more than fine and will not only survive the downturn in office, but will start thriving once we get to the other side.

American Assets Trust (NYSE: AAT) - AAT delivered a solid beat and raise for Q2 with revenue up 5% YoY and increased FFO guidance by 2% ($2.32 vs. $2.28). FFO per share for Q2 was up 8% YoY and NOI was up 7% YoY. Very happy with these results. I'm glad we added more shares during Q1.

META Platforms (NASDAQ: META) - What a turnaround from 2022. The stock has been on a tear, and I think there is still plenty of upside left. SPC initiated a position back in 2022 right at the height of all the pessimism. This turned out to be the right move as we are now sitting on very healthy gains. During Q2 META released results showing the company is back on its growth track and will be more profitable at the same time (which was my original thesis investing in META). Revenues grew 11%, operating income grew 12%, and net income grew 16%. Family of Apps daily users grew 7% and monthly active users grew 6%. Impressive results all around. We also see multiple avenues for monetization which we are already starting to see with WhatsApp, Reels, and now Threads (alternative to Twitter). META isn't necessarily cheap at current prices, but I am also not a seller unless the stock hits ~$400 which is about 30x on forward P/E.

Google (NASDAQ: GOOG) - Similar to META, GOOG has had a nice run YTD. GOOG's Q2 results revealed a return to growth with revenue up 7% YoY (9% in constant currency). Operating margin expanded 100 basis points to 29% and EPS grew 19% YoY. Very impressed. This is a great company that is still trading at a cheap valuation. Similar to META I wouldn't consider selling unless the stock gets to 30x forward P/E or roughly $170.

Warner Bros. Discovery (NASDAQ:WBD) - WBD's stock price has been running in place, but we are starting to see the hard work of David Zaslav and the team starting to bear fruit. Although Q2 results were a little mixed due to some choppy revenue (ie. The Flash underperformed in theaters), but a whopping surprise was FCF came in at $1.7 Billion, significantly higher than the $789 Million reported last year in Q2. Management's cost cutting efforts are paying off big time. On the cost cutting point management also increased their synergy target to $5 Billion and also stated this number could grow. The company also repaid $1.6 Billion in debt during the quarter and the company just announced a tender offer for an additional $2.7 Billion in debt. The company is repaying debt significantly faster than I am currently modeling (which directly increases equity value). WBD reaffirmed that net debt will be comfortably below 4.0x by year end. I am currently modeling 3.8x, but it really depends on how EBITDA shakes out. The Barbie movie has hit the $1 Billion mark and should be a nice bump to Q3 earnings, however, the advertising market is still pretty weak. Management has guided to the lower end of their EBITDA range for 2023 of ~$11 Billion. So lots of moving pieces, but I'll sum up the results by saying David Zaslav has got the ship moving in the right direction and continues to execute on the business plan they laid out during the initial merger announcement.

BlackRock Inc. (NYSE:BLK) - BlackRock beat on both the top and bottom lines as capital started flowing back into the markets and BLK's AUM reached $9.43 Trillion. Q2 adjusted EPS came in at $9.28, beating consensus estimates of $8.42. The company also repurchased $375MM worth of stock. I think this is a high quality company with fair value around $800/share vs. our cost basis at $596.

The remainder of our holdings are minor noncore positions that are less than 3% of the portfolio. I strongly believe our REIT holdings are the most undervalued in the market today. In fact, Bruce Flatt who is the CEO of Brookfield Asset Management recently noted that he's seeing the best opportunities in real estate since 2009. I believe there will be a wave of private equity firms acquiring publicly traded REITs if this undervaluation continues. There have already been multiple public REIT mergers and take-privates over the last 12 months. I think this will continue.

Overall I'm happy with the underlying performance of our portfolio companies at this time and I look forward to providing our next update in Q3.

Sincerely,

Daniel Fas

Founder & CIO at Seaside Private Capital