Three months later, Morningstar again says Forest City Enterprises stock is worthless

It looks like déjà vu from December. An analyst from Morningstar, in a report (subscribers-only) that repeats nearly verbatim the conclusions in a report issued three months ago, yesterday again warned that stock from Forest City Enterprises (FCE), parent company of Forest City Ratner, is essentially worthless.

And, most likely, company representatives will fire back, as they did in December, by contrasting Morningstar's take with more optimistic assessments from other analysts and pointing out that the Morningstar analyst didn't speak to them.

Indeed, for the past three months, five analysts tracking FCE have consistently rated the stock (FCE.A) as a buy, or 2, on a scale of 1 (Strong Buy) to 5 (Sell), according to Yahoo Finance.

Specifically, two called it a Strong Buy (1), one called it a buy (2), and two recommended Hold (3). No one rated it Underperform (4) or Sell (5).

Market cap plummets

Still, at least one dramatic change bolsters Morningstar's pessimism. Morningstar's December report, based on data from 9/30/08, calculated FCE's market capitalization (the number of shares outstanding multiplied by the price) at $605 million.

The report issued yesterday, based on data from 12/31/08, listed the market cap at $447 million, a 26% drop. The market cap, as of yesterday, had continued to fall, to $397.3 million, a 34% drop since the end of last September. Yesterday, the stock went down 11% to $3.84. Given that, in May 2007, the stock topped $72, the market cap was once nearly 20 times higher.

Another reason for pessimism is Forest City's decision, which apparently surfaced after the report was written, to start selling some prime properties to raise cash. 

Morningstar's take

Morningstar analyst David Rodziewicz (who, as a 2008 college graduate, presumably does not have the experience of other analysts tracking the company) offers some harsh conclusions:
Although the company has historically performed well, its increased position in retail real estate and high leverage should weigh on performance and will probably lead to financial distress. Volatile economic conditions, a challenging credit market, and the likelihood of bankruptcy lead us to a very high fair value uncertainty rating on this no-moat real estate company.

Specifically, while Morningstar estimates Forest City will earn 6.9% on its assets over the next decade, its weighted average cost of capital is estimated at 10.1%.

While Forest City specializes in mixed-use projects in partnership with municipalities, the strategy has become more difficult in "as credit markets continue to remain tight and government budgets are strained."

Defaulting on debt

Given such higher borrowing costs and decreasing earnings, Forest City faces a crossroads:
As underwriting standards become more conservative and property values decline, the likelihood increases that Forest City will have to sell off properties to pay down debt. If this scenario were to play out, there may be no value left for common shareholders.

This is why some investors are buying FCE bonds at a deep discount. And why FCE has begun to sell some prime properties. 

Valuation: worthless, most likely

The report concludes:
We are maintaining our fair value estimate at $0. In our opinion, the chance of common shareholders realizing any value from an investment in Forest City is very small. 

(Emphasis added)

If the economy recovers, or of the developer can find a cheap source of financing, Morningstar says the company could survive, with a $10 share price.

Note that analysts surveyed by Yahoo Finance suggest targets between $10 and $22, with a mean (average) of $15 and a median (middle value) of $13.

Note that the Barclays Center naming rights deal, coupled with triple tax-exempt financing for the planned arena, would constitute a cheap source of financing--at least for one project.

Trouble in the pipeline

The Morningstar report suggests that Forest City will have trouble achieving the returns anticipated in its $1.8 billion development pipeline.

Atlantic Yards has not yet reached that pipeline. FCE categorizes Atlantic Yards in the "initial development stage," one step behind the "shadow pipeline," which itself is behind the development pipeline.

Earnings estimate and upcoming info

Morningstar forecasts average EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) growth of 2.2% over the next three years. In December, Morningstar estimated growth of 2.1% over five years.

In December, Morningstar estimated that net operating income would increase "at a paltry 1.4%, on average, during the next five years." Yesterday's report estimates 2.1% over ten years.

We'll see what Forest City says. Their annual report is due in the coming weeks, and that will be followed by a conference call with investment analysts.