Forest City reports increased earnings, lower net loss; cites major milestones for Atlantic Yards but acknowledges risks, including need for equity

Forest City Enterprises, parent of Forest City Ratner, announced today some relatively good financial news, citing a 37.5 percent increase in annual earnings for the year ending 1/31/09 and a lower net loss--$30.7 million, or $0.22 per share, compared with a net loss of $113.2 million, or $1.10 per share, in 2008.

After cutting costs and seeing the economy recover, FCE even gained positive fourth quarter net earnings of $0.04 per share, compared with a net loss of $0.44 in the fourth quarter of 2008.

The Nets and Atlantic Yards

Still, the Nets lost a bit more in 2009 than they did in the previous year and Forest City absorbed an even greater percentage (updated and clarified):

Our equity investment in The Nets incurred a pre-tax loss of $43,489,000, $40,989,000 and $20,878,000 for the years ended January 31, 2010, 2009 and 2008, respectively, representing an increase in allocated losses of $2,500,000 and $20,111,000 compared to the respective prior year. For the years ended January 31, 2010, 2009 and 2008, we recognized approximately 68%, 54% and 25% of the net loss, respectively, because profits and losses are allocated to each member based on an analysis of the respective member’s claim on the net book equity assuming a liquidation at book value at the end of the accounting period without regard to unrealized appreciation (if any) in the fair value of The Nets.

Hence the importance to FCE that Atlantic Yards, as detailed below, was seen as reaching significant milestones.

Still, vacant possession of the project site--likely to be concluded by summer via eminent domain--is necessary for FCE to finish the transaction with Russian billionaire Mikhail Prokhorov to sell 80% of the New Jersey Nets and 45% of the arena.

Also, among the development risks--required boilerplate, maybe more--is the need to "meet required equity contributions," which suggests that, however Forest City Ratner and Prokhorov have pledged to fill an equity gap, it hasn't been consummated.

Note that the press release refers to "a refinancing from Gramercy Capital on a key $161.9 million land loan for the project," but doesn't explain, as Bruce Ratner suggested at the groundbreaking, that Gramercy progressed from "our land lender" to "our partner." There's no mention of any cash flow difficulties at FCR.

Conference call

Forest City also will hold a conference call with investment analysts on Thursday at 11 am; it will be available for webcast replay.

Dilution and growth

On a per-share basis, full-year 2009 earnings actually represented 2.4 percent decrease from the previous year, which reflect the dilutive effect of new Class A common shares as well as two convertible debt transactions.

"These accomplishments were made possible by continued adherence to the five strategies we implemented in the third quarter of 2008 to address financial and economic turmoil in the market and the real estate industry," said FCE CEO Chuck Ratner in the press release. "Since then, virtually every major action taken by our Company has been driven by these strategies: curtailing development and focusing on our portfolio; driving costs out of the business; generating liquidity from our portfolio and in the capital markets; proactively managing debt maturities; and selectively taking advantage of opportunities created by market dislocations."

"We certainly recognize the impact of this dilution on our shareholders," he said of the issuance of new stock, "but we believe the steps taken during 2009 were vital to the Company's future growth and success, and to the long-term interests of shareholders."

The stock has more than doubled since it was issued, though, even at $14, it is more than 80% off its high of more than $70 in 2007.

From the press release

Under Construction and 2010 openings

In late 2009, construction activity began on the Barclays Center arena at the Company's Atlantic Yards mixed-use project in Brooklyn. It was a watershed year for Atlantic Yards in 2009. Early in the year, the Company secured a refinancing from Gramercy Capital on a key $161.9 million land loan for the project. Throughout the year, a series of lawsuits and appeals filed by project opponents were decided in favor of the project and the Company. The most important of these was a favorable ruling in the final lawsuit challenging the State of New York's use of eminent domain to acquire property within the project footprint. This victory allowed three pivotal events to move forward before yearend: an agreement to sell interests in the NETS team and the Barclays Center arena to affiliates of Onexim Group, completion of the $511 million tax-exempt bond offering to finance a portion of construction for the arena, and execution of the Master Closing for the project.

As a result of these accomplishments, on March 11, 2010, Bruce Ratner, chairman and chief executive officer of Forest City Ratner Companies, the Company's New York-based subsidiary, and other Forest City executives, were joined by New York Governor David Paterson, New York City Mayor Michael Bloomberg, Brooklyn Borough President Marty Markowitz, Barclays PLC President Robert E. Diamond, Jr., NETS President and CEO Brett Yormark, NETS investor and cultural icon Shawn "Jay-Z" Carter and many other community leaders and supporters for a ceremonial groundbreaking at the project site.

Note the terms "construction activity" and "ceremonial groundbreaking." The groundbreaking didn't mark the "next phase of construction of the arena," despite statements in the official press release.

From the Form 10-K report

The Nets

On August 16, 2004 the Company purchased an ownership interest in The Nets, a member of the National Basketball Association (“NBA”). The Company accounts for its investment on the equity method of accounting. Although the Company has a legal ownership interest of approximately 23% in The Nets, the Company recognized approximately 68%, 54% and 25% of the net loss for the years ended January 31, 2010, 2009 and 2008, respectively, because profits and losses are allocated to each member based on an analysis of the respective member’s claim on the net book equity assuming a liquidation at book value at the end of the accounting period without regard to unrealized appreciation (if any) in the fair value of The Nets.

The purchase of the interest in The Nets was the first step in the Company’s efforts to pursue development projects, which include a new entertainment arena complex and adjacent urban developments combining housing, offices, shops and public open space. The Nets segment is primarily comprised of and reports on the sports operations of the basketball team.

On December 15, 2009, the Company entered into a purchase agreement with an affiliate of Onexim Group, an international private investment fund, to create a strategic partnership. Pursuant to the terms of the agreement, entities to be formed by Onexim Group will invest $200,000,000 and make certain contingent funding commitments to acquire 80% of The Nets, 45% of the Arena project and the right to purchase up to 20% of the Atlantic Yards Development Company. The Company will retain a noncontrolling ownership interest in The Nets under the agreement. The closing of the strategic partnership requires certain consents and is subject to the satisfaction of various conditions. While the parties are proceeding in good faith to obtain the consents and satisfy the conditions, the Company cannot assure you that it will be successful.

Development risks

Examples of projects that face these and other development risks include the following:

Brooklyn Atlantic Yards. We are in the process of developing Brooklyn Atlantic Yards, which will cost approximately $4.9 billion over the anticipated construction and development period. This long-term mixed-use project in downtown Brooklyn is expected to feature a state of the art sports and entertainment arena for The Nets basketball team, a member of the NBA. The acquisition and development of Brooklyn Atlantic Yards has been formally approved by the required state governmental authorities and final documentation of the transactions was executed on December 23, 2009. Tax exempt financing for the arena also closed on December 23, 2009, the proceeds of which will become available upon the satisfaction of certain conditions, including vacant possession of the project site. In the event these conditions are not satisfied by December 17, 2010, the bonds that were issued for the arena financing will be subject to mandatory redemption. Construction activities have commenced for (i) the potential removal, remediation or other activities to address environmental contamination at, on, under or emanating to or from the land, (ii) demolition of existing structures on the developments site, and (iii) infrastructure and other work necessary for the development of the arena and other elements of the greater Atlantic Yards development project. As a result of prior litigation, this project has experienced delays and may continue to experience further delays.

There is also the potential for increased costs and further delays to the project as a result of (i) increasing construction costs, (ii) scarcity of labor and supplies, (iii) a delay in satisfying the conditions of the tax-exempt financing and the potential mandatory redemption of the bonds issued for the arena financing, or the availability of additional needed financing, (iv) our or our partners’ inability or failure to meet required equity contributions, (v) increasing rates for financing, (vi) loss of arena sponsorships and related revenues, (vii) our inability to meet certain agreed upon deadlines for the development of the project and (viii) other potential litigation seeking to enjoin or prevent the project or litigation for which there may not be insurance coverage. The development of Brooklyn Atlantic Yards is being done in connection with the proposed move of The Nets to the planned arena. The arena itself (and its plans) along with any movement of the team is subject to approval by the NBA, which we may not receive. In addition, as applicable contractual and other deadlines and decision points approach, we could have less time and flexibility to plan and implement our responses to these or other risks to the extent that any of them may actually arise.

If any of the foregoing risks were to occur we may: (i) not be able to develop Brooklyn Atlantic Yards to the extent intended or at all resulting in a potential write-off of our investment, (ii) be required to repay the City and/or State of New York amounts previously advanced under public subsidies, plus penalties if applicable, and (iii) be in default of our non-recourse mortgages on the project. Together, costs associated with the risks outlined in (i) through (iii) in this paragraph, are approximately $590 million and could have a significant, material adverse effect on our business, cash flows and results of operations. Even if we were able to continue with the development, or a portion thereof, we would likely not be able to do so as quickly as originally planned, would be likely to incur additional costs and may need to write-off a portion of the development.

The Prokhorov deal

The Proposed Transaction With an Affiliate of Onexim Group to Create a Strategic Partnership for our Brooklyn Atlantic Yards Project May Not Close, Which Could Subject Us to Liquidity Risks.

The purchase agreement that we executed with an affiliate of Onexim Group requires certain consents and is subject to the satisfaction of various conditions. Both parties continue to negotiate reasonably and in good faith to obtain the consents, including consent from the NBA, and satisfy the conditions. However, the proposed transaction may not close and the strategic partnership for the Brooklyn Atlantic Yards project may not be realized. If the strategic partnership is not formed and the $200 million investment is not received, we could have heightened exposure to the development risks associated with the Brooklyn Atlantic Yards project. See “We Are Subject to Real Estate Development Risks” above for a more thorough discussion of the risks associated with the Brooklyn Atlantic Yards project and the impact those risks may pose to us.

In addition, if the proposed transaction does not close, we could also have heightened exposure to the risks associated with our investment in the Nets. See “The Investment in a Professional Sports Franchise Involves Certain Risks and Future Losses Are Expected for The Nets” below for a more thorough discussion of the risks associated with that investment and the impact those risks may pose to us.

Risks of Nets ownership

The Investment in a Professional Sports Franchise Involves Certain Risks and Future Losses Are Expected for The Nets

On August 16, 2004, we purchased a legal ownership interest in The Nets. This interest is reported on the equity method of accounting and as a separate segment. The purchase of the interest in The Nets was the first step in our efforts to pursue development projects at Brooklyn Atlantic Yards. For a more thorough discussion of the risks associated with the Brooklyn Atlantic Yards project see “We Are Subject to Real Estate Developments Risks.”

The Nets are currently operating at a loss and are projected to continue to operate at a loss at least as long as they remain in New Jersey. Such operating losses will need to be funded by the contribution of equity. Even if we are able to relocate The Nets to Brooklyn, there can be no assurance that The Nets will be profitable in the future. Losses are currently allocated to each member of the limited liability company that owns The Nets based on an analysis of the respective member’s claim on the net book equity assuming a liquidation at book value at the end of each accounting period without regard to unrealized appreciation (if any) in the fair value of The Nets. Therefore, losses allocated to us have exceeded our legal ownership interest and may become significant. While the allocation of losses would be reduced in future periods if our proposed transaction with an affiliate of Onexim Group closes, we cannot assure you that the proposed transaction will occur. See “The Proposed Transaction With an Affiliate of Onexim Group to Create a Strategic Partnership for Our Brooklyn Atlantic Yards Project May Not Close, Which Could Subject Us to Liquidity Risks.”

Our investment in The Nets is subject to a number of operational risks, including risks associated with operating conditions, competitive factors, economic conditions and industry conditions. If The Nets are not able to successfully manage the following operational risks, The Nets may incur additional operating losses:

• Competition with other major league sports, college athletics and other sports-related and non sports-related entertainment;

• Dependence on competitive success of The Nets;

• Fluctuations in the amount of revenues from advertising, sponsorships, concessions, merchandise, parking and season and other ticket sales, which are tied to the popularity and success of The Nets and general economic conditions;

• Uncertainties of increases in players’ salaries;

• Dependence on talented players;

• Risk of injuries to key players;

• Uncertainties relating to labor relations in professional sports, including the expiration of the NBA’s current collective bargaining agreement, or a player or management initiated stoppage after such expiration; and

• Dependence on television and cable network, radio and other media contracts.

Milestones

Significant milestones occurring during 2009 included:

• The formal approval of the acquisition and development of our Brooklyn Atlantic Yards project (“Atlantic Yards”), a 22-acre residential and commercial real estate project in Brooklyn, New York, by the required state governmental authorities with final documentation of the transactions being executed on December 23, 2009. The closing clears the way for additional work to proceed on the project, beginning with construction of the Barclays Center arena (“Arena”), the planned future home of The Nets. In conjunction, The Brooklyn Arena Local Development Corporation, an entity formed by the State of New York, issued $511,000,000 of tax-exempt bonds to finance a portion of the construction of the Arena at Atlantic Yards, the proceeds of which will become available upon the satisfaction of certain conditions including vacant possession of the project site. The interest rate on the bonds was 6.48%;

• Entering into a purchase agreement in December 2009 with an affiliate of Onexim Group, an international private investment fund, to create a strategic partnership for the development of Atlantic Yards and the Arena. Pursuant to these agreements, entities to be formed by Onexim Group will invest $200,000,000 and make certain contingent funding commitments to acquire 45% of the Arena project and 80% of The Nets, and the right to purchase up to 20% of the Atlantic Yards Development Company, which will develop the non-arena real estate. We will retain a noncontrolling ownership stake in The Nets, and will be managing partner of the Arena and majority owner of the balance of the Atlantic Yards real estate. As a 45% owner of the Arena and an 80% owner of the team, Onexim will be responsible for those respective percentages of the debt of each asset.