I have been looking forward to seeing General Growth Properties (GGP) spin off Rouse Properties (RSE). You may recall General Growth Properties, a real estate investment trust (REIT) that owns and operates shopping malls around the United States, famously went bankrupt in 2009 at the height of the credit crisis. At the time, the bankruptcy was the largest real estate bankruptcy since 1980. However, GGP has since re-emerged, first spinning off its real estate development projects into Howard Hughes (HHC) and now Rouse Properties.

Rouse Properties is a collection of 30 low-quality (Class B and C) malls across 19 states totaling about 21 million square feet of retail space. The firm is not yet a REIT, but plans to convert shortly. Unsurprisingly, many of the malls are located in out of the way locations such as Rock Springs, Wyo., and Logan, Utah. The malls are anchored by tenants across the retail landscape, including Macy’s, JC Penney, and smaller names such as Forever 21 and Chipotle. The firm is about the eighth-largest publicly traded owner of mall real estate in the U.S.

So, what could possibly prompt our interest in this collection of second-tier assets? The spin-off dynamics are quite compelling. First, the spin-off ratio was 26 to 1, and Rouse has a market cap today of around $490 million versus the $14 billion market cap of GGP. Second, despite its size, GGP is not particularly well covered by Wall Street with only three analysts on it, which means Rouse is unlikely to attract much attention at all. Third, Rouse was spun off on Dec. 28 when practically no one on Wall Street was paying attention. Fourth, hedge fund maven Bill Ackman and skilled real estate investor Brookfield Asset Management (BAM) are large holders of the stock, and Brookfield has offered to backstop a $200 million rights offering at $15 per share, which is well above the $11 per share where Rouse currently trades. Finally, unlike most spin-offs, the Rouse deal is taxable, which means most investors may actually choose to sell the stock rather than come up with the cash needed to pay the required taxes. Therefore, Rouse strikes us as a particularly compelling investment worth of further study.

Does Investing in Class B Malls Make for an A+ Investment?
Rouse's properties are decidedly toward the lower end of the scale. Tenant sales are $281 per square foot. For reference, $250 per square foot for a property is considered a "failure" by real estate standards, and peer Taubman (TCO) generates $615 in tenant sales per square foot. Occupancy levels are about 88%, down from 93% in 2006. But, there's cause for optimism. Rouse's properties were decidedly noncore for GGP, and probably weren't emphasized by a mall operator that was skewed toward the premium end of the scale. In addition, about 60% of Rouse's property portfolio is made up of malls that are located in one-mall markets with no competition, where they have a loyal consumer following and serve as social hot spots. One example is the Sikes Senter Mall in Wichita Falls, Texas. It is the only mall in a 100-mile radius with an Air Force base and a decent-sized university in the area. On the flip side, Rouse has a number of dogs that will require re-tenanting and a change in the merchandise mix to attract new mall shoppers. An example of this is the Bayshore in Eureka, Calif., which is the only mall in the area but contains too many shops and not enough big-box retailers. As a result, Rouse plans to redevelop the site to increase its tenants' sales and thus its own rents.

One of the challenges for REITs is access to low-cost capital, and lots of it. Rouse is somewhat unusual in that it should receive about $200 million from a rights offering shortly, which is being backstopped by Brookfield Asset Management at $15 per share. Brookfield is an important partner to have, as it is one of the world's largest property managers with about $150 billion in assets, which include power, infrastructure, and private equity. Brookfield already owns 37% of Rouse, as a result of its successful restructuring of GGP, and by backstopping the offering, it is essentially indicating its willingness to increase ownership of Rouse to 54% at $15 per share. As a result of Brookfield's involvement in GGP, it is probably better positioned than most to value mall-related assets. Thus, it's interesting that we're been given an opportunity to purchase shares at $11 each, a substantial discount to what Brookfield feels they are worth.

Rouse plans to reinvest the capital raised from the rights offerings in its malls over the next four years to improve occupancy levels, tenant sales per square foot, rent levels, and ultimately financial results. The $50 million in annual reinvestment is far above 2008 and 2009 investment levels of $20 million and $8 million, respectively, which argues that the malls were ignored by GGP and neglected in its bankruptcy. However, given the somewhat dire state of Rouse's properties, it's not surprising that a massive capital investment is needed to remake the portfolio.

The investment case for Rouse hinges on whether it is successful in allocating its capital. In that regard, we have a fairly experienced management team at Rouse. CEO Andrew Silberfein was previously the executive vice president of Forest City's retail portfolio for 16 years, and has 22 years of experience in the retail real estate industry. He will receive a one-time award of $1.9 million worth of restricted shares that vest over three years, plus another award of $10 million in options that vest over five years. The board is made up of several experienced GGP and Brookfield executives, as well as other real estate investors. Top executives also include CFO Rael Diamond, who previously worked for Brookfield's real estate arm, and two executive vice presidents who have lengthy histories with GGP. Thus, we believe there's a reasonable case to be made that some neglected assets will be polished into better shape in the next few years, with the prospects of meaningful returns if the malls can be successfully repositioned more favorably.

Risks
Real estate investments can be difficult. In Rouse's case, the malls are exposed to the continued deleveraging of the U.S. consumer as well as any increase in interest rates, which could boost Rouse's financing costs. That said, I think there are two big trends that will provide some headwinds for Rouse during the next few years.

The first is the rise of the Internet, which is disrupting many brick-and-mortar based businesses by making the retail mall store less important as a customer destination. The list of companies damaged or nearly destroyed by Amazon (AMZN) is growing longer on a regular basis: Borders, Best Buy, Barnes & Noble, Circuit City, Linens & Things, and Wal-Mart. There's even a growing trend called "showrooming," where customers visit retailers to look at the products and then go home to order it more cheaply on Amazon. It also means that retailers and popular restaurants are going to be less likely to want to locate new stores in decidedly substandard Class B malls. New store locations are more likely, in our view, to be in high-profile top-quality malls, where they can grab consumer attention and traffic. In order words, there should be a growing divergence in performance and financial numbers between top-end malls and low-end malls over time. In fact, the U.S. is frequently described as over-retailed, where too many retail stores compete for the  consumer, which ultimately means store closures and difficulty raising rents over time. Thus, marginal owners of real estate such as Class B mall operators face long-term headwinds.

The second major trend, admittedly less destructive than the Internet, is the rise of outlet malls. In a weak economic environment, consumers are flocking to value-focused outlet malls and retailers want to take advantage of the increased traffic. Industry insiders have noted that the outlet space is perhaps one of the only places in the U.S. that is actually under-retailed, and they are structurally attractive because people want value in good times and bad. Outlet malls are generally located far away from traditional malls and designed to cover a wide geographic area. Both factors mean that outlet malls are potentially a serious threat to Rouse's large base of isolated, regional, one-mall markets.

Valuation
The basic investment thesis for Rouse is that experienced managers can fix its merchandising and tenant issues while operating in an environment with several structural headwinds. The investment definitely leans toward the cigar butt end of the spectrum, and Rouse’s management team has quite a job ahead of it.

Rouse's financials are quite a mess. Core net operating income (NOI) probably will be around $150 million in 2011, versus more than $200 million in 2008. We value higher quality mall peers such as Simon Property Group (SPG), Taubman Centers (TCO), and Tanger Factory Outlets (SKT) at around a 5.7% to 7% capitalization rate on their 2011 NOI. Given Rouse's position at the low end of the market, it likely deserves a higher capitalization rate in the 8% to 10% range, which implies a $7 to $15 fair value estimate. Book value for the firm is around $435 million versus its $490 million market cap, which also suggests that the firm is reasonable valued. We note that Rouse is highly leveraged, with debt/EBITDA around 10 times and debt/gross property value of around 80%. EBITDA in 2011 should cover interest expense by about 2 times, but its major debt maturities are pushed off until 2013 and 2014, which gives the firm time to make progress on its turnaround.

Overall, we view Rouse as a highly speculative investment, as it is a heavily leveraged turnaround in progress facing both short-term and long-term headwinds. The poor quality of its mall portfolio and the absence of structural tailwinds mean that we are largely dependent on absolutely outstanding management to see significant value creation. As such, we'd be reluctant to make Rouse anything larger than a very small and short-term speculation on its very unusual spin-off dynamics, which may lead to a short-term pop in the share price once the initial selling pressure subsides.

We've talked a few times in recent weeks about Cloud Peak Energy's (CLD) travails  amid today's natural gas glut situation. After digesting the company's recent (excellent) earnings release and doing some financial modeling, we will set out more specific projections than we have shared in the past.

First, let's talk briefly about the company's fourth-quarter earnings. In short, they were excellent, and the stock rallied about 5% the day after the numbers were released. Cost controls were once again superb, and the company finished the year at the very bottom edge of its most recent cost guidance at $9.12 per ton. To put this number in some context, $9.12 per ton is only about 6.4% more than last year's already very strong result and is a rock-bottom rate of inflation compared to both regional peers and U.S. averages. For instance, Arch Coal, whose Powder River operations are a very close comp to Cloud Peak, suffered 12.8% of inflation versus 2011. Cloud Peak's cost trends have long been some of the best in the industry, and it's one of the biggest reasons I like this stock.

Adjusted EBITDA improved about 9% over last year to a record $350 million, and production surprised slightly to the upside as well. Cash continued to pile up and the company is now sitting on a $400 million war chest, versus $600 million of debt. All in all, we couldn't have asked for much better.

That said, the stock is languishing at around $18 per share. In fact, CLD is trading for something like 8 times adjusted 2011 earnings and less than 4 times 2011 EBITDA! Investors are obviously not taking a very optimistic view of this company. So what are they thinking?

As we've mentioned in past articles, the next few years probably won't be that pretty for Cloud Peak. While I don't think we are looking for anything like a catastrophic fall in earnings, it will be very difficult to return to the path of steadily expanding margins and EBITDA that the firm had been on for the last few years.

Fortunately, 2012 actually will be pretty decent. Management has prudently already sold forward nearly its entire planned production at pretty good prices. If cost control remains as good as it has been, profits won't change much versus 2011. I'm currently projecting EBITDA of about $330 million, and free cash flow should actually increase because capital expenditures are declining a bit.

Unfortunately, 2012 is not all we have to worry about. The truth is, Powder River Basin coal prices have taken a big tumble in recent days, down to $10 per ton from $14 or $15 at various points last year. Meanwhile, thanks to an unseasonably warm winter, utility coal inventories are sitting above their normal ranges. Through 2012, as power plants switch to cheap natural gas and as coal miners deliver on previously made contracts, inventories may continue to accumulate. An exceptionally hot summer would change the equation quite a bit, but obviously that's not something we can count on. Lastly, natural gas prices are still in the dumps and probably won't come back up anytime soon.

These dynamics create a problem for Cloud Peak. The company is one of the most conservative major miners when it comes to selling its coal forward (committing to sale contracts well ahead of time). For example, it substantially committed its 2012 production, and probably half of its 2013 production, by the end of 2011. On the earnings conference call, management hinted that it does not plan to change this practice much even in the face of extraordinary market conditions.

Therefore, if the energy markets do not improve by the latter half of 2012 (and I don't think they will), Cloud Peak will be busy locking in its 2013 and maybe even 2014 contracts. Thankfully, it already has 60% of its 2013 book committed at good prices, but by selling the rest cheaply, the company could be locking in substandard profits for at least a year, and maybe even two. As such, I am currently foreseeing 2013 profitability being flat to down from 2012, and 2014 is a wild card.

The good news: Throughout this time Cloud Peak should continue to generate decent (though not growing) earnings. It will generate some free cash flow, even after laying out a few hundred million dollars for coal leases. At the same time, major strategic projects, principally the building of West Coast coal ports, will push ahead. The bad news, of course, is that as long as energy prices remain low, Cloud Peak is probably dead money, or worse.

With the rock-bottom valuation today and a healthy balance sheet, I'm happy holding onto this stock. I think in the long run, there are plenty of good things to be excited about, and margins will resume their expansion. But for the next year at least, I don't expect too much good news.

--Mike

The headlines yesterday proclaimed that stocks had enjoyed their strongest January gain since 1997. We agree that it was a great month, both for the market and for the Opportunistic Investor. Our portfolio gained 9.1%, versus a 4.4% gain for the S&P. This was a nice showing for us relative to the index, and allowed us to close much of last year's performance gap with the broader market.  Since January 2010, our portfolio is up about 10%, versus 23.4% for the S&P.  Despite our showing in January, we still have a lot of lost ground to make up.

Virtually every one of our portfolio holdings did well last month. Notable contributors to performance included Icon Plc (ICLR) which rose 19%, Bank of America Trust Preferred (BAC-B) which gained 20%, Charles River (CRL) climbed 26% after takeout speculation, Autoliv (ALV) notched a 22% gain, and TripAdvisor (TRIP) soared 35% after we bought it just a few weeks ago. Life Technologies (LIFE) rose over 20% as well. Admittedly, it was a rare company that didn't at least have double digit gains. Our biggest drag on performance was Cloud Peak (CLD) which retreated about 2%. No other stock in our portfolio logged a decline for the month, a first for the Opportunistic Investor portfolio.

There was a lot for us to smile about during the month, including the acquisition rumors about Charles River, which has turned this investment into a decent moneymaker after a long period of languishing in the trenches. That said, I'm thinking of trading it in for another CRO: I'm leaning towards Covance (CVD) which just announced a relatively disappointing outlook, sending the stock into a slump. I don't know enough about this company to make the leap just yet, but it appears to be a strong candidate, and is almost certainly better managed than Charles River.

Cloud Peak's performance once again failed to mirror its lofty-sounding name. The picture for U.S. coal producers has turned definitively darker in the past few months as natural gas prices have plunged. Natural gas hit a new multiyear low this January, and is currently dithering about $2.50 per MCF, a level I would not have dared to imagine two or three years ago. At this price, a large swath of our coal output, largely in central Appalachia, has been effectively priced out of the market. Even Powder River Basin coal is only borderline competitive, and may begin to feel the pressure of demand destruction. During the next year, if natural gas prices persist at these depressed levels, it could result in the displacement of tens of millions of tons of coal demand. I'm actually surprised that the stock prices of Cloud Peak and its peers have been relatively stable thus far. Natural gas companies have already been hit hard, with many stocks falling over 20% in January alone. Given coal mining's operating leverage, one would imagine that these stocks would have reacted fairly violently too. I find the fact that they didn't to be unsettling, not reassuring.

Gas prices can't stay low forever of course, but it seems to me that they can stay low for quite a while. Despite the tough price environment, oil & gas companies have the financial wherewithal, drilling inventory, and inclination to glut the market further with yet more gas. An exceptionally warm winter was no help either, and was the final straw that pushed prices well below $3. Moreover, most natural gas producers have switched their focus onto so-called liquids rich plays, with wells that produce lots of heavier hydrocarbons like propane and butane (which are priced closer to crude oil, whose price is still sky-high) along with smaller quantities of plain old natural gas. Since most of the money is made on these natural gas liquids, it might not matter to these companies that natural gas prices are so low. They'll keep drilling and producing as long as oil prices stay high, and the wells make money. In other words, the huge disconnect between oil and gas prices may blunt the supply response that we've traditionally seen with commodities when prices plunge to unfeasible levels.

Of course, gas prices will recover eventually, but the question is one of timing. Liquids rich plays or no, at $2.50 per MCF it's simply unprofitable to drill most new wells today. Gas rig counts are already declining, but not quickly enough to arrest the price decline. Some companies have already started to show signs of rationing capital and cutting back production. Eventually people will stop drilling, thereby constricting supply. Meanwhile, demand will rise, whether from more gas power plants, export terminals, or chemicals factories, thereby allowing prices to rise. However, the problem is that I don't know whether this recovery is six months away, or three years. Until this happens, stocks like Cloud Peak may not have much upside, and downside risk could be substantial.

Even so, we're holding our position in Cloud Peak. I try not to churn the portfolio too much trying to pick through these air pockets (this is a very big air pocket) and I think its long-term outlook is still bright. That said, given the tremendous near term headwinds, I certainly wouldn't blame you if you took a little money off the table. Another alternative is to hedge your investment by shorting another coal producer -- such as Alpha Natural Resources (ANR) -- which I think is quite richly priced, and extremely strategically vulnerable besides.

Let's wrap up on a positive note: TripAdvisor (TRIP) almost immediately turned into one of the best performing stocks in our portfolio. As of this writing, we're up by about 40% in this position. As far as I can tell, there was no fundamental news that would account for this huge move. To put it mildly, this stock's rapid ascent took me by surprise, and it's now trading for perhaps 25 times 2012 earnings. While this isn't nosebleed valuation, especially considering the company's rapid growth rate, it's not cheap either. I probably wouldn't purchase additional shares at these levels, either for the portfolio, or personally.

Watch List Updates

Additions

CH Robinson (CHRW)
CH Robinson is a great business. It's a logistics company that knits together a huge network of shippers while deploying little capital of its own. This network continues to grow larger, denser, and more powerful. The company's earnings recently had a hiccup, and the stock, while not cheap at 21 times forward earnings, is trading near a 52-week low, the most attractive valuation it's had in a quite a while.

Deletions

DR Horton (DHI)
The homebuilder complex had a pretty sizable rally recently because of a few positive housing related data points, and the stocks are currently not far from our fair value estimates. I have a feeling that the rally is rather premature, and it's far from certain if we'll see a material homebuilding rebound in 2012. Homebuilding in general is a very mediocre industry, and I'm not sure if I want to buy these stocks unless they're priced at a truly exceptional discount.

Best Ideas

Icon (ICLR)
After the big gain in January, we are only down a mid-single digit percentage now on Icon. We've received some positive news in the sector. Close rival Paraxel (PRXL) reported an excellent fourth quarter, with solid new bookings, sending that stock's price up almost 20%. I think Icon will follow the same pattern when it reports later this month.

Anixter (AXE)
Even after a solid gain, Anixter is only trading for about 10 times earnings. As long as the economy doesn't completely implode, this company should be able to predictably generate shareholder value.

Autoliv (ALV)
I've been extremely impressed with the way this company has grown sales in a very weak global auto market. Moreover, the company is boosting its R&D firepower, which was already the most formidable in the industry, to blow ahead on the innovation curve. Finally, for the first time in an extended period, the company is in a net-cash position. There is still plenty of macroeconomic risk in Europe and in China, but with the stock at 10 times trailing earnings, the risk-reward profile has merit.

--Mike

It's been a pretty wild 12 months for what ought to have been a pretty stable security. Hitting a high of $24.24 last summer, our holdings of BAC-B plunged to as low as $16 during the nervousness last August. After enduring a few more 30% swings between the teens and low-20s, the stock is back up to near par levels. In fact, it's been one of the better performers in our portfolio in 2012.

A few months ago, I said that if BAC-B ever returned to these prices, I would look at it very seriously for a sale. The par here is $25, and it's unlikely that we will trade above that anytime soon. So our upside is pretty limited--probably about 9% a year, including the 6.75% yield, for the next few years.

On the other hand, as a relatively senior security in Bank of America's capital structure, I think BAC-B eventually will grind its way to $25. There is a very good chance that in the next two years, Bank of America will redeem these things at par because of changing regulatory requirements.

On the face of it, the return profile isn't bad. You are being offered a relatively "safe" high-single-digit return and reasonable income potential in the next few years, when interest rates are near zero. Even so, I think we are better off with cash in hand rather than waiting to clip a few more coupons. The problem is that even though they shouldn't be (Bank of America essentially would have to go bankrupt before wiping out our investment), these securities are very volatile. As we saw last year, the stock can drop 35% or more when there are strange things afoot in the financial markets. Last year, these drops prevented us from selling BAC-B and reallocating to more interesting stocks just when they were at their cheapest. In this light, we are opting for the safety and flexibility of cash over a little bit of extra return. In your personal investing, if you are comfortable with some interim volatility and the 9% total annual returns, we certainly wouldn't blame you if you held on instead.

Here are the transaction details:

SOLD 457 shares of BAC-B at about $23.36 for net proceeds of $10,666.45, commissions included.

We made an excellent return during our holding period. We made about a 108% return on our principal, and collected $4.68 per share in interest payments. This brings our total returns to about 143% in just more than three years. Unfortunately, as BAC-B was one of our larger positions, its sale will increase our cash balance to nearly 20%, just as the markets are offering relatively few bargains for us to exploit. Things may work out for the best if we see another bout of weakness, but if the recent 20% rally continues, we won't be looking quite so smart. Either way, in the next few months, we have our work cut out for us.

--Mike