The Coming Problems in Commercial Real Estate

Last week, the rent-regulated Riverton Apartments in Manhattan warned that it may not be able pay a $225 million mortgage payment due in September.  If they can't pay, it would be New York's largest commercial default to date.  Riverton's debt was packaged into a commercial mortgage-backed security (CMBS), split up and sold as bonds in the spring of 2007.  The owners had also assumed that worse case, the low-rent apartments could be sold at the then-high real estate prices.  

And thus comes the next stage in the credit crisis.  According to the New York Times, Deutsche Bank (DB) held $25.1 billion of commercial mortgage backed securities, Morgan Stanley (MS) held $22.1 billion and Citigroup (C) had $19.1 billion at the end of the second quarter.  Lehman Brothers (LEH) is trying to sell about $40 billion of commercial real estate assets, as well as its entire real estate business.  Moody's REAL Commercial Property Price Index has dropped 12% since its high last October.  

Over the next six months to a year, mortgages priced during the last throes of the real estate bubble should run into trouble.  As these real estate owners try to refinance, costs should be higher, making the problem even worse.  This will force writedowns at the banks mentioned above.  

Position: Ming is long C and MS.  

Is Tech the Next Trade?

In recent weeks, things have been looking up for the tech sector:

- In an interview with Jim Goldman on CNBC, Intel's (INTC) CEO Craig Barrett said that the company was shielded from vagaries in the US economy because 75% of its business is from outside the US.  Intel's customers have business models that have 60-80% of their sales outside the US.  So as long as the emerging markets are strong, he argues, Intel will do well.  (The interview was Tuesday, August 19, 2008 - see www.cnbc.com )

- IDC reported that PC shipments rose in the second quarter, growing 3.1% from the first quarter, and 16.1% from last year.  Usually the second quarter is the slowest period for personal computer chip shipments, so this activity is very unusual.  IDC analyst Shane Rau attributes this to strong demand for notebooks and Intel's "very aggressive push" in the PC chips market.  Intel's processor shipments grew almost 4.3% in Q1 and 20.8% over last year, while AMD's processor shipments were flat.  Intel is estimated to have 80% (up  1%) of the market for PC microprocessors, while AMD has about 20% (down 1.2%).  IDC expects the PC processor market to grow 7.5% in 2008 to $32.8 billion (www.smartmoney.com, August 18, 2008)

- On August 24, 2008, Gartner reported that worldwide server sales rose 12.2%, year over year,to 2.3 million units in Q2.  Meanwhile, revenue was up 5.7% to $13.8 billion.  The major drivers were the replacement of x86 servers, expansion of data centers for websites, and growth in emerging markets.  IBM had 31.2% of revenue, up 11.5% from 29.6%; HP was second with 27.6%, a drop from 28.4%; Dell held third with 13%, up 1%; Sun and Fujitsu share of revenue was down.  In terms of units, HP's share dropped from 31% to 30% (although units rose 8.7%); Dell's share rose from 22.3% to 24.7% (unit growth grew 24%); and third-place IBM also lost unit share.   

- Hewlett-Packard (HP) recently reported a 14% increase in quarterly profit driven by international sales and issued an optimistic outlook for the current quarter.  HP's PC revenue was $10.25 billion, up 15% from the same quarter last year.  This was largely driven by a 26% increase in laptop sales.  Corporate purchases were strong.  Enterprise servers and storage were up 5%, but sales of blade servers grew 66%.  The services division increased revenue 14%.  The company is estimating current quarter revenue of $30.2 billion to $30.3 billion and EPS of 95 cents to 97 cents (see wsj article, August 20, 2008)

- Cisco (CSCO) recently reported 10% revenue growth in the fiscal fourth quarter.  While John Chambers, the CEO, expects slower revenue growth of 8% in fiscal Q1 (the next quarter) and 8.5% in fiscal Q2, he anticipates a recovery early next year in the beginning of 2009 (Chambers noted that his fiscal Q1 and Q2 growth figures could be +/- 1%).  Overall, Chambers reiterated the company's annual growth forecasts of 12% to 17%.  In the current quarter, enterprise IT spending did grow 13% over last year's figure, compared with only 6% last quarter (see wsj article,  August 5, 2008).  While all this may not seem extraordinary, analysts consider these pronouncements positive compared to statements from the past year in which Chambers reported significantly weakening spending.  Keep in mind that it was Chambers' negative comments that started the decline in tech last fall.  

- EMC reported on July 24, 2008, that second quarter net income rose 13% while revenue grew 18%.  CEO Joseph Tucci called the environment "manageable" and said that customers were continuing to spend because they still need to manage an ever-increasing body of information.  Sales in the US were weaker, growing only 10% over the same period a year earlier, but sales outside the US grew 27% year over year and accounted for 48% of total second quarter revenue (see WSJ, July 24, 2008).  

All in all, these reports indicate that the tech market is not as soft as many analysts had feared.  Following the credit crisis, many thought that weakening financials - usually one of the biggest buyers of tech - would severely damage the tech sector.  As a result, tech pulled back over the last year.  Now it seems that corporations have not pulled back as much as previously expected, and that overseas spending is continuing.   

Positions:  Ming is long INTC, EMC