e enjte prill 06, 2006

Can real estate consolidation bridge CSC's $1 billion gap

Computer Sciences Corp, which over the last year has had talks with several potential purchasers, announced this week that it's hired Goldman Sachs to advise it and to find a buyer. Heretofore, offers have been $1 billion less than CSC thinks it's worth, and CSC obviously is hoping Goldman Sachs can find that extra value.

If ever there was an M&A deal that showed how a portfolio of office space, held solely for a company's own use, can determine whether a company is sold or not, this is it. The $1 billion bid-ask spread is not much given CSC's current valuation slightly above $11 billion. On the margin, the real estate portfolio could make enough difference as to how prospective purchasers value CSC so as to determine whether the decision is “go” or “no go”. Here's why....

CSC has a huge office portfolio relative to its $14 B of annual revenue. This is not surprising given the labor intensity of its business which employs legions of software engineers, systems admins, data architects, etc. all of whom need office space. According to its last annual 10K SEC filing CSC had 79,000 employees. Compare this to Sun Microsystems which has roughly the same revenue (or will once the StorageTek acquisition is fully integrated) but has about half as many employees (even after the StorageTek integration).

CSC's labor intensity leads it to being very office-space-intensive. At the end of its last fiscal year, CSC had 18 million square feet of offices around the world. The lion's share of this space – 14.5 million square feet – is in leased premises and costs the company about $350 million per year in rent obligations alone. Including other costs attendant to keeping the spaces operational, I'm guessing the total expense of the space is at least $500 million (or about $35 per square foot). The operating expenses related to the owned portfolio would be in addition to this.

So how does this large office portfolio affect the price that CSC might go for? Answer: There's evidence that CSC has excess space in its portfolio and, to the extent it can be excised economically, the enterprise value could easily increase by $1 billion.

Like a lot of tech companies, CSC ballooned in size over the last decade. In 1998, it had only 45,000 employees and 8 million square feet of space (versus 79,000 employees and 18 million square feet today). Also like a lot of other tech companies, including Sun, keeping square footage in proportion to people has been a challenge. In 1998, CSC had 177 square feet per person, today it has 227 square feet per person, and after the 5,000-person layoff it announced this week, it will have 243 square feet per person. This is a negative trend, but these metrics point to opportunity.

Assuming CSC only needs the 177 square feet per person it had in 1998 – granted a high-level assumption needing vetting – CSC is going to have 66 square feet too much per person for a total of 4.9 million square feet of excess space. If all of this space could be jettisoned from the portfolio, at my estimate of $35 per square foot, this amounts to $170 million of potential annual savings. About $100 million of this would flow to the bottom line after taxes. If anywhere near this full potential were realized, even accounting for the costs of achieving it which I discuss below, this will add measureable value to the enterprise.

Now, it's unlikely that all these savings could be achieved. Consolidating people so space can be excised from the active portfolio is easier said than done. Things like adjacency needs for work processes and employee commute patterns cannot be ignored in an attempt to reduce costs. If people cannot be consolidated so space can be exited in chunks, no savings are possible.

To the extent consolidation can be achieved, however, savings would be visible much more quickly than you might think if you're not familiar with accounting for excess property and company acquisitions. While it might take a few years for cashflow benefits to show up because rent on excess properties keeps flowing out the door until the leases expire, the expense of excess property would immediately be taken out of P&L upon exit of the excess properties. This is in keeping with accounting standards designed to allow P&L to better reflect the underlying cost structure of the company. And while assets would have to be written-off and reserves would have to be established for excess property rents, these costs would likely never hit P&L. They would be folded into the purchase price, result in increased goodwill on the balance sheet, and would only hit P&L if the goodwill were later written down.

There would be a downside to the accounting, though. The reserves would show up as liabilities on the balance sheet, representing real obligations that would eventually have to be paid off, mostly in the form of rent on the excess properties less any sublease income that might be possible. Understanding the scope and scale of these excess property liabilities is where potential purchasers will have their work cut out for them.

The scope and scale of the excess property liabilities will depend on the structure of CSC's real estate portfolio, something that is not that evident from its 10K. Are offices near enough to one another to allow inter-office consolidations of employees so that large blocks of excess can be disposed? What are the lease lengths and provisions for cancellations for the property to be deemed excess? Do floor plans allow demising of space to sublet and are those spaces built-out so subtenants could use them without a lot of further investment? At what stage of the demand/supply cycle are markets in which the subletable spaces sit and will sublets be at a profit or at a loss?

So, getting back to the central issue: taking all this into account, can $1 billion of value be gained by consolidating and restructuring CSC's real estate portfolio? Very possibly. Using the potential savings of $100 million as a benchmark, and applying CSC's Forward P/E ratio of about 16, the enterprise value would potentially increase by $1.6 billion. Netted against this would be the liabilities of the excess property. A detailed plan will be needed to figure out exactly how much space can be exited, what percentage of the $100 million can be saved (and hence what percentage of the $1.6 billion of gross value can be realized), and what is the net value after accounting for the excess property liabilities. Creating and evaluating such a plan will be the task before each potential purchaser.

A final note: I haven't even talked about the potential inherent in the owned office portfolio of 3.8 million square feet which I'd speculate has a market value somewhere between $300 million and $800 million depending upon the degree to which it were leased-back. Some or all of this owned portfolio could be sold to help finance a purchase. And while past prospective purchasers probably understood that these assets could be monetized via a sale-leaseback, unless they dug deeper into analyzing how much of the office portfolio might not be needed, they would not have realized that some of the space would not have to be leased-back.

It'll be interesting to see how the CSC sale plays out. There have been other big M&A deals that have been dependent upon real estate, but these have been the purchases of retailers, such as the $6.6 billion buyout of Toys R Us, where the value and obligations of store leaseholds loomed large. As for the purchase of a non-retailing, non-real estate public company, though, CSC could be the first that is so dependent upon investors rolling up their sleves and examining what can be done with the real estate portfolio.