CB Richard Ellis Group, Inc. (CBG)

For someone who has been bullish on a lot of commercial REITs, you might think that I would have a positive outlook for CB Richard Ellis. If you thought that, you'd be wrong.

While I'm not bullish on all REITs (just the quality ones without excessive leverage, good holdings, and profitable outlooks moving forward), I am not bullish on commercial real estate. Rather, my favoritism for REITs like Winthrop (FUR), Brandywine (BDN), and Lexington (LXP) comes from the fact that the stock prices reflect huge drops from the book values of their properties. Those properties also often end up understated on balance sheets due to the accounting treatment of assets.

CBRE, on the other hand, has very little RE holdings on their balance sheet. Their B/S consist more of receivables, goodwill, and various other items. The goodwill account is MASSIVE! For those not in the know, "goodwill" is simply an accounting concept. It shows the premium a company paid to acquire other companies. This "premium" is pretty much meaningless if the cash flows don't hold up in the future. Once you discount the massive goodwill account, you'll find that CBRE has about -$3.50 in net tangible assets. Note the minus sign in front of that figure.

Just to add fuel to the fire, CBRE's profitability has been severely impacted by the current downturn. They've gone from earning nearly $1.65 per share (in FY '07) to something closer to $0.80 - $1.00 per share (normalized FY '08). Their most recent quarter was downright ugly with a 0.006% operating margin. Things might only be worse moving forward. At the very least, I'm not totally convinced that they'll ever see a fiscal year with $1.35+/share earnings soon.

Then there's another little tidbit. CBRE recently completed an offering for senior subordinated notes. That will help them pay their bills, but check out the interest rate on that offering: 11.625%!!!!! That's really high and I question how a real estate services firm can stay profitable with such an extremely high cost of capital. And it's not like they didn't have a lot of debt to begin with! Long-term debt to equity is 6.41 even if I count goodwill to ascertain that ratio. And remember, goodwill is sky high! In reality, CBRE has negative equity.

All the same, there's still some possibility that CBRE is undervalued. If they could average $1.25 per share in free cash flows with a 3% growth rate in the future, I value them at around $10 with a 12% cost of capital. Costs of capital could also decrease in the future, which would drive that valuation up significantly. With a 10% COC, I come up with a $13.60 valuation.

Despite the risk that I outline above, I don't like CBRE's outlook moving forward and I don't like the fact that I see large insider sells lately. Yet, the stock is up nearly 14% today! Seems to me that upside here is somewhat limited and downside is still very significant. Moreover, I believe the rest of the market is undervalued by a bit. Given this, I believe that CBRE is an excellent underperform pick.