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Tarragon's Bitter Taste

The housing developer faces myriad financial issues that have shorts piling into the stock.


Tarragon Corp.'s


investor day at its New York City office last week, the housing developer's bow-tied chief executive, William Friedman, pitched his company as one of the bigger value stories being missed by the

stock market today


The solution to creating value, he said, is to separate the apartment and homebuilding divisions into two separate companies.

To back up his claim, Friedman pointed to several slides with fancy pictures but unaudited financial results, since the company was delinquent in filing its annual report. Tarragon's chief financial officer, Erin Pickens, was nowhere in the room to answer questions.

This lack of clarity is no surprise to those who follow the $300 million market-cap company, which builds condos and apartment buildings in the Northeast and Florida. Short-sellers say the reason the CFO is usually missing is that Friedman is running Tarragon as an overly complex and financially tenuous enterprise that only he can explain.

Helping some of the shorts' claims is the fact that Pickens, who is based in the company's Dallas office and not the New York City headquarters, has said a total of eight words on the company's past two quarterly earnings calls.

Hedge funds have piled into the stock over the past year, creating a 22% short interest in the company. The shorts also say that Tarragon could be facing near-term liquidity issues. The company has a debt-to-equity ratio of 5, compared to 2 at

WCI Communities


, another troubled Florida condo builder.

Friedman himself has a tarnished past. He was barred from the savings and loan industry by the Office of Thrift Supervision in 1994 for his involvement as vice chairman of Southmark Corp., a real estate investing fund that went bankrupt in the early 1990s.

Several of the larger short-sellers of Tarragon, who spoke on the condition of anonymity, portray Tarragon as a case of "where there is smoke, there is fire."

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"I know how this ends, I just can't tell you when," says one short, who says he made a fortune betting against Friedman and Southmark in the late 1980s.

Friedman -- who, with his family, owns about 50% of the stock -- is well aware of the short interest.

"I think it takes someone with brass balls to short 3.5 million shares of my company's stock. If I were in that position I would be spreading false rumors like crazy," Friedman told

in a recent interview, referring to the overall short interest in the company.

As for Pickens, the CFO, Friedman says she is based in Texas because the company's property management division is based there. He says she wasn't present at the investor day because she was working on the company's annual report, which was filed late Monday. The report had been delayed due to

Securities and Exchange Commission

"comments" about the proxy filing tied to the company's spinoff.

Pickens didn't return a call seeking comment for this story.

Numerous Issues

The shorts have many allegations about Tarragon's financial position. The primary one is that the firm is facing near-term liquidity issues and is rapidly selling apartment buildings because lenders have a gun to the company's head.

Moreover, Tarragon's homebuilding business, which has heavy exposure to the Florida condo market, could be in worse shape than the company is saying. Short-sellers believe the projected $14 book value of the division is in jeopardy of being marked down further.

The bears also say that Tarragon's apartment division is worth less than the $1.1 billion, or $7 per share, that Friedman has been pitching to investors.

Tarragon's stock has fallen from a high of $29 in July 2005 to its current price of about $10. The company's unaudited net income slid 88% in 2006 to $10.2 million, mostly because of impairment charges and slower closings at the company's troubled Florida condo business. The apartment division has held up better but has hefty debt payments.

Besides Friedman, it's hard to find vocal bulls on Tarragon. Neil Barsky, manager of Alson Capital Partners, the company's largest shareholder besides Friedman, declined to comment about the stock. Corsair Capital, another major shareholder, also declined to comment. The investment firm recently dumped 18% of its position after Tarragon said it would not file its annual report on time.

No Wall Street analyst follows the company, partially because it is so difficult to model. Alex Barron, a homebuilding analyst with JMP Securities, said he looked at the stock about two years ago but found the accounting tough to grasp.

"Conceptually it sounded good," Barron says, referring to the condo development story, but he shied away from covering it because much of Tarragon's homebuilding results were determined by percentage of completion accounting, which makes it difficult to forecast earnings. Percentage of completion accounting lets a builder book profits as a condo project is built, but before units are delivered.

Fellow builder

Toll Brothers

(TOL) - Get Toll Brothers, Inc. Report

also uses this method of accounting for its condo business, but it is a much smaller piece of Toll's overall operations.

Cash Questions

Tarragon has a history of restatements and late financial filings. Last year, the company restated its results to bring its large "Ansonia" portfolio of properties onto its balance sheet. Keeping it off the balance sheet allowed the company's debt to look lower (even though Tarragon owned 90% of the joint venture).

In Monday's 10-K filing, Tarragon reported a material weakness in its internal controls over its financial reporting. The company's auditor, Grant Thornton, said Tarragon's financial and accounting organization is too dependent on a few key personnel. This deficiency contributed to the errors requiring Tarragon to restate its cash flows for 2004 and 2005, the auditors said.

Besides the accounting issues, the most pressing question is whether Tarragon is facing a cash crunch.

Tarragon ended last year with $23.5 million of unrestricted cash. That's down from $29.1 million in the third quarter and $39 million at the end of 2005.

The company historically has relied on homebuilding sales to create cash for paying its large debt load. With the condo business slowing, Tarragon lately has focused on selling some apartment assets to raise funds.

In January, Tarragon closed on the sale of Newbury Village, an apartment complex in Meriden, Conn., for $30.3 million. The company netted $10 million of cash proceeds, reduced its debt by $20 million and recorded a pretax profit of $2 million.

Bears on the stock wonder why the company decided to face a tax hit on the sale, which likely reduced the net profit to $1.2 million, rather than refinance the property and hold it to create long-term value.

A person involved in the Newbury transaction says there was a sense of urgency on Tarragon's part. Sale books on the property went out around Thanksgiving of 2006, and Tarragon was looking to close by the end of the year, this person says. "They preferred to have the cash in the property, even though it was a trophy property," the source says.

The construction loan on the Newbury property came due at the end of last year.

Tarragon also is selling a project in Hoboken, N.J, that originally was eyed for condo development, but is now being offered as an apartment building. Incidentally, the construction loan on this project also comes due at the end of this year.

Friedman defends both sales. Referring to the Hoboken project, he says, "How is it a sign of weakness for us to sell it in entirety to a rental investor who is willing to pay more for it than we could get selling in today's market as condos?" he says.

Another piece of the liquidity puzzle regards the line of credit Friedman extends to the company. The end of last year was the first time there was a balance on the line, with Tarragon owing Friedman $10.4 million, according to financial filings. In March of this year, Tarragon raised the credit line from Friedman to $40 million, up from $30 million last year, and $20 million in 2005, according to the filing.

On Tarragon's recent fourth-quarter conference call, Friedman said the credit line is appropriate. Given that he and his family own about 50% of the company, Friedman said his family's "future is so entwined with that of the company that we feel it's appropriate to lend our support to the company, and I think the banks are very happy to see that."

Another issue altogether is how that credit line to the company is being funded. Friedman, in an interview, confirmed that he has pledged some of his personal stock into a margin account. He declined to specify if he had been using the borrowed funds from the margin account to fund the credit line or his own share purchases.

"I have some margin debt. Whether it was used for that or other things is really splitting hairs," he says.

The issue is interesting since Friedman has not been in the open market purchasing stock of late, even though he publicly says the stock is undervalued. If Tarragon's stock were to drop in value, Friedman could be facing margin calls on his brokerage account, which may affect his ability to lend to Tarragon.

Vexing Valuations

Tarragon's homebuilding business also has its own set of problems. Although Tarragon's newer condo projects are focused in areas of New Jersey near New York City, the company continues to sell its Florida condo and town house projects at discounted prices.

The $14 book value that the company says its homebuilding division will show after the spinoff doesn't take into account the potential for additional land impairments. In the fourth quarter, Tarragon booked $26.3 million of land impairments, but didn't specify the communities.

The apartment side of the business, which will be called "Sage" after the planned spinoff, has its own question marks.

Tarragon says Marcus & Millichap, a national brokerage firm, valued the properties in the portfolio at $1.1 billion, or $7 per share. The properties carry a negative book value because of accumulated depreciation.

The analysis used projected net operating income of $72 million for the Sage properties, and the analysis concluded the properties would sell for an average 6.4% cap rate, or initial rate of return.

However, Friedman admitted at the investor day that the NOI estimate will not necessarily be met, since the company will continue to sell buildings this year. Several developments are also coming online. Thus, trying to pinpoint the value of the Sage division is not a simple task. The apartment portfolio division posted $47.4 million of NOI in 2006. Average monthly rents on the properties are $889, among the lowest of public apartment owners.

On the fourth-quarter earnings call, Friedman said the Sage division will initially be cash-flow negative, assuming no refinancing or sale transactions. The issue is that the NOI of the portfolio is being eaten up by large debt payments and capital expenditures to maintain the properties.

The Sage division, centered in Connecticut and Florida, also is being stuck with a portfolio of several apartments buildings that Tarragon overpaid for in 2005 at the height of the condo mania boom.

Those buildings could no longer be sold at a profit as condos. Rather than take a writedown on those projects, Tarragon switched them into apartment rentals, and the properties remain unprofitable.

Add it all up and Friedman's numbers say the stock is worth at least $20. Value investors seem to have bought into this hype.

So far, the shorts are winning.