Simon Property: Fundamentals Solid, Shares Pricey

| About: Simon Property (SPG)

Summary

Fundamentals at Simon Property continue to move in the right direction, and management has raised its guidance a number of times in the past several quarters.

The company expects to achieve "industry-leading" FFO and dividend growth in 2016. Both metrics have increased at a mid-to-high teens compound annual growth rate since 2010.

The REIT cut its dividend and earnings forecast in 2009 at the depths of the Financial Crisis. Simon Property is still very dependent on healthy consumer spending and job creation.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Simon Property's Investment Considerations

Investment Highlights

• Simon Property (NYSE:SPG) develops and manages retail real estate properties, which consist primarily of malls, Premium Outlets, The Mills, and community/lifestyle centers. Its properties contain an aggregate of approximately 240 million square feet of gross leasable area. It was founded in 1960.

• Simon Property has had strong financial performance coming out of the depths of the Great Recession. Funds from operations and dividends per share, for example, have both increased at a mid-to-high teens compound annual growth rate since 2010.

• Investors should be cognizant of Simon Property's past. The REIT was forced to cut its dividend and earnings forecast in 2009 at the depths of the Financial Crisis. Though it has come a long way since then, the entity is still very much dependent on healthy consumer spending and job creation.

• Simon Property issued full-year 2016 FFO guidance in the range of $10.70-$10.80 per diluted share. The company expects to achieve "industry-leading" FFO and dividend growth in 2016 following nice increases in 2015. Executing on its priority to optimize results across its global portfolio of malls will be key.

• Simon Property's guidance for 2016 is based on the assumption that comparable net operating income for its portfolio malls, outlets and mills will be at least 3.5%, and total net operating income growth will be more than 6% for the entire portfolio.

• Fundamentals at Simon Property continue to move in the right direction, and management has raised its guidance a number of times in the past several quarters. We continue to like what we see.

Business Quality

Funds From Operations Analysis

Simon Property's FFO expansion has trailed that of its peer group but has been greater than that of its industry group during the past three years. We expect the firm's FFO to trail its peer group but outpace that of its industry group during the next five years. Federal Realty (NYSE:FRT) sports the highest expected FFO growth rate among peers, but we caution investors on the latter given that it's trading at more than 25 times this year's funds from operations.

Valuation Analysis

This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

Our discounted cash flow model indicates that Simon Property's shares are worth between $158-$238 each. Shares are currently trading at ~$208 per share, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $198 per share represents a price-to-earnings (P/E) ratio of about 22.2 times last year's earnings and an implied EV/EBITDA multiple of about 23.2 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 6.6% during the next five years, a pace that is higher than the firm's three-year historical compound annual growth rate of 4.2%. Our model reflects a five-year projected average operating margin of 54.9%, which is above Simon Property's trailing three-year average.

Beyond year five, we assume free cash flow will grow at an annual rate of 2.3% for the next 15 years and 3% in perpetuity. For Simon Property, we use a 7.5% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $198 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

In the graph above, we show this probable range of fair values for Simon Property. We think the firm is attractive below $158 per share (the green line), but quite expensive above $238 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Simon Property's fair value at this point in time to be about $198 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Simon Property's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes also is subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $226 per share in Year 3 represents our existing fair value per share of $198 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

Simon Property issued full-year 2016 FFO guidance in the range of $10.70-$10.80 per diluted share, representing 9%-10% growth compared to 2015 FFO. The company expects to achieve "industry-leading" FFO and dividend growth in 2016 following nice increases in 2015 (both metrics have increased at a mid-to-high teens compound annual growth rate since 2010). Executing on its priority to optimize results across its global portfolio of malls will be key in reaching these targets in 2016.

However, investors should be cognizant of Simon Property's past. The REIT was forced to cut its dividend and earnings forecast in 2009 amid the depths of the Financial Crisis. Though it has come a long way since then, the entity is still very much dependent on healthy consumer spending and job creation. Though Simon Property's fundamentals are moving in the right direction, we prefer other REITs such as Realty Income (NYSE:O). Simon's Dividend Cushion ratio is 0.9, and it currently registers a 7 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: O is included in the Dividend Growth Newsletter portfolio.