DDR Corp.: Time To Go Long

Summary

• Shopping center REITs, particularly lower end ones, have gotten battered recently.
• DDR Corp. has deep-rooted issues beyond the usual Amazon phobia: leverage, heavy Puerto Rican asset exposure, and continuous management shuffles.
• New management team in place has worked together in the past and seems to be leading the company on the right path.
• There is plenty that could go wrong here, but at 8x my estimate of 2017 FFO, the risk is more than reflected in the stock price.

DDR Corp. (DDR), like many shopping center REITs, has suffered from poor market sentiment over the past year. However, there is obviously more to the story, given share price declines have rapidly outpaced that of its peer group, with nearly all of that relative underperformance occurring this year. Yield chasers are out in full force; the distribution (for now) remains intact and is now more than three times what it was back in early 2013. What investor wouldn’t want to pick up a security yielding 8.5%? The question investors have to ask themselves is whether that distribution is safe and whether there is true alpha potential here, or is DDR Corp. just another example of a falling knife in an already troubled sector.

Business Overview, Recent Negative Developments

DDR Corp. is a self-managed REIT that focuses on open air shopping center development and leasing. In total, the company owned 106M square feet of gross leasable area (“GLA”) at the end of 2016, consisting of 317 shopping centers in total (nearly half through joint ventures). As far as asset quality goes, the company has been making a measured shift towards more expensive, higher-grade properties in recent years. Between 2014 and 2017, has disposed of a net of 74 shopping centers (170 sold, 96 acquired), but the purchase price of acquisitions outpaced disposals by $400M. Core tenants include TJX Companies (TJX), Bed, Bath & Beyond (BBBY), PetSmart (PETM), Wal-Mart (WMT), and Kohl’s (KSS), although no one tenant exceeds 4% of aggregate base rent. By and large, most tenants are healthy - or as healthy as one could hope to find within brick and mortar retail.

Issues stem from a couple of factors. The company’s Puerto Rico exposure is off-putting to many, and it isn’t immaterial: 13.6% of property level net operating income at DDR Corp. was generated on the island. Puerto Rico’s recent bankruptcy filing has nothing to do with the company, but it does point to the poor socioeconomic conditions present there. The country has been in a technical recession since 2006, and the citizens there have been suffering, bearing a heavy tax burden with poor overall economic opportunity. While most of the company’s tenants in Puerto Rico are American brands on some of the best real estate on the island, the question becomes whether these stores are profitable on a store level, and just how likely leases are to be renewed at favorable terms. DDR Corp., as part of its deleveraging process (more on that later), would love to be a seller of these assets, but cap rates are not favorable currently, and the company does not want to be a forced seller. If the company retains this asset as it sheds others within the continental United States that are much easier to find buyers for, overall exposure (as a percentage of retained assets) will only rise. It’s a tough situation to be in. Management is exploring all options, even creative ones like a spin-off, potential joint ventures (DDR Corp. owns 100% interests in all of its Puerto Rican properties), or mortgage financing. As Brad Thomas suggested in his own work on this company several weeks ago, Puerto Rico looks to be a dark cloud on the company that isn’t likely to go away anytime soon.

Secondly, DDR Corp. made several strategic investments with Blackstone in 2014 and 2015. Each of these joint ventures was structured with Blackstone holding the vast majority of control - DDR Corp. hold just a 5% interest in the common equity, which gives it very little say in overall direction in the joint ventures. For context, in 2014, DDR invested $19.6M in common equity and $300M in preferred equity to acquire 70 shopping centers for nearly $2B, with the company providing the leasing and management services. In return, the company has the right of first offer to acquire 10 of these assets. Similarly, in 2015, the two firms acquired six shopping centers, with DDR Corp. contributing a $12.9M investment in the common equity and $82.6M in preferred. In both cases, the preferred is set to pay 8.5% per year, which the company has been collecting.

However, in Q1 2017, DDR established a $76M valuation allowance for these two preferred investments. This is a non-cash allowance, so there is no immediate impact on company cash flow. However, as part of the setup of this allowance, the company will stop recognizing non-cash preferred dividends within interest income, which will impact the income statement (although no impact on funds from operations (“FFO”)). What matters most here is the structure of the deal. Under the initial terms, if the assets are liquidated prior to 2020 and 2021, the preferreds do not get preferential treatment (capital distributions made first) as they usually do. Blackstone, given its significant control, is actively pursuing the sale of these assets, despite an increase in cap rates since initiation. DDR Corp.’s expectation is that the company will liquidate the joint ventures prior to 2020 and 2021, and that the company will not make a full repayment on the face value of the preferreds - which means a GAAP loss on the investment as well as the loss of a non-inconsequential chunk of cash flows each year (near $20M annual). Put in terms of cash flow/share loss, this will be about $0.05-0.06/share in impact once the joint ventures are liquidated, although the company will recover most of its preferred investment, which it can use in deleveraging efforts. Keep in mind that DDR Corp. already excludes preferred share dividends from its funds from operations (“FFO”) calculation, so there is no impact there.

Not to stop the hits from coming, but the company is also dealing with some tenant issues. Sports Authority filed for bankruptcy late in 2016, and the company did have a fairly strong relationship with DDR Corp., leasing 13 locations. One year later and DDR Corp. has re-leased five locations since then, which isn’t exactly an expeditious pace. hhgregg filed for bankruptcy this year (12 locations, only two re-leased so far), and Golfsmith filed late in 2016 (three re-leased, three still in early stages of finding new tenants). Gander Mountain recently filed for bankruptcy as well, which has two stores in the portfolio. So while overall individual tenant exposure is low, in years where the company is having problems like this, it is going to have a strong negative impact on net operating income (“NOI”). In most instances, DDR Corp. is going to eat some capital expenditures to prep these locations for new tenants, and in today’s market, it can be a little slow to find new tenants for large square footage space. This is a prime reason for the guidance of negative NOI growth this year from management.

Balance Sheet Health

DDR Corp. has much higher leverage than most of its peer group; the company carries $4.5B worth of debt on its balance sheet, with another $440M of proportionate share in off balance sheet joint venture debt. Consolidated net debt/EBITDA is in the 8x range, which even in an industry known for leverage, is extremely high. To be fair, it isn’t current management’s fault that the company is in this situation: CEO David Lukes, COO Michael Makinen, and CFO Matthew Ostrower all joined the company this year in March after the Board took an axe to the leadership team. All three of these individuals come from Equity One (EQY), a retail developer that was taken out via merger this year, so they have experience working together. As a side note, I view this change as a positive. DDR Corp. has struggled to find top talent and retain it, and constant executive shuffling has most likely been a contributing factor for the company’s years-long struggles.

The new team here recognizes that less debt means less risk, and that today’s environment is not one that looks to be a market to be buying in given where cap rates are. There are costs to deleveraging, but management has stated that it will be careful to do so without significantly impairing value (meaning FFO/share). Expect management to press to get rid of secured debt via refinancing, as well as strengthening the maturity ladder. Measures here have already been taken, given the maturity of the sole secured term loan the company held ($200M), as well as the unsecured term loan ($400M) and a senior note maturity that occurred this year. Initially, this debt got thrown into the company’s revolving credit line, but since then the company issued $450M in unsecured senior notes due in 2027, and investors should expect another senior note issuance sometime this year, most likely on a shorter term (2023-2024 would be my guess). Given that DDR Corp. currently bears some of the highest risk premiums on these unsecured bonds compared to peers, the market is in a clear “show me” status, and I suspect that this premium will remain persistent even during the deleveraging process. Tracking asset sales through the rest of the year will be of utmost importance to investors in the common equity as well as the bonds, particularly sale impact on cash flows.

Suspension Of 2017 Guidance

Management has taken the step not to give FFO/share guidance, which is going to send most risk-averse investors into a tailspin. This is due to the unknown pace of asset disposal, with cash being directed towards leverage. Unfortunately, management hasn’t spoken to a leverage target, although it would need roughly $1B in sales to get numbers down toward the median of the peer group, which seems too heavy to be accomplished over the course of this year; $500M (net of acquisitions) seems more than attainable. Sales in that level, coupled with eventual recovery of funds from the preferreds, would be a wonderful start. There is some guidance on same-store NOI: -1.5-0% including the Puerto Rican assets. Numbers would be incrementally positive excluding Puerto Rico, and in the 2-3% range excluding the pressures from properties that are exposed to tenant bankruptcies. Occupancy rates are guided down to 93%, down 150 bps from year-end 2016.

Given the culmination of all the factors here, it should be clear that the $0.31/share in FFO run rate in Q1 is not sustainable. That isn’t necessarily a bad thing, given the distribution is $0.76/share; DDR Corp. can afford some contraction in distributable cash flow. To me, $1.10/share looks like the number this year, and, provided the Puerto Rican assets are not in far worse shape than I’m modeling, that marks a reasonable call for a bottom in FFO/share. I haven’t nibbled in brick and mortar real estate, but this looks to be as good a place as any I’ve found in the space, so I’ve recently initiated a position on the long side. Fair value for the sector to me would be around the 12x range, which is still well below most other REIT sectors. There is a mixed bag of valuations within the space; other slightly distressed players in the space like Brixmor Property Group (BRX) trades at 8.7x 2017 FFO while slightly stronger players like Retail Properties of America (RPAI) trades at 12.5x 2017 estimates. A 10.5x multiple seems more than reasonable, which puts fair value at the $11.50/share range, or 28% upside from today’s prices.

Analyst’s Disclosure: I am/we are long DDR. 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.