Dividend Raised, Beat On FFO, Strong Growth From 5% Yielding REIT

Summary

• On the fundamentals, Simon Property Group delivered an excellent quarter.
• They saw growth in sales for tenants, growth in rent, beat on FFO, raised guidance, and raised dividends.
• SPG’s success is contrary to the narrative surrounding retail.

Simon Property Group (NYSE:SPG) delivered an excellent third quarter. Q3 FFO comes in at $2.89 per share. That’s up from $2.70 per share a year ago and beats estimates of $2.87. New guidance for the year comes in at “$11.17 to $11.22”. The old guidance was "$11.14 to $11.22”. Simon’s guidance for FFO includes negative non-recurring impacts of $.36 for the extinguishment of debt in Q2 2017 which would be stripped out in AFFO. The dividend goes up to $1.85 from $1.80 in the prior quarter. The market reacts by dropping SPG about 3.8% (as of writing). SPG’s performance should be a huge positive factor for the sector since it is the largest mall REIT by a substantial margin. On the earnings call, transcripts not yet available, SPG’s management referenced retail sales figures stating “…absolutely an underreporting going on”. They are arguing that the transition to online sales is not as fast as it seems because tenants have an incentive to report their transactions as online sales.

Latest Figures

Time to break down the latest developments for SPG:

Occupancy is up slightly since last quarter (95.3% at September 30, 2017) and the base minimum rents are up 3.3% since last quarter and nicely year over year. The leasing spreads were solid at 11.2%, which reflects the growth in rent on new contracts compared to expiring contracts.

The dividend increase might have been tied to wanting to reach a nice even 10% growth in dividends. Otherwise, I would think using that little bit of capital for more buybacks might be more effective. I won’t complain, this still works, and given the prevalence of shorting mall REITs, having a smooth 10% increase might scare a few of the investors who wanted to short the stock.

FFO Reconciliation

Let’s get into the FFO numbers:

This is great. I see no problems. SPG’s reconciliations are top notch. High accounting quality is practiced at SPG. While a few REITs will try to inflate their numbers, SPG does no such thing. They don’t even stress that investors could be using AFFO to adjust for that $.36 charge in the second quarter that came from debt restructuring.

Overview for Simon Property Group

The overview looks solid. Credit ratings are good and the ratios are conservative. SPG uses a strong balance sheet.

For their debt covenants, they use a 7% capitalization rate. I’ve seen this in other mall REIT debt covenants as well. I believe there are relatively few malls in SPG’s portfolio that would sell at a mere 7% capitalization rate. Most will be valued materially higher. However, the debt covenants were designed this way to protect the lenders from any declines in asset values. SPG easily clears the hurdle.

More Financial Metrics for Simon Property Group

When we switch to using other metrics such as debt to total market capitalization, SPG continues to show a conservative capital structure. This is despite the mall trading for less than its net asset value. If SPG got to compare debt to the total appraised value of their malls, rather than using a 7% capitalization rate or using the current market capitalization of the stock, the leverage ratio would be even lower.

Spreads on Leasing Space in Their Malls

The spreads this quarter were down compared to last quarter (rental revenue growing slower), but they were still solid:

They still got a reasonable spread on the leases and we’re seeing sales per square foot and rental rates per square foot increasing. Both gains were around 3%. Remember, on the earnings call, management indicated they were confident sales were being underreported. That was a big statement and it suggests that sales per square foot are actually growing faster than we would expect.

Capital Expenditures for Simon Property Group

The mall REITs have 3 potential uses for FFO. They can pay dividends, repurchase shares, and perform capital expenditures. SPG has repurchased some shares, but it is a relatively small use of their capital. Primarily, they are paying dividends (65% of FFO) and investing in developing their properties (about 30.5% so far this year).

Capital expenditures for the JV are up slightly year over year, but the capital expenditures on consolidated properties is down around $90 million. To put these numbers in perspective, FFO for the first 3 quarters is $2.7 billion. Capital expenditures attributable to SPG (consolidated properties + their share) is about $838 million.

They are paying out 65% of FFO for trailing twelve months. Capital expenditures so far this year come to around 30.5% of FFO. That looks solid. SPG is very capable of covering both without putting the company into additional leverage.

Net Debt to Net Operating Income

This metric is very similar to using debt to EBITDA. It strips out some management overhead, but SPG’s operations are extremely efficient at reducing overhead. For SPG, this comes at 5.6x. Anything near 6x or lower is a relatively low level of leverage for a mall REIT. Metrics over 9x are very high.

Factors Driving Share Price Lower Today

There were a few negative developments recently for mall REITs and they sent share prices materially lower despite SPG’s very solid performance.

The Amazon (AMZN) impact weighted heavily on the mall REITs today. Amazon smashed estimates. While beating on earnings is nice, they also thoroughly beat on revenues. While their revenues were up substantially, the growth included the inclusion of Whole Foods Markets for $1.3 billion in sales and the growth in their Amazon Web Services. Consider that the growth was heavily influenced by those two factors:

1. Owning physical retail stores.

2. Growth in Amazon Web Services which is a platform that does not compete with malls.

Here is an excerpt from the release:

“Amazon Web Services (AWS) announced that the following customers are going all-in on AWS: Toyota Racing Development, one of the most accomplished and acclaimed engineering companies in motorsports; and Randstad, a leading global HR services company. GRAIL, a life sciences company whose mission is early cancer detection, Hulu, and FICO all selected AWS as their cloud provider. AWS was also named the preferred cloud provider for General Electric (GE) as it undergoes one of the largest and most important digital transformations in its history.”

The J.C. Penney (JCP) impact was present as well. JCP slashed their outlook. In early trading, shares were down 21%. Their FQ3 (fiscal quarter 3) adjusted EPS to be a loss in the range of $.40 to $.45, which is more than twice the previously anticipated loss.

My wife adds, “J.C. Penney, Macy’s (M), and Kohl’s (KSS) all have sales this weekend. I thought I might not have time for all of them, so I figured J.C. Penney comes last.”

Conclusion

SPG’s results were great, but the sector was far more interested in the results from AMZN and JCP. Even SPG’s price movement on their own earnings release was dominated by those external factors. On the fundamentals, SPG delivered an excellent quarter. They saw growth in sales for tenants, growth in rent, beat on FFO, raised guidance, and raised dividends. This is basically everything fundamental investors could be asking for. It also runs directly contrary to the narrative that all retail is dying. SPG was still able to lease their space. They maintained high occupancy. They did it all while raising rents.

This is great news compared to the prior release from Washington Prime Group (WPG) which showed declining sales per square foot. WPG’s sales per square foot metric suggested many retailers should have terrible performance on the quarter. SPG’s results were much better, but that is also part of the reason for SPG commanding a much higher valuation.

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Analyst’s Disclosure: I am/we are long SPG, WPG. 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.

No financial advice. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. CWMF actively trades in preferred shares and may buy or sell anything in the sector without prior notice. Tipranks: Buy SPG.