Taking Out The Trash: Washington Prime Is No Different

| About: Washington Prime (WPG)

Summary

After the dividend cut, CBL and WPG yield 14.5%.

WPG is not safer than CBL.

Sales per square foot must not be understated in importance.

I debunk the "slow fundamental decline" thesis.

Just avoid these names and buy best of breed instead.

(Time)

Introduction and summary

After lower tier mall REIT CBL (CBL) cut their dividend by 24.5% after their earnings release, Washington Prime Group (WPG) saw their shares slide by more than 12%:


(Google Finance)

I have seen it written many times by both authors and readers that WPG has the better portfolio of assets and thus should not suffer the same fate as CBL. Both of these companies are operators of lower tier malls as defined by sales per square foot. Is it true that WPG is significantly much better? Investors should not downplay the importance of sales per square foot and should realize that WPG is by in large in the same boat as CBL. I advise investors to stick with quality, with my personal favorites being Simon Property Group (SPG) and Federal Realty Trust (FRT).

The price action shows a correlation

(Google Finance)

For the majority of the past year, CBL and WPG traded at almost the exact same price per share. Now, after CBL's precipitous drop after their earnings report, they both trade at almost the exact same dividend yield 14.5%. Despite the claim that Washington Prime has better properties, Wall Street seems to believe that they should be valued very similarly, why is that?

A look at some key metrics

(Chart by Author, data from CBL Q3 Earnings and WPG Q3 Earnings)

On a cursory glance, WPG does not seem much better. Sales per square foot are comparable, occupancy rates are about the same, and both companies priced their recent bonds at the same interest rate.

Further, both have seen rather dramatic downward hits to FFO in 2017:

(Chart by Author)

As far as I see, the main difference with WPG is that it has not yet cut their dividend. Recall that CBL cut their dividend in order to spend more on redevelopments and to pay off debt.

Readers should note that WPG, like CBL, is spending heavily on redevelopments as seen by their recent capital expenditures numbers:

WPG FFO vs. Capital Expenditures (in 000's)

(Chart by Author, data from 2016 WPG 10-K)

On November 6th, 2017, Standard & Poor's downgraded CBL & Associates Properties Inc. from BBB- to BB+. Note that this is the parent company of the limited partnership (common stock) which was maintained at BBB-. They stated that this was due to the increasing rent concessions that were needed to stop occupancy declines (S&P). Special thanks to sometimeslongsometimesshort for alerting me of this.

With this downgrade, the cost of borrowing is increasing for CBL. CBL's latest notes were initially priced with a 5.95% interest rate. They recently traded hands at 6.6% YTM.

(FINRA)

Washington Prime has not experienced this kind of credit downgrade...yet. However, it is not really out of the woods, as Moody's has said that malls with sales per square foot less than $400 have the most credit risk, and they named CBL and WPG specifically in this release (Moody's).

Why does sales per square foot matter? I hear many investors saying that "there is a place for B malls" and that this is not a zero sum game. While there is some truth to this, I believe that many investors are downplaying the importance of sales per square foot as a differentiator between lower and higher tier mall REIT operators. Trapping Value wrote a great article about sales per square foot, saying that malls can distort this figure by adding certain stores (like an Apple store): The End Of All Non-A Malls? Painting With Too Broad A Brush. I wish to reopen this debate.

A simple illustration why sales per square foot matters

From the third quarter press release, CBL stated that tenants had sales per square foot of $373. Readers may be familiar with the magic $500 psf number which separates higher quality and lower quality malls. Investors should not gloss over this distinction lightly, as this is gives great hints into which malls will be most likely to offer rent concessions.

We can calculate the approximate average minimum rent per square foot using the following chart from the 2016 10-K:

(CBL 2016 10-K)

A comparison with top tier Simon Property Group (SPG) is found below:

(Chart by Author, data from SPG 2016 10-K and CBL 2016 10-K)

Readers may see that for both CBL and SPG, average base minimum rent is about 8% of tenant sales. This means that rent affects tenants in both malls equally, right?

Not quite. For retailers with large fixed costs, stores with lower sales will show much lower profitability (and perhaps not be profitable at all).

The following exercise is an illustration for just how different this profitability might be.

Using Limited Brands (LB) as an example, we can see their breakdown of sales to operating income from their 10-K (in millions):

(Chart by Author, data from Limited Brands 2016 10-K)

Let's assume for this example that these numbers represent stores at a Simon property. What would they look like for stores at a CBL property?

If we multiply net sales, base rents, and cost of goods sold by 373/614 (CBL sales / SPG sales), we arrive at the following (in millions):

(Chart by Author)

The difference is alarming - Limited Brands in this hypothetical scenario would not profit in CBL malls.

I want to emphasize that G&A and store operating costs will fluctuate based on the different revenue, especially when it relates to advertising and promotions. However, things like employee salaries and store operating costs will be much more fixed in nature between a lower and higher tier mall. The point of this illustration is to show how lower store sales affects retailers with higher fixed operating expenses.

While I am sure that the tenants in CBL's malls are not all operating at losses (yet), it should be clear that the lower sales per square foot indicates that they are definitely operating at lower levels of profitability than at Simon.

We can have a look at the operating expenses as a percentage of net sales for key tenants:


(Chart by Author, data from Morningstar)

These retailers all show varying levels of operating expenses, but we can better understand now why Ascena is showing such distressed financials and is closing stores left and right.

But Washington Prime has lower base rents!

In their 2016 10-K, WPG lists their average minimum rent per square foot:

Notice that this is much lower than the $32 figure reported by CBL, about 33% lower. One way to look at this is that WPG has less reasons to offer rent concessions than CBL due to lower existing rents. However, if I instead present the data in the following manner:

(Chart by Author, data from CBL, WPG, SPG 2016 10-K)

We can see that the difference between CBL and WPG with regards to potential rent concessions looks like a rounding error using this metric. When we determine potential rent stress based on net sales subtracted base minimum rent, we can see clearly the importance of having a higher store sales per square foot. Simon would have to raise their rent almost 500% before its tenants are seeing the same level of distress as CBL and WPG.

Again, this is mainly for illustration and that magic number for rent distress will vary.

The key takeaway from this is that WPG and CBL must find a way to improve their store sales per square foot. The current promotional atmosphere lowers gross margins making the situation even more dire for these retailers.

Debunking the "slowly dying but cheap enough" thesis

The main investment thesis that can be framed for buying CBL and WPG is as follows:

B mall operators will not die out so fast. Investors in this case are hoping that the large dividend yield will compensate for long term business declines. After all, 14.5% dividend is nothing to sneeze at!

This does sound good and it is an easy thesis to get behind, but let's stop to think about what this would mean business wise for CBL and WPG:

(by Author)

This is the cycle that best describes this investment thesis. If we agree that they will see long term steady declines, then they must ensure that occupancy rates remain steady. When retailers are struggling, the only way this is possible is through rent concessions. Then through a combination of rent concessions and redevelopment spending, their financial stabilize, until retailers start struggling again. Finally, the cycle continues.

There are two principle problems with this. First, as we saw above, this cannot happen forever - the cycle ends immediately when retailers simply cannot operate profitably. Second, they do not have unlimited rent concessions to give. At some point rent is free - certainly we should not expect CBL and WPG to pay their tenants to be at their properties? Further, what is to expect of the dividend at that point?

Similarly, we cannot assume that the bleeding will eventually simply stop and financials will stabilize because rents are low enough for retailers to operate - again, as we saw above, lowering sales and lowering rent hurts operating margins at tenants. If retailers are already suffering now, does it really make sense to expect stability at even lower sales?

With this investment thesis fully explained, we can now understand why 14.5% dividend is simply not enough to compensate for the risks. The end (bankruptcy) comes sooner rather than later (sales per square foot are already low, as are base rents per square foot). If I were investing in CBL or WPG thinking that they are going to have this fate, then I require at least a 20% dividend yield (I am specific about dividend as opposed to free cash flow in this case because management may use retained earnings are as good as null here). That would put CBL and WPG at $4/share and $5/share, respectively. And that would be the price for a nibble.

In my view, the only successful outcome is if they manage to increase their sales per square foot consistently on a long term basis. How likely is this outcome? If even after all these years, sales per square foot are still so low, why should we believe that they will suddenly turn for the better, especially at the highest peak of retail difficulty and with the rise of e-commerce and the Amazon monster? Would this really be logical investing? Or would it be dreaming? I call it gambling.

There is one thing that CBL and WPG can do that would make me consider buying their shares for this thesis: that would be deliver on management promises about redevelopments and continue driving sales per square foot. Seeing is believing. I would advise investors to wait until sales per square foot increases for several quarters and breaks a certain threshold, perhaps $420/foot.

Best of breed is playing offense

Let's compare CBL and WPG with two ultra-high quality operators Simon and Federal Realty.

We first look at 2017 projected performances:
(Chart by Author)

As well as their current valuations:

(Chart by Author)

Income investors may be tempted by the fat yields on CBL and WPG, but we saw that this yield is extremely volatile (CBL just cut their dividend by 24.5%). Furthermore, their dividends are not fully covered based on FFO - capital expenditures (including redevelopments). I covered that in my article, CBL: Wall Street Isn't Stupid.

In the cases of Simon and Federal Realty, they both have their growth levers in place to grow their dividends 7-10% in the next coming years and at least 5-7% in the long run. They are already priced to deliver market crushing returns by earnings alone, without any of the risk seen in CBL and WPG.

Last week Friday, rumors circulated that GGP (GGP) may be taken private by Brookfield Asset Management (BAM). I took advantage of this rally to sell CBL and WPG and use these proceeds to purchase more SPG and FRT. Investors mustn't think that CBL and WPG may also be taken private. If investors do not want to buy their common shares at these prices, why would anyone want to take them private at a higher price? It is possible to speculate that CBL and WPG might be able to reposition their malls for different purposes, such as office buildings or residential buildings. While this is possible - this is pure speculation and the price is not right for such a thesis.

Conclusion

It is true that the "malls are dying" thesis is overblown. Still, investors must realize that overblown does not mean false and that there are real risks to lower tier malls CBL and WPG. I would advise against anyone investing in these with the mindset that fundamentals can decline slowly forever - I showed that this is unsustainable. Avoid the drama, bite the bullet, and stick with best of breed.

Author's note:

If you liked this article, please follow me! There are definitely bargains to be found among high dividend yield stocks, but one must filter carefully to avoid the traps. And, there surely are lots of traps!

Disclosure: I am/we are long SPG, FRT.

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.

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