Washington Prime Group (WPG) is underestimated. Share prices were decimated by a combination of blind index selling, stagnating revenue growth, high debt levels, and fears about retail. They're down 25% from last year, and it was drastically undervalued back then.
Will WPG Go Bankrupt?
WPG has roughly $3 billion in consolidated debt according to 3Q 2017, versus assets of $4.5 billion. WPG reported debt-to-EBITDA of 6.2 for 2016. Debt looks steep upon a superficial glance.
The ratios ignore the difference between the types of debt that WPG owes. We need to separate the debt between mortgages and unsecured. Unsecured consists of bank loans and bonds. According to 3Q data, WPG has $1.6 billion in unsecured debt and $1.4 billion in mortgages.
(Note: WPG has $630 million in unconsolidated mortgages that don't show up on the balance sheet. This debt is held by joint ventures. Their true mortgage debt is $2 billion and total debt, $3.6 billion.)
About 47% of WPG's consolidated debt is mortgages (56% of total debt) and these get extinguished if the underlying property goes bust. So these are no great threat to WPG. Sometimes, they renegotiate the debt to reduce the total liability, as they've done before, adding value to the balance sheet.
The real threat is the unsecured debt. If WPG fails to pay that, those debtors can come after the company. But look how WPG is positioned.
Unsecured Debt Backed By The Best Properties
WPG's best properties are BY FAR the open-air malls. According to the 3Q press release, the open-air's comparable net operating income (NOI) increased by 3.4%. However, the small minority of Tier 2 properties masked this good performance by declining 9.1%. Thus, the "average" NOI growth was negative even though the open-air assets were healthy.
The re-leasing spreads for new open-air centers were 10.3% in 3Q. Everything else had flat or slightly negative re-leasing spreads. So the open-air properties are worth full value, not impaired, and growing. We can also say that new investments into these properties are NOT wasted and represent legitimate investment opportunities.
Here's the thing. WPG's open-air centers are mostly unencumbered. Only 14 of 51 actually have a mortgage. The 3Q supplemental shows that they are $233 million of the $2 billion total mortgage debt. So the open-air centers comprise 25% of WPG's total square footage, yet only represent 10% of mortgages.
Furthermore, many of the best, enclosed properties are unencumbered. CEO Lou Conforti often boasts that they've already transitioned most to the new, hybrid community centers. 30 of its 60 enclosed properties are not mortgaged.
What are all of these unencumbered properties worth?
Consider the O'Connor Joint Venture II, which closed during 2017. They sold 49% of 7 malls to O'Connor Mall Partners, LP. The transaction valued these at $599 million! That's $85 million for each property on average, which were mixed between 4 open-air and 3 enclosed.
WPG has 37 open-air unencumbered and 30 enclosed unencumbered properties, totaling 67. What is 67 times $85 million? That's $5.7 billion dollars to match the unsecured debt of $1.6 billion!
Let's not get carried away. I'm NOT saying the remaining, unencumbered properties are worth $5.6 billion exactly. That was a VERY, very rough estimate.
A more precise calculation accounts for the fact that O'Connor II was comprised of 1.1 million square feet of open-air properties, and only 314,000 square feet of enclosed. The average value, per foot, was $437. If we increase the value weighting toward open-air to $510 (because they're the best properties), then that transaction valued the enclosed at $192 per square foot.
Let's apply these numbers to value WPG's unencumbered properties.
Open-air value = $510 x 6.3 million feet = $3.2 billion
Enclosed value = $192 x 13.8 million feet = $2.6 billion
Total = $5.8 billion
Is $5.8 billion a fair value of WPG's unencumbered properties? Maybe. It's possible that the O'Connor deal was the meat of their assets and the others aren't worth as much. It's also possible that I'm not weighting the open-air properties enough, and because they comprise less footage than enclosed, that would drive the total value down. However, I AM SAYING that they're worth significantly more than the unsecured debt. These are many of WPG's best properties! My most conservative, educated guess is that the unencumbered properties are worth at least twice as much as the unsecured debt, or $3.2 billion.
Then it gets better. WPG adds $100-$150 million in redevelopment CAPEX each year. This strengthens the balance sheet, equal to 6-9% of unsecured debt.
As several analysts have stated, the ROIC for these redevelopment projects is 9.5%! Unfortunately, these improvements merely offset the declines in the worst properties over recent years. This is not a big deal at today's share prices. Eventually, the portfolio improvements will outpace the older properties' declines and we'll have growth again.
Do people really think WPG is going bankrupt? It COULD happen but it's HIGHLY unlikely.
Most of the worst properties are mortgaged and can be let go. The real threat is unsecured debt. The unencumbered property values outweigh the unsecured debt BY AT LEAST $2 to $1. The redevelopment CAPEX just locks it in, providing a very solid balance sheet.
Positive NAV With "Free Options"
Think of it this way. Most of WPG's best properties are unencumbered, and easily worth $1.6 billion after subtracting unsecured debt. Compare this to the present market cap of $1.15 billion. We're paying slightly less than fair value, right?
This doesn't count the value of the mortgaged properties. We're essentially getting them for free and they're non-recourse in the event of bankruptcy. Thus, we have a free option on 63% of WPG's total debt, or $2 billion, plus the equity contained inside.
WPG might owe taxes on extinguished mortgages if they all went bankrupt. So they're not quite a "free option". But it's not so bad. Let me explain.
WPG has $4.5 billion in total assets. They also have $3.6 billion in total debt (adding unconsolidated mortgages). So capital losses on their mortgaged assets would offset most gains on debt extinguishment. In fact, WPG already came out ahead selling many of its mortgaged properties, and renegotiating others. But in some cases, WPG would owe a small tax bill if the assets have been depreciated lower than the debt. I think it's a minor point that won't apply in most cases.
The mortgages ARE a free option, practically speaking.
The Market's Mistake
Refer back to the beginning. I quoted the 2016 annual statement that WPG's debt-to-EBITDA was 6.2. The market is making the mistake of lumping all the debt together, saying it's high, and calling the demise of WPG because the enclosed properties are in a slow, secular decline.
Well, the debt is not high. Unsecured debt is well covered by the value of the unencumbered properties, which happen to be the best properties. WPG kept most of the worst properties encumbered with mortgages, taking the free option on their recovery and receiving the cashflow in the meantime.
The best, unencumbered properties would have to decline substantially. That's the only way WPG goes bankrupt. And they're growing, instead. This fear is massively overblown.
WPG is a compelling value proposition. They guided a minimum of $1.63 FFO per share for 2017. That's a 27% yield at today's price. The dividend is 16%.
The properties are stable, with the best growing rents and roughly offsetting the worst. $100-$150 million is being reinvested, every year, at roughly a 9.5% return. Eventually, the new revenue stream will cross over the old and growth will happen again. While waiting, collect your dividend and enjoy your life.
If you take nothing else away, take this. Don't look at total debt metrics. Look at the unsecured debt versus the unencumbered assets. That is the true debt-to-equity ratio. Mortgages are no threat.
This is one of the best deals in the stock market. Period.
Thanks for reading.
Disclosure: I am/we are long 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.