Seritage Still Priced For Perfection

Summary

• Seritage reported Q1-2018 numbers.
• While Sears still appears to be hanging around, store closings have meant that Seritage has not even covered its dividend for two straight quarters.
• Taking into account potential capital raises and assets sales, Seritage will likely deliver less returns than most REITs on the market today, but with much higher risk.

Seritage (NYSE:SRG) reported Q1-2018 numbers that were about in line with what we expected. A large number of properties were handed back to them in the previous quarter by Sears Holdings (SHLD) resulting in continued weak performance. That was surely priced in. However, bulls have to be cognizant of how vulnerable the company is to a SHLD bankruptcy. Further, the capital raises that are poised to happen between now and a fully leased up Sears-Free portfolio will likely destroy significant amounts of upside that the bulls believe to exist. Allow us to show the numbers.

Where SRG has made progress

Redeveloping properties is a long slog and specially when you have been handed a portfolio that pretty much comprises the worst retailer on the planet, it will take time. However, from Q1-2016, where Sears comprised a whopping 73.3% of base rent,

Source: Q1-2016 supplemental

SRG appears to have made some progress.

Source: Q1-2018 supplemental

Sears is now down to just 45.7% of total rent. Certainly one can argue that the total vulnerability to Sears has decreased.

Why the numbers are actually quite bad

After two years of boasting about large redevelopment spreads, total annual rent is just up a mere 4% (from $208.3 million to $216.6 million). The reason is that the property and joint venture sales that SRG has had to do to finance this level of capital expenditures.

This number includes all signed but not yet operating leases as well, so several quarters ahead of upside to EBITDA are included in the numbers above. The current numbers are actually quite horrid with actual adjusted EBITDA coming in way below 2017 numbers.

During the quarter SRG sold properties worth over $60 million to finance the ongoing developments and we expect this trend to continue.

Source: Q1-2018 10-Q

Extrapolating the end

While the exact timing of a Sears bankruptcy and their actions post that will be the key factor in how much vulnerable SRG will be, one can make a base case assumption of how much capital needs to be raised simply by using management's 11% return on investment yields. This 11% is not a figment of our imagination but is a number consistently brought up by management.

Essentially what we are doing here is coming up with an ending number of what SRG's financials will look like once the entire portfolio looks picture perfect. Taking the current Sears rent on the portfolio and using the past guidance of getting rent to 400% of Sears rent we can estimate total capex required.

Source: Author's calculations

Now there are still many variables including timing of these transactions, interest on issued debt, price of shares etc. But most of these will work against SRG as capex is extremely unlikely to become self funding till many years down and in the interim asset sales and interest costs will reduce overall returns. So an optimistic case can simply assume all of this done today at today's prices without taking into account secondary effects. So if the capex was split 50-50 between debt and equity, you would get the following numbers.

Now we can assess the end game, the final FFO at the end of all redevelopment.

The FFO will be rather piddly $3.41/share. It would not be far fetched for the stock to trade at 10X FFO once the hype of this portfolio has been turned into reality. That would be $34 a share, a tad lower than today.

A few quick points about this calculation,

1) We disregarded tenant reimbursements as they are awash with property taxes and other property expenses, which we also left out.

2) We did not calculate the JVs separately, but as they are included in the total base rent above, we lumped them in here.

3) Over time base rents might increase due to inflation but so would capex so we did not make adjustments to either.

4) A Sears bankruptcy was not modeled as we were going for an optimistic scenario. Most likely it would make these assumptions impossible to achieve.

5) We left out preferred share costs as they are very small currently.

6) Changing the return assumption to a rather scintillating 15% also changes the end result very little (15% increase in FFO).

The bull argument will no doubt be that this level of equity and debt issuance will not be required as SRG will self fund this capex. We think that is highly optimistic as the last two years have required a sale of 3 million square feet of space just to keep funding going and today SRG does not even cover its dividend through FFO. So sure, there is improvement down the line but it won't come quickly enough to rescue additional issuance of equity, debt or sale of properties. Changing the debt to equity issuance ratio or even property sales to fund capex might change the final picture a bit, but it will not change the final outcome dramatically.

Conclusion

With SRG our question has always been, "Why?" Why would anyone want this incredibly convoluted idea to make a minimal long term returns if everything goes right? Certainly the price now is better than it was 7 months back, so potential returns are a bit better. But anyone looking at this with a multi-bagger potential has got the math sorely wrong.

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