Simon Property Group (SPG) is in the midst of a dramatic evolution of its properties as the company repositions its anchor properties to feature offerings beyond retail, such as restaurants, movie theaters, and a CBD surprise (to be discussed later). Management’s guidance for 2019 showed strained FFO growth due to some accounting changes, as well as temporary lost rents due to closed department store spaces. Beyond 2019, however, the growth thesis for this high-quality mall REIT remains strong. SPG is a strong buy.
“A Mall” Business Model
SPG is an “A mall” operator, which means that its uber-high quality malls average sales per square foot greater than $500 - in fact, in the past year it was over $600, indicating the strength of its properties. SPG is quite concentrated with only mall and premium outlet properties, but is diversified geographically:
(Source: 2018 Q4 Supplemental)
While the reader is likely very familiar with the “death of the mall” sentiment, SPG’s malls are far from dead and continue to generate healthy foot traffic and strong tenant sales. Poor sentiment creates attractive investing opportunities.
2018 - A Year In Defiance
In 2018, SPG nonetheless continued to defy the headlines through its strong financials. FFO increased 8.2% YOY to $12.13 per share. Leasing spreads remained strong at 14.3%, and sales per square foot grew 5.3% to $661. Occupancy increased slightly from 95.6% to 95.9%. Dividends increased 10.4%, from $7.15 to $7.90 per share. Management also increased the quarterly payout to $2.05 (or $8.20 annually) to begin 2019, which is a 2.5% increase sequentially. While I anticipate management to increase the dividend again later this year, I have a hunch that they might keep distribution growth slower this year in order to focus on redevelopments and share repurchases, before increasing it more rapidly again in 2020.
2019 - A Transition Year
SPG’s guidance for 2019 at first glance appears tame, as FFO is predicted to come between $12.30 and $12.40 per share. That’s a 1.81% increase over 2018 - definitely not inspiring. However, management notes that this includes changes due to the updated leasing accounting standards (all mall REITs are seeing the same thing), amounting to about $0.13 per share. Subtracting this as well as certain non-recurring items related to Aeropostale and international investments leads to adjusted 2019 FFO/share growth of 4-4.5% (Source: Q4 2018 earnings call). That’s still uninspiring, but I think the biggest elephant in the room is the fact that the company will see temporarily lost rents due to closed department store spaces, as those won’t be online during redevelopments. This, of course, will be resolved as those redevelopments come on-line in late 2019 and 2020. As we can see below, SPG has given the strongest guidance as compared to other A mall operators Macerich Company (MAC) and Taubman Centers (TCO):
This is despite the fact that MAC and TCO are frequently touted to have “higher-quality properties” in terms of tenant sales per square foot (TCO has sales per square foot north of $800). I have repeatedly emphasized that one shouldn’t invest in MAC or TCO over SPG solely due to the fact that they have higher quality properties - the stark contrast in forward guidance is yet another example showing that stronger management may lead to stronger financial results, which is what’s even more important for shareholder returns.
CBD An Unlikely Catalyst
As part of efforts to improve foot traffic at its properties, SPG revealed that it has plans to bring CBD products (through a partnership with Green Growth Brands) to 108 of the company's US mall properties. It is not immediately clear, but it seems that this means the company will be bringing these stores to its mall properties specifically and not its outlet properties. I view this to be a wise decision because SPG's mall properties are likely to be weaker in comparison to its outlet properties (in terms of sales per square foot), thus the company has higher urgency to bring more non-retail choices to play.
On a side note, for those who are unfamiliar with CBD, this refers to the natural chemical compound commonly found in hemp (now federally legal) and cannabis (legal in certain states), which has anti-inflammatory benefits. Note this is not to be confused with THC, which is the “secret sauce” which makes cannabis so popular. I can note from personal experience that CBD works miracles as a substitute for the typical pain medication, and thus, am very excited to see the rapid development of CBD as well as the potential for a store to show up a local mall. I anticipate the CBD stores to generate very high sales per square foot and to increase foot traffic significantly.
$2 Billion Share Buyback Program
SPG announced in February that it was authorizing a $2 billion share repurchase authorization, which would replace the company's previous program that had $633 million left authorized. Redevelopments continue to be the best use of capital even at today’s bargain prices, but as management noted on the Q4 2018 earnings call, it is having to wait to get permits approved which is the main stopping block slowing down the construction of some of the projects. If they could, they’d even be willing to take on a little leverage to speed up the redevelopment process - capital is not the problem. This might be a good time to once again applaud SPG for the enhanced liquidity that its high dividend coverage and low balance sheet leverage affords. The flip side of having to wait on redevelopment efforts means that the company is likely to have significant amounts of cash leftover after dividends and redevelopments - share repurchases would be an excellent option.
I should point out that since SPG began aggressively buying back shares in 2016, shares outstanding has fallen by almost 1%, including 0.6% in the past year alone. For a company that’s distributing 90% of taxable income as dividends and spending as much as it is on redevelopments, that’s a sizable amount, and I expect share repurchases to accelerate as SPG wraps up its redevelopment efforts.
SPG pays an annualized dividend of $8.20 per share, or a 4.6% yield based on recent prices. While this yield may not be so high as to attract those seeking high yield, I, on the other hand, view it as being unjustifiably high considering the high level of dividend safety and future growth.
Out of $3.78 billion in FFO in 2018, only $272 million was used in recurring capital expenditures, making the FFO payout ratio an appropriate measure for dividend coverage. SPG maintains a low 65% payout ratio:
(Source: 2018 Q4 Supplemental)
However, I caution readers to not focus so much on payout ratios as a predictor of dividend safety, but to instead focus on the sustainability and growth potential of FFO. For leveraged plays like REITs, a low payout ratio may mean little if FFO is declining, leading to increasing leverage ratios which can only be controlled through directing FFO towards debt repayment.
SPG does not face this issue because the high quality of its properties means that it can keep raising rents for years or even decades to come, leading to strong FFO growth moving forward. For an estimation of the long-term FFO growth potential, consider that the company typically has 2-3% annual lease escalators, is able to generate mid-to-high teens leasing spreads on expiring leases (about 7% leases expire annually), is able to generate 8-10% ROI on redevelopment projects, and is able to take on more leverage as EBITDA increases (to maintain its already low debt-to-EBITDA multiple). All of this added together leads to roughly 5-8% long term FFO growth - which, of course, should lead to dividend growth for the long term.
I continue to give credit to SPG’s strong balance sheet, which is rated A/A2 by S&P and Moody’s. Aside from the company's strong history of execution, this also has to do with the fact that SPG maintains a conservative leverage ratio, which sat at 5.1 times at the end of 2018. To give some perspective, peers MAC and TCO both have debt-to-EBITDA ratios north of 8 times. The strong credit ratings ensure that the company has sufficient access to liquidity, which is all too important considering the volatile retail environment and the high level of redevelopment spend planned in the next two years. This is a clear plus, which in my opinion is enough alone to put SPG above and beyond A mall peers.
As mentioned earlier, because maintenance capital expenditures are very low for malls (especially at SPG), FFO very closely approximates free cash flow and is thus an appropriate valuation metric. Trading recently around $176 per share, SPG trades at 14.5 times trailing FFO and 14.3 times 2019 FFO.
As compared to peers, the stock trades at a slight premium:
(Source: Chart by Author)
I believe that the premium is warranted, and arguably, should be even higher due to the superior financial track record at SPG in terms of FFO and dividend growth. I suspect that TCO and MAC trade so comparable to SPG because of speculation of potential M&A. Personally, I place little probability that either of the names will be taken out, and am highly skeptical that SPG is even considering such a maneuver considering the previous history of similar failed takeout attempts. With these mall REITs, it’s more important to focus on increasing cash flows over buying trophy assets - but with SPG you get both.
Long-Term Optimism - Price Target
As we can see below, SPG trades near its highest dividend yield over the past decade and beyond:
With US 10-year Treasuries recently yielding around 2.72%, SPG trades at a yield spread of about 1.9%. Compare this with 2006, when the yield spread was around minus 1%, or 2014, when the spread was around a mere 0.25%, and it is clear that the current stock price is projecting the greatest risk signals in recent years. Considering that SPG still maintains high and reliable dividend growth potential, a clear argument can be made for the spread to compress or even turn negative.
My 12-month price target range for SPG is $205-235, representing a dividend yield between 4% at the low end and 3.5% at the high end.
SPG may be able to reach the high end of the estimate if its yield spread as compared to US treasuries decreases or if interest rates as a whole drop. I view this as an ultra-bullish scenario.
The low end $205 is more attainable, and I think as the company's redevelopment projects come on-line in 2019 and 2020, leading to increased leasing spreads and FFO growth, we will see the modest multiple expansion needed for such a price move upward.
While SPG has lower leverage than peers, the debt load is meaningful, and thus, should interest rates continue rising, interest expenses will also inevitably rise as the company refinances maturities with debt of higher interest rates. It is unlikely that it will be able to pass on these costs to tenants, as the retail environment is already facing e-commerce pressures. SPG investors should hope for stagnant/falling interest rates or be prepared for near-term volatility of earnings.
A huge part of the thesis is that high-quality malls are still relevant. It is possible that I am wrong and long term even high-quality malls might see rents pressured. I, however, view this as unlikely considering the high profitability of SPG’s properties. Compared against its average $661 sales per square foot, average base minimum rents are only $54.18. There appears to be a lot of room for rent expansion even in the event that sales do not increase (but, of course, SPG properties continue to see improving sales).
While no one can say for sure when sentiment will improve for SPG and high-quality mall REITs, if ever, the company continues to defy low expectations and churn out strong financial results quarter after quarter. The longer shares stay down, the more effective its share repurchase program becomes, which looks to have potential to become more and more of a factor this year and beyond as the company completes its redevelopment projects. I rate SPG a conviction buy for the long term.
Disclosure: I am/we are long SPG. 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.