The Biggest Risk That Could Take Down CBL

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About: CBL & Associates Properties, Inc (CBL)
by: Compounding Cash
Summary

CBL's risk includes covenants on bonds and credit facilities that could force immediate repayment of all debts.

The most dangerous covenant is the income to debt service ratio.

This has enough room to potentially absorb several more years of losses.

Added income is likely to come in before then and provide more safety.

CBL's management has consistently deleveraged the business over the last decade and looks set to continue this after stabilizing income.

In my last article I showed how the risk in buying CBL (NYSE:CBL) common stock gets a lot smaller if the dividends are paid consistently for a few more years.

One of the only things that threatens those dividends is the debt covenants. The new credit facility announced in January as well as all of the bonds are covered by the same covenants.

Breaching those could make all of CBL's debts payable immediately and cause management and the common shareholders to lose control.

Is this likely to happen in the next few years? I've put together a historical view of how the debt metrics have changed so we can see this.

It includes data from 10-K filings going back to 2013 (prior to this there were different covenants applied based on the old credit facility) and up to Q1 2019.

According to CBL's investor relations, these metrics reported for the latest quarter include pro-forma adjustments for major changes such as disposing of a mall or paying off a loan, but may not fully account for further losses in income throughout the year.

Covenant Coverage

(Source: CBL 10-K filings, author's chart)

The first covenant shows how CBL has managed to consistently deleverage their balance sheet, and still stands in a good position. There may be some asset disposals later this year that affect this covenant, but there is also scheduled debt amortization that will continue to bring it down.

This is already at a healthy level and continuing the trend for another 5 years should see it improve more.

The total assets are the gross book value, not counting depreciation. Although the 52% debt level may sound close to the limit, CBL would have to lose around $900m in assets to hit the limit. This seems to be at a very safe level.

(Source: CBL 10-K filings, author's chart)

This metric changed a bit when the new credit facility closed. The blue line shows the historical performance and the green line shows the adjusted value with the changes for the new credit facility. The dotted part plots the historical data as though the new credit facility had been in place the whole time, to show a continuous trend.

Note that they did not actually breach the covenant in 2013 -- initially it allowed a limit of 45%, which is scheduled to drop to 40% starting in 2020. I use the more restrictive measure to be safe and the recent SEC filings do as well.

Once again there is a very healthy trend and the balance sheet has previously improved from worse levels. The debt amortization will be for the secured debts so there is an automatic paydown happening.

If they sell any encumbered malls and have enough cash left over after paying off the mortgage, this will improve further. There would be a similar effect if they foreclose on a property where the debt is close to the book value.

CBL would hit the limit on this if they lost $900m in gross book value (over 10% of assets) without reducing any secured debt at all or added $350m in secured debts. The anticipated losses and needs are nowhere near that over the next few years.

(Source: CBL 10-K filings, author's chart)

This metric has gotten gradually worse, and the closing of the new credit facility shifted it down a bit. However, the recent trend could continue for another 5+ years before it's a concern. That is more than enough time to execute redevelopment plans and pay out required dividends.

As before, the unencumbered assets are based on gross book value. Breaching this covenant would require a loss of about $500m in gross book value. Given that the total writedowns in 2018 were $175m, and most of them were for encumbered properties, this seems like a safe margin of error.

CBL can buy more time by paying off a mortgage to add to the unencumbered pool or potentially even using cash from the line of credit to buy additional assets (which is highly unlikely).

This may not be too hard -- a property is considered encumbered even if it has a mortgage that is only 10% of the value. So paying off some smaller mortgages might give a bigger boost to the unencumbered asset value.

(Source: CBL 10-K filings, author's chart)

This has stayed steady for several years, however, it could be a concern if the losses of the last couple of years continue.

Breaching the covenant would require a loss of around $170m in annual income. This still provides a margin of safety compared to recent losses and it's not likely to happen in a single year.

A breakdown by quarter shows that the steepest losses happened in the last 3 quarters. Prior to that even the alarming level of lease modifications didn't have much impact.

(Source: CBL 10-Q filings, author's chart)

Those quarters include most of the impact from the Bon-Ton and Sears anchors that closed, associated co-tenancy losses, inline store closings and lease modifications from last year, as well as two large malls being returned to lenders.

There may be some remaining impact that will show up throughout the rest of this year but it's likely to be a lot smaller than the reduction already reported. As an estimate this may carry the ratio down to 2.1 by year-end.

Additionally, my previous estimates show that if inline store closings and modifications are a lot worse this year than they were last year, next year's cashflow could be reduced by $24 - 52m. Those might take another 0.1 to 0.3 off of the ratio.

Debt reduction will have a positive impact. The recent trend shows a reduction of around 5% per year. This could add 0.1 to 0.2 to the ratio by the end of 2020.

All told this might leave the measure at 1.9 - 2.2 by the time the final 2020 report comes in. By that time CBL would have gone through 4 years of having to give up income on inline stores (2017 - 2020) meaning there couldn't be too many more waiting to fall since leases tend to be renewed every 5 - 7 years.

However, a couple of years of redevelopment and leasing should start to supplement this income and bring the measure back up. And the debt amortization will gradually bring down the debt service payments to give a little more room. The modified leases with reduced rent have shorter terms so after a few years there will be the opportunity to renegotiate those.

Until the added income shows up, if there is a need for action to avoid breaching the covenant the only way to do that would be to eliminate some of the debt service costs. This might include paying off a mortgage with a high interest rate by using the line of credit. Or management might redirect some of the cashflow to pay down debts. Foreclosure on a mall with minimal income would also improve this measure.

Reducing interest payments by $10m would allow for another $15m in lost income without crossing the limit. That would require paying off $125m in debts with an 8% interest rate (or more if the interest rate is lower).

What would a dangerous scenario look like? If there was another round of department store closures that was as big as the Sears / Bon Ton impact, as well as another 2 years of inline losses that are twice as big as what we saw last year, then I would see a real threat from this covenant -- unless CBL can take action to reduce debt by other means.

CBL's Deleveraging

A lot of commentary has focused on how CBL's management is irresponsible and hasn't taken action to reduce leverage. The only problem with that is that they did.

(Source: CBL 10-K filings, author's chart)

The debt has been steadily reduced over the last 10 years. The NOI remained stable most of that time, with gradual increases even as they were disposing of the lowest-quality properties.

Even with the losses of the last 2 years the leverage has improved, with the debt reduced by 1/3 and the NOI dropping by only half of that. Assuming some of that NOI loss is temporary and it can be replaced, CBL will have a better leverage level than at any time since 2008.

Management has been reducing leverage for years which gave them a better margin of safety for the recent trouble. It appears that this will resume as soon as the redevelopment needs pass and the income is stabilized.

Here's another look at the progress:

(Source: CBL investor presentation)

Some of the metrics on the left side might look familiar - for example, the interest coverage of 2.4x in 2010 compared to 2.3x in Q1 2019. The last time they were here they made consistent improvements to get impressive gains after a few years.

In 5 years the business could look completely different from today. And the corresponding stock price could be very rewarding for those who buy today.

Conclusion

CBL appears to be operating at a safe level of leverage and well within the covenants -- with the one warning sign of the income to debt service ratio that will have to be watched.

There are a lot of statements that CBL is out of options and they can't sell any properties at a reasonable price. However, they aren't yet at a point where this is absolutely necessary.

There is enough cashflow to sustain the business at the moment. If things deteriorate further and they need to raise additional cash, we may see them opt for moves that they haven't done yet.

All of that depends on making it through the next few years. That too looks manageable provided that the covenants are maintained.

We've already seen several years of fear and doubt, major store closings, and reduction in retail space. There is no guarantee this will turn around this year or next year but the problems facing the sector are likely smaller than they were a few years ago.

Any reduction in retail space and stores means that more customers will have to go to the remaining ones and increase their profitability. The weakest ones that couldn't stretch out their survival any longer have been picked off, and others have seen improvements (such as CBL's refinancing that extended debt maturities to 2023).

Where will this go after stabilizing the income? In my next article I'll look at the future for CBL and retail.

Disclosure: I am/we are long CBL,CBL.PD. 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.