Washington Prime Group: Another One Bites The Dust

Summary

• We've been urging caution on this name and comparable REITs for many quarters.
• WPG has joined peers such as CBL & Associates by substantially reducing its distribution.
• Let's review fourth-quarter financials, determine realistic capex and cash flow, and see where WPG stands.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

This article was co-produced with Williams Equity Research.

You no doubt know the song "Another One Bites the Dust."

Written by Queen's bass guitarist, John Deacon, and then recorded and performed by the larger group - thousands of times to millions of screaming fans - the chorus goes like this:

Another one bites the dust. Another one bites the dust. And another one gone, and another one gone. Another one bites the dust. Hey, I'm gonna get you too. Another one bites the dust.

This is hardly inspiring in mere black and white, I know. But when put to "an instantly recognizable funk bass riff and high energy, bordering on manic, vocals", it's a smash hit for obvious reasons.

How many movies and rallies and individuals have since used it to set or enhance the mood? I couldn't tell you except to say that it's a lot. Which makes it something far from original for me to use right now.

But that doesn't make it inaccurate when it comes to Washington Prime Group Inc. (WPG). That company's in trouble, as we just learned for sure this week.

Photo Source

Alas, This Ain't "We Will Rock You"

I wish I was writing about a different Queen song today. I truly do.

It would be awesome if I had "We Will Rock You" stuck in my mind instead. But Washington Prime is anything but rocking right now.

As Seeking Alpha noted early on Feb. 27, it declared a "quarterly cash dividend of 12.5 cents per share vs. 25 cents in the prior quarter" - a 50% cut.

To be fair (again, in Seeking Alpha's words), the troubled mall REIT "was in compliance with all of its unsecured debt covenants at the end of 2019. And, based upon current projections, [it] anticipates remaining in compliance through 2020."

That's good news for its near-term future. Plus, to quote Seeking Alpha one last time:

"This contrasts with Pennsylvania REIT, which has maintained its 21 cents-per-share dividend, but said on Tuesday it expects that it won't meet some financial covenants in 2020 as it continues to deal with retailer bankruptcies and store closings."

To each their own, I suppose. Each one of the mall REITs is, of course, in slightly (or vastly) different positions. Moreover, their different management teams offer different perspectives on handling the ongoing changes in the retail world.

Some of those positions, teams, and perspectives are just clearly doing better than others.

Despite many SA authors issuing positive coverage on weaker retail REITs like Washington Prime Group (WPG) for their tantalizing double-digit yield, not just recently but throughout 2018 and 2019, we've been cautious and recommended avoiding the stock.

Source: Yahoo Finance

It doesn't matter when you bought it; WPG has lost investors' money, even including the dividend. Sure, it's possible to trade any volatile stock profitably, but you don't want to fight the trend of 90% of equity being erased in the last few years.

We don't have anything personal against WPG, and we have consistently given credit to the CEO and the rest of the management team for taking on a serious challenge. Many firms wouldn't be able to "grind it out" as they have done.

We were skeptical of WPG's stock in the past because it had "Tier 2" asset quality, significant exposure to troubled tenants, and capex and distribution liabilities didn't reconcile with the firm's cash flows. The last point isn't subjective. The balance sheet didn't leave much to be desired either.

As Seeking Alpha noted early on Feb. 27, WPG declared a "quarterly cash dividend of 12.5 cents per share vs. 25 cents in the prior quarter", or a 50% cut. This was painful news for investors trying to convince themselves that the multiple dollars per share in capital losses would be remedied in a "few" years by the $1.0 per share annual dividend.

On the other hand, WPG maintained compliance with its unsecured debt covenants at the end of 2019, and we do not foresee covenant issues in 2020 provided a normal market environment.

That's positive for its near-term future. Not every troubled retail REIT is in the "damaged but not yet sinking boat" category.

Pennsylvania REIT (PEI), which has maintained its 21 cents-per-share dividend, said on Tuesday it expects that it won't meet all financial covenants in 2020 as it continues to deal with retailer bankruptcies and store closings.

It's critical to recognize we are now in the arena of distressed investing; every material aspect of the company and its finances must be scrutinized. We do not have the luxury of looking at these companies through a single lens, and no two situations are identical.

Reality Check

We've written several articles on WPG:

• Jan. 18, 2020: Blinded By The Dividend-Paying Light: Beware Of Washington Prime's 'Sucker Yield'
• July 11, 2019: Washington Prime Group: How To Evaluate Risk Like A Pro
• May 7, 2019: Washington Prime Group: Deep Value Vs. Deep Trouble

We continuously explained that WPG's distribution was unsustainable using fundamental accounting. Not potentially or probably unsustainable, but definitively. This stresses not only the distribution but fixed charge coverage ratios and capex. Throughout that time, management and many popular authors on SA considered this heresy. But as the saying goes, the numbers do not lie.

In some cases, such as with Macerich (MAC), it's theoretically possible for a firm to maintain its distribution to the detriment of other parts of its business; we still expect a cut to be announced by MAC. For WPG, however, the firm and many overly enthusiastic investors were in for a reality check.

Now that the stock trades near $2.0 and the distribution cut is in, the situation changes for this beaten down but still kicking REIT. Let's review the financials and assess the potential direction the firm - and it stock - might take.

Washington Prime's Story

At the start of the "retail apocalypse," WPG owned a good number of assets that investors were avoiding like the plague: large department stores in subpar markets with subpar tenants, and Toys"R"Us is one of many examples. Hindsight is 2020, and much of the current management team is not responsible for those properties; the assets were originally spun out of Simon Property Group (SPG) six years ago.

To understand how far WPG has come, we must assess the cash flows and value tied to the current portfolio. That includes incremental costs needed to continue to transform the portfolio into something viable in today's environment.

As CEO Louis Conforti will not hesitate to remind you of, the team has made progress in several areas despite having to slash the distribution. They've marched through difficult waters, and the light at the end of the tunnel, while dim, is brighter than before.

In the last four years, management has disposed of 17 assets - and knowing when to cut losses is part of the game. The language around the distribution has changed too.

This is from Louis Conforti, CEO, in the Q4 conference call transcript:

Notwithstanding there continues to - there continued to exist skepticism as it relates to the necessary capital required to accomplish this adaptive reuse mandate. The reset of the dividend is a tenant to alleviate any doubt whatsoever.

As opposed to acting out of weakness, the Board proactively made this decision at our earliest available opportunity. I mean to me it's just so darn simple, our fiduciary responsibility is to allocate capital accordingly and this decision to enhance - to enhance our liquidity was common sense and logical."

Let's go back to Lou's comments in Q2 2019's transcript:

Let's recap what turned out to be a very busy second quarter. All right, we're reaffirming both 2019 FFO and dividend guidance of $1.20 and $1 per diluted share respectively... At the current share price, Tier 1 assets trade at a goofy 29% cap rate, if just plain ridiculous and my colleagues and I are going to relish the moment when we prove the pundits wrong, who's stupidly placed our company and assets into the have-not category.

For those who invested based on the CEO's commentary, both the stock price and distribution are 50% lower in the six short months since.

We could continue this pattern, but one example gets the point across: management is not only chronically over-optimistic, but it incorporates that into public comments and guidance.

We aren't beating up on Lou or the rest of the team; we expect they had confidence in their statements. The importance of track records is not limited to trends in FFO or stock prices; every element of a business must be stress tested, including management's ability to deliver reliable information and projections to investors.

WPG scores poorly in this area. Understanding this aspect of WPG would have mitigated individuals from placing too much trust in management and saved themselves a lot of money and heartache in the process. It is the financials and operational aspects of the business that are most important. The confidence placed on management's guidance is never zero or absolute.

Measuring What Counts

Management's comment about improved financial flexibility following the 50% distribution cut is valid. Significant progress on the redevelopment side has been made, and we have more data to gauge capex needs in 2020 and 2021.

Source: WPG Q4 Report

Let's start with what's excluded from this chart. The earnings release lists distributions of $111.7 million for 2020 against funds available for distribution (FAD) of $177.700 million, reflecting the situation after cutting the distribution 50%. 2019's levels result in a 125.7% payout ratio.

On top of that, the firm plans on spending $80 million on redeveloping more department store properties. Backing out the $50 million from dispositions results in a more conservative cash flow figure of negative $14 million.

The board of directors seems to have assumed 2020's expected FAD, subtracted anticipated capex, and aligned the distribution to what's left over. Including capex, the true payout ratio is approximately 100% but back to a sustainable level based on management's guidance. Management also commented on seemingly incredible potential associated with three of their assets.

During last quarter's earnings release and conference call, we provided a summary of incremental NAV potential of ~$2.00 per share for three redevelopment assets. This analysis assumes we sell fully entitled land parcels to developers of residential, lodging and office product while retail remains the responsibility of WPG. Note, the capital investment required to deliver this fully entitled land parcels is deducted from NAV.

In this light, we are pleased to announce the first of the three redevelopments is underway at Clay Terrace. This redevelopment will be comprised of a ~290 unit multifamily rental project, a ~140 guest room hotel, new office space totaling 200,000 SF and an additional ~70,000 SF of space intended for lifestyle and food and beverage tenancy.

I won't beat what is surely a horse skeleton at this point, but we should take these projections with a grain of salt. We have a hard time proving to disproving these claims with publicly available information, but provided associated capex stays under control, even one of these projects meeting management's expectations could be very beneficial for stockholders. It's clear that WPG's better-quality assets are dragged down in valuation by its other issues which bears and bulls have correctly identified.

Another positive is that WPG should not need to draw on its credit facility to get through 2020 and stay the course with its redevelopment plan.

Key Operating Metrics

We've previously discussed management teams tend to become "creative" when aspects of their business are not working properly. This isn't limited to struggling REITs; large oil companies are well known for their custom reporting metrics, as we've dissected for subscribers.

WPG divides its portfolio into sub-categories so that it can demonstrate strengths that would otherwise be overshadowed. We don't mind this approach, but we urge caution in interpreting statistics of one division as those of the entire firm. Not long ago, WPG effectively removed reporting on the assets that don't qualify for Tier One or Open Air labeling. Here's a section from a previous WER article detailing these changes:

Starting in Q1 2019, Washington Prime Group is making a material change to the reporting metrics investors use to gauge their performance. I'll let them explain:

As over 90% of the Company's total NOI is attributable to Tier One and Open Air properties, as well as the vast majority of capital and corporate resources, going forward, Tier Two assets will be excluded from core operating metrics as of first quarter 2019.

The company further explains the decision in its most recent financial presentation:

The reason behind this action is straightforward: The inordinate amount of time spent discussing these assets is a distraction from our stated objectives. Remember, ~40% of the NOI associated with these assets is encumbered. Hence, we have a 'put option' which we have not hesitated to exercise upon maturity and if viable execute a discounted payoff. Enough said.

Tier One assets had sales per square foot 4.0% higher in 2019 versus 2018. New leasing spreads increased a modest but positive 1.6% over the same period.

With respect to tenant diversification, no tenant was responsible for more than 2.7% of total base minimum rental revenues for 2019. No individual property accounted for more than 5.7% of total base minimum rent over the same period.

Tier One occupancy cost improved 60 basis points, while combined Tier One and Open Air (outlet style properties) occupancy decreased 130 basis points to 93.4% of which 120 basis points was attributable to the bankruptcies of Charlotte Russe, Gymboree, and Payless ShoeSource. Given our experience with Tanger Factory Outlets (SKT), Simon Property Group (SPG), Taubman (TCO), and Macerich (MAC), these are acceptable figures.

Open Air and Tier One represent 27% and 66%, respectively, of total NOI as of the end of Q4. Most of WPG's net operating income (93%) is tied to these two categories. 2019 comparable NOI for the combined groups declined 5.2% relative to 2018. The losses were primarily attributable to bankruptcies we are all too familiar with: Bon-Ton Stores (OTC:BONTQ), Sears (OTC:SHLDQ), Toys R Us, et cetera.

Source: SEC.gov 10-K

This is the first page of WPG's properties in the latest 10-K. We highlighted the properties with below 85% occupancy signaling problems. Notice J.C. Penney (JCP), Barnes & Noble, Macy's (M), and Dick's Sporting Goods (DKS) are listed throughout.

In total, there were 13 properties in this troubled category, nine of which have occupancy below 80%. A few were below 75% with the worst in Matteson, Ill., at 51.1%; that property sold in early 2020, but the SEC filing does not provide additional details.

The key element to reversing the tenant problems is twofold:

1. reconfigure the stores to attract new tenants outside the department store category; and
2. quickly obtain new leases.

Leasing volume during 2019 saw a 6% increase versus 2018. WPG has increased leasing volumes by 200,000 square feet in each of the last three years, which is a good trend. Of the 4.4 million square feet released in 2019, 57% was attributable to lifestyle tenancy, including food, beverage, entertainment, home furnishings, and fitness and professional services. In other words, WPG is not only progressing on redeveloping stores for new types of tenants, but it is also releasing that space at a respectable pace.

WPG initially had approximately 25 department stores that needed redeveloping or "adaptive reuse" using the firm's terminology. 18 or 72% of those have seen progress or are now released to new tenants. There are a total of 30 stores needing repositioning, including five locations still occupied by Sears.

Source: WPG Q4 Release

"Addressed" properties include those that are under construction and merely "announced." The better figure to rely upon is the $300-350 million in anticipated capex over the next five years, of which $80 million allocated for 2020. In normal circumstances, a REIT doesn't have properties sitting around for years waiting for the capex to be available. As stated in the SEC filing, as of Dec. 31, 2019, WPG does not have decision-making authority regarding 13 properties. These are co-owned with other companies.

Source: SEC.gov10-K

Despite management's best efforts and releasing activity, there is a clear trend of declining revenues going back many years. Net interest expense dipped in 2017 but has been on a general rise with 2019's $153.4 million highest in many years.

Source: SEC.gov10-K

2019's $325.4 million in FFO is the lowest in many years and down approximately 28% since 2017's period high.

Source: SEC.gov10-K

WPG has minimal (<2%) month-to-month leases but will need to re-lease 40% to 50% of the portfolio between now and the end of 2023.

Since WPG began its transformation, we've been looking for concrete evidence within their financial statements that the releasing and redevelopment efforts are improving cash flows and leverage profile. And we still are.

• cash flow from operations of $176.7 million;
• net proceeds from dispositions of $53.4 million;
• investment in unconsolidated entities of $19.8 million;
• received distributions from those unconsolidated entities of $28.0 million;
• borrowed a net $158.1 million; and
• paid distributions of $237.5 million

Notice that the first line item easily surpasses the last, all but guaranteeing an unsustainable financial situation without a significant distribution cut.

Balance Sheet & Leverage Profile

When analyzing REITs with distribution concerns, it's especially critical to have a good grasp of its liquidity and balance sheet. WPG ended last year with $3.1 billion in debt compared with a market capitalization of exactly $500 million of the close on Feb. 28. $327.0 million of that debt is floating rate and tied to LIBOR, with another $641.3 million tied to LIBOR plus a fixed spread. WPG's properties are primarily unencumbered, and only a few have property-level debt.

Source: SEC.gov 10-K

This excerpt is both a strength and weakness for WPG. The current weighted average interest rates are quite good for a REIT of its size and quality and have kept interest rates manageable. On the other hand, 2019's $153.4 million in interest expense could rise significantly if the average interest rate applicable to its debt were to rise. The firm's credit ratings have been downgraded in recent years and are well into junk territory. Despite lows in the 10 year, I still expect WPG's debt to increase in cost as it is refinanced.

Interest expense has already been rising, and it doesn't need to go much higher to cause serious problems. Backing out non-cash expenses and gains/losses from extinguishing debt and dispositions, 2019 saw cash generation of $210.1 million before capex or distributions.

With about 180 million shares outstanding and the $0.50 annual distribution, coupled with LP obligations, this cash pile will be reduced by another ~$112 million in 2020. The leftover funds are just higher than 2020's capex target but leave minimal room for error.

Source: Q4 Supplement

WPG should be able to avoid tripping covenants in 2020 but note the highlighted 56.9% of total indebtedness to total assets. WPG absorbed $35.3 million of impairments in 2019 alone; a similar hit to total assets will push this ratio passed 60%, all other things equal.

Other Considerations

WPG has moved from 52-week lows of $2.17 to approximately $2.75 as confidence has improved on its long-term outlook following the distribution cut. That said, if the stock trades under $1.0 for 30 consecutive days, it risks delisting from the NYSE. At that point, debt obligations are at risk, and WPG's solvency risk increases significantly.

REITs rarely run into situations where maintaining their tax status as a REIT is at serious risk. WPG's heavy capex needs and the interest expense associated with $3.1 billion in debt could become an issue.

A major reason WPG held on to the $1.0 share distribution for so long was to satisfy the requirement to distribute 90% of taxable income to shareholders. Management would be forced to stall their development program if their status as a REIT became a concern.

Capital Stack Review & Conclusion

Washington Prime Group has stayed afloat despite very difficult times in its industry. Management has stayed the course on its redevelopment plan without disposing of critical assets or breaching debt covenants.

Capex requirements and challenges associated with releasing many troubled department store tenants remain extensive. The REIT's cash flow situation is now stable, but leverage remains elevated, and serious risks reside in an investment in Washington Prime Group common stock.

Source: Seeking Alpha

WPG's preferred stock (WPG.PH) (WPG.PI) trade at 70% of par and yield ~11%, signaling an elevated level of risk.

Source: FINRA

WPG's 6.450% bonds maturing 2024 trade at 82 cents on the dollar with a similar yield of 11.3%. This reinforces our concerns about WPG's interest expense as it refinances and issues new debt. WPG's cash flow position is improved, as is its portfolio compared with prior periods. We still urge significant caution with WPG common stock and consider investments in beaten-down Tier 1 retail REITs, such as SPG, Brookfield Property REIT (BPR), and SKT to provide better risk-adjusted returns.

Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

Analyst’s Disclosure: I am/we are long SPG, SKT, BPY. 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.