- As the reality of 2020 sunk in, we authored a piece describing the pending demise of Washington Prime Group.
- We ran the numbers and there was no path for the REIT to make interest and debt payments in a timely fashion with the cash flow available from the portfolio.
- This piece will provide an update on this rare event and discuss what we can take away from it.
- This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Learn More »
This article was coproduced with Williams Equity Research ("WER").
On Thursday Bloomberg reported that Washington Prime Group (WPG) "is preparing a potential bankruptcy filing as time runs out to avert a default after it skipped an interest payment on its debt, according to people with knowledge of the plans."
Bloomberg writes that Washington Prime "would use a 30-day grace period to continue negotiations with its lenders. Yet those talks are faltering...the plan to file for Chapter 11 protection isn’t final and could change if negotiations evolve..."
The Story Hasn't Changed
We still urge significant caution with WPG common stock and consider investments in beaten down Tier 1 retail REITs, such as SPG, BPR, and SKT to provide better risk-adjusted returns.
Subscribers frequently ask us about this mall REIT as the yield and valuation have appeared compelling at times. We recognize the temptation and have done our best to give a balanced perspective on the REIT and its management team over time.
This corresponds with one of the most important aspects of investing for individuals who manage their own portfolios.
There's a big difference between value investing and dumpster diving. Value investing incorporates core characteristics of a business and its valuation to assess when a stock is under or overvalued. It's often calculated against peers, the company's asset class, the broader equity markets, and/or the company's own historical earnings or cash flow multiples.
Dumpster diving, a term often thrown around the trading floor during WER’s hedge fund days, is much different. There is often minimal analysis involved and the investment "thesis" boils down to: it's already down 90%, how much further can it go?
Unfortunately, it can always go down another 100%.
That's the mathematical reality of any investment, no matter how far down it has already traveled. In a healthy economy, companies go bankrupt and their assets and market share are transferred to peers that provide better products or services.
That's why certain companies steadily grow over time and others collapse. Investing simply because a stock is already way down is not a strategy unless a comprehensive review of its financials suggests it is underpriced. Turnarounds are possible although that rarely occurs once bankruptcy talk is on the table.
How We Got Here
Source: Yahoo Finance
WPG's stock price has been in steady decline since its initial public offering ("IPO") in 2014. WPG was created as a spin-off of lower quality malls, mostly ranging from B- to C-, from heavyweight Simon Property Group (SPG). That alone, by the way, didn’t mean the new entity was a bad investment.
At the time of its inception, WPG owned or had an interest in 54 strip centers and 44 smaller enclosed malls encompassing 53 million square feet. The objective from Simon's perspective was to concentrate on the highest quality malls with the best geographical positioning. This turned out to be a very wise decision.
Fast forward five years and WPG ended 2019 with interests in 104 shopping centers containing 56 million square feet, or a couple percent more than it did at its IPO. Outside of a smaller $22.9 million transaction in June of 2014 for a 50% interest in Clay Terrace, the real M&A activity was the January 2015 acquisition of Glimcher Realty Trust for $4.3 billion. From that period through much of 2016, WPG was even named WP Glimcher.
In June of 2016, CEO Michael P. Glimcher resigned and Louis G. Conforti was named CEO. Shortly thereafter, the firm was renamed Washington Prime Group. As we've noted in previous articles, Mr. Conforti took on a major challenge. Retail in general was way overbuilt in the U.S. with lower quality malls right in the bullseye of several secular headwinds.
The uphill battle to redevelop and reposition these lower quality malls turned into a climb up Mt. Everest in flip flops with the government mandated lockdowns and general decline of investment interest in brick-and-mortar retail in 2020. The fact WPG lasted this long is a testament to management's determination to keep the ship afloat rather than a lack of resolve.
The Situation Today
Before we talk financials, let's review what the market currently has priced in. This will help guide us where to focus when we look through the financial statements and determine the firm's likely future.
Source: Yahoo Finance
This is WPG's series H preferred stock (WPG-H). We could choose any series for this example as the charts are essentially identical. WPG-H fell from 15% below par to 15% of par in March of 2020. As speculators betted on a recovery, the preferred made a substantial move back to $17 before recently plummeting to below $5 per share.
As a rule for preferred investing, anything below two thirds of par reflects high risk and a share price 50% below par is signaling a distressed company with a moderate risk of a near-term bankruptcy. $5 per share, where WPG's preferred stocks currently reside, is 20% of par and indicates near certain insolvency in the next few quarters.
WPG's only outstanding bond issuance, which matures in 2024, paints a gloomy picture. As shown above, these trade for roughly 50 cents on the dollar and yield 24.387% as of the last trade after the close on March 4.
Bonds are higher in the capital stack than preferred stock, and short of a big change in interest rates since the bonds' issuance, pricing below 80% of par signals trouble. This makes sense because the math becomes overwhelming the farther the bond trades from par.
In WPG's case for the $750,000,000 in 2024 bonds, the yield to maturity ("YTM") is nearly 25%. This tells us a few things. First, WPG is nearly certain to become insolvent in the near term.
Second, the remaining equity in the firm after the bankruptcy process takes place is highly unlikely to cover the principal amount of the outstanding bonds after higher priority liabilities are taken care of. Otherwise, a fixed income investor that believes there's even a reasonable probability the firm has sufficient value to satisfy the bonds at maturity would be buying feverishly.
As we expected, WPG failed to make a $23 million interest payment last month. In line with common practice, WPG had a 30-day grace period to make progress on the situation. That has yet to happen, however, and Bloomberg has reported that negotiations between WPG and its lenders hit it a wall.
To WPG's credit, peers CBL and Pennsylvania REIT both filed for bankruptcy protection last November and were not able to tread water as long as WPG. This is a math problem, not a personnel or portfolio problem.
Luck or Skill?
Differentiating between luck and skill is, for better or worse, an obsession for WER's founder. He has taken numerous graduate school courses on applied probability to quantify and rationalize decision making and decision analysis. So what about WPG?
Was our consistent and public avoidance of this REIT (and PREIT and CBL for that matter) since its IPO just chance or driven by a documented thought process?
Back in May of 2019, we authored a piece titled Washington Prime Group: Deep Value or Deep Trouble?. Here's the intro to that one since we are still amused by it:
The SUV on the right has a price tag of approximately $52,000 while the seemingly identical vehicle on the left costs a mere $18,200. Instinctively, this type of arbitrage is very attractive. At the same time, however, we know there is a catch. There is always a catch. This was in the news recently as Jaguar Land Rover won a landmark court case against the Chinese firm Jiangling Motor Corporation (JMC) for copying its successful Evoque model.
The article was extremely detailed and touched on every key aspect of WPG's business model, portfolio, and balance sheet. The takeaway in mid-2019?
For our purposes, however, this company's unstable footing and high probability of having to cut its distribution significantly in the next 12-18 months means it's not sufficiently attractive despite the upside potential.
We then authored Washington Prime Group: How To Evaluate Risk Like A Pro a couple months later in July of 2019. For those who want to improve their investing decision making and understanding, we encourage you to revisit this article independent of your thoughts or interest in WPG. Here's an excerpt from the section dedicated to analyzing WPG's balance sheet.
WPG has sold properties in line with its stated objective but it was unable to achieve a decrease in leverage ratios. In fact, despite decreasing total liabilities proportional to the reduction in the asset base, WPG’s ability to service its fixed obligations has deteriorated considerably since the new CEO took over. Using the above chart, we can reliably estimate that the remaining three quarters of 2019 will have interest expense of $38.0 million which is even higher than Q1 2019’s.
The story wasn't any better in the portfolio metrics section.
Despite the smaller asset base, WPG’s capital expenditures have grown linearly from $21.9 million in Q1 of 2017 to $32.50 million in Q1 of 2019. WPG is spending significantly more money in the form of redevelopments, expansions, tenant allowances, and operational capital expenditures than it did in previously despite having a smaller property portfolio and higher borrowing costs.
We finished up with a detailed conclusion and provided specific estimates on the firm's prospects.
These positive aspects, however, cannot offset the reality of decreasing margins and revenue, a rising dividend payout ratio, downgraded credit ratings into junk territory, elevated and growing leverage costs, deteriorating interest coverage ratios, and increasing capital expenditures with no short-term results on the income statement to show for it.
WPG’s 25% yield is not an accident. If management cannot resuscitate and transition its weaker properties in the next couple quarters, it will not have the ability to support fixed obligations and current distributions to investors.
In summary, our projections regarding WPG's inability to generate cash flow to support its necessary redevelopment expenditures came to fruition for the reasons we expected. The latest article on WPG, which focused on the dividend cut we were extremely confident would occur in 2020 pandemic or no pandemic, is here.
The coronavirus crisis was the final nail in an already constructed coffin. We expect that the common and preferred equity will soon go to zero and the 2024 bonds will hover around 50 cents on the dollar as negotiations with lenders continue.
Though the REIT deserves credit for making progress on certain items, Q3 2020 Tier One comparable net operating income (“NOI”) decreased 41.4% year-over-year. Q4 results aren’t out yet but even management concedes there will be another 10-20% decrease in comparable NOI.
As noted in the Q3 supplemental, 10 of the 28 problematic department stores were still unresolved. The Q3 earnings presentation, which most retail investors focus on in our experience, doesn’t mention any traditional REIT cash flow metrics or leverage ratios.
Source: Q3 WPG Supplemental
The supplemental filing shows a rapid deterioration in cash flow from an already rough 2019 to an unsurmountable 2020. Specifically, FFO for the first nine months of 2019 was $193.3 million compared to $66.1 million over the same period in 2020. The disparity is even more stark for Q3 of 2020 vs. the prior year with a 73.3% decline.
Source: Q3 WPG Supplemental
The REIT might have had a slim chance if not for its leverage profile. While a myriad of positive metrics declined from 2019 to 2020, interest expense rose slightly. Management stated they have just over $100 million in immediate liquidity but let’s put that into context to better understand why they are teeter-tottering on bankruptcy.
In Q3, the latest reporting period, the firm had approximately $70 million in cash operating expenses. From that, we need to add $40 million in quarterly interest expense and $3.5 million in preferred share dividends. That totals $113.5 million and understates the REIT’s true expenses by at least a few million for reasons we won’t delve into (see consolidated statements in the supplemental for specifics). WPG’s total revenue for Q3 of 2020 was $123.7 million.
That leaves almost no wiggle room to handle $1.1 billion in mortgage notes payable, $710 million in notes payable, $684 million in term loans, $642 million in drawn capacity on the revolving credit facility, and $86 million in Other Indebtedness on the balance sheet as of the end of Q3. That also excludes $257 million in “Accounts payable, accrued expenses, intangibles, and deferred revenues.”
The clock has struck 12.
Versus Tanger, Macerich and Simon
Couldn't much of the same logic apply to Tanger Factory Outlet Centers (SKT), Macerich (MAC), and Simon Property Group (SPG), all of which look to have survived the crisis and had significant outlet/mall exposure?
Fair question, but no.
Particularly in the case of SPG and SKT, the only two we've recommended without a “speculative” tag, they entered the crisis with
1) much higher quality assets,
2) durable balance sheets,
3) among the most experienced management teams in the business, and
4) positive cash flow generation even during periods of crisis.
That's evident when we look at how equity markets have priced the companies.
Source: Yahoo! Finance
Remarkably, Tanger’s stock is now in positive territory in the past 12 months excluding dividends. Simon is still down roughly 15% taking dividends into account with Macerich roughly 50% lower over the period. WPG is down 80% in the past year and that's despite losing over half its value in the 12 months prior.
These firms entered the crisis with markedly different tools at their disposal. Tanger and Simon maintain years of operating expenses on their balance sheets and that's excluding the reality that both firms generated positive cash flow in 2020.
Investing in undervalued companies is a strategy employed by many of the most successful investors of all time. They key is to differentiate between undervalued and distressed companies as their stock charts are often indistinguishable in the short-term but couldn't be more different long term.
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This article was written by
Brad Thomas has over 30 years of real estate investing experience and has acquired, developed, or brokered over $1B in commercial real estate transactions. He has been featured in Barron's, Bloomberg, Fox Business, and many other media outlets. He's the author of four books, including the latest, REITs For Dummies.Brad, with his team of 10 analysts, runs the investing group iREIT® on Alpha, which covers REITs, BDCs, MLPs, Preferreds, and other income-oriented alternatives. The team of analysts has a combined 100+ years of experience and includes a former hedge fund manager, due diligence officer, portfolio manager, PhD, military veteran, and advisor to a former U.S. President. Learn more
Analyst’s Disclosure: I am/we are long SPG, SKT. 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.
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.
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