A few months ago, we featured quite a surprising investment opportunity
here. It was completely against the market sentiment which was dominated by a ‘retail apocalypse’ kind of sentiment. At the time, Washington Prime Group, a North-American real estate investment company was valued at three years of rental profits for a dividend yield of 17%.
The latest earnings release of the company allows us to take a look at this file again.
First observation: while Amazon and the e-commerce industry are definitely shaking up customer habits, the retail apocalypse that’s so often being proclaimed is yet to be seen. The occupancy rate is stable - with 92.7% of leased spaces, against 93% last year during the same period - and the turnover of the tenants per square foot is slightly improving - at $377 against $375 in 2017.
The base rent also remains stable, at $21.68 against $21.73 last year. Washington compensates the decline of its most decrepit properties (Tier 2) for which the demand is dropping sharply, by making significant progress in the redevelopment of its best properties (Open Air) for which rental rates are increasing sharply (+11% on the new leases).
Second observation: the profit coming from rental activities (FFO) declines significantly - at $170 million against $204 million for the first semester of 2017 - without a doubt under the combined effect of struggling big retailers like Sears and Macy’s who are closing down their rented stores, and the spaces that are put to sleep while they are being renovated.
Since the maintenance budget of the properties reaches $25 million for the first six months of the year, the cash profit that’s actually redistributable to the shareholders comes down to $145 million. The distribution of $118 million is well-covered, and the quarterly dividend of $0.25 maintained.
The management indicated an investment budget between $170 and $200 million per year, maintenance included, or grosso modo $85-100 million per semester. We suppose they’ll have to increase their debt significantly over the next months. That’s by the way what they’ve already done during the first semester to finance $80 million of new acquisitions, among which six Sears stores that have been abandoned by the latter.
This should a priori not cause any problems: according to the management - but that’s something that is hardly verifiable - the return on investment on the redevelopments is around 10% gross which, with an average cost of debt of around 5%, allows for 5% of value creation for the shareholders.
WPG’s balance sheet remains solid: two thirds of the debt is ‘unsecured’, meaning no real estate asset is put up as collateral; the Tier 2 properties (which are of a lower quality) are for 42% ‘encumbered' which means that the management can - if for example things turn badly - simply give the keys back to the banks and their debt at the same time.
This very appreciable flexibility allows the management to better manage their different options, and explains perhaps partly the market inefficiencies: unless they’ve thoroughly gone through the annual report of the company, we doubt that all the investors are familiar with this very particular debt structure…
The coverage of the interest expense remains within the norm of North American real estate investment companies with an EBITDA that’s three times higher than the interest payments. Let’s note, however, that said coverage is declining compared to the same period last year; back then, the EBITDA covered the interest expense almost four times.
The management actively negotiating the re-lease of the spaces that have been abandoned by the big retailers. They dispose of a certain latitude to do this because the latter - whose situation is indeed getting worse every six months - represent only 1.7% of WPG’s rental income on its best assets (Tier 1).
In short, the initial thesis remains perfectly unchanged and the undervaluation is still there: on an annualised basis, WPG still trades at between four and five times its rental profits before investments, and still correctly ensures its dividend distribution - a strong commitment made by the management who certainly will be evaluated for a big part depending on how well they kept this promise.
The dividend yield is close to 13% and the growth option remains intact if the redevelopment of the properties delivers the expected results. If something goes wrong and supposing that the dividend has to be cut in half, the yield of 6.5% will still be almost 3 times higher than that of the traditional, no risk alternatives (government bonds and corporate AAA bonds).
The author highly recommends readers to take a look at the transcript of the latest conference call
of the company’s CEO, Lou Conforti.
Translated from the original article
Article published on 08/28/2018 | 10:14