Summary

Simon Property Group is retracing toward five-year lows around $150 per share, and recently crossed the 5.0% yield threshold. Does a high-quality stock fall 30% by accident?

We’ve always respected Simon, and for good reason, but have rarely owned it. This is not a stock we’ve recommended in the past, and we are taking an unbiased approach.

The sheer panic in anti-retail continues. As WER has reiterated in the past, we are a stoic group, but we love panic like a fat in a donut shop.

Is Simon Property Group best in class or a discounted used car about to cost someone a lot of money? Let’s go through the numbers and find out.

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You Are Skeptical, We Know

Most financial assets are in the hands of individual investors that are middle-aged or older men with fairly consistent demographic and behavioral traits. Many are business owners or professionals in the fields of law, medicine, and finance. Malls don’t focus on this group. They target the people who spend that segment’s money (women, teenagers, etc.). This may be old news to a few of you, and rest assured, malls bore the me to death personally.

That is irrelevant when it comes to whether owning Simon Property Group’s (SPG) stock is smart. What you or I personally feel about malls should have no influence on our investing decisions. It is difficult enough without letting personal bias blind us.

Setting our personal thoughts on malls aside, let’s see how Simon has actually performed and what’s realistic going forward. For those who haven’t taken a deep dive into Simon’s historical and recent performance, you are in for a surprise.

Source: Simon Property Group 2018 Annual Report

Who Is Simon Property Group?

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For those less familiar with this REIT, Simon began in the mid-1990s as a rather unremarkable middle market mall property owner in suburban areas. Since then, as consumer shifts and market dynamics have changed, it has grown its portfolio from $3.5 billion to $90 billion in premier assets, while increasing FFO by over 25 times. The compound annual return of 14% since inception for Simon shareholders not only beats the S&P 500’s of 9%, which is impressive enough, but exceeds it by over 55% (2,750% total return). Put another way, by the end of this quarter, Simon Property Group will have paid over $100.00 in cumulative dividends per share. Just how powerful is that? The IPO price was $22.25.

Simon Has Navigated Difficult Seas Before

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We at Williams Equity Research are the first to mention the limits of past performance. Things change. At the same time, we need to give credit where credit is due: Simon Property Group has faced challenges in its 25-year history and not only surmounted them, but dominated the broader equity markets in the process in terms of total shareholder return (it outperformed its peer group and the S&P 500 in 2018 as well). We can, and should, be skeptical of management’s ability to execute, while respecting the fact that track record matters.

Source: Yahoo Finance

Simon Property Group recovered most of the gap pictured above before very recently experiencing a -13% delta versus broader indices such as the Vanguard Real Estate Index Fund ETF (VNQ). This pullback has pushed Simon to 52-week lows and within 10% of two- and five-year lows.

Source: Yahoo Finance

It’s not the broader market causing the decline in prices either, so let’s take a look at the underlying performance starting with last year.

2018 Numbers Are In: Good, Bad, Or Ugly?

Source: Simon Property Group 2018 Annual Report

If you are like me, you expect a firm that has sold off hard to have at least a few significant weaknesses in its performance metrics. Despite the decline Simon has suffered as of late, it’s easier to climb Mount Everest than tie the recent sell-off to 2018’s financial performance.

Last year’s results were an all-time record in terms of profitability. This is the exact type of opportunity we strive to identify for our subscribers: a very strong company misunderstood by the broader markets, resulting in a total dislocation between price and value. Simon is special case where the company is not only strong, but among the best in its entire segment.

Source: Simon Property Group 2018 Annual Report

Net income of $2.437 billion, or $7.87 per share, in 2018 was a record result for Simon. Funds From Operations ("FFO"), the metric generally used to ascertain the amount of cash flow available for sustainable distributions to investors, rose 7.6% to $4.325 billion, or $12.13 per share, which was another record for the firm.

How about the past few years? A marginal increase in FFO could technically be a record but not be meaningful. Simon has generated an 8% compound annual growth rate in FFO in the past four years. Total portfolio net operating income ("NOI") grew 3.7% to $6.464 billion. And yes, you guessed it, that’s another all-time record for Simon. Comparable property NOI at its U.S. Malls, Premium Outlets, and The Mills division grew at a slower but still respectable 2.3% year over year. Despite the high 5.0% yield given the firm’s conservative investment grade balance sheet and excellent long-term track record, Simon generated over $1.5 billion in excess cash flow after paying shareholder dividends. It used much of these proceeds to repurchase 8.1 million shares compared to Q1 2019’s 308.98 million shares outstanding, or approximately 2.6% of the total. The Board of Directors has already authorized a larger $2.0 billion buyback program for 2019.

Source: Simon Property Group 2018 Annual Report

Fair enough, there is no arguing that 2018 was a stellar year for Simon. We’ll get into Q1 2019 momentarily, but let’s look at trends in occupancy and sales per square foot ("sq. ft.") first. These two items have been canaries in the coal mine before other retail-oriented REITs experienced severe share price declines (e.g., Tanger Factory Outlet Centers (SKT)).

Occupancy for Simon’s U.S. Malls and Premium Outlets ended 2018 at 95.6% and 97.6%, which is effectively full occupancy for real estate of these types. Sales per sq. ft. were very strong at $661, which was an increase of 5% year over year. For context, not only is that a very favorable sales figure, but the 5% increase is a true testament to the company’s excellent management team and strategy. Every other top-tier REIT with retail exposure struggled to avoid declines in this area. In fact, Simon’s sales productivity across all its platforms reached record levels in 2018.

Balance Sheet and Liquidity

Simon’s $3.5 billion unsecured multi-billion currency revolving credit facility was recently amended with a lower pricing grid for the next five years, which is positive for the firm and investors. Its commercial paper facility was also amended higher at $2.0 billion. Simon has approximately $7.5 billion in total liquidity and minimal financing requirements in the next couple years.

Simon’s recently constructed outlets in the Denver, CO area

Simon’s recently constructed outlets in the Denver, CO area
(Source: Simon Property Group 2018 Annual Report)

Across the board, Simon has industry-leading or near-industry leading balance sheet metrics. Its net debt-to-NOI of 5.1 times is the lowest in its peer group. The interest coverage is also 5.1x and strong. Perhaps the most important is the A/A2 long-term issuer rating, which remains the highest in the entire real estate industry. Simon’s excess cash flow, coupled with its credit rating, provides optionality few have. The firm’s strategy is not by chance; it has learned this degree of flexibility is a requirement for long-term success rather than a bonus. As consumer shifts change, so must every REIT’s portfolio.

Simon completed more than 30 redevelopment projects globally in 2018 for approximately $600 million, versus a total redevelopment pipeline of $3.5 billion. $725 million of former department store space renovation was in process at the end of 2018. The company’s management team is smart to resist announcing a broad "solution" to the large department store issues; it’s best to tackle each space in a unique fashion, which is what management is focusing on. Lastly, Simon continues to selective develop new properties, such as the 328,000 sq. ft. Thornton, Colorado property recently opened and a 50/50 joint venture in Los Angeles in one of the city’s most attractive markets. The $5.0 billion new development pipeline is sufficient to maintain recent growth trends in the coming years without being so aggressive that it threatens the REIT’s excellent credit metrics.

Simon’s famous properties inside Caesar’s palace in Las Vegas, NV.

Simon’s famous properties inside Caesar’s palace in Las Vegas, NV.
(Source: Simon Property Group 2018 Annual Report)

Q1 Specifics

It’s a battle determining which data should carry the most weight, but the best course is usually more is better. Let’s take a look at Q1 2019 in the context of what we’ve already learned about Simon’s 2018 and long-term track record. Consolidated net income fell meaningfully year over year from $715.5 million to $631.9 million, though net cash provided by operating activities was approximately flat (-0.8%) after adjusting for non-cash charges. The year-over-year "drop" in consolidated net income is due to a $135.3 million non-recurring gain in Q1 2018 which was not repeated last quarter. If we back out gains from property sales, Q1 2019’s consolidated NOI was up approximately 10% compared to the previous year, and this is despite the problems less popular giant department stores caused. FFO per share also rose 5.9% year over year, which was very strong.

Simon ended Q1 with a modest 65% FFO payout ratio, which is favorable. It ended Q1 with an average weighted expense ratio of 3.5%, which is among the best in its peer group, as is its 10% return on invested capital. Net Debt/EBITDA of 5.1x is better than the peer average just below 6.0x. That being said, I’d prefer to see the number with a 4-handle. The weighted average duration of 5.7 years helps offset interest rate volatility. The combination of low cost and moderate debt multiples earned Simon a "A" credit rating. Compared to an analysis of Simon entering the Great Recession, the firm is on much stronger ground. It has also maintained its focus strictly on Class A malls. This is the real "secret" to how it has avoided any major impact from the issues in retail brick and mortar. Class B and C malls are a different story, and that is why Simon divested those assets into Washington Prime Group (WPG) five years ago.

Respect, But Do Not Fear, The Bear Case

We spend as much time evaluating the counter-argument to each of our theses (bearish or bullish) as we do any other part of the analysis. There is concern regarding the approximately 22% rollover in leases from the second half of 2019 through the end of 2021, which is not all that far away. Doubters suggest this is unusually high and or represents significant releasing exposure. The first component isn’t accurate; the next few years (2022-2024) have similar lease expiration schedules. Secondly, there is no evidence suggesting Simon will have difficulty releasing its stores to the existing or replacement tenants. Sales per sq. ft. are at all-time highs, so its tenants, on average, are succeeding alongside Simon.

Another bear argument is derived from reviewing Simon’s tenant concentrations. To start, the Big Box problem children J.C. Penney (JCP), Macy’s Inc (M), and Sears (OTCPK:SHLDQ) represent less than 1.0% of Simon’s exposure by sq. ft. The Gap Inc (GPS) recently reported same-store sales down 4% year over year in Q1. Notably, all of Gap’s key brands saw comparable store sales declines. Back in February, during fiscal Q4 results, the company announced an aggressive store closing plan through 2020 to improve profitability. The Gap is a key tenant for Simon. Ascena Retail Group (ASNA) is a name we’ve discussed several times previously, and it continues to close weaker-performing stores, though none of these appear to be in Simon’s portfolio. L Brands Inc. (LB), which relies heavily on its Victoria’s Secret brand, also reported weak comparable store sales and is shuttering the doors on 35 of the latter’s stores. PVH Corp. (PVH), which owns Calvin Klein and Tommy Hilfiger, among others, reported in-line results but nothing extraordinary. It’s true that Simon has exposure to retailers that, with declining same-store sales year over year, resulted in some closures. What is easy to overlook is the fact Simon appears to have these brands’ better-performing locations. Given many of us are not the target market of these malls, we tend to default that 10% of store closures means just that. What it really means is that zero of its stronger stores close, a small percentage of its average-performing stores suffer closures, and a moderate percentage of its poorly located and, not coincidentally, poorly performing stores close their doors.

As long as Simon continues to incorporate the better-performing stores in its portfolio and drive above-average traffic through excellent locations and amenities, continued weakness in some areas of brick-and-mortar retail will not cause major issues. Remember, last year experienced one of the highest numbers of store closures in many years, yet Simon posted record-breaking financial and operating performance across nearly every segment.

Bottom Line
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Simon isn’t just firing on all cylinders, it’s a V12 engine firing on all cylinders. While the headline level valuation versus competitors like Kimco Realty (KIM) don’t appear to warrant enthusiasm, I suggest incorporating balance sheet and distribution risk into the equation. Using this, it’s clear that Simon is at least as attractively valued as any even mid-quality peer. It has not sold off nearly as hard as Tanger Factory Outlet Centers because it’s not warranted. Tanger is doing far, far better than its stock price suggests, but recent quarters have seen momentum sway modestly against it in some areas. We’ve covered Tanger in-depth some time ago, and recently issued our first buy notice on the stock to our Institutional Income Plus subscribers. It’s also a much less diversified business than Simon.

That being said, some of the aforementioned concerns brought up by the bears are justified, which is why we waited to buy Simon at a great – not just good – price and 30% discount to 52-week highs. In terms of dividend yield and FFO multiple, Simon is a currently attractively priced. We reserve specific entry and exit points for subscribers, but hope this conviction gives you an adequate idea of where we stand.

Thank you for reading.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SPG, KIM over the next 72 hours. 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.

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