Description

CBL: An Underappreciated Opportunity

Introduction and Thesis:

          Over the last several years CBL & Associates LP (NYSE: CBL, “CBL” or the “Company”) has witnessed a plummet in the value of its stock, even as the fundamentals at the business have improved. With dividends reinvested investors have lost over 30% over the past year and 46% over the last five years. The decline in price does not make sense based on the fundamentals at the company, or as compared to comparable public or private companies. This dynamic has created one of the most attractive risk-reward opportunities on the market.

History and Company Overview:

          CBL has been written up twice in the last several years, once in 2014 when it was trading around $18, and once in 2016 when it was trading at $9.50. Interested parties should read both those articles and the subsequent messages as there are some interesting points brought up throughout the threads.

          CBL is a mall REIT focused on properties at the lower end of the quality spectrum compared to its public comps. Sales per square foot, one of the key metrics used to measure mall quality, for the twelve months ended 6/30/2017 were $373 across the portfolio. This compares with $465 at Pennsylvania Real Estate Investment Trust (“PEI”) and $368 at Washington Prime Group Inc. (“WPG”), two of the most comparable lower end mall REITs. By contrast, Simon Property Group (“SPG”), one of the highest end mall REITs, averaged $618 sales psf over the same time.

          Although CBL has traditionally been focused on low end (B & C class malls), it has made a concerted effort over the last several years to improve the quality of its malls. As of June 2017, 43% of its operating income over the preceding 6 months came from Tier 1 malls (those with over $375 in sales psf), with those malls averaging $435 in sales psf over the previous year. This compares with Tier 1 malls generating just 33.9% of NOI in 2014. NOI from Tier 3 malls (those generating under $300 in sales psf) has dropped from 11.3% to 5.3% over the same period.

          Note that the absolute worst malls usually are not owned by public REITs. The picture one should get is of a REIT with middle to low tier mall assets in mostly rural locations. Oftentimes CBL malls are the only mall in town.

Short View Reasoning and Responses:

          CBL short sellers are anchoring to several ideas, some of which have more validity than others. Below are some of the most common points made, as well as some responses.

1.       Physical retail is dead. E-commerce is going to take over the world leaving a wake of devastated and closed malls.

a.       For many CBL bears the consideration of its value ends at this point. We need go no further in discussing its merits. Online retailers will win because they have lower operating costs, are more convenient, are more dynamic, etc. Mall REITs like CBL are corporate versions of the walking dead. On a philosophical level, people propagating this narrative would probably not meet Benjamin Graham’s definition of ‘investor’. Buying into and spreading a narrative requiring prediction about an unknowable and distant future seems to perfectly illustrate the type of speculation Graham warned about in his last articles. Does it seem likely that online retail will grow significantly in the next 5/10/15/20 years? Absolutely! Does that mean physical retail is dead? Of course not. Physical retail composes over 90% of sales in a US market where consumers can already shop for virtually anything online. This is NOT to say that one shouldn’t consider the impact of online retail on malls. Obviously evaluating the competitive landscape is part of the calculus that goes into the calculation of intrinsic value. However, if you are reading this and believe you can respond to every qualitative and quantitative argument put forward by shouting “Online retail”, you will not get much out of reading further. To quote Howard Marks, “In the end, trees don’t grow to the sky, and few things go to zero.” The online vs. physical retail world will almost certainly conform to this maxim.

b.       The expansion of online retail at the expense of physical retail has been exaggerated. Online sales were just 8.4% of total sales in 2016 with pure play online comprising only 3.7% of the total. Physical retail has continued to grow even as online has taken market share. To the extent retailers have struggled to compete, it usually comes down to company specific errors and too much leverage, not a complete inability for physical sales to compete with online.

c.       Most retailers, including ones that started as online only, are giving more mouth service to the omnichannel concept. Companies that close physical locations lose not only the direct business from that location, but see their online sales in the surrounding region decline. When Amazon is buying or building physical supermarket and bookstores, you know that even the biggest bull for online retail sees a real future ahead for the omnichannel.

d.       To the extent there are stores that struggle to compete with online retailers, new stores with more competitive concepts will replace them. If Wet Seal is no longer a competitive market player, perhaps replacing it with more relevant retailers will improve the quality of the mall! This is a natural part of an evolving market and will make tenants stronger over time.

2.       CBL has significant exposure to Sears, JC Penney, and Macy’s, all of which are systematically shutting down locations. If/when these companies go bust or shut down more CBL locations it is likely the associated malls will plummet in value.

a.       The market has built up some cognitive dissonance on this issue. Whereas the market views the potential collapse of these retailers as a mortally threatening issue for CBL, it takes the view that the redevelopment of these locations will be a panacea for Seritage Growth Properties (“SRG”), a REIT composed mostly of Sears locations that is rapidly closing the Sears stores and redeveloping them for alternative uses. Based on SRG’s most recent presentation, they anticipate earning roughly $100mm in NOI from the 50 stores that they are currently renovating at a cost of $625 million. They have completed or are working on 65 projects to date and plan to eventually work through most if not all their existing store base. Let’s assume that they can generate another $400 million in NOI from their other roughly 200 stores, and that to redevelop the lot will cost roughly $2.5 billion. They will need to raise this cash, so assuming they take on more debt and their market capitalization doesn’t change, we are left with a company generating roughly $500 million in NOI with an enterprise value of nearly $6 billion. So SRG, a company currently almost completely exposed to Sears, which would likely need to either restructure debt or raise new capital at what would be the most inopportune moment imaginable in the case of a Sears bankruptcy, is trading at a 8.3% cap rate off of a best case scenario for the redevelopment of its properties and a 6.7% cap rate off its current unimproved NOI (which has not grown for 3 quarters), while CBL, where Sears, JC Penney, and Macy’s COMBINED make up at most 2.5% of revenue (probably less than 2.0%) trades at a cap rate approaching 12%. Does this pass the smell test for sensible investing? Does it make sense that the company with a higher cost of debt, a higher leverage ratio, less operational certainty, and dramatically less (actually negative) cash flow trades at this kind of premium compared to CBL? It seems clear that both theses cannot be accurately reflected in the market. We believe, given the history of successful redevelopment of fading department stores by literally every mall REIT in the country, that CBL is the one being misjudged here.

b.       In fact, the potential to redevelop struggling department stores is one of the best opportunities for growth from CBL. One of the most consistent themes across both high and low-quality mall REITs is that redeveloping struggling department stores can be a boon for malls if done correctly. With most projects expected to generate somewhere between 7 and 11% ROIC, and the cost of debt substantially below that, the redevelopment of these locations generates value for investors. Historically CBL’s redevelopment projects have generated an 8.5% ROIC. Even in a world where CBL is trading at a cap rate above the cost of capital for the project, it is probably still a good idea to execute these projects because 1) they enhance foot traffic in the mall, 2) they prevent the breaking of leases from other tenants, 3) they may be generating returns in malls that have a lower cost of capital than CBL does as a whole, and 4) because CBLs cap rate right now is too high and doesn’t reflect intrinsic value.

c.       Finally, of all the department stores that have closed over the last several years, CBL has seen relatively few anchor closings, and has been able to successfully rent out the vacancies that have been created. At year end CBL had just one vacant anchor that was not already under redevelopment. Since 2013 CBL has seen just eight JC Penney closures and five Sears closures. It has redeveloped or sold 12 of those locations and generated an 8.6% ROIC on the redeveloped location. The narrative that CBL malls are getting crushed by anchor vacancies is simply not true.

3.       Malls and retail space in the US are overbuilt compared to other countries. A significant number will need to close to make the rest sustainable.

a.       Although it is true that the US has substantially more square feet dedicated to retail per capita than much of the rest of the world, analysts often miss that this retail is concentrated in urban environments with class A malls. Rural America, where CBL maintains most of its properties, sees far fewer retailers. There exists more GLA in the top 12 MSAs than the rest of the United States put together. On a per capita basis, those markets have 45.4 GLA per capita as opposed to 17.2 in the rest of the US. Moreover, class A malls are concentrated in those 12 MSAs, meaning CBL and other rural competitors face less effective competition in their markets. 93% of CBLs NOI comes from malls that are either market dominant or the only game in town. These stores are on average 23 miles away from the closest competition. Additionally, the ability for online retailers to do things like same day delivery should be much harder to accomplish in spread out rural areas than compact cities. It isn’t clear why the threat of online seems to be most reflected in the stock prices of the companies who it might logically stand to impact the least. Despite the narrative surrounding the future success of class A malls in large cities and failure of class B malls in smaller ones, if one of these two is overbuilt it’s the larger malls in the bigger cities.

b.       Even if some rural malls need to close, for the most part they won’t be ones operated by CBL. To start, there are much worse malls in the hands of private investors, with much lower sales PSF and far lower occupancy rates. Those malls will close first. This should be a positive for CBL as these customers are driven to the next closest retail locations. The few malls that CBL has given over to lenders have 1) not shut down for the most part, but were simply over levered compared to operating income, and 2) do not reflect the quality of the majority of CBLs remaining assets. With 93% of NOI coming from Tier 1 & 2 malls CBL malls should not be among the first to go.

4.       CBL management is poor. They continue to invest in capital projects with rates of return significantly below the cap rate of the overall business. Good managers would have bought back stock or paid down debt instead.

a.       The managers of CBL deserve the opprobrium they have brought down upon themselves. It is hard to explain the lack of significant stock buy backs given the prevailing stock price over the last several months. This should not have taken management by surprise. People have been making this argument for years. Management has done little to prove that it cares about the stock price. On the other hand, when the only thing stopping the realization of a sizeable amount of value is a poor management team, that creates opportunity for a positive catalyst to revalue the stock. If management decides to 1) sell the company, 2) sell additional assets and use the proceeds to pay down debt and buy back shares, or 3) use excess cash flow to buy back shares, we could see a major revaluing of the stock. Even if all three of these ideas seem beyond the current team, it does not seem farfetched to think that a savvy activist will pounce on this and push for changes that will unlock value.

Financial Analysis:

          For a value investor, security of principal is paramount when selecting an investment. One of the chief concerns for CBL raised by those shorting the stock is its capital structure and ability to survive in the medium to long term. Those concerns are materially overstated and miss a bit of helpful nuance in the way debt has been structured at the Company.

          To start, note that the Company has issued new long-term debt in the last month with a yield of 5.95%. Those notes are now trading above par, and all three note issues are trading with yields slightly above 5%. Insofar as debt now makes up roughly two thirds of the enterprise value of the Company, it seems strange that the debt would trade for such a low yield given a cap rate for the entire business approaching 12%. Given all the rhetoric surrounding the imminent demise of physical retail and the mall, it also seems strange that a company exposed to medium tier malls would be able to issue debt going out ten years at such a modest rate. The conclusion one is drawn to is that debtholders have a fundamentally different view of the risk profile of this business than equity holders. With an investment grade credit rating, low yielding and long-term debt trading around par, and a proven ability to raise capital at a time when the rhetoric surrounding their business could not be worse, the debtholders understand this story much better than the equity investors.

          Comparing relevant metrics with investment grade peers makes CBL’s credit profile appear even better. Below are graphs showing where CBL stands compared to its closest competitors on both debt/EBITDA and EBITDA/interest metrics. It stands out as one of the least levered of the mall REITs currently trading, and its EBITDA/interest fits in around the average of the group. Ironically it does not have a better interest coverage profile because it pays a higher interest rate than some companies with much higher leverage ratios. It is important to note that the decline in sales PSF during the financial crisis at CBL were comparable or better than many of its peers. CBL saw a decrease in sales PSF of around 10% from peak to trough, whereas Simon saw a 12% decline. Higher quality malls are not significantly less cyclical in economic downturns.

          Not only does CBL have credit metrics that are among the best in the industry, but management has also placed a concerted emphasis on improving the credit quality of the Company over time. Below is a chart showing LTM interest coverage for CBL over the last ten years.

          The Company maintained a steady coverage ratio throughout the worst of the downturn and has dramatically improved its ability to cover interest payments since then. Although this metric has weakened slightly in the last 6 months, it is still up dramatically from just a year or two ago. Does it make sense to be more concerned with credit quality now when credit metrics are near a long term high than two years ago when the ability to weather a downturn was lower and the stock price was twice as high?

          Furthermore, this high-level analysis of debt coverage misses some attractive optionality present from the non-recourse mortgage debt that covers many the Company’s malls. The ability to dispose of properties that are not covering interest payments out of NOI effectively allows the company to dispose of those assets at a cap rate slightly lower than that interest rate. Given interest rates for this debt average below 5%, every time the Company turns a mall back over to a lender they are creating a tremendous amount of value for the rest of the Company by boosting net income and removing a liability at a huge premium to the markets current value of that asset.

          Finally, on the question of credit, it is important to remember just how much operational flexibility CBL has. The chart below shows total corporate capex, as well as capex psf over the last ten years. Note that the company dramatically curtailed capital expenditures during the downturn, and keep them low for a long period of time as it worked to boost its credit metrics. In a downside case, we believe a similar curtailment of expansion plans would enable the company to generate even more cash to boost credit metrics (which are already starting from a much better place).

          Moving now to equity metrics, it is on its face obvious that this is one of the cheapest and least loved REITs on the public market. Price / AFFO is below 4, less than half its historical level, less than half the average compared to its comps, and nearly 20% below the next closest player. This despite having a dividend yield (~13%) that is nearly twice the industry average, and is the best covered (in comparison to FFO) compared to all its comps. CBL is projected to pay out less than 50% of AFFO as dividends in 2017 as compared to an industry average of around 60%. At the opposite end of this extreme, take Macerich, which yields around 5%, is levered nearly 8x, and pays out over 70% of AFFO as dividends. Which of these two companies seems more likely to cut its dividend, particularly in a downturn? Does it make sense for the quantitatively stronger company to sell with a dividend yield 2.5x as high as the weaker one? Have the managers at Macerich proven they are willing to take down debt, even if it means shrinking the company, in the way that CBLs have?

          While undoubtedly cheap based on financial metrics, critics might counter that these hide fundamental problems in the operations of the business. This is not true. Below you will see charts showing leasing spreads, portfolio occupancy, and sales per square foot over the last 10 years.

          Up until last quarter leasing spreads had been positive for 25 straight quarters. Last quarter they were down 0.8%, a blip compared to spreads in the high single or low double digits that have been the norm over the last 6 years. Moreover, remember that last quarters spread, which was essentially flat, took place against a backdrop of one of the worst quarters for retail bankruptcies since the recession. In other words, it took one of the worst quarters in the last ten years to drop rates from high single digits to flat. A flat projection for the next several years would imply a significant appreciation of the stock price though!

          Perhaps more impressive is the consistency of the occupancy rate. Average second quarter mall occupancy rates over the last 10 years have been 91%. Average occupancy rates for all quarters have been 92%. The latest quarter saw a 90.2% rate, just 0.8% off the average, despite one of the worst quarters for retail in recent history. Moreover, the Company believes it will get back to that 92% occupancy rate by the end of the year. These are not the metrics of a dying company! The fourth quarter of 2016 had the fourth highest occupancy rate of any quarter in the last 10 years. That is not the metric of a dying company! Second quarter overall retail portfolio occupancy is over 0.2% better than the average Q2. That is not the metric of a dying company!

          Finally, and most damagingly for those who are currently dumping on CBL while simultaneously fetishizing sales PSF numbers, are the dramatic increase in sales PSF that CBL has seen over the past decade. From a bottom around $315 that metric has grown to around $375, over 20% from trough to peak. Certainly this has been in part driven by the disposal of several lower quality assets, but that doesn’t change the fact that the Company had a dramatically higher value / lower cap rate back when it had those crumby assets and had a lower sales PSF metric. It’s hard to square the fact that financial risk and leverage has come down, average asset quality has gone up, yields have remained relatively flat, and yet equity multiples have plummeted. Either the market was wrong in how it valued CBL for 10 years, or the market is way off now.

Conclusion:

          The arguments above all point to an undervalued CBL. It is now time to consider a proper value. For a downside case, let’s set appropriate cap rates for Tier 1, 2, 3, and excluded malls at 9%, 11.5%, 15%, and 20%. Then let’s group other retail together and set 10% as a conservative cap rate. The tier 1 and 2 values are based on Penn REIT and Washington Prime respectively, which have similar sales psf and cap rates around there. The rest are guesses at fair value based on conservative estimates and private market transactions. The other retail cap rate is particularly conservative. Using those assumptions, the implied enterprise value is roughly $500 million higher than today, generating a stock price increase of roughly 35%.

          On the upside, note that all the equity research we’ve seen puts the NAV of the mall portfolio more than twice as high as the current price implies. Grant’s Interest Rate Observer wrote up this idea twice a couple years ago, once when it was trading at an 8.6% cap rate, once when it was trading at a 9.3% cap rate, both times arguing the rate should drop down to a more normal 7.6%. At those three rates, the stock would be up around 130%, 90%, and 205% respectively. Although we think getting down to the mid-7s may be a bit aspirational at this point, we wouldn’t view those prices as out of the question given prevailing interest rates. All the while an investor is paid around 13% (a dividend that should increase the next couple years). That is a risk/reward tradeoff we like!

Catalyst

- Market realizes extent of misvaluation of underlying assets

- Management moves to realized value of underlying assets

- Activist pushes for changes to unlock value of underlying assets