Separating The Wheat From The Chaff – Washington Prime Group, Inc. (NYSE:WPG)

You may recall that back in March I wrote an article titled, Forget ‘Grind It Out,’ Bite The Bullet. In that article, I explained that “my quibble with Washington Prime (WPG) is not cheapness; I have been pounding the table on that subject for nearly two years.” I added:

“My concern with this mall-based REIT is that the company is saying that it’s “grinding it out” and that is no strategy… WPG needs a viable strategy; the management team should be telling investors that it’s not an earnings growth issue – there’s no cash flow to grow the company when you’re selling ugly duckling malls at double-digit cap rates.”

Essentially, I was making the argument (back in March) that Washington Prime Group, Inc. was a value trap and that shares appear “cheap because the stock has been trading at low multiples of earnings, cash flow or book value for an extended time period.”

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So far, the value trap thesis has played out as I suggested, there has been little to no price appreciation over the last 5 months.

But that doesn’t mean investors should panic, the dividend is well-protected thanks in large part to a “seemingly” healthy FFO Payout Ratio:

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But remember that FFO does not consider adjustments made for recurring capital expenditures (to maintain the quality of the underlying assets), straight-lining of rent, leasing costs, and other factors. Here’s the Payout Ratio for Washington Prime Group using AFFO:

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To be perfectly clear, I’m not trying to talk you out of owning shares in WPG, as noted, I was once a bullish buyer. However, I have become more critical of this particular REIT given the commentary that I will provide below.

More Bad News In Retail

My daughter, Lauren Thomas, has become a terrific source of retail news and I often refer to her work on CNBC. In a recent article she wrote,

“With talk of a retail apocalypse hitting malls and their anchor boxes hardest, department stores have been trying to inch back to growth, putting in place their own turnaround strategies. But meaningful payoffs take time, Wall Street learned Thursday.”

She added,

“Department stores across the board have been struggling to lure shoppers to stores, as more and more purchases are being rung up online. To combat this trend, retailers are closing unprofitable stores to make a leaner brick-and-mortar footprint, trying to keep inventory light, and often using promotions to drive excitement around shopping. But should markdowns and heavy promotional expenses continue, profits will be hurt.”

In the Mall sector, I am paying close attention to Sears (SHLD), J.C. Penney (JCP), Macy’s (M), and Dillard’s (NYSE:DDS).

I was especially interested in my daughter’s research report on J.C. Penney. Here are a few bullets:

  1. JCP is focused on growing one category that many retailers are seen fleeing today: apparel.
  2. Same-store sales in its apparel business underperformed during the second quarter, largely because of a “tough” environment for kid’s clothing. But Penney’s is forging ahead in rolling out a better and broader assortment of clothing, specifically for women.
  3. Penney’s hopes to accomplish this by expanding key relationships with outside partners Nike (NYSE:NKE) and adidas (OTCQX:ADDYY), while also beefing up its own athleisure-focused label, Xersion. Many are saying this move is a long time coming for Penney’s.
  4. In the second quarter, Penney’s liquidated 127 of the 138 full-line stores that are scheduled to close, something the company said allowed for “less desirable apparel inventory to make room for… more casual and contemporary women’s apparel being launched for back-to-school and the fall season.”
  5. In a sense, Penney’s is following in Nordstrom’s (NYSE:JWN) footsteps and hoping to emulate the retailer’s success. After a week of mixed department store earnings, Nordstrom was the only name to deliver same-store sales growth.
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My daughter summed it up,

“But one can’t help but wonder why Penney’s is only now making such a big push in apparel, when other retailers in that same business are fighting to stay alive. Brands like J Crew and Nine West are on so-called bankruptcy watch, while clothing retailers Gymboree, BCBG, Wet Seal and Rue21 have already been forced to file.”

She also provided commentary on Dillards,

“Dillard’s, which missed Street expectations on both the top and bottom lines, said that significant markdowns led to a disappointing loss during the latest quarter, as the retailer had to deal with excess inventory. Dillard’s stock was last falling more than 14 percent.”

Sears has not announced Q2-17 earnings but most fear that the results will fall in-line with Penney’s and Dillard’s.

In fact, Sears is the weakest link in the department store chain, and that’s one of my concerns with Washington Prime. Let’s take a look at WPG’s top tenant list:

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As you see, Penney’s and Sears appear on the list with 1.3% and 1.1% of average base rent (or ABR) respectively.

Recently, WPG made the decision not to renew the Sears lease at Markland Mall, located in Kokomo, IN, and the company intends to redevelop the space. This is the only Sears store in Washington Prime Group’s portfolio expected to close in 2017. Here is a snapshot of the Sears’ leases with WPG:

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J.C. Penney announced on March 17 the specific location of one store in Washington Prime Group’s portfolio, which will close in 2017. The store location: New Towne Mall located in New Philadelphia, OH. WPG is currently in discussions with several potential new tenants for this space. Here is a snapshot of the J.C. Penney leases with WPG:

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In total, Washington Prime Group has 39 stores leased to Sears and J.C. Penney. As you can see, the leases are laddered, but in the event of a default (by Sears or J.C. Penney), WPG will have considerably more vacant space to redevelop.

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But you’re right, even if Sears and J.C. Penney were to close all of their stores today, that would only be 3.4% of rent, and the dividend would not be impacted…

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Not so fast, Sears and J.C. Penney represent over 11 million square feet and if 10% of the space is vacated, that would equate to roughly 1 million square feet. Washington Prime Group would be required to pay for taxes, insurance, and maintenance and that could cost (my guess) around $5.00 per square foot or $5 million annually.

In other words, the dividend is not as safe as it seems…

What About The Tier 2 Properties?

Around 80% of Washington Prime Group’s Net Operating Income (or NOI) is from Tier One and Open Air assets and the balance (20%) is made up of Tier 2 properties. According to WPG’s Investor Presentation, “Tier One Enclosed is defined as $398 Sales PSF and Tier Two is defined as $301 Sales PSF.”

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Here is a snapshot of the Tier 1 and Tier 2 properties:

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Here’s a list of the Tier 2 properties based on SS (square foot) owned and loan balances:

As you can see, I have highlighted a few of the properties with the most leverage per square foot. Cottonwood Mall in Albuquerque, NM has the highest leverage (per SF) followed by Rushmore Mall and Lincolnwood Town Center.

Cottonwood Mall is anchored by Dillard’s, J.C. Penney, and Sears and is the second largest mall in New Mexico.

Anderson Mall, another Tier 2 Mall, is located closer to my hometown. This mall is anchored by Belk, Sears, J.C. Penney, and Dillard’s. I’m most familiar with this property since I purchased an outparcel from Simon Property Group (SPG) a number of years ago and I developed a Hollywood Video and Lifeway Christian Supply.

One of the big concerns with Tier 2 Malls (like Cottonwood and Anderson) is that if a department store closes, there are fewer big box retailers to replace the space. While Washington Prime Group’s dividend appears well-covered based on FFO, a deteriorating retail market could be problematic for the lower-quality properties.

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Deteriorating Results

In the latest quarter, Washington Prime Group reported weaker SS NOI, down 1.9%. The company’s Mall SS NOI decreased by 3.4% as the lower Tier 2 assets fell by 11.5% due to a 100 bps drop in occupancy to 86.9%.

WPG reported FFO of $40 per share, as this earnings metric continues to slide:

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At $.25 per share, the dividend is still well-covered, but as noted above, the AFFO per share is not as safe.

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As REIT analyst, Floris van Dijkum wrote in a research report,

“WPG continues to have exposure to troubled retailers. Ascena is the company’s fourth largest small shop tenant at 1.9% of ABR and 128 store locations while Sears and J.C. Penney ate the largest anchor exposure of rent. In addition, the company has 15 Bon Ton locations that represent .9% of rent.”

My Takeaway: I am continuing to recommend the higher-quality retail REITs (like SPG and Taubman Centers, Inc. (NYSE:TCO)) that generate higher SS NOI growth. Washington Prime Group is making improvements to the balance sheet but as van Dijkum wrote, “we remain Neutral on WPG and believe its shares could be range-bound for the time being.” Thus, my value-trap argument stands, at least for now…

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Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research while also providing a forum for second-level thinking. If you have not followed him, please take five seconds and click his name above (top of the page).

Sources: F.A.S.T. Graphs and WPG Supplemental and Investor Deck.

Disclosure: I am on the Advisory Board of NY Residential REIT, and I am also a shareholder and publisher in theMaven (OTCQB:MVEN).

Disclosure: I am/we are long APTS, ARI, BRX, BXMT, CCI, CHCT, CLDT, CONE, CORR, CUBE, DLR, DOC, EXR, FPI, GMRE, GPT, HASI, HTA, IRM, JCAP, KIM, LADR, LTC, LXP, O, OHI, OUT, PEB, PK, QTS, ROIC, SKT, SNR, SPG, STAG, STOR, STWD, TCO, UBA, UNIT, VER, VTR, WPC.

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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