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Simon's Portfolio of Class A Malls Should See Strong Growth Coming Out of the PandemicSimon's Portfolio of Class A Malls Should See Strong Growth Coming Out of the Pandemic Kevin Brown Equity Analyst Business Strategy and Outlook | by Kevin Brown Updated Mar 29, 2021 Simon Property Group, the largest mall real estate investment trust, manages one of the top retail portfolios in the country. It owns and operates Class A traditional regional malls and premium outlets in markets with dense populations and high incomes; these malls frequently have domestic or international tourist appeal. The high-quality properties will continue to provide consumers with unique shopping experiences that are hard to replicate elsewhere, and as a result, we think Simon's portfolio will be sought after by retailers that are increasingly pursuing an omnichannel strategy. E-commerce continues to pressure brick-and-mortar retail as consumers increasingly move their shopping habits online. When excluding categories of retail sales that are generally found neither in malls nor online, like autos, gasoline, groceries, and building materials, e-commerce now accounts for more than 20% of all retail sales. While we believe that online sales will continue to grow at a significant spread over brick and mortar, we also believe physical retail sales growth will still be positive over the next decade. Retailers are becoming more selective with their physical locations, opting to locate storefronts in the highest-quality assets that Simon owns while closing stores in lower-quality malls. Additionally, many e-tailers are beginning to open stores in Class A malls to take advantage of the high foot traffic, as a physical presence provides additional marketing, a showroom for products they want to highlight, and another source of sales. However, Simon must deal with the fallout of the coronavirus pandemic. Shopping at brick-and-mortar locations has fallen as many consumers have shifted purchases to e-commerce platforms. While Simon's revenue is somewhat protected by long-term leases, we see retailer bankruptcies causing a significant drop in occupancy and Simon has been forced to offer rent concessions to keep others afloat. We believe that Class A malls will rebound and that these high-quality malls will eventually return to their prior occupancy and rent levels, but the short-term impact to Simon's cash flow has been significant. Economic Moat | by Kevin Brown Updated Mar 29, 2021 We assign Simon a no-moat rating. Simon's portfolio contains very high-quality assets in the largest metropolitan areas and are strategically located in some of the best submarkets, with high population density and high household incomes. However, the continued growth of e-commerce places significant pressure on traditional brick-and-mortar retail. While the concentration of high-quality tenants across Simon's portfolio can provide an experience for consumers that is hard for other retailers to replicate, there is significant uncertainty about the future of sales growth even from this segment stemming from the coronavirus. Additionally, while rent levels and rent increases the company achieved on its properties in the past five years compared with its initial capital investment produced returns that were above its weighted average cost of capital, we expect the economic impact on the malls to send economic returns below WACC for a significant period, which leads us to conclude that there is no support for a moat for the company. The continued growth of e-commerce is putting significant pressure on traditional brick-and-mortar retail. The U.S. currently has approximately 24 square feet of retail space per capita, a ratio that is 2-10 times greater than in other industrialized countries. As consumers change their habits from shopping in physical stores to shopping online, the demand for retail space will shrink, and many existing stores and malls will go away. There are approximately 1,100 traditional malls in the U.S., and many will not survive the shift of consumer buying habits to e-commerce. However, we expect the reduction in retail space will occur almost entirely at the lower end of the quality spectrum. The approximately 350 Class C and Class D malls are struggling and are either currently in or on the precipice of the mall death spiral, in which vacancies lead to lower sales for remaining tenants, which lead to more vacancies and so on. We do not expect any of these malls to exist as they currently stand 10 years from now. The approximately 400 Class B malls might survive the growth of e-commerce, but they will probably need to come up with very creative solutions and find non traditional tenants to attract shoppers. Meanwhile, the 300 Class A malls should not only survive but thrive in the future retail landscape. Simon derives more than three fourths of its net operating income from Class A malls and almost 90% of its NOI from B+ or better malls while Class C+ or lower malls make up less than 1% of its NOI. Therefore, we do not assume Simon will follow the path of the average mall but rather the path of the Class A mall. The likely winning strategy for retailers will be to pursue an omnichannel strategy where they have an online presence while maintaining a few stores in the top locations. An online presence is extremely important for most retailers in order to capture a share of the growing preference for e-commerce. However, brick-and-mortar stores will still play an integral role for most retailers. Not only does brick and mortar present the traditional way for people to shop, it will also benefit the online store. The physical store provides an important component of marketing the online business. The physical store provides a location to pick up goods purchased online when you don't want to wait for them to be shipped to you. Shoppers may prefer to shop at online stores where they know they can easily return purchases to a physical store rather than ship them back to the e-retailer. The physical store can act as a showroom for large products before they are bought online or as a place to try on an item before the shopper explores the online store for a larger selection of colors. Most retailers do not need the number of physical stores that they currently have, but they will want to maintain a presence in all markets in order to enjoy the benefit of the physical store to the omnichannel strategy. The locations in the worst trade markets that see the smallest foot traffic and generate the fewest sales are the stores most likely to be closed. Conversely, retailers will want to keep their stores located in the top malls, as they have strong demographic trends and high foot traffic and generate high sales. Additionally, many previously exclusive e-retailers are seeing the benefit of opening physical locations to enjoy the benefits of the omnichannel strategy. Amazon, Warby Parker, Bonobos, Boll & Branch, Athleta, and Casper are all examples of companies that got their start as online-only retailers that have opened select physical locations. These retailers are looking to put their new stores in the top retail locations, providing additional demand for space in the top malls in the U.S. Finally, Class A malls are being redeveloped to provide more food and recreation options to present themselves as destinations for entertainment rather than simply places that consumers shop. These trends should all support the health of the Class A mall in an uncertain retail environment. We believe that the primary potential moat source for a mall REIT like Simon is efficient scale, as the regional mall could dominate its own submarket. Retailers are becoming more strategic in selecting the placement of their stores, but all high-end mall companies like Simon could secure leases with many of the most desired tenants in its malls. Simon's assets are among the highest quality, see a significant volume of foot traffic, and are surrounded by markets with favorable demographics. Historically, locations like these are highly sought after by any retailer, and Simon has been able to leverage the overall size of its portfolio by insisting that retailers put stores in lesser-quality assets in order to gain access to the best-quality ones. However, we are concerned that the coronavirus lockdown is changing the behavior of consumers and that the impact will even be felt by the relatively insulated Class A malls. Consumers are forced to do much of their shopping online during the coronavirus crisis, and we believe that many of the changes to shopping habits will be permanent even when the malls reopen. While retailers will still have a strong preference to place their physical stores in Class A malls, the significant shift of business to their online portals will give them more negotiating leverage that will likely eliminate the economic profits Simon might have enjoyed from this moat source. While Simon's portfolio still has the characteristics that could produce a moat in the future, the economic uncertainty is too great at this point to grant a moat from efficient scale. Simon's mall portfolio could also produce an economic moat from the network effect among the tenants at each property. Consumers prefer to make their shopping trips efficient by visiting their favorite stores and comparing prices in a single trip, making sought-after retailers located next to one another desirable. High-quality anchors, in line tenants, and entertainment options has historically drawn significant foot traffic to the mall, which makes placing a store in the mall attractive to other retailers, as their store would benefit from the large number of people already heading to the mall. Therefore, having high-quality tenants improves the quality of the mall, which traditionally has attracted more higher-quality tenants to the mall. While Simon's malls are in densely populated, high-income submarkets that support high foot traffic and high sales for tenants, we are concerned about a change in consumer behavior that may reduce the impact of the network effect. If lingering fears of the coronavirus cause consumers to avoid shopping at the busiest retail centers, foot traffic may fall despite the concentration of high-quality tenants. While Simon's portfolio may be able to draw on this moat source in the future, we believe that the potential for a change in consumer behavior is too significant a threat to assign the company a moat rating. We use an adjusted ROIC calculation to determine whether a company has shown or is forecast to have the characteristics of an economic moat. After adjusting the ROIC calculation to use maintenance capital expenditures instead of accounting depreciation, we calculate that over the past few years, Simon has averaged an adjusted ROIC approximately 220 basis points above our 7.0% WACC. However, in our forecast, the adjusted ROIC drops below this level in 2020 due to the loss in EBITDA from the coronavirus and never recovers to its prior historical spread over WACC. While the company has had a moat in the past, we believe there is currently not enough quantitative evidence of a moat in our outlook for Simon. Fair Value and Profit Drivers | by Kevin Brown Updated Mar 29, 2021 We are slightly reducing our fair value estimate to $149 per share from $151 per share after updating our model for fourth quarter results and tweaking our assumptions for the impact of the coronavirus. Our fair value estimate implies a 5.1% cap rate on our forward four-quarter net operating income forecast, 16 times multiple on our forward four-quarter funds from operations estimate, and a 3.5% dividend yield, based on a $5.20 annualized payout. We assume that the coronavirus will cause occupancy to drop to under 90%, though occupancy will increase over the coming years back to a 92.5% level. We also believe that long-term brick-and-mortar retail sales will slightly weaken. Simon should continue to see positive sales growth, but re-leasing spreads have turned and will remain negative. The occupancy, minimum rent growth, re-leasing spreads, and margin assumptions drive total company annual same-store NOI growth averaging 3.3% across our 10-year forecast. We assume that Simon won't have any significant acquisition opportunities as most Class A malls are already owned by long-term investors. We project $1.0 billion of investments in the company's pipeline of new development and redevelopment projects at an 7.8% average yield in 2021. We estimate Simon’s net asset value to be approximately $137 per share based on a 5.5% cap rate assumption. We use NAV as an assessment of potential private-market value, essentially viewing the firm as a portfolio of assets. To calculate NAV, we utilize recent asset transactions to assign a cap rate to each segment of the portfolio, apply the cap rates to arrive at gross asset value for the company’s real estate, put a multiple on the company’s non-real estate assets, add the non-income-producing tangible assets, then net out the company’s liabilities (excluding corporate overhead considerations). We find NAV to be a useful data point in gauging the underlying value of the firm, especially the likelihood of realizing this value through potential asset sales, recapitalization, or merger and acquisition activity. Risk and Uncertainty | by Kevin Brown Updated Mar 29, 2021 The growth of e-commerce has caused e-tailers to take market share away from physical retail sales. Additionally, many traditional retailers are moving more of their business online to compete with the prices and convenience offered by e-commerce. The U.S. is significantly overretailed on a square foot per capita basis, so shrinking market share for physical space will worsen the situation and makes store closures more likely over time. Several of Simon’s major in line tenants have experienced declining sales and expect to close stores. Simon will have to re-lease vacant space to new tenants, which may be at lower rents in a negative sales environment. Similarly, several major anchors face uncertain futures and some, like Macy's, are closing stores. Anchors do not typically pay significant base rent (low double-digit dollars per square foot versus over $50 per square foot on average for in line tenants), but they still contribute to a mall’s overall health and can be part of certain co-tenancy clauses with other mall tenants. The closure of an anchor usually means less traffic for a mall and many in line tenants opting out of their leases, which exacerbates the situation. Even healthy retailers are likely to become more selective in their physical presence. The number of stores required to enjoy the full benefits of an omnichannel strategy is lower than the actual store count many retailers currently have in many markets. While we believe tenants will prefer to put stores in the highest-quality assets, the competition from lower-quality space will continue to shift pricing power to tenants. Simon may be forced to offer lower rents, rent concessions, shorter lease terms or higher tenant improvement spending to attract and retain tenants. Additionally, many retailers are looking to reduce average store square footage to increase efficiency and profitability, increasing the number of tenants Simon will have to attract to fill its portfolio. Stewardship | by Kevin Brown Updated Mar 29, 2021 We assign Simon Property Group an Exemplary stewardship rating. CEO David Simon has been with the company since 1990, becoming president and directing the initial public offering in 1993, becoming CEO in 1995, and then becoming chairman of the board in 2007. Brian McDade was promoted to CFO at the end of 2018, adding the position to his role as Treasurer, which he has served at Simon for the past 14 years. The board of directors is made up of primarily independent, well-accomplished members who are elected annually. The experience of the management team gives us confidence that the company will continue to make smart capital decisions and source accretive development projects. Simon Property Group has a long history of acquiring and developing high-quality malls and has delivered shareholder returns that have beaten the S&P 500 and REIT indexes over the long term. Simon was founded in 1960 by brothers Melvin Simon and Herbert Simon as a developer of high-quality malls. After going public, the company began utilizing its access to equity capital to acquire competitors that owned other high-quality assets. Acquisitions include rival DeBartolo Realty in 1996, Retail Property Trust and Corporate Property Investors in 1998, Rodamco North America in 2002, Chelsea Premium Outlets in 2003, Mills in 2007, and most of Prime Retail and Capital Shopping Centers in 2010. Simon also tried to acquire Class A mall REIT peers GGP and Macerich in 2010 and 2015, respectively, though its bids were ultimately rejected. Simon spun out its smaller and lower-quality malls into mall REIT Washington Prime Group in 2014 to focus on Class A malls, shedding the company of the assets that would struggle to compete with e-commerce. Simon Property Group in February 2020 attempted to acquire 80% of Taubman Centers for $3.6 billion. Taubman Centers owns 26 high-quality retail properties, including 21 malls throughout the U.S. and three malls in Asia. We have a very favorable view of Taubman's portfolio of Class A malls, with Taubman reporting same-store sales per square foot of $972 in the fourth quarter of 2019, above Simon's average portfolio quality given that Simon reported $693 for the fourth quarter. After calling off the deal in June, Simon renegotiated the terms of the deal at a lower price in November. We were initially in favor of the deal, though our outlook on the acquisition turned neutral once the coronavirus caused the likely yield to dip. We do like that management was able to secure a more favorable price for Simon shareholders, but it still may take a few years for the deal to translate to cash flow accretion. |
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