Deep Value And 18.5% Yield From Washington Prime

Co-produced with Beyond Saving for High Dividend Opportunities

Washington Prime Group (WPG) is a mall REIT that is beaten down and trading at highly opportunistic valuations. Investors have been very negative on anything that is retail related, despite the fact that WPG has made significant progress in re-positioning their portfolio and is set to return to growth soon. No credit is being given by Mr. market for this progress. The dividend yield is today sky-high at 18.5% and unlikely to be reduced anytime during the year 2019. The bears have been betting on a dividend cut, and they have been wrong. We will explain in our report why we are very bullish on WPG, and this is likely one of the best opportunities in the Property REIT space.

Washington Prime Group has seen their share prices fall due to extreme pessimism surrounding malls, highly publicized tenant bankruptcies like Sears Holdings (OTCPK:SHLDQ), and the actions of CBL Properties (CBL) a REIT in the same space which has dramatically cut its dividend.

When the market is at its most pessimistic, it can create an opportunity to invest in a solid company at a substantial discount. We believe this is the case with WPG.

  • WPG malls remain high-quality real estate with fundamentally strong values. Malls are changing, not dying.
  • WPG has a good plan to redevelop vacant and soon to be vacant big box stores. The new tenants will be more attractive to modern consumers and will pay higher rents.
  • WPG has the ability to fund their plan, without taking extraordinary measures.
  • WPG is committed to maintaining their dividend at $1.00/year.
  • Significant insider buying suggests that those who know the most believe shares are trading at a significant discount and that insiders’ interests are well-aligned with shareholders.

‘Retail Redefined’ Source: WPG website

Too Much Pessimism Creates Opportunity

We recently highlighted the preferred stocks of WPG in an article entitled: Washington Prime Group: Top Preferred Stock Pick With 10% Yield, 40% Upside

The two preferred stocks were yielding over 10% at the time:

  1. Washington Prime Group, 7.50% Series H Cumulative Redeemable Preferred Shares (WPG.PH)
  2. Washington Prime Group Inc. 6 7/8 % Cum Red Pfd Series I (WPG.PI)

Both preferred shares are up by 22% since our recommendation, and we believe they are still opportunistic with yields over 8.5%. Today, we will argue in our report that the common shares are even more opportunistic and offer deep value for investors.

Fundamentals

Tenant bankruptcies have been a leading headline, and despite some big name bankruptcies and store closings like Bon-Ton (OTC:BONT) and Sears, sales at malls have remained strong.

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After a brief dip in 2017, WPG’s sales per square foot have regained ground, reaching $377 at the end of 2018.

Additionally, despite higher than average levels of bankruptcies, WPG has managed to maintain a stable occupancy rate between 93% and 95%.

For tenants, malls remain an attractively priced option as occupancy costs continue to decline.

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Occupancy cost is the total cost that tenants have to lease the space as a percentage of gross revenues. In other words, mall tenants are making more revenue per dollar spent on rent today than they have in the past.

Occupancy cost frequently declines when rents are increasing more slowly than sales per square foot. It can often be a leading indicator that rents are going to start to increase more aggressively.

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Retail sales continue to climb, the National Retail Federation predicts that sales grew 4.5% in 2018.

With average sales of $377 per square foot and climbing, WPG’s malls remain attractive properties for retailers to have access to significant traffic at a reasonable cost.

Redevelopment

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We like how WPG has been very transparent about their plans to redevelop vacant and soon to be vacant department stores. As of Q3 2018, most of the projects were in the “active planning” stage, which means that WPG is in the process of negotiating with potential tenants. When they reported their Q4 earnings, it was revealed that they have agreements for 7 of the properties.

WPG has been hampered by the uncertainty of the fate of specific locations. As of Q4 earnings, 21 of the 28 stores were closed or scheduled to close. With the bankruptcy sale of Sears to Lampert approved, there will be some clarity in the near future which of the remaining stores are closing and which will remain open in the near future.

We anticipate that WPG will continue making announcements of agreements with new tenants in the next few months. As redevelopment projects make their way through the pipeline, it will reduce uncertainty as well as provide incremental revenue and FFO growth.

With much of the space newly vacant, WPG will experience downward pressure on their 2019 revenues and FFO, from direct loss of rent (approximately $4 million) and up to $8 million in co-tenancy impact. That downward pressure should be somewhat offset by the completion of several development projects throughout the year.

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WPG has 6 projects that will be completed in 2019 and 3 more slated to be completed in 2020. As projects are completed, we anticipate that new ones will be started creating a consistent source of growth over the next several years.

Assuming that WPG can continue these redevelopments at the current 7-9% yields, the completion of the 28 store redevelopment should increase NOI $21-31 million directly. There will also be additional benefits as the new stores increase traffic and support higher rents for other storefronts in the malls.

Funding

As of the end of Q4, WPG has $42 million in cash and $350 million available on their revolver. Additionally, WPG continues to bring in additional cash with the closings of the previously announced sales to Four Corners Property Trust (FCPT).

That liquidity will be more than sufficient to fund their redevelopment plans for 2019.

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Additionally, WPG has put a lot of effort into deleveraging and increasing their unencumbered assets over the past 4 years. One of the primary reasons they did that is to ensure they had a flexible balance sheet to handle the large redevelopment expense of a Sears bankruptcy.

WPG has a significant amount of room in their most restrictive covenants to use debt to fund some redevelopments. With a significant portion of their assets unencumbered, they have the option of adding property level non-recourse mortgages should they have difficulty getting unsecured debt.

We do not believe that WPG will have to resort to using mortgages, the debt markets have remained open to them as demonstrated by their ability to recast their revolver in January of last year.

Situation with J.C. Penney

WPG bears have been sounding the warning that J.C. Penney (JCP) will be the next major retailer to fall. A JCP bankruptcy in the near future would put significant pressure on WPG. The recent earnings release from JCP helped clear up a lot of that uncertainty. JCP soundly beat market expectations and has made progress in their attempted turnaround. They managed to do the following:

  • Decrease inventory 13%
  • Reinstate the “Chief Merchant” position
  • Have liquidity of $1.9 billion at quarter end, and over $2 billion in February
  • Only $50 million in unsecured debt is maturing in 2019 and $110 million in 2020
  • Free cash flow of $111 million in 2018 and they project positive FCF in 2019
  • Are closing 27 underperforming stores (none in the WPG portfolio)

JCP continues to struggle with declining same-store sales, and it is entirely too early to determine whether their turnaround efforts will prove successful for the long term. What we can be confident about is that JCP is unlikely to file for bankruptcy in 2019 or 2020 and that store closures for 2019 will not impact WPG.

The Dividend

When a company is yielding 18.5%, it is natural to worry about the safety of the dividend. Management has consistently stood behind the dividend, and they recently declared and paid the dividend for Q1 of 2019.

To maintain their REIT status, WPG is required to distribute 90% of their taxable income. WPG’s taxable income has been quite high, primarily due to taxable gains when they have turned properties over to lenders. In the Q3 conference call, Mark Yale said,

Finally, in terms of our dividend, we remain comfortable with current coverage, which will allow us to generate approximately $50 million to $55 million of free cash flow during fiscal year 2018. We also intend to be in a position to absorb any taxable gains incurred in connection with the resolution of our aforementioned non-core assets.”

During 2019, WPG will be turning over at least two more malls to lenders. Towne West Square in Wichita, where they owe $45.5 million and West Ridge Mall in Topeka where they owe $40.1 million. Those transactions can be expected to be completed sometime this year and will inflate WPG’s taxable income.

The most likely scenario is that the dividend will be maintained at least through 2019 as lender givebacks will increase WPG’s taxable income. The lender givebacks that will occur this year will at least limit the maximum amount WPG could reduce the dividend and might prevent a dividend cut completely.

Going into 2020, WPG will have more redevelopments coming online, which will increase their free cash flow and reduce the likelihood of any dividend cuts in the future.

  • There is a plausible path forward that sustains the dividend.
  • Lender givebacks will significantly limit how much the dividend could be cut in 2019.
  • As redevelopment projects are completed, free cash flow will improve reducing the need for a dividend cut.
  • Even if the dividend is reduced, WPG can still have an attractive total return.

Risks

The main risk to the buy thesis is that investor sentiment remains extremely negative towards mall REITs. Mr. Market can stay irrational for an extended period of time. This is why we recommend to build a position very slowly and limit your investment to no more than 1% of your overall portfolio at this time. We are following up closely on WPG and are ready to add a position on any further pullback, if we see one. On the very positive side, investors are getting in very cheap valuations with a good likelihood of getting a full dividend for 3 quarters a least, if not longer.

Insider Buying

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We are also encouraged by a spike of insider buying at the end of 2018. In December, insider buying spiked up to levels that are the highest they have been since June of 2015.

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CEO Louis Conforti has been a consistent buyer, and December saw Sheryl von Blucher and Robert Laikin significantly increase their positions as well. We interpret this as a strong positive sign that insiders are confident in WPG’s ability to implement their plan. Management has not only shown confidence through insider buying, but has also featured CEO Louis Conforti as Freddie Mercury from the legendary band “Queen” on the landing page of WPG singing the famous song “we will rock you“!

Unfortunately, the photos have been recently removed from the website. The bottom line is that WPG has one of the best management teams that any company can wish for, and this is what matters the most in such a situation.

Magnificent Short Squeeze Waiting to Happen

There have been many WPG bears over the past two years, but we can note that they are becoming less and less visible. The reason is simple: WPG’s management has done tremendous efforts to put the company on track, and they have been successful so far. Still, it seems that many speculators have been shorting the stock hoping for a dividend cut that is unlikely to happen anytime soon. Those shorting WPG stock are paying huge expenses to do so.

  • First, they have to pay us, those who are long WPG common, the 18.5% dividend yield.
  • Then, they have to pay borrowing costs to short the stock.

With the chances of a dividend cut less and less likely, those shorts will have to run for cover sooner rather than later. Let us look at the specific data in the table below:

Source: Shortsqueeze.com

Based on the latest data available from shortsqueeze.com, speculators are short 20.9% of the market cap of WPG. This is an enormous level of short interest. Most importantly, based on WPG’s trading volume, it will take 12.2 days of average daily volume for these shorts to cover their positions! Once these shorts start covering, we are likely to see a huge rally in these shares – one of the most magnificent ones that we will probably see in a very long time.

Conclusion

The market has been extremely pessimistic towards mall REITs in general, and especially towards WPG. Despite the market’s pessimism, the fundamentals remain strong.

  • Sales per square foot are growing.
  • Occupancy is stable.
  • Occupancy cost is declining.
  • Monthly retail sales are growing.

The retail sector headlines have been dominated by antiquated retail giants that failed to adapt to changing consumer preferences. Brands like Sears, that were once dominant, have become insignificant to the modern consumer.

For mall owners like WPG, regaining control over the large amount of space that has been dedicated to a dying brand is a great opportunity to bring in brands that are more appealing to modern consumers.

WPG has a good plan to redevelop the space they have recently or soon will acquire. The SHLDQ bankruptcy is not a surprise to anyone. It is something that WPG has been preparing for, and they have positioned their balance sheet for maximum flexibility.

For common shareholders, the dividends are now yielding an enormous 18.5%. We believe that the dividend will be maintained at least through 2019 as lender givebacks will increase WPG’s taxable income.

While a cut in 2020 or beyond cannot be ruled out, increasing cash flows will make a dividend cut less likely. We believe that even with a potential dividend cut down the road, WPG’s long-term prospects still make it an attractive investment opportunity. Investing in WPG is a case of chasing a deep value stock, not chasing yield. The high yield of 18.5% is a cherry on the cake. Note that WPG goes ex-dividend again on May 31, 2019, or in two months.

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Disclosure: I am/we are long WPG, WPG.PH, WPG.PI. 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.