|Shares Out. (in M):||368||P/E||0||0|
|Market Cap (in $M):||2,696||P/FCF||0||0|
|Net Debt (in $M):||4,288||EBIT||0||0|
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DDR is a REIT active in the open-air strip mall format. In our work presented below, we show why we believe DDR’s intrinsic value to be in the $11.50 per share area. With the stock price currently trading at $7.30 per share, we estimate the discount to intrinsic value to be around 37%. DDR is also in the process of undergoing a significant restructuring with the spin off of a third of its portfolio into a new company called Retail Value Trust (RVT). We believe the spin off could serve as an excellent catalyst to narrow the discount to intrinsic value.
Why does this opportunity exist?
- Open-air strip mall REIT is an unloved sector, due to perceived existential threats from online shopping. Despite the media’s focus on the demise of the sector, we note that occupancy remains well above 90% for good quality portfolios. There is a rotation in the tenant base for sure with traditional multi-line apparel retailers on the decline. However, these tenants are being replaced by discount chains and new “lifestyle” tenants (movie theaters, restaurants, fitness centers, etc.). We further believe that transactional cap rates in the 7% area already price in a certain element of disruption.
- DDR has a history of mismanagement with an extraordinary level of executive turnover in recent years. Five different CEOs in the past seven years. The current management team, led by CEO David Lukes, is highly regarded and comes from Equity One where it was successful in engineering a takeover by Regency. Since being hired in March 2017, the team has been active in restructuring the portfolio (asset sales, reducing leverage, spin-off of RVT). We believe these actions will create substantial value for shareholders. The team’s financial interests are also well aligned with those of the shareholders’. They collectively have exposure to $10 million worth of stock price-sensitive instruments of which $4 million is through direct share ownership.
- The REIT investor base is largely focused on the level and predictability of the dividend yield. Because of the upcoming portfolio’s split, it is difficult to project what the combined dividend yield will be on both stubs. This is irrelevant for total return value investors.
- The recent rise in interest rates has put pressure on REITs in general. We view the current sell-off as the typical knee jerk reaction from investors who have been trained to believe that a rising rate environment is negative for REITs and other fixed assets. Many studies have shown that REITs’ performance is not correlated to the level of interest rates over the long term.
Given the upcoming split of the company, we suggest valuing DDR using a sum of the part analysis. In the next section, we will try to estimate a fair value for RVT. To do so, we will value the U.S. assets separately from the Puerto Rico assets. We will then aim to conservatively value the RemainCo (new DDR).
1. What is RVT worth?
First, some basic considerations: RVT will be set up as a Trust consisting of 50 properties, of which 38 will be located in continental U.S. and 12 in Puerto Rico. The goal of the Trust will be to liquidate these properties within a two-to-three year time frame— although note that RVT is not a liquidating Trust. DDR will be the manager of the Trust. The Trust will be capitalized by a $1.35 billion loan expiring in 3 years (with two 1-year extensions available). The loan is secured by the U.S. properties and an equity pledge from the entity that owns 100% of the Puerto Rican assets. The loan will be interest-only with RVT having the possibility of paying down the principal after one year using proceeds from the properties sales. The loan is being syndicated at 1-month U.S. libor +3.3% at the time of writing.
1.1 U.S. assets
DDR has been a net seller of assets in the last two years and we believe one can study these transactions to extrapolate what RVT’s U.S. assets are worth. We combed through the 29 fully owned properties that DDR sold since the beginning of 2017. We analyzed the relationship between Sale Price per Square Foot and Average Base Rent Per Square Feet (ABR PSF). We did so under the premise that the more productive assets (high ABR PSF) should command higher sale prices (higher sale price per square foot). After analyzing the 29 transactions, we do indeed see a strong relationship (r2=0.79) between the two variables.
We then apply the same regression analysis to each of the 38 U.S. assets held in RVT. We come up with an undiscounted portfolio value of $1.92 billion. We believe this appraisal to be reasonable for the following reasons. First, we estimate that $1.92 billion approximately translates into a 6.8% weighted average cap rates on the portfolio. This is consistent with management’s statement that the RVT U.S. asset pool is “measurably superior to the DDR assets sold to date with better demographics, leased rates and rent PSF”. (See form 8-k filed on 12/14/17, p20). These assets that they are referring to, were sold at a weighted average cap rate of 7.8%. Second, a $1.92 billion asset value implies a LTV of 70% for the loan being underwritten, which is, we believe, a standard LTV for this type of portfolio. For a detailed analysis on a property-by-property basis, please refer to appendix A and B.
1.2 Puerto Rico assets
While we can take comfort in the recent sale transactions to estimate the value of RVT’s U.S. portfolio, the level of uncertainty is certainly higher when it comes to the assets located in Puerto Rico. In addition to a severe economic crisis, the country also had to contend with the devastating impact of Hurricane Maria. As it relates to DDR specifically, we note that 76% of the leased GLAs are open for business. Also worth noting, monthly cash receipts on the portfolio look to be around 80% of the pre-hurricane levels.
When facing uncertainty, conservative value investors tend to value assets on a worst-case scenario basis, which is what we will do by valuing the Puerto Rico portfolio using a 10% cap rate, which implies a $720 million undiscounted valuation. Interestingly, DDR recently sold two assets (Plaza del Oeste and Rexville Plaza) for $57.25 million. We estimate that the assets were sold at an 8% cap rate. We also note that the transaction took place on June 30, 2017, i.e. before Hurricane Maria, but already deep into the economic recession engulfing the island. We will also increase the margin of safety in our analysis by modeling the sale of these properties happening only in the second half of 2021 (i.e., much latter than the U.S. assets).
1.3 Timeline and RVT valuation estimate
The table below shows our valuation estimate for RVT. Some of the important modeling input is:
- The U.S. portfolio is liquidated in two and half years. We note that DDR already started the marketing process in February. We model that $240 million worth of properties will be sold before the spin off takes place (scheduled in July 2018).
- No sales proceeds are released to shareholders until the loan principal balance is fully repaid. The speed at which the assets are sold is the most important input to the valuation. We are modeling $420 million worth of U.S. asset sales every six months, which we think is not overly demanding. For example, DDR liquidated on average $700 million worth of properties every six months over the past three years. For context, there was around $60 billion worth of shopping center transactions in 2017, so that the $840 million we’re modeling for a full year should not overwhelm the market.
- No Puerto Rican assets will be sold until the second half of 2021. These assets will be sold as one portfolio at a 10% cap rate. NOIs from that portfolio do not grow from the current level.
- We anticipate only modest distributions from the portfolio’s AFFO.
We value RVT under our base case at $1.2 billion or $3.25 per share
2. What is the RemainCo (New DDR) worth?
We believe value will be created at new DDR by the re-rating of the common stock. The re-rating will likely occur thanks to 1.) a much more conservative financial profile and 2.) a better-positioned portfolio. Ultimately, we think these two factors will lead to better trading multiples for New DDR.
2.1 New DDR’s balance sheet becomes materially stronger
RVT will dividend out $1.35 billion (the proceeds from the secured loan) back to New DDR. New DDR will then use these proceeds (along with supplemental asset sales) to retire some of its existing debt. This marks the culmination of the company’s effort to substantially reduce financial leverage. Below we compare New DDR’s balance sheet to Kimco (KIM), which is widely regarded as the benchmark name in the open-air strip mall industry.
One can readily see that New DDR’s creditworthiness improves tremendously with the RVT transaction. The credit metrics will be very similar or even better than KIM. There is a large difference is scale with KIM being five times larger than New DDR as measured by the number of wholly owned properties. While some investors may ascribe a discount based on that metric, we view it as generally neutral. The smaller scale of New DDR could make it an attractive M&A target for one of the larger companies in the sector or for a private equity investor.
2.2 New DDR portfolio’s quality improves meaningfully
We refer to the company’s 8-K filled on December 12, 2017. The management team has hand picked what they believe are the best properties to remain within New DDR. These properties have a higher potential for organic NOI growth and also offer more redevelopment opportunities. The below statistics lead us to believe that the portfolio’s quality will be on par with some of its best competitors:
- New DDR’s average household income = $99k (KIM around $88k)
- Annual Base Rent PSF = $17.42 (KIM around $15.9)
- Green Street Advisors Tap Score = 65 (KIM is 62)
New DDR occupancy rate will be 93.6% (up from 90.4% currently) and in that respect, it will still lag most of the industry (KIM is at 96%). However, we do note that the management team targets an improvement to pro-forma 94.5% occupancy rate through new leasing opportunities.
2.3 What cap rate to use for New DDR and final DDR NAV computation
We believe asset quality and creditworthiness are the two most important inputs when valuing commercial real estate. Based on the previous two sections, it seems unwarranted that New DDR should trade at a discount to the sector. Following that line of thought, we note that KIM currently trades at an implied cap rate of 8%, which we will use as our starting point of reference.
One can also use the same regression analysis offered to value the U.S. assets of RVT. If we plug in new DDR’s ABR PSF ($17.42) in the regression, we get a total value of real estate at $6.7 billion, which implies a 6% cap rate. Note the logical train of thought here: First, we know that DDR has been selling unwanted assets in 2016 and 2017 at around 7.8% cap rates. Second, our analysis of RVT suggests the U.S. properties will likely be sold in the 6.8% cap rate area. Therefore, it is only logical that the new DDR portfolio, which has been specially curated by the management team, should be valued using a cap rate meaningfully lower than 6.8%. Nonetheless, for the sake of conservatism and taking into account KIM’s cheap stock market valuation, we settle on using a 7% cap rate when valuing new DDR’s consolidated properties. Note that we use 8% for the JV assets. Our base case therefore values New DDR at $3.06 billion or $8.31 per share.
We present below the recap of our work. Under our base case scenario, we believe the fair value of DDR, as it stands today, to be around $4.25 billion or $11.55 per share.
Because we are cognizant of the dramatic influence cap rates have on estimates of fair value, we also offer the below sensitivity analysis:
3. Recent insiders’ transactions
Mr. Alexander Otto, a member of the board of directors, has been actively buying DDR common stock in recent weeks. We believe this is significant given the aggressiveness of the purchases— he acquired 5.7 million shares worth around $42 million since February 21, 2018— but also because of his familiarity with commercial real estate and his long history with DDR in particular. As a way of background, Mr. Otto’s current net worth is estimated at $6.3 billion by Bloomberg. It comes mainly from widespread commercial real estate holdings in continental Europe, through a company called ECE (of which Mr. Otto is the CEO). The Otto family also is involved in the U.S. real estate market through the Paramount group (ticker PGRE), an office REIT where the Ottos own a 25.9% stake. The Ottos initially invested in DDR in 2009 in the depth of the global financial crisis. The family provided liquidity to the company by purchasing 30 million shares of common stocks at between $3.5 and $4 per share. Since then, the Otto family has been a net buyer of shares and now owns around 52.9 million shares or 18.7% of the company. Given the familiarity of Mr. Otto with the asset base, we view his recent buying activity as a great support to our bullish view of DDR.
We believe DDR represents a compelling opportunity at current prices with a significant margin of safety that should limit the risk of permanent loss of capital. A valid criticism of our thesis could be that many retail REITs currently trade at wide discounts to NAV and that DDR does not differ from that norm. We would however argue that the DDR opportunity is different in the sense that the discount between asset values as implied by the stock market and the “private buyer” fair value is about to collapse on one third of the NAV through the liquidation of RVT. We believe this offers a clear catalyst for value realization. We also like the opportunity for New DDR to “re-rate” and potentially be acquired at a substantial premium to its currently implied valuation.
A quick side note on trade sizing: We would suggest investors not to establish a full position size for the time being. We believe there will likely be opportunities to invest in RVT at heavily discounted prices given 1.) the negative sentiment surrounding the asset base (25% of the NAV is in Puerto Rico, U.S. assets being labeled as “slow growth”, etc.) and 2.) the typical spin-off dynamics with indiscriminate selling pressures likely to emerge in the first few days after the spin’s completion.
APPENDIX A: DDR wholly owned properties - sale transaction analysis - 12/31/2016 to 02/07/2018