TAUBMAN CENTERS INC TCO S
September 28, 2009 - 8:15pm EST by
agape1095
2009 2010
Price: 35.73 EPS $0.815 $0.665
Shares Out. (in M): 53 P/E 42.0x 51.0x
Market Cap (in $M): 1,898 P/FCF n/a n/a
Net Debt (in $M): 2,735 EBIT 78 0
TEV ($): 4,759 TEV/EBIT 61.1x n/a
Borrow Cost: NA

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Description

 

Taubman Centers, Inc. operates as a real estate investment trust.   The company owns, leases, develops, acquires, and manages regional and super-regional shopping centers.  As of year-end 2008, it owns and/or manages 23 urban and suburban shopping centers in 10 states across the United States. These centers are located in metropolitan areas, including New York City, Los Angeles, San Francisco, Denver, Detroit, Phoenix, Miami, Dallas, Tampa, Orlando, and Washington, D.C.

Bull Story

  • Strategically located in major metropolitan, affluent areas, where traffic flow and barrier to entry is higher.
  • 5 of TCO's malls have GLA over 400,000 sf (regional shopping centers). The other 18 malls have GLA over 800,000 sf (super regional centers). The average size of the mall is the largest in US.
  • Large malls are less vulnerable to competition because anchors and retail chains avoid opening stores near an existing location for fear of cannibalizing sales. The large average size of TCO's malls allows it to sign up more retailers as tenants.

 

  • Larger malls are more attractive to consumers because they offer more selection of retail stores, and broader types of goods.
  • Over 90% of mall GLA leased to national firms, who are more credit-worthy, and more likely to expand and take up additional space than small, local firms.
  • In the shopping center business, sales per square foot, is the main driver behind rent rates and occupancy. TCO's malls generates the highest sales per sf number at $539/sf relative to other US mall REITS.

Investment Thesis

Unfortunately, the good news end here.  Although the real estate portfolio is sound, I am recommending a pair trade: short TCO, long DDR with the thesis based on a short on TCO because of its  

  • 1) accounting irregularities that understate total liabilities
  • 2) deteriorating operations
  • 3) capital structure

The Accounting

TCO is the publicly traded entity.  The Taubman Realty Group Limited Partnership (TRG), a majority -owned partnership subsidiary of TCO, owns the real estate.  16 malls are consolidated and the remaining 7 malls are accounted for as joint-venture using the equity method of accounting.

 

As of 2008 Year end

 

Name

Location

Mall GLA

Year open/expand

Ownership

Consolidated

 

 

 

 

Beverly Center

LA

572

1982

100%

Cherry Creek

Denver

546

1998

50%

Dolphin Mall

Miami

636

2007

100%

Fairlane

Detroit

589

2000

100%

Great Lakes

Detroit

536

1998

100%

International plaza

Tampa

576

2001

50%

Macarthur

Norfolk

522

1999

95%

Northlake

Charlotte

465

2005

100%

Partridge Creek

Detriot

366

2008

100%

Pier at Caesars

Atlantic City

282

2006

* handed the keys back to lender.

Regency Square

Richmond

233

1987

100%

Short Hills

NY/NJ

520

1995

100%

Stony Point

Richmond

296

2003

100%

Twelve Oaks

Detroit

548

2008

100%

Wellington Green

Palm Beach

460

2003

90%

Willow Bend

Dallas

523

2004

100%

 

 

 

 

 

JV

 

 

 

 

Arizona Mills

Phoenix

535

1997

50%

Fair Oaks

Washington

564

2000

50%

Millenia

Orlando

516

2002

50%

Stamford

Stamford

452

2007

50%

Sunvalley

SF

485

1981

50%

Waterside

Naples

197

2008

25%

Westfarms

Hartford

518

1997

79%

 

 

 

 

 

 

Westfarms

I am never a big fan of JV and equity method of accounting because they hide leverage off the balance sheet.  What is alarming about Westfarms is that TCO owns 79% of the asset, but puzzlingly, concluded itself as a noncontrolling partner.   I have contacted IR to inquire about this issue and the response is that the other partner contains certain rights that justify TCO's claim.

The last time TCO consolidated a previously unconsolidated asset was in 2006.

"the Company has determined that in the first quarter of 2006 it will begin consolidating the

entity that owns the Cherry Creek Shopping Center...As of January 1, 2006, the impact to the balance sheet will be an increase in assets of approximately $128 million and liabilities of approximately $180 million, and a $52 million reduction of beginning equity representing the cumulative effect of change in accounting principle."

2005 10K, note 21

The negative equity in Cherry Creek comes from higher dividends paid by the JV than its GAAP earnings.  The difference results from GAAP depreciation expense.  While I believe that GAAP book values does not reflect economic reality (I will address the valuation of JV later), three conclusions are obvious:

  • 1) Reported leverage ratios are lower when Westfarm is unconsolidated.
  • 2) Since Cherry Creek, a 50% owned entity, was consolidated, there is a high probability that all malls in the JV portfolio (ex Waterside) would be consolidated.
  • 3) When unconsolidated JV are brought onto the balance sheet, there will be impairment charges/write-downs given that previous payouts exceed GAAP earnings.

Finite Life Entities

"At December 31, 2008, the Company held controlling majority interests in consolidated entities with specified termination dates in 2081 and 2083. The minority owners' interests in these entities are to be settled upon termination by distribution or transfer of either cash or specific assets of the underlying entity. The estimated fair value of these minority interests were approximately $104.3 million at December 31, 2008, compared to a book value of $(96.8) million, which was classified as Deferred Charges and Other Assets in the Company's Consolidated Balance Sheet."

2008 10K, note 1

 

TCO records minority interest as other assets valued at $96.8m, which implies negative equity for minority partners.  Nonetheless, the fair value is $104.3m.  If accounted for correctly, on the right side of the balance sheet, a total reduction of $201.1m of reported equity would be required.  These entities started in 2004.  At first, TCO record zero book value and just understated minority interest, and then start recording as other assets in 2006.

 

Preferred Shares Series F, G, H

The reported value for the preferred stocks is $29m.  However, 2008 note 14 points out that the liquidation value for series F, G and H are $30m, $100m, and $87m respectively.  Although they have no stated maturity, sinking fund, or other mandatory redemption requirement, I believe they should be recorded at liquidation value because

  • 1) Dividends are cumulative
  • 2) It represents the actual amount of $ for TCO to exit the obligation
  • 3) TCO has a history of redeeming earlier series.

The net result for these irregularities is that equity is overstated and debt is understated.  True leverage is higher.

Deteriorating Operations

Mall tenant sales is the single most important measure because it determines rents and occupancy.

sales / sf

2003

2004

2005

2006

2007

2008

2Q09

 

441

466

508

529

555

539

nm

 

  • Tenant sales/sf number started declining in 2008.
  • Year-over-year, the first half of 2009 is down 12% from 2008 level.

Occupancy

2003

2004

2005

2006

2007

2008

2Q09

 

86.60%

87.40%

88.90%

89.20%

90.00%

90.30%

88.80%

 

  • Occupancy is down in 2009 and already below 2005 level.

new lease signed

2003

2004

2005

2006

2007

2008

2Q09

Consolidated

43.41

44.35

42.38

41.25

53.35

53.74

42.96

JV

40.06

44.67

44.9

42.98

48.05

55.26

47.64

 

  • Market rents have fallen 13 - 20% from 2008 level.

The tenant mix is predominately fashion retailers and target up-scale customers.  However, I believe the so-called up-scale segment is actually middle class consumers with inflated wealth because of the now busted housing bubble.  Most up-scale fashion retailers have experienced, and some are still seeing sales slump.   I expect TCO's malls to under-perform on an absolute basis and on a relative basis to the value-oriented malls such as DDR and Kim in the near future.

The key conclusion here is 07 & 08 results represent peak cycle earnings, and in the near future results (at least the next 24 months) will be worse unless consumers start spending again.

 Capital Structure

Reported balance sheet are meaningless because of the accounting irregularities I mentioned above and the fact that GAAP real estate (RE) values are distorted by depreciation charges (fair value is usually higher unless the company bought at the top of the market).

For margin of safety, I am going to give TCO the benefit of the doubt and

  • 1) Count the fair value of minority interest as equity.
  • 2) Mark up RE at fair value by assigning 9% cap rate to 2008 NOI.
  • 3) Mark up JV investments by assigning 6x FCF to JV even though JV has off b/s contractual obligations that are not disclosed, and is itself highly levered.

 

 

As of 2Q09

 

Liabilities & Shareholders' Equity

 

 

 

  + Accounts Payable

234.07

 

 

Operating lease

10.50

  + Cash & Near Cash Items

11.77

current LTD

14.40

  + Accounts Receivable

34.45

purchase obligation

61.00

Current Assets

46.22

Current Liabilities

319.97

 

 

 

 

RE at fair value

4,055.13

LTD

3,174.14

Operating lease

440.10

  + Distributions, NI from Unconsolidated JV

155.14

FV of JV investments

319.68

preferred at liquidation value

217.00

Total Real Estate Investments

4,814.91

 

3,546.28

 

 

 

 

intangibles

(37.46)

Total Liabilities

3,866.25

purchase obligation

61.00

 

 

Finite life entities

(96.80)

Reported Equity

(289.90)

  + Other Assets & Deferred Charges

121.72

Adjustment

753.44

 

48.46

adjusted equity

1,043.34

Total Assets

4,909.59

Liability & equity

4,909.59

 

 Other Adjustments made

  • 1) Write-off all intangibles
  • 2) Capitalized operating leases and purchase obligations.
  • 3) Record preferred stock at liquidation value.

Leverage

Leverage defined as asset/equity is approximately 5x, which means 20% decline in asset values would wipe out the equity.  My valuation of RE asset and JV are based on 2008 NOI.  As of 2Q09, with occupancy down 2% , market rent 4% lower than 2008 average portfolio rent ( $44.58/sf), it is reasonable to assume market value of RE is at least down 6% from 2008 level, which would translate into a 30% loss for equity.

Northlake

You might ask how TCO built up this huge debt.  The company certainly did not go on a huge buying spree.  The Northlake financing transaction showed management's intention.

Northlake is a mall that is developed by the company at a cost of about $171m.  It opened in September 2005, and in January 2006, TCO placed an interest-only mortgage on the mall for $215.5m.  Since the loan is non-recourse, TCO effectively "sold" the property to the lenders and bought a put option because it can always let the loan default and hand the keys back to the lender.  In a RE bull market, it seems smart to borrow non-recourse vs selling as the downside is limited (ex, Pier at Caesars) and the borrower retains the upside.  TCO has capitalized on this strategy and now have only one unencumbered asset left.

Unencumbered Assets

At the consolidated level, all properties are encumbered except for Willow Bend.  This means that unlike other REITs such as Simons, TCO does not have much breathing room if unsecured credit dries up. 

The leverage here means this company is built for a RE bull market only.  The other way to look at this is would you own a cyclical business with high leverage, with peak earnings just passed and the cycle turning the other way?

Valuation

Consolidated

FY 2003

FY 2004

FY 2005

FY 2006

FY 2007

FY 2008

Cash From Operating Activities

133.45

135.54

184.58

223.48

257.84

253.42

stock compensation

 

 

(2.40)

(4.60)

(6.80)

(7.60)

interest adjustment

(5.59)

(16.48)

(16.38)

(18.16)

(11.91)

(3.14)

  + Preferred Dividends

(25.60)

(29.69)

(30.08)

(26.18)

(17.09)

(17.09)

  + debt issuance cost

(5.13)

(11.90)

(2.76)

(3.48)

(2.89)

(3.42)

  + equity issuance cost

 

(4.05)

(3.16)

(0.61)

 

 

maintenance capex

(19.04)

(33.03)

(27.79)

(37.78)

(30.02)

(21.81)

Free cash flow

78.08

40.38

102.02

132.68

189.13

200.36

 

 

 

 

 

 

 

JV FCF

FY 2003

FY 2004

FY 2005

FY 2006

FY 2007

FY 2008

Net income

66.55

76.90

226.64

59.28

69.81

74.52

interest expense

82.74

74.03

67.59

57.56

66.23

65.00

gain on asset sales

 

 

(145.88)

 

 

 

maintenance capex

(14.29)

(30.82)

(11.96)

(13.66)

(8.86)

(19.42)

Depreciation

53.41

57.39

51.94

43.12

37.36

39.76

approximate NOI

188.42

177.50

188.32

146.31

164.53

159.86

interest expense

(82.74)

(74.03)

(67.59)

(57.56)

(66.23)

(65.00)

FCF

105.67

103.46

120.73

88.74

98.30

94.86

TRG's share

53.47%

50.91%

50.60%

57.53%

58.04%

56.17%

TRG's JV FCF

56.51

52.67

61.09

51.05

57.06

53.28

 

With the stock trading at $35.73, it is trading at 11x 2008 FCF.  EV/EBITDA - ttm is 12.75x.  At first glance, the multiples are not high.  However, I believe 2008 represent peak earnings and going forward FCF will decline as occupancy and rents continue to trend down.

Recommendation

Short TCO and hedge with long DDR.  Both companies face the same problem: high leverage.  DDR's tenants are value-oriented (Wal-mart, T.J. Maxx) and should hold up better.  Secondly, even after the recent dilutive offering, DDR at $9.8, is trading at less than 4x 2008 FCF.  Therefore, if high leverage RE companies can survive this downturn, DDR will have more upside.

I strongly oppose a pure short because I think the risk/reward is unfavorable.

 

Risks to my recommendation

Liquidity

Liquidity Analysis

2009

2010

2011

Hard Maturities

 

 

 

Mortgage

7

199.7

71.6

* If no extension option

7

199.7

600.6

 

  • Only $278m of debt due before 2012 if all extension options are exercised. I expect TCO to generate $170m FCF in 09. So liquidity is not an issue.
  • If 2011 would be very dangerous for TCO if operations deteriorate to a point that the extension option cannot be exercised.

V-shape recovery with consumer spending leading the way

  • Deteriorating operations is a vital assumption in my thesis. I expect the US consumers to stay frugal and shun luxury. If discretionary spending goes up, this idea would not work.

Possible take-over target

  • The operating RE portfolio of TCO is very high quality. The problem is the capital structure. If the current crisis is indeed over and cheap financing returns, I expect TCO to become a target. SPG had shown interest before and made an offer in 2002.

 

Catalyst

1) declining occupancy and rents

2) Pier at Caesars impairment is a wake-up call. Expect more impairment charges coming, especially on the unconsoidated JV side.

3) continue decline in market value of commercial real estate.  One useful index is the Moody's/REAL Commercial Property Price Indices.

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