CBL & Associates: Undervalued, But Lesser Margin of Error Than Alternatives
Since early March, I have promulgated the idea that REITs have been overly punished by the market. While there are certainly some garbage REITs out there, there are also high-quality REITs selling at bargain-basement prices. Prices have risen since early March, but I still believe REITs in the aggregate tend to be undervalued. All the same, I want to focus my investing efforts on particular companies with attributes I like.
In my recent article on Pennsylvania REIT, a dissenting commenter wrote:
“I would invite the author to do the same recovery analysis on CBL at current prices, I would suggest a far better result."
I have decided to take the commenter up on his/her offer. This will be Part IX in my “Quest for REIT Value” series and it will focus on CBL & Associates (CBL).
In my previous articles, I have mentioned several factors I initially search for when examining REITs. My list has evolved a bit since my first articles, but here’s the general rundown of what I am looking for:
(1) Relatively low leverage
(2) Insider buying and a substantial amount of inside ownership
(3) High levels of liquidity
(4) Property in markets near a bottom, with no excessive exposure to “bubble markets”
(5) Strong asset quality in real estate holdings and other balance sheet accounts
(6) Focus on residential RE favored over commercial RE
(7) Office and industrial RE favored over retail RE
CBL could arguably meet three of these prongs. Their properties are concentrated in smaller and middle markets that did not “bubble up” as much as the larger markets, so you could argue their properties are closer to a bottom. Their properties could also be considered relatively high quality for a retail REIT. Plus, there have been some large insider buys over the past few months.
CBL & Associates is a REIT primarily focused on developing and operating regional shopping malls; however, they also deal with community centers and some office properties. CBL mostly operates in medium-sized and small- markets, which gives them some advantages of the companies operating in the big city environments with the biggest bubbles.
CBL’s top 5 markets are laid out below:
CBL has a diversified base of tenants and the biggest names are the typical retailers you would find in malls across America, such as Foot Locker (2.5% of total revenues), The Gap (2.36%), Abercrombie & Fitch (2.1%), and Zale’s (1.5%). The tenant that drives the highest percentage of their total revenues is Limited Brands, LLC (2.9%). While it is my belief that mall and retail properties will continue to suffer in the coming years, CBL is fortunate to not be overly exposed to any one tenant.
Earnings Call Takeaways
From CBL’s most recent earnings call, we learn that total portfolio occupancy declined to 88.6% from 91.6%. The good news is that the most significant chunk of their renewals is in the 1st Quarter, so it might be the worst quarter when it comes to increasing vacancies. Three retailers in CBL’s portfolio announced bankruptcies included Strasburg Children, Ritz Camera, and S&K Menswear. Those three retailers bring in about $2 million in total annual revenues, which is slightly less than 1% of CBL’s total revenues.
CBL is currently paying out a 40% cash dividend and 60% stock dividend, totaling $0.37 per share for the first quarter. FFOs for that quarter were $0.72, which is down from $0.75 in the prior year. FFO guidance for FY ’09 is in the range of $2.95 to $3.09 per share. CBL states this has been adjusted to take into account for further dilution, but given CBL’s liquidity issues, I’d have concerns of further dilution.
During the first quarter, CBL closed a non-recourse $74.1 million loan secured by the Cary Towne Center in Cary, NC with a fixed interest rate of 8.5%. It replaces a loan with a fixed interest rate of 6.85%. They also entered into a one-year extension on another $59 million loan secured by St. Claire Square in Fairview Heights, Illinois with a fixed interest rate of 7.5%. I mention these two items because they suggest that the costs of capital for CBL are rising whether it be because the market perceives a greater level of risk or market conditions are driving up interest rates in general (or a combination of the two).
CBL outlined plans on deleveraging in the earnings call, but those “plans” were so vague, that I would almost consider them non-plans. This worries me more than anything else, especially after examining CBL’s balance sheet.
The most immediate thing that jumps out at me from CBL’s balance sheet is their 6 to 1 debt to equity ratio. Their Liability/Value ratio is relatively high at 85.8%. There is not a lot of cash on their balance sheet, either, as cash makes up only 0.6% of their total assets. Even if I add all their receivables and cash together, it still only makes up 2.3% of total assets. This might not seem so bad if their free cash flows had been strong. Free cash flows were negative for in FY ’07 and only slightly positive for FY ’08 and ’06.
Here’s a chart that lays out their earnings and cash flows:
As you can see, FFOs look strong. While all REITs will tell you that Funds from Operations (FFOs) are the most reliable indictator of real earnings, I question that wisdom when it comes to some of the retail oriented REITs. Malls require a very high amount of maintenance to keep up and I’d argue that their value is totally dependent on a lot of factors that can be easily undermined. One thing to note for CBL is that Net Income + Depreciation & Amortization [NI + DA] tends to be significantly lower than FFOs on a consistent basis.
I’m simply not convinced that I can take FFOs at face value as a real measure of earnings, particularly for a company that’s balance sheet is not the most terribly liquid one I’ve seen and seems to have a high amount of leverage. FFOs might be exaggerating earnings by understating the amount of what I will call (for lack of a better term) “real depreciation and amortization”; or that is, there might be enough capital expenditures required to maintain property value so that instead of the properties naturally appreciating over time with little effort, it requires heavy capital expense to maintain that appreciation.
So what’s the best real estimate for earnings? I’m not sure. I’d suggest that it might be somewhere between FFOs and FCFs (if the latter stabilizes moving forward). One measure I really like to look at is the Increase in Stockholders Equity [INCR in SE] coupled with dividends paid out; but due to heavy capital expenditures by CBL in the past, those measures are not necessarily completely meaningful. In any case, here is part of the above chart in per share figures:
Note that due to minority interests, a large number of preferred shares taking away a piece of the pie, and other complicated accounting features for CBL, these numbers were very difficult to calculate. For CFOs, FCFs, and FFOs, I used the abbreviation “-T-Cont” which stands for “To Controlling Common Shareholders.” These are merely estimates and I would not put too much faith in them with the exception of the "NI to Common" and "Dividends" numbers. Add confusing accounting to the issues that contribute to more uncertainty with CBL.
Property Holdings and Macroeconomic Outlook
CBL’s biggest advantage in my book is that they are not concentrated in any bubble markets. In fact, from a glance at their depreciation schedules, it appears they have virtually no properties in the bubble markets like Los Angeles, the Bay Area, New York City, Washington DC, Florida, or Hawai’i. The age of their properties seems to vary between about 1-12 years. They have enough recently-purchased properties to lead me to believe that those properties might be slightly overstated on the balance sheet given the forward outlook. On the other hand, they have enough “older” properties to give them some “book value cushion”.
I believe that commercial real estate, and particular retail commercial RE will face pricing pressure moving forward. When you take that with the “book value cushion” of their properties, I think it is likely that CBL's properties in the aggregate are either fairly valued or slightly overvalued (maybe by 0% - 5%). However, the problem with CBL is that there is little margin for error due to their leverage.
The chart below shows how relatively small price declines could completely change the underlying value of their properties. Note that I took a slight charge-off for what I call “circular intangibles”:
As you can see, a 0% RE impairment puts CBL’s book value per share at $8. However, a 10% RE impairment drops their book value per share down to $0. As I said, this creates uncertainty.
As I believe the macroeconomic outlook for commercial REITs is poor for the next few years (if not the next decade!), I think it’s important to conduct some sort of revenue impairment tests when evaluating REITs. I’ve made two attempts at doing so, in order to determine the effect on CBL’s FFOs.
The first chart is a “Raw” revenue stress test that makes no adjustments to expenses. This would be unrealistic over the long-term, but the chart can shed some light on worst-case scenarios:
The second chart is an (arguably flawed) attempt to incorporate the expense side and margins into the equation:
If we believe that FFOs are a reliable measure for CBL’s “real earnings”, this would actually be a very positive chart since it essentially says they will be alright even in a commercial real estate disaster of epic proportions. However, as I stated earlier, I question FFOs as a completely reliable measure of true earnings power and I also question my chart because I calculated extremely high cash margins for CBL (not included in this chart) and they didn’t jibe well with a lot of the other numbers. In fact, a whole lot about CBL’s earnings is confusing if you ask me.
Predicting a range for the underlying properties for CBL is not the most difficult aspect of the valuation. While leverage does create uncertainty, I believe that assuming a 0% - 12% drop in their portfolio relative to stated book values should be sufficient. Predicting CBL's average free cash flows moving forward is a completely different hand. It is extremely problematic given aforementioned considerations, coupled with my own believe that there’s a substantial likelihood they will undergo further dilution.
My estimate for real FCFs is in the $1.15 - $1.60 range per common share. I derived that number from examining CBL’s free cash flows for FY ’08 and their first quarter for FY ’09. Then, I made projections regarding how those would change once they lowered capital expenditures and stopped developments. However, there is then the issue of further dilution to consider.
The chart below is a table of possibilities with the yellow area representing the most likely valuation range according to my analysis and the orange squares indicate my “most probable” valuation of $17:
But be careful, because the heavy leverage and illiquid balance sheet creates a lot of uncertainty. My downside probable valuation is $6. My upside probable is $30. Downside risk is $0; however, I believe even in the event of bankruptcy, someone would come along and buy out their assets for at least a buck or two per share. My upside potential is $40.
My feelings on CBL & Associates are mixed. On one hand, it looks to be undervalued, there is insider buying, and their property portfolio looks fairly solid. On the other hand, they have high leverage, have not articulated much in the way of a clear plan towards deleveraging, and they are in the high-maintenance environment of managing mall retail properties in a very bad period to be involved in retail.
As with many REITs, this can be a good buy right now. However, I felt like Pennsylvania REIT (PEI) is very similar to CBL but has lesser leverage and a greater margin for safety, all while having a slightly higher upside. If you are looking for a more sure bet, I think Brandywine (BDN) and Winthrop (FUR) are better investments on that front. If you are looking for the highest returns with a reasonable quality REIT, I believe Lexington (LXP) is a better buy than CBL. All the same, I would rate CBL as a "Buy" right now and it could be a good pick-up for a well-diversified portfolio under $6. If it were to dip below $3.50, I believe the upside might be enough to make it one of the stronger buys in the sector.
In conclusion, I respectfully disagree with the user who commented on my article favoring CBL over P-REIT. CBL may give you good returns moving forward, but I'd feel safer with P-REIT due to lower leverage, clearer accounting, and a bigger "book value" cushion. It is certainly a debatable issue, however.
Disclosure: No position in CBL. Long LXP, BDN, and FUR.