Washington Prime Is A Sell: Analyzing A Critical Debt Covenant

Washington Prime Is A Sell: Analyzing A Critical Debt Covenant

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Washington Prime Group (WPG) remains a battleground stock, as evidenced by its high double-digit short interest and surprising universal love on this site. The typical bull thesis falls back on hefty dividend payments helping to reduce the risk. On the conference call, analysts appeared to be razor-focused on the future of their dividend. Some shareholders might have thought that this is too short term minded – I, however, believe that there is a very important reason why analysts are focusing on the dividend, namely, the dividend appears to be adding significant balance sheet risk. I explain why a certain debt covenant may impact WPG’s access to capital in the coming years, as well as impairing the above bull thesis in the process. I reiterate my strong sell rating.

Financial Results Give Reason For Optimism

While this past quarter saw continued financial stress, there were indeed significant reasons to warrant optimism that a turnaround may be starting (though I am skeptical as I discuss later).

Tier 1 same-store net operating income (‘SS NOI’) decreased 8.8%, and Open-Air increased by 2.6%, resulting in a combined 5.5% decrease in SS NOI, at $6.4 million. Management, however, pointed out that $4.3 million was a negative impact as a result of co-tenancy and rental income loss from 2018 anchor bankruptcies in Bon Ton, Sears, Toys, with the remaining $2.1 million attributable to 2019 bankruptcies in Charlotte Russe, Gymboree, and Payless. Bulls may find this reason to believe that future SS NOI results should be stronger as WPG works through retail bankruptcies from weak retail tenants, which should not reflect their entire tenant base.

As for the recent Forever 21 bankruptcy, out of 6 Forever 21 locations, WPG expects to lose 2 or 3 locations, which is hardly the end of the world.

Management on the conference call mentioned that they expect Tier 1 occupancy to improve sequentially by 150 to 200 basis points by year-end. It is unclear if this is including temporary leases (which usually don’t even reach 50% of full-term rent), but regardless, such progress would only benefit the bottom line.

Balance Sheet Progress

WPG addressed a $47.6 million secured debt maturity with a 7.5% interest rate by issuing $117 million in 10-year notes at a 3.67% interest rate secured by the same four properties. This resulted in interest cost savings as well as providing a source of additional capital. The $68.1 million in net loan proceeds from the above transaction plus $180 million from a previously executed secured loan are enough to address the upcoming April 2020 unsecured maturity, meaning that they do not have any other unsecured debt maturity through 2022. As I discuss later, however, WPG likely will need to address their unsecured issues much earlier than 2022.

If there were one obvious knock on their balance sheet, it would be the fact that their total indebtedness to total assets continues to rise dangerously close to the 60% covenant requirement:

(2019 Q3 Supplemental)

There are at least two ways to look at this. On the one hand, bears might point out that the covenant limits their access to capital so long as the unsecured debt issue is not redeemed. Further, if WPG decides to refinance unsecured debt with a longer-dated alternative, the definition of total assets might not be the same. Currently, total assets are defined using a 7% cap rate, but this might not be so reasonable if WPG’s financial issues are proven to be secular instead of cyclical. If this cap rate were to be lifted even slightly, that would further reduce WPG’s wiggle room and might require more aggressive debt pay downs. This fact alone appears to suggest that WPG will need to pay down the unsecured issues with either free cash flow or secured debt issuance.

On the other hand, bulls might point out that secured debt would not have such covenants and would conceivably give WPG more breathing room. I don’t foresee any issue with WPG issuing secured debt and using an equal amount of cash to pay off unsecured debt. This covenant is very important to the bear thesis, as I explain later.

Redevelopment Project Update

WPG pointed out that out of 29 department store locations, they have signed leases for 17, with 6 of the locations still having an operational tenant. This means that 74% of their empty department store space has been addressed. Management also guided for around $350 million of additional capital spend over the next 3 to 5 years to transition all 29 locations.

Coming Back To The Ground Lease

I previously explained why the $98.9 million ground lease on 4 Tier 1 properties was being misunderstood and, as a result, was a big warning sign. There, I pointed out that since WPG is only receiving net loan proceeds of $42.4 million, but was paying net interest expenses of $5.1 million, this represented a net interest expense rate of…

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