Simon Property Group: Omnichannel is the Future of Retail by Austin Crites, CFA
We believe high quality real estate will play an important role in the future of retail
Location, Location, Location
Simon pays an attractive and growing dividend that supports its valuation
Macro
We recently purchased shares of Simon Property Group for clients in our Core Equity Strategy.
During the dotcom boom of the late 90s people were enthralled by the possibilities of the internet. I remember hearing that there would be no more stores in the future as everything would be purchased online. The internet has proven to be wildly transformative, and the rise of Amazon and e-commerce has led to a common refrain, “Brick-and-mortar is dead”. Coupled with common visuals of empty storefronts all around the country has contributed to investors shunning retail real estate. As with any dominant narrative, there is some truth behind the idea. However, I would suggest the truth is much more nuanced.
First with the truth. According to Statista, the US has more retail space per capita than any other country with over 23 square feet per person as of 2018 with the next highest being Canada at 16.8. For reference, France comes in at just 3.8. We have too much space in general and the rise of e-commerce has led to the shuttering of many storefronts. Retail e-commerce has been growing at a brisk pace and is expected to continue taking share.
I know what you are thinking. “Austin, you’re off your rocker! Why would you buy shopping malls?”
Typically, when a narrative becomes so entrenched as to become common knowledge people stop asking questions. Is this true? To what extent?
The truth is that retail has turned to “omnichannel”. Most retailers discovered that the best approach was to have both brick-and-mortar as well as a seamless online experience. Many use their storefronts as showrooms to build awareness and develop relationships with consumers. In fact, Simon reported that foot traffic to their malls had returned to pre-pandemic levels by the third quarter of 2021. What’s different is that retailers now desire less stores in each market. This has led to the decline of many strip malls in less desirable locations. Instead of say 5 or 6 stores in a market, they may choose to only have one or two. With the ease of e-commerce, it’s no longer important for many retailers to be a short drive to consumers, but they do find value in having locations in prime real estate.
Shopping malls, as with other commercial real estate, are segmented by “class” A through D depending on sales/sq ft with A being the highest and D being the lowest. Class C & D malls are struggling mightily for traffic and losing the battle attracting tenants. By contrast B malls are doing ok and A malls are thriving. According to Morningstar, there are approximately 300 Class A malls in the US which drives scarcity for companies looking for the best locations in each market. Class A malls comprise more than 75% of Simon’s net operating income and they have negligible exposure to Class C and below, having divested those properties through a new entity called Washington Prime back in 2013.
Still not convinced? Take a visit to a high end mall. The Keystone Fashion mall in Indianapolis is a great example. The lot is almost always full. You won’t find a zombie Sears store. You will see companies with strong consumer followings like Apple, Williams-Sonoma, West Elm, Warby Parker, Lovesac, lululemon, See’s Candies and Tiffany. You also find more restaurants than in the past such as Shake Shack, Chipotle, Napolese Pizzeria. Keystone also has a movie theater (I know this is not a new idea). Entertainment options have been growing at these types of properties in recent years to help drive traffic as Simon diversifies away from apparel. For example, my family visited LEGOLAND in one of Simon’s Orlando malls. Simon’s malls have a 93.3% occupancy rate as of the end of 1Q2022 and net operating income grew 8.8% from a year earlier allowing them to increase the dividend by 21.4% year over year.
But aren’t we headed for a recession? Yes, based on the latest data we are likely in a recession right now that started sometime in the first quarter. The Federal Reserve Bank of Atlanta estimates -1.9% GDP growth for Q2 as of July 7th. I don’t know where the economy will head from here. The Federal Reserve is focused on fighting inflation. This battle may do further damage to the economy or we may start to see signs of recovery earlier than expected.
However, I believe much of the bad news is reflected in the current stock price. As of this writing, the stock trades at just 8.4X funds from operations expected for 2022. The expected dividend is $6.81/share and the company has a $2B buyback authorization. Since its IPO in 1996, the company has raised its dividend by an average of more than 5% per year. The current dividend yield is 6.9% so assuming they can continue to fund that and grow the payout over time this should lead to a strong return over the long run.
Is the future uncertain? Yes, but therein lies the opportunity. Warren Buffet once said, “The future is never clear. You pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”
Moat
Simon’s moat is really in the quality of the real estate. Large properties in highly trafficked and affluent areas are difficult to replicate and should increase in value over time due to scarcity of land. The other moat source is scale. This allows Simon to engage with retail, restaurant, and entertainment groups on a national (even global) expansion program that is difficult to match. I would not consider this a “wide moat” company. They don’t have Coca Cola’s brand or Eli Lilly’s patent protection, but they do have a collection of highly desirable properties that contribute to a network effect at the local level for the consumer and at the national level for ambitious retailers looking to engage with affluent shoppers.
Governance
Simon has exhibited strong capital allocation in the past. The dividend record has been solid and the new buyback program is a positive development given the current stock price. The company was able to offload lower quality malls in 2013 through the Washington Prime spinoff before Wall Street recognized the decline in those assets.
Valuation – Is there a Margin of Safety?
Simon is a mature company that pays out a significant dividend making a simple dividend discount model an attractive choice to determine valuation.
Bear Case - If we are wrong about the retail landscape and Simon has to manage a prolonged decline in their portfolio, we project a significant loss on our investment. If the dividend were to decline by 2% per year, we estimate the value of the shares to be only $56 versus the current price of $98.05.
Base & Bull Case – Historically, Simon has averaged dividend increases of over 5%. At 5% the stock is estimated to be worth $145.71 and at 6%, $184.82. For these scenarios to play out, Simon will need to continue to evolve their real estate to fit the demands of tenants and consumers while making prudent capital allocation decisions.
Risk
While I attempt to capture risk within my valuation framework, the greatest risk is often in the unknown. I foresee the greatest risks to this investment to be an evolution to retail that excludes the expected role of prime location real estate or of potential mismanagement by the company’s executives. However, it is possible there are holes in my thesis I have not yet found that could materially depress the intrinsic value of the company. Do your own homework prior to investing.
In Summary
At Aurora, we are constantly looking for “the right pitch” in our sweet spot where we believe the probabilities are in our favor. This blog represents our thinking at the time of publication. By the time you read this, our opinion may have changed. If you are a DIY investor, use this only as a starting point for your research and be sure to do your own due diligence. For questions regarding our individual stock strategies, please reach out to us!
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.
