I hope everyone is having a wonderful holiday season!
This month’s stock is Simon Property Group (SPG), which is a real estate investment trust (REIT) that owns high-end destination malls and premium outlet centers.
This is a segment of brick-and-mortar retail that many experts believe will not only survive, but will thrive as the retail landscape changes to include an increasing percentage of online shopping. Some experiences cannot be duplicated online.
Simon’s Dividend Record
Simon Property Group’s dividend record reflects the challenges of its brick-and-mortar retail industry. It is widely considered to be best-of-type within that industry, but it does face challenges as the retail landscape changes.
At 5.8%, its yield is high. Its long-term double-digit annual dividend increases, however, stopped in 2019. Simon has been increasing its dividend twice per year, and the combination of two increases in 2019 amounted to a 5.1% payout increase over 2018. That is still fast for such a high-yielding stock, but it was not as fast as Simon’s prior history.
Simply Safe Dividends (SSD) awards Simon a dividend safety score of 65, based on their thorough analysis of factors that impact dividends. The score is within SSD’s 2nd-highest ratings category. That suggests that Simon’s dividend is safe and unlikely to be cut. SSD notes that Simon carries pretty high debt, which we will examine in the Financials section later in this article.
Given its combination of high yield and most recent dividend growth rate, I would label SPG as a high-yield-fast-growth dividend growth stock. Normally a dividend growth rate of 5.8% would not be considered “fast,” but to me anything over 5% is fast when the stock itself yeieds over 4% per year.
Taxation note: As a real estate investment trust (REIT), Simon owns income-producing real estate. REITs typically pay out all of their taxable income as dividends to be relieved of taxation at the REIT level. In turn, shareholders pay the income taxes on those dividends. In other words, REIT dividends are not “qualified” dividends under federal tax laws; they are taxed as ordinary income to the shareholders.
Simon’s Business Model and Company Quality
Simon Property Group was founded in 1960, went public in 1993, and is headquartered in Indianapolis. SPG is a REIT specializing in the acquisition, ownership, development, management, leasing, and expansion of income-producing retail real estate assets.
Simon owns, develops, and manages premier shopping, dining, entertainment, and mixed-use destinations, consisting primarily of malls, premium outlet centers, and Mills centers.
Simon is America’s largest mall owner. SPG owns or has an interest in 233 retail real estate properties across North America, Europe, and Asia, comprising 191 million square feet. Simon is self-administered and self-operating. That means that its expertise is in-house, which of course helps it to see its visions through.
You are certainly aware of the secular change happening in shopping and retail as more and more customers choose to order online and have packages delivered to their doors. Physical stores still account for 90% of retail sales, but online shopping increases every year and is taking share away from physical stores.
Simon is strategically positioned to defend its real estate assets against the incursions of online shopping. It appears that online shopping is most harmful to malls in secondary or tertiary markets, with weak or shrinking populations and relatively low average income levels. Simon owns predominantly Grade A properties in large population areas.
Some mall experiences, of course, cannot be duplicated online. An example would be a fitness center or restaurant, which provide experiences rather than goods. An important part of Simon’s philosophy is to see and develop its properties as community gathering places.
Most of Simon’s net operating income (NOI) comes from malls and premium outlets in the USA, which number 175 and are about 95% occupied. Mills centers add an additional 24 properties around the country and are 97% occupied.
Major anchor tenants include some chains that are experiencing difficulties, such as Macy’s, Penney’s, and the like. Such large anchor stores, perhaps surprisingly, do not account for a high percentage of Simon’s base rent. Smaller but more numerous operations – such as Gap, L Brands, Ascena, Tapestry, and Signet Jewelers – account for higher percentages.
In order to keep up with the changing retail landscape, Simon has many development projects underway and planned. More than $3 billion in projects are in progress and in the pipeline.
Twenty-eight percent of SPG’s development spending is for “densification.” That refers to redevelopment to adjust to changing markets and to keep the real estate relevant. Densification often means adding nonretail tenants to the mall, such as fitness centers, restaurants, hotels, office space, apartments, and medical service providers.
More traditional mall development accounts for 31% of Simon’s development spending. Many of these projects involve redeveloping and repurposing former Sears stores with such replacements as Dick’s Sporting Goods, smaller retailers, and non-traditional mall tenants.
Simon describes its investment merits like this:
Simon has received numerous accolades over the past decade, including:
- Best-performing global CEOs by Harvard Business Review in 2013, 2014, 2016, 2017 and 2018
- #1 CEO in real estate industry by Institutional Investor, 2009-2018
- Fortune’s Most Admired Real Estate Company in 2018 (eighth time)
Simon’s credit rating of A from S&P is the highest in the industry, which helps lower its cost of capital. Many REITs get BBB and BBB+ grades, and some are not even considered to be investment-grade.
Morningstar awards Simon a narrow-moat rating. Among the reasons are these:
- Simon’s efficiencies of scale that result from the company’s portfolio of high-quality, well-located, and productive properties;
- Morningstar’s belief that there will always be demand for high-quality retail locations;
- Simon’s locations in many of the best markets with dense populations and high disposable incomes;
- Simon’s ability to provide a shopping and activity experience that is hard for other retailers to replicate.
Value Line gives Simon Property Group a Financial Strength grade of A, which is a good rating (3rd-highest of 9 grade levels). The company has held that grade since 2007.
Let’s look under the hood at some of Simon’s key financial categories.
Return on Equity (ROE) is a standard measure of financial efficiency. ROE is the ratio of profits to shareholders’ equity.
The average ROE for all Dividend Champions, Challengers, and Contenders is 10%-11%, and for S&P 500 companies it is 14%. Simon’s ROE has been quite a bit higher in recent years.
[Source of all yellow-bar charts in this section: Simply Safe Dividends]
SPG’s latest trailing-12-month ROE continues the trend at 72%.
Debt-to-Capital (D/C) ratio measures how much a company depends on borrowed money. Companies finance their operations through a mixture of debt and equity (shares issued to the open market) as well as their own cash flows.
A typical D/C ratio for a large, healthy company is 50%. D/C is a measure of financial risk. All else equal, stocks with high D/C ratios are riskier than those with low D/C ratios.
Simon’s D/C ratio is a lot higher than the average company’s, not surprising for a REIT with many capital-intensive development and redevelopment projects. Nevertheless, this level of debt is a weak point in the company’s financial picture. Because of the way the math works, the high debt does raise Simon’s ROE, which we saw above is quite high.
Operating margin measures profitability: What percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses?
Per recent research, typical operating margins for S&P 500 companies have been in the 11-12% range.
Simon’s operating margin is outstanding, running above 45% for the last decade. That is an impressive record for a retail-property REIT. Simon’s most recent trailing-12-month operating margin has remained high at 50%.
Earnings per Share (EPS) is the company’s officially reported profits per share. Official earnings are not considered an insightful figure for REITs, because their ongoing high capital expenses associated with purchasing and developing properties distorts official earnings.
Free Cash Flow (FCF) is the money left over after a company pays its operating expenses and capital expenditures. Whereas EPS is subject to GAAP accounting rules, cash flow is a more direct measure of money flowing through the company. It’s the cash a company has available for dividends, stock buybacks, and debt repayment.
Simon’s FCF record is strong. It is unusual to see a company that has increased cashflow every year, but Simon has done it for nine straight years. And 2019 should add to the streak, as its most recent trailing-12-month FCF amount is $9.82 per share.
Share Count Trend shows whether the company’s outstanding shares are increasing in number, decreasing, or remaining flat.
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and expanding each remaining share into a larger piece of the pie.
That said, REITs are capital-intensive businesses, depending on debt and share offerings to finance their ongoing acquisition and development activities.
Simon has been holding its share count basically steady for several years. In our era of relatively cheap debt, Simon (like many corporations) has been leaning more on debt than share issuance to obtain the capital it needs.
Here is a summary of the financial items above:
That is a very good financial record for a capital-intensive business. On a simple A-F scale, I would give Simon Property Group a B+ for its financials.
Simon’s Stock Valuation
I use four different valuation models, then average them out.
Model #1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value. For REITs, I use the funds-from-operations (FFO) metric rather than “official” earnings. FFO is universally considered to be a more useful measure of profits for REITs.
The basic FASTGraphs model for a REIT assigns a price-to-funds-from-operations (P/FFO) ratio to represent a typical historical fair-value reference line for the REIT under consideration.
In the following chart, the orange fair-value reference line is drawn at a P/FFO ratio of 14.7 for Simon, and the black line is Simon’s actual price. I highlighted both Simon’s current P/FFO ratio and the reference ratio of 14.7 used to draw the orange line.
Since the black price line is below the orange fair-value reference line, Simon is undervalued by this first assessment method.
To calculate the degree of undervaluation, we make a valuation ratio out of the P/FFO ratios.
Calculating Valuation Ratio from FASTGraphs
(Actual P/FFO ratio) / (Reference P/FFO ratio)
12.1 / 14.7 = 0.82
That suggests that SPG is undervalued by 18%.
We calculate the stock’s fair price by dividing the actual price by that valuation ratio.
We get $146 / 0.82 = $178 for a fair price.
Remember, valuation is an estimate or assessment, not a physical trait like length or width. We are making a judgement about the future without being able to know the future. Different models will result in different estimations.
Model #2: FASTGraphs Normalized. In the second valuation model, we compare Simon’s current P/FFO to its own long-term average P/FFO.
I circled SPG’s average 5-year P/FFO ratio, which is 17.3. This model suggests that Simon is even more undervalued than the first model.
The calculations use the same formulas as in the first step:
- Valuation ratio = 12.1 / 17.3 = 0.70, suggesting a 30% discount
- Fair price = $146 / 0.70 = $209
Step 3: Morningstar Star Rating. Morningstar takes a different approach to valuation. They ignore P/FFO ratios in favor of a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
The DCF model is based on the idea that a company is worth all of its future cash flows, discounted back to the present to reflect the time value of money.
Obviously, no one actually knows a company’s future cash flows. Estimates must be used. My experience with Morningstar is that they employ a careful, comprehensive, and conservative process for determining the inputs to their DCF formulas.
Morningstar gives Simon 4 out of 5 stars, meaning that they consider the company to be undervalued.
Here is a historical graph of their fair value estimates (red) compared to the stock’s price (black).
As you can see at the bottom right, Morningstar calculates that Simon is selling at a valuation ratio of 0.77, or a 23% discount. They calculate a fair value of $189.
Model #4: Current Yield vs. Historical Yield. The last model uses yet a different way to estimate fair value: Relative yield. In this model, you compare the stock’s current yield to its historical yield. The idea is that if a stock’s yield is higher than usual, it may indicate that its price is undervalued.
This chart shows Simon’s current yield (green dot) compared to its 5-year average yield (black line).
[Source: Simply Safe Dividends]
SPG’s 5-year average yield is 4.3%, which is well below its current yield of 5.8%. The valuation ratio is thus 0.75. However, when using this model, I cap the spread at 20%, because I think that this is the least direct and “noisiest” approach to valuation.
Using the 20% cap, the valuation ratio is 0.80 and the fair price is $183.
All four models concur that Simon is undervalued right now. In fact, the average of the four models suggests a significant discount of 23% and a fair price of $193 compared to Simon’s current price of about $146.
That’s what we call a holiday sale.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
- They present fewer occasions to react emotionally to rapid price changes like price drops that can induce a sense of fear.
- There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
Simon’s 5-year beta is 0.5, which means its volatility has been, on average, about half that of the overall market. This is a positive factor.
In their most recent report on Simon, CFRA gathered the recommendations of 21 analysts covering the stock. Their average recommendation is 3.9 on a 5-point scale, where 4 = buy. This is a slightly positive factor.
What’s the Bottom Line on Simon Property Group?
- Good dividend resume: High 5.8% yield, double-digit 5-year dividend growth rate, 10-year dividend growth streak, and 65-point dividend safety score from Simply Safe Dividends.
- Excellent management with record of staying ahead of the curve as retail undergoes secular changes, especially with more shopping being done online rather than in physical stores.
- Portfolio of high-quality properties in good demographic locations remains attractive to retailers and other businesses (such as restaurants, fitness centers, and the like), even including online retailers looking to establish physical stores.
- Above-average business quality ratings across the board: Narrow moat rating from Morningstar; A credit rating from S&P; Value Lines ratings of 2 for safety and A for financials.
- Good financial management, with high return on equity and profitability, and steadily-growing cashflow record. High reliance on debt to finance capital projects detracts, although it has allowed Simon to keep its share count under control.
- Significant undervaluation; stock selling at more than 20% discount.
- Dividend growth in 2019 fell to 5.8% from steady double-digit increases in prior years.
- Shifts in consumer behavior, especially growth in e-commerce, are secular headwind requiring constant adjustment for mall and other retail property owners.
- High debt levels, balanced by good credit rating and associated lower cost of debt.
I consider Simon Property Group to be an attractive high-yield opportunity, even if its dividend growth rate should remain in the single digits. Its 5.8% yield seems safe. Simon’s management appears to have a solid strategy to pursue and maintain high-quality retail properties that offer experiences that cannot be matched by online retailing.
Remember that this is not a recommendation to buy, hold, or sell Simon Property Group. Always do your own due diligence. Think not only about the company’s quality, yield, dividend growth outlook, and business prospects, but also about how it fits your personal financial goals and complements other stocks that you already own.
— Dave Van Knapp
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