I believe Brixmor (BRX) is attractive at current levels.  Like other retail real estate names BRX is off 30% in the past year.  While no one is immune from shifting shopping trends and US overbuild of retail space, I argue BRX is well positioned to ride out the storm and add value while you're waiting.

• Valuation is cheap on a relative and absolute basis and compared with the private market
• Flexible assets with low rent basis helps ride out a potentially length period of significant retail disruption
• After decade long period of undermanagement and constrained capital, meaningful value add opportunities through redevelopment and capital recycling.

Business Description

Brixmor owns a collection of ~500 open air properties, geographically dispersed.  The bulk of gross leasable area (GLA) is in neighborhood centers of 100-250K square feet--think grocery and/or discounter anchor with attendant small shops, drawing shoppers from <5 miles away.  About a third of GLA is in larger power centers (~300-650K square feet--think multiple anchors like TJ Maxx or Bed Bath & Beyond--or a Staples or KMart… with most properties including grocery.)  The portfolio consists of older assets, with an average effective age of 24 years and built 35 years ago, meaning in aggregate lower rents but also fewer zoning or structural impediments.

Blackstone bought the US assets and platform of Centro Properties Group (Australia) in 2011, changed its name to Brixmor, did an IPO in 2013, and fully exited their stake in August 2016.  An accounting scandal (smoothing earnings) led to the 2015 resignations of the CEO and CFO.  In mid-2016 they brought in new CEO James Taylor (was CFO of Federal Realty) and new CFO Angela Aman (was CFO at Starwood Retail partners, and prior at Retail Properties of America.) 

BRX will do about ~$2.10 in FFO this year, and I estimate AFFO of $1.82 (which I define here as backing out straight line rents plus maintenance capex at $.40/square foot.)  At a recent stock price of $18.50, that's 8.8x FFO/~10.2x AFFO and a material discount to peers like KIM, CDR, BFS, KRG,  RPAI and WRI (which trade at an average of 14-15x AFFO using the same definition.)  BRX does carry about 10% more debt than peer average, which accounts for ~.6x turns of the valuation.

Dividend yield is 5.6%, and payout is ~80% of distributable funds even with elevated growth capex levels (payout is <60%  on AFFO.)  Capex is elevated due to a strong redevelopment pipeline; management describes this as >$1B of scrubbed projects at a run rate of close to $200M per year.  Redevelopment projects have NOI yields averaging 9%, and their past investment has led to meaningful growth in revenues and FFO.  

At the current entry, seems like a significant amount can go wrong and you can still come out okay. 

Reasons for the Discount

Intensifying retail disruption is the obvious backdrop against which to underwrite this investment.  There will be somewhere around 10,000 store closures in 2017, more than in 2008 and as much as the past three years combined.  But there will still be net store openings in 2017.  The two categories with negative net store growth are department stores and full priced fashion, and  BRX has limited exposure to both (<3% of ABR is full priced fashion and <5% combined).  They've had on average a little over 1% occupancy impact the past three years from bankruptcies and distressed retailer store closures.  Their major exposures were A&P in 2015, Sports Authority & Hancock Fabrics in 2016,  Radio Shack, Gordmans, Payless, Rue21 & Ultra Foods in 2017. 

A quick scan of their current top 20 tenants show several immediate concerns.  Kmart, Office Depot and Staples total a combined 2.3% of annual base rent (ABR).  Outside of their top 20, they have exposures to Sears (10 stores including outlets/showrooms), Office Depot/Max (28), Barnes & Noble (10), Savers (6), David's Bridal (4), Conn's (3), .99 Only (2).  We don't have the rent rolls for all, but based on square footage can assume close to 4% of revenue from these in the immediate term.  It's probably a fool's errand to attempt to predict BKs, but it's reasonable to underwrite BRX to the expectation that the next three years will look somewhat worse than 2015-2017.  Their top 9 tenants (17% of ABR) seem well positioned, though, at least right now: Kroger, TJ Maxx, Dollar Tree, Publix, Walmart, Ahold, Albertsons, Burlington, Ross Stores. 

To quantify bankruptcy impacts, Sports Authority (SA) is a useful example.  Under the previous BRX management, they still added a Sports Authority as a "high quality replacement" for a Kmart in late 2014.  SA liquidation happened in April 2016 and BRX got 5 locations back totaling 211K sq ft, at just under $10/sf ABR, about 25 bps of occupancy and 20 bps of consolidated revenue.  BRX talks up their opportunity on these properties: they get 50-70% rent spreads, and 12-14% NOI yields on anchor space repositioning.

Translating that from REIT-speak into ROIC: if a tenant liquidates, your costs are capital investment (net of lease termination income), plus lost rent and remarketing costs (not included in the "NOI yield").  BRX talks about $40/sf of capital investment for Sports Authority, and 50% rent spreads imply $5/sf incremental base rent, which is the math on their 12-14% NOI yield (their direct operating costs and RE tax expense are broken out separately as a tenant reimbursement; incremental rent dollars do fall almost completely to NOI.  But I think the 12-14% number is inflated, at least for my purposes.)

• Summing the anchor space repositioning from their supplemental disclosures over time, I get total anchor repositioning costs of ~$70, not $40.  They say it's because they don't include square footage of leases that aren't yet signed, which makes some sense.  But I can't quantify this exactly, and it also depends on how much work needs to get done (for instance, 3 of 5 SAs got split up; new tenants Aldi and Petco require less capital than the location that got Dave & Busters with food service requirements.)  So I'm using $60.
• On average it'll take 18 months to get rent from new tenants, so I include $15/sf in the cost of capital, and $4/sf in remarketing costs.
• That gets me to $79 in capital, for $5 in incremental rent.  The ROIC under those assumptions would be 6.3%.

Obviously 6.3% is far from 12-14% - but as a return on investment in the case where the most undesirable outcome is forced on you, it's also far from disastrous.

It's significant that Sports Authority rents were $10/sf and not $20.  Their ability to generate positive outcomes on bad situations hinges on having low rents in place.  Across the portfolio, they get ~$13.20/sf in ABR (lower for anchors, higher for small shops).  Expirations over the next 5 years average <$12/sf.  They break out rent by tenant for their top 20: Kmart pays $4.35, Staples/Office Depot $11-12.  Kmart size of 80-90K sf incurs expense as many likely get split.  The office supply stores are popular sizes (around 20k), and may need less expense to re-lease. 

The other key piece that's significant is that there has been sufficient demand for the closed space.  How do we know that demand continues?  Supply is very slow growth (~50 bps on average from 2010-2020), but it's very hard to take off line.  If you assume retail grows at US GDP, and then just subtract the portion of growth from online retail (10% of total retail by sometime soon, maybe growing at something like 15%, that's 1.5 points out of the total retail growth.)

I don't have a total answer to that question.  There are positive signs in terms of their type of property: look at the planned openings for discount grocers, dollar stores, C-stores, fitness and shopping center based restaurants.  Delivery of grocery items in particular depend on customer density to make the economics work, and if you just randomly sample a dozen BRX properties off their website you'll see that these are not the most ripe opportunities for Amazon Fresh.  Finally, the economics of their spaces continue to be compelling: grocer sales per square foot average $550 across their portfolio, and occupancy costs run <2%.  That's a direct result of having conveniently located properties.

Value Add Opportunities

Broadly, the company is now in the hands of two former RE I-bankers.  Taylor and Aman have good reputations as financial managers--though they don't have prior RE operating experience.  New managements often identify areas they will do better than their predecessors, but in this case I consider several points credible and sufficiently significant to move the needle on cash flows over time. 

Under Centro and Blackstone, the portfolio was somewhat starved of capital and objectives were primarily near term cash flows.  Over time, underinvestment makes a difference in terms of maintenance, property upgrades, and management of their RE portfolio.  The new approach includes significantly higher redevelopment spend combined with a realignment of incentives.

The redevelopment pipeline now includes $1B in "fully scrubbed" opportunities, which they will work through at a pace a little higher than $150mm per year.  (2016 & 2017 will be a little light to that number, but they are clear about ramping up. Total capex includes maintenance, which at a run rate of $.40/sf is $35mm, and I model it at $40mm.)  These projects can range in cost from $5mm to $30mm, are coming in on time and on budget, with average NOI yields of a little over 9% and I estimate real ROIC of about 8% (* see below for calculation.)  Capitalization is roughly half debt at just over 4%, and whatever you want to use as a cost of equity, so 8% returns may or may not be hugely exciting to you but to me it seems value added and a very large sized opportunity. 

They will do some capital recycling.  In 2017 they will be a modest net seller of property, as private market prices are better than public.  They are getting ~7% cap rates on disposition, and it's been mainly properties they don't want, against an implied portfolio cap rate a little over 8%.  The biggest opportunity they'll pursue is exiting their 85+ single asset markets (or, in a few cases, building density).   These lag on occupancy by a few hundred basis points, and generally don't maximize rent.  Their peers such as Kimco figured this out a long time ago, but for BRX now opportunity comes just from copying other people.  I think there's a bigger opportunity to aggressively buy back stock, but it's unlikely to happen (** see below for details.) 

They are doing the stuff you'd expect with the balance sheet.  Trend is to de-lever a little as they carry more debt than peers.  They're moving to fixed rate (now 90%+) and extending maturities (Aman has already extended from 3 to 5.5 years).  They are also moving to unsecured, with a little more opportunity in ~$1B in mortgage loans due in 20 and 21 at 6% cost. 

Perhaps as significantly, there are real opportunities to improve operating efficiency. Incentives before were consistent with short term cash flow targets: corporate level occupancy targets and cost controls.  They've shifted to give ownership to local leasing teams who now are responsible for ROI, with decision making localized and the national sales team supporting with penetration & coverage instead of production.  Incremental decisions seem supportive of a shift: they moved to four regions instead of three (no longer running the west coast out of Chicago) and got rid of 3rd party property management (don't underestimate the negative impact of not being able to keep garbage from overflowing dumpsters.) 

Valuation

Valuation looks undemanding under almost any metric (unless you compare with certain mall players.)  P/FFO is <9x, lowest in the peer group (I see best comps as KIM, CDR, BFS, KRG, WRI, trading on average 13x.)  Implied cap rate at 8% is higher than peers, and private market transactions of similar properties are getting done around 7%; that would imply ~12.5% discount.  EV/Sales of 10.3x is about 10% cheaper than peer average.  Dividend yield of 5.6% is on the high end for shopping center REITS, with a lower payout ratio of 50% of FFO.

From an owner's earnings perspective: FFO/share is $2.10.  Take out $.17 to adjust straight line rents to cash and you're at $1.93.  Maintenance capex is estimated in the industry at $.30-$.40 per square foot, we could use $.50 assuming some of it was deferred too long (though they are getting good return on capex, so maybe that's overly conservative.)  That's $.14 per share to maintain earnings power.  About $1.80 in owner's earnings, trading at 10.5x at the current price.

Add in the near term operating improvements (~50 bps from debt refinancing and capital recycling), and then they're reinvesting about 4% of that owner earnings yield at something better than their cost of capital, and I have an expected return around 11% that's inflation protected.  I figure the rent bumps are running at least 1.5% in the current environment, and if inflation goes up you have some protection. 

Sensitivities and Notes

Rent levels: they give you "rent spreads" of 13%, which is the cash ABR increase in the first year of a new lease, compared to the prior year.  It's not a hugely helpful number, as it ignores capital costs and vacancies while renovating.  

The lease spreads are broken out by type, numbers here are TTM.  Option exercises by tenants at 6.5-7% have no interruption and no capital required.  Renewal leases increased by $1.50 per square foot or 11%; they spent $2.50 in tenant improvements/allowances to sign those.  If you charge that capital at 8% that brings the rent increase to 1.30 or 9.5%.  New lease spreads were up $4.27 or 35%, but capital cost was $24 and lost rent (assume 12 months on average) was $12 more.  After subtracting an 8% charge for this capital, the rent increase is ~11%. 

Options and renewals are about equal size in GLA, and together account for 85% of the leases signed.  Historically, they've had annual escalators of ~1% on 60% of their properties, while over the last couple years they're getting those escalators on 90% of new leases.   Weighted average lease terms run ~5 years.  Summing the YoY cash increase with the escalators, it's a total rent increase of 11.25% over 5 years, or a ~2.1% CAGR.  Seems like a solidly decent number achieved during the "retail apocalypse."

Fixed costs (G&A plus unreimbursed opex and maintenance capex) run about 22% of base rent, and interest payments run another 23%.  For every 1% drop in base rent, FFO drops about 1.8% (though the impact would actually be spread out over 5+ years as contracts expire.) 

Interest Rates:

The maturity schedule is quite evenly spread out at over the next ten years.  In 3 of the next 4 years they have ~10% of total debt in LIBOR based term loans which they'll presumably extend.  In 2020, the bulk of the mortgage loans come due, which as mentioned above provides ~$20mm of upside if they can refinance at their average interest cost.  A 1% move in interest rates has ~$16mm impact, or $.05 per share.    No bonds are due until mid-2022.

* Calculation on ROIC:

NOI yield is not ROIC number for three reasons. 

1) they don't include rent base if there's been a vacancy for >12 months (I can get a rough estimate of this from comparing their redevelopment properties with newspaper articles/Yelp reviews/Google streetview maps - I figure redevelopment properties average a little over 10% >12 month vacancies, which dings the yield by 90 bps).

2) as above, they don't include the lost rents in invested capital, impacting by 50 bps for average 9 months vacancy. 

3) they point out that they don't include any bump to small shop occupancy/rents from having modernized properties/better anchor tenants.  This is the most difficult piece to size, but small shops are 30% of their portfolio and >50% of rent, I'd put a lower bound of 50 bps of positive impact and recognized it's probably higher. 

Summing those up I get ROIC on redevelopment of just over 8%.  They don't do much ground up development, except for some outparcel development (bring in primarily fast food/quick serve in small corner of parking lot.)  This is higher return (up to mid-teens %), but a much smaller opportunity, ~5% of growth capex.

** Additional Color on Buybacks/Management

Perhaps someone with more a more extensive REIT background can help with this, but I can't think of a single example where a REIT engaged in a really significant stock buyback.  IREIT and British Land bought back this year, somewhere around 5% of their shares, but I can't immediately find more significant examples than that.  I understand the distribution of net income requirement, but if your shares are cheap and your stock is expensive, why not jump in to whatever extent you can?

I heard an interesting conversation on this topic at a conference in the spring, where an investor stood up to berate CBL management: they authorized a buyback in 2015 when their stock fell from the $20s to $15 but didn't act, and then 18 months later the stock is at $8 with no authorization in place, and still they're saying everything is going fine.  The liquidity answer seems only partly correct: if their comment is that private market values are not collapsing, why not arbitrage the public/private market?  I don't know a ton about CBL, so maybe bad example, but I think the point stands.

In BRX's case, I know management gets the buyout math since we've talked about it extensively.  Their stock once was 28, now it's <19.  They're clearly trading at a higher cap rate than they're selling, and I have several reasons to believe they are selling on balance below average property.  The points they've made about why they haven't done it:

• Long term thinking.  Basically the message is: as a stock picker, you can think short term and arbitrage value, but if you're building a business then you have to think long term.
• Buybacks not shown to move the price.  (*Note, this was early discussion with IR, and not repeated by Taylor or Aman.  My counterpoint: I'm not looking for you to move the stock price, I'm looking for you to allocate capital dollars to their highest and best use, regardless of what the market thinks about that in the short term.  Message received I think, but no further commentary to date.)
• Portfolio discounts.  This point I see as more valid: to date they have sold assets one at a time.  If you wanted to bundle assets for sale, you take a haircut.  DDR recently transacted at something like a 20% discount on BRX rough math to move a portfolio.  Obviously this would makes the transaction less compelling.  (My counterpoint: how much could you sell if you ramped up your disposition team?  Answer was somewhat more, but they are very reluctant to make short term hires.) 
• They have better investment opportunities in redevelopment.  NOI yields on redevelopment are so good, they want to work through this bucket of $1 billion as quickly as possible.  If anything, they'd want to go faster.

This section does raise a couple questions for me.  I've walked through with their executives my math to translate NOI yield to ROIC.  They certainly haven't blessed my math, but early on they pointed out a couple missing pieces, which leads me to think I'm probably at least in the ballpark.  So what assumptions lead to a conclusion that a buyback will yield lower than a 10% return?  The more positive answer is that, like a number of capable public market executives, their strength is not in stock picking or valuing their own stock.  The more negative answer is that they have other reasons for actions than maximizing returns.  Right now I lean toward the positive answer - given conversations, my sense of how they make decisions, and the fact that exec incentives are well designed (biggest component of comp is 3 year total returns relative to shopping center com set, balanced with appropriate one year per share operating metrics; also Taylor is accumulating stock including a couple open market purchases.) 

At the end of the day, you invest in the management team that's there.  Despite this disagreement, I find them reasonable and capable.  Their use of capital is likely to add value.  They've done quite well with the balance sheet.  They understand with admirable depth the local scale nature of real estate, and are thinking deeply about how to build that understanding into their operations.  And to date, enough positive signs that I don't worry a lot about past lack of operating experience.