Investment Thesis

Mr Market is temporary offering investors an opportunity to invest in a partially monopolistic business with stable cash flow.  I believe a long position in CBL at current levels represents 40 – 50% upside with minimal downside risk.

Business Overview

CBL is a US REIT that owns 79 regional shopping malls with about 68.2m sf of gross leasable area (GLA).  A majority of the malls are located in the Midwest and Southeast part of the US.  It also owns a small portfolio of offices and community shopping centers.

Why does the opportunity exist?

• Interest rate has gone up since May 2013.  The US 10 year treasury is now at 3% compared with 1.65% 7 months ago.  US REITs were sold off given its bond-like characteristic.
• CBL missed its earnings and lowered guidance in 3Q13, citing weak SS NOI.  The stock is down another 10% since the call.

Malls 101

• Generally, malls depend on anchors to drive foot traffic.
• Higher foot traffic = higher sales by tenants; Malls with no traffic are worthless.
• Higher sales by tenants = higher rents for the landlord
• Malls in prime locations (i.e. affluent neighbourhood, high population density) are not beholden to the strengths or weaknesses of its anchors.  Any anchor is replaceable because traffic at these malls is strong.  The Bal Harbour Shops in Miami and The Grove in LA are two examples of what I call “super A malls”.
• Contrary to general opinion, mall stores and online retail can co-exist.  Retailers need a physical store to “showroom” the merchandise and build brand awareness.

CBL’s mall portfolio

To understand CBL’s portfolio, it helps to describe what it is not.  SPG (post spin-off), MAC, TCO and GGP utilize a high quality mall strategy.  They invest in malls with high sales/sf, affluent neighbourhoods, metropolitan locations and upscale tenants.  CBL invests in an opposite way; its malls are located in rural, less populated areas like Minot, ND and Laredo, TX.  None of malls it owns are of “super A” quality.  A typical CBL mall is likely to be anchored by a JCPenney or Sears vs a Saks or Neiman Marcus in a high quality mall.  Low quality comparables are RSE (spun off from GGP) and PEI.

The Hidden Gem

What makes CBL standout among its low quality mall peers is “only game in town” malls.  As the name implies, these malls are located in small rural cities/towns and generates about 50 % of NOI.  They are monopolistic in nature because the economics of the surrounding radius cannot support another mall.   The unattractive economics has created a barrier to entry.  An example will be the Fayette Mall in Lexington, KY where it is the only mall within a 60 mile radius.

Growth is not spectacular but CBL should be able to grow earnings at 2 – 3% range given operating and financial leverage.

Valuation

CBL is attractive on a relative and absolute basis.

Due to the superior economics of its “only game in town” portfolio, CBL should trade at a premium to PEI and RSE.

On an absolute basis, in my normal case I assume 1% growth in revenue, 56% operating FCF margins (avg from 2004 – 12), 5.5% cost of debt (including the preferred), and that equals $1.70 FCF/share.  Applying a 15x multiple the stock is worth $25.5.

Worst case, 5% drop in revenue, 53% operating margins translate into $1.32/share.  Applying a 13x multiple is worth $17.16.

* Operating FCF defined as cash revenue – real estate operating expense – G&A – maintenance capex,

Catalyst

• Private market cap rate for asset of the same calibre as CBL is trading at low 7% cap rate, even after the rise in bond yield.  Recently announced deals (i.e. BRE, CWH) have shown that there is ample liquidity for REIT assets regardless of quality.  The significant discount to NAV will attract bids.
• SPG will spin off its lower quality portfolio later this year.  By then there will be 4 low quality mall REIT in the space.  I believe longer term there will be 2 players or less in the space.  If CBL’s discount to NAV still exists after SPG’s spin-off, SpinCo or RSE may make a bid for CBL

Risks

• Interest rate continues to go up, causing increase of cap rate
• High leverage : CBL is vulnerable to fundamental downturn or stress in the bond market
• Online Retail; this risk is somewhat offset by the retailers’ need to have a show room.  Nonetheless, it does have an impact on the mall’s sales/sf number.