We believe the common shares of Entertainment Properties Trust (EPR) are a compelling short.  EPR is a REIT that started out following a fairly simple and straightforward business model of providing triple-net leases to multiplex movie theaters.  The company was spun off / IPO'd from AMC Theaters to execute a sale-leaseback of some of their movie exhibition properties.  While the movie-theater property business has proven to be a stable, predictable & non-cyclical business that makes strategic sense for both theater operators and income oriented real estate investors alike, in recent years EPR has expanded its business by investing in riskier types of entertainment & entertainment related properties as well as underwriting commercial mortgage loans to startup wineries / vineyards, casinos, charter schools, waterparks & metropolitan ski resorts.  Their aggressive growth strategy in these new markets has transformed the risk profile of EPR making it more economically sensitive & susceptible to the vagaries of unproven operators / entrepreneurs.  Mortgage loans made at the peak of the real estate bubble in recent years have plagued EPR's balance sheet with numerous problem assets that continue to show signs of distress and will likely need to be further restructured or written down.  Furthermore, EPR has mismanaged its leverage and liquidity having recently cut its dividend and materially diluted shareholders year after year by issuing shares to cover cashflow shortfalls while failing to add income producing assets in lieu of new shares (more below). 

 

On the surface, recent acquisitions of additional triple-net leased theater assets may seem like a shift to refocus on their core business; however these investments clearly are an attempt to dilute their problem assets across a larger asset / share base.  In other words, they seem to be attempting to "grow" their way out of their impaired, non-performing assets by using their inflated valuation & favorable REIT fundraising environment - capitalizing on the spread between a 6% source of funds (common equity dividend rate) and 10% cap rate deals they are pursuing.  The recent increase in common shares to 46.4 MM outstanding (~ $2.0 Billion mkt cap @ a 2.60 per share dividend rate = $120.6 MM) plus their $416 MM of preferred shares, which consume around $30 MM / annum in dividends, add up to around $150 MM in annual dividends, which considering the AFFO of the last three years ($120.5 MM, $132.0 MM, $109.0 MM in 2009, 2008 & 2007 respectively), puts pressure on the current dividend payout despite new income producing assets being added to the balance sheet.  To make matters worse, EPR will likely face increasing interest costs as it rolls over its $1.3 billion in mortgage debt in upcoming years (213 MM by 2012) as bankers demand higher rates or more equity (or both) as a result of too much leverage on collateral that has / is declining in value.  These and other factors described below, will put pressure on equity cashflow in the next few quarters / years.

 

Finally, while the movie exhibition business is undoubtedly a stable business, we expect upcoming expiring leases (around 17% of revenues in the next two years) to face pricing pressure at renewal negotiations.  A recent decision by AMC, EPR's largest tenant representing 38% of revenue, not to renew an EPR property in Dallas is noteworthy.  A quote from AMC's CEO is also very telling "It's disappointing that we have not come to terms on a historical, and to us, a somewhat sentimental property, but in our opinion, the proposal advanced by EPT is simply untenable. We continue to negotiate with EPR on several other properties and will see where those discussions take us."  Recent consolidation and rational competition by movie operators give them substantial negotiating power on a regional basis, which could put EPR in a difficult position as the economy and commercial real estate continue facing challenges.

 

 

 

As mentioned above, EPR started out buying out properties and then leasing them back to operators on a triple net, cross-defaulted basis.  What is a triple net lease?  The basic difference between a triple net lease and a regular lease is that the tenant assumes the responsibility for most expenses related to the property - i.e. taxes, utilities and maintenance capex - while the REIT holds the land/buildings on its balance sheet and collects rent.  This allows the operator to monetize an asset that can be used to grow its operations, while the REIT acquires a stable, recurring revenue stream that can be used to pay dividends without the hassle that comes with managing the actual property.  EPR's total portfolio consists of a around 96 theaters, 1800 screens and encompasses 7.8 million square feet - which is approximately 10% of nationwide megaplex screens and 3-4% of total industry screens.  EPR operates single tenant properties under long-term leases, which generally provide a base rent, inflation escalators, and a percentage of the tenant's gross sales over a predetermined level. 

 

In general, demand for movie theater properties is driven to a large extent by box-office revenues which in turn is a function of general economic trends, blockbuster releases and, more recently, new projection technologies to compete with home entertainment alternatives.  A multiplex operator's ability to cover their lease obligations is mostly a function of revenues per screen (coverage ratios range between 1.6 - 2.0 times).  Occupancy at EPR's theaters are 100%, with average lease terms around 12 years.  Their theaters are on average less than 5 years old and are mostly in prime locations in metropolitan areas.   Recent technological trends in digital & 3D movie projections, as well as alternative content (sports, opera etc...), have driven box-office receipts higher and provided new revenue sources for exhibitors - this has benefited EPR indirectly through better coverage ratios as well as through direct participation in % of rent agreements (revenue from participation is a marginal immaterial amount).

 

EPR also acquired restaurant & retail properties through its Entertainment Retail Centers (ERC's).  It is worth noting that retail / restaurant tenants have less stable business models and are not immune to the business cycle, which have lead to vacancies & lost income.

 

Most investors buy EPR for its 6% dividend and for the attractive attributes of its core exhibition business, as described above.  Our bearish thesis, however, is based on the numerous challenges EPR faces which are a direct result of their flawed growth strategy.  Despite cutting their dividend by more than 20% last year, we believe the current dividend will prove difficult to sustain.

 

 

After being spun out of AMC (American Multi-Cinema Inc) in 1997, EPR's deal flow with AMC decreased dramatically which prompted EPR to pursue growth through acquisitions of new theater properties to other theater exhibitors, such as Regal Cinemas & more recently Cinemark.  In an effort to grow further, in recent years EPR has branched out to other real estate assets related to "destination entertainment, entertainment-related, recreational and specialty properties".  As of December 2009, in additon to their 95 megaplex theaters, EPR had 9 entertainment retail centers & land parcels leased to restaurants & retailers, a metropolitan ski area in Ohio, 10 wineries & 8 vineyards in California and 22 charter schools (27 in March '10) across 9 states.  In the last 5 - 7 years EPR has also aggressively invested in a mortgage loan portfolio that grew from $42 MM at end of 2004 to $523 MM (almost 20% of assets) as of Dec of 2009.  Unfortunately most of these loans went to risky ventures that were either in development stage or looking to grow by leveraging their assets.  As of December of 2009 more than half of these loans were deemed impaired and non-performing by EPR, which represents over 10% of EPR's total assets.  While the core of EPR's investments in megaplex theater properties still represents the bulk of its assets, producing a steady stream of recurring revenues & EBITDA, the poor underwriting of its loan book and management's cavalier deal-making & financing strategies have and will continue to put pressure on its results.

 

Snapshot / Breakdown of Assets:

 

Property Type	$ in MM	% of Total
Theater Megaplex	2000.0	70.50%
Metropolitan Ski Areas	148.6	5.24%
Vineyards & Wineries	218.2	7.69%
Charter Schools	173.6	6.12%
Water-Parks	163.3	5.76%
Casino	133.1	4.69%
Total Assets	2836.8	100%

 

 

EPR's current payout appears to be unsustainable.  AFFO in recent years has been relatively flat (~100MM in 2006 to 119MM in 2009), despite growth in assets (in non-performing mortgage loans), increasing debt & a ballooning sharecount that has almost doubled from 26 MM in 2006 to 46 MM today.  EPR also has 4 series of preferred shares which consume $30 MM in cashflow.  At today's $2.60 rate, EPR needs $121 MM in AFFO (after preferred dividend payments) to meet its current common payout, which leaves little/no room for error in terms of managing future investments, renewing upcoming leases and rolling over its CMBS.

 

 

Overall the loan portfolio is the main source of EPR's problems.  As metioned above, EPR has been borrowing large amounts against its theaters and lending it to wineries, charter schools, start-up casino projects, etc.  Mortgage notes in these businesses now total 20% of assets.  Close to 60% of these loans are now impaired and EPR is doing everything possible to buy time by extending & attempting to modify these loans.

 

In the midst of the real estate bubble (2006 - 2008) EPR acquired loans in 10 wineries & 8 vineyards (eight in California).  It goes without saying that the timing of their foray into the wine business was spectacularly bad.  The wine business is more competitive than ever and a recent inventory glut in Sonoma, CA has hurt pricing for EPR's operators.  Most of these loans are impaired and 4 of the properties have been reclaimed by EPR.  While provisions have been made, it is very unlikely ERP will see income from these deals anytime soon; in fact, it is almost certain that EPR will have to further writedown the carrying value of these properties - current carrying value of wine loans / properties is $218.2 MM.

 

 

EPR's relationship with Louis Capelli has only lead to troubled deals that inevitably lead to distressed investments.  The Concord Resort development, the largest Capelli deal, was a grandiose casino and resort project envisioned for the Catskill region of upstate New York.  I underline was because the unrealistic $1 billion project has been stalled since its inception, as Capelli has been unable to attract the additional needed financing to keep the project alive.  The project size has been cut to 500 MM and still, no financing & no construction.  The original idea was to build a spa hotel, waterpark hotel, convention center, two golf courses and residential properties across 1,600 acres.  EPR's investment was $133 MM and was financed with a $56.3 MM mortgage in 2008.  Amazingly, there have been no loan loss reserves despite the loan being impaired (Capelli stopped making payments pretty much right away) & having been originated in late 2008.

 

In addition to the Concord deal EPR has struggled with 3 other co-investments with Capelli, including New Roc City the City Center in White Plains New York & other ERC's that have been deemed impaired.

 

 

A number of other property loans have faced numerous challenges.  While some of these have performed, others have had their maturities extended and/or have missed payments.  The Toronto Dundas Square Project, which was originally a 90MM mortgage note receivable, was recently acquired by EPR after having struggled and gone into receivorship and auctioned off.  While occupancy has risen in the property, it still faces challenges.  The ski & water parks, which are cross-collateralized, meanwhile have delivered relatively flat yoy results.

 

 

As metioned at the beginning of this writeup EPR has used plenty of leverage to finance their growth projects.  Typically EPR would mortgage the properties they were acquiring and/or existing properties to fund other purchases or loans.  The value of the properties / loans securing these mortgage notes payable have been marked down by 2 - 3 yoy - an arbitrary and aggressive assumption.  Even so, the loan to value on present carrying values is extremely high with many exceeding 100%.  As these notes mature, the mortgage market will command higher rates to refinance and/or additional equity to secure the loan.

 

 

EPR is pretty pricey using pretty much any valuation metric - i.e. trading at 1.57x book value (with book likely overstated), 16x AFFO, 13x EV/Sales & 16x EV/EBITDA.  While a high multiple on FFO might be warranted if the business solely consisted of stable and safe triple net leases, we feel EPR doesn't deserve such a premium due to its higher risk profile and potential problems that might lie ahead.  EPR's low quality loan book, its levered balance sheet and what appears will be insufficient cashflow to fund its current dividend payouts are just a few sources of concern.  Management attitude seems cavalier pursuing growth by partnering with unproven operators.

 

 

Unadjusted, from CapIQ

Key Financials¹
For the Fiscal Period Ending	12 months Dec-31-2006A	12 months Dec-31-2007A	12 months Dec-31-2008A	12 months Dec-31-2009A
Currency	USD	USD	USD	USD
Total Revenue	196.6	237.2	288.1	270.8
Growth Over Prior Year	18.0%	20.6%	21.5%	(6.0%)
Gross Profit	177.9	214.2	261.3	171.0
Margin %	90.5%	90.3%	90.7%	63.1%
EBITDA	134.2	197.3	243.9	153.2
Margin %	68.2%	83.2%	84.7%	56.6%
EBIT	132.2	159.8	200.1	105.5
Margin %	67.3%	67.4%	69.5%	39.0%
Earnings from Cont. Ops.	81.6	100.6	129.9	8.0
Margin %	41.5%	42.4%	45.1%	3.0%
FFO	101.0	113.7	142.6	4.9

 

 

 

The shares are easy to borrow with short interest around 8%.  The main risks to our thesis are:

• Impaired loans start generating income
• Economy strengthens and commercial real estate recovers
• Management successfully expands balance sheet acquiring more high-quality theater assets and/or is successful expanding its charter school business

 

 

 

 

Potential dividend cut.  Further provisions & writedowns.