Description

Prime Retail is a factory outlet REIT. The Series A 10.5% senior cumulative preferred shares trade at 20% of face value, 16% of accredited value, and are worth par at 84% of book value.

As of March 31, 2002 Prime owned 44 outlet centers, aggregating 12,388,000 sq.ft GLA, which was 87.2% occupied; 2 community shopping centers aggregating 219,000 sq.ft GLA, which was 75% occupied; and 154,000 sq.ft GLA of office space, which was 95% occupied.

I think most everyone is familiar with the Factory Outlet concept. There are three publicly traded REITs (including Prime Retail) that focus on Factory Outlets. All three have websites that allow you to view the properties and get a good sense of locations, merchants, and how they market the centers.

Chelsea Property Group (ticker CPG), owner of Woodbury Commons in New York, owns 57 centers, aggregating 12,600,000 sq.ft GLA comprised of 27 properties, with 8,300,000 sq.ft GLA being considered “Premium Properties” and 30 properties with 4,300,000 sq.ft GLA (acquired September 25, 2001) comprising the rest. Chelsea is clearly the industry leader, very well capitalized (they have been buying back their own preferred shares), and have recently purchased some of Prime Retail’s outlet centers. Chelsea trades for about 2.0X book value.

Tanger Factory Outlet Centers (ticker SKT), at about half the size of Chelsea or Prime, owns 29 properties with 5,330,000 sq.ft GLA. In general, Tanger’s properties are probably closer, in the merchants represented and in the audience targeted, to Chelsea’s non-premium properties and the majority of Prime Retail’s properties. Tanger trades for about 1.3X book value.

Prime Retail’s Balance Sheet Summary:

Assets: $1,163,488,000

Liabilities: $ 903,880,000

Equity Value: $ 259,608,000

There are 2,300,000 Series A 10.5% $25 face value cumulative preferred shares that have about $6.56 of accrued interest per share (2.5 years worth since November 1999). The total claim for principal and accrued for the Series A shares is $72.6MM. A value of 84% of book value gives you a par recovery, for a total return of over 600%. Of course, the preferred continues to accrue dividends so your claim continues to build over time.

There is also a junior class of preferred, the Series B 8.5% $25 face value cumulative preferred that has about $5.31 of accrued interest per share and trades for just $2.65 per share. The problem with the junior preferred is that it is a very large issue of 7,828,125 shares with an accreted claim of $237MM. I do think the value of Prime exceeds the value of the Series A preferred, but the Series B preferred will no doubt be impaired. The Series B should still prove to be a good investment. I just think that risk/return adjusted, I would rather have my money in the Series A that has to be worth 6X today’s trading price before the Series B is worth a penny.

What happened to Prime Retail?

Prime expanded too quickly (they were the industry’s largest player until Chelsea’s portfolio purchase in September 2001) and many of their locations simply weren’t (aren’t) that good. At the same time Prime was expanding, so was the competition.

The good news is that there has been industry/sector consolidation and the number of publicly traded players was cut in half. Today there are only 3 REITs left that focus on Factory Outlet Centers. Both Chelsea and Tanger continue to expand by building new centers, expanding existing centers and through acquisition. With the number of available quality locations limited by existing retail competition however, both Chelsea and Tanger have targeted acquisitions as their primary mode of growth. Chelsea’s purchase last year of 30 outlet centers and several of Prime’s outlet centers is proof enough of this trend.

While Prime’s EBITDA is sufficient to cover interest expense, preferred dividends and maintenance capx, it is insufficient to cover their maturing debt. This is why Prime stopped paying preferred dividends in 1999. The way Prime financed their outlet centers was to finance most of the centers individually through mortgage debt vs. funding the company with one or two bond issues. The result for Prime was several mortgage properties maturing starting in 2000. Why didn’t they sell or refinance these centers before they absolutely had to, I don’t know, but they didn’t. (My guess is they were greedy and wanted to try and maximize the value of the properties before sale). While Prime did start to sell some properties, they decided to enter a restrictive 3 year secured Mezzanine Loan in December of 2000 with Fortress and Greenwich Capital for $90MM. The balance of that loan (through asset sales) as of May 14, 2002 was $36.7MM.

Short-term triggers:

Prime has limped along for 2.5 years, now things are about to change.

(1) As of 12/31/01, Prime had total debt of $855MM with $501MM maturing in 2003. Prime’s large maturing debt combined with their bridge and mezzanine loan covenants/restrictions guarantees that Prime will now have to take a more holistic approach to fixing their balance sheet. To date they have been able to sell a property here and there and squeak by with the help of their 14.5% (interest rate) mezzanine loan.

(2) Prime missed their preferred stock dividend payments for 6 quarters and, as a result, two large preferred shareholders, Howard Amster and Robert Kanner (who together control about 6% of the Series A and 15% of the Series B preferred shares), were elected to the board of directors at the end of last year. Clearly, it is in their (and our) best interest to create value for preferred shareholders sooner rather than later.

(3) On April 1, 2002 Prime sold Prime Outlets of Edinburgh to Chelsea Property Group for $27MM. While this was a high occupancy property at 98%, the center had low sales per square foot and clearly did not fit the profile of Chelsea’s “Premium Outlet” centers. The good news here is that Prime can probably count on both Chelsea and Tanger to bid on Prime’s non-premium properties.

Opportunity:

While most of Prime’s remaining debt is recourse, they do have a large center called Prime Outlets at Jeffersonville II that is 314,000 sq.ft GLA, has an occupancy rate of a dismal 42%, a mortgage of $18MM and is carried with a book value of just $4MM. Prime plans to hand the keys to the lender, which will effectively increase equity an additional $12MM. Getting rid of this one center will also increase the average of Prime’s portfolio occupancy by about a full percentage point.

How good is Prime’s Book Value:

In addition to depreciation, Prime has taken about $150MM of impairment charges over the last 3 years. Taken together, these two charges have already reduced the carrying value (book value) of the assets substantially to what is probably close to realizable value. The good thing here is that the assets can be written down roughly another 16% and the Series A preferred is still worth Par!!

Data Points of Book Value:

On April 19, 2002 Prime sold Bellport Center II and III (197,000 sq.ft GLA, 62% occupied) for $6.5MM, generating $800K of net proceeds after refinancing the first mortgage of $5.5MM and closing costs. Bellport was a 51% owned JV interest and unfortunately the book value is not broken out on the balance sheet.

On April 1, 2002 Prime sold Edinburgh Center (298,000 sq.ft GLA, 98% occupied) for $27MM, having a book value of $36.4MM. The significant discount to book value (approximately 26%) was due to the center’s relatively low sales per square foot.

On January 11, 2002 Prime sold Prime Outlets at Hagerstown (487,000 sq.ft GLA, 96% occupied) for $80.5MM, having a book value of $54.6MM. This property was sold at a significant premium to book value (approximately 47%) due to the property’s high occupancy and cash flow.

Unfortunately, the company does not break out individual centers’ sales and cash flows and it is nearly impossible to determine which centers might sell for above or below book value. The above does give you a flavor for the demand for factory outlet assets and the ability of those assets to be sold for an average of book values.

Prime is an okay company with a bad balance sheet. Not a great company, but not a bad company either. A financial buyer, another factory outlet REIT or possibly another REIT wishing to expand into retail could acquire assets here cheap. For those of you familiar with Omega Healthcare (a VIC and personal favorite of mine) remember how Explorer made a ton of money by fixing the balance sheet of short-term maturities? That is exactly what is needed here. Prime has to sell off the properties one by one or organize a single or series of bulk sales to a well-capitalized entity that won’t be crippled with high cost debt and short maturities. Given Prime’s pending debt maturities over the next 18 months, something certainly has to happen sooner rather than later. Given the excess equity value, even in the case of Chapter 11 (which I would welcome as a short-term trigger) it is hard to see how the Series A gets hurt from today’s trading price of just $5.00 per share.

Catalyst

(1) Short-term debt maturities
(2) Recent election of 2 new board members (with significant share ownership) representing the preferred shareholder's best interests.
(3) Industry consolidation, asset sales
(4) Improving cashflows due to increased retail sales
(5) Possible Chapter 11 filing that would unlock value