Description

Seritage Growth Properties (NYSE: SRG)

Share Price: $39.60/share

Share Outstanding: 53.3mm

Market Cap: $2.1 billion

Total Debt: $1.2 billion

Enterprise Value: $3.3 billion

Background

We are recommending a long position in Seritage Growth Properties (NYSE: SRG) common equity. Seritage is a newly formed REIT (as of 6/3/15) created as a result of its spinoff from Sears Holdings (Nasdaq: SHLD). Seritage owns 235 properties (~93% Sears/Kmart) totaling 36.7mm square feet and a 50% equity interest in three JVs with mall REITs GGP, Simon and Macerich (12, 10 and 9 properties, respectively). In conjunction with its spinoff from Sears Holdings, Seritage entered into a Master Lease Agreement (MLA) whereby it would lease all Sears/Kmart properties back to Sears Holdings, effectively consummating a sale-leaseback. This transaction was broadly marketed as a way for Sears Holdings to raise liquidity as it continues to burn cash. However, below the surface it is clear that this transaction was designed as a way for existing Sears equity owners to carve out high quality commercial retail property into a new entity that they could participate in at an attractive valuation. The rights offering associated with the transaction was 97.3% subscribed and well-known owners of Sears Holdings, ESL Investments (hedge fund controlled by Eddie Lampert) and Fairholme Capital Management received ownership stakes in Seritage of 46.5% and 17.0% respectively at a subscription price of $29.58 per share (see detailed ownership structure in the appendix). Had this transaction not taken place, the same valuable real estate would have ultimately been owned by Sears Holdings creditors. Given this backdrop, we believe there is a significant opportunity to invest in this high-quality real estate at an extremely cheap valuation.

Thesis Summary

The market currently discounts Seritage as a single-tenant REIT with Sears as its overwhelming majority tenant and a perceived high-risk counterparty. However, the details of the Seritage MLA make this investment particularly interesting. The existing lease terms with Sears Holdings for Sears/Kmart properties were struck at an average rent of ~$4.60/square foot. We believe these lease terms to be particularly low given its poor performance (rents are typically set at a discount to sales/sqft) and Sears/Kmart properties’ common position as the anchor tenant for many Class B malls (anchor tenants are typically charged lower rents). The Seritage MLA contains “recapture rights” that allow Seritage to reclaim up to 50% of the gross leasable area of its properties and release this space to third-party tenants at no cost to Seritage other than the cost to partition the stores. In other words, Seritage can divide all of its stores in half, erect a wall and release 50% of its space to likely higher quality anchor tenants (Dick’s Sporting Goods is an ideal one, Cinemark, etc.). We believe that the released space will command significantly higher rents on the order of $8.50-$12.50 per square foot at relatively minimal redevelopment costs. Additionally, Seritage also has the right to recapture the remaining 50% of the GLA at a larger subset of properties provided that it pay a termination payment equal to 10.0x store-level EBITDA. Fortunately, store-level EBITDA is zero to negative at most Sears/Kmart locations meaning that Seritage can recapture almost 100% of its square footage for close to nothing. Pro forma for 50% GLA recapture, we believe that Seritage currently trades at a 9.0% cap rate and 8.5x AFFO, while comps trade at a ~6.5% cap rate and ~17.0x AFFO (see capitalization below). At these levels we see ~53% upside to the current share price of $39.60 over the next few years. Should 100% GLA recapture materialize, we see at ~110% upside.

Company Overview

1.    Seritage Growth Properties (“Seritage”) is a publicly traded REIT created on June 3, 2015 as a result of its spinoff from Sears Holdings

2.    Seritage’s portfolio consists of 235 properties (“Acquired Properties”) that are owned by Sears Holdings Corporation

a.        Approximately 36.7 million square feet of building space diversified across 49 states and Puerto Rico

b.    84 properties operated under the Kmart brand, 140 operated under the sears brand, and eleven leased to third parties

c.        Third party tenants initially represent ~6.6% of the overall portfolio as a percentage of total leasable space and 10% of existing rent

3.    Three 50% JV interests in an additional twelve, ten and nine properties (the “JV Properties”) that will be sold to Seritage in the transaction

4.    Will lease a substantial majority of the space at all but eleven of the Acquired Properties back to Sears Holdings under a Master Lease Agreement (“Master Lease”) with the remainder being leased to third parties

5.    A substantial majority of the space at the JV Properties is also leased to Sears Holdings by GS Portfolio Holdings (a JV with General Growth Properties hereby referred to as “GGP JV”), SPS Portfolio Holdings (a JV with Simon Properties hereby referred to as “Simon JV”) and MS Portfolio LLC (a JV with The Macerich Company hereby referred to as “Macerich JV”). Each JV is under a separate Master Lease (“JV Master Leases”) with Sears Holdings. Seritage will acquire Sears Holdings’ 50% interest in each JV in the transaction

6.    Generates revenues by leasing properties to tenants including both Sears Holdings and third-party tenants who will operate retail stores in the leased premises. In addition Seritage will have a 50% interest in each JV

The Transaction

7.       Acquired entities incurred $1,161.2 million of indebtedness and established a $100 million future funding facility for future redevelopment activities

8.       Operating partnership  purchased the Acquired entities and the JV Interests for an aggregate purchase price of approximately $2,677.3 million (value includes $2,248.3 million for the Acquired Properties as appraised by Cushman & Wakefield) and includes the amount of debt assumed

9.       Purchase price is funded with:

a.       Subscription rights to Sears Holdings shareholders to acquire Seritage common shares

b.      Common shares sold to GGP and Simon in private placements 1,125,760 common shares at a purchase price equal to the subscription price in the rights offering for $33.3 million each

c.       Fairholme Capital Management (“Fairholme”) entered into an agreement to exchange its subscription rights for 11.7% of Seritage common shares for 9,527,194 Class C non-voting common shares ($29.58 per share)

d.      ESL Investments (“ESL”) exchanged cash and subscription rights for 3.1% of Seritage common shares for Operating Partnership units and Class B non-economic common shares (5.4% of the voting power of Seritage, but no dividends or distributions)

Terms of The Master Lease

10. The Master Lease provides Seritage with the right to recapture up to approximately 50% of the space within the Sears or Kmart stores located at the Acquired Properties (the “Stores”)

11. Seritage has the right to reconfigure and rent the recaptured space to third-party tenants on potentially superior terms

12. Upon exercise of its recapture rights, Seritage must pay all costs and expenses for the separation of the recaptured space from the remaining Sears Holdings space

13. The JV Master Leases provide each JV with a similar right in respect of its JV Properties

14. The Master Lease also provides the right to recapture 100% of the space within the sears Holdings main store located on each of 21 identified Acquired Properties by making a specified lease termination payment to Sears Holdings at 10.0x store level EBITDA – currently, the majority of Sears/Kmart stores operate at negative EBITDA

15. Sears Holdings will also have the right to terminate the lease to an Acquired Property or a JV Property if its LTM EBITDAR is less than the rent attributable to it

a.        Ability to exercise this right is limited so that the rent in the Master Lease cannot decline by more than 20% in a given year

16. Key question is what might happen to the existing lease agreement should Sears Holdings file for bankruptcy. We believe this would actually be value enhancing for Seritage equity holders.

a.        Interestingly, the MLA is comprised of a single lease for all 235 properties. Typically, leases are separable at the property level. The MLA explicitly mentions Section 365 of the US Bankruptcy Code, which relates to the assumption, assignment and rejection of executory contracts.

b.    Presumably, Sears would not be able to exit bankruptcy with rent due on 235 properties and there is no potential tenant we can think of that would be able/want to occupy 235 locations and 36.7 million square feet.

c.        Therefore, the contract would be rejected by Sears Holdings and Seritage again would be able to release 100% of its property space to third parties

Rent Recapture Rates

17. Based on a large sample set of rents for Class B mall tenants it’s clear that there is a high correlation between tenant size and rent/sqft

18. Fairly clear that recaptured rents can be triangulated at ~$10/sqft

Valuation

Risks – Fraudulent Conveyance

19. Largest risk to the thesis are fraudulent conveyance claims from existing Sears Holdings noteholders

20. If a fraudulent conveyance claim were to succeed in court, shareholders would receive the original IPO price of $29.58 per share (~30% downside)

21. Constructive fraudulent conveyance requires that (1) in exchange for the transfer of an asset the debtor must receive less than “reasonably equivalent value” and (2) that the debtor is unable to pay debts either at the time the transfer was made or as a result of the transfer itself

22. Fraudulent conveyance claims are mitigated for several reasons

a.        The Seritage MLA explicitly contains a section on fraudulent conveyance outlining the reasons why this transaction did not qualify. We have confidence that existing Sears had the requisite counsel to ensure the transaction would not be unwound.

b.    Duff & Phelps conducted an appraisal in connection with the rights offering suggesting the transaction was done at fair value

c.        It is unclear whether “reasonable equivalent value” must include the value of the “recapture rights” instead of value in their current use as Sears occupied properties

d.    Would be hard to argue that Sears Holdings was insolvent at the time of the transaction – SHLD had and continues to have a roughly $2.0 billion market capitalization

Appendix:

Other Notes

23. G&A expenses include compensation costs, professional services, legal expenses, property management and leasing costs, office costs and other costs associated with development activities

24. Incremental public company operating expenses are ~$15 million

25. Leases are all “triple net” leases with an average renewal term of 10 years with between 2-4 5 year renewals at the option of Sears Holdings

26. Class B Malls are generally defined to have sales between 300-500/sqft. Malls that generate more in sales are considered to be “Class A” and malls that generate less are considered “Class C.” Historically many Class B malls have had Sears or JC Penney as Anchor tenants

27. CBL redevelopments costs are estimated to be $1-3mm per store

Catalyst

Lease recapture leading to uptick in NOI