Description

This writeup was completed before the COVID-19 outbreak, and as such is broken into two parts: pre- and post-coronavirus analysis. While the general setup is the same, considerations for pre- and post-virus are different. Despite these differences, we still believe SKT is a mispriced asset with a margin of safety.

Pre-COVID Analysis

Tanger Outlets (SKT) is the largest outlet mall REIT (real estate investment trust).

We analyzed Tanger two years ago at a much higher price of $25 and passed on it. It just did not seem cheap enough. At the time we struggled with a question: Do outlet malls have a reason to exist?

Fast-forward two years, and SKT’s stock price declined to $15. We took a second look and discovered something interesting: Customer traffic in their outlets went up almost 2% and sales per square foot increased 3% to $395.  These data points really piqued our interest, as they showed that despite internet disruption, consumers want to be there (both traffic and sales per square foot were up!).

So we did some more digging and realized that outlet malls are a beneficiary of the disruption that is happening in retail today.

Clothing brands – let’s take Nike, for example – are in the business (in part) of convincing people that whatever they bought six months or a year ago is no longer as fashionable and thus not as good as the stuff the stores have on their shelves today. In other words, Nike needs to move last year’s merchandise by discounting while preserving the perception by consumers that Nike is a premium brand.

Nike will do some discounting of merchandise in its own stores, but it is limited in how much it can do it before it starts chipping at the perception customers have of its brand.

Enter outlet malls.

Outlet malls are usually built away from the cities, for two reasons: first, to create physical distance from retailers’ core stores. The distance insulates their core stores from last year’s merchandise discounting. Second, real estate is cheaper in the middle of nowhere, thus outlet malls must charge lower rent. The total rent Tanger charges its retailers/brands (occupancy cost) is about 10% of their sales, while the occupancy cost in a traditional mall is 12–13% of sales.  Considering that the retail business has razor-thin margins, this 2–3% makes a difference.

Tanger tenants allow brands to unload their prior year’s products in bulk without damaging their images. There are a few exceptions, but you’ll rarely see a general clothing or merchandise retailer in Tanger outlets.

Individual store fronts at Tanger malls are built like boxes that can be easily combined or subdivided and accommodate any tenant. They are really just three solid walls and a glass one. It takes two weeks to recondition (mainly repaint) a store for a new tenant when the old tenant leaves.

There are a lot of things we like about Tanger. It has been an extremely stable, well-run, growing business with a return on equity of about 15%. It has outstanding management. Tanger is run by Steve Tanger, and the company was started by Steve’s father, Stanley, in 1981. Tanger occupancy has never dipped below 95% in the 38 years of its existence, and has usually stayed around 97%. (That’s one of the highest occupancy numbers we’ve ever seen.)

In 2008, during the Great Recession, SKT actually raised its dividend. We have read hundreds of reviews of Tanger outlets, and shoppers love them. (Here are reviews for its Riverhead outlet – take a look). The company manages its outlets almost as theme parks; they’re well-designed and clean, with seasonal themes and entertainment. SKT has a good, conservatively financed balance sheet. Overall, it’s one of the best of all the REITs we have looked at.

Unlike the rest of the retail, outlets as a category do not look over-retailed. There are seven billion square feet in the US dedicated to retail, with about a billion dedicated to traditional malls, and outlet malls occupy only about 70 million square feet – 1% of the total. Tanger recently sold a few lower-quality outlet malls it owned, and today it owns mostly class A properties.

The average annual household income of a Tanger customer is $93,000 (not your typical Walmart shopper, more like a Costco shopper). Tanger should benefit from the demise of low-end shopping malls and the shrinkage of department stores. (Macy’s is closing 125 stores, JC Penney is fighting for its life.) Also, outlet malls have what Americans always want: bargains. As Steve Tanger likes to say, “During good times they want it. During bad times they need it.”

Tanger stock sold off because the company will be facing bankruptcies of some of its tenants, the likes of Forever 21 and Dress Barn (owned by Ascena). In the short run, in 2020, Tanger is guiding that its occupancy will drop to 93%. Though 2020 looks particularly brutal, this is not an atypical environment. In a 2016 interview Steve Tanger mentioned that his top ten tenants from ten years earlier (in 2006) were out of business.

However, as long as consumers want to keep shopping at Tanger stores – and increasing traffic and sales per square foot show that they do – retailers will want to be there, too. Tanger should be able to re-lease vacant space, and it will do so at a higher rate. (The average tenant today pays $26 per square foot, while new tenants pay $36 per square foot).

Tanger stock is incredibly cheap. We are paying about 7–9 times free cash flows. Also, Tanger pays a $1.41 dividend, providing us a dividend yield of 9–11%. Let us give you some context about how secure this dividend is. At 93% occupancy and $26 per square foot rent, it should generate $1.70 of free cash flow per share. If occupancy falls to 87%, Tanger will still be able to pay this dividend from free cash flows.

It is very unlikely that we’ll see 87% occupancy, as Tanger is a very profitable outlet for retailers. As 2020 shakes out weak retailers, the new square footage is re-leased at higher rent, and occupancy comes back to normal (95-97%), our estimate for SKT free cash flow is around $2–2.10 per share.

Here is what Steve Tanger said in March in his presentation, answering the question, would SKT be able to fill the space that became available in January:

Let me put it in perspective. In the last 4 years, ending December 31, 2019, we got back about 5% of our space. And during that period, we were successful in re-leasing the space and ended last year at 97% occupied. To my knowledge, that’s the highest occupancy rate of any of the mall sectors. Proves the strength of our leasing team, … and the demand for space in Outlet Centers. We start this year with 300,000 feet.… We have about 180 million shopping visits a year to Tanger Centers around the country, which is attractive to new groups of people. So our expectation is that during the year, we will fill most of the space.

SKT stock is a typical case of time arbitrage: There is a lot of uncertainty in the short run, which pushes out short-term-oriented investors and creates an opportunity for investors who are willing to buy a significantly undervalued company and are comfortable seeing the stock price decline further in the short run.

Post-COVID Analysis

When we were buying the stock we did not have to think about coronavirus; now we do. In the short term at least the virus has sharply hit travel, retail, leisure, and casual dining (at restaurants), as people have stopped going to public places in fear of getting infected. This will definitely have an impact on SKT tenants’ short-term profitability. However we think SKT can weather this storm for 3 reasons:

1.      In our stress testing, half (50 - 60%) of its tenants have to stop paying rent for SKT to start losing money. We think that is extremely unlikely.

2.    SKT has long-term leases, and thus it should have little impact on revenue. Even tenants whose leases come up for renewal in 2020 (about 10% of total leases) are going to be thinking about what lies ahead over the next 10 years, not the next six months. 

3.    Tanger has sufficient cash on hand, in our opinion, to weather this storm. After suspending their dividend (a wise move in our opinion), they tapped a $680 million line of credit that should give them sufficient liquidity to operate even with closed stores for a considerable period of time.  

Overall, we believe SKT has the ability to weather this storm and emerge in an improved competitive landscape, with at least some degree of pent up consumer demand.

Catalyst

Post - COVID Recovery