Description

Taubman Centers, Inc. operates as a real estate investment trust.   The company owns, leases, develops, acquires, and manages regional and super-regional shopping centers.  As of year-end 2008, it owns and/or manages 23 urban and suburban shopping centers in 10 states across the United States. These centers are located in metropolitan areas, including New York City, Los Angeles, San Francisco, Denver, Detroit, Phoenix, Miami, Dallas, Tampa, Orlando, and Washington, D.C.

Bull Story

• Strategically located in major metropolitan, affluent areas, where traffic flow and barrier to entry is higher.
• 5 of TCO's malls have GLA over 400,000 sf (regional shopping centers). The other 18 malls have GLA over 800,000 sf (super regional centers). The average size of the mall is the largest in US.
• Large malls are less vulnerable to competition because anchors and retail chains avoid opening stores near an existing location for fear of cannibalizing sales. The large average size of TCO's malls allows it to sign up more retailers as tenants.

• Larger malls are more attractive to consumers because they offer more selection of retail stores, and broader types of goods.
• Over 90% of mall GLA leased to national firms, who are more credit-worthy, and more likely to expand and take up additional space than small, local firms.
• In the shopping center business, sales per square foot, is the main driver behind rent rates and occupancy. TCO's malls generates the highest sales per sf number at $539/sf relative to other US mall REITS.

Investment Thesis

Unfortunately, the good news end here.  Although the real estate portfolio is sound, I am recommending a pair trade: short TCO, long DDR with the thesis based on a short on TCO because of its  

• 1) accounting irregularities that understate total liabilities
• 2) deteriorating operations
• 3) capital structure

The Accounting

TCO is the publicly traded entity.  The Taubman Realty Group Limited Partnership (TRG), a majority -owned partnership subsidiary of TCO, owns the real estate.  16 malls are consolidated and the remaining 7 malls are accounted for as joint-venture using the equity method of accounting.

Westfarms

I am never a big fan of JV and equity method of accounting because they hide leverage off the balance sheet.  What is alarming about Westfarms is that TCO owns 79% of the asset, but puzzlingly, concluded itself as a noncontrolling partner.   I have contacted IR to inquire about this issue and the response is that the other partner contains certain rights that justify TCO's claim.

The last time TCO consolidated a previously unconsolidated asset was in 2006.

"the Company has determined that in the first quarter of 2006 it will begin consolidating the

entity that owns the Cherry Creek Shopping Center...As of January 1, 2006, the impact to the balance sheet will be an increase in assets of approximately $128 million and liabilities of approximately $180 million, and a $52 million reduction of beginning equity representing the cumulative effect of change in accounting principle."

2005 10K, note 21

The negative equity in Cherry Creek comes from higher dividends paid by the JV than its GAAP earnings.  The difference results from GAAP depreciation expense.  While I believe that GAAP book values does not reflect economic reality (I will address the valuation of JV later), three conclusions are obvious:

• 1) Reported leverage ratios are lower when Westfarm is unconsolidated.
• 2) Since Cherry Creek, a 50% owned entity, was consolidated, there is a high probability that all malls in the JV portfolio (ex Waterside) would be consolidated.
• 3) When unconsolidated JV are brought onto the balance sheet, there will be impairment charges/write-downs given that previous payouts exceed GAAP earnings.

Finite Life Entities

"At December 31, 2008, the Company held controlling majority interests in consolidated entities with specified termination dates in 2081 and 2083. The minority owners' interests in these entities are to be settled upon termination by distribution or transfer of either cash or specific assets of the underlying entity. The estimated fair value of these minority interests were approximately $104.3 million at December 31, 2008, compared to a book value of $(96.8) million, which was classified as Deferred Charges and Other Assets in the Company's Consolidated Balance Sheet."

2008 10K, note 1

TCO records minority interest as other assets valued at $96.8m, which implies negative equity for minority partners.  Nonetheless, the fair value is $104.3m.  If accounted for correctly, on the right side of the balance sheet, a total reduction of $201.1m of reported equity would be required.  These entities started in 2004.  At first, TCO record zero book value and just understated minority interest, and then start recording as other assets in 2006.

Preferred Shares Series F, G, H

The reported value for the preferred stocks is $29m.  However, 2008 note 14 points out that the liquidation value for series F, G and H are $30m, $100m, and $87m respectively.  Although they have no stated maturity, sinking fund, or other mandatory redemption requirement, I believe they should be recorded at liquidation value because

• 1) Dividends are cumulative
• 2) It represents the actual amount of $ for TCO to exit the obligation
• 3) TCO has a history of redeeming earlier series.

The net result for these irregularities is that equity is overstated and debt is understated.  True leverage is higher.

Deteriorating Operations

Mall tenant sales is the single most important measure because it determines rents and occupancy.

• Tenant sales/sf number started declining in 2008.
• Year-over-year, the first half of 2009 is down 12% from 2008 level.

• Occupancy is down in 2009 and already below 2005 level.

• Market rents have fallen 13 - 20% from 2008 level.

The tenant mix is predominately fashion retailers and target up-scale customers.  However, I believe the so-called up-scale segment is actually middle class consumers with inflated wealth because of the now busted housing bubble.  Most up-scale fashion retailers have experienced, and some are still seeing sales slump.   I expect TCO's malls to under-perform on an absolute basis and on a relative basis to the value-oriented malls such as DDR and Kim in the near future.

The key conclusion here is 07 & 08 results represent peak cycle earnings, and in the near future results (at least the next 24 months) will be worse unless consumers start spending again.

 Capital Structure

Reported balance sheet are meaningless because of the accounting irregularities I mentioned above and the fact that GAAP real estate (RE) values are distorted by depreciation charges (fair value is usually higher unless the company bought at the top of the market).

For margin of safety, I am going to give TCO the benefit of the doubt and

• 1) Count the fair value of minority interest as equity.
• 2) Mark up RE at fair value by assigning 9% cap rate to 2008 NOI.
• 3) Mark up JV investments by assigning 6x FCF to JV even though JV has off b/s contractual obligations that are not disclosed, and is itself highly levered.

 Other Adjustments made

• 1) Write-off all intangibles
• 2) Capitalized operating leases and purchase obligations.
• 3) Record preferred stock at liquidation value.

Leverage

Leverage defined as asset/equity is approximately 5x, which means 20% decline in asset values would wipe out the equity.  My valuation of RE asset and JV are based on 2008 NOI.  As of 2Q09, with occupancy down 2% , market rent 4% lower than 2008 average portfolio rent ( $44.58/sf), it is reasonable to assume market value of RE is at least down 6% from 2008 level, which would translate into a 30% loss for equity.

Northlake

You might ask how TCO built up this huge debt.  The company certainly did not go on a huge buying spree.  The Northlake financing transaction showed management's intention.

Northlake is a mall that is developed by the company at a cost of about $171m.  It opened in September 2005, and in January 2006, TCO placed an interest-only mortgage on the mall for $215.5m.  Since the loan is non-recourse, TCO effectively "sold" the property to the lenders and bought a put option because it can always let the loan default and hand the keys back to the lender.  In a RE bull market, it seems smart to borrow non-recourse vs selling as the downside is limited (ex, Pier at Caesars) and the borrower retains the upside.  TCO has capitalized on this strategy and now have only one unencumbered asset left.

Unencumbered Assets

At the consolidated level, all properties are encumbered except for Willow Bend.  This means that unlike other REITs such as Simons, TCO does not have much breathing room if unsecured credit dries up. 

The leverage here means this company is built for a RE bull market only.  The other way to look at this is would you own a cyclical business with high leverage, with peak earnings just passed and the cycle turning the other way?

Valuation

With the stock trading at $35.73, it is trading at 11x 2008 FCF.  EV/EBITDA - ttm is 12.75x.  At first glance, the multiples are not high.  However, I believe 2008 represent peak earnings and going forward FCF will decline as occupancy and rents continue to trend down.

Recommendation

Short TCO and hedge with long DDR.  Both companies face the same problem: high leverage.  DDR's tenants are value-oriented (Wal-mart, T.J. Maxx) and should hold up better.  Secondly, even after the recent dilutive offering, DDR at $9.8, is trading at less than 4x 2008 FCF.  Therefore, if high leverage RE companies can survive this downturn, DDR will have more upside.

I strongly oppose a pure short because I think the risk/reward is unfavorable.

Risks to my recommendation

Liquidity

• Only $278m of debt due before 2012 if all extension options are exercised. I expect TCO to generate $170m FCF in 09. So liquidity is not an issue.
• If 2011 would be very dangerous for TCO if operations deteriorate to a point that the extension option cannot be exercised.

V-shape recovery with consumer spending leading the way

• Deteriorating operations is a vital assumption in my thesis. I expect the US consumers to stay frugal and shun luxury. If discretionary spending goes up, this idea would not work.

Possible take-over target

• The operating RE portfolio of TCO is very high quality. The problem is the capital structure. If the current crisis is indeed over and cheap financing returns, I expect TCO to become a target. SPG had shown interest before and made an offer in 2002.

Catalyst

1) declining occupancy and rents

2) Pier at Caesars impairment is a wake-up call. Expect more impairment charges coming, especially on the unconsoidated JV side.

3) continue decline in market value of commercial real estate.  One useful index is the Moody's/REAL Commercial Property Price Indices.