I might very well be one of the longest-running bears on CBL & Associates (CBL). I’ve had a negative opinion about the company for going on two years now. With good reason.
The larger story here is one that REIT investors should be able to learn a lot from. Bulls made three core mistakes when they went long on this stock:
- Under-appreciating the importance of real estate values
- Ignoring the glaring leverage in the capital structure
- Taking management statements at face value.
The common stock has been left for dead, as well it should be. Yet we’ve seen investors move into the preferreds and bonds using the same logic that lured them into the common in years past:
- High yields
- Low multiples
- The idea that underlying property value would provide enough support in the case of bankruptcy.
But investor should ask themselves: What’s different this time vs. 2016? This question applies particularly for the preferreds, which sit below a massive glut of senior secured and unsecured debt.
Knowing this, I want to outline my thoughts here in greater detail, as well as address some of the bull themes being pushed on this trade. While I don’t dislike the preferreds at face value today… I also don’t think they provide the opportunity that many seem to be presenting.
Making It to 2023
The view that CBL & Associates operates at a wide discount to net asset value (NAV) is a pervasive one. We can all argue back and forth on this – as I did last year in my article, “CBL & Associates: Is the Stock Worth $0?.” But the NAV story is one that unfortunately exists in a realm with little data to support either viewpoint.
Junk malls are an illiquid market, and there just isn’t much selling data to point toward. That lack of liquidity is a large reason why I fall into the bearish camp.
In a liquidation scenario, I just don’t see a case where the preferred or common make any meaningful recovery. Bankruptcy costs, selling expenses, transaction fees, and a good old fire-sale discount would ensure that common or preferred shares don’t see any recovery. Bond prices would imply that consensus as well.
And since actual transaction data is so limited for these kinds of junk malls, consider a few things:
Heading into the recent refinancing, management opted to recast the facility by shifting to secured debt. The company bore higher interest costs, forced loan amortization, and a continuance of several financial covenants that restrict financial flexibility.
Management could have sent a massive signal to markets by selling just a handful of properties to lower leverage, likely dramatically improving the granted terms of this facility. Hypothetically, selling $60 million of net operating income (NOI) at a 7% cap rate would have raised $850 million to delever.
This would have taken leverage down from 9.2x on a run-rate basis in Q1 to 7.6x. And that would have been in line with many other REITs. This would represent roughly 10% of NOI – hardly enough for the company to lose meaningful scale.
So the fact that it took no action on this path is telling.
You can make the argument that management doesn’t want to sell at the bottom – if this is the bottom. Likewise, you can argue that, for some reason, the Lebovitz family is content to see their common stock’s value slide into the abyss. Perhaps they’re not willing to take action to eliminate a public vs. private market disconnect… for some unbeknownst reason.
But where are all the distressed buyers willing to take it over regardless of management’s willingness? Vultures ought to be circling if there really was any value to be had.
Brookfield, after all, made a name for itself by being contrarian and buying GGP. In general, private equity should love the opportunity to take this private, fix the capital structure, and re-IPO down the line when the retail apocalypse is over. The high cash flow nature of this business would make it incredibly appealing to those kinds of buyouts.
Yet here we are with barely a sliver of market cap remaining, and we haven’t heard a peep – not even a rumor – of takeover speculation. So it’s hard not to conclude that the book value of the entire portfolio is junk, no matter when the property basis was established.
Management isn’t claiming a discount to NAV either – at least not in a concrete way. If they could, they would in my view. Many other REITs have done so, including hoteliers like Pebblebrook (PEB) and single-family home operators like Front Yard Residential (RESI). It’s a great way to put forward a bull case as an executive team.
But the only material sales made from its mall segment – which constitutes more than 90% of revenue – was Janesville last year in July and The Outlet Shoppes at Oklahoma City in 2017. Those were for $18 million and $49 million net after mortgage and joint venture proceeds, respectively.
This lack of action is telling. Despite free cash flow, the asset value just isn’t there anymore. It should be plain as day that, if CBL could have sold a good chunk of properties to delever, it would have by now. Likewise, if there was a white knight on its way to buy out the firm… that entity would have arrived before this point.
Now, that doesn’t mean the company is dead in the water. Implied asset values have fallen much more steeply than actual property cash flow, meaning this business is still wildly profitable. By somehow convincing lenders to base property valuation off of GAAP book value, the recent credit facility refinance has shifted doomsday out until July 2023 – before the unsecured bonds come due.
The above chart assumes that CBL hits the midpoint of its 2019 guidance and then sees same-store NOI comps slip 5% per year into 2023. It’s meant to be a worst-case scenario to illustrate the power behind the bull thesis.
According to this theory, as NOI slips, operational leverage will work against the company as the burdensome financial structure and corporate costs bleed off free cash flow. By 2023, free cash flow available to the equity would be gone and the preferreds would be in rough shape. However, interest coverage covenant clearance would remain intact.
In my view though, the only way this defaults before those maturities is if CBL takes significant enough impairments to blow out the book value and cause covenant violation.
Obviously, management has perverse incentives to structurally delay or run aggressive assumptions on those impairment tests to avoid falling into violation. Frequently in recent years, impairments have only been taken on properties once they’re going to turn back the keys. And market value clearly has to be below book value for that to make sense.
Likewise, management tends to write down properties once sold (or in the process of a sale) after it becomes clear they will not get book value. This isn’t surprising because impairment tests are based on un-discounted future cash flows, which carry assumptions on future same-store sales comps.
Management has given poor guidance on same-store trends and, by extension, I would imagine that impairment testing has been based on similarly rosy projections. And, truth be told, if management continues to model a recovery, then impairment charges can be avoided for quite some time.
Only if the auditor pushes back could the firm find itself in trouble here. So, on the net, I agree with the bulls that the odds are high for CBL making it to its next refinance.
However, here’s where the bull case falls apart…
Current bond prices imply another $60 million in interest costs upon refinance. But, honestly, it’s unlikely they can place $750 million in new unsecured 2023 and 2024 debt against a company with a $250 million market cap. Current covenants wouldn’t allow any more secured debt to be placed. And asset sales, particularly on unencumbered Tier 3 assets today, would not be very accretive given current property price trends.
I put the odds of bankruptcy before 2024 at 80% today – higher if 2020 operating results continue to degrade. At some point, banks will say enough is enough and push CBL & Associates to bite the bullet. There’s just no more room on asset value covenants for a lender to give the firm a pass.
The Bull’s Case: Free Call Options
The current view is that the preferreds will collect near their face value by the time these issues crop up. For example, between now and 2023, the Series D preferreds will receive roughly $7.82 per share in income by the time the drop-dead date on the revolver.
With those preferreds trading at $9.68 per unit as of this writing, it’s easy to view them as a cheap call option on success. After all, if CBL survives all this mid-2020 refinancing work, it’s likely they’ll keep paying out for some time. While not likely to rally back to par, if the company did (hypothetically) manage to survive, it should see a material increase in price. So expecting a double wouldn’t be outlandish.
At least that’s the common way of looking at it.
However, these investors continue to ignore the time value of money. A dollar today is worth more than a dollar of value down the line.
If I offered you $100 today or $100 in 2023, which would you take? Obviously, the first one. How much would I have to increase my 2023 offer to get you to choose a later time? That would vary based on your perception of risk; however, 8% required rates of return (the inverse being an 8% discount rate) have become commonplace in the equity markets. That’s because it’s the market’s long-term track record.
What that means is that, for an investment opportunity to receive interest, investors have to see more than 8% return over the next year. Which takes us back to those CBL preferreds. A 2023 call option and associated income has to be discounted back to form its net present value (NPV).
See the below chart as an example using an 8% discount rate:
Here are the three potential outcomes:
- A bull scenario assumes full collection of preferred payments on the Series D until mid-2023… at which point CBL would execute a successful refinance and the unit price would surge to $20.
- A base scenario assumes full collection of preferred payments until mid-2023, at which point CBL would restructure in Chapter 11. The preferreds wouldn’t make a recovery.
- A bear scenario assumes something bad occurs, such as a recession. This would then forces impairment charges and structural default by early 2022.
You can assign whatever probabilities to these scenarios that you want. And, arguably, you can model out a gradual improvement in the preferred’s pricing through 2023 if the refinance looks more likely vs. backloading.
But even then, that doesn’t change the NPV materially. Price improvement, spread equally over the years, would still move the NPV of the bull scenario to somewhere around $15.
Based on my assumptions, I wouldn’t pay more than $8.20/unit for these preferreds – and that’s if I was looking for mediocre returns. For an investment today to make sense, I think you have to think the odds of CBL surviving its 2023 challenges at better than a coin flip. That’s just not the likelihood that I see here. Individuals might come to different conclusions but that’s my take.
Until proven otherwise by material asset sales or large institutional interest, the base-case scenario for recoverability on any of CBL & Associates’ equity components in a bankruptcy should be a goose egg. While I do think the recast of the credit facilities has pushed out doomsday until that 2023 period… management will have the added issue of dealing with the unsecured bond refinancing at that time.
If results don’t materially improve by then, I don’t think the company can dodge a filing scenario. Management keeps kicking the can down the road on NOI stabilization. What once was supposed to be flat comps in 2019 is now a guidance of -7% guidance. So I don’t see a reason to take a gamble here.
Furthering that narrative, the recent class action settlement shows just how abusive this management can be to its own tenant group. In a world with ample retail space, what tenant wants to get involved with a firm that almost had racketeering charges levied against it?
I think too many people have ignored the broader impact on releasing spreads from that event. In short, if an investor is going to gamble in the market, there are better places to roll the dice.