Value and Later-Stage Principal Investing Blog: Analysis and Recommendation for Seritage Growth Properties

Recommendation: Long

‘Orphan’ REIT / under-followed / 3-in-1 ‘eventdriven’ special situation / hard catalyst will take 36 to 60 mo. to realize

Seritage

Associated Financial Valuation Model:

Click Here

Thesis

Investment Thesis:

  • SRG investment thesis is premised on the fact that the Master Lease (‘ML’) has a provision which allows SRG to ‘recapture’ 50.0% of the Gross Leasable Area (‘GLA’ or ‘gross sq. ft.’) at ~ 235 existing wholly-owned location properties (amounting to 36.8mm sq. ft.) in addition to ‘100.0% recapture rights’ of GLA at ~ 21 existing wholly-owned location properties (amounting to 3.9mm NET sq. ft. BUT 7.4mm GROSS sq. ft. when including free-standing automotive centers). Hence, an ~ total of 20.681mm sq. ft. will be subject to recapture by SRG to be re-tenanted. Sear’s Holdings constitutes an existing 33.663mm sq. ft. of retail space @ $4.40 annual rent per sq. ft. per annum, with 3rd Party tenants constituting the difference of 5.543mm sq. ft. of retail space @ $15.07 annual rent per sq. ft. Hence there is a VERY substantial ‘uplift’ in rental income per sq. ft. as SRG recaptures back the ~ 20.681mm sq. footage from Sears and leases to new tenants. However, SRG cannot instantly ‘recapture’ the sq. footage, and based on ‘back-of-the-envelope’ calculation, there is an ~ 20.9% ‘annual recapture / re-tenanting absorption rate’, meaning based on the provisions of the ML, it will take ~ 4.7 years for potential 20.681mm sq. ft. to be 100% recaptured by SRG (note: <= 50.0 total properties can be recaptured in any 12 mo. period, w/ average property = 155,498 sq. ft. lot size). As of 12/31/2016, SRG portfolio consists of ~ 42.2mm sq. ft. of GLA, consisting of 235 wholly-owned properties and 31 joint venture (JV) properties. Over the next 36 to 60 months, Funds from Operations will MATERIALLY increase (as will Adjusted Funds from Rental Operations), and once SRG obtains ‘favorable IRS Tax Ruling Letter’ re: its ‘IRS flow thru REIT status’, the substantial increase in FFO / AFFRO will in turn result in VERY large dividend payouts (which have NOT yet been factored into stock price since initial dividend was just initiated in FY 2016 (due to IRS REIT-status not yet being completed). The concept here is similar to a ‘Oil & Gas E&P Integrated Major’ spinning off a wholly-owned midstream pipeline subsidiary via a rights offering, and structuring the ‘pipeline spin co.’ as a Master Limited Partnership (‘MLP’). Once the ‘IRS [favorable] Tax Ruling Letter’ is received, 95% of after-tax profit will be paid out in from of dividends, and it will take a few fiscal quarters before the market will ‘reassign’ the multiples (aka ‘multiple expansion’).

Top Reasons to Buy SRG:

  • SRG is allowed to recapture ~ 20.0mm sq. ft. to re-tenant out @ substantially higher rental rate per square foot ($15.07 per sq. ft. vs. $4.40 per existing tenants)
  • Major improvement to Net Operating Income (‘NOI’) / FFO / AFFRO due to re-tenanting

  • Triple Net Leases are VERY favorable to SRG and result in MINIMAL maintenance CapEx reinvestment requirements

  • Complex misunderstood ‘3 layers of event-driven’ special situations in 1 (spinoff vis-a-via rights offering and REIT conversion)

Top Risk Factors

  • Greater than 50%+ of total rental income currently derived from one single company (Sear’s Holdings)…very concentrated customer revenues makeup (FY2016 Sear’s rental income constituted 79.5% of total rental income)

  • Potential bankruptcy of Sear’s Holdings will SEVERELY impair Revenues / NOI / FFO / AFFRO in short-to-intermediate term

  • If the re-tenanting does NOT result in substantial ‘uplift’ in rental income per sq. ft., then pro-forma FFO / AFFRO projections will be severely depressed resulting in impairment in intrinsic value estimate per share

Key Summary Metrics:

  • Current Share Price (03/13): $44.46

  • 3 Yr. Price Target: ~ $90.00

  • % Upside (‘Margin of Safety’): ~ 65.0%+

  • Shares Outstanding (include. OP Units): 59.5mm

  • Market Cap.: $2.811bn

  • Total Debt: $1.167bn

  • Cash & Equivalents: $52.0mm

  • Market Enterprise Value: $4.120bn

  • FY 2016 EV/EBITDA: 24.1x

Capitalization and Financial Info:

  • 52 Week Range: $39.60 to $57.31

  • Revenue (mm) 2: $248.7

  • EBITDA (mm) 2: $171.3

  • Fund from Operations (‘FFO’)(mm) 2 : $127.3

  • EPS 2 : $(1.64)

  • FFO per Share 2 : $2.29

  • AFFRO per Share (mm) 2: $2.07

  • Book Value per share 2 : $25.50

Valuation Summary Metrics:

  • Price / Sales : 5.41x

  • Price / Book Value: 1.75x

  • Price / Tangible BV: 4.13x

  • Price / FFO per share: 26.40x

  • Price / AFFRO per share: 24.44x

  • FFO Yield: 3.79%

  • AFFRO Yield: 4.09%

  • Premium / (Discount) to NAV per Share: 31.1%

  • Enterprise Value / EBITDA: 24.05x

  • ROIC (2 yr. historical avg.): 0.9%

Company Background:

  • Seritage Growth Properties (‘SRG’) was spun off from Sear’s Holdings via a rights offering announced on 06/11/2015…and ‘spin co.’ (aka ‘new co.’) was transformed into a ‘REIT conversion’

–Rights offering ended 07/02/2015 and SRG began trading on NYSE on 07/06/2015

  • As of 12/31/2016, SRG total real estate portfolio has 42.2mm sq. ft. consisting of:

–235 Wholly-Owned properties totaling 36.8mm sq. ft.

–31 JV properties totaling 5.4mm sq. ft.

  • As per Master Lease agreement, SRG has ‘recapture rights’ on following:

–50% recapture rights on all of 224 Wholly-Owned properties

–100% recapture rights on 21 identified properties (i.e. 3.9mm sq. ft. + 3.5mm sq. ft. of freestanding automotive care centers)

  • Terms of Master Lease & JV Master Lease:

–Triple Net Lease

–10 year duration w/ 3 options for 5 year renewals

–Minimal Maintenance Capital Expenditure requirements

Catalysts:

  • This is a 3-in-1 ‘event-driven’ / special situation with the following catalyst:

–(1) Spinoff (which has already been completed)….

–(2) vis-a-via a rights offering (which has also already expired)

–(3) a corporate reorganization (i.e. ‘REIT-conversion’)

–(4) Provisions of the Master Lease allows recaptured sq. ft. being re-leased out at major ‘uplift’ to market rental rates (measured in $’s per sq. ft.)

  • The above catalysts # 1 thru 3 can be considered the ‘hard catalysts’ which have already come to pass but are still relevant to the investment thesis playing out over the investment holding period (which I estimate to be between 36-to-60 months / i.e. ‘3 to 5 year holding period’)

Valuation:

  • Multiple valuation methodologies were employed to triangulate on fundamental intrinsic value per share:

–(1) Dividend Discount Model (based on pro-forma achievement of Funds from Operations)

–(2) Discounted Cash Flow Analysis (based on Levered Free Cash Flows)

–(3) Net Asset Valuation per Share (based on ‘marking-to-market’ the Balance Sheet)

  • Multiple Scenarios were also utilized:

–(1) Base Case Scenario

–(2) Upside Case Scenario

–(3) Downside Case Scenario

  • In general the following implied intrinsic value were concluded:

–(1) Dividend Discount Model: range of prices between ~ $95.00+ per share to ~ $101.00+ per share

–(2) Discounted Cash Flow Analysis: ‘Not Meaningful’ (due to flat 15.0% required return threshold used)

–(3) Net Asset Value per Share: ~ $91.00+ per share to ~ $114.00+ per share

Investment Risks:

  • Main investment risks include:

–(1) HIGHLY concentrated customer revenue profile (i.e. > 70% of existing revenues from single Sears tenant)

–(2) If general macro-economy goes into recession, then occupancy rates (that are currently near~ > 95.0% full) may fall substantially

–(3) Possible bankruptcy risk of Sear’s Holdings

–(4) Macro risk that softening of economy may result in major decline in occupancy rates, which in turn will negatively affect major ‘uplift’ in rental income per sq. ft. (which is crux of the investment thesis)

–(5) 3 to 5 year (long) investment holding period increases risk that of possible softening in macroeconomic outlook


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