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Barring Another Lockdown, Simon's Cash Flow Can Continue Covering the Dividend For Now

Simon's third-quarter earnings report released on November 9 showed that mall fundamentals remain weak.

While the REIT collected 85% of its net billed rents, up from 72% in the prior quarter, Simon's sales were still down 25% year-over-year due to elevated levels of rent deferrals and abatements given to struggling tenants.

Tenant bankruptcies and lease expirations also caused occupancy to slip 1.5% from the second quarter to 91.4%, its lowest level in at least a decade and down from more than 97% at the end of 2014.

Despite these ongoing headwinds, Simon in the third quarter generated funds from operations (FFO) of about $630 million.

This was more than enough to cover the REIT's capital expenditures of nearly $60 million, plus its $400 million quarterly dividend (a payout ratio of about 70%).

All else equal, we estimate Simon's rent could fall around 15% from its third-quarter level before the REIT's dividend, which was reduced by 38% in June 2020, would once more no longer be covered by cash flow.

Given this margin of safety, coupled with the firm's investment grade balance sheet and healthy liquidity, we are upgrading the REIT's Dividend Safety Score to Borderline Safe.

That said, Simon's business needs to continue recovering in the years ahead since we expect the company's capital spending needs to rise significantly.

The REIT was in the middle of executing redevelopment plans at more than 30 of its 200-plus properties when the pandemic struck.

Space previously leased to department stores was being swapped out for restaurants, gyms, hotels, offices, apartments, and entertainment centers.

These efforts were expected to cost more than $1 billion annually over the next several years, but in the second quarter management suspended or eliminated more than $1 billion of capital for development projects as Simon hunkered down.

As a result, Simon is only working on projects that were nearing completion with an expected net cash cost to the firm of $140 million through the end of 2021.

While this approach provides Simon with short-term financial flexibility, the company can't put off these investments forever.

Redevelopment projects are critical to Simon's long-term future as real estate trends change, especially with the pandemic accelerating headwinds for malls.
Management will eventually need to return to their plan of investing more than $1 billion per year in redevelopment work.

Annualizing Simon's third-quarter results, we estimate the firm is on track to retain around $600 million to $700 million per year in cash flow after covering maintenance spending needs and paying its dividend.

This isn't enough to cover Simon's future development needs, so it's important that business trends improve in the year ahead.

Besides development projects, Simon this year has also funneled some cash into acquiring stakes in failed retailers such as JCPenney, Forever 21, Brooks Brothers and Lucky Brand.

These unconventional investments do not represent major bets for the company, but Simon believes it can potentially make more than $1 billion from them.

We think these deals are more a signal of Simon's desperation to buoy its occupancy rate and preserve the network effect that's so crucial to a mall's health.

For example, JCPenney represents over 5% of Simon's U.S. square footage. Ensuring this anchor tenant stays alive will keep traffic flowing to the mall and take away a reason for smaller tenants to negotiate lower rent payments.

This strategy could help Simon continue to fare better than lower-quality malls, some of which have recently closed or declared bankruptcy.

Looking ahead, management hopes the worst is behind the company but acknowledges the recent surge in COVID-19 cases creates uncertainty.

Stay-at-home recommendations are popping up nationwide to slow the spread of the virus, which could further hurt non-essential brick-and-mortar retailers. 

However, public officials do not appear eager to return to the days of sweeping lockdown measures. Based on what we know today, we would be surprised if Simon's malls were forced to close again.

Barring another prolonged and severe lockdown, Simon appears to have the flexibility to continue paying its dividend for now. We will continue monitoring this dynamic situation with the all-important holiday season arriving for retailers.

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