A WSJ report on Amazon (AMZN) being in talks with mall REIT major Simon Property Group (SPG) to convert the now-available JCPenney and Sears department store square footage into Amazon fulfillment centers bumped SPG by more than 10% just ahead of the latter’s Q2-20 earnings call on August 10, 2020. While this is still a matter of speculation, a possible deal between the two retail-oriented companies could prove far less valuable than it appears on the surface. Let’s look at the two sides to see what each one has to gain and lose from such an agreement.

Key Thesis Points:

  • SPG has more to lose than gain from a deal with Amazon, and this is something investors should be aware of.
  • There are several other reasons to invest in this mall REIT, a possible deal with Amazon certainly NOT being one of them.
  • SPG is a buy on its own strengths: investments, retail recovery, occupancy rates, and acquisition moves.

Upsides for and Benefits to Amazon

Hubs in Time for the Holidays:

Holiday season 2020 is likely to represent a tremendous windfall for eCommerce activities. Judging by figures reported for May 2020, the impact could be as much as a +75% increase over the 2019 holiday quarter. As physical retailers struggle to stay afloat and continue to experience reduced foot traffic, all that additional traffic will need to be handled by eComm majors like Amazon.

The most obvious benefit to Amazon is an additional 65 distribution hubs (57 JCPenney and 8 Sears) close to residential areas wherever Simon malls are located. As we approach the crucial holiday season, it’s going to be more important than ever to minimize delivery times and costs. With SPG locations being ideally placed to save on last-mile delivery to residences, it’s not hard to imagine why Amazon would enter into such a discussion.

Pre-empting Walmart (WMT):

The retail giant recently started testing out a partnership with Instacart (ICART) for same-day deliveries in four cities in California and Oklahoma. Potentially, this could be the key to aggressively rolling out Walmart+ across the country using Instacart’s existing delivery infrastructure. Walmart+ is a much-hyped subscription service that would attempt to rival Amazon Prime. However, with the same-day and one-hour delivery capabilities of Instacart coupled with Walmart’s massive store presence to act as fulfillment centers for digital orders, it could end up competing with Prime Now, which currently operates in around 30 or so cities in the United States.

For Amazon, the deal with SPG represents a pre-emptive move to fill in the gaps in its fulfillment strategy. While the Whole Foods acquisition gave it a leg up in online grocery ordering and deliveries, Amazon still faces the challenge of last-mile delivery, which even prompted the company last year to start funding employees to start their own delivery businesses to service its needs.

COVID-19 made the delivery situation worse: “at least 30 of Amazon’s 175 fulfillment centers are affected”, according to an April report in GeekWire. Amazon is very likely to be looking out for opportunities to increase its fulfillment footprint near residential areas, and malls fit the bill perfectly. With such an agreement in place, it can rapidly expand its Prime Now coverage to a much larger shopper base and pre-empt Walmart’s potential plans with Instacart.

Downsides for and Risks to Amazon

Higher Rentals:

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Rental rates for warehouses, which is basically what Amazon’s fulfillment centers are, are obviously a lot lower than mall space. According to REIT analyst Alexander Goldfarb at Sandler O’Neill + Partners:

Warehouses typically pay between $5 to $10 per square foot in rent, whereas department stores can pay closer to $20.

The dire situation that the coronavirus pandemic has inflicted might make a community more willing to accept an industrial tenant moving into the local shopping mall

Moreover, since fulfillment operations would be considered industrial rather than commercial, it would entail rezoning and all the associated costs. It’s possible that Amazon may find a workaround by allocating pick-up points or even retail space within these locations so they still qualify as commercial space, but that’s highly unlikely.

While Amazon does have the edge in these discussions because of SPG’s relatively weaker negotiating position, it may be forced to pay a premium for these fulfillment centers. Alternatively, it could impact the lease agreement and tie-in the e-tailer for a longer period. Either way, it’s likely that Amazon will be willing to pay more for having fulfillment centers at locations closer to residential areas. But it will definitely impact the bottom line.

Time Constraints:

The time between now and the start of the holiday shopping season could be insufficient for Amazon to set-up, fit-out, and staff nearly 75 fulfillment centers. They could deploy equipment from centers affected by COVID-19, but that would bring on a whole new set of problems related to health and hygiene.

Besides, we don’t know what stage the discussions have reached or even whether or not the deal will materialize. If it takes longer than the next few weeks it could negate any benefits that Amazon expects from such an agreement, at least as far as the 2020 holiday quarter is concerned.

Upsides for and Benefits to Simon Property Group

Immediate Rental Revenue Flow:

As reported in the Q2-20 earnings release, SPG’s FFO or Funds From Operations came in at $2.12 per diluted share against the prior period’s figure of $2.99 per diluted share. FFO for the quarter was reported at $746.5 million against the prior period’s $1.064 billion.

Although its financial position is relatively strong, the company continues to lose cash due to reduced lease income, rent abatements, and anchor store closures. As of June 30, 2020, SPG had cash and cash equivalents worth $3.3 billion and net tenant receivables and accrued revenue of about $1.5 billion. On that front, a lot of rent payments are still being negotiated or under litigation – somewhere in the range of 28% to 30%, per SPG CEO David E. Simon:

Some of – we have a one really big receivable out there that is of public record. And obviously that’s out there as a big receivable. We think that’s going to get collected, but that’s a big increase in our accounts receivable. So the deferrals and the abatements were clearly under – not anywhere near the majority of our rental rent roll, and we still have what I’d say about 28% to 30% of our negotiations still to be done.

Mr. Simon’s statements at the Q2 earnings call painted a less-than-bleak picture of the current situation, but the guaranteed rental income from Amazon could still prove to be beneficial in the short term. However, there are several negatives for the long term, as I show below.

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Basically, that’s the only benefit for SPG with this potential deal, other than the fact that the company can increase occupancy rates, albeit marginally. Considering that JCPenney and Sears locations at SPG’s malls only account for just over 6% of its total U.S. square footage, the positive impact will be minimal, if any.

Source: 1Q-2020 Supplemental

Moreover, SPG’s base rental income from JCPenney and Sears stores was less than 0.4% of the total base minimum rent. That’s why Amazon and SPG have also considered buying out additional space from other retailers, presumably those currently occupying adjacent floor space. This is where the real potential benefit to SPG lies.

Downsides for and Risks to Simon Property Group

Reduced Income:

Amazon will obviously negotiate hard on base rent and likely be opposed to any kind of revenue sharing. The result might be higher rentals and possibly longer lease periods, which would be good for SPG’s top line but might not compensate for the loss of JCPenney and Sears income.

The prospect of having an Amazon fulfillment center in their midst is not something mall store owners will relish. Either way, there’s going to be some reduction in rent and lease incomes that will negatively impact SPG if the deal goes through.

Risk of Triggering Co-tenancy Provisions:

Another major risk is the co-tenancy clause that mall operators have in their lease agreements. The upshot of it is that smaller stores occupying mall space where anchor tenants leave or shut down can legally renegotiate their base rents or lease amounts.

Co-tenants may have the capacity to drive landlords to decrease rent so that these groups are able to cope with lower revenue when other stores close down. The less traffic overall, the less income the co-tenants will earn in their own stores. To help with these financial matters, the landlord may decrease the rent or lease amounts for all co-tenants.

According to Joseph Malfitano, founder of turnaround and restructuring firm Malfitano Partners:

A tenant like Amazon … could trip co-tenancy provisions for other tenants, which will also cost landlords money

That’s a significant downside for SPG should the deal go through. Will Amazon be willing to compensate the group in this eventuality? It depends on how badly Amazon needs these locations.

Investor’s Angle

Side Note: The case to invest in Amazon is almost a no-brainer at this point. The still-present pandemic and its impact on the overall eCommerce market has already been established, giving Amazon shares a significant upside. The average 12-month price forecasts by 44 analysts on CNBC show an average median upside of 17% from the current as-of-writing price of $3,159.64. That would put Amazon’s market cap at $1.85 trillion and well on its way to breaching the $2 trillion mark over the next 18 months or so.

The question here is whether or not to invest in SPG.

The risk-benefit analysis clearly skews on the side of risk. Even if the deal goes through, it will only impact a small portion of SPG’s total space and, thereby, total revenues. The downside is much greater – prolonged lower revenues from not only the space Amazon occupies but from potential renegotiations with other retailers sharing mall space.

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That being said and notwithstanding the talks with Amazon, SPG could still represent a viable investment opportunity for several reasons:

Diversification

The single largest inline tenant for SPG is The Gap (GPS), which represents 2.1% of total square footage and 3.5% of total base rent revenues from its domestic properties.

Source: 2Q-2020 Supplemental

SPG also records nearly $24 billion in at-cost investment properties, net of depreciation, on its balance sheet, split between its interests in the U.S., Europe, and Asia.

Investments

More recently, SPG completed the redevelopment of the Gotemba Premium Outlets (Phase IV) in Tokyo, Japan, and expects annual retail sales in excess of $1 billion. SPG owns a 40% stake in this project.

The company also recorded the opening of Siam Premium Outlets Bangkok during the quarter, in which SPG owns a 50% stake.

As for the acquisition of Brooks Brothers by Sparc Group, a JV between SPG and Authentic Brands Group:

…all stores are projected to have a four-wall EBITDA upon assumption of lease. These investments are expected to generate positive EBITDA. Soon after their integration in the Sparc we expect any equity investments should be returned within a year after integration of operations.

Finally, SPG and Brookfield Property Partners (BPY) have thrown their hats into the ring to bid to buy JCPenney out of bankruptcy and are touted to be the preferred option for the bankrupt retailer and its lenders. If the deal goes through, the talks with Amazon might not proceed further, considering that JCPenney stores at SPG’s malls form the bulk of that deal as well.

Retail Recovery and Occupancy Rates

Per Mr. Simon at the Q2-20 call:

Just a little color on that and the centers that reopened in early May, tenants who reported sales, reported May was approximately 50% of their previous year volume for the same period. And in June, that increased to more than 80% of prior-year volumes. Tenants continued to reopen, and we currently had 91% of all tenants, or nearly 23,000 tenants across our US portfolio are open and operating.

Internationally, all of our designer and international premium outlets are open and operating. 100% of all those stores and our designer outlets are open and operating with shopper traffic and retail sales at approximately 90% of prior-year levels.

With its mall tenants on the path to recovery, SPG faces less intense headwinds from rent deferrals moving forward, which means we should see receivables coming down meaningfully in the next quarterly report.

Occupancy rates for Mall and Premium were down 110 basis points on a sequential basis between Q1-20 and Q2-20, with a 60-bps impact from “standard bankruptcies and lower specialty leasing.” However, the average base minimum rent per square foot was up nearly 3% for Q2 on a YoY basis.

Verdict: These factors, combined with a healthy balance sheet and the fact that SPG is only cutting its dividend by 50%, the company represents a solid investment at the current price.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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