2/8/2010
By Brian Sozzi, Research Analyst

If there is one valuable take away from the market meltdown of 2008/early 2009 it's that investors need to question everything.  A company's earnings beat consensus forecasts, great, would they have eclipsed consensus sans that one-time tax credit discussed in a succinct manner on the 10-Q?  Is 40 to 1 leverage and the subsequent creation of fake wealth throughout the economic system sustainable for a company when an economy turns down?  Investors, armed with considerable resources at their disposal (Benjamin Graham would be licking his chops at the historical data available at the click of the mouse), could have avoided the harsh losses if exposure was had in the names Lehman Brothers, Countrywide Financial, Bear Stearns, and AIG.  All investors had to do was ask questions, listen to the contrary- minded money managers who pressed management teams (David Einhorn and his analysis of Lehman Brothers comes to mind), or made basic interpretations of SEC filings and then used conventional lines of reasoning.

I can only hope that when the market once again gets turned upside down, and it will as the U.S. is a capitalistic society, investors will have in their arsenal the lessons of 2008 and 2009.  Such lessons include: (1) market psychology is a very powerful force, so attempting to pick a bottom is a suckers game, (2) modern finance has evolved to a degree that the accumulation of subprime borrowers mailing in keys in California impacts banks and local mom and pop retailers, and (3) "decoupling" as a theory does not make much sense; for further confirmation just spy the reactions of the DJIA and S&P 500 to the Dubai debt scare and sovereign wealth risk in Spain, Portugal, and Greece.

The reason I rehash this array of unfriendly history is because I have had difficulty squaring the market's positive reaction to the latest earnings release from Simon Property Group (SPG) with what I see as a potentially interesting situation looking forward three years.  By interesting, I mean rather worrisome.  For perspective, Simon Property is a REIT that owns/manages 382 properties totaling 261 million square feet.  Property categories include outlets, regional malls, and lifestyle centers.  The company successfully navigated the peak of the credit crisis hysteria by having enough available liquidity and a generally stable base of retail tenants.  Debt refinancing is critical to a company like Simon Property, so a recent credit agreement and loosening of funding markets have been quite welcome news.

The stock yields 3.3%, and Simon Property has gone on an acquisition hunt of sorts, picking up debt laden rivals at attractive prices.  However, though there have been favorable developments for the company, the road ahead is fraught with risk that I believe is not being captured in present valuation (PEG: 2.7x; P/S: 5.5x; P/EBITDA: 14.0x).  Let's examine a few of the risks:

* Any re-freeze in debt markets will make it that much harder for Simon Property to roll over maturing debt obligations.  From 2010-2012, Simon Property has $9.8 billion in debt coming due.
* From 2010-2012, a total of 8,446 stores representing 35,543 of square feet will have their leases expire.  Any closure of stores en masse or give in on rental rates may harm Simon Property's credit ratings, which are currently investment grade with stable outlooks by the three main ratings agencies.  A credit downgrade would raise the cost of capital, and put in danger the dividend.

In my estimation, there is a strong probability for a wave of retail store closures irrespective of the U.S. economy returning to some form of growth.  The consumer spending levels of 2005-2007 may not occur again in most people's lifetimes; a meaningful amount of the stores opened in 2005-2007 were based on unsustainable, unrealistic growth assumptions.  Retailers are well aware of the need to scale back their operations to further improve cash flow prospects given a "new reality" base of consumer spending.  Simon Property has outsized exposure to companies actively seeking to shutter stores, including:

* Gap Inc. (GPS): 281 stores in SPG portfolio
* Abercrombie & Fitch (ANF): 232 stores in the SPG portfolio
* Foot Locker (FL): 399 stores in SPG portfolio
* Zale (ZLC): 314 stores in SPG portfolio
* Macy's (M): 150 stores in SPG portfolio
* Sears Holding (SHLD): 121 stores in SPG portfolio
* JC Penney (JCP): 113 stores in SPG portfolio

Investors, be mindful on this name.