The Next Blow For Struggling Mall REITs: Victoria’s Secret’s Downward Spiral

A rising tide of store closures has put mall owners on the defensive in recent years. Uncertain about how long this „retail apocalypse“ might last and how great the damage may be, investors have dumped shares of mall REITs.

In fact, over the past three years, sector leader Simon Property Group (SPG) has posted a total return of -8%, trailing the S&P 500 by 60 percentage points. Yet it performed far better than any other mall REIT. Shares of Macerich (MAC), Taubman Centers (TCO), Pennsylvania Real Estate Investment Trust (PEI), Washington Prime Group (WPG), and CBL & Associates (CBL) have all lost at least 44% of their value over that period, including an 87% plunge for CBL.

Data by YCharts

This carnage has led to some great bargains for deep value investors willing to ride out the volatility. However, not every mall REIT is a great turnaround investment. Owners of lower-quality properties, like CBL, are especially likely to struggle with store closures, forcing them to cut rents to bolster occupancy levels.

The downward spiral at L Brands‘ (LB) Victoria’s Secret and Pink chains could be the next big threat for mall REITs. With sales falling fast and profitability nearing zero for its Victoria’s Secret business unit, L Brands could start closing Victoria’s Secret and Pink stores in the U.S. at an accelerated pace over the next few years. Given that L Brands is a top tenant for CBL and most other U.S. mall REITs, mass store closures for these ubiquitous chains could be quite painful.

Victoria’s Secret goes from bad to worse

Just a few years ago, Victoria’s Secret was a massively profitable business that dominated the U.S. lingerie market. In fiscal 2015, L Brands‘ Victoria’s Secret segment (which includes Victoria’s Secret and Pink in the U.S. and Canada) produced operating income of $1.39 billion on sales of $7.67 billion. That put its operating margin at an incredible 18.1%.

The segment’s growth slowed dramatically in fiscal 2016. Sales rose 1.4% to $7.78 billion, but operating income fell to $1.17 billion. Still, this left Victoria’s Secret with a very strong 15.1% operating margin for the year. However, sales and profitability both declined significantly in fiscal 2017. Sales trends flattened out a year later, but at the expense of profitability. In fact, the Victoria’s Secret segment’s operating income totaled just $462 million in fiscal 2018, putting its operating margin at a mediocre 6.3%.

This downward spiral has continued in fiscal 2019. Through the first three quarters of the year, Victoria’s Secret segment sales declined 6.5% and operating income plunged by $235 million. By the end of Q3, operating income stood at just $227 million on a trailing-12-month basis.

Last week, Victoria’s Secret reported a 12% comp sales decline for the critical November-December period. Store traffic was down 15%. Pink suffered a mid-teens comp sales decline, too. The company also warned that merchandise margin declined. Given that the segment was unprofitable through the first nine months of the fiscal year, this dreadful performance could leave Victoria’s Secret with little or no profit on a full-year basis.

(Image source: Victoria’s Secret)

More store closures on the way?

Victoria’s Secret is still likely to produce positive free cash flow in fiscal 2019, as management has reduced capex to well below the segment’s (non-cash) depreciation and amortization expense. However, it’s increasingly clear that the brand’s image problems in the #MeToo era will be hard to overcome.

To be fair, there’s still plenty of demand for its products, with combined sales for Victoria’s Secret and Pink in the U.S. and Canada on pace to total nearly $7 billion in fiscal 2019. But with sales having fallen by about $1 billion over the past three years and still plunging, a smaller retail footprint may be appropriate for Victoria’s Secret going forward.

Victoria’s Secret has already started closing stores. Victoria’s Secret and Pink had a peak of 1,177 stores in the U.S. and Canada at the end of fiscal 2016, but reduced that number to 1,143 by the end of fiscal 2018 and closed another 32 (net of six store openings) in the first nine months of fiscal 2019.

Even after these store closures, Victoria’s Secret and Pink are a virtually ubiquitous presence in malls in the U.S. and Canada. Yet while the best malls in the U.S. are still drawing strong traffic, the majority are suffering from stagnant or declining traffic, anchor vacancies, and underinvestment by their owners. Thus, many Victoria’s Secret stores may be producing little or no cash flow today, with little hope of a recovery.

Mall owners depend on L Brands: especially CBL

L Brands (and Victoria’s Secret/Pink in particular) is a key tenant for virtually every U.S. mall owner, accounting for 4% or more of a REIT’s annual base rent in some cases. The Victoria’s Secret and Pink brands account for 62% of L Brands‘ square footage in the U.S. and Canada.

Mall REIT

L Brands Portion of Annual Base Rent

CBL & Associates

4.28%

Pennsylvania REIT

4.0%

Macerich

3.0%

Washington Prime Group

2.6%

Taubman Centers

2.3%

Simon Property Group

2.2%

Source: 2018 10-K for Macerich; Q3 2019 quarterly supplementals for all others.

From this table, we can see that there’s a range of exposure levels for the main U.S. mall REITs. However, the percentage of rent derived from L Brands isn’t the only relevant factor in assessing the risk from Victoria’s Secret closing stores. If Victoria’s Secret decides to pare back its retail footprint, it will probably start by closing stores in less productive malls, while maintaining its stores in higher-traffic malls.

That’s bad news for CBL & Associates. In addition to having the highest exposure to L Brands of any mall REIT, CBL has a subpar mall portfolio. More than half of its NOI comes from malls with sales per square foot of less than $375. Even among its „Tier One malls“, sales per square foot averaged just $466 in the 12 months ending last September. Based on these dreadful statistics, Victoria’s Secret could close a huge number of stores at CBL’s properties in the years ahead, as leases expire.

4.28% of annual rental income may not seem like a lot to some readers, especially since it likely implies that only 2.5%-3% of CBL’s annual rent comes from Victoria’s Secret and Pink. However, as of 9/30/18, Forever 21, Charlotte Russe, and Sears Holdings (all of which filed for bankruptcy over the following 12 months) accounted for just 3.02% of CBL’s annual rent combined (see p. 32). Other retailers that filed for bankruptcy last year, like Gymboree and Payless ShoeSource, didn’t even make the list of CBL’s top 25 tenants, which means they each contributed less than 0.68% of its annual revenue.

Even though these tenants didn’t seem to represent that big a piece of CBL’s business, CBL reported a 5.5% decline in same-center NOI, a 9.6% plunge in total NOI, and a 23.4% drop in adjusted FFO in the first 9 months of 2019. The problem is that there is often a multiplier effect from store closures. As more and more major mall tenants close up shop, traffic to the interior of the mall tends to decline. As a result, it becomes increasingly difficult to find replacements without drastically cutting the rent. Meanwhile, other tenants may leave or demand big rent reductions.

Like many of its peers, CBL is trying to address this issue by redeveloping vacant former department stores as fast as it can. It is trying to attract entertainment, fitness, and food & beverage concepts (see slide 6) to these spaces to diversify its tenant mix away from apparel. Yet CBL bulls may be expecting too much from redevelopments of this sort. In the first half of 2019, CBL competed redevelopments representing a total investment of about $50 million, but same-center NOI still plunged 5.9% in Q3.

Indeed, alternative use tenants like entertainment, fitness, medical, and restaurants have less need to be located in a mall than apparel retailers. They are also less likely than department stores to attract shoppers who will spend lots of money in the rest of the mall. As a result, this shift in leasing has exacerbated CBL’s loss of pricing power. Leasing spreads came in at -7.9% for small-shop leases (under 10,000 square feet) in the first 9 months of 2019. (See p. 29 of the Q3 2019 supplemental.) Thus, CBL can ill afford the loss of additional major tenants like Victoria’s Secret.

Other mall REITs have less to fear

While Victoria’s Secret store closures could also hurt other mall REITs, the threat is far more manageable. For example, Macerich gets 3% of its rent from L Brands, but 83% of its NOI comes from its top 30 malls, 26 of which have sales per square foot exceeding $640. As a result, the vast majority of Macerich malls are properties where Victoria’s Secret would be least likely to close. Taubman Centers and Simon Property Group are even better positioned, with lower exposure to L Brands than Macerich and high-quality mall portfolios.

PREIT and Washington Prime are in between in terms of risk. PREIT has the second most exposure to L Brands at 4% of annual rent, but it gets about half of its NOI from its top six malls, all of which have sales per square foot of more than $550. Its next six malls comprise a quarter of NOI and averaged comp sales growth of 5.4% in the 12 months ending last September. The quality of its portfolio isn’t on par with the likes of Macerich, Taubman, and Simon, but there are only a handful of PREIT properties where Victoria’s Secret would be likely to close.

(Image source: Victoria’s Secret)

Washington Prime is in the bottom half of the group in terms of exposure, with only 2.6% of rent coming from L Brands. However, its malls are roughly similar to those of CBL in terms of quality, with average sales per square foot of $413 for its top 42 malls in the 12 months ending last September. That points to a high likelihood that Victoria’s Secret could look to close stores at many Washington Prime malls in the years ahead.

A slow burn

There’s still little near-term risk of L Brands filing for bankruptcy, as Bath & Body Works continues to churn out strong profits. That means Victoria’s Secret can’t get out of paying rent on underperforming stores until the leases expire (or it negotiates lease buyouts). This should give mall REITs some time to adjust as Victoria’s Secret rationalizes its store base.

As of early November, L Brands reported that its weighted average remaining lease term stood at 7.4 years. Average remaining lease terms may be a good deal lower for Victoria’s Secret stores in the U.S., as few new locations have opened in recent years. Nevertheless, it seems likely that a reduction to the Victoria’s Secret store count will be gradual rather than abrupt.

That’s good news for otherwise healthy mall REITs. But for already-struggling mall REITs like CBL & Associates (and to a lesser extent, Washington Prime and PREIT), it will be just one more headwind over the next several years.

CBL still has significant exposure to struggling department store chains, which will likely continue closing stores at a rapid pace in the years ahead. CBL’s #2 tenant, Signet Jewelers, has been closing stores and demanding rent reductions in lower-tier malls in recent years. Among its other top 10 tenants, Ascena Retail and Gap are both struggling with weak results at some of their retail concepts and closing stores in response. If Victoria’s Secret were the only major tenant that was likely to downsize significantly, CBL would be able to absorb the blow. However, it is just one of several problem tenants.

Some mall owners‘ pain could be others‘ gain

Owners of high-productivity malls like Macerich, Taubman Centers, and Simon Property Group may not have to worry about large-scale closures of Victoria’s Secret stores in their portfolios. Yet they could still face near-term headwinds from the chain’s poor performance, as plunging sales at Victoria’s Secret will mean lower percentage rent payments to mall owners.

Looking further out, though, that dynamic could change. If Victoria’s Secret is able to recapture sales from locations it closes in its remaining stores, store closures in lower-tier malls could prop up sales (and percentage rents) at Victoria’s Secret locations in nearby higher-productivity malls.

There has already been a meaningful divergence in performance between owners of the very best malls and REITs like CBL, Washington Prime, and PREIT that mainly own low- and mid-tier malls. Downsizing by Victoria’s Secret in the years ahead could reinforce this trend, particularly for CBL, due to its unique combination of high exposure to Victoria’s Secret and low sales productivity at its malls.

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Disclosure: I am/we are long MAC, PEI. 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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