Merger Monday In The Casino: Why SPG's Paying 56X For Macerich's Going Nowhere Malls

Now comes a prime example of central bank financial repression at work.  It's downright ugly and crystalizes how the Fed and other central banks are generating massive mis-allocations of capital and staggering windfall gains to Wall Street gamblers and their top 1% patrons.

In this case, the nation's largest luxury mall operator, Simon Property Group (SPG), has announced a hostile offer for the other large US luxury mall operator, Macerich (MAC). Naturally, that made for "Merger Monday" cheerleading on CNBC, and a market surge well above the offer price----indicating that the Wall Street arbs expect SPG's offer to be fattened considerably before its all over.

The reason this kerfuffle is about financial repression and gambling games in the liquidity intoxicated Wall Street casino rather than an honest capital markets transaction is evident in a single number------namely, 56X. That's the ratio you get when you divide the deal's TEV by free cash flow-----and it represents a completely lunatic valuation.

So this warrants some elaboration. During the LTM period ending in September 2014, MAC posted EBITDA of $636 million and CapEx of $230 million, meaning that it generated $406 million of operating free cash flow. But SPG's hostile offer at $91 per share plus assumption of existing debt results in a deal TEV (total enterprise value or debt plus market equity) of $22.4 billion.

Now here's the thing. In an honest free market no one in their right mind would pay 56X cash flow for what amounts to a static portfolio of 52 Class A luxury malls and 6 strip malls.

The crucial point is that MAC is not an operating business with dynamic growth prospects owing to a red hot product, gee wiz technology or a world beating branding strategy with global markets to conquer. Instead, its just a dumb financial engineering portfolio which matches up a mountain of debt and REIT shares on one side of its balance sheet with a pile of long-term retail leases (10-20 years) at fixed rental rates on the other side. Its profits represent the arb between the two sides of its property balance sheet and these spreads are inherently fixed in nature.

Other than plowing the snow in the parking lot, operating the HVAC system in the mall and keeping the lights bright and the floors shiny,  mall REITS provides virtually no business value added. Their leasees sell Apple gadgets and Prada fashions, but as a business MAC and SPG are actually an anti-Apple enterprise. At best their organic operating income can creep forward a few percentage points a year, and even that would represent positive inflation in the periodic roll of their store leases.

Stated differently, mall REITs are financial vehicles for the ownership of low growth rental properties that in a honest market would be valued at a 8X-12X free cash flow. To value an enterprise at 56X, by contrast, requires deep value added and double digit growth as far as the eye can see.

Needless to say, neither MAC nor SPG remotely correspond to the latter formulation-----nor do they have the capacity to generate the so-called synergies which are often used to justify huge takeover premiums. In fact, the discretionary operating costs of these property portfolios are downright trivial and amount to less than 5% of revenue.

Thus, today's combined TEV of the two REITS at the deal offer price is about $96 billion. By contrast, the SG&A of Simon Property Group is about $350 million and MAC's is about $26 million. Since SPG has been a serial deal machine and has done more than $40 billion of acquisitions over the last two decades, it has presumably squeezed every dime of possible synergy out of its existing base of operating expense---at least that's what is claimed by its management and the equity analysts who follow it. So even if all of MAC's operating expense could be eliminated-----it would amount to a 0.0003% improvement in free cash flow yield from the combined enterprise.

Likewise, mall level expense is almost entirely fixed, representing maintenance, depreciation, land leases and vendor services; and these expenses are heavily location and facility specific depending upon mall age, layout and similar factors. There is no reason to suppose that SPG would be any more proficient at operating MAC's malls than the local management teams and routines already in place.

By the same token, SPG's public rationale for the combination is the typical thin gruel that comes from the C-suite in deal heat. In this case, SPG claims that the combination will have more clout with the retail chains domiciled in the malls, and therefore will be in a position to extract higher rents.

C'mon. Rents like all real estate are local, local, local-----and depend on occupancy, the sales and traffic yield of specific retailers and much more. Why Simon Property Group would get more juice out of the leasees at a prime property like Tysons Corner Mall or the Biltmore Fashion Park (Phoenix) than would Macerich when these leases roll-over slowly under unpredictable conditions during the next two decades is not evident in the slightest.

In short, this deal is about combining two capital intensive property portfolios with virtually no operating synergies and scant organic property level growth capacity. Accordingly, its all about the cap rate------and that's set by the massive intrusion of the Fed into financial markets, not the long ago discarded law of supply and demand and the process of price discovery by at- risk investors.

The truth is,  both companies were trading at lunatic values even before SPG's November 18 announcement that it had taken a toehold position in MAC. Specifically, SPG trades at 22X its operating free cash flow and MAC was trading at 44X prior to the announcement. And the manner in which these absurd valuations were attained in the Wall Street casino is not hard to divine.

Mall property REITs are essentially a bond in drag with a tiny equity kicker. Under the Federal tax law, they are relieved of the corporate income tax, but in return must distribute approximately 90% of their earnings each year to shareholders. So what theoretically gets valued by the stock market is their ample dividend stream-----and the heart of the matter is this: REIT dividends compete with bond yields, meaning that the capitalization rate or valuation multiple for REIT dividends track the 10-year treasury note with a small spread for risk.

Moreover, the principle cost of semi-leveraged REITs like SPG and MAC is their carry cost of long-term debt, which is their second source of capital to fund mall assets in addition to REIT shares. At the present time, for example, SPG has about $20 billion of debt net of cash, and pays about $1 billion of annual interest or about 4.5%.

Needless to say, ever since the Greenspan money printing era began in the 1990s, both the debt costs and the dividend yields of the REITs have been falling. Conversely, their valuation multiples have steadily risen, generating massive capital gains for investors who have been happily pleasured by the Fed's crushing of interest rates over the last two decades.

The graph below shows the dramatic decline in SPG's dividend yield since the 1990's. Other than during the 2008-09 panic, when its share price plunged with the overall market, the dividend yield has trended steadily lower from about 9% to 3% at present.  At the same time, its earnings were flattered by an equivalent drop in its long-term debt costs----making for a double whammy of more earnings and more multiple on its share price.
">SPG Dividend Yield (TTM) Chart

SPG Dividend Yield (TTM) data by YCharts

And, folks, this is how the Fed actually plays the wealth effects game. Since 2007, SPG's EBITDA has risen by about 60% and its per share earnings have doubled. Furthermore, even these modest gains are primarily the result of acquisitions-----especially its purchase of the nation's largest factory outlet mall company.

By contrast, there is nothing modest about it share price and its total market capitalization. Since the turn of the century its share price has increased 7X and its market cap has soared from $4 billion to $57 billion.
SPG Chart

SPG data by YCharts

In this context, the pure financial engineering of the Macerich deal is quite evident. SPG proposes to fund the $16 billion equity purchase price with $8 billion of new debt and an equal amount of new share. In combination with assumed debt of $6.4 billion, SPG will take-on $14.4 billion of debt at a carry cost of under 3% or about $400 million. That will leave it with about $230 million of acquired free cash flow on $8 billon of new share for a yield of about 3%.

In short, the deal is completely pointless, generates no appreciable economic value, efficiency gains, new jobs or service capacity in the shopping mail market. But it does permit the company's empire building CEO, David Simon, to upsize SPG's holdings by about 40%.  And to pay the absurd price of 56X free cash flow without apparent dilution to his earnings!

David Simon will undoubtedly send a heartfelt thank you note to Janet Yellen. It would complement the ones he should have sent to Greenspan and Bernanke as his growing warehouse of mall properties exploded in value over the years.

And, yes, the fast money traders who "got wind of something" before the public announcement on November 18 owe Yellen a thank you, too. In an honest capital market there would be no point in this deal whatsoever. But in Yellen's casino, the market value of 59 malls doing nothing more than running in place soared by $5 billion virtually overnight.

That's financial repression at work. That's another day in the casino. No wonder they celebrate merger Monday with so much enthusiasm on bubblevision.

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