Premium Post: Taubman (TCO) preferred arbitrage
I prefer the preferreds to the common.
On February 10, Simon (SPG) entered a (poorly timed!) deal to buy Taubman (TCO) for $52.50/share in a deal expected to close in the middle of the year. Obviously, the world has changed an awful lot since February 10. Corona has shut the nation (and Taubman's malls!) down, and, with TCO's shares trading at ~$44/share, the market is expressing significant doubt the deal goes through.
I personally believe the deal is highly likely to go through, but this write up is not focused on TCO's common stock. Instead, I'd prefer to play the deal through Taubman's preferred shares (yes, pun obviously very much intended). These preferreds will get paid off at par (plus accrued divs) when / if the Taubman deal goes though (see section 6.08 of the merger contract), so at today's prices I think you're taking significantly less risk by buying the preferred but making a similar return to the common.
Let's start with the basics: if the SPG deal goes through, SPG will give TCO common shareholders $52.50/share and pay off the preferreds at par. At today's prices, the market is offering you a better return from buying the preferred stock through deal close than it is offering from buying the common stock (I only show upside to deal closing below; with the deal scheduled to close in the middle of this year, the IRR to the deal closing for all of these is obviously quite substantial!).
That discrepancy shouldn't exist. The preferred are higher in the cap structure than the common, so they should have lower downside in stressed scenarios (i.e. in bankruptcy, the preferred would need to be paid before the common would have any recovery). The combination of lower downside with higher upside creates the opportunity for some really interesting trading dynamics: for example, you could go long the preferred and hedge it out by shorting the common. If the deal goes through, you'd make more on the preferred than you did on the common. If the deal broke, the common should be down substantially more than the preferred (the common traded for ~$26.50/share before rumors of SPG buying them leaked in early February, and given most peers are down >50% since then I would expect the downside to the common in a break is significantly lower than the pre-deal price). Either way, you win (compliance note: this is not investing advice. Shorting in particular is risky; this is just a discussion of a hypothetical trade).
So there are two ways to play this trade:
The "riskless" (again, compliance disclosure: nothing is riskless): buy the preferred and short the common (or buy TCO puts with a $40 or $35 strike): if the deal goes through, you'll make more profits on the preferreds than you will lose on the common. If the deal breaks, the common should be down significantly more than the preferred.
Note I've ignored dividends here: both the TCO common and the preferreds both pay divs and will pay through the deal close. The preferreds yield is significantly higher than the stock's at current prices, so you'll get a positive carry / a bit more upside from the yield difference.
Why recommend the $40 puts as hedges? As I'll discuss later, the preferred has an option to convert into the common in a takeout scenario if the company doesn't call the preferreds at par; the conversion price is around $40/share so hedging there saves you in some super tail scenarios where the deal is recut and the preferreds are screwed over.
The "normal" route: believe the preferreds are attractive in their own right, buy the preferreds, and wait (hope?) for the deal to close.
You can play the deal either way. The rest of this article is going to focus on the investment from the "normal" standpoint (without the hedge), but I wanted to highlight the two options since they are both quite interesting.
Ok, that out the way.... why does the situation exist? There are two possible reasons:
The first, and overwhelmingly most likely, is that the market stress has introduced some weird dislocations in the stock market. Judging from the overall price action in preferreds in the past week, I wouldn't be surprised if some preferred ETF blew up and force liquidated. TCO only has ~$360m in preferred stock outstanding (split roughly evenly between their J and K series), so the combination of a preferred market breaking down + market dislocation could easily cause a small series of preferred to trade for weird prices for a while.
With $360m outstanding, these are a little on the illiquid side. However, if you're patient, you can build a decent sized position in these, and every now and then there will be a seller of size who pops up.
The second risk is the big risk here: there's something in the preferred docs that would allow them to get screwed. Screwing the preferreds could take a variety of flavors; for example, SPG and TCO could try to recut the deal so that they can leave the preferreds outstanding (similar to the DTLA preferreds). Or the SPG deal could break and TCO could figure out a way to screw preferred shareholders as a standalone company.
Again, I think the reason the opportunity exists is the former (the market is just bonkers right now), but I'll address the second risk later in the article. For now, I want to spend the rest of this article highlighting three things
Why I think this deal will close
Why I think preferred will not get screwed
Why I think the preferred are covered even in a deal break scenario
Let's start with the beginning: why I think this deal will close.
First, there's the contract. This is a relatively tight contract. The material adverse effect (MAE) clause excludes pandemics (see p. 82) unless they have a disproportionate effect on TCO versus other industry participants. Taubman has shut basically all of their stores down in response to the virus; in normal times, that would likely be a MAE, but since every industry participant has shut down as well (here's Simon shutting their stores down), not sure how you could argue TCO has been disproportionately effected. There are no financing or other conditions to stand in the way here except for antitrust approval (which should not be an issue). And there's no breakup fee from SPG; if they tried to break the contract, TCO could sue for specific performance (forcing SPG to close the deal), and they should win.
A few more notes on MAE: an MAE needs to have a long term effect on a business (years, not months), and MAE's generally need to be claimed quickly in order for them to be recognized (as a buyer, you can't get bad news, wait for four months, and then try to break the contract under MAE. You need to do it quickly). So if Simon wanted to break the contract under MAE, they'd need to do so soon (TCO shut their stores down March 19th), and they'd need to argue that Corona will have a permenant effect on TCO's earnings. I mention the former simply to talk timing; on the laterr, I think that would be difficult to prove in court (though certainly not impossible; there's likely about to be a wave of retail bankruptcies and SPG could use that to claim the MAE. Here's an article on the bloodbath in arbitrage that includes a lawyer suggesting in general it would be tough to use Corona as an MAE).
Taubman has >$100m in cash on their balance sheet, ~$425m undrawn on their revolver, and no major near term maturities, so they can finance themselves until the deal is set to close (just to eliminate the "what if things get so bad they have to file before the deal can close" risk)
Second, there's Simon. I'm sure they wish they hadn't struck a multi-billion dollar deal a few days before a global pandemic broke out, but they have the wherewithal to close (they just refi'd their credit facility and have ~9.5B in credit capacity versus ~$3.5B required to close this deal) and this is a deal they've wanted to a long time (they've been trying to buy TCO for almost 20 years). Given this is a strategic deal they've wanted for decades, the contract is tight, and they have the finances to close it, I think Simon is going to close the deal.
Finally, there's the Taubman family, who control TCO. As part of the deal, the Taubman family is selling ~33% of their ownership to Simon and rolling the rest into a private partnership. Initially, I thought that part of the deal gave off huge "conflicts of interest" vibes; a controlling family cashing out the rest of shareholders for cash but rolling a huge piece of their stake into a private partnership certainly gives the vibe the family thinks there's way more upside to be had long term. But, given the current devastation, I think now the family is going to be thrilled that they're getting to cash out 33% of their stake at a huge premium. Either way, the Taubman family is going to be hugely motivated to get this deal through.
Putting it all together: this is a strategic deal with a buyer who is more than financially capable of closing. The controlling shareholders for TCO are motivated sellers, and the contract is tight. I think it's extremely likely this deal closes.
Moving to the second point: I don't think the preferred will get screwed.
You have to worry about the preferred in two different ways: how could they get screwed in the current deal, and how could they get screwed if the deal fell through?
Let's start with the former: how could the preferreds get screwed if the deal goes through? The current contract calls for the preferreds to be cashed out at par (plus accrued interest) when the deal closes, so TCO and Simon would need to go change the merger contract to screw the preferreds. I don't think that's likely. TCO's market cap at $52.50 (deal price) is ~$3.7B (including the Taubman family units) and the face value of the preferreds is ~$360m. Given that small size, it's probably not worth going back and trying to recut the contract to screw the preferreds.
Even if they did want to screw the preferreds, the preferreds do have some rights in the event of a change of control that results in Taubman's stock getting cashed out (you can see the series K prospectus here and the series J prospectus here). In particular, in a change of control, the preferreds have the ability to convert into shares of TCO stock (assuming that the company isn't redeeming the preferreds at par; see p. S-4). So, in order to screw the preferreds, TCO and Simon would really have to stretch. First, they'd need to recut the deal to not redeem the preferreds. They'd then need to either 1) do so in a way they doesn't trigger the change of control put provision (that would be very difficult to do, but companies have come up with clever legal structures that make change of controls not legally / technically a change of control before) or 2) cut the price below $40/share (the Series J converts at 0.6361 common shares per preferred share, so $25 / 0.6361 = ~$40/share common stock price for the preferreds to get par through the conversion feature).
The question is why they would go through all that hassle? Again, the preferreds are a very small piece of the overall deal here; I'd be surprised if either side is looking at ways to specifically target the preferreds. And why would TCO have any incentive to go back and modify the deal to screw the preferred? Doing so would likely invite a lawsuit; why would TCO do Simon a favor and recut the contract to shift a little extra value from the preferreds to Simon when doing so gets them a lawsuit and no real upside? There's really nothing in it for TCO to screw the preferreds. In fact, there's no real reason for TCO to go back in and revisit the contract at all. The Taubman family controls TCO and they've got no incentive to revisit; they're already cashing out a third of their stake at prices probably 4x where the stock would trade if it was trading standalone right now; why would they go recut an all-cash deal to get some type of stock when they struck such a good deal? Sure, Simon would probably love to do that, but why would TCO?
So I don't think the preferreds get screwed in the current deal. Let's talk super downside scenario: if the Simon deal broke, could TCO try to screw the preferreds to transfer value from the preferreds to the common? Absolutely they could try, but I'm not sure what they could do to materially impair the preferreds. Obviously they could shut the preferred dividends down, but those would likely be turned back on eventually. The preferred dividends are cumulative, and as a REIT TCO needs to pay out its taxable earnings as dividends every year and the preferred dividends must be paid before any other dividends. As long as you assume Taubman (and the mall space) will recover from Corona eventually, at some point in the future tax law would require TCO to pay the preferred dividends. You could obviously dream up more aggressive scenarios where TCO tries to dividend all their assets to the common and strand the preferreds in some other way, but I can't figure out a way they could actually do that in compliance with their debt covenants that wouldn't be an obvious fraudulent conveyance case. And, again, there's only $360m of value in the preferreds; screwing the preferreds over would get the common a very small amount of money versus TCO's ~$9B enterprise value.
Alright, at this point I've covered why I think the deal will close and why I don't think the preferreds will get screwed. The last point I want to cover is the most likely downside case: what happens to the preferreds if Simon finds a successful way to break the TCO deal.
Again, I think that's unlikely. The contract is reasonably tight, and if Simon tried to break it TCO would sue for specific performance and should win. But let's say I'm wrong and Simon claims an MAE and wins the court case. TCO would walk away with nothing and remain a standalone company. how would the preferreds look then?
I think they would be well covered. I've included two cap structures below. The top is the cap structure at the Simon deal value of $52.50/share; the bottom is the cap structure if I took TCO's price before Simon rumors came out (~$26) and haircut it by 60% (in line with how hard peers have been hit; that share price would result with a valuation roughly in line to slightly below where MAC currently trades).
Cap structure at Simon deal
Cap structure at peer draw-down
Either way, the prefs still have a decent equity cushion. In order to believe the prefs are impaired, you would need to believe that a business that Simon just valued at ~$9B has seen their asset value cut by almost 50%.
Obviously, near term earnings for TCO (and the sector overall) are going to be awful. But TCO's real estate isn't going anywhere, and they easily have the liquidity to get through the current crisis. It would shocking to me if the current crisis resulted in a big enough hit to TCO's earnings power to justify impairing the preferreds.
Note too that TCO's financing is mainly done at the asset level, not the corporate level (only ~$1.2B of TCO's debt is recourse to the holdco), which should increase the chances of recovery for the preferred in a real downside scenario.
It's also worth remembering that TCO is positioned significantly differently than a typical mall. Going over a full overview of the mall sector is a bit beyond the scope of this article, but I'll do a quick overview. Malls and retailers in general are struggling; however, trophy malls (class A are better) have been an exception. There are a few reasons class A malls have been doing well; for example, the clicks to bricks phenomenon where online retailers see boosts to their sales when they open physical locations has created a whole new class of tenants, and higher end malls have found success driving new attractions / experiences / dining options to replace older stores closing. Obviously a lot of those trends will be paused or stop for a while with Corona, but I doubt those trends stop longer term. Even if they did, class A malls are generally located in the best areas in a city and represent some of the city's most valuable real estate. They're generally surrounded by businesses and other stores and they've got great access to public transit and interstates. This real estate will always have significant value; if it wasn't in mall form, a lot of them have value redeveloping into condos and high rises.
That "class A malls are thriving / have underlying real estate value" bodes really well for TCO, as they probably have the best collection of malls out of all of their public peers. I've posted some slides from their July 2019 investor deck below to highlight how their malls are positioned, but the bottom line is that however you want to judge a mall portfolio (sales per square foot, rent per square foot, etc.), TCO's portfolio is significantly better than peers and is among the best positioned for the "class A malls outperform" trend.
Ok, so TCO, on the whole, probably has the best positioned malls out of all their peers. MAC and SPG are probably the most comparable to them, so we can use their current trading multiples to spot check where TCO would be if it was a standalone company.
I'm going to use MAC because SPG's share price is certainly incorporating some extra pain from being in contract to buy TCO right now. I'll note that a comparable valuation is kind of tough to do on any company right now; we only have 2019 earnings for these companies, and it's so laughable to use 2019 earnings when 2020 is going to be so bad and each company's near to medium term outlook is going to be so influenced by how hard hit their regional area is. Still, it's better than nothing, and it's helpful to see how much of a equity cushion the prefs would have if the deal broke and the equity was trading standalone.
MAC is currently trading for ~$7.50/share. I've got all the basic valuation stuff below; it shows that if TCO was trading at MAC's multiple shares would currently be ~$12. That would leave ~$800m of equity cushion behind the preferreds. Again, this is a bit rough as who knows what near term earnings look like and obviously an $800m market cap against ~$5b of debt (as TCO would have in this scenario) implies some level of distress (though, again, most of the debt is non-recourse), but I think it's kind of helpful to think about.
Anyway, I'll wrap it up here with a quick summary. Obviously, I've gone through a lot in the article. Hopefully I've shown that there's likely a bit of an equity cushion even if Simon somehow gets out of this deal, and that TCO's management has no incentive to screw preferred shareholders in this deal. The major investment thesis here is simple: TCO's preferred are getting paid at par in the Simon / TCO deal, and based on the contract the deal is overwhelmingly likely to go through. The preferreds are trading at a larger discount to their takeout price than the common stock despite materially less downside; I think it's pretty clear there's some major dislocation from the market volatility here, and I expect that dislocation to resolve in time (either because markets get more sane or because eventually the Simon deal closes and preferreds are cashed out).
Odds and ends
Customer base: I didn't discuss Taubman's customer base too much, because I'm not sure how much it matters. There are clearly going to be a bunch of retail bankruptcies. That said, TCO's base is probably a bit stronger than most of the other malls. Macy's is their major anchor (taking up ~19% of lease area). Nordstrom's is second with 6.5%. No other company is more than 5%. Exposure to the real distressed anchors (JCPenney, Sears, etc.) is a bit lower than peers, though (again) in this environment it's tough to say there's a retailer that isn't in some type of distress.
Downside in deal break: I tried to highlight that there's equity cushion here even in a deal break, but given how volatile markets are and how depressed the common stocks of mall companies are they're really trading for more optionality value (i.e. market pricing in distress and common is an option on it coming through) than actual fundamentals. There are a few mall companies with preferred stock outstanding; Simon has a perpetual preferred that pays an 8.375% dividend that is still trading above par (SPG-j; par $50, currently trading ~$58). BPY has a few different preferred stocks (BPYPP, BPYPO, BPYPN) that are all trading for about half of face. Again, there are reasons to believe neither of those is a great comp for TCO's prefs, but based on them plus a little bit of my guy I'd guess TCO's prefs would trade for ~a bit lower than BPY's prefs (so a bit under half of par) or a in a deal break scenario today.
How does this break? Again, this is a pretty good contract, and Corona shouldn't qualify as an MAE. So how could this feasibly break in a way TCO wouldn't win a suit again Simon? The most likely is the government makes crazy demands on divestitures, which would meet the burdensome conditions clause of the contract (see section 5.03). If that happened (and I don't think it would) and Simon didn't want to make the disposal, Simon would be required to go to court to challenge the disposal (and they would almost certainly win).... but if they lost, they'd be within their rights to break the contract.
Work in progress assets provide additional asset protections: The near term for malls is absolutely going to be rough, and trailing earnings numbers are kind of worthless since the near to medium term will look so different. That said, class A malls like TCO's do not trade for ~10% cap rates (where they are priced in on trailing numbers in my downside scenarios / break scenarios that see shares fall to <$15), and TCO has ~$284m in capitalized construction costs (at Q4'19; see 10-k p. 69) that should improve their assets / add to future earnings power once all of this blows over.
