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Morningstar | Fantastic 4Q From Macerich, but Investors Will Focus on Disappointing 2019 Outlook

Mall fundamentals exceeded our lofty expectations in the fourth quarter for Macerich, but management's guidance for 2019 seems conservative. Despite the strong quarter, we don't anticipate changing our $59 fair value estimate for the narrow-moat company given the lower 2019 outlook. Sales per square foot was up 10.0%, driven by 15.3% growth from the unconsolidated portfolio, though the consolidated portfolio still saw solid 4.8% growth. Occupancy costs declined to 12.4%, the lowest point in at least six years. Along with the strong sales growth, this shows that Macerich's tenants are very healthy despite e-commerce headwinds. Occupancy sequentially went up 30 basis points to 95.4%, above our 94.8% estimate. Re-leasing spreads remain in double digits at 11.1% for the total portfolio, leading to average base rent growth of 3.7%. Same-store net operating income excluding lease termination income was up 4.2%, ahead of our 3.5% assumption for the quarter. Funds from operations for the fourth quarter was solid at $1.09, $0.03 below our estimate, but the difference is due to higher interest expense that doesn't affect our outlook for the company.

Management's 2019 guidance was disappointing, which makes us wonder if they are being conservative to set themselves up to positively surprise investors as the year progresses. While we expected a slowdown in sales and internal growth from a very strong 2018, same-store NOI growth for 2019 is only expected to be 0.5% to 1.0%, well below our 2.5% estimate. 2019 funds from operations is expected to range between $3.50 and $3.58. After incorporating a new run rate for the interest expense into our model and making the $0.15 adjustment due to adoption of new accounting rules, our estimate for 2019 comes to $3.66, above the high end of Macerich's guidance. We were hoping for better guidance from management, but we will wait to see if malls are going to radically slow or if management is just being conservative.

Management provided some additional details on their 2019 guidance that lead us to believe that the lowered outlook either won't be as bad as the initial numbers suggest or will be limited to just this year and that 2020 and beyond should prove to be better years. First, part of management's guidance includes occupancy declines of 50 to 100 basis points. Due to the occupancy gains in the second half of 2018 that were higher than we anticipated and that we already expected 25 basis points of occupancy decline in 2019, management is guiding to a 2019 occupancy level in line with what we have estimated.

Second, management recognizes that three tenants filed for bankruptcy in the past week, Gymboree, Charlotte Russe, and Things Remembered, and that they collectively have 90 stores with Macerich. While there have been no discussions on how the bankruptcies will affect their stores with Macerich, management is being conservative and embedding 100 basis points of disruption into their NOI guidance from store closures or rent concessions to these retailers. Management also believes that while most tenants are very healthy (which we think is backed up by the low average occupancy cost for the company's tenants), another one or two might declare bankruptcy in the near future and close stores, which brings further down their 2019 guidance. While we recognize that there will be some negative impact from these closures, we believe that Macerich ultimately will be able to release the stores to healthier tenants. Management said that all three of these companies were on its watch list for the past several years, so the only surprise to them is that they all declared within the same week, and that removing these 90 stores reduces the total number of stores on the company's watch list from a range of 400 to 600 over the past several years to around 300. Therefore, we think that 2019 might not be as bad as Macerich is conservatively predicting depending on what these tenants end up deciding to do, that re-leasing the stores could provide a bump to NOI growth next year and that while 2020 will see tenant bankruptcies and store closures the total number likely won't be as great or concentrated.

Third, management released a significant amount of space to an existing junior-anchor tenant to new terms at a reduced amount of total rent. Given the company's high re-leasing spreads of the past few years, this is worrisome if it becomes a trend. However, the company did note that it entered 32 new leases this past year with rent reductions and still put up 11.1% average re-leasing spreads, so this is nothing necessarily new. Additionally, Macerich said that as part of the negotiations it was able to move the retailer into new stores, which increases occupancy, and in others the tenant wanted a smaller footprint, freeing Macerich to lease the space to new tenants that generally pay much higher rent. So while there is some disruption from a negative re-leasing spread this year, we don't think it is a sign of a broader trend, and we can see some small positives to offset the negative impact.

Finally, the company believes that the announced Sears closures will negatively affect the company's results. While Macerich has removed Sears from its same-store pool, so the lowered NOI outlook isn't explained by Sears, management explained that they expect an $0.08 negative impact from Sears on 2019 FFO. However, management did concede that they were being conservative in assuming that they won't collect any rent from the Sears locations that have closed since Feb. 1. Even though there are 13 closed Sears locations in Macerich's portfolio, Sears has yet to reject the leases and might still pay Macerich rent for a few more months. Alternatively, a bankruptcy judge could order Sears to pay Macerich owed rent, though that is not in management's guidance. Either of these scenarios would increase Macerich's 2019 FFO. For 2020 and beyond, we still believe that Macerich will benefit from the closure of the unproductive Sears locations as it redevelops the properties into new anchors or smaller stores, both of which should drive significantly more rent to Macerich. Management gave an example of where they turned an unproductive Sears box into stores for Zara, Burlington, Primark, and JCPenney, who collectively produce five times the total sales of Sears. While this may be a cherry-picked example and we shouldn't assume this high level of turnaround on all of the Sears locations, we think it does show that there is a lot of potential to be unlocked. Even if the Sears impact is as bad as management is conservatively pegging for 2019, we think the accelerated closure of Sears only means that Macerich is that much closer to realizing the potential from these locations in 2020 or 2021.