Seeing Through the Mills Mess

Analysts say the troubled mall REIT's stock could show growth if investors can hang on for the ride.
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Mills Corp.

(MLS)

was once regarded as one of the best mall developers in the country and one of strongest value-creators in the REIT universe.

Now, the company is better known as a financial mess. But for long-term investors with iron stomachs, analysts say the stock could be a nice value play.

Mills, which is developing the giant Xanadu project in New Jersey's Meadowlands, earlier this month

spooked investors when it pulled the plug on 10 development projects, laid off 19 executives to cut costs, and said it would restate its earnings going back five years.

On Wednesday, the latest dire news came from Germany, where Mills' key equity partner,

KanAm

, said it froze the assets in two of its open-ended property funds for three months. KanAm said investors had been pulling out money because of the negative press reports about Mills' financial restatements.

The first KanAm fund, US-Grundinvest Fonds, froze its $579 million in assets to avoid breaching a 5% minimum liquidity threshold after $50 million of investor outflows, according to Legg Mason analyst David Fick, who downgraded Mills to hold from buy Thursday.

The frozen KanAm fund is invested directly in two Mills mall projects: Opry Mills in Nashville and the Great Mall of the Bay Area in Milpitas, Calif. As of Dec. 31, 2004, KanAm held 50% equity stakes in each project. KanAm can force an outright sale of the two Mills assets, according to Mills filings with the

Securities and Exchange Commission

. However, if Mills wants to buy out KanAm's interest, it may have trouble accessing capital due to its financial problems, Fick adds.

The KanAm issue will continue to be a dark cloud over Mills in the near term. KanAm was a founding partner of the Arlington, Va., company, and the German investment firm's closed-end funds, which have not been frozen, were significant equity investors in 10 other Mills projects. KanAm also effectively owned 1.23% of Mills' operating partnership units (as of Dec. 31, 2004), which can be converted into Mills' common stock or the cash value of the stock.

From 1994 to the end of 2004, KanAm invested $1 billion in equity in Mills' development projects. "One of the more beautiful things about Mills has been this KanAm stake," says Dean Frankel, a portfolio manager with Urdang Securities Management, which owns Mills shares but sold a significant amount of the stock last year.

In the late 1990s, the relationship was particularly helpful because it allowed Mills to raise funds without issuing equity and creating dilution, Frankel says.

One of the worries now is whether this relationship has been tarnished for the long term and KanAm will look to pull out its equity. The issue could put a damper on the high-profile Meadowlands Xanadu development. The project, which has begun construction and is slated to open in late 2007, is supposed to comprise 2.2 million square feet of retail shops, along with a roller coaster, an indoor ski park and other entertainment offerings.

KanAm has committed $400 million to the $1.2 billion project. "What if there is a forced liquidation there?" Frankel asks. "Mills doesn't have the equity right now" to pay off KanAm, he says.

Frankel, though, expects the Meadowlands project to be completed and create value. He says

Simon Property

(SPG) - Get Report

and

General Growth Properties

(GGP)

could be interested in buying the property if Mills were forced to sell.

Many of the REIT's joint ventures with KanAm require Mills to buy out KanAm's equity position if certain conditions aren't met -- one of which is not securing construction loans by a certain date. Mills still hasn't announced whether it has received a construction loan for the Meadowlands project.

The KanAm issue only adds to the numerous question marks surrounding Mills. Investors continue to hammer the stock. Mills shares hit a 52-week low of $36.38 in intraday trading Thursday, and closed the day at $37.66, down $1.79, or 4.5%. Shares are well off their 52-week high of $66.44, reached last summer.

Given that Mills' stock is trading so low, there is speculation that a sale of the company could be coming. Fick, the Legg Mason analyst, estimates Mills could fetch $51 to $61 a share in a buyout. Malls remain popular investments, and Mills' portfolio is top-notch. Fick believes Mills' properties would sell at capitalization rates, or first-year yields on purchase prices, of 6.25% to 6.75% -- which is how he calculates the $51 to $61 per-share value of the company's assets.

However, one real estate investment banker, who asked not to be named, said an outright sale of Mills isn't likely. Instead, the banker expects Mills to do property-level joint ventures with partners outside KanAm, such as U.S. pension funds, in order to create liquidity.

"The company needs to get the Street comfortable that they can get the capital that they need to finance their development pipelines," the banker says.

If liquidity returns and confidence is restored in management, Mills could once again hold its crown as one of the great value-creators of the REIT universe. "Mills has created a lot of value over time. It's on paper, it's hard to miss," says Frankel, the portfolio manager at Urdang.

"If you've got a very long-term approach and time horizon, it's a reasonable buy right now," Frankel says.

"There's a lot of issues ... but the stock is trading at a very low price, relative to the value of assets and the development pipeline," says Keith Pauley, chief investment officer of LaSalle Investment Management, which owned 1.79 million Mills shares as of Sept. 30. Pauley declined to say if LaSalle still owns any Mills shares.

For now, Fick says Mills' dividend is covered. The dividend yield is now 6.7%, but if there's a liquidity problem, the safety of that payout comes into question.

Investors also have to grapple with an SEC inquiry into Mills' earnings reports, along with possible shareholder lawsuits. In all, it's a lot to digest. But putting faith in Mills now could pay off in the future.