Mills and the REIT Malaise, and What Applies to Applied Materials

Stock Exchange gives readers a chance to listen in as staff writers James Peltz and Michael Hiltzik debate the merits of individual stocks.

Mills Corp. (MLS)

Jim: This is our first chance to talk about REITs, that is, real estate investment trusts such as Mills.

Mike: It’s a painful subject.

Jim: Uh-oh. You’ve been burned?

Mike: I own shares in a REIT mutual fund, which I thought would be a great performer last year. Instead I’m going to be licking my wounds for quite a long time.

Jim: Worse, many thought the stocks would turn the corner in 1999, but . . . .

Mike: They haven’t made the turn, and a lot of people on Wall Street are stumped as to why.

Jim: Let’s start by explaining that a REIT--it rhymes with “beet”--is an entity that either owns property or lends money for real estate, and it has a special tax structure. If it passes through at least 95% of its earnings to its stockholders in the form of dividends, it escapes corporate income tax. Hence, REITs historically provided above-average dividend yields, predictable growth and low volatility.

Mike: Though the holders have to pay tax on the payouts, of course.

Jim: Right. Now, what bugs me about the REIT business is how they and the analysts who follow them have concocted a wacky method of calculating their earnings. Instead of focusing on after-tax net income the way most companies do, the REITs focus on something called “funds from operations,” or FFO.

Mike: And you resent that.

Jim: A lot. Reporting FFO is perfectly legal, but whenever one industry goes off and creates its own way of measuring its financial health, I’m suspicious about exactly how healthy it is.

Mike: What is FFO, exactly?

Jim: Good question, because if you’re going to invest in REITs, you’re going to hear a good deal about this number. But to me, FFO really muddles the picture. Listen to how Mills defines it, based on guidelines provided by the REITs’ trade group, the National Assn. of Real Estate Investment Trusts.

Mike: I’m not sure I want to hear this.

Jim: It’s the income before minority interests, excluding gains from debt restructuring and sales of property, but plus real estate depreciation and amortization etc., etc. Is this confusing or what? I mean, this number sure seems a long way from the bottom line.

Mike: Especially since it indicates that the REIT is minimizing what can be pretty painful expenses for a real estate business.

Jim: Exactly. Heck, I’m sure General Electric or Microsoft would love to back out their depreciation, amortization and what-not and then brag about the resulting number to their stockholders. But, like most companies, they don’t. They have to factor all that in to come up with the earnings that everyone watches so closely. And that’s not all. Mills says the way it calculates FFO might be different from the way other REITs do, which makes comparing REITs that much tougher.

Mike: What about Mills itself?

Jim: Mills specializes in owning shopping malls and leasing space to the retailers. It has several properties, including the gargantuan Ontario Mills outlet mall and the new Block at Orange, a funky outdoor mall in Orange County.

Mike: Their strategy, as I see it, is to take your basic shopping center and throw in new and interesting themes, like a zoo and aquarium at Ontario Mills, and the skateboard park at the Block at Orange.

Jim: Not a bad idea, because the world certainly doesn’t need another shopping center.

Mike: But is this enough to keep Mills ahead of the pack?

Jim: On an operating basis, perhaps, but as a stock I’d avoid it, because the whole pack is in such lousy shape. In the mid-’90s, many properties were undervalued and REITs bought them with a vengeance, and so they scored hefty returns on investment. But that sent property prices higher, and, starting last year, investors began worrying that the REITs might not be able to keep growing their earnings if they were paying top dollar for new real estate. It didn’t help when a number of REITs posted disappointing financial results last year.

Mike: As evidenced by their stock prices.

Jim: Mills’ stock has dropped 34% in the last 12 months, and it’s been a slow, grinding descent. And get this: Because of the price drop, Mills’ dividend yield is now a whopping 11.6%! That compares with the industry’s already lofty average of about 7.5%.

Mike: Makes one wonder if Mills’ dividend is in danger of being cut.

Jim: I wondered that too, but earlier this month Mills hiked it 3% more. One has to admire Mills’ confidence in its outlook, but did you see the reaction? Wall Street yawned so loudly you could hear it in Ontario. And that says a lot about the dreary outlook for REIT stocks right now.

Mike: I agree. Investor psychology is definitely negative on this sector, it doesn’t look as if it’s going to change and I’d pass on this stock as well.

Jim: Mills has a lot going for it. It’s got an interesting portfolio of malls, it’s expanding nicely, it’s been able to raise capital lately and it’s in a business--retail--that’s growing nicely these days. But it’s also a victim of the REIT malaise on Wall Street.

Applied Materials (AMAT)

Jim (Buy)

Mike (Buy)

Mike: To my mind, this is one of the few pure plays in the semiconductor industry.

Jim: It’s the world’s biggest maker of chip-making equipment.

Mike: No matter what type of semiconductor company you’re talking about, it most likely buys a lot of its gear from Applied Materials. So if you can’t decide whether to invest in Intel or Advanced Micro Devices or VLSI Technology, you can just invest in this stock.

Jim: Now, as our readers might recall from our chat about Western Digital a while back, this whole industry is extremely volatile, constantly going from boom to bust. Right now it’s booming.

Mike: And the lesson here is: These are stocks you own for the long haul. The semiconductor industry will keep growing smartly over the next few years, but it won’t be a straight line up. You’ll get your head handed to you if you try to step in and out of Applied Materials.

Jim: Here’s the latest evidence: Earlier this year a whiff of a slowdown in the personal computer industry sparked a meltdown in tech stocks, and Applied Materials wasn’t spared.

Mike: But over time?

Jim: This stock has soared 3,000% since 1990, and a good chunk of that has come in just the last few months, as evidence mounted that the semiconductor industry was rebounding. Applied Materials has more than doubled since Sept. 30. The question now, of course, is whether the chip business is still in the clover.

Mike: Well, the key measurement of health in this business is the book-to-bill ratio, which is basically a ratio of new orders to old orders.

Jim: The ratio has been running above 1.0 lately, which is good news, especially since it had been lagging below 1.0 for much of last year.

Mike: True. But chip-making is an industry in which there’s almost too much information. People watch these cycles of chip purchases and capital spending so closely, and project forecasts from the existing numbers so frequently, that it’s hard for investors to keep their eyes on the long-term goal. But they should.

Jim: Shut out the noise.

Mike: Right. As for Applied Materials, I like that it’s not dependent on any one product line. In other words, it doesn’t matter much whether there’s a PC slowdown ahead, or a cellular-phone slowdown or what have you, because none of them by themselves will sink the company.

Jim: It will matter in the short run, as we saw earlier this year when Applied Materials’ stock suffered the same fate as all tech shares.

Mike: That will happen, and you just ride it out. Look, there’s going to be great demand for semiconductors in the coming years because the number of devices that use these things is proliferating at an unbelievable rate. Every day there’s some new device that incorporates a microprocessor or memory chips. All of this makes Applied Materials a dynamite player.

Jim: But let’s not forget Applied Materials’ own skills. I like how management has made it a high priority to boost the company’s profit margins, to about 20 cents per dollar of sales after taxes. The company’s order book is swelling, and Applied Materials is rolling out a bunch of new products this year. And it doesn’t hurt that Asia, which has lots of chip makers, is starting to recover. I always get a little nervous when I see a stock--even a tech leader--selling for 57 times earnings. But I’d still buy this one.

Mike: There are going to be uses for this company’s equipment that we cannot even imagine today.

Jim: One other thing: That recent sell-off of the tech stocks has ...

Mike: ... Made this stock an even better buy.

Jim: You’re way ahead of me.

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Mills hiked it 3% more. One has to admire Mills’ confidence in its outlook, but did you see the reaction? Wall Street yawned so loudly you could hear it in Ontario. And that says a lot about the dreary outlook for REIT stocks right now.

Mike: I agree. Investor psychology is definitely negative on this sector, it doesn’t look as if it’s going to change and I’d pass on this stock as well.

Jim: Mills has a lot going for it. It’s got an interesting portfolio of malls, it’s expanding nicely, it’s been able to raise capital lately and it’s in a business--retail--that’s growing nicely these days. But it’s also a victim of the REIT malaise on Wall Street.

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Write or e-mail with a stock you would like to see discussed in this column. James Peltz ([email protected]) covers the markets and corporate financial trends. Michael Hiltzik ([email protected]) covers technology and entertainment and is the author of a new book, “Dealers of Lightning: Xerox PARC and the Dawn of the Computer Era.” Either can also be reached at Business Section, Times Mirror Square, Los Angeles, CA 90053.

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Mills, Monday: $17/31