Investment View
Scentre came out with a strong result with FY23 FFO guidance set slightly ahead of the market expectations. The inflationary environment provided a tailwind over the period due to SCG’s CPI +2% rent escalations and given inflation is yet to dissipate, we believe this continues through FY23.
Retail sales were stronger than expected with business partner sales ~7% above FY19 (pre-COVID). Cinema and travel are yet to recover to pre-pandemic levels although Group sales ex Cinema and Travel improved by 11% which represents strong retail sales in the face of an expected consumer downturn.
Operations remained strong. Leasing Spreads improved to -3.3% (from -3.8%) and occupancy increased by 0.2% to 98.9%. Major fears of asset valuations falling off a cliff were quashed as the weighted average cap rate (WACR) only increased by 0.06% to 4.93%, decreasing the Net Tangible Asset base by a minor ~2.5%.
Balance sheet has gearing at the lower end of historical range, with high levels of interest hedging in place for 2023/24. SCG retains flexibility adjust the timing of the development pipeline or divest some of the Group’s A$19.8bn portfolio of 100% owned assets if additional balance sheet flexibility was sort.
Development continued to churn away. Scentre is positioning itself to be increasingly defensive towards the shift to online retailers by lifting its recreational and services-based assets (e.g. Westfield Knox (VIC) Library and recreational sports area).
SCG is trading below its long-term average Price/Funds from Operations (P/FFO) of 15x (currently trading at 14x). At current levels, SCG has fallen in-line with peer Vicinity Centres (VCX), which it historically has traded at a premium to. As operating conditions improve, we would expect this premium to re-emerge given the strength of Scentre’s asset base.
We are upgrading our rating to Buy as we believe the discount to book value remains far too significant. We are taking a 12–18-month view and are looking through an expected slowdown in consumer demand. SCG’s CPI-linked leases should be able to offset any major impacts from potentially lower retail sales.
What did we get out of the result?
A strong result with some indication that underlying conditions are improving due to strength in occupancy and improving leasing spreads. Shopping centre operators are moving on from difficult pandemic conditions and are seeing a return to normalised operations. CPI-linked rents are continuing to soak up the benefits from the inflationary environment and should continue to do so well into CY2023.
FFO guidance was set at 20.75cps to 21.25cps (3.4%-5.9% growth on FY22 and ~1% ahead of mkt) and Distributions to be at least 16.5cps (4.8% growth on FY22 and 4.5% ahead mkt). Both are driven by the rental uplift from the CPI link leases (+6.8%).
Leasing Spreads saw a minor improvement of ~0.5% -(3.3% vs -3.8% FY22). This likely remains negative as retail sales slowdown, but we expect it will continue to move closer toward positive territory. Occupancy increased to 98.9% (vs 98.7% FY21) continuing the recovery post-pandemic.
Figure 1: Midpoint of FFO guidance marginally ahead of consensus estimates.
Retail Sales
Business partner sales increased by 21% on 2021 and ~7% over 2019 (pre-Covid) and visitation grew +67m in the period.
Retail sales remained resilient throughout the period, although we expect a slowing to emerge by mid-2023 as impact from rate hikes is felt. Peer Vicinity Centres (VCX) management team suggested the slowdown had begun through Jan and Feb.
Retail sales continue to rebound from pandemic lows and are fighting against the structural fears of a shift to online. Sales conditions are likely to remain slower over the next 6 months, but we’d expect the centre visitations to remain robust as services-based operations improve.
Figure 2: SCG sales up ~7% on pre-pandemic levels
Balance Sheet
SCG balance sheet has gearing at 27.3% (up 0.2% from 1H22, typically remains within 25-33% range) and interest rate hedging is 81% (slightly below 1H22’s 85%).
We believe it’s unlikely that we see pressure build to lower balance sheet leverage. SCG retains flexibility adjust the timing of the development pipeline or divest some of the Group’s A$19.8bn portfolio of 100% owned assets if additional balance sheet flexibility was sort.
Asset Valuation Fears
Fears of assets values falling remained unfounded throughout the period. Cap rates expanded 0.06% (to 4.93%) driving Net Tangible Asset Value to fall to A$3.57 (vs A$3.66 CY21).
The market was expecting a far larger expansion in cap rates, with the share price still representing a ~16% discount to book value.
Whilst we still expect cap rates to expand above 5%, we don’t see a significantly large cap rate cycle occurring 2023/2024 due to:
a. Asset quality and scarcity. SCG has not seen a net increase in Gross Leasable Area (GLA) over the past 14 years. Australian population has grown by 18% over the same time.
b. This economic cycle likely to still see resilient corporate earnings and minimal pick up in unemployment rate.
c. Cash interest rate cycle likely to peak mid CY23.
Figure 3: SCG and peer VCX have the strongest FFO growth outlook of the AREITs.
Active Development and the Future Pipeline
Scentre’s long-term development pipeline is more than $4.5bn. Key projects include Sydney (NSW), Parramatta (NSW), Albany (NZ), Barangaroo (NSW), and Doncaster (VIC). Management continues to push forward with the target development yield of 6-7% with an incremental IRR of 12-15%.
Westfield Knox development continues to churn away with stage 1 being completed in December 2022. Stages 2-4 are now underway, these stages include Sport, Athleisure, a 2000sqm library, indoor and outdoor recreational spaces, and coworking facilities. This is all part of SCG’s plan to expand the services-based operations in order to drive higher centre foot traffic.
Risks to Investment View
Investment Thesis
We are upgrading our rating to Buy as SCG remains in a solid position to benefit from the normalisation of operating conditions and inflation-linked rents which are growing at the highest level in over 7-years. We are taking a longer-dated view toward retail centres and are willing to look through an expected slowdown in consumer demand.
At a 16% discount to book value, we believe that the market is mispricing Scentre’s operational performance. The AREITs are continuing to normalise post-pandemic, and we believe this trend will continue given bond yields unwind and pandemic disruptions in operations fade.
Like peer VCX, Scentre has continued lifting its service-based operations through its development and redevelopment program. The current Westfield Knox will be a key project to contribute to the shift to services due to its recreational spaces. It is clear that Australian retail centre operations are now looking to create reasons to visit the centres that are outside of typical shopping, and which are not at risk from online penetration.
A 3yr FFOps CAGR of ~4.7% offers sector leading growth along with peer VCX. The dividend yield of 5.9% (76% payout) should provide some value in current market conditions.
We are taking a 12–18-month view and upgrading our rating to Buy. We note that retail demand is expected to slow down due to the rate hike cycle, but we believe this will only have a minor short-term effect on retail centre operations and is reflected in the current share price.
Figure 4: SCG PER below long-term average
Figure 5: SCG PER vs ASX200
Figure 6: Dividend yield approaching 6.0%, with a sustainable dividend over 2023-24
Figure 7: SCG trades at a 15% discount to price to book
