Vicinity Centres is an Australian Shopping centre manager and developer which hosts a A$14.5bn portfolio of 59 commercial assets. The group has the largest exposure within Victoria ~35% of its centres located within the state (50% of net asset value). On average VCX’s assets are lower quality than peer Scentre Group (SCG), which provides less flexibility with potential asset recycling.
The balance sheet well positioned into interest rate headwinds. Gearing is manageable at ~25%, low end of 25%-35% target range. Weighted average cost of debt (WACD) is 4% and the group is ~80% hedged into FY23. VCX has $1.4bn of cash and available liquidity. The key risk over 2023/24 remains the potential for falling shopping centre valuations, following higher interest rates/falling house prices.
Amazon Australia launch in 2017, introduced a structural valuation discount to shopping centres. 3-year average pre-COVID price to book was 0.8x for VCX and 1.1x for SCG given the superiority of SCG’s assets. Post-COVID this gap has now closed, with both VCX and SCG at 0.8x. We believe that the listed market will continue to apply a discount to book value in the share prices of retail malls given ongoing structural changes and emergence of cyclical headwinds.
Development pipeline directed into non-retail developments. >60% of VCX’s A$2.9bn development pipeline has been earmarked for non-retail developments. We believe this introduces a new layer of capital deployment risk for VCX. The redirection of capital spending is a response to retail shopping centres having reached market saturation, due in part to the rise of on-line shopping. This limits the prospects for future growth in the core retail shopping centres.
Valuation risks remain. VCX price to book of 0.8x, in-line with the 5yr average. This represents a ~10% premium to SCG, despite VCX having inferior assets. The prospects for shopping centre valuations to fall over the coming 12-18 months, remains a clear risk to the book value of retail assets. In this environment share price outperformance is vs the market is unlikely.
Our view: The development pipeline can only do so much in the short-term. And with much of spend directed away from the core retail, the development pipeline carries additional risk.
The willingness of the market to discount shopping centre asset values, suggests that structural and cyclical factors, will continue to weigh on the share price next 12-months. We rate VCX a Sell.
Key Issues
Does the Development pipeline offset structural headwinds?
Vicinity’s A$2.6bn development pipeline, representing ~6% of the asset base, introduces the company to office and residential exposure, having taken on hotel development in 2019.
The move to residential can be viewed in two ways; 1). Shopping centre saturation across Australia, leading VCX to pursue higher returns in non-core areas; or 2). Utilising the air space assets above the existing developments and maximising return per sqm.
In our view, the move into office/residential development suggests that the business is losing confidence in its ability to sustain growth purely through shopping centres. This view has been reflected by the market, with VCX having traded below book value since 2017.
The development pipeline provides around 7-8 years of project asset growth based on annual spend of A$250-300m pa. This should add around 2-3% pa to earnings. We expect the development pipeline to be funded by debt, asset sales and JV partners, particularly in residential and office. Whilst VCX could accelerate the pipeline, and earnings accretion, it would risk the return profile given the tight building market at present.
Development pipeline scenarios analysis at different spending rates.
We expect development expenditure for FY23E to be at ~A$275m (mid-point of the A$250-A$300 guidance range) and expect capital expenditure to increase to ~A$300m-A$400m over the mid-term given the chunky nature of office and residential developments.
We estimate ~75% of the development pipeline is into non-retail assets. This raises the risk profile of the development given they are outside VCX’s core area of expertise. Of the Retail development, we estimate less than half is genuine growth CAPEX adding additional leasing sqm to the retail portfolio.
The development returns are long dated, and unlikely to step-up from the ~2% pa earnings accretion until the middle part of the decade. In our view this incremental earnings growth will not be enough to close the discount to book value.
Figure 1: Development pipeline to 2027. 70% is exposed to non-retail developments in office and residential.
2. Do rising interest rates create balance sheet vulnerabilities?
Rising interest rates are unlikely to pose a threat to the balance sheet over 2023. Hedging increased to 80% for FY23E. $475m of bank debt refinanced in FY22 until FY28E. The group has a high level of liquidity (~A$1.4bn) after cancelling $800m of debt in FY22. Gearing is 25% which is at the lower end of the 25%-35% target range.
The capitalisation rate (or cap rate) differential between VCX and SCG has closed since FY15. In FY15 there was a ~2.1% gap between the two. Today there is a 0.40% gap which in our view, is not reflective of superior asset quality of VCX. The compression of cap rates has been evident for the whole sector over the past 8 years. This in our view is unlikely to continue given the change in macro-economic conditions.
If cap rates expand by 1.0% for VCX, the implied NTA would fall by 20%, lifting the gearing from 25% to 30%. Another way to look at the current share price, is that it is factoring in an implied 1.0% lift in cap rates, which would equate to a 20% fall in NTA valuation.
SCP and other large cap REITs also have current share prices implying 20% fall in asset prices (which would equate to P/NTA of 1.0x).
31 of VCX’s 59 assets are 100% owned which provides balance sheet flexibility. These assets are of lower quality than SCG’s and make up only ~42% of the group’s total asset value vs 58% for SCG.
Figure 2: VCX gearing at the mid-range of the sector.
Figure 3: VCX asset portfolio ownership structure by value
3. Price to book value discount since 2017
Valuation discount to book: Since 2017, VCX has traded well below book value, with the market implying shopping centres valuations need a structural discount. The disruption from COVID over the last two years (uncollected rent) also weighs on the valuation.
Structural headwinds have become evident since the introduction of Amazon in 2017 and were exacerbated by the COVID-19 pandemic. The current ~23% discount to book value is in-line with the 5-year average, suggesting that COVID-19 headwinds weren’t the only driver for the valuation disconnect.
Capital management unlikely at this point in the cycle. Prior to COVID-19 VCX had a buy-back underway for 5% of shares on issue (initiated 2017, equating to A$500m) which was halted once the pandemic started.
The buy-back (upsized to A$600m) was cancelled in March 2020 and was followed by a A$1.2bn placement (June 2020). This was to ensure the balance sheet was in a strong position during the pandemic.
With this background, we think management are unlikely to be aggressive with capital management, given the outlook for rising interest rates (and slowing consumer sales).
In our view, the price to book ratio is likely to continue to fall further, potentially bottom out at 0.5x-0.6x. We don’t believe it will return to the COVID-19 low of 0.3x-0.4x, but in a scenario of restrictive interest rates and slowing consumer sentiment, we could see ~0.6x. We reiterate our Sell rating.
Figure 4: Price to book valuation now vs 5-year average. VCX trading slightly above the 5-year average, vs peers which all trade at discount.
VCX shopping centre assets are largely in regional areas. Ex Chadstone (VIC, 50% interest), the most valuable mall in the country representing 22% of VCX asset base, VCX’s assets are predominantly in regional areas. Regional shopping centres don’t command the same value as metro malls and are more susceptible to new competition given available land. This is currently reflected in higher cap rates of VCX (5.3%) vs peer SCG (4.9%).
Whilst it can be argued that regional malls are less susceptible to online competition, they don’t offer the same growth rates over the cycle or command the same valuations.
In our view, it will be difficult for VCX to achieve book value (if assets were to be sold) on many of these regional assets over the next few years as higher interest rates and slower spending growth impact shopping centres. This is likely to limit balance sheet flexibility around partial sell-downs of centres.
Figure 5: VCX asset breakdown: Chadstone anchors the asset base for VCX. Sub-regional represents ~41% of the assets, only ~18% of the portfolio value.
Risks to investment view
| What obstructs our view? | What supports our view? |
|---|---|
|
1). Retail sales remaining stronger for longer and normalising earlier than expected. 2). Interest rate headwinds unwinding earlier in the cycle providing less pressure to retail consumption. 3). Divestments of assets to streamline development pipeline. 4). Capital management/share buyback given the discount to book value. |
1). Falling occupancy rates driven by low consumer sentiment. 5). Negative dividend growth in 2024E |
Investment thesis
Current market conditions provide little support for VCX as evident by the market’s willingness to discount the asset portfolio. On a valuation basis VCX is not cheap. Despite the stock derating notably from pre-COVID levels, the 12mth fwd P/E is in-line with the 5-year and 10-year average. This suggests that the share price could be vulnerable if tougher macro conditions present themselves in 2023.
The development pipeline offers a renewed approach to Vicinity’s operations. Office and residential exposure should offset some of the structural growth headwinds, but this is only expected to first contribute to earnings from FY25/26E.
The share-price outperformed most AREITs (although notably from a lower base) this year. Peer SCG’s share price has begun to roll over given the prospect for tougher retail trading conditions. VCX will not be immune. Until the oncoming macro conditions unwind and the development pipeline is further underway, we rate VCX a Sell.
Figure 6: 12MTH FWD PER BELOW LONG-TERM AVERAGE
Figure 7: PER RELATIVE TO MARKET: 5% discount to S&P/ASX 200
Figure 8: Div Yield approaching 6%
Figure 9: Price to book at 0.8x
