INVESTMENT VIEW
Scentre Group (SCG) is an Australian shopping centre manager and developer of Westfield super regional shopping centres. SCG holds a portfolio of 42 Australian shopping centres (12 of which are 100% owned). The group felt the brunt of the impact from COVID-19-driven lockdowns although expectations are that trading will normalise as lockdowns move further into the past.
Balance sheet well positioned into rising rates. Gearing ~27%. A$800m of debt was paid down over the first half. The hedging profile increased to 80% for 2H22 and 70% for FY23. A$2.6bn of new and extended banking facilities provides A$4.8bn of available liquidity which is sufficient to traverse through the rate hike cycle. The average net interest cost of debt is ~4.2%. SCG is open to divesting all or part of their wholly owned 12 assets within the portfolio (A$20bn), given the right opportunity, or if necessary for the balance sheet.
Structural shift. Amazon’s 2017 domestic introduction to Australia was a catalyst for the structural shift in the valuation of shopping centres. Since the US retailer made its way into Australia, SCG and peer Vicinity (VCX) have remained below book value. Online sales have grown notably over the past 5 years and strengthened during the pandemic. SCG trades at a 23% discount to book value despite transactions on the property market trading at book value for the past 5 years. The market is sceptical about the sustainability of SCG’s asset valuations given an ongoing change in consumer behaviour.
Inflation tailwinds for rent growth. Between ~70-80% of collected specialty store rents are linked to a CPI +2% pricing structure. Inflation is expected to remain elevated through to FY23 so SCG should soak up the benefits until well into next year. Roughly half of SCG’s leases typically roll over in the second half of the year so more accretive contracts may come into play if inflation persists.
Valuation metrics and investment thesis: P/FFO is ~14x, 0.8x book value, 5.4% dividend yield at a payout ratio of ~75% and a 3yr DPS CAGR of ~4%. FY22 FFO guidance is 19cps and DPS guidance is 15cps. Interest rate headwinds and changing consumer behaviour in our view make it unlikely that SCG is going to close the valuation gap in the short-term. SCG’s A$20bn portfolio of 12 assets is ripe for capital restructuring (or capital management). We rate SCG a Hold.
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3 Key investor issues
1. Is the balance sheet strong enough to withstand higher interest rates?
Yes. We view the balance sheet as well positioned moving into the rate hike cycle. Recent capital restructuring pushes debt concerns out until FY25. Interest rate hedging increased to 80% over the past 6 months, ~A$800m of debt was paid down into the 1H22 result and A$2.8bn of debt was refinanced providing A$4.8bn of liquidity.
In our view, the market has been overly concerned about the rate hike vulnerability. At its current position, the 2H22 and FY23 outlook is satisfactory. The cost of debt is at the higher end of the sector yet still maintainable. The debt profile, while higher than peers, does not create cause for caution.
Management is willing to consider divestments in the A$20bn wholly owned portfolio (12 assets). In our view, the company appears unlikely to significantly deviate from the long-standing Return on Assets (ROA) model they have operated for many years. The ideal model is torn between its long-standing ROA model with a newer Return on Equity (ROE) one. Nevertheless, it provides flexibility when moving into a higher rate environment.
2. Can development offset higher interest rate costs?
SCG has a development pipeline of >A$4.5bn at a target yield of 6-7%, generating an incremental Internal Rate of Return (IRR) of 12-15%. The A$355m redevelopment of Westfield Knox (VIC) should be complete by Q422/1Q23. Stage 1 should open for December 2022 and is currently 96% leased.
Notable projects in the pipeline include 1). 101 Castlereagh which is expected to commence shortly 2). Booragoon, Parramatta, and Albany (NZ) which are in substantial predevelopment and 3). Liverpool lifestyle precinct and office building.
At a run rate of A$350m-A$400m this should carry the development pipeline out 10+ years. The development pipeline provides long-dated incremental growth, something the group has done over its lifetime. The structural shift to online may put this approach at risk. As more people move online, the ability to develop and fill these centres (at the right margin) becomes increasingly difficult. Whilst we don’t see that today in vacancy levels, leasing spreads still remain negative (i.e. new specialty leases are struck at rates below existing leases).
3. Structural change to consumer behaviour
A structural discount in SCG equity price has emerged since Amazon entered Australia in April 2017. Online shopping was accelerated over the pandemic period, gaining a foothold in the Australian retail market at~18% of total sales.
The market has taken notice of the shift, which is reflected in the long-term discount to book value and underperformance in the share price vs A-REIT peers. VCX and SCG share prices have both been weak compared to asset valuations as investors are questioning whether property values can be maintained.
Online sales growth ex-COVID remains well intact and is likely to present as a structural headwind over the medium and longer term. Australian online sales penetration remains well below other comparable countries like the UK and US.
4. Is the valuation discount and earnings upside enough?
The current P/FFO (Funds from Operations, the REIT measure of earnings) isn’t excessively cheap at ~14x and despite mid-single growth expectations for FFO, we are not fully convinced the full impact of higher interest rates is factored into the share price.
Earnings Growth: Consensus forecasts imply FFO will return to the pre-pandemic average of 23cps by FY25E, implying 3yr fwd CAGR of 4.8%. This represents the highest growth in the sector ex Charter Hall Group (CHC) and Goodman Group (GMG).
Driving this is the normalisation of trading conditions post-COVID-19 and inflation-linked rent growth. FFO growth is in the context of a 41% reduction in FFO due to COVID-19. Recovery is front-end loaded as rent collection moves back to 100%. FFO growth for FY24e-FY25e is subdued at ~3%. We our view long-term FFO growth is well below GDP growth, like what was seen the years prior to COVID-19 (flat FFO growth).
Price to Book Value: SCG currently trades at ~25% discount to book value. Pre-pandemic this was at ~13%. SCG and peer VCX have remained well below book value since early 2017. The expanded discount reflects the increased awareness of the structural headwinds and potential for shopping mall valuations to fall given the rise in interest rates.
In our view, it is difficult to identify catalysts to close the discount in the short-medium term. Capital management is unlikely, as is Merger & Acquisition (M&A) given the size of the asset base A$20bn. Earnings improvement or an acceleration in the development pipeline is unlikely to close the discount.
Investment thesis
Consumer demand for online retailers is highly likely to continue to present a headwind for shopping centre earnings, but more importantly equity market valuations. SCG continues to pivot into services-based expenditure to address this structural shift.
The balance sheet position should alleviate downside risk on debt fears, which was a core focus of investors ahead of the 1H22 result.
Mall valuations remain hostage to rising interest rate pressure and long-term structural issues, including the growth of online sales. Therefore, shopping centre REITs are likely to trade at a wider discount to net asset valuations than previously.
In our view SCG’s share price is unlikely to close the gap to book value in a world of rising interest rates and potential for slowing retail consumption.
We rate SCG a Hold.
Figure 1: Discount to Book Value vs 3yr FFO CAGR. 6 out of 8 REITs trading below book value.
Figure 2: Majors (Purple) and Specialty (Gold) sales growth 1H22. Service-based sales continue to display strong growth.
Figure 3: Rental growth is linked to inflation. Potential upside to earnings on rental growth in FY23e.
Figure 4: 80% of leases to benefit from CPI plus 2%. CPI is expected to remain elevated well into FY23.
Figure 5: P/FFO below the historic average. FY25E FFO EXPECTED TO BE BELOW FY17/18 LEVELS
Figure 6: SCG P/E REL remains below the market GIVEN LONG TERM GROWTH PROSPECTS ARE BELOW MARKET
Figure 7: Dividend yield has remained within a range of 4%-6%. DPS CAGR of ~4%.
Figure 8: P/BV below book value since 2017, structural shift in consumer behaviour BECAME EMBEDDED IN THE SHARE PRICE.
