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Morningstar | More Conservative View on Market Rent Review Sees Moderate Reduction in Our ALE FVE

A change in analyst prompts a reduction in the fair value estimate for ALE Property Group to AUD 4.60 per security from AUD 5.10 and moat rating to none from narrow. Our fair value estimate cut stems from moderately lower expected rent increases from the 2018 rent reviews and a more cautious view on the 2028 rent reviews. However, we maintain our overall positive view on the defensive characteristics of the real estate investment trust. At our new fair value estimate, ALE has a fiscal 2019 dividend yield of 4.8%.

We forecast that the 2018 market rent reviews will result in a circa 8.5% rent increase on the properties subject to the reviews. Our previous forecast was a 10% increase, which is the maximum increase under the 10% cap and floor. Our estimate is based on what has already been announced and management’s expectation of a positive outcome. We understand ALE and ALH have agreed to the maximum 10% increase on about half the properties under review. We believe there are currently a little over 30 properties in dispute, which will be assessed by mutually agreed independent valuers. Although we expect ALE’s properties are generally below market rents, we think it will vary by individual property and not all disputed properties will achieve the maximum 10% rental increase. These properties are diversified among states and will require separate valuations, so the timeline for completion is unclear. ALE is likely to provide an update at its half-year results scheduled for Feb. 13.

Our base case expects a positive rental uplift from the full market rent reviews scheduled for November 2028. We expect a positive uplift because of the strong locations of its properties, which mostly in major eastern state capital cities and highly populated metro areas. Also, ALH has proved it can generate growth in earnings before interest, tax, depreciation, amortisation, and rent from its pubs at a rate significantly above the consumer price index.

We expect strong population growth and difficulties in new entrants obtaining liquor and gaming licences should support strong continued EBITDAR growth at ALE’s pubs. Independent valuers typically assess market rents at 35%-45% of pub EBITDAR. However, given that these reviews are just under 10 years away, there is a high degree of uncertainty about their outcome. It will depend on things like the economic and regulatory environment at the time.

It is our lack of certainty on what may happen at the 2028 full market rent reviews that prompted us to downgrade our moat rating to none from narrow. Although our base case is for a positive uplift in rents, there are a number of risks to our base case that could negatively affect pub EBITDAR over the next 10 years, including adverse changes in gambling and liquor regulation. Recently, there has been increased political and media scrutiny of problem gambling in Australia. Woolworths and ALH have recognised community concerns and in late 2017 engaged Canada’s Responsible Gambling Council (an independent nonprofit organisation dedicated to problem gambling) to conduct a review of ALH’s gambling operations against world best practice.

This review was extended in early 2018 following allegations by former ALH employees and federal MP Andrew Wilkie that some ALH staff collected information on customers in order to encourage them to gamble longer at ALH-operated pubs. The review uncovered some conduct that was identified as being below ALH’s expectations and contrary to its policies. ALH confirmed that these practices have ceased and it is implementing the review’s recommendations. Additionally, there has been speculation, albeit denied, that Woolworths is looking to exit its 75% interest in ALH. There have also been reports that Woolworths' major competitor Coles is looking at ways to exit its pubs business, which may prompt a rethink by Woolworths of its interest in ALH. Despite these risks, the saving grace for ALE is the location and quality of its properties. Its portfolio of properties may be converted into alternative and better uses if the regulatory environment changes. Nevertheless, given these types of risks, including uncertainty as to rents under an alternative use and the investment required to achieve these rents, we do not have enough confidence that ALE will be able to generate a return above its cost of capital over the long term to assign it a narrow moat.

We forecast a 6% increase in dividends per share in fiscal 2019. This forecast is based on a combination of factors, including gearing (net debt/total assets less cash) being maintained at current levels and increases in distributable income and fair value gains from the 2018 rent reviews. However, there is a significant uncertainty as to future dividends, as these will ultimately depend on the results of an upcoming board review on appropriate gearing levels.

ALE has been reducing its gearing from 65.2% at the end of fiscal 2008 to a historically low 41.6% at the end of fiscal 2018. The REIT has been managing gearing levels by paying distributions out of capital. Cap rate compression combined with CPI-linked rental increases has seen fair values of properties increase significantly from fiscal 2014. Accordingly, if management had not paid distributions out of capital, gearing levels would be materially lower. For example, AUD 5.97 cents per share of dividends (AUD 11.7 million) was paid out of capital in fiscal 2018 and AUD 5.53 cents per share (AUD 10.8 million) in fiscal 2017. Management have recently indicated the board will review appropriate gearing levels following the 2018 market rent reviews and future distributions will depend on the results of this review.