EUR 850.00 For Business Accounts Only

Morningstar | Arena Performing Well but in Line with Expectations. Securities Remain Undervalued.

No-moat-rated Arena REIT continues to traverse the turbulent child care sector well and the 6.5% increase in earnings per security, or EPS, in fiscal 2018 is in line with both our forecasts and management's guidance. We have maintained our fair value estimate of AUD 2.50 and, at the current market price of AUD 2.21, continue to believe the securities are undervalued. Our fiscal 2019 distribution forecast implies a 6.3% increase versus fiscal 2018 which is in line with management's new guidance. The market price implies a fiscal 2019 price/distributable earnings, or P/E, ratio of 16, versus 18 at our fair value, and a distribution yield of 6.1%, versus 5.4% at our fair value. As a trust, Arena's distributions are unfranked.

We were particularly intrigued that Arena's child care centre tenants managed to increase fees by 5% in fiscal 2018, which drove like-for-like revenue growth of 2% and EBITDA growth of 5%, despite a fall in their occupancy rates. Arena management also said they'd noticed a growing confidence from operators that the expected long-term positive benefits from the introduction of the child care subsidy would be felt earlier than previously expected. This contrasts with the market view that child care centre oversupply will impact operator's earnings, as implied by the relatively low earnings multiples on which child care centre operators trade. However, it is in line with our view that the introduction of the child care subsidy, or CCS, in July 2018 will benefit most child care customers and provide a significant boost to the sector.

In addition to the growth in operator's EBITDA, management said increasing competition for children was driving an increase in operator's capital expenditure. However, we're not too concerned about this trend materially impacting the operator's cash flows as depreciation and amortisation, a proxy for capital expenditure, only comprises around 4% of revenue for Goodstart and around 2% for G8 education, versus underlying EBIT margins of around 15%. We're also increasingly of the view that the worst of the oversupply of child care centres may have passed, considering Arena management reiterated comments made at the interim result in February, and more recently by Folkestone Education Trust and Mayfield Childcare, that new supply is abating and that private investors in particular are increasingly mindful of the operating environment.

We weren't concerned by the 33% fall in Arena's statutory net profit after tax in fiscal 2018 because this largely reflects a fall in the positive contribution from property revaluations which are noncash and have a degree of subjectivity and volatility anyway. Of more relevance is the 21% increase in distributable income, which reflects a combination of organic rental income growth, acquisitions, and developments. Arena also strengthened almost all its key performance indicators in fiscal 2018, including its, already relatively long- weighted average lease expiry, or WALE, to 12.9 from 12.8 years. These improvements echo similar improvements at peer REIT Folkestone Education Trust, and reflect strong underlying long-term child care sector trends, despite short-term challenges. Importantly, the oversupply of child care centres appears to be having little to no impact on the child care REITs, and Arena's tenants appear to be showing early signs of improvement.

The majority of Arena's fiscal 2018 EPS growth was attributable to child care centre development and acquisitions, with like-for-like rental growth falling to 2.8% versus an average of 4.5% over the previous four years. However, we aren't at all concerned that this drop reflects structural weakness as rental growth is impacted by the proportion of market rent reviews across the portfolio which varies from year to year. We expect an increase in market rent reviews in fiscal 2019 to help drive average like-for-like rental growth of 3.9% over the next four years.

The 18%, or AUD 108 million, increase in the value of Arena's investment portfolio to AUD 700 million reflects revaluations worth AUD 32 million and developments and acquisitions worth AUD 76 million. Arena, like other REITs has benefited from low interest rates in recent years from both a lower interest expense and the associated increase in asset values as asset yields have compressed. This thematic has been a key driver of the portfolio expansion, EPS growth, and the increase in the net asset value per share, or NAV.

Management are conscious of the benefit they've received from falling interest rates and the risk of a reversal of trends should interest rates begin to rise. However, in preparation for this possible scenario, the development pipeline has been curtailed and gearing (borrowings/total assets) lowered to 24.7% from 27.5% in the prior year, below management's target range of 35% to 45% and well within the covenant of a loan/value ratio of 50%. The interest coverage ratio of 6, as at June 30, 2018, is also comfortably within the covenant of 2. This reduces, if not removes, the risk that Arena could end up being a forced seller in a falling and illiquid market and we remain comfortable with debt metrics. Although Arena hopes to grow and diversify the portfolio in the social infrastructure sector with a likely focus on healthcare, our financial model only includes the announced development pipeline due to the wide range and uncertainty of alternative potential expansion scenarios.