EUR 850.00 For Business Accounts Only

Morningstar | Arena REIT in Great Shape Following 1H Result as Child Care Recovery Continues

The key takeaway from Arena’s first-half result was that the child care sector continues to strengthen following the introduction of the child care subsidy, or CCS, last July. Child care properties comprise around 85% of Arena’s portfolio by value and the combination of weak demand and an oversupply of child care centres has been a concern for investors over the past couple of years. However, the child care market is improving in line with our investment thesis, outlined in our February 2018 report "How to Play the Australian Child Care Bonanza" with management confirming the CCS is boosting demand. This helped drive an increase in Arena’s tenant occupancy rates of around one percentage point in the first half, marking a reversal of falling occupancy rates experienced across the industry in fiscal 2018.

The oversupply of child care centres is also easing with Arena claiming the industry added 275 child care centres in 2018, down from 291 in the prior year, implying an increase of around 3.7%. The reduction in new centres is likely due to the more difficult funding environment following the Royal Commission into the financial services sector and the reluctance of child care centre operators to commit to new projects. We think the industry growth rate has fallen close to a sustainable level, of about 3.5% per year, considering likely population growth, female work participation rates, and long daycare participation rates.

Management maintained full-year distribution guidance of AUD 16.5 cents per share which is also in line with our unchanged forecast. We increase our fair value estimate by 2% to AUD 2.56 per unit, reflecting the time value of money impact on our financial model. The current unit price of AUD 2.67 is fairly valued, coming with a fiscal 2019 unfranked distribution yield of 5.1%.

Although Arena's statutory net profit fell by 8% versus the previous corresponding period, this was due to smaller noncash gains from property revaluations. More importantly, distributable income increased 9%, or 6% on a unit basis which is in line with our 6% full-year forecast.

Arena’s acquisition of the portfolio of three disability accommodation properties for AUD 24 million isn’t particularly material or surprising. Aside from the fact the trust has ample balance sheet capacity, the properties fit well with the social infrastructure strategy. Arena already has a portfolio of healthcare properties leased to Healius (previously Primary Healthcare) so has expertise in the sector. Further acquisitions and development are also likely although not included in our model at this stage.

We are not concerned by the surprise departure, with immediate effect, of long-standing CEO Bryce Mitchelson. He took part in the result call and his reasons for leaving are plausible. We have no concerns his departure may reflect operational issues at the trust. The appointment of Rob de Vos, previously Arena’s head of property, as new CEO is a good choice. Mr de Vos has extensive industry experience and has been employed by Arena REIT for over six years, making him a low-risk appointment. Otherwise, the trust continues to perform very well with all key metrics moving in the right direction. Importantly, the weighted average lease expiry increased to 14.2 from 12.9 years.

Arena’s balance sheet remains in good shape, with the interest coverage ratio of 5.85 well within the covenant of 2.0. Gearing (borrowing/total assets) increased slightly during the half to 26% from 25% but remains comfortably within the covenant of 50%. There is ample headroom for development and acquisitions, in addition to providing a buffer against a downturn in real estate prices. We expect the trust to be insulated by the defensive nature of the assets which are ultimately supported by the federal government via child care subsidies. As we don’t forecast unannounced developments or acquisitions, we forecast a gradual deleveraging of the balance sheet.