EUR 850.00 For Business Accounts Only

Morningstar | Investor Demand for BWP’s Properties and Defensive Distributions Drives FVE Increase to AUD 3.30. See Updated Analyst Note from 22 Nov 2018

A change in analyst prompts an increase narrow-moat BWP Trust's fair value estimate to AUD 3.30 from AUD 2.85 per security.

Our new fair value accounts for the difference between BWP’s contracted rents and estimated market rents as well the fair value increases in its properties driven by continued strong investor demand which we expect to persist subject to an adverse market event. The company’s long duration lease agreements to Bunnings, the undisputed leader in Australian home improvement retailing, provide for annual rent increases tied to Australia’s consumer price index, or CPI, as well as fixed increases, with market rent reviews on individual properties about every five-to-10 years capped at 10%. While this provides investors with a relatively defensive rental stream, the contracted rent may not be reflective of current market rents. BWP’s properties have consistently increased in value and it recently agreed to sell four properties in fiscal 2019, all at amounts higher than their recorded fair values, resulting in realised profits of about AUD 10 million.

We expect these profits to be distributed to security holders and our new modelling attempts to account for these type of fair value increases. Our new fair value is derived from a combination of our discount cash flow model, a regression model that used the trust’s end of financial year net tangible asset per security as the independent variable and price as the dependent variable over the last 20 years, dividend yield, plus price to fund flow from operations, or P/FFO. At our new fair value estimate, the trust has a fiscal 2019 P/ FFO of 17.8 times, the same as its average P/FFO over both the last three and five years and has a fiscal 2019 dividend yield of 5.5%, equivalent to its average dividend yield over both the last three and five years.

Although there is concentration risk in having one business generate most of its rental income, we believe having a strong investment-grade tenant like Wesfarmers (owner of Bunnings), which is intending to focus more investments into growing its Bunnings business, more than offsets this concentration risk. Wesfarmers recently divested its major Australian grocery business Coles via an IPO and sold its home improvement business in the United Kingdom, making Bunnings its key growth business. Wesfarmers stated intention is to open 10-to-14 Bunnings stores per year into the foreseeable future and invest in upgrading its existing Bunnings properties, including those owned by the trust.

Wesfarmers has strong bargaining power over the trust but in practice has treated the trust as an important capital partner. We believe this is because of its long 20-year relationship with BWP and due to the trust now owning 66 properties that are key to Bunnings operating performance. Store location is a critical aspect to Bunnings’ operating success and Wesfarmers undertakes extensive due diligence in identifying and buying store locations, developing them and then entering into a sale and leaseback agreements with entities such as the trust. Wesfarmers has the balance sheet capacity to acquire properties but because it generates much higher returns in its Bunnings business than from owning properties, we expect it to continue to take this capital-light approach.

In fact, we believe the trust’s contracted leases with Bunnings provide it with a narrow economic moat. This proposition was recently tested when Bunnings' major competitor: “Masters” closed-down. Bunnings only sought to secure 11 of 63 Masters properties, reflecting the strength of Bunnings' existing locations. While this led to Bunnings vacating some stores owned by the trust, and moving into previously owned Masters’ locations, this was a unique situation. Notwithstanding, it only had a minimum impact to the trust’s performance because the lease agreements provide for rents to be paid up to the end of the lease term irrespective of whether Bunnings was operating at the location. Therefore, while on occasion land may become available at a reasonable price which is also at a more suitable location than a Bunnings' property owned by the trust, these tend to be relatively rare such as during the GFC or with Masters closing down. The trust has also proven successful in either finding alternate uses or divesting these properties without materially impacting its returns.

One concern we have is that the trust is an externally managed REIT, with management fees linked to the value of assets. We generally do not like these structures because they may incentivise management to acquire potentially overvalued properties. However, we don’t believe this has occurred. We think management has shown discipline in not acquiring any new properties since fiscal 2015 and taking advantage of strong demand for warehouse properties by selling a handful of properties. We believe this is sensible given the compression in cap rates on new Bunnings properties, which have fallen significantly from between 7% to 8% from the period 2011 to 2013 to now be about 5% to 5.5%. The last acquisition the trust made was a property in Melbourne during fiscal 2015 which was bought on a cap rate of about 6.5%. The lack of acquisitions and its recent divestments may place some pressure on rental income growth in the near term, but we believe distributions should continue to be supported by realised capital profits, contracted rental increases on existing properties and proposed upgrades on some of its existing properties.

We also agree with management’s strategy of maintaining a strong balance sheet. At the end of fiscal 2018, the trust had low gearing (debt/total assets) of 19.3%, slightly below its target gearing of between 20% to 30%, and high interest cover (earnings before interest/interest expense) of 6.5 times. It also has an investment-grade issuer credit rating of “A3 Stable” from Moody’s Investors Service and “A- Stable” from Standard & Poor’s. Combined with its defensive recurring rental income stream, we believe the trust’s strong balance sheet and investment-grade credit rating provides it with the flexibility to take advantage of investment opportunities if they present themselves. Overall, the trust’s management have proven to be good stewards of securityholder capital since inception of the trust in 1998. This is reflected by the strong returns generated since inception, which have been significantly higher than both the ASX All Ordinaries Accumulation Index and the S&P/ASX 200 Property Accumulation Index.