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Morningstar | Charter Halls Purge of Struggling Malls Removes Earnings Drag. FVE Increases to AUD 3.90. See Updated Analyst Note from 16 Aug 2018

Charter Hall Retail's fiscal 2018 operating earnings of AUD 123.2 million or AUD 30.5 cents per security, or cps, were up 0.4% on the prior year as expected. The tepid growth reflects earnings dilution from selling 15 lower-growth, but higher yielding properties for AUD 309 million, partly offset by AUD 215 million of acquisition. Leasing outcomes for specialty tenants are turning around with new and renewed leases negotiated 1.3% above prior leases for the year. This is better than the 0.2% leasing spread a year prior, but still points to a sector that faces challenges. Guidance is for earnings to grow by more than 2% in fiscal 2019, implying operating earnings of AUD 31.1 cps.

We've raised rental growth assumptions largely due to a stronger performance from the supermarkets and our fair value estimate for no-moat-rated Charter Hall Retail increases to AUD 3.90 from AUD 3.70. Currently trading around AUD 4.30, the firm screens as overvalued, with our forecast fiscal 2019 distribution of AUD 28.8 cps implying a yield of 6.7%.

We are increasingly warming to Charter Hall's "convenience plus" strategy. At its core, the strategy involves focusing the portfolio on malls that offer extremely high amenity, ideally with the three major supermarkets of Coles, Woolworths, and Aldi. The strategy makes sense as a mall with three supermarkets will face very low risk of a competing supermarket opening nearby. Further, shoppers appear to be making more frequent visits to the supermarket, presenting a good opportunity to garner sales for the high rent paying specialties in cafés, beauty, take-away, and pharmacy. In time, we expect medical services will become a more important feature in the tenant mix, enabling the landlord to leverage the ample car-parking facilities.

The decision to sell assets looks like it has started to deliver for Charter Hall. Net property income growth has jumped to 1.8% for the year to June 2018 as compared with 1% in the prior year. Retail sales have similarly improved. Supermarket sales and specialty sales for the year are both up, to 2.8% and 1.4%, respectively. The specialty sales figures still trail landlords whose portfolios are in the major east coast cities, highlighting the significant disparity in spending power, population, and salary growth between regional Australia and the commercial hubs.

Even though specialty leases in the portfolio are reported to contain fixed annual rental escalators averaging 4.2%, we think long-term rent growth will be significantly lower. First, sales for specialty tenants have been growing at a far lower rate for some time, which means rents are eroding retail operating margins for many tenants. Second, household spending has been buoyed by extremely stimulatory monetary and fiscal policies for some years. The eventual windback of these will impact household disposable income and in turn retail sales, but most particularly discretionary spending. Third, unemployment across Australia is very low and at some point in the next decade is likely to rise, putting pressure on the retail sales as a higher proportion of households become dependent on government handouts.