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Morningstar | Goodman Loosens Development Throttle on Surging Demand. FVE up 10% to AUD 11.20

In what has now become a recurring theme of underpromising and overdelivering, Goodman Group has upgraded fiscal 2019 earnings guidance to growth of 9.5% from 7% previously. The raised guidance is mostly due to a step up in performance fees as the returns for wholesale investors in Goodman managed funds were materially above benchmark, a major catalyst being ultra-loose monetary policies and falling bond yields. After years of tight reins on its development business, Goodman has said the high demand supports a more aggressive stance and development work in progress will exceed AUD 4.0 billion after hovering around AUD 3.5 billion in recent years. The faster rate of development will have a multiplier effect on earnings, increasing development fees, but also accelerating the growth rate in external funds under management, the firm’s highest return on equity activity.

We’ve made multiple forecast revisions, which include higher medium-term performance fee expectations underpinned by across-the-board outperformance of Goodman management funds. Raised rate of development completions, feeding into higher development earnings but more importantly a faster rate of growth in external assets under management.

Our fair value estimate for narrow-moat-rated Goodman increases 10% to AUD 11.20 from AUD 10.20. At current levels, Goodman screens as overvalued, trading around AUD 12.40. We suspect the main reason for the divergence in our fair value and Goodman’s share price is our modelling an outer-year rise in bond yields, triggering a circa 20% fall in the value of commercial property (yields across the platform are at an all-time low of 5.2%) and in turn, a retracement in base and performance fees.

There are numerous attractive features of the Goodman business strategy, but at current levels, we believe the share price assumes the surging demand for logistics and ultra-high development gains will persist in perpetuity, a scenario we don’t believe is realistic.

One of Goodman’s better conceived strategies was the decision taken a few years ago to have development occur within funds rather than on Goodman’s balance sheet. Goodman initially suffered through lower development profits on the sale of assets to its funds. However, it is now being amply compensated in numerous ways. First, Goodman receives modest fees for providing development services to the funds; and second, it has been able to shrink its balance sheet as developments now occur off rather than on-balance sheet. Most importantly, the enabling Goodman managed funds to acquire assets at cost (often a discount of 20% to market value) has materially boosted the returns metrics of each fund. This in turn has flowed into higher performance fees. Goodman is reaping the rewards of this at present, with the AUD 39.6 billion of external funds achieving average returns around 15%, materially above the industry return benchmark of circa 10%. Returns comprise rents and higher asset values, which have been driven by low global bond yields. Goodman managed funds were revalued AUD 2.3 billion higher in the six months to December 2018, an increase of 6.6%.

The focus in recent years has been to operate at the pointy end of the industrial development spectrum rather than the commoditised end in shovel-ready sites on city-fringe locations. The strategic preference is on inner city sites of major cities where development approval is costly and protracted, requiring extensive negotiation with city planners. Goodman is one of a very few industrial developers that has the balance sheet, risk appetite and patience to acquire sites where time between site acquisition and first rent generation is often around five years. A major reason why Goodman can sustain long lead times is many of the investors on its funds management platform are sovereign wealth funds whose investment horizon is in decades rather than years. Development in inner city sites is currently generating superior returns as e-commerce firms are prepared to pay significant rental premiums to operate from sites that offer strategic benefits in terms of faster delivery times.