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Morningstar | Putting Customer First Provides Goodman With Long Growth Runway. FVE Increases 14% to AUD 10.20

Goodman Group's fiscal 2018 operating earnings rose 8% to AUD 46.7 cents per security, or cps, marginally above guidance and our forecast. Compositionally, this was a strong result, with Goodman beating our expectations for growth in assets under management, or AUM, and margins on development completions. Upgrades to our forecasts for management fees, development margins and rents, results in a 6% and 12% upgrade, respectively, to our fiscal 2020 and 2021 EBIT forecasts. Our  fair value estimate for narrow-moat-rated Goodman increases 14% to AUD 10.20. Goodman screens as fairly valued, currently trading at AUD 10.60. Guided fiscal 2019 earnings (adjusted for forthcoming dilution of staff options) is AUD 50.0 cps, implying growth of 7% and a forward P/E of 21.

We've raised our fiscal 2019 earnings forecast by 2% to align with the guided 7% growth and we've also raised outer year growth assumption for AUM on the surprisingly large 11.4% jump in external AUM in the six months to June to AUD 35.1 billion. Rent growth across the portfolio accelerated to 3.2% over the year. This is a strong growth rate for logistics, reflecting the surging demand from online retailers and Goodman's strategy to focus on sites in strategically important locations. We don't see this level of rent growth being sustained for long. Our long-term annual rental growth assumption is 2.0% to 2.5% for fiscal 2023 and beyond. EPS has grown at a six-year CAGR of 7.4% and our forward forecasts imply a 10-year forward CAGR of 5.3%.

The strategy put in place by management a few years ago is delivering above expectations. Goodman formerly performed development on its own balance sheet and sold most of the completed assets to funds it managed and collected a development profit in the process. Under the revised strategy, the developments are occurring in the funds themselves, with Goodman collecting a development management fee of circa 5% plus a performance fee if the development achieves prescribed hurdles on completion. This is a fundamental change as the lion's share of the development profits do not vest with Goodman, rather external investors on the Goodman property management platform.

The transition to this approach has weighed on earnings in Goodman's development division. The compensation for this comes first from lower gearing, with Goodman gearing now at 5%, and 16% on a look-through basis. Second, business risk has reduced materially as an increasing proportion of the development and leasing risk has been transferred to the funds. The silver lining in this strategy is funds on Goodman's property management platform are acquiring assets far cheaper than previously. This provides a significant boost to fund performance (which includes revaluation gains). The AUD 35 billion of external assets generated a return for the past year of 15.0%, 14.4% in fiscal 2017 and over 20% in fiscal 2016. This outperformance has resulted in a large build-up of performance fees, that will be released over the next five-plus years. The performance fees in the year gone were approximately AUD 100 million, up over 250% on the circa AUD 35 million for the previous two years.

Not all funds are assessed against performance benchmarks each year (generally occurs every three to five years), but there is substantial cumulative outperformance for the remaining funds. Providing there is no major event impacting asset values, management expects performance fees to track around current levels for a few years. We have assumed performance fees as a percentage of AUM gradually decline materially in outer years, mainly due to an unwinding of the very favourably tailwind of ultra-low interest rates. But the effect of annual lower performance fees (in basis points) will be compensated for in outer years by a substantially large base in fee-generating assets.

Goodman's AUM look set to rise by AUD 3.5 to 5 billion annually.
Around AUD 3 billion of the logistics facilities that Goodman develops annually are acquired by funds on Goodman’s property management platform. The assets on the platform also increase in value, broadly in line with the annual growth in rents, or 2% to 3.5% (assuming capitalisation rates remain stable). When this asset value appreciation is applied to the AUD 35 billion in funds under management, Goodman's fee earning base increases by a further AUD 1 billion each year. Our long-term forecast assume rents grow by 2.5% annually, but property values and Goodman's externally managed assets decline by 10% due to an eventual rise in interest rates. If we incorporate a 15% decline in external AUM due to a 50 basis point increase in capitalisation rate over fiscal 2022 to 2023, this detracts AUD 30 cents or 3% from our fair value estimate.