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Morningstar | Scentre Taking the Fight to Evolving Retail Landscape. FVE Unchanged at AUD 3.85

Scentre Group reported 2019 earnings on a funds from operations, or FFO, basis of AUD 24.24 cents per security, up 3.9% and in line with guidance from a year ago of 4% growth. Guidance is for growth in comparable net operating income of 2.5%, FFO growth of 3%, and distribution growth of 2% to AUD 22.6 cps. We’ve made minor revisions to our forecasts to account for the timing of the delivery of AUD 810 million of redevelopments in the second half of 2018. Our forecasts align with guidance. There was nothing in the result or outlook that significantly impacted our view of narrow-moat-rated Scentre and we leave our fair value unchanged at AUD 3.85. At current levels, the stock screens as fairly valued.

Like retail landlords across the globe, Scentre is facing fast-evolving consumer spending patterns. The common thread is more sales--and especially discretionary retail--are going though online channels, hurting the high-margin specialty retail categories of apparel and jewellery. Further, the consumer basket has evolved with far more spent on consumer electronics, a category where the landlords take of the tenant sales is comparatively small. While overall specialty sales of malls may have held steady, some are doing exceptionally well and others are struggling. Further, younger consumers especially are less inclined to visit the mall preferring instead to spend more time on screens. The landlords' challenge is to redevelop or remix the mall in a way to attract more customers or get those who visit the malls to stay longer, in an attempt to increase their spend per visit and hence lift mall sales and support rents. Scentre is no different to peers, elevating entertainment and dining, but this comes at a cost and also needs a corresponding lift in foot traffic to support a significant increase in restaurant area.

The remixing towards contemporary categories also comes at a cost as many of the new categories or tenants have a lower rent-paying capacity than the outgoing tenants. This is no more evident than in leasing, where new and renewed leases were negotiated at rates 3.5% below prior levels even after investing AUD 112 million in lease incentives and maintenance capital expenditure, a full 8.5% of FFO.

We think Scentre is making the best of its opportunities, but it is hard to swim against a strong tide. We forecast Scentre to generate ongoing rental growth, but at a far slower rate than the landlord has been able to achieve until consumer spending changed. Key assumptions that underpin our AUD 3.85 fair value are rents to grow at a compound annual growth rate of 2.2% over the next decade and the firm invest 0.55% of the value of its malls annually into tenant incentives and maintenance capital expenditures. We assume this level of lease incentive enables the landlord to maintain occupancy around the 99% level. We also forecast annual investment in expansionary capital expenditures of AUD 360 million annually generating a stabilised yield on cost of 7%.

Notwithstanding the challenges in retail, Scentre, which has a high weighting to discretionary retail categories has been generating respectable sales performance, with many. Should the Australian or New Zealand economies face a period of economic contraction, we’d expect a sharp-pull back in discretionary retail spending, hurting sales in Scentre more than the retail REITs whose tenant register is predominantly nondiscretionary retailers.