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

Scentre Group’s first-quarter 2019 operating update revealed the structural challenges for retail landlords persist unabated. The tough environment is clearly evidenced in specialty retail sales up just 1.3% for the year to end March and for the March quarter in isolation up 0.8%. While sales performance was lacklustre, it was nonetheless pleasing to see all but three of the 15 retail categories report positive--albeit low-single-digit--sales growth.

Our unchanged 2019 forecasts align with reiterated guidance for growth in funds from operations of approximately 3% and distribution growth of 2% to AUD 22.6 cents per security. Narrow-moat-rated Scentre Group is fairly valued, currently trading in line with our fair value estimate at AUD 3.85.

We continue to forecast the weak sales performance will persist for the foreseeable future reflecting ongoing evolution in consumer spending patterns. The most profound of which is the increasing proportion of consumer spending occurring through digital channels. This is well advanced and Scentre (and most other landlords) have responded by reducing floorspace allocated to smaller fashion retailers and increasing the floor space allocated to health services and dining. In the short-term this is a credible strategy, but there are limits as each additional unit of space allocated to dining dilutes the sales of existing restaurateurs and hence their rent-paying capacity. Long-term success of this strategy requires increases in foot traffic. The problem is foot traffic for most malls is hardly growing, a major headache for landlords and a key factor why we forecast very low outer-year rental growth.

Aside from recent sales performance data there was no information of consequence in the release accompanying the quarterly update. Scentre Group has only one major development project underway, the NZD 790 million expansion of Westfield Newmarket in Auckland (50% owned by Scentre). The firm reiterated its future development pipeline continues to exceed AUD 3 billion and targeted development yields continue to exceed 7%. Assuming the completed developments are valued at a 5% yield, a AUD 3 billion pipeline generating 7.5% yield on cost has an embedded value of approximately AUD 1.5 billion equivalent to AUD 28 cents per security.