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Morningstar | Still No Sign of Kick in Consumer Spending in the Scentre; FVE Unchanged at AUD 3.85

Scentre Group reported first-half fiscal 2018 funds from operations, or FFO, of AUD 12.38 cents per security, up 3% on the prior corresponding period. Distribution growth was lower at 2% to AUD 11.08 cents per security for the half as Scentre retains more cash to help fund developments. Our fair value estimate is unchanged at AUD 3.85. At current levels Scentre screens as fairly valued, with the guided 2018 distribution of AUD 22.16 cents per security representing a yield of 5.3%. Forecast revisions are minor, including slightly raised expectations for redevelopment projects at Eastgardens in inner Sydney for AUD 720 million.

Specialty sales remain sluggish, with sales for retailers under 400 square metres up 0.9% for the year. This is in sharp contrast to the 3.6% growth reported for specialties over 400 sqm. We see the divergence being mostly due to sales cannibalisation of smaller fashion retailers by low-cost international giants like H&M, Zara, and Uniqlo. The unresolved challenge is how to level the playing field with the larger-format retailers, which can negotiate better rental deals by reason of their scale and ability to lure foot traffic to the mall.

Sales performance has slightly improved over the past six months, with trailing six-month sales for all specialty (under and over 400 sqm) up 2.1% versus trailing 12-month sales growth of 1.6%. We had expected a stronger showing from the specialty retailers across Scentre’s portfolio, given low unemployment and management's efforts to remix to more contemporary categories.

There were very few categories with solid results. The strongest performers over the six months to June were fashion, general retail, and retail services, which were up 3.3%, 7.6%, and 3.3% respectively. The weak categories were technology and appliances, cinemas, and department stores, down 0.7%, 2.6%, and 0.4%, respectively. Supermarket sales were weak, up 0.8% over the 12 months to June and marginally down on the 1.1% comparable sales growth reported by Coles food and liquor division.

Scentre’s sales results point to a cautious consumer, particularly given the backdrop of a growing Australian population, increasing household densities, and modest growth in consumer prices. This is not altogether surprising, given anaemic wages growth, falling house prices, and rising costs of living.

Scentre reiterated guidance for full-year growth in net rental income of 2.5%-3.0%. Moderating growth is mostly due to lower inflation, as most specialty leases contain annual escalators of CPI plus 2%. But it also reflects headwinds to tenant sales growth and short-term leasing at malls that are about to undergo redevelopment. The longer tenant sales trail rent growth, the more likely it is that Scentre will have to reduce rents when leases come up for renewal. We still forecast long-term rental growth around 2.5% across the portfolio. This is at the bottom end of Scentre’s current 2.5%-3% near-term rental growth guidance and may explain why our fair value estimate is 9% below Scentre's current share price.