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Morningstar | SCA Property Delivers Solid Result in Sluggish Retail Environment. FVE Increases to AUD 2.30

Shopping Centres Australia Property Group, or SCA Property, delivered a clean fiscal 2018 result, with earnings on a funds from operations, or FFO, basis in line with expectations, up 4.1% to AUD 15.24 cents per security, or cps. Sales and rental outcomes for the speciality tenants were above expectations at 3.3% and 2.3%, respectively. An improved outlook for specialty retail rents is the primary reason behind the small upgrade in our fair value estimate to AUD 2.30 from AUD 2.22. At current levels, no-moat-rated SCA Property screens as broadly fairly valued, with the guided fiscal 2019 distribution of AUD 14.3 cps implying a yield of 5.9%. Guidance is for fiscal 2019 FFO of AUD 15.6 cps, but our forecasts are marginally higher at AUD 15.7 cps on better than expected outcomes in specialty leasing and borrowing costs.

Sales performance for the supermarkets was robust, up 3.4% (when development impacted supermarkets are excluded), demonstrating an unwavering demand for convenience-based supermarkets. Our long-term forecasts remain for supermarket like-for-like sales annual growth of approximately 3%, with rents growing a similar amount.

Discount department stores have staged a turnaround in performance of late, with comparable sales growing 1.9% for the year to June compared with a decline of 4.3% in the previous year. But we view this as a temporary recovery, with this retail subsector expected to suffer over the longer term from further growth in online retail.

The key growth driver going forward is expected to be specialty retailers, where rents are very affordable at AUD 716 per square metre or 9.8% of sales. We take some comfort in evolving retail spending patterns, where customers visit convenience malls to perform smaller shopping trips more frequently. Providing this continues, this will provide ongoing sales momentum for the low-cost specialty retailers, such as pharmacies, cafés, and those providing health and beauty services.

We continue to see attraction in the business model of SCA Property, which is to focus on shopping centres that offer a higher convenience through ease of access and a range of supermarkets. Nonetheless, there are still a series of risks that provide reason for caution. Household spending and employment in many sectors in Australia have both been buttressed by extremely stimulatory monetary policies that are in the early stages of being unwound.

The eventual gradual normalisation in interest rates will impact employment and household disposable income. An expected fall in employment and rise in borrowing costs will also pressure federal government finances and most likely result in a rationing in government handouts. The timing and rate of change of interest rates is highly uncertain but in the unlikely event, should rates rise quickly it will impact sales in some of the more discretionary retail categories, weighing on rents. We account for this risk by forecasting specialty rents rise by 2.8% over the longer term rather than the 3%-4% implicit in most specialty leases.

A rise in borrowing costs will hurt through downwards pressure on property values. Yield-focused wholesale investors will also likely reallocate capital away from property stocks towards bonds, which will weigh on the share price of SCA Property and all other REITs.