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Morningstar | SCA Property's Focus on Convenience Delivers a Resilient Result. FVE Unchanged at AUD 2.30. See Updated Analyst Note from 04 Feb 2019

Shopping Centres Australia Property Group, or SCA Property, delivered first-half 2019 earnings on a funds from operations, or FFO, basis of AUD 8.1 cents per unit up 7.7%. This puts it firmly on track to deliver a small beat to reiterated fiscal 2019 guidance of AUD 16.2 cents per unit, or cpu, and distribution guidance of AUD 14.7 cpu. We’ve made minor compositional revisions to our forecasts and no-moat-rated SCA Property screens as slightly overvalued, currently trading at AUD 2.48 versus our unchanged fair value estimate of AUD 2.30.

We remain supportive of the business strategy to focus on convenience-based smaller malls, typically those with a major supermarket and 10 to 15 specialty retailers. Most of the assets owned by SCA Property are in regional Australia, a long way from the distribution hubs of the major online retailers. This type of asset seems to be well insulated from online grocery retailers, who we suspect will find it uneconomic to offer same-day delivery to regional areas of Australia in the foreseeable future.

The most significant long-term pressure we see for SCA Property’s earnings is moderating growth in Australian household disposable income. Disposable income is being impacted by gradually rising mortgage costs and a deterioration in workforce composition as a higher proportion of new jobs are part-time or lower-paying jobs. We see these pressures on the household purse persisting. Consequently, we don’t see a strong catalyst for Australian retailers to benefit from a rebound in sales. Landlords like SCA Property are expected to achieve ongoing rental growth, albeit at a slow rate in the range of 2% to 3% annually.

An ongoing pressure faced by smaller malls that we think many investors underestimate is the sales dilution caused by new developments. This is particularly relevant to smaller retail assets (neighbourhood malls) where there are limited barriers to the opening of new supermarkets or neighbourhood malls in the catchment area of an existing asset. The lack of sustainable entry barriers is the major reason why we view SCA Property as not benefiting from an economic moat. This view is reinforced by SCA Property advising that six of the 10 malls recently acquired from Vicinity in October 2018 suffered from weak sales due to new competition in their catchment.

Our major takeout from the result is not to expect a rebound in rents as there appears to be little rental tension to speak of. The specialty vacancy rate on existing centres was unchanged over the past year to be 4.7% at December, at the top of the target range of 3%-5%. Comparable specialty sales growth was slightly stronger than expected, up a respectable 3.5% over the year. But there isn’t s a strong correlation between this and rents. As average specialty gross rents rose only 2% over the year to $723 per square metre, even though 84% of specialty leases have fixed rental annual increases of 3% to 4%. This implies market rent reviews were weak.

Gearing (drawn debt net of cash to total tangible assets) increased to 34.2% from 31.2% over the six months to December, a result of multiple acquisitions, partly offset by a AUD 383 million capital raise. This aligned with the midpoint of SCA Property’s target gearing range of 30% to 40% and the firm has advised it currently has a preference for gearing to remain below 35%. This level of gearing is currently able to be easily managed as average borrowing costs are 3.8% and the interest coverage ratio is 4.4 times. However, we’d like to see gearing closer to 30% as geopolitical and credit market risks both seem elevated, warranting a wider interest rate buffer.