EUR 850.00 For Business Accounts Only

Morningstar | URW Updated Forecasts and Estimates from 18 Jul 2018

We initiate coverage of Unibail-Rodamco a France-based REIT that recently merged with Westfield Corporation. We ascribe Unibail a narrow moat rating and expect no major changes in the company's competitive positioning. The moat source is efficient scale, which is where a market is effectively serviced by existing players and potential competitors are dissuaded from entering as doing so would depress returns for all players. In the case of shopping centres, once a large mall is established, there is little incentive for a new entrant to attempt to similarly service the same market. Our fair value estimate for Unibail-Rodamco Staples Securities is EUR 177, with the firm assessed as having medium uncertainty and a Standard stewardship rating. Unibail is close to fairly valued, with the securities currently trading at a modest 5% premium to fair value.

Unibail-Rodamco is the largest listed commercial property company in Europe, with the portfolio allocated 87% to shopping centres, 7% to offices, and 6% in convention centres. The portfolio is skewed to OECD countries, with major geographic weightings at 37% France, 22% United States, 7% U.K., and 6% Germany, with the 28% balance spread throughout continental Europe. Around 90% of earnings are rental in nature, with the 10% balance derived from provision of fund management, leasing, and property development services to coinvestment partners.

The retail portfolio comprises stakes in 104 shopping centres, with around 85% of rent derived from the "flagship malls" Unibail's term for its larger more dominant malls that capture a high proportion of the retail trade in the catchment area. In most respects, Unibail's strategy mirrors that of Westfield Corporation, which is to own malls in built-up areas with an affluent demographic. Unibail strives to make its malls "iconic" shopping destinations with a vibrant tenant mix.

The tenant mixing strategy includes a heightened focus on entertainment and dining, with an aim to increase visitation rates and extend the dwell time. We see this as a credible strategy as the affluent demographic has high disposable income which has been increasing faster than the broader population in recent years. Further, this cohort has high levels of discretionary spending less sensitive to economic cycles.

Redevelopment of existing assets remains a potential upside catalyst for earnings and our fair value estimate. Unibail has ample development opportunities with an identified development pipeline of EUR 12 billion. Yields for the developments under way and those in the near-term pipeline are expected to be earnings- and value-accretive. If we exclude future development opportunities from the EUR 12 billion identified and beyond, this would reduce our fair value by approximately 10% from our valuation. The shopping malls are used exclusively for retail purposes, but there are options to develop apartments and/or offices above many of the better-located malls. The existence of efficient transport infrastructure adjacent to many of the malls is a big positive for the business case of developing above existing malls.

The tenant mix includes a high weighting or designated precinct focused on retailers selling luxury and aspirational products. This is underpinned by the global trend for luxury retailers to operate physical stores in close proximity to each other in a limited number of luxury precincts. Examples of this include Fifth Avenue, New York; Bond Street, London; Via Monte Napoleone in Milan; Avenue Des Champs-Elysees, Paris; Ginza, Tokyo; and Causeway Bay, Hong Kong. Unibail has developed or is repositioning its malls to become luxury retailer precincts. This supports high sales productivity, rents and also creates a backlog of demand from up-and-coming retailers. The focus on tenants with aspirational products supports foot traffic as the mall will attract customers outside the normal trade area.

Unibail has a strong customer value proposition and benefits from powerful entry barriers. Nonetheless, the business faces a series of company-specific and industrywide risks that could materially impact medium-term earnings and distributions. First, following the Westfield merger, financial leverage is very high resulting in an outlook highly sensitive to interest rates. We estimate a loan/asset ratio of 48% and net debt/EBITDA of 11 times. Unibail plans to sell noncore European assets and most of the U.S.-based regional malls to deleverage over the next one to three years. The high level of debt is currently able to be comfortably serviced as borrowing costs are exceptionally low, around 1.5%, and the weighted average term of debt is seven years. But if interest rates were to rise sharply, asset values will fall and the firm will receive less than anticipated for the assets slated for sale. The gradual blending in of higher borrowing costs will reduce earnings available for distributions. Further, the high household indebtedness across Europe, the U.S. and the U.K., means discretionary retail spending is likely to fall as bond yields rise. This will impact in mall sales and the rental growth trajectory.

The second risk is industrywide and relates to sale leakage to online retailers. This impacts tenants' sales productivity and the rate at which the landlord can raise rents. This threat will not abate, rather intensify as brick-and-mortar retailers are at a competitive disadvantage to online retailers, with the latter paying significantly lower rent per unit sold and high sales staff overheads. Unibail is responding to the challenge of online by replacing Internet-impacted retailers with new retailers, many of whom sell food services or general services (medical, fitness and beauty including hair, nails and massage). These services provided by these new retailers are more labour-intensive than stores selling product and hence are likely to have lower operational leverage and by extension, pay lower rents. We attempt to account for the downward pressure on rents from remixing and sales loss to online retailers by assuming retail growth slows from the current 4.3% to 2.8% a decade from now.

Our narrow economic moat rating for Unibail-Rodamco is premised on the large and dominant malls benefiting from efficient scale. New entrants are dissuaded from building new larger-format malls in Unibail's catchment due to the higher relative cost to add new supply and likely oversupply given the asset size required to reach an economic scale. These barriers would depress expected returns on capital, particularly for the prospective new entrant. Their scale and dominance of malls in the catchment area generates high patronage and supports the development of dedicated or adjacent transport routes, which drives footfall and reinforces the moat. Unibail's strategy to focus on assets in built-up areas means land is inherently expensive and it is also very rare to be able to procure land parcels of suitable size to develop a competing mall.

There are also traces of competitive advantage from intangibles. Aspiring competitors are discouraged by long lead times and regulatory approval is inherently difficult to develop a competing asset nearby due to the disruption it causes to traffic flows. It is common for regulatory approvals encompassing traffic flow assessments and design plus social impact studies to exceed five years. Construction typically adds a further three years.

Unibail's capital structure comprises Unibail-Rodamco stapled securities (denominated in euros traded on Euronext Paris and Euronext Amsterdam) and Unibail-Rodamco CDIs tradable on the ASX and denominated in Australian dollars. Each 20 CDIs represents a beneficial interest in one Unibail-Rodamco stapled security. The Australian listed CDIs have a beneficial interest of 23.9% in Unibail-Rodamco, but do not have voting rights.