Staying the centre of attention

Westfield has built a global empire on what economist Joseph Schumpeter called "creative destruction". Fresh-but-flimsy retail concepts, such as stationery retailer Smiggle and Ghermez Cupcakes, in effect subsidise larger "anchor" tenants, such as department stores and supermarkets, which bring in traffic. These "specialty" stores deliver 96 per cent of Westfield's US income (83 per cent in Australasia).

The big question following the collapse of book seller Borders isn't whether new retailers will continue to emerge - they will - but whether they'll do so in Westfield shopping centres or on the internet.

Specialty stores

When old concepts fail, Westfield has little trouble attracting new tenants. Westfield has hardly had a vacancy in its Australian and New Zealand shopping centres since 1996, while rents have increased from about $850 a square metre in 1996 to about $1400 last year.

It has been successful at maintaining high occupancy and, at the same time, increasing rents.

Like airport owner MAp group, shopping centres are high-fixed-cost businesses; they are expensive to build but cheap to operate.

Once fixed costs are covered, most of the additional revenue adds to the bottom line. That's how Westfield consistently produces profit margins above an eye-popping 70 per cent.

Much of that comes from specialty retailers that pay up to six times more rent than anchor tenants. Herein lies Westfield's problem: not only are specialty retailers more likely to move online than department stores and supermarkets, the rents they pay add to their argument for doing so.

It would take only a small number of specialty retailers to abandon Westfield, or merely force through lower rents, for it to have a big impact on profits and distributions.

A 5 per cent fall in average specialty rents would cut Westfield Group's profits and distributions by 8 per cent. A 10 per cent fall would deliver a 16 per cent fall in profits.

That sensitivity helps explain why tough retail conditions for Harvey Norman and Billabong, for example, have shaved 10 per cent off Westfield's share price since January.

Ahead of the game

"I skate to where the puck is going to be," ice hockey legend Wayne Gretzky said, "not where it has been." Like Gretzky, Lowy brothers Steven and Peter (now joint chief executives) are positioning Westfield to minimise the impact of the online threat before it gains real momentum.

Westfield's online strategy includes a virtual mall website, Twitter and Facebook accounts and smartphone applications that can be used to advertise sales, buy products or help to find stores. All should foster loyalty with a new generation of shoppers.

Sensible as it is, this strategy alone won't save Westfield's luscious margins. The fight to protect them is taking place on other battlegrounds.

First, Westfield's flagship centres are attracting new outlets that previously wouldn't go near them.

At the top end, brands such as Louis Vuitton, Chanel and Prada, which are far less vulnerable to online substitutes, are signing up.

The addition of upmarket brands, quality fitouts and restaurants and bars make Westfield centres places of entertainment that attract a broad demographic, making them less vulnerable to the online threat.

At the opposite end of the spectrum, discount membership warehouse retailer Costco is now a significant drawcard, anchoring three shopping centres in California. This helps offset the potential decline of stores most exposed to the online threat, especially electrical retailers.

Westfield is also concentrating on developing destination-style centres, such as in Sydney's central business district and Westfield London, and finding new ways to increase returns on capital.

It's divesting poorly performing US shopping centres and taking on financing partners for flagship centres such as the #1.45 billion ($2.2 billion) Stratford development at the site of next year's London Olympics. That frees up cash for new developments while delivering management and development fees. It adds up to a coherent, sensible response to online retailing.

"You don't have to predict the future," says US fund manager Bruce Berkowitz, "if you know the company has the assets and management to do well in difficult times." That sums up our view of Westfield Group, a company that retains its place on our buy list and is the cheapest it has been in years.

Nathan Bell is research director at Intelligent Investor. This article contains general investment advice only (AFSL 282288).