The nitty-gritty of the Westfield merger

Amid all the emotion and aggression that has erupted around the proposed restructuring of the Westfield empire, it is curious how little public analysis has been done of the core critiques of the proposal. Similarly, there has been too great a focus on the 25.9 per cent of the Westfield Retail Trust votes against it rather than the 74.1 per cent of votes in its favour.

The arguments against the proposal relate to a view that WRT is being asked to over-pay for Westfield Group’s operating platform; a perceived dilution of the quality of the income flowing to Westfield Retail Trust securityholders; an apparent substantial increase in the leverage those security holders would be exposed to and a general increase in risk flowing from the combination of the exposure to development activities and the increased gearing.

The proposal involves the hiving off of Westfield Group’s Australasian operations and assets and their merger with WRT to form the Scentre Group. The underlying asset bases the two entities would contribute are essentially identical but Westfield Group would also vend in its operating platform, including the management rights it has over WRT’s interests.

At a strategic level, there has been no meaningful criticism of the logic of the proposal, which would create the largest and highest quality retail property portfolio in the region while separating it from Westfield Group’s international property ownership and development activities.

Moreover, it would internalise the management of WRT’s interests. WRT is the only one of the top 10 property trusts externally managed and bring it into line with what the market regards as the best governance structure for property trusts.

WRT chairman Dick Warburton addressed some of the criticisms of the transactions in an opinion piece published by Fairfax today and produced perhaps the most coherent response to them that has yet emanated from the Westfield camp. (This wouldn’t be hard -- the camp has done a very ordinary job of selling the transaction.)

A consistent and strong view among opponents of the deal is that WRT securityholders are being asked to pay far too much for an operating platform that generates low-quality and higher-risk income.

WRT’s independent expert valued the platform at $3 billion but Westfield Group’s decision to reduce the debt that would go into Scentre by $300 million (in an attempt to placate the opponents) lowers that to $2.7bn.

That platform generated almost $300m of earnings before interest and tax last year but KPMG discounted its project management income because of its variability to come up with maintainable earnings of $216.5m.

The point Warburton makes is that most of the platform’s income actually flows from property management fees that are actually a percentage (believed to be 5 per cent) of the gross rents generated by the underlying retail centres.

In other words, that income (about $160 million a year) is exactly the same and the same quality as the rents that flow through to WRT securityholders. Use a 6 per cent cap rate and that fee income is capitalised at $2.67bn; WRT securityholders would effectively get the development income for next to nothing.

That probably explains why Westfield Group wasn’t prepared to improve the terms of the deal by anything more than $300m.

Buying the operating platform will have a marked impact on gearing, which would rise from WRT’s 22 per cent to Scentre’s 37 per cent. It would compare unfavourably with, for instance, CFS Retail Property Trust Group’s gearing of 31 per cent. CFS Retail recently bought its management rights from Commonwealth Bank.

That comparison, however, is somewhat misleading.

CFS Retail paid cash for its management rights, so their value is included in its balance sheet and positively impacts stated gearing. The Westfield platform is being vended in for scrip and the value of the intangible assets within it aren’t included in asset backing or gearing calculations.

It is instructive that both Scentre and CFS Retail would have identical interest coverage of 3.4 times and both would have a single-A credit rating from Standard & Poor’s.

The prospect of the elevated risk posed by the exposure to Westfield Group’s development activities is also less straightforward than it might appear.

WRT might not undertake development itself but Westfield Group undertakes development of the centres in which WRT has an interest on its behalf. All good shopping mall owners are continually upgrading and expanding their centres.

In recent years Westfield Group has invested close to $2 billion in developing the centres in which it and WRT have a common interest and, as Warburton pointed out, has been paid nearly $300 million in fees by WRT for those developments.

WRT isn’t exposed to the construction risk of the developments but it is to the commercial risks associated with them, whether they generate an acceptable return from increased rental income on WRT’s share of the investments made and the fees it pays Westfield Group for managing those developments.

Whether it is indirect or otherwise, there is an existing and continuing exposure for WRT securityholders to development risk. Within Scentre, the fees associated with the developments (other than from other investors in the malls) wouldn’t exist.

It is also worth noting that most of WRT’s peers’ securities trade at a premium to their net tangible asset backing of between about 5 per cent and 10 per cent. WRT trades at a discount of about 8 per cent, so there is a potential value up-lift from internalising the management and having some exposure to non-rental income.

For some investors, of course, that’s not a positive. For investors/institutions focused purely on yield, the lower the security price the better the yield and net asset coverage.

For others -- the 74.1 per cent -- the prospect of capital growth and a double-digit accretion to their funds from operations is more appealing.

Given that Westfield Group has outlined and committed unconditionally to its fall-back strategy of spinning off its own Australasian operations independently if WRT securityholders vote down the merger proposal on June 20, the securityholders will at least have a clearer understanding of their options.

Remaining independent but externally managed while a virtually identical entity with internalised management trades alongside it at a premium to its valuation wouldn’t be a disaster for WRT securityholders. However, it probably isn’t ideal.