Westfield's $7 billion puzzle

Has Frank Lowy, the billionaire behind the Westfield group lost his touch? Many shareholders might be asking themselves the same question if its recent stock performance is anything to go by.

After many years of strong growth the property group, which has built a legion of loyal private investors, has suffered a weaker share price as the wider market powered ahead. The stock is changing hands for about $19 – below the recent rights offer price of $19.50 and about where it was last October.

Flagging retail support for the stock was highlighted when a $3 billion capital raising was largely ignored by retail investors. Under the terms of the raising, shareholders were offered two Westfield shares for every 23 they already held. However, underwriter Goldman Sachs JB Were recently reported that retail shareholders took up only 30% of the allocation.

Westfield's exposure to the US has hurt the operation as the greenback weakens in relation to just about every major currency around the globe: in the past six months Westfield has been one of the weakest performers among the leading LPTs in terms of price growth.

Meanwhile, lagging yields are threatening to work against the world’s largest retail property group. Forward looking estimates have Westfield with a grossed up yield of 5.7% versus a sector average of 6.4%.

Is Lowy behind the pack or way ahead of the game? It’s a question that’s been puzzling analysts and investors alike.

One of the factors driving the Westfield price down has been the sheer volume of capital being raised by the group. Over the past six months Westfield has amassed about $7 billion. Officially, the company has stated that it needs the equity for its five-year plan '¦ but what does this really mean?

With Lowy keeping quiet on details, the market watches as one of the most brilliant players in the property market holds $7 billion close to his chest. Could Westfield be courting an approach from private equity? Or is it planning to do some acquiring of its own?

So far this year, the S&P/ASX 200 Property Index has fallen about 8.4%. In the US, real estate investment trusts have suffered just as much with the Dow Jones REIT index Wilshire dropping 6.3% to date.

Meanwhile, despite the sluggishness in the sector there have been some spectacular private equity deals. In November 2006, private equity outfit Blackstone kicked off the current period of consolidation with the $US39 billion purchase of Sam Zell's Chicago based Equity Office group. Back in Australia, Morgan Stanley Real Estate put together a $6.6 billion bid for Investa as recently in May 2007.

So what are the options for Lowy and the team at Westfield to unlock value in the weakened share price? A report from Merrill Lynch analyst John Kim outlines several options:

• Booking profits from development by selling projects into funds. Westfield established its $1.25 billion UK Shopping Centre Fund last month. The fund contains a 25% interest in four shopping centres in the UK, which it has spun off into wholesale funds for base, property and management fees. This also allows the company to bank the rises in net asset value, which would otherwise be difficult to capture.
• The acquisition of a either a UK or US-based real estate investment trust (REIT). In the past, Westfield has said that it would not pursue growth via China and there’s no evidence to suggest that this is about to change. The report names five possible REIT targets: $US2.7 billion Taubman, $US5.5 billion Macerich, $US4.4 billion Federal Realty, the $US13.6 billion Hammerson and the $US7 billion Liberty International. Although Westfield is only sitting on $7 billion worth of equity, a mild gearing ratio of 50% could see it take out any one of these operations.
• A dual listing on the New York Stock Exchange (which is unlikely given that Westfield ADRs already trade on Wall Street). Kim also runs the numbers on the potential for private equity partnership and management buyout. While Sam Zell's Equity Office Property deal showed everyone that 'no deal is too big’ for private equity, it is hard to imagine a scenario that would see the Lowy family selling down their stake. Nevertheless, Kim assumes a takeout price of $25 which is roughly a 30% premium to today's (August 8) intra-day price of $18.92

Anyone entertaining the idea that Frank Lowy might be considering taking his company off the market after 47 years might want to consider just how tightly investment grade property is held in Australia. The Lowy family owns about 9% of the company, according to the share register; Australian institutions own the bulk of the company and, as we saw with the spoiled takeover of Qantas, these institutional investors are certainly not shy about holding out on a deal when it suits them.

What’s more likely is that Lowy continues to bank profits from spinning developments into funds, generating fees all the while. Westfield has another 38 projects listed on its books outside of those 20 projects scheduled to start this year.

Still, with some of these projects already spun off into funds, is the $7 billion equity war chest really necessary?

A report from Macquarie Bank dated June 13 notes that Westfield’s current focus of spinning off assets while raising capital at the same time and asks whether this is really necessary given its development schedule. “Management noted it is investigating a $US1.5 billion US wholesale fund. Given this, we don’t see the need to raise this amount of money and therefore ponder whether a large acquisition might be on the horizon”. Overall, the big brokers remain divided: Deutsche Bank, Merrill Lynch and Citigroup have a Buy on the stock, while JP Morgan, UBS and Macquarie all have Neutral.

Westfield hasn’t so much lost its way, but rather the law of diminishing returns has finally caught up with the $37 billion monster. With organic growth becoming increasingly difficult, Lowy has succeeded in creating a huge deal pipeline and massive pile of equity offering extraordinary flexibility in a period when cash is becoming increasingly difficult (and more expensive) to raise.

Investors may not be thrilled with the yields offered by Westfield, but at the very least they should be pleased with the possibilities. Westfield is cashed up, trading at a serious discount with a very stable and respected management team in place. In a time where many listed property trusts in Australia are relying on increasing property valuations to prop up distributions, Westfield has proven methods of banking rises in net asset value.

Anyone who chose to ignore the two for 23 rights issue at $19.50 would be confident now that they made the right decision. But investors with a view to the long term would know that it would be premature to write Westfield off just yet. And Frank Lowy's 50 years of experience in the retail sector is a testament to that.