No time to bail on Unibail

Make no mistake, the retail property industry is facing its biggest test since Victor Gruen, an Austrian-born architect who emigrated to the US, designed the first outdoor suburban shopping plaza near Detroit in 1954. Lower prices for many goods and services, rapid growth in online shopping, and high rents are conspiring to send many retailers bankrupt. 

The Lowy family, which started building the Westfield empire over 50 years ago, saw the writing on the wall and sold its flagship US and UK stores to French shopping centre owner Unibail last year. We should've paid them more respect but, instead, upgraded Unibail-Rodamco-Westfield - the merged entity - shortly thereafter (Buy - $14.24).

Since then, the company has announced weaker than expected results in the US and UK and a major profit downgrade earlier this year. As a result, the share price has been grinding lower and now sits about 30% below our original Buy price. To make matters worse, Australian investors have been irked by a French withholding tax administration issue exacerbated by custodian Computershare. 

Green shoots?

Still, Unibail's latest results suggested some resilience.

Like-for-like rental income increased by 3.3% across the portfolio; tenants achieved sales growth in the mid-single digits; and flagship stores achieved re-leasing spreads (the difference between old and new rent for the same space) of 13.8%. These numbers were above national sales indices - which provides some evidence that premium properties are holding up better than average ones.

Management also highlighted the 'strong impact of the deliveries of the Tesla Model 3', which provided a 2% boost to sales across the Continental European portfolio. It shows Unibail is adapting by introducing new retailers, although we can't be sure this isn't just a sugar hit.

Footfall across the portfolio also increased by 3.2% and management even upgraded earnings guidance by 2.5% to between €12.10 and €12.30 - albeit largely due to a lower cost of debt. 

These are decent numbers but the share price has continued to fall. What gives?

For starters, the news wasn't all good. Unsurprisingly, net asset value fell 2.6%. The current 43% gap between the company's net tangible asset value (NAV) and share price suggests NAV is overstated. After all, if it were reliable, the entire portfolio should be sold to realise a 80% profit for shareholders. We'd expect further lower revaluations to come, subject to changes in vacancies, rents and/or interest rates. That's problematic as it means gearing is likely to rise, which increases the odds of further asset sales.

Management has also reduced its development pipeline by 10%, while pivoting towards more office and residential property to complement its retail centres. It appears to be doing a decent job of transitioning the business, but the reduced development pipeline suggests a more cautious outlook from management.

The company also made progress in its debt reduction, offloading non-core properties - primarily office buildings and regional malls. Total sales have reached €3.2bn; around half of management's €6bn target. That's come at a premium to book value. The sooner the company jettisons its lower quality stores across the globe the better, but we worry that management is holding out for prices in the lower quality assets that aren't likely to come.

Getting Intu trouble?

Besides this, we think there are two other reasons.

We've highlighted in the past management's credibility problem. While the headline numbers appeared good, the market might be taking a wait and see approach before taking them at face value. We continue to worry about what management aren't telling us.

But the more immediate reason appears to be a shocking result from London-listed peer Intu Properties, which owns 4 of the top 8 shopping centres in the UK (while URW owns the top 2) amongst others. On the back of a number of retailers in administration and slower leasing activity from retailers pre-Brexit, it saw rental income fall 7.7%. That saw valuations across its portfolio plummet 9.6%, with the knock-on effect of a rise in gearing to 60%. The share price has fallen almost 40% and the next step for Intu is probably a capital raising. The UK was also a sore point for Unibail, with sales falling 6.3% mainly due to Westfield London.

While this might portend bad news for Unibail, it's important to note the differences between the two. Unibail is more diversified; less than 8% of its portfolio is UK-based. And while Intu's portfolio is of high quality, URW's is even better. 

This is important, as the performance of flagship centres have consistently outpaced lower-quality centres. The US portfolio grew net income by 2.2% versus 5.5% for flagship centres, for example. 

We currently estimate that flagship stores constitute more than 85% of the company's portfolio. That figure should increase over time as lower quality centres are sold and the company's €10.3b development pipeline takes shape. 

Price guide lowered

While over the very long term, we expect property values in major cities will increase, where debt is involved, the shorter-term matters too. The transition to experience-based stores is not without risk and the ride will be bumpy - particularly given Unibail's leverage. The Intu result highlights that given the structural challenges retail landlords face, they're more vulnerable to cyclical shocks. It's why we recently showed a range of outcomes for the company's profitability and distributions in Unibail-Rodamco-Westfield: A bear case. 

We still expect Unibail to survive and prosper given its first class property portfolio - these assets are difficult to replicate and landlords have more options to redevelop shopping space than many doomsayers predict. But we're lowering our growth expectations and demanding a greater margin of safety, given that risks are elevated. That means slashing the Buy price to $10.50, while the Sell price will drop to $16.

The recommendation has been a disappointment so far, but the stock's 8.9% pretax distribution yield means that any sort of growth from here will see holders achieve an attractive return. We ultimately think patience will be rewarded. BUY.

Note: A number of members have encountered issues with the French withholding tax, in which Computershare (the custodian of the Australian CDIs) is yet to work out a way to exempt Australian holders from paying the full 30%. Please read the recent Q&A where we covered this topic and consider your personal tax situation (preferably in consultation with your accountant or financial advisor) before deciding to buy shares in URW: https://www.intelligentinvestor.com.au/urw-withholding-tax-1912011

Note: Our Model Growth and Model Income portfolios own shares in URW. The Intelligent Investor Equity Growth Fund and the Intelligent Investor Equity Income Fund own shares in URW.