Reassessing Westfield—Part II

‘We said to the landlord, “we're going to shut” and our rent reduced 30%’, declared Mark McInnes, chief executive of Premier Investments. The self-appointed champion of lower rents for retailers is the bearer of very bad news for the owners of Australian shopping centres.

Reassessing Westfield—Part 1 explained our negative view on retailers, especially discretionary retailers that generate over 85% of Westfield’s rents, and posed a question: How can one be negative on the sector but have positive recommendations on the retailers’ landlords?

The incongruity will be resolved in this review, which models the impact of a decline in retail rents on Westfield Retail Trust, the owner of primarily Australian assets. Westfield Group, reviewed next week, with offshore shopping centres and development activities is much less exposed.

Long-suffering shoppers know they’re being gouged. But expanding gross margins in retail have been lining the pockets of landlords rather than retailers. Westfield, owner of 15 of the top 20 shopping centres in the country, has been a chief beneficiary. With regular annual rent increases, the company has paid generous distributions and financed overseas expansion.

Mean reverting margins

Following the 2010 demerger, two Westfields emerged (see Westfield locks and loads with capital raising). Westfield Group owns shopping centres in Australia, New Zealand, US, UK and, shortly, Brazil plus Italy. It also banks development profits and project management fees. But Westfield Retail is the passive owner of primarily Australian assets. Its future is therefore tied to Australian retail rents in a way that Westfield Group’s isn’t.

Margins, Jeremy Gratham says, ‘are possibly the most mean reverting series in finance’. Certainly, perpetual rent increases from taking a larger slice of sales revenue is unsustainable, especially in the face of online competition. But now retailers are desperate.

They’re no longer bluffing about extracting rent reductions. With Sydney retail rents overtaking Paris, London and Singapore as the second highest in the world (with Melbourne and Brisbane not far behind), something has to give.

In fact, it already has. Since listing, Westfield Retail Trust has traded at a persistent discount to net-tangible-assets, currently sitting at 21%. That suggests investors don’t believe the book values. And neither do we.

The question, then, is: How will Westfield Retail be impacted by falling rents?

Modelling decline

That depends on the extent of the declines. Table 1 models a deliberately bearish picture, showing what would happen in the event of rents falling by 30% as leases roll off, retail sales stagnating and vacancies increasing by 5%.

At today’s price, the cash yield would dwindle from 8.2% now to 3.1% by 2016. Let’s call this the ‘McInnes scenario’. If all retailers enjoy the same negotiating success as him (and they probably won’t), Westfield Retail’s profits will be severely impacted.

Table 2 offers a more realistic picture, modelling the effect of flat retail sales and Westfield’s sales take falling back to 1995 levels of around 12% from the current 14.5%. It also assumes occupancy rates remain stable at 99.5%. In this case, the cash yield in 2016 drops to 6.1%.

Either way, it isn’t especially pretty (download this Excel spreadsheet to enter your own assumptions. Call 1800 620 414 if you need assistance). Who, after all, wants to invest in a company where income is about to decline?

But there are a few important caveats to the ‘sell now’ case. First, whilst owning the best retail assets isn’t an insurmountable defence against the threat of online retail, it certainly helps. Rent falls will first be felt by privately held retail real estate that’s suffered underinvestment over the past decade. Take a walk along Rundle Mall in Adelaide or Chapel Street in Melbourne and take note; these landlords will face rents drops well before Westfield.

Second, the decline won’t be swift: A retailers' leasing arrangements will see to that (see Chart 1). If and when it does look as though the McInnes scenario is playing out, we’ll get some forewarning.

Third, Westfield is a far more defensive business than an individual retailer. It’s no JB Hi-Fi or Harvey Norman. Currently, Westfield has a pipeline of eager retailers willing to fill available vacancies. Last year, for example, it only took a few weeks to fill the space vacated by the collapses of Borders and RED Group, without having to offer massive rent discounts.

These factors, attractive as they are, will slow rather than arrest any decline. Rents have probably peaked and are likely to decline over time. That means we’re no longer keen to remain as exposed to Westfield’s Australian assets in the form of Westfield Retail Trust. In Part III, we’ll explain why Westfield Group is our preferred pick in the sector.

Reducing exposure

Westfield Retail’s security price has barely moved since 11 Nov 11 (Long Term Buy – $2.51) but is down 9% from first recommending it in the 2010 demerger. This reassessment means we’re reducing our recommendation prices (see guide) and lowering our portfolio weighting from 6% to 4%.

Importantly, for members invested in Westfield Retail and Westfield Group, we’re reducing our total recommended exposure from 8%-9% to 6%-7% with a heavier weighting to Westfield Group (e.g. 2% in Westfield Retail and 5% in Westfield Group). If you own both stocks we recommend reducing your exposure to match these new portfolio weightings. 

Finally, we’re downgrading the company to HOLD. In light of the latest developments the original recommendation, whilst not a disaster, was a mistake. Part III will model the impact on Westfield Group, which in preview, is far less severe due to its more diverse asset base and growth potential. Watch out for it next week.

Note: As a consequence of this reassessment and the 23% portfolio weighting to property in the model Income portfolio, including the two Westfields, which account for almost 10% of the portfolio, we’re selling 2,343 Westfield Retail Trust securities, netting the portfolio $5,880.93. The Growth and Income portfolio own shares in Westfield Group.