Stockland: building a profitable future

As the security price of property group Stockland hit a record $9.28 on 07 Dec 07, the global credit boom was beginning to come unstuck. In the two short years that followed, Stockland’s security price plummeted 76% to $2.17. It was a savage fall for a supposedly low-risk blue chip investment.

As capital raisings flowed and governments bailed out banks, the fear subsided and stock prices rebounded. But then Stockland's security price came back, and has slumped 28% from a post-GFC high of $4.21 to $3.03 today.

For many people, us included, residential property prices sit atop the worry list. Even Stockland’s chief executive, Matthew Quinn, thinks home prices are too high. Chart 1 reveals why. Building approvals have plummeted, as has credit growth. Property price growth looks unlikely and the general malaise facing property groups has seen the entire sector fall from favour.

It’s with this mindset, and that described on 7 Oct 11 in Clouds clearing for A-REITs, that one hopes to uncover an opportunity. Risks remain of course, but the strategies have changed, assets values are now more reasonable and balance sheets are far less leveraged.

In Property trusts don’t add up and Property trusts slash distributions, we criticised management’s wild disregard for risk and leverage that left many investors with permanent capital loss. Stockland, in fairness, survived better than most. Indeed, the sector is now a very different proposition from what it was five years ago.

The company operates a diversified property business, owning commercial, industrial and retail properties dotted across the country. This makes up around 60% of the business (see Chart 2). The remainder consists of housing and retirement living development operations.

Unlike Westfield’s premium city shopping centres, Stockland’s are located in regional areas and suburbia. This changes the tenant mix. Only around 10% of Westfield’s rent comes from anchor tenants like Woolworths and Target. For Stockland, it’s 35%, with another third from food and services businesses.

This is significant because it reduces the reliance on discretionary retailers—those most exposed to the threat of online retail. With retail property becoming a more important part of the business (see below) and at a time when retailers are struggling, having tenants somewhat protected from this threat is reassuring.

Stockland has also made a reasonable fist of developing residential property, earning over the past decade adequate rather than brilliant returns on capital employed of between 10 and 15%. Though we acknowledge that the credit boom over the past decade produced a favourable operating environment for property developers.

Value proposition

The value proposition is sound, too. The company builds homes for the lower end of the market where demand is less flexible. If the average punter can afford $300,000, that’s what Stockland builds, holding prices flat but increasing profits by reducing block and home sizes in a way not too noticeable to prospective buyers—members that enjoy Cadbury’s chocolate will remember a similar strategy used with their boxes.

The company has also learnt from its mistakes. An ill-fated expansion into the UK and getting caught in the apartment building boom dusted some capital but the company has realised its error and moved on.

The recent move into retirement assets is less proven. So far no Australian retirement group has been able to generate decent returns from the business. Whether Stockland can is yet to be seen.

The strategy is evident from these facts. There’s a focus on the 3Rs—retail, residential and retirement—and a reduced exposure to commercial and industrial property. It makes sense. By reweighting the investment portfolio toward retail assets—historically more reliable than industrial and office property—not too exposed to the threat of online retailing, the company aims to generate above-average, recession-proof returns.

The most risky and suspect part of this strategy is retirement living. With gusto it has purchased Australian Retirement Communities (2007) and Auvem (2010), swiftly making it one of Australia’s largest three operators.

Retirement units are essentially residential property aimed at retirees over the age of 55—the first option after selling their family home (not aged care). They offer cash poor but asset rich retirees a way of extracting value from their property without having to pay rent (see the company announcement from 02 Dec 09), with the company taking a cut of the final exit price.

It’s an attractive proposition for retirees but whether Stockland can take advantage of this favourable demographic change and make decent returns (see Cashing in on the retirement boom) is very much open to doubt.

Low gearing

Even if it can’t, the impact on the company’s ability to pay distributions and remain committed to paying around 75% of operating earnings out each year shouldn’t be affected.

What brings most comfort, however, is not the strategy but the balance sheet. Gearing, at 23% measured by debt-to-tangible assets, is low with the company preferring long dated notes rather than large licks of flighty bank debt. In the event of a disaster, a capital raising and the permanent loss of capital that would follow is unlikely.

So what’s it worth?

Let’s take into account the inflated nature of Aussie property prices and discount the current property book by 25%. Let’s also knock 50% off incomplete developments and exclude the capitalised interest, intangibles and property, plant and equipment. That delivers a conservative valuation of around $3 per security, not so far from the current security price.

Stockland isn’t going to be a ten-bagger but for income investors—the stock pays an 7.9% yield—looking for a reasonable inflation hedge it could be an excellent choice. Were the stock price to fall another 10-20% we’d hope to be able to upgrade it but, for now, we’re refraining from providing a recommendation guide, starting our coverage with HOLD and slotting it into a spot on our watchlist.