A Reflation Trade, A Dividend Play & A Pair of A-REITs

This week we examine a pair of listed property groups that may be worth a buy, not least because both of them have sat in the frontlines with regards to the Covid-related lockdowns and look set to benefit from any opening up. The first is Scentre Group (SCG.ASX) and the second Unibail-Rodamco-Westfield (URW.ASX). 

Scentre Group (SCG.ASX)

Author: Sid Ruttala

​Of all the A-REITs, Scentre Group remains one of my favourites. Firstly, around 70% of the rental income remains inflation indexed and subject to escalations. For those that have read my previous writing, I remain an inflationista with an expectation of seeing a transition toward secular inflation. Assuming this is the case, SCG’s high proportion of retail tenancies should see substantial increases to profitability given the pro-cyclicality of earnings in the industry. Secondly, much of the doomsday scenario about e-commerce and competition from pure-play online is, we feel, much overdone. This is evident from SCG’s continued low-turnover in tenancies and high occupancy rates, around 98.5%. That being said, some of the incentives that were given in order to make this happen are somewhat concerning with rental spreads on new leases coming in at 13.1% and a 5.1% discount for specialty leases. That is to say, the company offered a discount of 13.1% and a sign-on bonus of 5.1% on average. This will be one of the most important metrics to watch for going forward. 

Digging deeper into the numbers, FUM (Funds Under Management) came in at an implied rate of 14.76c per security, slightly disappointing but acceptable nevertheless. Operating profit for the six months ended December came in at $402m (an increase of +11.6%) and customer receipts continued to increase. Getting to the most important metrics, 71% of the group's debt remained interest rate hedged, debt to EBITDA stands at 5x and the group maintains liquidity of 6.9bn. Importantly, the longer duration for most of the group's debt is prudent with any uptick in CPI effectively acting as a transfer of wealth mechanism from debt holders to equity holders. The group’s prudent use of hybrids rather than traditional debt is also a plus. This opinion stemming from my belief that it offers a superior risk reward for the issuer (fixed income returns for equities risk). 

The biggest concern  on the balance sheet for me remains duration risk, the debt has a weighted average maturity of 4.6 yrs with a large proportion of the senior secured bonds coming into expiration in 2026. It will be important to see if management is able to decrease duration risk as well as hedge-out interest rate risk. My view is that, despite the rhetoric from central bankers, inflation will not be transitory and there will be little choice but to normalise policy sooner rather than later.

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Red Flags & Risks: The biggest risks continue to be within the broader policy environment. SCG, like many of her peers in the shopping mall operating space, has focused on categories such as specialty, services, entertainment and food. This is a prudent strategy as the risks from e-commerce are greater within particular categories like apparel and footwear retailing, for example. However, this also means that a greater amount of capex is required along with higher operational expenditure. It also means that the business will be especially susceptible to continued or future lockdowns. 

What has also been evident to date, looking at the terms of the rental contracts, has been the historic pricing power and the resulting favourable terms of trade to Scentre. With increasing competition and many of her competitor operators moving into the same categories, it will be important to watch whether continued discounts and incentives are required.

My Expectations: Solid business and good management with a clear vision for delivering shareholder value. What has been disappointing is the payout ratio though management has said that it should normalise through this year and go to incremental increases from next year. The disadvantage of this approach, while prudent, is that having a greater cash drag places downward pressure on the return, especially given the group's liquidity position and undrawn facilities.

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Dividend Yield: 5.1% assuming a share price of $2.75 and a 2021 dividend of ~14c p/s. My expectation is for this to grow at a high single digit pace over the next 5-10 years. 

Unibail-Rodamco-Westfield (URW.ASX)

​Firstly, credit where it is due. Kudos to the Lowy family for selling out when they did and any investor who has held URW would really have a rather painful awareness of what I am referring to. Nevertheless, we feel that URW presents a unique risk-reward opportunity at this price. The business is a turnaround story and management has been making headway; disposing of $2.6bn in assets, streamlining products and categories. Most importantly, and what has this author particularly excited, was raising debt on eye wateringly great terms. The most recent of which was €650m at 7-year maturity at 0.75% and €600m at 12-year maturity at 1.375%. Using those numbers as a hurdle for a return on investment, one would hope it isn’t much of a battle. Maybe, just maybe, SCG should consider accessing the European DCMs (Debt-Capital Markets)?

Nevertheless, the shorter term outlook does continue to be messy for the business. The big question mark remains the speed and price at which URW can rid itself of legacy commercial assets and the recovery across most of its major markets in Europe. While the debt can be off putting to many market participants, it is one of the most interesting aspects of the business in my opinion, especially given the terms and interest payable (net debt/EBITDA stands at 14x). There have been significant closures across some of the US and European operations with a return to normal seemingly slower than many were expecting. At the time of last disclosure, March 2021, over 51% of the centres effectively remained closed. 

The business has significant competition from online retail but management seems to have a clear vision for the categories it will continue to play in and where the value-add may come from. For the yield-hunters, this will be a waiting game with distributions now likely to return in 2023. That being said, for the patient this may be lucrative. Assuming CPI of 3.5%, my fair value for the business: $8 AUD (trading around the $5.75 mark at time of publishing). 

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Red Flags & Risks: Like SCG, the biggest risks will be the broader policy environment and slower than expected recovery across most of their markets. That being said, the Eurozone (and the rest of the OECD) has been rather more effective than Down Under in getting vaccinations through, so it will be a case of patience being rewarded. The earliest date at which I see distributions returning is 2023, with the reduction in debt taking close to ten years to get it below 10x. Much will also be contingent on management getting the right price for some of their asset sales. To date, the price at which Village 3, 4 and 6 offices were sold has been disappointing. 

My Expectations: A clear turnaround story and waiting game. The group is complex but there is a clear strategy to clean up the balance sheet and create a more defined focus (as is evident from the disposal of non-core assets). In addition, I remain comfortable with the US retail exposure where their focus on Class A malls should see them benefit from the closure of lower-quality centres. The US is also likely to be where the next set of growth is to come from.

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Dividend Yield: 0 
The earliest possible year for a return to dividend will be 2023 in my view. Nevertheless, buying at this price will potentially lock in a future dividend stream that is within the double digits with substantial upside. Not a short-term play and quite definitively a reflation trade.

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Disclaimer:  Both SCG and URW are held in TAMIM individually managed account portfolios.