Retail property a better bet than retailers

Contrarian investing is much easier in theory than practice. Spotting an oversold sector that can recover is only half the battle; getting the timing right separates great investors from the rest. Buying too early exposes portfolios to horrific losses.

Mining services is an example. The sector was on life support at the start of 2016 as investors feared further earnings downgrades and bankruptcies. Those who bought when everybody else rushed for the exits deserve every dollar of profit from the mining-services recovery.

A similar story is unfolding in retail. Persistent consumer gloom and fears about new competition from Amazon in Australia have smashed the sector. One retailer after another has downgraded earnings and many retail stocks have lost more than 40% in a year.

It’s a bloodbath. The signs are there of irrational pessimism; it’s hard to picture decent wage gains – the key to a retail revival – after years of record-low growth. Or retail sales growth quickening as consumers struggle with a mountain of household debt.

Or Australian retailers, in segments such as apparel, fighting off international competition. Or department stores having a future. Or discount department stores, such as Big W, ever turning around. Or smaller retailers combating the online threat and living with lower margins.

Inevitably, it’s when the market gives up on a recovery that real value emerges. The smart money notices emerging green shoots in the sector and slowly starts accumulating stock, adding to positions as more evidence emerges of a sustained turnaround.

That could be the case in retail. I spoke to almost a dozen fund managers and analysts about retail stocks last week. Few were bullish on retail, but most could see long-term value emerging in the sector, and several were starting to buy retail stocks for the first time in years.

The big unknown among fund managers was the timing of a retail recovery. Make no mistake: retailers are battling awful conditions; cyclical weakness from a struggling consumer and structural weakness from greater online and international competition.

On the first point, I’m looking for a modest improvement in wages growth in the next two years. We’re starting to see more workers testing their bargaining power through industrial action and pushing more forcefully for wages growth (think Unilever and industrial action in its Streets ice-cream factory, and warehouse workers at Woolworths). One can picture more workers following suit as they push for higher wages growth in an improving jobs market.

On point two, the Amazon threat looks vastly overhyped. Amazon will have a big impact here, but so far has public plans for a 24,000 square metre fulfilment centre in outer Melbourne – hardly enough infrastructure, just yet, to turn Australian retailing on its head.

The online threat is well known to local retailers and e-commerce is nothing new to consumers here. Many retailers have invested in online capabilities for years and large players overseas, such as Best Buy in the US, have shown they can compete with the Amazon juggernaut.

Although the macro outlook for retail looks marginally better in 2018, and valuations for several quality retailers are undemanding, it’s too soon to take big bets on the sector.

Risk-reduction strategies in turnaround sectors

It pays to look for lower-risk plays in contrarian investing when the outlook is unclear. Buying the highest-quality players in the sector at the start of a recovery, and moving up the risk curve as certainty starts to return is the best strategy. Buying higher-risk companies in higher-risk sectors can produce stellar gains, but too many speculative plays destroy capital rather than create it.

The big shopping-centre owners are an interesting way to invest early in a nascent retail recovery. Think Westfield Corporation in the United States and United Kingdom, and Scentre Group and Vicinity Centres in Australia with their “fortress” shopping malls.

Put another way, these trusts are a bet on the owners of retail property rather than retailers themselves. Both, of course, are inter-related, but I’d back the big shopping-centre owners to maintain performance a lot longer than their tenants if retail hits new lows.

Westfield, Scentre and Vicinity have fallen this year amid broader retail fears. Westfield is almost 20% down from its 52-week high. Scentre is down 16%; Vicinity is off 14% . The market is worried about key tenants, such as Myer Holdings, closing stores and the risk of discount department stores, such as Big W, rationalising space in shopping centres.

Myer’s depressing quarterly sales update this week added to the gloom about department stores and the likelihood of more lease exits at shopping centres.

Moreover, general retail weakness is expected to lead to higher occupancy rates at shopping centres and lower rentals when leases are reset. Longer term, rapid growth in online retail must reduce demand for bricks-and-mortar retail and the shopping centres it occupies.

That’s the theory. The reality is the big shopping-centre owners have almost full occupancy despite hyperbole that the retail sky is falling in. Retail experts I know say rents at the best shopping centres have held up reasonably well, despite tenant protests.

I’m not as convinced about the near-term risk of space rationalisation from department stores and discount department stores at shopping centres. Granted, it can be costly for shopping centres when anchor tenants with large space footprints exit; capital expenditure is usually required to upgrade the space and incentives may be needed to backfill it with new tenants.

But large store rationalisation programs are also costly for retailers, a point Macquarie Equities Research made in its excellent review of retail property trusts this week. Macquarie believes there is a variety of tenants willing to backfill space from Myer stores in quality shopping centres. The best centres may be able to increase rents as new tenants are found; second-tier centres that house department stores will probably suffers from department store exits.

Department stores and discount stores must reduce shopping-centre space to combat the e-commerce threat and increase their own online capabilities. That trend is entrenched in the US, although comparisons with Australia are problematic because the US has a lot more shopping-mall space per capita. Department-store rationalisation here will take years to play out.

Longer term, the fortress shopping malls are fabulous assets. A prime shopping centre, such as Chadstone in Melbourne, or Westfield Bondi Junction, is impossible to replicate at the location. As they attract more service outlets, such as fancier restaurants, consumers are visiting the mall as much for entertainment as to buy basic products.

In time, newer fortress shopping centres will offer upmarket housing accommodation and hotels, as integrated property developments. Westfield is embracing this trend offshore.

The changing retail mix at fortress malls will lead to a higher average spend per customer, per visit, in the next five years. More people will eat breakfast at the mall when they shop early; or dinner when they go to a movie there. We’ll buy more goods and services at fortress malls and fewer at strip shopping malls and sub-regional (or second-tier) malls.

It’s no surprise that Westfield is rationalising its US, UK and European portfolio away from second-tier assets to fortress centres. The shopping-centre giant wants to own the world’s premium shopping-centre portfolio and is investing billions to get there.

Westfield is a story of short-term pain for long-term gain. Its shopping-centre redevelopment will drag on earnings as rents are foregone during construction. But the medium-term effect should be faster growth in Westfield’s net tangible assets and a rising share price.

I nominated Westfield as a preferred Australian Retail Estate Investment Trust for the Switzer Report at $9.50 in late 2015. The AREIT is down 20% on that price, but my positive view on Westfield remains. It is the pick of the retail property trusts.

An average share-price target of $6.86 for Westfield, based on a consensus of 10 broking firms, implies the AREIT is overvalued at the current $7.70. The market is too bearish; Morningstar’s $8.70 fair value for Westfield and accumulate recommendation looks more realistic. Macquarie has a $9.72 price target and outperform tip. I’ll stick with the bulls on Westfield.

Chart 1: Westfield Corp

Source: nabtrade  

Elsewhere, Scentre Group and Vicinity Centres have more exposure to the coming space rationalisation of department and discount department stores. About 30%  of Vicinity’s gross leasable area is in department and discount department stores; Scentre has 35%  exposure on Macquarie numbers. That’s a lot of space potentially at risk.

My hunch is the big retailers will exit space at sub-regional centres with lower sales productivity; the tier-two shopping centres rather than the fortress malls. Vicinity has more exposure to department-store rationalisation in sub-regional centres than Scentre Group.

There’s less risk of department stores exiting space at fortress malls, such as Chadstone in Melbourne, which have higher sales productivity. And if they do, the top shopping centres have a longer backlist of new or existing tenants wanting that space. The cost of exiting prime shopping-centre space for department stores is probably greater than the cost of riding out the lease for an underperforming store.

Brokers are more optimistic on Vicinity; a consensus price target of $2.94, based on 11 firms, compares to the $2.64 price. An average price target of $4.49 for Scentre Group, based on the consensus of 12 broking firms, suggests it is fully valued at the current $4.

Chart 2: Vicinity Centres

Source: nabtrade

Chart 3: Scentre Group 

Source: nabtrade

I’ll go against the market and suggest all three retail AREITs are reasonably valued at the current price and attractive investments for those with a medium-term outlook (at least one to three years).

Shorter term, these trusts could remain out of favour for some time as the market frets about department-store rationalisation and the threat of online retailing. But that is creating the value opportunity for investors who sensibly bet on the owners of retail property, rather than their higher-risk tenants, in anticipation of a sector upswing in the next few years.