The Mall mauling is over

Aftershocks from the financial crisis will remain with us for quite some time, but Westfield’s first half result to June 2010 clearly demonstrates that the worst is in the past.

The shopping mall giant delivered its first return to profit since the 2008 first half. Westfield’s earnings have of course been considerably more robust through this period from an operational perspective. The previous losses were driven by contracting valuations within the company’s property portfolio, which eroded more than $3 billion last year alone. The tide now appears to have turned with the property portfolio recovering $349 million of value in the six months to June 2010. This contributed to first half bottom line earnings of $961 million, compared to last year’s loss of $708 million.

As we have pointed out in the past, property revaluations do not represent actual cash flows and neither is Westfield in the property trading business. It is for these reasons that we prefer to focus instead on Westfield’s operating earnings, which provide a better gauge of management’s performance.



On this front, Westfield’s first half result slimmed 2.6% from $1.057 billion in 2009 to $1.029 billion. The fall was driven by a 7.3% fall in property revenue. Although the fall in operating earnings suggests that all is not well within Westfield’s malls, this is not quite the case. The weakness is actually a function of the considerably stronger Aussie dollar and operating earnings gained 1.6% after adjusting for this.

Westfield’s most significant overseas market is the US, which accounts for 39% of the group’s operating earnings. The UK contributes 5%, while the company’s home base of Australia continues to lead the way with 49%, plus 7% from New Zealand.

In local currency terms, Australia and New Zealand’s net property income gained 5.8% to $725 million. The US grew by 3.2% to US$457 million, while the UK expanded by 15.6% (albeit from a lower base) to £37 million. The UK’s growth was primarily due to the Westfield London project, which opened its doors in 2008.

A key element of the stronger performance is an encouraging recovery in occupancy rates within Westfield’s US portfolio. The company’s US retail space was 92.9% leased as at the end of June 2010, representing an impressive 2.5 percentage point increase from June last year. The occupancy improvement is a positive indication for the broader US recovery. It is also a reflection of Westfield’s superior portfolio in terms of its ability to attract tenants even during a more difficult retail environment.

Australia and New Zealand has remained at essentially full capacity, while the UK has gained 1.5 percentage points to reach 98.8% occupancy. As one might expect, the improvement in occupancy has been accompanied by an easing of bad debts and rental arrears across the group.

Projects

As we have discussed in the past, one of Westfield’s key strengths is its ability to successfully develop major new sites. The slowdown has seen management take its foot off the development throttle somewhat, but there are still a couple of significant developments set to open their doors soon. Indeed, Westfield’s UK growth has really only just begun with the £1.45 billion Stratford Centre in London on schedule to open in September 2011.

Stratford is currently around 70% leased by area, or around 50% by income. Westfield’s malls are generally about one third anchor tenancies, one third major store units (which in the UK would be the likes of Primark, Next, Boots etc) and the rest is made up of smaller speciality stores. Tenancy agreements are first set in place for the anchors, then the major stores and finally the specialities. Anchors get the best deals because their presence is used to attract the rest of the tenants. This is why 70% of Stratford’s area is leased, but only 50% of its expected income.

The Stratford mall will benefit from the 2012 Summer Olympics which will be contested in the area. Most of the attendees will travel to the Olympics via local rail services and they will then have to walk through the mall once they exit either of the two train stations. Some 400,000-500,000 people will attend the games each day. There will also be considerable volumes of people in the weeks leading up to and following the main event, all but ensuring Stratford gets off to a good start.

The company’s other major development is the $1.2 billion Sydney CBD project. The project is currently around 70% leased and the first 100 stores will be open in October.

In terms of longer term development, management essentially takes its lead from the strength of demand for retail space. Occupancy rates are a decent proxy for demand and given that Australia is running at essentially 100% it’s no surprise that the country is Westfield’s main development focus for the future.

There has been an improvement in the US as shown by the region’s stronger occupancy levels, but there is still quite some way to go before the country’s retail environment recovers sufficiently to justify another major development. The same is also true for the UK and management would at any rate prefer to bed down the Stratford and Sydney CBD projects before embarking on anything else of a similar size.

Costco

The trend of improving US occupancy rates looks set to continue following the announcement of the integration of retail giant Costco into three of Westfield’s US malls. The malls in question are located in Los Angeles, Florida and Maryland. As Members may be aware, Costco operates huge warehouse style discount stores focussed on food products and other household goods.

Costco’s low pricing ensures its stores consistently attract a high volume of shoppers. The stores’ physical presence in the malls, rather than as separate satellites, will therefore serve to drive higher footfall for Westfield. Management should be able to leverage the increased traffic through the malls to further improve occupancy rates and also to secure better tenancy terms.

Costco is also in the UK and recently entered the Australian market too, so it is quite possible that the alliance could extend to these regions if it provides value in the US.

As one would expect for a property trust, Westfield is highly geared with 73% net debt to equity as at 30 June 2010. Gearing has increased through the six months to June, rising from 66% at the end of 2009. We would expect gearing to fall following a boost in Westfield’s equity base once the major projects of Stratford and Sydney are complete. These projects are held at cost and the development value does not hit the balance sheet until they are operational. At any rate, the high degree of certainty attached to Westfield’s property income facilitates a higher level of gearing, in light of which we view its interest cover ratio of 2.8 times as quite comfortable.

The ability to service debt is one thing, but in the post-GFC world we must also be cognisant of the potential for credit market volatility to hamper refinancing as debt facilities mature. Westfield faces a number of maturities in the years ahead, rising from A$1 billion in the second half of this year, to A$3 billion in 2013 and A$2.9 billion the following year. The company is in our view unlikely to experience any significant difficulty in rolling over its facilities. This is primarily due to the high quality of its asset base but also because Westfield has $7 billion of undrawn debt that is available to cover most of its requirement through to 2013.

Turning to the charts, Westfield continues to flirt with both the 50 (green line) and 200 (red line) moving averages. A supportive development is occurring as support from both moving averages is likely to drive Westfield higher towards the downtrend line in place since April around the $22.65 region. The strengthening RSI is supportive of the current upward move.

 

The weekly chart reveals the upward trend in place since March 2009. The 39 week moving average (green line) has continued to provide dynamic support since February. Once this consolidative phase is complete, we would expect an upside target towards the October 2009 high of $24.92. The consolidation above the 50% Fibonacci retracement bodes well for a continual move higher over the medium to longer term.

Shareholders will receive a first half distribution of $0.32 per share and management confirmed a full year distribution of $0.64 against expected operating earnings of $0.90. This equates to a payout ratio of around 71%, which is within management’s previously revised range of between 70% and 75% of operating earnings.

Westfield currently provides a distribution yield of 5.1% and consensus forecasts are for this to increase towards 6% by 2014. At around 15 times consensus full year earnings, Westfield is not particularly cheap, but neither is the stock very expensive, particularly given the growth that its current development projects will deliver in the years ahead. We therefore remain comfortable continuing to hold Westfield in the Fat Prophets Portfolio.