Since URW’s full-year results came out last week, I have been scratching my head a bit trying to decide whether they were good, or just OK, or not-so-good, and what I should do with my holding. For context, I bought my current shares in July/August 2019, at a price not very far from today’s.
I will share a few thoughts here, for those who are interested, starting with a little recap of what URW does and how its earnings are derived.
Business model and earnings structure
The company owns, develops and manages an international portfolio of premium-quality shopping malls, office buildings, convention/exhibition centres and airport terminal buildings; shopping centres are by far the largest component of URW’s asset portfolio, representing ~86% of total Gross Market Value (GMV).
The portfolio’s geographic breakdown by GMV is roughly as follows:
France: 35%
Continental Europe (ex-France): 32%
US: 25%
UK: 8%
The vast majority of URW’s Revenue consists of rental income from the tenants (predominantly retailers) to which the space in the Company’s property assets is leased out. Net Rental Income (or NRI) represents the aggregate of the rents received, net of operating expenses, i.e.
[Net Rental Income] = [Gross Rental Income] - [Operating Expenses]
In addition to that, URW earns some extra income from new property development activities, and also from property management services; I will indicate the corresponding aggregate amount as [Other Income].
Against the total asset value (65.0bn EUR as of December 2019), there is a significant amount of debt (24.7bn EUR, plus 2.0bn EUR of hybrid debt securities). But, because over 70% of this debt is EUR-denominated, and the Company’s bonds are rated investment-grade (A/A2, by S&P/Moody’s respectively), the average interest rate paid by URW is extremely low; in 2019 the average rate was 1.6% pa, for an average debt maturity of 8.2 years.
In conformity with the REIT-type structure of the Group, once Net Interest is paid out, the vast majority (~90%) of the resulting net income is distributed to shareholders as dividends and taxed at that level directly, instead of at a Company level.
Therefore, URW’s underlying recurring earnings can be simply represented as:
[Recurring Earnings] = [Net Rental Income] + [Other Income] - [Net Interest]
For the calendar year 2019, the above breakdown looked as follows:
[2019 Recurring Earnings] = [1,985m EUR (NRI) + 166m EUR (OI) - 392m EUR (NI)] = 1,760m EUR
Subtracting from this the 48m EUR fixed annual interest cost associated with the 2bn EUR of hybrid debt securities issued as part of the Westfield deal financing, and dividing by 138.35m total outstanding stapled securities, one then arrives at the reported Adjusted Recurring Earnings Per Share (AREPS), i.e.
[2019 AREPS] = (1,760m - 48m)/138.35 EUR = 12.37 EUR
Integration of Westfield assets, 2019 results and 2020 guidance
The current structure of the URW Group is the result of Westfield Corporation (US/UK assets, corresponding to ~33% of current total GMV) being acquired by Unibail-Rodamco (European assets, ~67% of current total GMV), with effect from June 1st 2018. Given that 2019 was the Company’s first full reporting year under this new configuration, comparing URW’s 2019 AREPS against the previous years is not exactly a comparison of “apples with apples”. However, a quick look at historical AREPS can help put the Westfield acquisition into some context:
AREPS (EUR/Share)
2011: 9.03
2012: 9.60
2013: 10.22
2014: 10.92
2015: 10.46
2016: 11.24
2017: 12.05
2018: 6.58 (1H) + 6.34 (2H)
2019: 12.37
2020: 11.90-12.10 (guidance)
Annualising the 1H 2018 result (to which WFD contributed for only one month), the implied pre-WFD CAGR over a 6.5-year period is (6.58*2/9.03)^(1/6.5)-1 = 6.0%; on the other hand, the post-WFD CAGR on the subsequent 2.5-year period (including 2020 mid guidance) is negative, i.e. (12.00/(6.58*2))^(1/2.5)-1 = -3.6%.
While asset disposals in Europe explain most of the EPS decline since 1H 2018 (and into 2020), it seems fair to say that the Westfield acquisition hasn’t so far had the EPS-accretive impact it was supposed to have.
In Like-For-Like terms, NRI Growth for European assets was +3.0% in 2019; nonetheless, because URW disposed of 3.3bn EUR of assets in the region between late 2018 and 2019, total NRI for Europe showed a -1.9% YoY decline. In particular, because 1.3bn EUR of those disposals occurred around mid 2019, NRI in 2H 2019 was lower than in 1H 2019; this also explains the difference in URW’s overall NRI between 1H 2019 (1,007m EUR) and 2H 2019 (978m EUR).
Looking at the Westfield assets in particular, US operations saw comparable Net Operating Income Growth by +2.4% (which reversed the previous year’s -1.6%), whereas in the UK it was a pretty ugly year (-4.2% in LFL NRI) due to a) expiries of long-term leases increasing the vacancy rate, and b) a number of tenants under administration paying lower rents. The issues in the UK appear to be cyclical in nature, though, rather than structural, so it seems reasonably likely that UK LFL NRI will resume growing from its 2019 levels.
So, when it comes to modelling 2020 earnings, if we simply assume:
a) NRI for European assets (67% of GMV) growing at the current Like-For-Like rate of +3.0%, before disposals.
b) NRI for US/UK assets (33% of GMV) flat vis-a-vis 2019 levels.
c) Other Income growing roughly in line with CPI, i.e. ~1.5%.
d) Average Interest on Debt ~10bp higher (as Management have guided a “slightly higher” Interest Expense)
and taking as a starting point the Group’s NRI in 2019 (i.e. 1,985m EUR), we then have:
[2020 Recurring Earnings (Estimate)] = [1,985m*(1+3%*67%+0%*33%) + 166m*(1+1.5%) - (1.6%+0.1%)*24,700m] EUR = 1,773m EUR
Subtracting from this the fixed 48m interest expense on the hybrid securities, it follows that
[2020 AREPS (Estimate)] = [1,773m EUR -48m EUR]/138.35m = 12.47 EUR
From this figure we then need to subtract the impact from the 1.3bn EUR disposals that occurred during 2019, and from the additional 1.5bn EUR disposals that will occur in 2020; this aggregate impact has been quantified by Management as ~0.50 EUR per stapled security, or ~69m EUR.
Without going into the detail of these transactions, and simply assuming that 1) the net rental yield on the disposed assets is in line with the Group average of 4.3% pa, 2) 2019 disposals affected the last six months of the year, and 3) 2020 disposals will affect the last eight months of the year (completion expected in 2Q 2020), then a quick sanity check gives an estimated impact of
4.3%*[1,300m*(6/12)+1,500m*(8/12)] EUR = 71m EUR,
which is very much in line with Management’s guidance.
Thus, without factoring any positive rental contribution from new developments being delivered in 2020, and without assuming any organic growth from US/UK assets, we are already getting to a 2020 AREPS of 12.47-0.50 = 11.97 EUR, which is pretty much in the middle of the 11.90-12.10 guidance range.
But, because there is 2.0bn EUR of deliveries coming in “towards the second half of 2020”, even if we assume only four months of rental contribution at the average 4.3% yield, we would then get an uplift by
4.3%*2,000m*4/12 EUR = 29m EUR, or 0.21 EUR per stapled security.
Therefore, Management’s 2020 AREPS guidance looks very conservative to me, and the 10.80 EUR dividend does not look at risk on a one-year horizon. The same reasoning can then be applied to the additional 1.2bn EUR of planned disposals (which at this stage should occur no earlier than 2021), whose impact will be offset by further developments being delivered.
Structural risks and a look at prospective yields
Assuming (conservatively, as seen above) that 2020 AREPS will come in the middle of the guidance range at ~12.00 EUR, and relative to its current price of 127.00 EUR (10.25A$ per CDI), URW looks very attractive at a first glance, with a Price-to-AREPS of ~10.6x and a dividend yield of 8.5% pa.
What cannot be overlooked, though, is that this is a very leveraged business: [Net Debt]/[Recurrent Earnings] is ~13.7x, or ~11.2x on a pre-Interest basis (similar to [Net Debt]/EBITDA). These ratios are somewhat inflated by the fact that some of the Company’s operations (where URW only owns a non-controlling share of the business) are accounted for using the equity method; at any rate, even if the same ratios are re-calculated on a proportional basis, the corresponding values are ~12.0x and ~10.1x respectively.
It also cannot be overlooked that the assets the Company is leveraged to are directly exposed to the discretionary retail spending cycle: in the event of a recession, tenant bankruptcies will increase, vacancy rates will soar, leases will get re-negotiated and the Net Rental Income from each asset will drop accordingly.
The question then becomes whether or not there is enough margin of safety, at current price, against such a scenario.
As of December 31st 2019, URW had Total Assets of 65,003m EUR (of which 55,928m EUR of Investment Properties) and Total Liabilities of 39,052m EUR (including 1,988m EUR of hybrid securities and 3,913m EUR of non-controlling interests). Therefore, the Book Value of the Equity attributable to holders of the stapled securities was 25,951m EUR.
If we now solve for the implied negative growth rate X such that
55,928m*(1+X) + (65,003m-55,928m) - (39,052m-3,913m) - 3,913m*(1+X) EUR = 138.35m*127.00 EUR,
i.e. if we solve for how much Investment Properties and Minority Interests need to depreciate, in order for the new Net Asset Value to match the current Market Cap, we get
X = [138.35m*127.00 - (65,003m-55,928m) + (39,052m-3,913m)]/[55,928m-3,913m] -1 = -16.1%
As the book value of the Investment Property assets can be viewed as the Present Value of future Net Rental Income flows, what this means is that the market is already factoring in a permanent loss of net rental power to the tune of -16% vis-a-vis current levels.
In order to better understand the resilience of the overall business model, let’s now look at a stressed scenario where future Net Rental Income drops by -30% and the average Interest on Debt increases by 100bp. Note that the latter is a conservative assumption, because almost 100% of the Company’s debt is either fixed-rate or hedged, so it would require a widening in benchmark yields and credit spreads by a lot more than 100bp in order for that to be the net impact on the aggregate cost of funding.
Going back to the [Recurring Earnings] formula for 2019, we would then get:
[Recurring Earnings (Stressed Scenario)] = [1,985m*(1-30%) + 166m - (1.60%+1.00%)*24,700m] EUR = 913m EUR,
hence AREPS (Stressed Scenario) = [913m-48m]/138.35 EUR = 6.25 EUR and, assuming a constant dividend payout ratio of 90%, the stressed dividend would be 90%*6.25 = 5.63 EUR; relative to the current SP of 127.00 EUR, that would correspond to a 4.4% dividend yield.
Note that, even under this stressed scenario, URW would still remain well within its bond covenants.
Conclusion
In synthesis, we have here a company with a portfolio of high-quality long-term assets that is paying a dividend yield of 8.5% pa in an ultra-low-yield environment. Absent some shock to the current macro-economic scenario, this dividend does appear to be sustainable for the foreseeable future, and should ultimately resume growing from its current levels at no less than CPI inflation.
By all means, because the unlevered yield from the underlying property assets is inherently low, this high dividend yield is mainly (but not only) the result of a) a high level of financial leverage, and b) a ridiculously low cost of debt. Importantly, though, the Company has locked in this “ridiculous” level of Interest Expense for a long period of time (8.2 years average); therefore, when it comes to analysing a possible future “bear case”, I personally see the Net Rental Income side as the main source of concern.
As seen in the previous paragraph, under a stressed scenario of -30% in NRI and +100bp in Average Interest, the dividend yield at current price would still be well above the prevailing level of long-term investment-grade bond yields.
So, while I am fully aware that this is not a perfect business (i.e. it is inherently cyclical and leveraged), I personally do see value at current levels. I suspect the current SP is likely to be the consequence of a Westfield acquisitions that hasn’t yet been digested too well by the market. That is not entirely surprising, given that URW is effectively being pressured by shareholders to deleverage (that is the gist I got from last week’s earnings call) by selling assets in an EPS-dilutive way, to offset the balance sheet strain from an acquisition that was supposed to be EPS-accretive. This is far from ideal but, with the acquisition now fully finalised, and with 80% of planned disposals already out of the way, EPS should have now found a base, all else being equal.
Finally, let’s take a quick look at a close comparable within the same industry: Scentre Group (SCG), which operates the shopping centres under the Westfield brand in Australia/NZ and is experiencing similar growth rates, is currently trading at a P/B ratio of ~0.84, vis-a-vis ~0.68 for URW; having factored in the differences in the capital structure (SCG is not as leveraged as URW), that valuation implies a ~10% market discount to the book value of SCG’s Investment Property assets. On the other hand, as seen above, for URW the corresponding market-implied discount is to the tune of -16%.
If, by way of illustration, we applied to the book value of URW’s Investment Property assets the same market discount as SCG currently has, URW’s Market Cap would increase by ~3.4bn EUR, or ~25 EUR per stapled security; that would represent a ~20% increase relative to current price.
Even if only 70% of this valuation uplift occured over the next two years (i.e. by the time all planned disposals are completed and EPS growth resumes being driven by NRI growth), the corresponding +14% capital gain plus the 8.5% pa dividend yield would generate a two-year annualised total return of ~15% pa. Given that SCG itself is trading at a discounted valuation to start with, this sort of prospective total return for URW looks entirely reasonable to me.
Based on all of the above, and especially in light of what I see as a conservative 2020 earnings guidance, I have decided to add to my URW holding; accordingly, I have been buying shares this morning, increasing my portfolio weight from ~3.0% to 4.0%.
As usual, my two cents only, and all the usual caveats apply.
(20min delay)