When Armageddon creates opportunity

The retail sector faces Armageddon! Amazon’s arrival is killing lazy, inept local outfits, and online retail sales are booming. It’s just a matter of time before the tumbleweed rolls down the empty corridors of your local shopping centre...

...Or that’s the conventional narrative at least. But it's one forged in the fire of alarmist headlines, and through inappropriate parallels with US retail.

The facts just do not support the notion that bricks and mortar retailing is dying.

In 2011, online sales accounted for just 5% of traditional bricks and mortar sales. Last year, the NAB Online Sales Index had the figure at less than 8% (the ABS says 4%). This remains a small number, and one that is growing less quickly than it was five years ago.

Baron Rothschild, who made a fortune buying stocks amid the panic of the Battle of Waterloo, put it well when he famously said: 

“Buy when there’s blood on the streets!"

So for our contribution to Livewire's Easter Eggs series, we want to make the case that while the facts don't support the idea that it's all over for retail, the opportunity is created by the widespread belief that it is.

Australia is not the United States

The parallel with the US is misplaced. The US has more than twice the retail floor space per capita than Australia, almost twice the department store space per capita and four times the retail vacancy rate.

Delivery costs, meanwhile are incomparable. The incremental parcel cost of next-day delivery in major US cities is $4. In Australia, it’s 10 times that.

Despite having more than 1.5 times the physical retail space per capita than Australia and Canada’s proximity to the US, six years after launching, Amazon accounts for just 8% of Canada's total online sales. 

The hype that Amazon, and online retail more generally, will crush conventional retail reminds me of the Y2K bug from 1999, minus the opportunity. It’s a fantastically emotive story with very little substance.

Australian malls are constantly adapting to changing conditions

There’s another thing the market neglects. Many US malls are dying because of their failure to adapt; Australian malls are highly adaptive and lead the world.

Since it opened in 1960, Melbourne’s Chadstone has undergone 40 upgrades and has just started work on a $130m Sofitel hotel.

Vicinity Centres, meanwhile, has increased its weightings to cafes, food courts and restaurants by 20% over the past five years.

Flagship malls are moving away from department stores and fashion in favour of food, wellness and leisure categories, renting out the newly available space to the likes of Mecca Maxima, Sephora and JD Sport, that pay 3-4 times the rent paid per square metre by David Jones and Myer.

Scentre Group offers proof: since 2014, it has replaced more than a third of its retailers. In 2017 Scentre let 1258 stores, including about 300 new brands. And around 600 existing retailers opened almost 1,000 new stores.

AREITs are in good shape

The impact of these truths was on display in the recent reporting season, which showed AREITs in good health on many measures.

• First, retail net property income growth is keeping pace with GDP growth, suggesting it’s sustainable.
• Second, at 2% a year, total sales growth is also keeping pace with GDP growth. In fact, many AREITs remarked on strong trading conditions in December persisting through January. Unsurprisingly, department stores recorded negative growth while mini-majors (like Sephora and JD Sport) recorded the strongest, a trend we expect to continue.
• Third, while sales growth for specialty retailers slowed a little, there were no signs of tenant weakness from arguably the most fundamental of measures – rental arrears. Tenant debtors remain in line with historical averages while vacancy rates remain extremely low. These are telling data points.
• And finally, retail asset valuations increased by 4.2% for the half, driven by a number of property sales completed last year, giving confidence that book values are justified.

None of this would be remarkable if this performance was reflected in share prices. Instead, many investors have drunk the retail Armageddon Kool-Aid, pushing the price of many AREITs (excluding Westfield and Goodman Group) below per share net tangible assets.

This effectively has the market implying an immediate decline in asset values and removal of lucrative management fees in some cases.

And yet JP Morgan recently forecast AREIT earnings growth of 3.8% for the current financial year and distribution growth of 3.0%. Taken with the sector's current forward distribution yield of around 5.5%, our total return estimate of 8-12% over the next 12 months is reasonable.

Which means AREITs, in our view, are cheap.

What of the risks? Long-term, modest growth in retail sales is the worry. Many commentators put this down to Amazon’s arrival and poor retail management. Anaemic wages growth is a better explanation. Without that we cannot expect much in the way of retail sales growth. But you can’t expect to buy cheap stocks and not also expect one or two (often overstated) problems.

There’s a widespread belief that the days are numbered for the country’s leading shopping centres, the evidence suggests the opposite. They are heaving with foot traffic and new retail concepts, and we believe the AREIT sector remains an attractive option for income-focused investors. 

The fact that this is not well understood has led to a heavily oversold sector where bargains abound.

Rothschild was on to something.

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