Stock Talk | Observations on the biggest M&A deal in Australian history

On 12 December 2017, the process began to create the self-described “world’s premier developer and operator of flagship shopping destinations”. By June 2018, the merger completed, Unibail-Rodamco-Westfield (URW) was created and along with it, the landscape of global shopping centre ownership had  materially changed.

Westfield (WFD) had developed and owned some of the largest shopping centres in the US and UK. The group also had a large scale, internal property management and development team, which has been taken on by the newly combined company. French-based Unibail-Rodamco (UR) owned and operated real estate across continental Europe, with the vast majority of its portfolio made up of shopping centres. The remainder of its assets were offices and convention centres mostly in France. The new company will seek to leverage the best of both to become the “premier” operator globally.

Unsurprisingly a deal of this magnitude came with a lot of information to digest. This included:

  • A 548-page WFD shareholder booklet (including a 191-page independent expert report);
  • A 194-page OneMarket demerger booklet;
  • An 821-page UR prospectus; and
  • Countless press releases, articles and presentations.

This article provides our perspective on some of this material.

Unibail-Rodamco’s earnings track record is solid

As a long-term investor, short-term earnings trajectories serve only as a guide as to whether our assumptions are solid. Furthermore, the investment case for WFD was built on the assumption of a successful roll out of the company’s large development pipeline. However, in assessing the UR merger proposal, we were forced to re-focus a little more on recent history, and when we did that, UR’s track record looked better than WFD’s.

Based on “Funds from Operations”, or FFO, WFD’s underlying operating performance declined over 10% in 2016 and grew by less than 1% in 2017. While this measure improves on the statutory earnings figures by eliminating asset revaluations, it still fails to take into consideration the impact of asset divestments that have been made to reshape the portfolio and to fund the development pipeline.

Not unlike WFD, UR has also seen its underlying earnings impacted by asset sales, and for the last three calendar years reported growth of -4.2% followed by two years of +7.5%.

In the absence of a merger, UR had expected to grow recurring earnings per share by approximately 6.5% in 2018 and for the medium term, to grow its recurring earnings per share at a compound annual growth rate of between 6% and 8%. WFD had declined to make any forecast for 2018.

WFD had development capability in house

WFD carried out its own design and construction for development activities and had built a strong record over many years. Furthermore, WFD earned fees from development management on behalf of joint venture partners.

In contrast, UR outsources design and construction for its developments, using fixed price contracts to the maximum extent possible.

It is important to note that operating earnings ignore the positive revaluation impact that future development activity delivers. For example, if an asset is developed and delivers a yield on cost of 7.5%, shareholders get the economic benefit from a high running yield compared to what might have been achieved had they bought the same asset in the open market on a yield of say 5%.

WFD’s development pipeline, in comparison to the size of its mature portfolio, was bigger than UR’s and was a key driver of stock valuation.

OneMarket is difficult to value

OneMarket is Westfield’s homegrown “tech hub” that is seeking to deliver technical solutions to help bricks and mortar retailers compete effectively with online businesses. This business has been spun-out of the merged entity and trades on the ASX separately.

In 2017, the OneMarket business generated revenue of US$2.4 million and incurred operating costs (after capitalisation of certain costs) of US$22.9 million, resulting in an Earnings before Interest and Tax (EBIT) loss of US$20.5 million (and a tax benefit of US$11.9 million). We have estimated the costs that were capitalised amounted to US$52.9 million. Had these costs not been capitalised, the earnings of OneMarket would have been a loss of US$73.4 million for the 2017 calendar year.

In short, OneMarket, like any tech stock in the early days, is losing money and the path towards positive cash returns is uncertain. However, considerable investment has been made under WFD’s ownership and the business starts life as a separately listed entity with a strong cash position and no debt. We believe this deserves some consideration.

“Independent” expert uses non-public information provided by WFD

We always struggle with the term “independent” in transactions of this nature, particularly where management’s interests may not completely align with those of other securityholders. While there is less to argue about with respect to the use of independent valuations on properties, assessing the value of the development and funds management business is substantially more subjective and we note the use, by the independent expert, of non-public material provided by WFD including:

  • Operating projections for the year ending 31 December 2018;
  • Stabilised operating projections for the 2018 calendar year (prepared on the basis that all projects recently completed or in progress were completed and fully stabilised as at 1 January 2018);
  • Information on the current and longer-term development program for WFD as at 31 December 2017; and
  • Other confidential documents, board papers, presentations and working papers.

Furthermore, in preparing the report, representatives of Grant Samuel held discussions with, and obtained information from, senior management of WFD and its advisers and the Chief Financial Officer of UR.

In fairness to Grant Samuel, the independent expert’s report does acknowledge that while any forward-looking information is assumed to have been prepared on a reasonable basis, it has not been reviewed by an investigating accountant for reasonableness or accuracy.

Adjustments made to estimate a “very full” value of WFD’s platform

When WFD owns 50% of an asset, but manages 100%, WFD earns and recognises management fees on the proportion of the asset owned by third parties. However, when assessing the capability and value of the overall WFD operating platform, it is constructive to consider the value of the “internal” management and development capability that is not recognised in accounting earnings, despite being a valuable capability that WFD brings to the merger. In the Independent Expert’s Report, Grant Samuel have made these estimates, on the basis that revenues and costs for internally managed and developed assets are similar to those managed on behalf of third parties.

While we believe the value of internal management is important, there is some risk of double-counting the benefit, as the value of the physical shopping centre asset already encapsulates to some extent at least the impact of good internal asset management.

While we do not have access to the same level of minutia on the development pipeline as has clearly been provided to the independent expert, we have made some assumptions and our conclusion, is not dissimilar.

Independent property valuations taken at face value

73% of WFD’s portfolio was valued by independent valuers at 31 December 2017. A further 24% was valued at 30 June 2017. The resultant accounting book value has been largely used as the basis of value for the hard assets. From this base, Grant Samuel has applied an adjustment to reflect capitalised management costs and more importantly, a “portfolio premium” to reflect upside from factors such as:

  • Future residential opportunities on land already owned and adjacent to WFD Centres;
  • The uplift in value associated with current development in progress, held at cost; and
  • The iconic nature of the overall portfolio.

We don’t disagree with these adjustments conceptually. However, in our own “Sum of the Parts” valuation for WFD, we also consider the evidence provided by global listed, comparable REITs, which are typically trading at prices that reflect a double-digit percentage discount to book value. Were such an adjustment to be made, the implied value of WFD would be materially lower.

Overhead savings are easy to achieve

Grant Samuel has been able to access far greater granularity than is available in public accounts over the split between overheads associated with running the management and development businesses and the costs associated with the senior management team, legal, IT and statutory items. Whichever way you cut the numbers,
approximately 75% of the US$100 million of overhead appears to be readily saved. How much of this saving could be delivered on a stand-alone basis with the implementation of a more sensible remuneration structure for senior management? – we suggest plenty!

Total transaction costs are how much?

Whilst there is a lot of uncertainty surrounding some elements of the deal, one part with which we can be certain is that transaction costs are large. Subject to exchange rates, total costs are estimated at approximately €346 ($A550) million. This includes around €100 million associated with costs of accelerating the Westfield employee share plan. Ouch! Total costs represent around 1.25% of the pro-forma market capitalisation of the combined group.

A deal worth doing

In conclusion, we believe, along with over 97% of shareholders, that the merger of Westfield into Unibail-Rodamco-Westfield delivers a strong outcome and positions the combined group very well for the future. Moving forward, the shopping centre industry faces multiple challenges, particularly from disruptive online activities. However, we consider a well-managed and multi-jurisdictional portfolio of “flagship” assets will continue to have relevance for all stakeholders.