Abandoned takeover deal
On November 29, 2018, a consortium comprising of Brookfield Property Group, Peel Group and Olayan Group abandoned its plans to acquire British shopping center REIT Intu Properties (OTCPK:CCRGF) for £2.85 billion ($3.63 billion). With the consortium citing “uncertainty around current macroeconomic conditions and the potential near-term volatility across markets” as the reason for not going through with the takeover, it comes to no surprise that many analysts are blaming the failure of the deal on Brexit jitters.
Of course, Brexit uncertainty hasn’t helped with the pressures affecting the retail sector and the impact that has had on rents and property valuations. Only a day before the consortium withdrew from takeover talks did the Bank of England warn that a disorderly Brexit scenario could cause UK commercial property prices to plummet as much as 48%, a potentially much bigger drop than in the aftermath of the last recession. But it’s also clear that many of Intu’s problems go beyond Brexit.
The British shopping center group has long been rocked by a combination of structural and operational headwinds. As it is happening elsewhere in the developed world, the brick-and-mortar retail scene in the UK is confronting the challenges of growing overhead costs, rising e-commerce competition and changing consumer preferences.
Tenant failures are the most direct effect of the challenging trading environment, driving down both rents and occupancy. And with a string of UK retailers having gone bust in recent months, market conditions will likely get a lot tougher for retail REITs.
Intu, which has greater exposure to smaller town center shopping districts compared to most large-cap REITs in the sector, is particularly more exposed to the pressures affecting the troubled UK retail market. Many of these smaller town center shopping districts are more susceptible to the growing lure of online shopping and the impact of other societal changes.
As millennial consumers increasingly prioritize experiences over product ownership, traditional town center shopping districts have struggled to adapt and appeal to this growing market segment. The impact of this has become all the more pronounced in the last few years, with the closure of important anchor stores and a greater struggle to get customers through the door.
Meanwhile, Intu’s high leverage has constrained the group’s ability to undertake the kind of large-scale investment needed to make its underperforming properties competitive and relevant to the modern consumer. Intu’s loan-to-value ratio was 50.6% at the end of September, above its previously stated target range of between 40-50%.
Unsurprisingly, Intu suffers from higher financing costs than many of its large-cap peers, with an average cost of debt of 4.1%. Hammerson (OTCPK:HMSNF), its most comparable rival, pays a weighted average interest rate of 2.8%.
The group’s high leverage also greatly amplifies the effect of falling property valuations on its net asset value (NAV). As an illustration, in the three months from June 30 to September 30, NAV per share is estimated to have fallen by 5% on a decline in like-for-like property valuations of 3%. Year-to-date, its estimated NAV per share has shrunk by more than 16% on a property revaluation deficit of nearly £950 million (~9%).
Falling valuations, together with the recent spate of high street retail failures (which included House of Fraser and Coast), quickly raised concerns about the riskiness of the takeover deal. Before long, the rapidly deteriorating conditions made the price offered by the consortium seem overly generous.
Though the consortium’s £2.85 billion offer still represented a 39% discount to its NAV at the end of September, the spread between Intu’s discount at the offer price against sector peers had narrowed significantly. If Intu's rivals, which arguably have higher quality assets, were trading at similar discounts to their underlying NAVs, it would seem then that Intu's £2.85 billion price tag quickly looked a lot less attractive for the consortium.
Investors in the consortium, Peel and Olayan, remain invested in 405,669,386 shares of Intu in aggregate, representing approximately 29.9% of the share capital of Intu.
It’s the second time this year that a takeover of the firm has collapsed, after rival Hammerson dropped its £3.40 billion offer to buy Intu in April. Citing similar concerns to the Brookfield-led consortium, including the deterioration in the UK retail property market, Hammerson said the deal was “no longer in the best interests of shareholders”.
Address rising debt ratio
In failing to sell itself for a second time, Intu must now address concerns about the impact of falling valuation on its leverage ratio, which could soon rise to dangerous levels. Although there is still significant covenant headroom and minimal maturities until 2021, the group should act quickly as financing options could become more limited if market conditions continue to deteriorate, as they seem likely to do so. Otherwise, the spread between its financing costs and its leading competitors could get a lot wider, and perpetuate a cycle of underperformance.
On the same day the takeover fell through, Intu announced that it intends to reduce its dividend payment, starting with its final payout for 2018. It’s a small step in the right direction, but much more drastic action may be necessary as property valuations are dropping fast and could have a lot further to fall over the medium term. Annual cash dividends totaled just £188 million last year, which suggests any reduction in the dividend would likely pale in comparison to this year’s property revaluation deficit - which I expect will rise to well above £1 billion.
What to expect
Sadly, there doesn’t seem to be an easy fix. Property sales would be tricky in the current market environment (as the failure of Intu’s attempts to sell itself shows), with potential buyers likely to demand big discounts on valuations. This would crystallize further declines in the group’s NAV, lessening the reduction in its leverage ratio.
Analysts from Peel Hunt reckon Intu may need to sell as much as £3 billion worth of assets, roughly a third of its total assets, just to keep the loan-to-value ratio at around 35% in the near term. Intu, which owns 17 shopping centers in the UK and a further three in Spain, would thus be stuck between a choice of selling its ‘best-in-class’ assets and ending up with a portfolio of lower grade properties, or suffer a bigger valuation hit by selling underperforming properties at substantially bigger discounts as would be required in such market conditions.
And that would only be possible if Intu is able to find any willing buyers. The value of UK shopping centers sold in the third quarter fell to its lowest level in at least 23 years, with just £73 million changing hands, according to data from Savills Estate Agents.
Given the circumstances, Intu would likely instead pursue an equity raise to lower its leverage ratio. Although deeply dilutive to shareholders, a cash call will help protect the REIT against the downside risks of further falls in property values and thereafter position the business to exploit attractive opportunities in its development pipeline.
However, this option may not be so straightforward, as some analysts worry that the company might find itself unable to attract the necessary backing for such an equity raise. There’s a limited availability of capital for UK commercial property in today’s market, meaning would-be investors would likely refuse to commit fresh capital to the shopping center group unless the company puts in place an effective management team with a convincing turnaround strategy.
The REIT, which is in the midst of searching for a new chief executive officer to replace David Fischel, will now need to move quickly before capital markets start to demand wider spreads.
A turnaround in its performance is possible - Intu is not without its strengths. The retail REIT has a strong digital offering, with an innovative online shopping platform which seeks to create a seamless shopping experience in-store and online. With an annual digital audience of 26 million, there’s a big opportunity to drive sales through its website and increased footfall into its malls.
Intu also has one of the biggest development pipelines, with £562 million committed to improving and expanding existing assets in the next three years. Execution is a worry, however, with past capital spending not showing much in terms of value creation or rental income growth.
Meanwhile, Intu faces an uphill struggle with ongoing structural and cyclical challenges showing few signs of easing. Going forward, management expects like-for-like net rental income growth to be in the range of 0-1% in 2019, before taking into account the closure and repurposing of four House of Fraser stores post administration and subject to there being no further material tenant failures.
Property valuations may not fare so well. Reflecting current negative sentiment towards UK retail property, another big downward property revaluation adjustment seems likely in the fourth quarter of 2018, with possible further revaluation deficits in 2019 depending on consumer trends and the outcome of Brexit negotiations.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.