Federation Centres chief executive Steven Sewell tells Business Spectator's Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:
-- The economic benefit of Federation's merger with Novion is driven by cost synergies and the ability to reduce duplicated costs
-- The role Gandel Group played in the negotiations between Federation and Novion
-- Despite a slip in the share price, institutional investors are supportive of the transaction and its benefits over the medium and longer term
-- He hopes to get the growth profile of the merged vehicle closer to what he achieved at Federation
-- What he thinks of the merged company being a potential takeover target
-- There is a risk of oversupply in the supermarket scene in Australia
-- He views the changing retail environment since the GFC as an opportunity rather than a threat
Alan Kohler: Well Steven, welcome to Business Spectator. Thanks for joining us.
Steven Sewell: Thank you. Good to be here.
AK: Now, can you tell us the average cap rates of the two businesses that you’ve used in the merger?
SS: So there’s about a spread of about 100 basis points between the two, just on 6 per cent for Novion and just under 7 per cent for the Federation portfolio to date.
AK: And is it really a takeover by Federation of Novion or the other way around, because obviously that company ends up with more of the merged business than Federation?
SS: They’re almost double the size by value of our portfolio, so close to $15 billion under management and we’ve got about $7bn under management. But I think the essence is that you’ve got two incredibly complementary platforms that basically do the same thing, as in Australian shopping centres, and that’s really the whole basis of the merger. And a lot of the economic benefit that flows from the merger is the cost synergy that exists between the two businesses and the ability to reduce some of those duplicated costs.
Stephen Bartholomeusz: As Alan alluded to, in effect there’s a reverse takeover occurring. Is that because you’re concerned about the threat of a gatecrasher? With Gandel Holdings having a big shareholding in Novion, presumably that’s the protection you have against a third party.
SS: Well, no. The structure of Federation acquiring Novion has been driven predominantly by the efficiency of that structure. We have a high proportion of assets in Western Australia, about 26 per cent of our assets, and in Western Australia there’s no concessional stamp duty for corporate relief. So there’s actually quite a big driver in transaction costs as to the reason why it is Federation acquiring the Novion units.
SB: Nevertheless, I think everyone’s aware that there were a number of approaches to Novion, or CFS as it was in the old days, by third parties before your deal was settled on. One assumes that the Gandel Group, which has got 21.6 per cent of Novion, played a big role in the way the negotiations panned out.
SS: Yeah. So I have a pre-existing relationship with the Gandel Group, Peter Kahan and John Gandel in particular through Charter Hall. They’re a very large stakeholder of Charter Hall and I previously ran Charter Hall Retail and showcased that fund to the Gandel Group, and they ended up buying 6 per cent or 7 per cent of that stock as well.
What we offer as part of the merger is exactly what the Gandel Group were looking to do and that is to focus in on a back-to-basics Australian shopping centre company, consolidated in a single location, preferably here in Melbourne. So, for us, I think we gave him what he wanted and some of the alternatives predominantly came from diversified vehicles and obviously exposure into diversified vehicles was not what he was looking for.
Robert Gottliebsen: John is a very good negotiator. His asset backing goes through the roof – I think it’s from $1.97 to $2.32, I think it is – and yours goes down.
SS: Asset backing goes down predominantly because of the costs of a transaction and the largest part of the cost…
RG: His went up with the costs of transaction. His went up.
SS: Well, no. With the way the merger ratio comes together, they are, as I said, almost twice the size of us. So you would expect they get the lion’s share and they end up with 64 per cent of the merged company.
RG: But their asset backing per share rose.
SS: It does. Ours to a lesser degree reduced because of the transaction costs. Most of the transaction costs came about because of the resetting of the debt and that is a very large impost on the deal metrics.
AK: Isn’t the key to it the difference in cap rates? Six per cent to 7 per cent.
SS: Higher yielding, lower yielding.
AK: I mean that’s the difference.
SS: Exactly. And I think for us and our investors in the 30 or 40 meetings I’ve had since the announcement, the scale benefits that are delivered by putting these two platforms together in immediate terms from the commercial benefit of the operating cost savings and reset of the debt, but really importantly what we get out of it by far as having a far greater development capability and ultimately where we can take the assets.
RG: The other part of this deal that’s interesting is that your gearing was about 25 per cent. Their gearing was just a smidgen under 30 per cent and they’re bigger than you as well, so…
SS: Yeah.
RG: The group itself, its gearing goes to 31 per cent.
SS: Yes. Because of the transaction costs, the $470m-odd worth of transaction costs which are borrowed as part of the transaction, so not raising any equity; the merged entity is borrowing funds to pay those transaction costs.
RG: $470m of transaction costs. Where’s that going? Who gets that?
AK: What's that? Who gets that money?
SS: About $280m is the reset of the debt, the debt book. So we’ve got a $5bn debt book on both sides of the transaction.
AK: And you’ve got to pay the banks $280m to reset it?
SS: We’re breaking swaps and resetting, most of which is driven by change of control, so it’s a contracted obligation and we’re also taking the advantage in that debt reset to take costs from 5.3 per cent on the Novion side, 4.6 per cent on our side down to around 4 per cent or 4.1 per cent, with an average debt term of greater than five years.
RG: So this is a lower rate you’re talking about?
SS: Lower rate and much longer-dated debt because it is a sweet spot in the market today in debt markets.
RG: Ok. But to break the old deals costs you…
SS: $270m to $280m.
SB: But you get a $35m interest cost saving.
SS: Exactly. A straight-away benefit, straight to the bottom line, but importantly our average debt term today is about 2.7 years and theirs is about 3.9 years and we’re confident now we’ll issue debt for 10, 12, 15 years, even potentially longer in the US market.
The other advantage that’s driven by the scale benefit is that we get to talk to debt investors that historically wouldn’t have even taken a meeting with us, so these are people, big pension funds, life companies in the US that want to place a bet of $50m or $100m in to a debt book and they’re now willing to take a meeting with us.
AK: So your interest rate is going to be 4.1 per cent?
SS: 4.1 per cent on the whole debt book.
AK: So you really ought to be borrowing more if you’re getting 6 per cent or 7 per cent yield on these shopping centres.
SS: Well, at 31 per cent…
AK: 4.1 per cent, that’s a bit of a laydown as well.
SS: Almost a record low and the spread to yield…
AK: That’s the point, but this is an unbelievable time, isn’t it?
SS: It is. Our debt ratio range is between 25 per cent and 35 per cent on a balance sheet basis. We think conservatively it’s better to be on the 25 per cent to 30 per cent end of that range because that then gives us the balance sheet capacity to, as much and as fast as we can, invest back in to our properties with redevelopment and organic growth opportunities and that’s certainly the business plan going forward.
SB: Steven, despite the earnings and distribution accretion that this merger's planned to produce, your security price is down more than 5 per cent and theirs is down about half that. So there’s a task, isn’t there, to convince the market that these benefits are significant and compelling enough to vote this thing through?
SS: I think you’ve got to put in context our share price with all REITs and in the context of other investment classes. We’d risen to an all-time high, just in advance of the announcement. And if you look at the REITs sector, you know, the index has gone substantially outside of its bracket of where it’s been trading in the last three or four months.
So we’ve come off a record high -- I get that -- but at the end of the day when we spell out the transaction's immediate and then medium to longer-term benefits to our shareholders, all the institutional investors that I spoke to last week are incredibly supportive of the transaction, as are, as you’d expect, the Novion institutional investors.
SB: That negative response… Apart from the terms which Bob’s alluded to, the appeal of Federation has always been that it’s seen as defensive. It’s those sort of regional and sub-regional exposures which are less vulnerable to consumer sentiment, changes in consumer behaviour, higher interest rates, discretionary spending. You’re putting yourself together with a group which is far more exposed to super-regional and regional…
SS: Discretionary, yeah.
SB: Can you understand investors who think that this is not necessarily a great thing?
SS: I think that the other aspect and dynamic that was at play is that in the last couple of years we’ve been able to craft a growth story around Federation with our asset base that was reasonably high growth relative to the sector.
So, you know, consensus growth of 5 per cent to 6 per cent, three years’ growth is very high for a rent-collecting REIT, as you described us. I think, for us, looking at the opportunity of putting, the good business at Novion together with our business, we can see opportunities across implementation of technology, a lot of the operational cost savings and elimination of costs and we would be hopeful of being able to bring the growth profile of the merged vehicle closer to where we’ve been able to get the Federation story.
So there is some negativity around, you know, people liked Federation as it was, but equally I think when people appreciate particularly the exposure that we now get to the full asset spectrum of Australian shopping centres, from some of the best direct factory outlet centres, through the neighbourhood and sub-regionals that Federation is exposed to, up to the best shopping centre in Australia at Chadstone, which is a super-regional, and four or five other very strong regional models, when you look at that in totality and the fact that we become $22bn in the top ten of listed retail REIT managers in the world, people understand what the medium-term value of this transaction is.
AK: In fact, some people are talking about the possibility of the merged company coming under takeover [pressure], particularly with your share price down a bit. I wonder whether firstly whether you think that’s a possibility and secondly, what about Gandel? Do you think there’s a chance they’ll look to rebuild their shareholding back towards the mid-20s?
SS: So, on, you know, the takeover potential, of course, you know, we’re a target every day we trade on the ASX for a takeover and we’ve traded strongly in the last couple of years and delivered very strong total returns for the investors.
I think from a merger point of view looking at what the merger delivers to investors, it’s difficult to see how another party could come in and offer that same benefit to investors because of how complementarily the two platforms lined up, so there is, you know, enormous synergy benefit. As far as the Gandel Group’s intentions, we’re not privy to those discussions or decisions, but certainly, you know, his track record in CFX and now Novion has been to accumulate his stake, so you know, they do have the 21 per cent direct stake he has today. He also has rights over the balance of the CBA stake, which is another 4 per cent of Novion. We’re not sure what he will do with that, but it would be no surprise to see him accumulate more and more of the direct stock.
AK: And would you like to get a 100 per cent of Chadstone?
SS: Anybody in the world would like to get a 100 per cent of Chadstone.
AK: Sure. But is that a possibility? I mean most of your centres are fully owned. I mean obviously Chadstone is in a different class of its own.
SS: Well, we’ve actually put capital partners in to about 15 of our biggest assets in the last couple of years, so capital partnering with high strength, very liquid partners is one of our strategies. The challenge with Chadstone is its value. You know, the 50 per cent stake in that asset is worth nearly $1.8bn, 50 per cent, so it takes very deep pockets to accumulate additional or get additional exposure. We see the opportunity there. As you’d be aware, it’s under redevelopment today. There’s an office building being built, a new entertainment and leisure precinct. There are plans for four and five star hotels to be built on the complex. So the value add and the organic growth of that property is yet to be fully maximised and we just will be very thankful to have the Gandel Group along as partners.
RG: I want to take you in to a wider sphere, a total retail scene that’s from strip shopping centres right up to the very top of the market with Chadstone. Do you think we’ve got overcapacity as a totality?
SS: The one big operating metric or market dynamic about Australian shopping centres is because of the planning regime, and it has been very diligently applied across all the markets in Australia, on a per square metre basis per head of population, we are well and truly contained versus a lot of other markets, in fact about 30 per cent to 40 per cent less than the US market, for example, in lettable area per head of population.
So what that translates to is very high occupancy at Australian shopping centres -- the whole portfolio will trade at about 99.5 per cent occupancy -- and secondly, extraordinarily high productivity rates, which is sales per square metre.
So I would challenge that we’re over-shopped or have too many shopping centres because what we have in Australia with the strong supermarkets, discount department stores, some of the best national brands of domestic specialty stores and, as you’d be aware, some of the greatest international speciality stores coming into Australia, like H&M, Zara, Uniqlo, the sales productivity of the space is actually increasing on average. So that gives us the confidence to plough as much money as we can into organic growth and enhancement and redevelopment opportunities.
RG: Is there any part of the scene and yet I’m sure that’s the largest, that you think is vulnerable?
SS: I think the only area that we see there is risk of oversupply is in the supermarket based, small scale neighbourhood shopping centres and that’s mainly being driven by the two national brands, Coles and Woolworths, pumping a lot of new stores in to the market.
They each deliver about 20 or 30 stores every year new in to the market. Now, most of that is to take up the population growth, but you do see in some areas where that does cannibalise existing stores. But other than that, you know, we see, particularly with active developers such as ourselves, the ability to remix and reposition and particularly to position properties so that they meet consumer demands. And technology is driving a lot of changes in consumer demands today and what it’s doing is forcing a lot of retailers to put their best foot forward to make sure that the offer they have is right, the look and feel of their tenancies is right and they also have a connection to the consumer, whether it be through smartphones or in the store where they know the consumer, they know what their preferences and priorities are and they market directly to those consumers.
RG: Is it possible that the online purchasing though might end up with 10, 15, 20 per cent of the market?
SS: I think the way it’s trending at the moment and certainly growth is coming off very substantially at the moment in online sales, a very strong correlation with the US, Aussie dollar exchange rate. As the Aussie dollar, you know, dropped in value, the online growth rate dropped substantially. Whether it gets to 10 per cent which would be almost double where it is today, that probably would be in line with most other markets in the world, but equally when you speak to most strong national or international brands, they see online as just one of their avenues that they can connect with a consumer, be it in a wholesale, bricks and mortar or through the online channel.
AK: And, in fact, are you seeing a switch of business from strip shopping centres? You see a lot of strip shopping centres in trouble actually. Is there a shift of business from them to your malls?
SS: So where you have more of a viable tenant base potentially, you know, a bit more offer, it really boils down to convenience. It boils down to the population and income of the catchment area and what’s accessible, what can people get to quickly, what provides the services, the safety and convenience that people are looking for.
AK: And the merger actually reduces your exposure to supermarkets from 41 per cent to 32 per cent.
SS: It does.
AK: Is that a good thing?
SS: Well, it’s offset, as you mentioned, by the discretionary piece, by that, you know, fashion and high end and even up in to the luxury brands in malls like Queen’s Plaza, Chadstone and Emporium here in Melbourne. So we see it as a good balancing that, you know, through good times and bad, the portfolio we think on our projections will offer very strong certainty of income and income growth going forward.
SB: Steven, over the last several years as the retail environment has become tougher, the major department stores, the discount department stores, the major specialty fashion groups have all said that they want to renegotiate the terms of their tenancies as they expire. Have you experienced that and how significant is it?
SS: We have. The part of that discussion that usually comes to the fore is that the retailers are becoming much more scientific and accurate about which markets they want to be exposed to. So, whereas previously, you know, in the lead up to the GFC retailers would open whatever stores they could, you’re now seeing them become a lot more selective. They understand where they get their growth, they understand who their consumer is and they want to get stores in those specific locations. That means they will close and all the speciality retailers, some department stores will back out of stores where they can, where they can either walk away from a lease or where they can renegotiate with the landlord.
SB: Is that a threat to your portfolio? Is it meaningful?
SS: I see it actually more as an opportunity because of the development upside and the remixing that we’ve got underway across the portfolio and certainly in the discussions with Novion, you know, they’ve got master planned expansions on a lot of their malls like Chatswood Chase up in Sydney, Queen’s Plaza and the Myer Centre up in Brisbane, so where you get that intent by landlords to invest in malls and, you know, enhance the consumer proposition, that’s where retailers want to be. They don’t want to be in the mall where the landlord’s just put their head in the sand and walked away.
AK: Thanks for joining us, Steven.
SS: Thank you.
SB: Thanks, Steven.