A September-quarter trading update from no-moat Unibail-Rodamco-Westfield (ASX: URW), supports Morningstar Equity Analyst Alex Prineas’ view that the REIT’s recovery is on track. Despite a 37% rally since late October, URW securities still screen as undervalued at a 37% discount to Prineas’ unchanged fair value estimate of $7.80 per Australian-listed Chess depositary interest.

URW owns a portfolio of quality malls, about two thirds in continental Europe. Since acquiring Westfield in 2018 the REIT also has about 10% in the U.K. and about 25% in the U.S. The plan is to drastically reduce exposure to the latter. More than 90% of rent comes from shopping centres, the remainder from offices, mostly in Paris, as well as some offices attached to mixed-use assets around the world, and a similar amount from a conventions and exhibitions business in France.

URW

Trading update

Risks remain given URW’s heavy debt load, but debt is near 100% interest-rate-hedged until circa 2027, which Prineas thinks gives the REIT time to sell assets and continue to benefit from improving retail conditions. The recent URW rally was likely helped by moderating bond yields—euro area inflation dropped further than consensus expectations, with November inflation moderating to a 2.4% annual rate, down from 2.9% in October.

While a less challenging macroeconomic picture is welcome, the strong quarterly update reflected good trading conditions for URW. Management increased its 2023 guidance, now expecting adjusted recurring earnings per security at the high end of the previous guidance. Prineas made no change to his estimate, though noted that management’s guidance suggests the REIT could do even better.

Like-for-like gross rental income across URW’s global portfolio was up 11.5% for the nine months to September 203, compared with the same period in 2022. Strong rental growth was driven by retail conditions and indexation, with European mall rent typically tied to inflation, and many malls in the United States earnings sales-based rents.

Strong leasing activity bodes well for future rents, with 1,685 deals signed over the nine months to September, 5.5% more deals than the same period in 2022. And strong tenant sales, up 7.9%, bode well for future leasing. Strong retail conditions also support our view that URW will be able to continue its asset disposal program and further reduce debt.

Economic moat

Prineas doesn’t ascribe a moat to Unibail-Rodamco-Westfield, due to relentless pressure from online competition. We expect e-commerce will continue to undermine sales growth and pricing power for physical retail, and thereby undermine rents.

He continues to believe that URW’s retail assets are among the best in Europe and the United States, supported by proximity to affluent population catchments, strategic land footprints that would be difficult to replicate, integrated into major public transport and road networks, and with planning consents that are unlikely to be duplicated.

Prineas believes it is unlikely that rival retail developments could threaten most of URW’s assets. He expects retailers will continue to be located in URW facilities, and they will maintain high occupancy in most circumstances.

The issue is that he doesn’t believe URW's negotiating power with tenants will be as strong as it was historically, due to competition from e-commerce. By avoiding the costs of storefronts and distribution of goods to multiple retail sites, online portals can be incredibly competitive on price and convenience. Physical stores will continue to charge a premium for the ability to see and try goods, and for experiential purchases that cannot be purchased online.

However, Prineas believes there is a limit to the additional price that physical stores can charge, and that this limit will be anchored to the price available for goods online, plus a margin. Historically, retailers in high-end malls could charge a huge margin as there were fewer alternatives for consumers. However, in the future Prineas believes that if that margin gets too large, consumers will simply purchase goods online. Historically dominant retail landlords were able to capture a large chunk of the retail value-added chain, however, that is unlikely to be the case in future.

Risk and uncertainty

Prineas assigns a Morningstar Uncertainty Rating of High to URW. URW's highly geared balance sheet made the company particularly vulnerable to earnings weakness during the COVID-19 pandemic. Shareholders' rejection of the proposed EUR 3.5 billion equity raise in November 2020 reintroduced balance-sheet risk. We expect the company to continue raising cash via asset sales, and using the proceeds to further deleverage the balance sheet. But it could take several years before URW returns to comfortable levels of debt, and high inflation and interest rates could undermine the prices it achieves for asset sales.

URW faces other longer-term risks, the main one being the threat from e-commerce. While much of the damage has been done, we expect online rivals to gain traction in new categories such as food. The ability to do price comparisons online could also affect categories that can only be provided in person, such as services and entertainment, by putting pressure on prices in these categories, and therefore rents.

URW also has development risk, with a large pipeline of potential projects. We believe the company has a good record on development, mitigating many of the execution risks. However it has scaled back its pipeline due to its debt load, leaving it at risk of either falling behind competitors, or reinstating developments with the effect of taking on too much financial risk.