Sunday, 14 June 2020

Things Don't Look Good for Retail Landlords

The massive sell-down in Mar brought many REITs to rare, multi-year lows. This re-ignited my interest in REITs, as I have been out of them for many years due to their increasing debt levels and decreasing yields. However, I passed up the opportunity while I analysed what could be the impact of COVID-19 on REITs. Despite the massive government interventions, things do not look good for retail and F&B companies. And when tenants struggle, their landlords will also suffer. In this blog post, I will examine the potential impact of COVID-19 on 2 retail companies and 2 F&B companies.

Before we begin, it is good to recap what are the measures the government has taken to cushion the impact on retail and F&B companies. 

Wage Support

Through 4 extraordinary budgets, the government will provide support to wages via the Job Support Scheme (JSS). The level of wage support varies across industries. The JSS will last for 10 months. For the first 2 months, it will cover 75% of $4,600 of wages of all local employees for all companies. The 75% support level will continue if companies are not allowed to operate during the gradual lifting of Circuit Breaker, until Aug. For the remaining months, the wage support will be as shown in Fig. 1 below.

Fig. 1: JSS Support for Remaining Months

Thus, both retail and F&B companies will get the following wage support:
  • 3 months of 75% wage support (assuming they are allowed to reopen in Jul)
  • 7 months of 50% wage support
This translates to 48% reduction in annual wage costs for FY2020 (assuming that all wages of employees are at $4,600).

Rental Relief

In addition to wage support, the government has also implemented measures to help companies cope with rental costs. The Government will provide property tax rebates and cash grants equivalent to 2 months' rent for qualifying commercial properties and 1 month's rent for industrial and office properties for Small and Medium Enterprises (SMEs) with annual turnover of less than $100M. On top of that, the government also passed a law requiring landlords to waive 2 months' rent for commercial properties and 1 month's rents for industrial and office properties for SMEs that have seen a significant drop in their monthly revenues. The total amount of rental relief for SMEs in commercial and industrial/ office properties is summarised in Fig. 2 below.

Fig. 2: Rent Relief for SMEs

Thus, retail and F&B SME companies will get up to 4 months of rental relief, translating to a 33% reduction in annual rental costs for FY2020.

Revenue Hit

COVID-19 has stopped people from shopping and dining out, either because of government-mandated lockdowns or fear of contracting the virus. It is anyone's guess how soon people will go back to their normal lifestyles after shops and F&B outlets are allowed to operate. China is the first country to exit the lockdown and provides the first glimpse of how consumers would react in a post-COVID world. Figs. 3 and 4 below from Capitaland Retail China Trust's (CRCT) investor conference in May shows that shopper traffic is only picking up gradually after the end of the lockdown. Year-on-year, total shopper traffic and tenants' sales in 1Q2020 declined by 37.6% and 42.5% respectively.

Fig. 3: Shopper Traffic at CRCT Malls in 1Q2020

Fig. 4: Tenants' Sales at CRCT Malls in 1Q2020

For the revenue hit on retail and F&B companies, I assume the following:
  • 3 months of closure during Circuit Breaker: 0% revenue
  • 2 months of gradual re-opening: 50% revenue
  • 7 months of recovery: 80% revenue
This translates to a 45% decline in annual revenue for FY2020. Will retail and F&B companies survive this kind of harsh business conditions? Let us take a look at 2 retail companies and 2 F&B companies.

Retail Companies

Company F

Company F is a barely profitable retail company. In FY2019, it generated net profit of $0.2M. See Fig. 5 below for its income statement for FY2019.

Fig. 5: Company F's Income Statement for FY2019

It is insightful to note that of the gross profit of $64.7M, staff costs ($21.4M) take up 33% of the gross profit and rental costs ($22.3M) take up another 34% of the gross profit. In total, staff and rental costs take up 68% of gross profit. It is no wonder that the government had to act quickly to relieve the pressure of staff and rental costs on companies!

Applying the estimated declines in revenue, staff and rental costs above (plus some other assumptions for other costs), Company F might see its net profit turn from positive $0.2M to negative $5.4M. See Fig. 6 below for the computation.

Fig. 6: Estimated Impact of COVID-19 on Company F

As at end FY2019, Company F had cash of $7.8M. The estimated loss of $5.4M is equivalent to 69% of its cash and 10% of its equity.

Company C

Company C is a fairly profitable retail company. In FY2019, it generated net profit of $17.7M. Applying the same analysis as Company F, Company C might see its net profit reduced from $17.7M to $9.1M. See Fig. 7 below for the computation. Company C will likely have no problem going through the COVID-19 situation.

Fig. 7: Estimated Impact of COVID-19 on Company C

F&B Companies

Company S

Company S is a barely profitable F&B company. In FY2019, it generated net profit of $0.8M. See Fig. 8 below for its income statement for FY2019.

Fig. 8: Company S's Income Statement for FY2019

Like retail companies, staff and rental costs take up a large portion of the gross profit of F&B companies. Staff costs ($14.3M) take up 43% of gross profit and rental costs ($7.9M) take up another 24% of gross profit. In total, staff and rental costs take up 66% of gross profit.

Applying the same analysis, Company S might see its net profit turn from positive $0.8M to negative $2.6M. See Fig. 9 below for the computation. The estimated loss is equivalent to 32% of its cash and 27% of its equity as at end FY2019.

Fig. 9: Estimated Impact of COVID-19 on Company S

Company J

Company J is a fairly profitable retail company. In FY2019, it generated net profit of $10.9M. Applying the same analysis as Company F, Company J might see its net profit reduced from $10.9M to $1.9M. See Fig. 10 below for the computation. Company J will likely have no problem going through the COVID-19 situation.

Fig. 10: Estimated Impact of COVID-19 on Company J

Conclusion

We have run through the estimated impact of COVID-19 on 2 retail and 2 F&B companies. Staff and rental costs consistently take up around 2/3 of gross profits. When there is no or poor business due to government-mandated lockdowns or fear of contracting the virus, the impact on the bottom lines of retail and F&B companies is very significant. As in all crises, stronger companies with leaner cost structures and/or significant retained earnings will be able to weather the storm while weaker ones will end up in losses, despite the extraordinary government interventions. 

The companies I analysed above are all listed companies. How about unlisted companies? Would they have stronger financials than listed companies? Some food for thoughts.

Last week, Department of Statistics released the retail and F&B sales figures for Apr 2020. Fig. 11 below shows that retail sales declined by 13.3% in Mar (before Circuit Breaker) and 40.5% in Apr (during Circuit Breaker) on a year-on-year basis. Almost all sectors were impacted, with the exception of Supermarts & Hypermarts, Mini-marts & Convenience Stores, and to some extent, Computer & Telco Equipment.

Fig. 11: % Changes in Retail Sales

Fig. 12 below paints a similarly bleak picture for F&B sales, with a decline of 23.6% in Mar and 53.0% in Apr on a year-on-year basis. No F&B sector escaped the decline.

Fig. 12: % Changes in F&B Sales

Lastly, Fig. 13 below shows the tenant mix at Frasers Centrepoint Trust's Malls.

Fig. 13: Tenant Mix at Frasers Centrepoint Trust's Malls

F&B accounts for 38% of Gross Rental Income. Fashion takes up 14% while Beauty & Health accounts for 11%. All these sectors will be impacted by COVID-19. The only sector that has a roaring business during COVID-19, Supermarts & Hypermarts, contributes only 5% of the Gross Rental Income.

In conclusion, COVID-19 has resulted in a very challenging business environment for retail and F&B companies. When tenants struggle, landlords will also suffer. Things do not look good for retail landlords.

P.S. I am vested in Capitaland.


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Sunday, 5 April 2020

Not All Hospitality Trusts Are Created Equal

In the past 2 months, investors have been selling off Hospitality Trusts (HTs) listed on SGX due to travel restrictions imposed by governments around the world to stem the spread of COVID-19. There are 6 HTs listed on SGX, namely:
  • ARA US HT
  • Ascott Residence Trust
  • CDL HT
  • Eagle HT
  • Far East HT
  • Frasers HT
While all hotels will suffer revenue decline due to the travel restrictions, not all HTs will be impacted by the same extent. One important factor affecting the impact on HTs is their operating models. Traditionally, hotels have been owned and operated by the same party, but there are increasingly more investors who wish to invest in hotels but might not have the expertise or time to manage them. Thus, hotels might be owned by one party but operated by another, with revenue-sharing agreements between them. If you buy into HTs, you are buying into the ownership of the hotels. The operating model adopted by the HT will affect how the revenue and/or profit are shared between the owners (i.e. HTs) and the operators (i.e. hotel chains like Mariott, Hilton, Accor, etc.).

Some of the major operating models are as follow:
  • Owner Operated - The owner owns and operates the hotel, bears all costs and risks, and receives all profits. HTs usually do not adopt this model.
  • Master Lease - This is the simplest model when the owner and operator are different parties. The owner leases the hotel property to the operator in return for a fixed rental fee. The operator bears all costs and risks of operating the hotel. The owner does not have any share in the profits from operating the hotel. Nevertheless, there are variants to this model in which the rental can be variable and pegged to a percentage of the hotel revenue and/or profit. 
  • Management Contract - In this model, the owner engages the operator to run the hotel. The operator receives a management fee which is pegged to a percentage of the hotel revenue and profit. The owner bears all costs and risks of operating the hotel and receives all profits after deducting the costs and management fee to the operator.
  • Franchise - In this model, the owner runs the hotel using the franchisor's brand. The franchisor receives a franchise fee which is pegged to a percentage of the hotel revenue. The owner bears all costs and risks of operating the hotel and receives all profits after deducting the costs and franchise fee. A variant of this model is the owner outsources the operation of the hotel to an independent third-party operator. This arrangement is similar to a management contract, except that the third-party operator is not associated with the franchisor.
Fig. 1 below summarises the responsibilities of the owner and the operator/ franchisor in running the hotel.
Fig. 1: Various Hotel Operating Models

Needless to say, given the severe travel disruptions currently in place, the master lease model (especially the fixed rental model) would have the least impact to the revenue received by the HTs. Let us look at the operating model adopted by each of the HTs. Do note that a lot of these information are sourced from the annual reports. For HTs whose financial years end in Dec, the FY2018 annual reports are the latest ones available.

ARA US HT

ARA US HT owns 41 hotels, of which 38 carry the brand of Hyatt and 3 carry the brand of Mariott. Fig. 2 below shows the operating model adopted.

Fig. 2: ARA HT's Operating Model

The figure shows that all of ARA US HT's hotels are franchised by Hyatt and Mariott and operated by independent third-party operators.

As explained in the section above, under the franchise model, all costs and risks are borne by ARA US HT, which is not a good thing during the current COVID-19 situation.

Ascott Residence Trust (ART)

ART owns 87 hotels and serviced residences. It recently merged with Ascendas HT to form the largest HT in Asia Pacific. ART adopts a combination of master leases and management contracts. Fig. 3 below shows the breakdown of gross profit from the various operating models in 4Q2019.

Fig. 3: Breakdown of ART's Gross Profit in 4Q2019

25% of the gross profit comes from master leases, while another 13% comes from management contracts with minimum guaranteed income.

Notwithstanding the above, there are fixed and variable rent components in the leases. ART disclosed that its operating lease receivable within 1 year of FY2018 is $70.3M. This is based on the fixed rent component in the leases. This amount represents only 14% of both the gross rental income and total revenue (rental and other income) in FY2018. In the worst case scenario whereby there is only fixed rental income, ART could see its revenue dropping by 86%.

CDL HT

CDL HT owns 16 hotels, 2 resorts and 1 retail mall across 8 countries. It has a combination of master leases, management contracts and owner-operated hotel. Fig. 4 below shows the operating model.

Fig. 4: CDL HT's Operating Model

Of the 19 properties, 13 are under master leases, 4 are under management contracts and 2 are owner-operated.

Although master leases form the majority of the hotels, they have fixed and variable rent components. Fig. 5 below compares the minimum and actual rental income received in FY2018.

Fig. 5: Minimum & Actual Rental Income for Master Leases

In total, the minimum rental income from all master-leased hotels forms only 49% of the actual rental income received in FY2018. As a percentage of total revenue, the minimum rental income constitutes only 35%. In the worst case scenario whereby there is only minimum rental income, CDL HT could see its revenue dropping by 65%.

Thus, although the majority of CDL HT's hotels are under master leases, the variable rent component in these master leases reduces the stability of income received by CDL HT in situations like COVID-19.

Eagle HT

Eagle HT was listed on SGX recently. It owns 18 hotels in US, most of which carry the brands of IHG, Mariott and Hilton. The operating model appears similar to that of ARA US HT, i.e. franchise model.

Far East HT

Far East HT owns 9 hotels and 4 serviced residences in Singapore. Fig. 6 below shows the operating model adopted.

Fig. 6: Far East HT's Operating Model

All their hotel and serviced residence properties are master leased to its sponsor, Far East Organisation and its related subsidiaries. Although Far East HT did not disclose the fixed and variable rent components of the master leases, it disclosed that its operating lease receivable within 1 year of FY2018 is $85.1M. This is based on the fixed rent in the master leases. This amount represents 93% of the rental income received from master leases and 75% of total revenue in FY2018. In the worst case scenario whereby there is only fixed rental income, Far East HT could see its revenue dropping by 25%.

Frasers HT

Frasers HT owns 9 hotels and 6 serviced residences in 6 countries. 14 of the properties are under master leases and 1 is under management contract. Like all HTs, the master leases have fixed and variable rent components. Fig. 7 below shows the minimum and actual rental income received in FY2019.

Fig. 7: Minimum & Actual Rental Income for Master Leases

In total, the minimum rental income forms only 49% of the rental income received from master leases and 38% of total revenue in FY2019. In the worst case scenario whereby there is only minimum rental income, revenue can fall by 62%.

Conclusion

The table below summarises the operating models adopted by the various HTs listed on SGX. For HTs with master leases, the table also shows the minimum rental income from master leases as a percentage of their total revenue.

Hospitality Trust Operating Models Min. Lease Rental
as % of Revenue
ARA US HT Franchises Not Applicable
ART Leases, Mgt Contracts 14%
CDL HT Leases, Mgt Contracts & Owner-Operated 35%
Eagle HT Franchises Not Applicable
Far East HT Leases 75%
Frasers HT Leases, Mgt Contracts 38%

Like most REITs, HTs have been well-liked by dividend investors. However, as this blog post shows, the revenue received by HTs is highly variable, depending on the operating model adopted. In theory, master leases provide the greatest stability compared to management contracts and franchises. However, most master leases of HTs have fixed and variable rent components. The higher the variable rent component, the more variable is the revenue stream. Dividend investors should really consider whether HTs should form part of their portfolios.

Although the segregation of roles and responsibilities between the owner (i.e. HT) and the operator through the various operating models splits the risks between them, it is ultimately a zero-sum game. When the hospitality industry faces a severe downturn like the current COVID-19 situation, neither the owner nor the operator wins. Even when the owner is relatively shielded at the expense of the operator via master leases with fixed rentals, investors need to check the credit risks of the operator. If the operator cannot pay the fixed rentals, the owner will also lose. Investors in hotel companies and HTs can only pray that the COVID-19 crisis is resolved quickly.


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