Dexus Convenience Retail REIT (DXC) Earnings Call Transcript & Summary

Thank you, and good morning, everyone, joining on the call. I'm Jason Weate, Fund Manager of Dexus Convenience Retail REIT, and I'm pleased to be delivering the 2024 half year results. I'd like to start proceedings by acknowledging the traditional custodians across the many lands on which we operate across Australia. We pay our respects to the Elders, past and present, and remain committed to supporting reconciliation across our business. Today, I will touch on DXC's investment proposition. Key highlights for the period, the financial outcomes as well as trends we have seen in the broader market. Moving to Slide 5. DXC's investment proposition is to provide investors with defensive income with embedded growth through the cycle. We delivered this firstly by preserving portfolio attributes that deliver high certainty of income. Secondly, we maintain a prudent capital structure, having regard to the broader macroeconomic environment with a target gearing range of 25% to 40%. And thirdly, we take an active but disciplined approach to portfolio optimization, including the pursuit of value-enhancing investment opportunities. We leverage Dexus' capabilities across transactions, development and asset management to execute these objectives. Turning to the highlights for the period. Notwithstanding a challenging macroeconomic environment, today's result demonstrates the continued resilience of the portfolio's ability to generate defensive and secure income, which helps support asset valuations and the strength of the fund's capital position. In terms of financial performance metrics, the portfolio delivered like-for-like income growth of 2.8%, reflecting an attractive blend of fixed and CPI-linked escalators embedded within our lease structures. We also increased the bottom end of our FY '24 guidance range with FFO and distributions now expected to fall within a range of 20.8 to 21.1 cents per security. Over the past 18 months, we have divested and settled on $52.3 million worth of asset sales, which has served to maintain conservative gearing in line with the midpoint of our target range. We will continue to pursue additional asset sales to enhance redeployment optionality and view the stabilizing interest rate outlook as a positive catalyst for the fuel and convenience transaction market. The DXC portfolio reflects a high yielding valuable land bank across the network of 101 assets across Australia. Our portfolio is backed by some of the highest quality tenant covenants in the market with 95% of income derived from major national and international tenants. We also retain close to full occupancy across a rent roll with long average lease tenure and less than 5% of major leases expiring prior to FY '30. We have also diversified DXC's income streams with over 50 direct tenancies with the retail operators that contribute 12% of income, up from 6% 3 years ago. Our portfolio benefits from high traffic flows with 9% of Australian car fleet passing our assets each day. We also have a majority weighting of 85% to metro and highway sites, which over the long term, will continue to provide an essential service to local communities and support long-haul travel and transport. From a tenancy exposure perspective, we have sought to diversify our tenant base over time. Our top 3 tenants, which generate 2/3 of portfolio income, are each continuing to reinvest in the long-term and performance of their network. Viva's recent acquisitions of Coles Express and on the Run group to facilitate the transformation of its convenience retail offering provides a strong example of how our tenants are reinvesting in their lease operations in response to the shift in the energy mix. In addition, 7-Eleven International's acquisition of the Australian business is a positive for the sector. The investment thesis is hinged upon improving 7-Eleven Australia's food offering, which will leverage expertise gained in running various retail formats globally that are more progressed than ours. Turning to sustainability. Our approach aligns to the DEXUS sustainability strategy, which includes 3 priority areas, being customer prosperity, climate action and enhancing communities. At a portfolio level, we seek to drive outcomes where we have operational control, which is circa 15% of our portfolio by value. Some key achievements include sourcing 100% renewable electricity and maintaining a carbon neutral position. Where we do not have operational control, we support our tenants on their varied ESG objectives. This includes having appointed a supplier to execute the rollout of solar to 20 properties leased to Chevron and embedding ESG initiatives into the Glass House Mountains redevelopment design such as rooftop solar, rainwater harvesting and EV charging stations. Turning to the financials. Over the half, FFO decreased 7.1% to $14.5 million or 10.5 cents per security. The decline reflects like-for-like income growth of 2.8% being more than offset by the higher cost of debt due to an increase in interest rates. This aligns with our expectations factored into guidance provided the FY '23 result in August last year. Distributions were 10.4 cents per security, reflecting the payout ratio of 98.7% of FFO. For the full year, our FY '24 distribution payout ratio is expected to be in line with FY '23 at 100% of FFO. NTA per security decreased 3.2% to $3.63, the majority of which was attributable to $12.6 million in asset valuation declines and $4.6 million of net fair value losses on derivatives. As I touched on earlier, an active approach to asset divestments over the past 18 months has supported the balance sheet with gearing of 32.6% at 31st of December 2023 or 32.2% on a pro forma basis following the sale of Lonsdale in South Australia. Reflecting the midpoint of the fund's target range of 25% to 40%. These investments have resulted in approximately a $40 million reduction in average debt balance. In an environment where the funds cost of debt increased by 60 basis points over the period, driven by average floating rates increasing by 150 basis points, while our average hedge rate increased by 50 basis points. We continue to explore asset divestment opportunities to further strengthen our capital position to increase value enhancing redeployment optionality at this point in the cycle. During the half, hedging levels averaged 81% and which is expected to remain above 70% despite hedges rolling off in the second half. We also continue to assess opportunistic incremental near-term hedging. We also continue to actively manage our debt book having canceled a $30 million surplus facility with no debt maturities until FY '26. The Glass House Mountains project presents an opportunity to significantly enhance the convenience retail offering at the 88,000 square meter dual highway site. On the Northbound side, which reflects Stage 1 of the overall project, we soon expect to have achieved all relevant approvals and finalization of lease terms that would allow us to commence redevelopment over the third quarter in FY '24. Total costs for Stage 1 are expected to be around $20 million and to deliver a yield on cost within a range of 5.5% to 6%. We also expect to deliver strong development returns in comparison to DXC's cost of capital. The commencement of Stage 1 would reflect a 100% derisked income position backed by Viva and a number of high-quality quick service restaurant tenancies over a 15-year average lease term. Post completion of the first stage, the site's income mix would reflect a balance of 45% to quick service restaurant retailers, with the Viva lease reflecting the balance with a brand new on-the-run convenience retail format. Independent valuations were undertaken across 45 assets in the portfolio. The remainder was subject to internal valuations based on comparable assumptions to inform the external process. In total, property valuations decreased 1.7% on prior book values. Valuations continue to be supported by predictable cash flows with contracted rental growth, partly offsetting the impact of cap rate expansion. Our average cap rate expanded to 6.30% and which remains above the marginal cost of debt. And in the direct property market, we are seeing this appeal to a broad range of investors seeking high-yielding opportunities. In light of the challenging macroeconomic environment, fuel and convenience, property transaction volumes were down by over 40% in 2023. Although volumes remained relatively robust with 53 individual transactions in total. And this transaction activity has resulted in a material repricing of asset values and capitalization rates, which now sit above marginal cost of debt for the fuel and convenience segment. In the direct market, we are seeing investors take a long-term view on underlying land value growth and tenant lease renewal potential. This has supported interest in the sector with smaller average asset sizes also appealing to investors. We expect this to support relative valuation resilience for the asset class as well as the stabilization in the interest rate outlook, which should provide further support for transaction volumes going forward. In summary, we are well placed to deliver on our investment proposition for security holders and will retain our focus on enhancing portfolio attributes that deliver certainty of income preserving balance sheet strength to support investment in growth initiatives and leveraging Dexus' market-leading capabilities. In relation to FY '24 guidance, we expect to deliver FFO and distributions per security of $20.8 to $21.1, reflecting an attractive distribution yield of approximately 8% for investors backed by strong income visibility. Thank you for joining the presentation today. And with that, I'll hand back over to the moderator for Q&A.

[Operator Instructions] Your first question comes from Andy MacFarlane from Bell Potter..

Just a couple of quick questions for me. Just question 1 just in terms of -- or in Glass House Mountains. Interested to know, I guess, if you're committed to doing it and what does strong development returns made to you guys?

Apologies for the delay. The first question comes from Andy MacFarlane from Bell Potter.

Just a couple of quick questions for me. First question, just on Glass House Mountain. Wondering if you're committed to doing it and what does strong development returns mean to?

Yes. Thanks, Andy. And apologies for the technical difficulties just earlier. But as it relates to Glass House Mountain, I mean, we think that's a good capital deployment opportunity for us with considerable upside through development potential. We are in the final stages of the leasing phase. And once that's complete, we'll have everything in place to commence. And I think based on where that product sits in the market today, the returns on the attractive tenancy mix that we will be able to gain access to, we will be inclined to proceed with that stage. And sorry, I think your second part of the question related to strong development returns, what does that mean? For us, any capital deployment option needs to have regard to the funds, cost of capital. And any decision to proceed with Glass House Mountains is no different. We believe unlevered development IRR on the project would reflect a comfortable positive spread to both the cost to release capital in the form of asset sales, which we've been undertaking over the last 18 months, but also a positive spread to the implied unlevered IRR of DXC's asset base at the prevailing share price. So screening well on all cost of capital benchmarking.

No, that makes sense. I guess a follow-on from that, in terms of gearing, just thinking about how you're thinking of managing it at this juncture and where you really want to be right now in relation to the target gearing, it's 25% to 40%?

Yes, well, you rightly called out, a range is 25% to 40%, and that is to reflect an operating range for the cycle, providing flexibility to capitalize on opportunities as they arise. And at this juncture, our focus remains on maintaining balance sheet strength. So as we release and deploy capital, it will be with a view to continuing to manage at around the midpoint of the target range. And I think the fact that we've had 80 months' worth of book value adjustments that have reflected transaction activity in the new high for longer environment provides us with confidence in that approach.

Makes sense. Look, a final one just for me. Yes, there was a bit of press around the new fuel efficiency standards that have to be introduced. I appreciate it's [indiscernible] there's any initial observations from your end and what that might mean?

Yes. And yes, it's quite recent. We've had a little bit of time to digest that broad out release. And for those in the call that aren't familiar, I mean, that is something that is looking to commence at the beginning of 2025, whereby new cars from manufacturers will be required to reduce the average emissions per kilometer targets across their fleets in aggregate. So they'll need to reduce that by some 12% per annum over the next 5 years. So that doesn't mean that car manufacturers can't continue to produce 100% traditional internal combustion engine vehicles or [indiscernible] for that example. But it does mean that they'll need to increase the proportion of lower emission vehicles across their sales fleet to meet the lowering emissions targets. Importantly, the move relates to passenger and light commercial vehicles. It does not include haulage, which does form a big part of diesel volumes in the market. And by the of context, in 2023, diesel volumes represented close to 50% of total fuel sales volumes. A couple of, I guess, other observations from a landlord perspective, the rate of change to the domestic car fleet will be gradual. The average age of cars is on the road right now, it's roughly 10 years. And last year alone, there were 1 million new ICE vehicles sold in the market, which represents roughly 5% of the total Australian fleet. And secondly, fuel and convenience operators are already meaningfully investing in their operations to capture incremental sources of revenue that are less rely on fuel volumes. So from a landlord perspective, we'll continue to work with our tenants as they seek to evolve their product offering more generally, but also in response to the release of the fuel efficiency standards.

Your next question comes from Leanne Truong from Ord Minnett.

Just a couple of questions from me. It looks like you ended up selling Lonsdale a bit higher than when you took it to auction in October. So just wondering if you are seeing the market improve slightly given you sold it at a slightly higher price. And also, I guess, why you chose to sell the asset now versus back in October?

Surely, and I'll start with the first part of the question. And I think the calendar year of 2023 was really a tale of 2 halves. And you can see in light of the slide that we've put forward that the second half reflected meaningful declines in volumes and that was in line with the significant increase in interest volatility that we saw over that period. And I guess like we have seen with previous interest rate fluctuations over the last 18 months, initial buy caution is generally shortly followed by a return in demand. And I think that's what we're seeing in the market now. And that's really due to a combination of the improving outlook for interest rates more broadly, the extent of positive cap rate spreads compared to marginal cost of debt for this asset class. And I think some of the positive things from fuel and convenience tenants more broadly, including the meaningful reinvestment back into the operations and sites. And so in that context, we feel pretty comfortable with the market outlook and indeed, our portfolio average cap rate of 6.3%. So as it relates to why did we sell Lonsdale now as opposed to then that option round that we took Lonsdale to initially was unfortunately, in the lead up to the Melbourne Cup RBA meeting in early November, and that's the point in time when interest rate rise concerns really took hold in the market, and we saw a lot of by caution into the market. Moving on 2 to 3 months from then, the outlook is fundamentally different and we're seeing a return to buyers that were active at that point in time, but then subsequently fell away are now back in the market. And that extends to multiple buyer groups. High net worth and privates have typically formed the vast majority of transaction activity over the last 18 months. I think the incremental buyer segment that has come back into looking at buyer inquiries is probably syndicated as well.

And just on a follow-up on what you just mentioned. So it sounds like the market, especially in transactional market is slightly improving there. You said that you will see further divestment opportunities. Is there a set target that you're looking at? Yes, just color on that.

Look, there's no hard target per se. Our focus does remain on maintaining balance sheet strength. So as we release and deploy capital, it will be with a view to continuing to manage it around the midpoint of the target range. And I think the fact that we've had 18 months' worth of book value adjustments that have reflected transaction activity in this new high for longer environment provides us with confidence in that approach.

Okay. And I guess one -- sorry, second question. You mentioned that nonfuel exposures have increased to 12%. So I was just wondering, ideally, where would you like to see that going forward? What's your target there?

Again, there's no specific target per se. I mean the increment that we have seen in that exposure over time was, for the most part, achieved during better capital environments, whereby we were able to access capital to buy assets whereby we could get greater exposure to that tenancy base. Obviously, over the last 18 months, one of the only ways that we have been able to manage that has been via asset divestments. And so that rate of change has slowed for now. But certainly, as and when we reach a point in time whereby capital market conditions normalize, we expect to resume incremental direct tenancies with retailers in line with what you've probably seen in the prior 3 or 4 years.

[Operator Instructions] Your next question comes from Murray Connellan from Moelis Australia.

I just wanted to touch on the announcement of the buyback that was out last week. Would you be able to comment on what sort of gearing levels you would need to see before you might look to start deploying there? I guess under what conditions you may look to start deploying capital?

Thanks, Murray. Look, I mean, that announcement was really to retain flexibility on our ability to buy back stock more broadly. We always take a balanced approach in terms of how we think about further deployment of capital into a buyback. As a general rule, I mean we view buyback activity as kind of activity whereby you have excess capital. And we're probably not quite at the stage where we can say we have an abundance of excess capital right now. And as we -- as Leanne highlighted on the earlier question, obviously, we will continue to seek further divestments. And depending on the strength of terms that we can achieve, that may will dictate the kind of asset sale volumes that we're willing to potentially accept and then we'll be in a better position to determine whether deployment of capital into a buyback is appropriate at that time. But again, it's very much subject to where the market conditions in the direct property market move to and strengthen the terms that we might be able to achieve.

And then just on Glass House Mountains. Is there an update on the timing of the wave park development that's adjacent to it?

There's no specific timing update on that just at the moment, Murray is the short answer.

There are no further questions at this time. I'll now hand back to Mr. Weate for closing remarks.

Thanks, everyone, for joining on the call today and looking forward to catching up with all of you in due course over the coming days. Thank you.