The Shopping Mall Massacre Part I: No One Saw It Coming

This story features MACQUARIE GROUP LIMITED. For more info SHARE ANALYSIS: MQG

The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

The sad thing about the demise of Centro Property Group ((CNP)) and its subsidiaries is that the writing has really been on the wall for half the year but no one paid any attention. If you’d collected a dollar for every time someone – strategist, economist, analyst or onlooker – suggested Australia was immune to the global credit crunch over the past six months then you wouldn’t need to trade in shares.

Many US analysts described the initial subprime scare as a storm in a tea cup around about July-August, only to be confronted with a complete freeze of global credit markets. It took a while for the stock market to react, but the short and sharp correction was reversed when the Fed did what it had to and cut the cash rate. The stock market then returned to new highs.

But there was one slight problem – the credit markets never unfroze. This little revelation eventually saw the stock market back at its previous lows as global finance institution after global finance institution finally admitted to massive write-downs, having conned the market earlier into thinking write-downs would not be quite so bad.

Again there was supposedly a light at the end of the tunnel, following further Fed rate cuts, liquidity injections, rescue plans, and even Arab money pouring into US financials. But again – the credit markets never unfroze. There was some lending going on at the top end of credit quality, but basically it’s been every man for themselves on the life boat. Those with any food have not been prepared to part with it, particularly just to keep the weak alive. Throughout the whole credit crunch saga the most important global lending rate – Libor- has never managed to return to any reasonable level. And as the economic situation in the US has become grimmer, Libor is now actually as high as it has been. The cost of borrowing has only become more and more prohibitive – no matter what the business. And that’s still assuming you can find anyone to lend to you.

It has appeared as if the credit crunch has moved in two waves, the second hitting around November when it became apparent central bank actions were not having any effect. But the reality is only sentiment has moved in two waves – the underlying problem has always been there. Global financial markets had been operating at a level of unprecedented leverage, and until that leverage is worked out of the system – down to levels of sensible business investment – the problem will persist.

Outside of a couple of hedge funds that no one much cared less about other than those invested in them, the only notable victim of the credit crunch to date in Australia had been RAMS Home Loans ((RHG)). It was a no-brainer – RAMS business model involved writing mortgages and packaging them up for sale in security parcels which would then finance the next round of mortgages and on the roundabout went. As long as there were always buyers of mortgage securities, RAMS could always write more mortgages and make a profit. It was nothing less than borrowing on one side and lending on the other. The problem was, however, that RAMS retained the obligation to keep on doing it. Mortgages last for 20 years.

When mortgage securities became toxic, one side of RAMS’ money churning business evaporated. And so it was over.

What is a property trust? Well, there are plenty of variations on the theme but basically a property trust borrows money to buy property, and returns the net rental income to the unit-holder after costs and fees (including the performance fee). As the collateral involves some large asset like an office tower or, perhaps, a shopping mall, there is usually little difficulty in finding someone to borrow from to finance the initial purchase. Until there is.

In a way the property trust is not dissimilar to an individual homeowner who was also hoping to profit. The whole credit crisis began when US house prices started to fall and the realisation hit that a vast number of homeowners could no longer pay their mortgages. So no one would lend money for mortgages anymore if they involved unsustainable levels of leverage. The problem for Centro is that it, too, has been riding on dangerous levels of leverage – levels that have only increased markedly over the past 18 months as the trust piled into the US shopping mall market to bolster its asset portfolio. The Centro group of trusts had built up leverage of some 70% all up and relied on constant refinancing from a bank syndicate to keep the money churning over.

Banks have enough problems of their own right now in simply safeguarding their own capital levels. They are also under pressure (in the US) to provide relief to a number of American homeowners, which may simply end up a balance sheet cost. At the same time there is a growing fear that US consumers will stop spending and the economy will recede. American consumers, of course, mostly shop in…oh dear.

Centro’s announcement yesterday hit the market like a freight train. Only this August were property trust analysts glowing in the wake of Centro’s full-year result, and taking heart in the fact Centro had declared that post its big expansion phase the next step was to reduce gearing down to a manageable level. With a strong yield Centro should be able to attract the sort of levels of funds under management that other more traditional trusts had enjoyed.

With the benefit of hindsight, it’s interesting to look back at some analyst views. In August, for example, the Macquarie analysts suggested Centro’s capacity to acquire and gear more assets would probably be hurt by the credit crunch but they retained an Outperform rating. Merrill Lynch analysts remarked on just how strong the full-year result was and were happy to retain Buy knowing the intention was to reduce gearing. By November, when the credit crunch appeared to be getting worse, Citi analysts upgraded to Buy given the market had sold down Centro stock when its yield was very strong and there was upside from higher performance fees.

Of the seven brokers in the FNArena database covering Centro as we entered December, four rated the stock a  Buy. Three rated it as Hold and there were no Sells. When Centro went into a trading halt last week, Merrill Lynch lost faith and downgraded to Sell. Merrills had downgraded to Neutral in September, believing the US economic situation had deteriorated and Centro would now be looking at raising capital to fund any further acquisitions. So as at yesterday morning, the B/H/S ratio was 4/2/1.

Today it is 3/2/2, with Macquarie the only mover – a double-whammy from Outperform to Underperform. UBS stated “We have previously raised questions of the short-term headwinds facing this vehicle particularly in light of opaque disclosure” and is now reviewing its valuation. The concerns can’t have been too great as UBS did have a Buy. Credit Suisse (Hold) did not post a report on Centro this morning. GSJB Were (Hold) is also reviewing Centro among a full review of all property trusts in light of yesterday’s carnage.

The average target price in the FNArena database has fallen from $8.14 to $4.44, but $4.44 is misleading given the number of brokers still reviewing the situation. To appreciate the change in targets, it’s best to note JP Morgan ($10.60 to $2.74), Citi ($8.03 to $2.33) and Macquarie ($9.54 to $0.92). At midday the stock is trading at 71c having been to 42c.

JP Morgan’s new target reflects the analyst’s calculation of net asset value, although they warn of further downside. There is a slight chance the banking syndicate (lead by Bank of America) will have a rethink about their decision come February – the time it has provided for Centro to pay its debts – and the analysts are hanging their hat on that for the moment. They suggest that it would be more beneficial for the syndicate to keep Centro going than to let it fold (a bit like a subprime mortgage). As such, and because it seems pointless to change now anyway, JP Morgan has retained Overweight. No sense in cutting and running just yet they say, but the analysts warn this stock is now a very big risk.

Citi’s new target reflects a simple sum-of-the-parts valuation, which provides no goodwill for the corporation itself. The analysts are hanging their hat on Centro achieving required asset sales and making the February payment. Hence Buy is retained. They have moved their risk caveat from Medium to High, however.

Macquarie has just flat out suggested the uncertainty surrounding Centro’s ability to refinance is too high, and that asset sales will no doubt come at a loss. Macquarie has thrown in the towel, and noted for their client’s gratification that the Macquarie Group ((MQG)) is a “substantial” shareholder in Centro.

Any apologies? No.

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