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Edited Transcript of ARF.AX earnings conference call or presentation 13-Feb-20 12:01am GMT

Half Year 2020 Arena REIT No 1 Earnings Call

MELBOURNE Mar 3, 2020 (Thomson StreetEvents) -- Edited Transcript of Arena REIT No 1 earnings conference call or presentation Thursday, February 13, 2020 at 12:01:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Gareth Winter

Arena REIT - Company Secretary, CFO & Director

* Robert Andrew de Vos

Arena REIT - CEO, MD & Director

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Conference Call Participants

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* Darren Leung

Macquarie Research - Analyst

* Simon Chan

Morgan Stanley, Research Division - VP & Equity Analyst

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Presentation

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Operator [1]

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Thank you for standing by. And welcome to the Arena REIT HY '20 Results Conference Call. (Operator Instructions)

I would now like to hand the conference over to Mr. Rob de Vos, Managing Director. Please go ahead.

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [2]

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Good morning, everyone. And a very warm welcome to Arena REIT's results presentation for the first half of financial year '20. Our announcement, investor presentation and financial statements were released to the ASX earlier this morning. My name is Rob de Vos, Arena's Managing Director; and joining me on the call today is Gareth Winter, Arena's Chief Financial Officer.

The format of today's call will have Gareth and I present Arena's half year investor presentation. And as always, we will be happy to answer any further questions at the end of the session.

Moving straight to the presentation on Page 3 for the highlights. The first half '20 has been another productive period for Arena, with our major highlights being the replenishment of our development pipeline, which will further enhance future earnings growth as well as recycling of assets to maintain our strong portfolio quality. We've also extended the maturity and capacity of our debt facility, and post balance date, we've increased our exposure to the health care sector. Net operating profit for the half is $21.4 million, up 17%; earnings per security of $0.0717; and distribution paid of $0.0715 per security, both up 6% on half year '19. We've seen further growth in our net asset value, up 4% from financial year '19. Our average rent increases for the period was 3.1%, assisted by the resolution of 3 uncapped market reviews from financial year '19. And we maintain a relatively low-risk funding profile with gearing at just over 23%. So pleasing headline numbers for the first half, in line with our expectation and positioning us well for the full year.

Moving to the next slide. The strong numbers we are reporting today are a result of positive outcomes across our portfolio and capital management programs. There's our team's consistency and approach, strong industry relationships, high conviction and ongoing strategy discipline that is supporting Arena in providing our securityholders sustainable long-term returns.

Highlights for the period under the team's key focus areas: 100% occupancy is being maintained; average rental growth of 3.1%, which includes those 3 uncapped market reviews that were resolved in the period, but related to financial year '19. Those market rent reviews provided an average increase of 15%.

3 operating centers in Victoria and Queensland were acquired in high demand locations, with existing and new tenant partners where we've been able to introduce our preferred 20-year triple net leases and obtained an initial yield on all costs of 6.2%.

We've completed 1 development in the period in Spring Farm in Greater Western Sydney for a total cost of $5.6 million, and an initial yield on all costs of 6.5%. We've also acquired 11 new early learning centre development sites that are located across 3 states. Each are pre-committed to new and existing tenant partners on 20-year triple net leases on sustainable rents of between $3,000 and $3,500 per license place.

During the period, we commenced our renewable energy program that is focused on working with their tenant partners to install and promote the use of solar and reduce the energy intensity of our portfolio. We currently have approximately 10% of the portfolio using solar power and are in advanced negotiations for further 18 properties to have solar installations completed over the course of the second half. We've also undertaken further upgrade in rejuvenation works with 2 of our tenant partners across 6 properties that had allowed us to improve asset quality and access better rental profiles. Our WALE has been maintained at 14.1 years. We've sold 5 early learning centres that, relative to the balance of the portfolio, were older and less efficient, each located in regional Queensland for total proceeds of $13.3 million and a premium of 11.6% to book value. And we've seen further valuation growth across the portfolio of $20.3 million or 2.5%. The passing yield for the portfolio now sits at 6.3%. So we maintain ongoing discipline to our long-term strategy, and we believe that we are well positioned for ongoing positive operational outcomes.

I'll now pass you over to Gareth to present the financial results in more detail.

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Gareth Winter, Arena REIT - Company Secretary, CFO & Director [3]

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Thanks, Rob. And good morning, everyone. On Page 6, you will find a summary of Arena's operating income statement for the half year, which shows a 17% increase in net operating profit. The net operating profit represents Arena's cash-based earnings and is the source of distributions to investors. There is a reconciliation of net operating profit to statutory profit in the appendix of the presentation. The most substantial adjustment is the periodic revaluation of investment property. The EPS of $0.0717 for the half is 6% higher than last year and is tracking to expectations, with a 6% EPS growth expected to be maintained in the second half of FY '20. The key driver of the growth is the 13% increase in property income. This income growth has been derived on a basis consistent with prior years, and it is coming from the rent reviews, which averaged 3.1% in the half, with further market rent reviews to be completed in the second half of FY '20 and the benefit of new income from Arena's continued investment in ELC developments and acquisitions over the past 18 months. In that time, we've invested a net $102 million in new projects.

Looking at some of the line items. Property expenses are stable, notwithstanding the increase in assets. Cash operating expense is also relatively stable, given the growth and the scale of the business over the past year, with the increases largely driven by regulatory and compliance costs such as the ASIC industry funding and corporate insurances and custodian fees.

Finance costs also stable. A slight decline, primarily due to a small decline in the cost of borrowing and also timing on debt draws following the mid-2009 (sic) [2019] capital raise, after which we've repaid some debt. We've been drawing that back.

Higher statutory profit primarily due to the increase in property revaluations in the first half of FY '20, which, at $20 million, was around $2 million more than the prior period. We also did not have a spot mark-to-market recur in 2019. That was $2 million in the comparative period in 2018. And there was also a circa $1 million gain on sale of properties during the half.

With operating performance being in line with expectations, we have paid distributions of $0.0715 for the half, which is in line with our full year distribution guidance of $0.143 per security. As I mentioned, this represents annual growth of around 6% on FY '19. The full year payout ratio is expected to be consistent with recent years at a little over 97%. This reflects the strong underlying cash flows generated by the business and the predominantly triple-net nature of our leases.

Just turning to Page 7. This slide presents a summary of Arena's balance sheet. The full balance sheet is in the appendix to the presentation. Key points to note here, the growth in total assets is primarily due to net $35 million invested to ELC developments and acquisitions during the first half and asset revaluations of $20 million, which I just mentioned. The revaluations is also one of the primary drivers of the 7% increase in net assets and the 4% increase in net assets per security.

Gearing has remained stable at around 23%, which remains well below Arena's maximum gearing range of circa 35% to 40%. This level of gearing continues to give Arena substantial scope to take advantage of new growth opportunities and also provide a buffer around any future market volatility. Gearing is expected to increase by a few percentage points as the development projects are completed.

Turning to Page 8, capital management summary. Arena's approach to capital management prioritizes resilience and risk reduction in the face of market volatility. During the period, we finalized our SPP in July 2019, which raised $16 million. We have maintained a near 5-year average duration in our interest rate book -- in the interest rate hedge book, sorry, over the period, with a 76% cover at present. And we have also recently increased our access to liquidity with a $50 million expansion of our syndicated debt facility, and we also have extended our debt maturities by 12 months, so that our weighted average term is now 4 years. And I know that there is no expiry in the next 3 years.

As Rob mentioned, we've also sold 5 ELCs during the period, which will settle throughout FY '20, the proceeds of which will be recycled into the new developments and acquisitions.

Now all in, average cost of debt reduced 10 bps to 3.55%. If interest rates stay around current levels, we would expect that our average cost of debt will further reduce over time as there is a positive reversion of value in the existing hedge book.

Finally, it is important to note that Arena is operating well within the requirements of our debt facility, and we have substantial headroom in both our LVR and ICR covenants.

I'll hand you back to Rob now who will take you through the property portfolio and development pipeline.

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [4]

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Thanks very much, Gareth. On Page 10, Arena owns 233 properties across Australia, with a value of just over $850 million. The portfolio's passing yield is 6.32%, which has seen compression over a period of 6 basis points. In terms of diversification, we continue to improve our spread of tenant partners, and geographically, with over 80% of the portfolio located in the eastern seaboard states. Sector diversity remains unchanged for the period given the strong macroeconomic drivers of health care accommodation. We would like to be doing more in this space. But outside our acquisition in Kalamunda, which we'll discuss later in this presentation, we've seen limited opportunities in the period, and the transactions that have taken place have been on pricing metrics that are not consistent with our view of long-term value.

Moving on to the lease expiry on Page 11. The portfolio WALE was maintained at 14.1 years during the period as a result of proactive management initiatives, strong tenant relations and new development and acquisition activity. We've no current vacancies and no income expiry in the next 3 years. As you can see on graph on this slide, we have less than 3.5% of the portfolio's income expiring in the next 9 years. And from there, the expiry profile of the portfolio is staggered relatively evenly from financial year 2029 to 2039 and a small proportion of income expiring financial year '42 and beyond. So very long term, highly transparent and predictable cash flows that have annual escalations providing real growth to our securityholders.

Moving on to our rent review profile on the next slide. And we've broken down the half year '20 review structures that made up the 3.1% like-for-like growth in the first column. As you can see there in gray, we still have 4.8% of this period's income subject to a market review that has not yet been resolved. We also have the 7 uncapped reviews that relate to financial year '19 that are in determination. We anticipate all of these will be resolved over the course of the second half.

Looking forward for the next few years, you'll note the vast majority of our rent reviews continue to be those fixed or CPI with at least 2.5% ratchet. Our exposure to market rent reviews is 7.8% for the current year, 9.1% for the financial year '21, and reducing to 3.9% in financial year '22. Each of those has the cap of 7.5% increase and a collar at the prevailing passing rent.

Moving to Page 13, acquisitions and developments. Our origination programs are working well. We've benefited from a period where developers, in general, have not been as active in the market and allowed us to secure some great projects that will provide a strong and sustainable business propositions for our tenant partners. We've also benefited from our strong tenant relationships, which has allowed us to jointly acquire going concern properties where Arena can buy the freehold, subject to a new long-term lease and our tenant partner can buy the business. We've acquired 3 operating centers in the period, 2 in Victoria and 1 in Queensland, for a total cost of $15.5 million and an initial yield on cost of 6.2%.

In total, our development pipeline now has 16 early learning centre projects that are located in Queensland, South Australia, Western Australia, Tasmania and New South Wales, with a forecast cost on completion of $86 million. Each of our development projects are being undertaken on a fund-through basis, and we've secured agreement for leases with strong tenant partners on each project in our standard 20-year triple net lease format.

We anticipate that our current development programs will provide 1,700 high-quality early learning places in undersupplied communities that will deliver us a little over $5.7 million in additional rent, equating to a 6.7% yield on all development costs.

We have a strong track record in executing on our development pipeline, having completed 38 successful early learning centre developments in the last 6 years, significantly more than any other group in the country. During the period, we completed 1 development in Spring Farm, a new and quickly-expanding community in Greater Western Sydney. The total cost was $5.6 million, and initial yield on all costs was 6.5%. The property is located adjacent to a recently constructed retail precinct and has great exposure being on a major thoroughfare and close to the local primary school. The development was completed on time and on budget, is operating well in its first couple of months of trade. We're on schedule to complete a further 3 exciting development projects in the second half, with the balance of our current pipeline scheduled to be completed over the course of financial year '21. Of the $86 million total anticipated cost, we've invested just under half, with $44 million of capital expenditure outstanding as at balance date.

Moving on to the next slide, ELC sector. Demand drivers for the early learning sector continue to be strong. So the Coalition Government's Child Care Subsidy is doing exactly what it was designed to do, increase early learning participation and promote higher workforce productivity. Australia recorded its highest number of children attending long day care here in 2019, with attendances up 12.5% since the introduction of the Child Care Subsidy. Supporting this number has been the decline of the informal family day care sector, with attendances reducing by 27% over the same period. So long day care attendances are up, and we're seeing a large swing out of informal care into formal center-based care.

Female workforce participation has again increased and is also at a record high of 64%. Affordability for early learning services has increased and remains 4% more affordable than before the Child Care Subsidy introduction in July '18. However, operator fee growth is increasing at a rate above the subsidy escalation, which will be an area of interest to the industry and government over the coming years.

In relation to supply, it's something we continue to watch carefully. As anticipated, we saw a moderation of growth in calendar year 2019 up to the third quarter and an increase in the December quarter, which resulted in overall annual increase of new centers of 319 or 4.2% growth. Based on our assessment of the progress of current development applications across the country, and generally, a more measured approach from operators in relation to their expansion programs, we anticipate supply growth is likely to remain at around that 4% mark in the medium term.

Importantly, while you can look at supply growth at a headline level, it is more meaningful to consider both supply and demand at an individual catchment level. This analysis is inherent in Arena's ongoing investment and portfolio management programs.

So what does that all mean for Arena's early learning centre portfolio? I'm now on Page 15. Arena's portfolio is in a strong position. We're 100% occupied. Every 1 of our 223 early learning centres provides operating data, and that data provides us important information that assists our capital allocation decisions and provides insight into the general health of the sector. Across our portfolio, underlying operator occupancy has improved for our tenant partners, which, in aggregate, in the 12 months to September, was up 5%. Daily fee growth has increased 3.6% from 30 June and 5% from 30 September 2018 to reflect an average of $107 per day, which remains significantly below the government's benchmark fee of $130 per day.

As you can see on the graph at the bottom of the page, the government funding package suits our early learning centre portfolio, which is typically geared towards middle-income families. And to give this some context, 99% of our early learning centres have daily fees under the government's benchmark fee.

Our average rent per place across the portfolio is $2,300 per place. And given that we have developed more than 25% of the portfolio over the last 5 years, remains highly affordable, with rent-to-revenue ratio continuing to sit below 11%.

Moving on to the next slide, Page 16. In the health care sector, the macro trends are also positive. A higher number of people moving into the older age brackets and a higher proportion of the population living with chronic illness, which underpins an increased need for health care services and the infrastructure to accommodate those services. Our largest health care tenant partner, ASX-listed Healius, have commenced enhancement works across our medical centers aimed at improving customer experience and ultimately to drive better utilization. SACARE, our specialist disability accommodation tenant partner, continues to perform well, maintaining high occupancy and increasing profitability over the period. Finally, on this slide, we're very pleased to confirm the recent settlement of an $11 million medical center at an initial yield of 6.5%, which is co-located with the Kalamunda Public Hospital, approximately 17 kilometers east of Perth's central business district. The property was purpose-built 6 years ago, is majority leased to Mead Medical, a leading local health care provider that has been operating in the Kalamunda community for over 60 years.

Moving on to the outlook on Page 18. And today, we are reaffirming our full year distribution guidance for the financial year '20 of $0.143. This represents an increase of 6% on financial year '19. And looking forward, we maintain our positive outlook, which is underpinned by contracted annual and market rental growth and new investment, which is enhancing underlying earnings and distribution growth.

We have a highly engaged and dedicated management team with strong relationships with tenant partners and in-house origination development expertise. We've replenished our development pipeline and increased our funding capacity to execute on selective further acquisition and development activities. And from a macroeconomic perspective, Australia has a growing need for social infrastructure services based on population growth and changing community needs and values. Arena is well positioned to benefit from that structural demand and to continue delivering benefits to communities that use our assets and on our investment objective of providing long-term predictable distributions to our securityholders, with good prospects for growth.

That concludes the formal presentation. So I'll now pass you back to the operator to open up for questions. Thank you.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Darren Leung from Macquarie.

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Darren Leung, Macquarie Research - Analyst [2]

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Two quick ones from me. You've talked about the occupancy uplift in terms of the tenant base, Rob. Can you give us an indication of how -- what the quantum of that was in the last 5 or 6 or 12 months?

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [3]

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Yes. So 5% up in the 12 months to September, Darren. So yes, significant increase spot to spot there.

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Darren Leung, Macquarie Research - Analyst [4]

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Is that, say, like 80 to 85? Or is that 5% of it...

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [5]

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It's lower than that. So we haven't typically given out that, but it's slightly lower than the numbers you're quoting there.

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Darren Leung, Macquarie Research - Analyst [6]

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Okay. I understand. So that looks like a good outcome. Is there any color as to what was driving the occupancy uplift? Was it more, I suppose, family utilization? Or was it more days per family?

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [7]

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Its days per family, mostly, Darren. And no question, if you look at it, it's the government subsidy that's promoting that.

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Darren Leung, Macquarie Research - Analyst [8]

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Second one, just around the market rent reviews. So the 3 that happened, obviously, very solid outcome here. Can you give an indication as to what you're expecting for the remaining uncapped market rent reviews?

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [9]

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Indetermination at the moment is always sort of a little bit reticent to provide color on that in that they're outside of our hands. Look, candidly, I don't think they'll be as strong as that. But at this stage, we've got a good position. We think that they'll be higher than what we have seen in the [capped to collared] reviews, which is our standard review, I should emphasize. But they are only 7 in a portfolio of 223. So perhaps not material earnings, but I think that you'll see them in something more significant than the sort of running 6% that we've seen in the [capped to collars].

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Operator [10]

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(Operator Instructions) Your next question comes from Simon Chan from Morgan Stanley.

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Simon Chan, Morgan Stanley, Research Division - VP & Equity Analyst [11]

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I just want to clarify one thing. In your answer to the previous question, you said occupancy increased by 5%. In your previous slides, you said average daily fee increase, say, 4% to 5%. Your like-for-like income increased by less, right? Like your rent only increased by, say, 3%, 3.1%. How did occupancy costs actually go up there under those numbers? Occupancy costs should be coming down, shouldn't it?

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [12]

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Yes. I think it's actually timing is the answer to that, Simon. So it's -- the 5% up is -- includes a number of centers that have moved into that portfolio now that they're stabilized. So that 5% up to September was a meaningful number. The like-for-like is probably closer to the 4, I suspect. And then obviously, those meaningful rent increases that we've seen coming out of last year and early into -- and into this period's market rent reviews. So that's the answer.

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Simon Chan, Morgan Stanley, Research Division - VP & Equity Analyst [13]

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Okay, very clear. And you've maintained your 6% growth guidance today, yet you've got a bunch of half year '20 market rent reviews unresolved and a bunch from FY '19. What assumptions have you made about those in your guidance?

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [14]

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As you'd expect from us, pretty conservative on -- in respect to the market rent reviews, is, in fact, the point again that they are now [in formal determination]. So certainly not baked any of that in. So there's very little that we've baked in that's not -- that we can't see at the moment.

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Operator [15]

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(Operator Instructions) There are no further questions at this time. I'll now hand back to Mr. de Vos for closing remarks.

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Robert Andrew de Vos, Arena REIT - CEO, MD & Director [16]

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Thank you very much for your attendance on the call today. That concludes today's investor briefing. Please don't hesitate to contact Sam, Gareth or I directly with any questions. And we look forward to seeing a number of you over the coming weeks, thank you.