GuocoLand - Maybank Kim Eng 2017-08-16: Riding The Singapore Upcycle

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GUOCOLAND LIMITED F17.SI

GuocoLand - Riding The Singapore Upcycle

Tap Singapore’s upcycle via this laggard – 39% upside 

• We initiate coverage on under-researched GuocoLand at BUY and SGD2.75 TP, implying a 22% discount to RNAV of SGD3.55. We believe its small free float, lower trading liquidity and limited analyst coverage are technical reasons for the underperformance and steeper valuation discount when compared to its larger peers. 
• Fundamentally, we see a company with improving financials and attractive valuations. The stock trades at a 44% RNAV discount and 0.67x P/BV. 
• Key risks could arise from a sharp fall in property prices in Singapore and China.

INVESTMENT THESIS

Structural improvement to its financials 

• GuocoLand’s earnings quality will improve materially over the next few years. The gradual stabilisation of TPC will lift recurring EBITDA to over SGD140m or almost 40% of the group’s income by FY19E. This is a marked improvement from the SGD40m EBITDA or 18% of earnings in FY16. 
• Its capital position has also improved structurally post-disposal of Dongzhimen and we see gearing moving to 0.6x over FY16-19E, from 1.6x in FY11-15. This deleveraging has lowered the risk profile of the stock, in our view. 
• Furthermore, returns on capital should improve with the release of SGD2.3b of trapped capital at Dongzhimen and the recent completion of SGD3b TPC. We see ROEs rising to an 8% range from prior years of about 5%. 
• Lastly, with a stronger recurring income base and lower leverage, we believe GuocoLand can progressively raise DPS back to its historical levels of 8cts by FY19E.

Beneficiary of a Singapore property price rebound 

• With Singapore accounting for almost 70% of its valuation, we believe GuocoLand is a good proxy to an impending rebound in property prices. We see an inflection point in Singapore’s residential market and expect GuocoLand to benefit from this development. 
• Four residential projects, worth a combined GDV of SGD5b, accounts for 25% of its valuation. Strong pre-sales at Sims Urban Oasis provides good earnings visibility as the project gets completed in the year ahead. We believe it can ride on improving sentiment in Singapore’s residential market and expect sales volume and ASPs to rebound off a low base. 
• Its stakes in Guoco Tower, 20 Collyer Quay and its reversionary interests in prime office space offers a 35% exposure Singapore’s office market, which could bottom out by early-2018. 

Value-unlocking potential 

• The recent completion of TPC has opened up various options to unlock shareholder value. Instead of holding this property for the long term, we believe it could capitalise on strong investment demand today with an outright sale.
• Alternatively, it could establish an S-REIT platform to partially monetize its stake. We believe the latter may be a better option as it could unlock SGD1.7b of value while retaining a stream of recurring income. Strategically, it builds another avenue to recycle capital in future developments. 

Sector laggard with attractive valuation 

• GuocoLand has been a sector laggard with YTD returns of just 9%. This compares with the 31% return on the FTSE Straits Times Real Estate Development and Holding Index. 
• We believe its small free float of 22%, lower trading liquidity and limited analyst coverage are technical reasons for the underperformance and steeper valuation discount when compared to its larger peers. At 44% RNAV discount and 0.67x P/BV, the stock’s valuation is attractive when compared to the 19% RNAV discount and 0.96x P/BV for larger Singapore proxies - UOL (UOL SP, BUY, TP SGD9.05) and City Developments (CIT SP, BUY, TP SGD12.05).
• Fundamentally, we see a company with improving financials and expect the valuation gap to narrow.

VALUATION 

• Our TP of SGD2.75 implies a 22% discount to RNAV of SGD3.55. Key assumptions include:
  1. office cap rates of 3.50% and hotel & retail cap rates of 4.75%;
  2. SGD2,400 & SGD3,250 psf for Martin Modern and Wallich Residence respectively; 
  3. Maybank KE TP of MYR1.12 for its stake in EcoWorld International; and
  4. market value of its stake in GuocoLand Malaysia. 
• In deriving our target price, we apply no discount to Singapore residential (improving sentiment), 10% to its office and retail assets (strong demand), 25% discount for its overseas businesses (execution risks) & hotel assets (illiquid nature); and no discount to the market value of its listed entities. These discount rates are consistent across the sector.
• At 0.67x P/BV, the stock is trading at the low end of history. 
• We believe the steep book value discount is unwarranted considering: 
  1. Tanjong Pagar Centre. Strong demand for commercial properties in Singapore implies that newly-completed TPC could be sold at a significant premium to development cost. Our office cap rate of 3.5% remains conservative when compared to recent transactions of 3.2%.
  2. Reversionary interests in offices. We believe reversionary interests on 20 Collyer Quay and 61 Robinson Road will rise in value given elevated land prices and passing of time.
  3. SG Residential. Nearly 80% of Sims Urban Oasis has been sold and its development profits will be realised as construction progresses.
  4. Changfeng Residence. 90% of this joint venture project has been sold. Profits should be booked as it delivers the 664-unit project upon completion.
  5. Undeveloped land in Shanghai. With escalating land prices, we estimate the market value (net of LAT) of its undeveloped commercial land parcel in Changfeng has risen 2.8 folds since its acquisition in 2005.

Sensitivity analysis. 

• Valuation of the stock is most sensitive to our cap rate assumptions for its commercial properties in Singapore. 
• Narrowing our cap rates by 50bps will lift our valuation by 44 cts or 12%. 
• A 20% increase in our home price assumptions for its unsold stock in Singapore and China will drive a 5.5% and 5.6% respective increase in our RNAV estimate. 
• Assuming property prices in both markets go on a bull run, the combined impact of a 50bps cap rate compression and a 20% increase in our ASPs will drive a SGD0.83 or 23% increase in our RNAV estimate.

COMPANY BACKGROUND

• GuocoLand is the property development arm of Malaysian billionaire Tan Sri Quek Leng Chan. His stakes in the company are held through Hong Kong-listed Guoco Group (53 HK, Not Rated), which owns an effective 69.6% stake in the company, and other entities related to him owning another 5.4%. The stock, which has been listed on the Singapore Stock Exchange since 1978, has a market capitalisation of SGD2.2b and trades just under SGD1m a day.
• Outside of its headquarters in Singapore, GuocoLand has businesses in China, Malaysia and Vietnam. Its Malaysian business is listed separately on Bursa Malaysia as GuocoLand Malaysia (GUOL MK, Not Rated) with GuocoLand owning an effective 68% stake. Beyond these core markets, it recently acquired a 27% stake in EcoWorld International (ECWI MK, HOLD, TP MYR1.12), which gives it exposure to the Australian and UK markets. 
• In Singapore, GuocoLand offers exposure to the recovering mid to high-end residential market and the recent completion of TPC has increased its exposure to a potential pick-up in Singapore’s office market.

Refreshed management team. 

• GuocoLand has a refreshed management team with the current leaders assuming their appointments less than four years ago.
• The company is led by Group CEO Mr Raymond Choong - a career banker who joined the company in Sep 2015 from Hong Leong Financial Group. 
  • CFO Mr Richard Lai joined the company in March 2015 with extensive experience in the finance and property sector, including Mapletree Logistics Trust Management and Tee International. 
  • Mr Cheng Hsing Yao was appointed the head of its Singapore business in 2014 after a two-year stint as COO. Prior to that, he held leadership positions in the public sector, including the URA. 
  • Mr Hoon Teck Ming assumed the role of Country Head China in 2016 after 17 years of experience in that country with Wing Tai and CapitaLand. 
  • Datuk Edmund Kong was appointed Managing Director of GuocoLand Malaysia in 2016 after 26 years of experience in the property development and construction industry.

Sector laggard. 

• Developer stocks performed strongly with the FTSE Straits Times Real Estate Development and Holding Index achieving total returns of 31% YTD. However, GuocoLand has been a laggard with returns of just 9%. 
• We believe its small free float of 22%, lower trading liquidity and limited analyst coverage are technical reasons for the underperformance and steeper valuation discount when compared to its larger peers. 
• Fundamentally, we see a company with improving financials and expect the valuation gap to narrow.

Capturing a rebound in Singapore’s residential market (25% of valuation) 

• We see an inflection point in Singapore’s residential market and expect home prices to pick-up by the end of the year. With four projects worth almost SGD5b under development, we see GuocoLand as a proxy to this positive trend.
• GuocoLand started out developing mid to mass-market homes in the 1990s catering to demand from HDB upgraders. Since the mid-2000s, it has shifted its focus to the high-end market with significantly fewer projects in the mass market. Including the four projects under development today, GuocoLand is responsible for building over 11,000 homes from 35 residential projects. Strong pre-sales at mid-range project Sims Urban Oasis will underpin near-term earnings ahead of its completion in 2018. We believe it can ride on improving sentiment in Singapore’s residential market and expect a rebound in sales volumes and higher ASPs off a low base. 
• Nonetheless, with key cooling measures remaining in place, we believe a volume pick-up will remain contained and have built in fairly conservative forecasts. A stronger-than-expected rebound in sales volume presents upside risks to our forecasts.

Proxy to a bottoming office market in Singapore (35% of valuation) 

• We expect Singapore’s office market to bottom by early-2018 and believe investors should position ahead of this turning point. Developers have already turned more bullish on Singapore’s office market. For example, the predominantly office site at Central Boulevard was sold in November last year to IOI Properties (IOI MK, Not Rated) for a record SGD1,689 psf ppr. This puts the replacement cost of an office building in Singapore at SGD2,800 psf NLA.
• Similarly, several property consultants have flagged a slight uptick in office rents in 2Q17. CapitaLand (CAPL SP, HOLD, TP SGD3.75), one of Singapore’s largest office landlords, have also turned more bullish and it is targeting SGD12-14 psf rents for the redevelopment of Golden Shoe Carpark. This implies that it is pricing in a 30%+ increase in rents over the next 3-4 years. 
• With office assets at 35% of its valuation, we see GuocoLand as a good proxy to a potential rebound in this market.

1. Guoco Tower. Guoco Tower is the office component of TPC. With 890,000 sf of net lettable area, it is amongst the newest office buildings in Singapore’s CBD. The office building is 90% committed with tenants from a diverse trade mix including Uber, Accor Hotels and ING. As the majority of the tenants were signed near the recent trough of the office market in 2016, we estimate average committed rents of about SGD9 psf. With Singapore’s office market showing signs of rebound, we see scope for the landlord to raise rents when leases are up for renewal in three years’ time.
2. 20 Collyer Quay and other reversionary interests. The 24-storey office building is located near Raffles Place MRT station and offers an excellent view of the Marina Bay area. It is currently leased to several international tenants, such as BNP Paribas, Munich Management and HL Bank Singapore. GuocoLand owns the majority of the 999-year leasehold building, but have disposed part of its interest via two separate tranches of 50-year and 99-year leases to third parties. Apart from these reversionary interests on 20 Collyer Quay, GuocoLand also holds reversionary interests on the freehold land at 61 Robinson Road. We believe these reversionary interests will rise in value given elevated land prices in Singapore and the passing of time.

Plenty of options to unlock value for shareholders 

• With the completion of TPC, we see various options for GuocoLand to unlock value in this property for shareholders. Instead of holding this property for the long term, management could consider selling it to capitalise on strong investment demand today. Alternately, it could establish an S-REIT platform to partially monetize its stake. 
• We lay out these options below and compare the pros and cons of each move. We believe the latter may be the best option for the company. While it requires substantial human capital investment into the platform, GuocoLand can unlock value in the asset while retaining a stream of recurring income. Strategically, it builds another avenue to recycle capital in future developments.

Option 1: Outright sale 

• Driven by a global hunt for yields, investment demand for commercial assets in Singapore has been very strong with deals struck at very tight cap rates. The SGD3.4b sale of Asia Square Tower 1 in June 2016 has set a narrow benchmark cap rate of 3.2% for subsequent transactions. More recently, a 50% stake in One George Street was transacted at 3.2% and suburban mall Jurong Point was sold for 4.2%. 
• With the buoyant investment market, we believe an outright sale could achieve the highest upfront return for the asset. However, the company will lose a substantial stream of recurring income and management may struggle to redeploy the large amount of capital released from a sale.

Option 2: Establishing an S-REIT platform 

• We believe establishing an S-REIT platform with TPC may be the best option for GuocoLand. While it may not be able to monetize its stake at the highest possible value in order to clear the yield hurdle of a REIT, we see multiple benefits of taking this option. 
• By retaining a sizeable interest in the REIT, it can unlock capital within the property while enjoying a stream of recurring income from dividends and fund management fees. This is on top of the tax benefits of a REIT model. Furthermore, by establishing an S-REIT platform, the company can build another avenue to recycle its capital in future developments. This would open up more options for the company when the cost of capital rises from the current lows.
• We estimate a combined value of SGD2.7b for TPC’s office, retail and hotel components. This makes it slightly smaller than Raffles City Singapore, which was last valued at SGD3.3b. GuocoLand’s 80% equity stake in the property is worth approximately SGD1.3b assuming a 40% gearing. A potential REIT will have a market capitalisation of about SGD1.6b, which makes it comparable to other established REITs, such as Starhill Global REIT (SGREIT SP, Not Rated) and CDLHT (CDLHT SP, Not Rated). It would in fact be larger than several listed office peers, such as Frasers Commercial Trust (FCOT SP, Not Rated) and OUE Commercial REIT (OUECT SP, Not Rated).
• Assuming that GuocoLand pares down its stake to 32% (from 80%), this REIT will have a sizeable free float of 60%. This will release SGD771m of equity for its shareholders. Apart from this, another SGD94m in value will be created from the fund management platform. This assumes a 4% AUM valuation and 20x P/E multiple for the REIT manager. Together with the SGD857m share of debt deconsolidated into the REIT, we estimate that SGD1.7b of value can be unlocked for its shareholders. Proceeds from this deal can be used to deleverage its balance sheet, pay a special dividend or redeployed for better returns.
• Although GuocoLand would incur transaction costs upfront and lose part of the recurring net profit contribution of SGD49m by paring down its stake, we opine that the post-divestment recurring income stream of SGD24m (SGD20m of dividends from its retained interest, SGD4m from fund management business) remains decent. 
• Having said that, just like most office REITs, we believe the biggest challenge to establishing a REIT would be the yield hurdle that it has to clear. With a blended property yield of just 3.7%, we estimate that the platform can only achieve a DPU yield of 3.9%. This is low when compared with the typical trading yield of 5% for most office REITs. To clear the yield hurdle, we believe rental support may be needed to enhance its yield before a pick-up in market rents raises its underlying income. This yield hurdle could also be cleared if a sustained rally in office REIT prices drives down the trading yields of benchmarks in the market.

Option 3: Hold for the long term 

• While we believe that substantial value can be unlocked from this property, management may choose to hold on to this asset for the long term in order to capture the full benefits of a potential pick up in Singapore’s office market. It will continue to enjoy a regular bottom line contribution of SGD49m a year and would have maximum flexibility around it, such as taking a higher leverage on it.

China – Largest overseas market (27% of valuation) 

• China is GuocoLand’s largest market outside of Singapore accounting for 27% of our valuation. All its properties are located in the Chinese cities of Shanghai and Chongqing. Two projects are currently under development, while another is in the planning stage.
• Changfeng Residence. GuocoLand has a 50% stake in this 664-unit residential project in Changfeng, Shanghai, while its parent company Guoco Group (53 HK, Not Rated) holds the remaining stake. 
• The partners acquired the land parcel in 2010 for CNY3.0b (CNY24,812 psm ppr) and have sold two thirds of the project over the past two years. The property is close to various subway lines and within 30mins drive from prominent landmarks such as People’s Square, The Bund and Hongqiao International Airport. 
• We believe the company has not recognised any of the profits from this project yet pending completion and handover to the buyers. We expect progressive handover and sales of the final phase in the project to drive an uptick in associate income in the next two years. Our CNY60,000 psm ASP assumption for all the entire project is not aggressive when compared to other projects in the locality. For example, UOL (UOL SP, BUY, TP SGD9.05) sold the first phase of Park Eleven at CNY77,000 psm last year.

Malaysia and other international markets (6% of valuation) 

• GuocoLand has other business units in Malaysia, Vietnam and other international markets. However, they are not material to the stock as they account for just 6% of our valuation. 
• GuocoLand’s Malaysia is held through a separately-listed entity GuocoLand Malaysia (GUOL MK, Not Rated). Adjusting for shares held by the company for Executives’ Share Option Scheme (ESOS), we estimate that GuocoLand holds an effective 68% stake in this unit. It acquired a 27% stake in EcoWorld International recently, which gives it exposure to the Australian and UK market.

FINANCIAL ANALYSIS

Singapore and China are its largest markets. 

• Singapore accounts for the bulk of its assets and earnings with China as its second largest market. While its revenue has been falling in recent years, we believe income contribution from newly-completed TPC and stronger home sales in Singapore will underpin a rebound. 
• We see sales reaching a record SGD1.7b in FY19E with a kicker from its China business as it start to deliver on its Chongqing project. With EBITDA margins sustaining at around 20%, we believe the rebound in sales will also lead to a rising EBITDA profile.

Improving earnings quality. 

• We also see a significant improvement in GuocoLand’s earnings quality over the next few years. The gradual stabilisation of TPC should lift its recurring income to over SGD140m a year from about SGD40m in FY16. With almost 40% of its EBITDA from recurring sources and a stronger balance sheet post-divestment of Dongzhimen, we believe the risk profile of the stock has improved structurally. 
• FY16 has set a high net profit base of SGD607m due to disposal of the Dongzhimen project last year. Stripping out the estimated post-tax impact from its bottom line, we see a doubling of net profit to SGD374m in FY17E, which includes its share of fair value gain on completion of TPC. Beyond that, we see bottom line of about SGD290m.

Stronger capital position. 

• The market appears to have ignored the significant improvement in the company’s capital position in recent years. 
• Between 2008 and 2015, SGD2.3b of capital was trapped in a troubled Dongzhimen project in Beijing, China due to a long drawn legal dispute. Fortunately, after years of impasse, it managed to exit this project in August 2015 with a divestment gain of SGD561m in FY16. While this translates into a paltry annual return of 3% over the eight year holding period, we believe the release of trapped capital has allowed the company to deleverage its balance sheet and redeploy the proceeds into higher yielding projects. 
• Furthermore, TPC’s long gestation period has consumed over SGD3b of capital, which generated no income since 2011. With the recent completion of this mega project, we see stronger returns for the group with ROIC rising to over 5% from sub-3% in prior years. This should take ROEs up to an 8% range on lower leverage.

Scope for higher dividends. 

• With a stronger recurring income base and lower leverage, we believe GuocoLand has the capacity to progressively raise DPS back to its historical levels of 8 cts per share by FY19E, from a base DPS of 5cts in FY16. 
• With recurring EBITDA of over SGD140m and net interest expense of about SGD50m a year, we believe this recurring income stream alone can comfortably support a dividend distribution of 8cts a share or SGD89m. This could enhance the yield appeal of the stock. 
• As highlighted earlier, if GuocoLand capitalises on the strong investment demand with an outright sale or establishes a REIT with TPC, there is scope for a special payout.

RISKS 

Overpaying for land and cost overruns on developments. 

• We believe this is the biggest risk factor for a property developer today. Competition for land is intense in its key markets of Singapore and China and overpaying for land could result in huge development losses for the company. 
• The developer is subjected to cost overruns and other execution risks.

Sharp fall in Singapore’s property prices. 

• With nearly 70% exposure to this market, a sharp fall in property prices could lead to a decline in earnings and RNAV. With a large office exposure, trends in this market will have an outsized influence on the company. 
• In the residential market, it is highly sensitive to developments in the luxury market as it accounts for the bulk of its unsold stock.

Sharp fall in property prices in Shanghai and Chongqing. 

• China is its largest overseas market with all its properties located in Shanghai and Chongqing. As 90% of its Shanghai residential project is already sold, it is slightly less exposed to this market. 
• On the other hand, the land parcels were only recently acquired in Chongqing and a sharp fall in property prices in the city would have significant impact on its earnings and valuation.

Regulatory risks. 

• The property development business is highly regulated and policy changes could impact its business. For example, tightening measures could affect residential demand and our home sales forecasts may not materialise.

Interest rate risk. 

• With over SGD4b of debt and 1.0x net gearing, a sharp increase in interest rates could lead to higher financing costs. This could erode its earnings.

Derrick Heng CFA Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2017-08-16

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