Frasers Commercial Trust - DBS Research 2017-10-23: Removal Of Stock Overhang Soon

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FRASERS COMMERCIAL TRUST ND8U.SI

Frasers Commercial Trust - Removal Of Stock Overhang Soon

• Frasers Commercial Trust (FCOT)'s 4Q17 DPU of 2.41 Scts (-2% y-o-y), FY17 DPU of 9.82 Scts (flat y-o-y) in line with expectations.
• Announces S$38m AEI to rejuvenate retail podium of China Square Central.
• Still awaiting HP Inc’s decision to stay or vacate Alexandra Technopark but this risk is mainly priced in.

Laggard office play. 

• We maintain our BUY call for FCOT with a revised Target Price of S$1.55. 
• While Frasers Commercial Trust (FCOT) has rallied year to date, it has lagged the other office REITs such as CapitaLand Commercial Trust (CCT) and Keppel REIT (KREIT) given concerns over HP Inc vacating (c.11% of group gross rental income) Alexandra Technopark (ATP) in November 2017.
• We believe that FCOT’s share price should catch up, as the current 2% yield differential between FCOT and its large cap peers is higher than the historical average spread of c.0.8%.

Where we differ – tailwinds to price-to-book. 

• While consensus has a BUY call on FCOT, it continues to peg FCOT at a significant discount to its book value of S$1.58. We believe this is too conservative, given expectations of a recovery in the Singapore office market, further compression of cap rates in the Australian market, and potential tailwinds from an appreciating AUD. Therefore, once the HP lease is resolved, in our view, FCOT will re-rate closer to book as implied in our TP of S$1.55.

Clarity over HP lease. 

• We expect the announcement of whether HP Inc stays at ATP in November to finally remove the overhang over FCOT and act as a further re-rating catalyst. Irrespective of whether HP Inc partially or fully vacates ATP, in our view, FCOT should be able to maintain its current DPU through paying 100% of its management fees in units and/or distributing c.S$40m of capital gains, allaying any fears of a collapse in its DPU. 
• In addition, we believe the market should react positively as the change in tenant mix at ATP provides an opportunity to refurbish the property, resulting in higher rents.

Valuation

• After incorporating higher shares on issue, impact from AEI at China Square Central and delay in achieving higher rents at ATP, we lowered our DCF-based TP to S$1.55 from S$1.61.

Key Risks to Our View

• A key risk to our view is the market ignoring FCOT’s ability to mitigate the loss of HP as a tenant.

WHAT'S NEW - Stable FY17 DPU 

4Q17 DPU in line with expectations

• Frasers Commercial Trust (FCOT)'s 4Q17 DPU came in at 2.41 Scts (-2% y-o-y) which resulted in flat DPU y-o-y for the whole of FY17 at 9.82 Scts. This was in line with our expectations. Stripping out S$0.92m worth of capital distributions, underlying 4Q17 DPU fell 3% y-o-y. The weakness experienced over the quarter was largely attributed to a 9% y-o-y drop in NPI which was tempered with a proportion of management fees paid in units.
• NPI from China Square Central (-18% y-o-y) was impacted by planned lower occupancies as FCOT gears up to refurbish retail mall at the property. Overall occupancy at the property fell to 79.8% from 99.4% in 4Q16. 
• Contribution from Alexandra Technopark (ATP) also fell 5% y-o-y as occupancy fell to 76.2% as HP Enterprise announced its decision to vacate the building.
• Meanwhile, effective occupancy at Central Park in Perth fell to 69.6% from c.80% in 4Q16 resulting in 4Q17 NPI for the property to drop 8% y-o-y. However, earnings should recover as committed occupancies now stand at 88.9%. Furthermore, contribution from Caroline Chisholm Centre was weak, down 17% y-o-y as the property undertook additional repair and maintenance worth c.S$900k. An equivalent amount of repair cost is expected to be incurred in FY19.
• Overall, FCOT’s portfolio committed occupancy remains healthy at 85.9%, although down from 92.6% as at 30 June 2017, mainly due to the loss of HP Enterprise as a tenant.

Positive rental reversions at ATP and Central Park

• FCOT achieved 1.1% and 27% increase in signing rents over expiring rents in 4Q17 at ATP (c.44,900 sqft) and Central Park (c.9,600 sqft) respectively. This was partially offset by negative rental reversions at China Square Central and 55 Market Street of 2.7% and 6.5% respectively. Overall, FCOT achieved 3.1% positive rental reversions in 4Q17 and +1.9% for the whole of FY17.
• Going into FY18, there remains risk that FCOT will still report negative rental reversions at China Square Central and 55 Market Street given expiring office rents for these properties are at S$7.62 and S$7.33 per sqft per month respectively, above current spot Grade B office rents of S$6.85 Marginal decrease in gearing to 35%
• Owing to revaluation gains over the quarter, FCOT’s gearing fell to c.35% from c.36% in the prior quarter, with overall cost of debt stable at c.3%.

The proportion of fixed debt now stands at 80.7%.

• Due to the increase in property values, NAV per share rose to S$1.58 from S$1.52 (excluding distributable income).
• The 0.2% and 10.1% increase in valuation for the Singapore and Australian properties respectively were largely attributed to 25-50bps compression in cap rates.
• While occupancy is projected to soften near term at China Square Central and 55 Market Street, property values were generally stable. FCOT’s new valuer has now applied a cap rate of 3.75% and 3.25% for the office component of China Square Central and Market Street down from 4.0% and 3.75% respectively.
• The increase in values for the Australian properties was due to a combination of firmer rents, lower cap rates and a stronger AUD.

AEI at China Square Central retail podium

• FCOT announced that it will commence asset enhancement works at the retail podium of China Square Central starting from 1Q18. The target completion date is mid-2019, in line with the expected opening of the adjacent Capri by Fraser hotel in 2019.
• Costing S$38m, the refurbishment works are expected to result in an improved tenant mix, focusing primarily on F&B, wellness and services.
• As part to the AEI, there is also potential to increase the NLA of the retail podium from 64k sqft currently to c.75k sqft.
• Assuming ROI in the high single digits, we assume rents at the retail podium to increase from S$4.50-$5.00 to S$8 in the medium term.
• Combined with the S$45m AEI at ATP, we expect FCOT’s gearing to increase to 37-38% from 35% currently.

TP lowered to S$1.55

• Following the 4Q17 results, we have lowered our DCF-based TP to S$1.55 from $1.61. This largely attributed to the higher than expected shares in issue (impact of DRP) and short-term impact from the closure of the retail podium at China Square Central.
• In addition, we understand that there is potential for HP Inc whose lease expires in November to retain some space at ATP. However, it is unlikely for HP Inc to renew all of the c.305k sqft that it currently occupies. We had a previously assumed HP Inc stays but now only project HP Inc to only renew half of its lease.
• Furthermore, at ATP, while FCOT has already found tenants for c.61k out of the c.192k sqft of space vacated by HP Enterprise, we understand the signing rents for these new tenants are not materially different from HP Enterprises’ expiring rents given the challenging market conditions. Thus, we have extended the time taken for FCOT to raise rents at ATP post its planned AEI.
• Nevertheless, despite expectations of lower earnings near term, we believe FCOT will deliver stable DPU of 9.82 Scts per annum over the next few years, given it has yet to distribute c. S$40m worth of capital gains from the sale of the development site at China Square Central and the ability to adjust the proportion of management fees paid in units to 100%.

Maintain BUY

• With a 10% capital upside and 7% yield, we maintain our BUY call with a revised TP of S$1.55.
• We believe the risk of HP leaving ATP has largely been priced in given FCOT already trades at c.2% yield spread to the large-cap office REITs versus its historical spread. Thus, once there is clarity of the HP lease, in our view the stock overhang will be remove, triggering a rerating of FCOT’s share price.

Melvin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2017-10-23

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 1.55 Down 1.610