Frasers Commercial Trust - DBS Research 2017-11-06: Breaking Up Is Sometimes For The Best

FRASERS COMMERCIAL TRUST ND8U.SI

Frasers Commercial Trust - Breaking Up Is Sometimes For The Best

HP Inc to vacate Alexandra TechnoPark (ATP) on a staggered basis with exit completed by end-Dec 2018.
Disappointing news but provides FCOT with income and time to find replacement tenants.
AEI at ATP to be completed by mid-2018 should enhance value proposition to prospective tenants.
DPU to remain stable given c.S$40m worth of capital gains to distribute.

We maintain our BUY call with a 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%.

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. Thus, in our view, FCOT should re-rate closer to book as implied in our TP of S$1.55.

With news that HP Inc will now stagger its exit from ATP, it finally removes the overhang over FCOT and should as a further re-rating catalyst.
FCOT now has time and some income while it finds its replacement tenants, compared to the worst-case scenario of zero income for the vacant HP Inc space. However, we believe FCOT should be able to maintain its current DPU by 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, the market should react positively as the change in tenant mix at ATP provides an opportunity raise rents post the completion of the AEI.

While HP Inc will be vacating, we believe with ATP undergoing an AEI, FCOT will be able to back fill the vacant space. Thus, we maintained our DCF-based of TP to S$1.55.

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

FCOT announced it has been notified by HP Inc that it intends to stagger its exit from ATP.
HP Inc currently occupies approximately 304,920 sqft of space at ATP with its existing lease expiring on 30 November 2017. The lease represents c.29.2% of the total net lettable area of ATP and 11.1% of FCOT’s total gross rental income for the month ended September 2017
At the end of its existing lease, HP Inc will extend the lease for 266,905 sqft of space as follows based on similar terms to its existing lease. We understand HP Inc currently pays rents of around S$4 psf per month.
1. 93,195 sqft for 13 months commencing from 1 December 2017
2. 42,561 sqft for five months commencing from 1 December 2017
3. 131,149 sqft for between two to three months commencing from 1 December 2017

While the news that HP Inc will be eventually moving out is worse than our current assumption that half of HP Inc would remain at ATP, as discussed in our prior reports, even in the worst-case scenario of HP totally vacating ATP, FCOT can maintain a stable DPU given the c.S$40m worth of capital gains that it can distribute and it can increase the proportion of management fee paid in units to 100%.
A positive from the announcement is also the fact that HP will be staggering its exit, which provides FCOT with some income and time while it undertakes a S$45m AEI and looks to secure replacement tenants.
In addition, the exit of HP allows FCOT to finally reduce its tenant concentration risk and in the medium term drive an increase in rents at ATP post the AEI.
Furthermore, this announcement finally removes the uncertainty surrounding the HP lease, which has been an overhang on the stock, causing FCOT to trade at a 2% yield premium to the large cap REITs compared to its historical average spread of 0.8%.

Post the announcement of HP Inc leaving, we have tweaked our assumptions for ATP in FY19 and FY20, and now project an average occupancy of 80% and 90% respectively, down from 85% and 95% previously. For FY18, we have maintained our 71% occupancy estimate. This compares to an estimated effective occupancy of around 69% and 63% for ATP in FY18 and FY19 respectively, based on HP Inc’s exit schedule and FCOT not finding any replacement tenants.
We believe our assumptions are realistic and FCOT should be able to find replacement tenants, given a better product available post the AEI at ATP, the expected improvement in CBD office rents, and the lack of new business park supply.
Following the change in our assumptions, we have also lowered our operational DPU by 2% but given FCOT’s ability to pay out its capital distributions, we have maintained FCOT’s annual DPU at 9.82 Scts. We have also retained our DCF-TP of S$1.55.

With the overhang and uncertainty over the HP Inc having now been removed, we believe there is potential for FCOT to re-rate, given it has been a laggard compared to its large cap office REITs.
In addition, FCOT offers an attractive 7.1% yield and trades at c.10% discount to book.

Melvin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2017-11-06

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 1.550 Same 1.550