ESR-REIT - DBS Research 2018-01-19: Acquisitions Driving Earnings Higher

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ESR-REIT J91U.SI

ESR-REIT - Acquisitions Driving Earnings Higher

• 4Q17 results in line.
• Acquisitions to drive earnings from FY18 onwards.
• Pricing in equity fund raising of S$125m.

Maintain BUY, Target Price S$0.63 maintained. 

• After its recent announced portfolio reconstitution exercise and an infusion of new capital through perpetual securities and proposed fund raising, we believe that ESR-REIT is back on a growth path. Planned acquisitions will drive earnings higher. 
• Stock offers an attractive yield of close to 7.0%. BUY.

Where we differ: Acquisition driven growth; more optimistic.

• We are optimistic that investors will over time appreciate the REIT’s strategy to reconstitute its portfolio which would enhance returns. While 4Q17 results was weak, we believe that earnings have bottomed. 
• Post the issuance of S$150m in perpetual securities and S$35m in divestment proceeds, the Manager has quickly redeployed the funds into Tuas South Lane and 7000 Ang Mo Kio, which are both sizable assets worth close to S$400m in total. 
• We have also factored in an equity fund raising exercise of S$125m in FY18 to part fund the announced purchases.

Potential catalyst: Clarity on roadmap from the new Sponsor.

• We believe that the market will start to price in premiums to NAVs once we have clarity on the roadmap put forth by Sponsor and the REIT, which might mean diversifying overseas.
• One of the immediate benefits is the ability to be more active in acquisitions, given a potentially more significant pipeline of deal opportunities.

Valuation

• Target Price at S$0.63, limited upside but with high yield over 8%.

Key Risks to Our View

• Lease conversion from single- to multi-tenant. The unfavourable rental reversion resulting from the ongoing conversion of tenancy may bring downside surprises.

4Q17/FY17 Results: Reversion still negative despite improvement in occupancy; Issue of Perps to keep gearing low 

Topline and profitability slipped, however contributions from newly acquired assets will offset downward trend. 

• ESR-REIT recorded gross revenue of S$27.2m in 4Q17, 2.2% lower y-o-y mainly due to the non-renewal of CWT lease at 3 Pioneer Sector 3 (3PS) as well as the impact of two divestments. 
• Net property income (NPI) however increased by 1.2% y-o-y to S$19.9m thanks to lower repair and maintenance expenses. Management fee increased to S$1.9m from S$1.7m y-o-y due to higher assets under management from new acquisitions in 4Q17. 
• Borrowing cost was 2.3% higher at S$5.3m due to debt drawdown to partially fund the new acquisitions. On 3 Nov 2017, ESR-REIT issued S$150m of subordinated perpetual securities (Perps) that confer the right to receive distribution at a rate of 4.6% p.a. As a result, although the total distributable income for 4Q17 was S$13.3m or 2.2% higher y-o-y, only S$12.2m was distributed to unitholders, down 6.1% y-o-y, after reserving S$1.1m for Perps holders. 

4Q17 DPU fell by 6.7% y-o-y to 0.929 Scts due to a slightly enlarged unit base as a result of the Dividend Reinvestment Plan (DRP).

• FY17 gross revenue of S$109.7m and NPI of S$78.4m were 2.1% and 4.7% lower y-o-y, respectively. The lower top line contribution was primarily due to divestments. 
• Overall, NPI and EBIT margins in FY17 compressed to 71.5% (from 73.4%) and 63.2% (from 65.4%) respectively due to
  1. loss of revenue during transition phase of the properties from single to multi-tenanted, which we attributed to reduced occupancy in a weak market; and
  2. increased operating expenses due to the loss of efficiency.
• Notwithstanding lower profitability, finance costs were also 3.3% lower to S$20.4m through debt repayment, which saw its EBIT interest coverage remain stable at 3.5x (vs 3.6x a year ago). FY17 operational cash flow (OCF) remained flat at S$69.0m due to lower working capital drain.
• Distributable Income for FY17 was 5.5% lower whereas distribution paid to unitholders was 7.2% lower due to S$1.1m reserved for Perps investors in 4Q17. FY17 DPU was 7.7% lower y-o-y at 3.85 Scts, in line with our expectations.

Portfolio occupancy improved to 93.0% q-o-q in 4Q17 from 91.1%, though still lower than 94.7% at the end of FY16. 

• The improvement in occupancy over the quarter was mainly due to backfilling some of the vacancy at existing properties as well as higher occupancy from the newly acquired assets. Compared to a year ago however, the decline in occupancy was mainly due to the non-renewal of CWT’s lease at 3PS. 
• CWT Ltd, which previously contributed around 4% of ESR-REIT’s total rental income, did not renew its master tenancy at 3PS after the 3-year agreement ended around mid-2017. The vacant space continues to be actively marketed. 
• After the new acquisitions in FY17, rental income composition by trade sector saw salient increase in the high-specs industrial sector, from 12.9% to 23.4%.

Continued to record negative rental reversion, at -15.8%, and lower tenant retention rate of 51.1%, for FY17. 

• In FY17, ESR-REIT renewed and leased more than 1.2m sqft of space. The impact on tenant retention rate and rental reversions was mainly due to the conversion of assets from single to multi-tenancy. 
• Although full-year reversion rate was very low, we noticed that general improvement was registered in 4Q17 as the rental reversion rate inched higher from -18.8% for 9M17 to -15.8% for FY17. While ESR-REIT’s Manager expects the leasing market to remain competitive, we believe the reversion rates going forward will start to moderate as most of the multi to single tenancy conversions have been completed. 
• In FY17, 22.8% of lease expiries came from single-tenanted buildings, whereas only 7.2% will come from this in FY18.

Debt maturities are relatively stretched out with due dates ranging from FY18 to FY23; shortened WALE due to S$155m borrowings due within one year.

• ESR-REIT’s debt profile comprises of only unsecured borrowings and this implies that all its assets are unencumbered. Its debt maturity profile is stretched out with a WALE of 2.4 years. Debt repayments will start from 4Q18 when the S$155m EREIT 3.5% 11/2018 bond becomes due. 
• ESR-REIT has two unsecured loan facilities – as at 31 Dec 2017, a total of S$107m out of S$150m was drawn down on the TLF1, which means the committed undrawn 3-year revolving credit facilities (RCF) is S$43m. TLF2 (S$200m) was fully drawn down.

Aggregate leverage increased to 39.6% due to higher borrowings and lower asset base due to revaluation loss; Issuance of S$150m Perps in 4Q17 at 4.6%.

• ESR-REIT’s aggregate leverage increased from 37.5% to 39.6% over FY17 as gross debt increased 4.7% but investment properties mainly due to acquisition only increased by 1.1% - due to a much larger base effect as well as a S$47.8m revaluation loss due to weaker assumptions from the independent valuer. 
• NAV as a result decreased from S$0.63 to S$0.59 whereas aggregate leverage increased from 37.3% to 39.5%, treating 100% of the Perps as equity.
• Assuming Perps as debt, the aggregate leverage would be 48.4%. We expect equity fund raising in the near-term to partially fund the new acquisition of 7000 Ang Mo Kio Ave 5 in Dec 2017.

Switched-on Dividend Reinvestment Plan (DRP) helps to conserve cash.

• Since its implementation in April 2017, the take-up rate for the DRP has been relatively encouraging. The pricing of the DRP units issued will be based on the market price less 2% discount. 
• For the full-year of FY17, ESR-REIT issued new units amounting to S$5.2m, which constituted c.10% of total distribution. This helps cash conservation in the long run, which can be deployed opportunistically.

Singapore Research Team DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2018-01-19

DBS Vickers SGX Stock Analyst Report BUY Maintain BUY 0.63 Up 0.620