ESR-REIT - CGS-CIMB Research 2018-06-01: Could This Be The Bean That Grows Into The Giant Beanstalk?

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ESR-REIT SGX: J91U

ESR-REIT - Could This Be The Bean That Grows Into The Giant Beanstalk?

• ESR-REIT and Viva Industrial Trust (VIT) could soon find themselves in Singapore’s corporate history books, should the planned merger of these two REIT vehicles go through.
• We have done a comprehensive rework of ESR-REIT’s  model, and hence the DPU reversions. Post-merger ESR-REIT would be the fourth-largest industrial S-REIT.
• Propelled by the addition of Viva Industrial Trust as well as an expected bottoming in the Singapore industrial market, we now forecast FY19F DPU to expand by 12.8% y-o-y.
• A major postulation to REIT merger is that large-cap REITs trade at a premium against small-mid caps and enjoy lower costs of funding.
• We maintain our ADD call for ESR-REIT with a higher DDM-based Target Price.

First merger in S-REIT history

• ESR-REIT has proposed a merger with Viva Industrial Trust by way of a trust scheme arrangement. The scheme consideration payable to Viva Industrial Trust unitholders is S$0.96/unit, implying 1.26x current P/BV. 
• The scheme consideration will be satisfied via 10% cash and 90% through the issuance of new ESR-REIT units at an issue price of S$0.54/unit, implying a gross exchange ratio of 1.778x.

How would the enlarged trust look like?

• We expect the post-merger ESR-REIT to become the fourth-largest industrial S-REIT with a combined AUM of c.S$3bn. In fact, it would be the largest S-REIT with pure exposure to the Singapore industrial market. Including the potential acquisition of 15 Greenwich Drive, the enlarged trust would have a portfolio of 57 properties with total GFA of c.13.6m sq ft. 
• Post-merger, high specs industrial and business park would form 46% of the REIT’s AUM. We forecast its gearing to rise to c.40% (as at end-FY19F). Tong Jinquan will own c.33.8% of the enlarged trust; ESR will own c.9.1%.

Our comprehensive rework of ESR-REIT’s model

• For simplicity, we incorporate the merger on “day one” of FY19F. Propelled by the addition of Viva Industrial Trust as well as an expected bottoming in the Singapore industrial market, we now forecast FY19F DPU to expand by 12.8% y-o-y. 
• We see FY18F as a “work-in- progress” as additions to the portfolio are counteracted by on-going weakness and capital management actions. We now forecast FY18F DPU to decrease by 6.3% y-o-y.

Size matters because large caps trade at a premium

• Historically, large-cap industrial S-REITs have averaged 5.8% trailing dividend yield or c.210bp spread vs. small-mid caps. In terms of P/BV, large caps have averaged 1.18x or 0.23x premium against small-mid caps. Given that ESR-REIT will now join the “big league”, we believe that it would be re-rated closer to its large-cap peers. 
• Furthermore, we believe that ESR-REIT would be able to narrow the large-small issuer credit spread. We assume that ESR-REIT’s  all-in cost of debt would decrease by 10bp y-o-y to 3.45% p.a. in FY19F.

First merger in S-REIT history

• In the famous fable, Jack and the beanstalk, Jack exchanged his milk cow for magical beans. This was thought to be a foolish bargain until his bravery yielded him untold riches. Drawing parallels with this story, we believe ESR-REIT’s  unit-swap with Viva Industrial Trust would land unitholders a “golden goose”.
• In this deep dive report, we have done a comprehensive re-work of ESR-REIT’s  model and baked in the merger of ESR-REIT with Viva Industrial Trust. For simplicity – even though the manager expects the merger to be completed by 3Q18 – we incorporate the merger on “day one” of FY19F. Given the re-work, we reduce our FY18F DPU by 4.9% and raise our FY19-20F DPU by 2.5-3.0%.
• Propelled by the addition of Viva Industrial Trust as well as an expected bottoming in the Singapore industrial market, we now forecast FY19F DPU to expand by 12.8% y-o-y to 4.03 Scts. We see FY18F as a “work-in-progress” as additions to the portfolio are counteracted by on-going weakness and capital management actions. We now forecast FY18F DPU to decrease by 6.3% y-o-y to 3.57 Scts. Altogether, we project a 3-year DPU CAGR of 2.8% through FY20F.
• Apart from the substantial DPU-accretion, we believe that ESR-REIT would benefit from a larger, stronger and more diversified AUM. We expect a post-merger ESR-REIT to become the fourth-largest industrial S-REIT, with a combined AUM of c.S$3bn. It would also be the largest S-REIT with pure exposure to the Singapore industrial market.
• Moreover, we found that large-cap industrial S-REITs trade at a premium against small-mid caps. Historically, large-cap industrial S-REITs have averaged 5.8% trailing dividend yield or c.210bp spread vs. small-mid caps. In terms of P/BV, large caps have averaged 1.18x or 0.23x premium against small-mid caps. Given that ESR-REIT will now join the “big league”, we believe that it would be re-rated closer to its large-cap peers.
• Following the merger, ESR-REIT would gain immediate access to business parks. We consider business parks to be the pinnacle of industrial space sophistication and a real estate proxy for Singapore’s shift towards higher value-added activities. Post-merger, we estimate that high specs industrial and business park would form 46% of the enlarged trust’s AUM (asset under management). Pre- merger, high specs industrial and business park formed 29% of ESR-REIT’s  AUM.
• Lastly, a bigger clout commands lower borrowing costs. As at 31 Mar 2018, the large-cap industrial S-REITs had a simple average all-in cost of debt of 2.7% p.a. This compares to small-mid caps’ 3.5% p.a. We believe that post-merger, ESR-REIT would be able to narrow the large-small issuer credit spread and reap the benefits of lower cost of funding. We assume that ESR-REIT’s  all-in cost of debt would decrease by 10bp y-o-y to 3.45% in FY19F. With the addition of Viva Industrial Trust’s borrowings, we estimate that ESR-REIT’s  gearing would climb to c.40% as at end- FY19F (30% as at 31 Mar 2018).

Maintain ADD with a higher Target Price of S$0.62

• We value ESR-REIT using a DDM valuation and arrive at a Target Price of S$0.62. With all eyes on the merger, we roll forward our DDM-valuation to FY19F.
• Our DDM-based Target Price implies a 6.5% FY19F yield and 1.25x FY19F P/BV, in line with what the large-cap industrial S-REITs are trading. Given ESR-REIT’s DPU accretion in FY19F, its larger market cap, higher trading liquidity and potential index inclusion, we believe that ESR-REIT would re-rate closer to its large-cap peers.
• Compared against its own historical trading bands, our Target Price implies that ESR-REIT could re-rate to one s.d. above its 5-year mean. The REIT is currently trading one s.d. below its 5-year mean.

We forecast 12.8% increase in FY19F DPU with the merger with Viva Industrial Trust

• With the addition of Viva Industrial Trust’s portfolio (assume merger would be completed at the start of FY19F), we expect ESR-REIT’s  FY19F NPI/DI to rise by 94%/125% to S$195.5m/S$127.9m. While the increase is propelled by the Viva Industrial Trust merger, we also penciled in same-store improvement for ESR-REIT’s and Viva Industrial Trust’s portfolio as we view that the challenging industry conditions would abate by end-FY18F.
• However, accounting for the enlarged unitbase – 1,561.2m new ESR-REIT units would be issued for the merger with Viva Industrial Trust and 23.8m of acquisition fee in units payable to ESR-REIT manager – we estimate FY19F DPU to increase by 12.8% to 4.03 Scts. In addition, we have assumed that 100% of manager fees would be paid in cash.

What are the potential pitfalls of the merger?

• As with all M&As, one would acquire the good with the bad. While the merger is yield-accretive for ESR-REIT, it is NAV-dilutive. We project FY19F NAV to shrink to S$0.50/unit (FY18F: S$0.58/unit). This is because ESR-REIT is acquiring Viva Industrial Trust at implied 1.26x current P/BV (refer to overleaf Transaction summary of the merger).
• We also note that income support for UE BizHub East (business park component) would expire in Nov 2018. On an annualised basis, the income support forms around 11% of Viva Industrial Trust’s FY18F NPI. Nonetheless, we believe that organic improvements from UE BizHub East and Viva Business Park would partially make up for the absence of income support in FY19F.
• In addition the underlying land leases at Viva Industrial Trust’s Viva Business Park (27% of its AUM) and Jackson Square (6% of its AUM) are relatively short at 13.3 years and 11.4 years respectively. That said, we believe that successful land lease extensions could unlock value in Viva Industrial Trust. We also point out that the weighted average land lease of ESR-REIT’s  portfolio is similar to Viva Industrial Trust’s, at 34.2 years vs. 33.5 years.
• Lastly, we acknowledge that the merger impact on ESR-REIT’s  valuation is only marginally positive.

What’s next after Viva Industrial Trust?

• Post-Viva Industrial Trust merger, investors are curious about ESR-REIT’s next steps and wonder whether the REIT would undertake another M&A in the near future. Prior to Viva Industrial Trust, ESR-REIT were in M&A discussions with Sabana REIT. However, talks fell through in Nov 2017.
• As there are other small-mid cap industrial S-REITs which count both Chinese property tycoon, Tong Jinquan and ESR (developer-sponsor of ESR-REIT) as significant unitholders (ESR-REIT and VIT), we would not be surprised if ESR-REIT targets these names following its integration with Viva Industrial Trust. Moreover, these independent REITs could be more willing to merge after seeing the benefits of the Viva Industrial Trust merger.
• Of these REITs, we note that ESR emerged as a significant unitholder of Sabana REIT in Mar 2017. Bloomberg estimates that ESR currently has a c.7.9% stake in Sabana REIT. Tong Jinquan, who owns c.50% of Viva Industrial Trust and c.18.3% in ESR-REIT, also has a 6.2% interest in Sabana REIT. He has another 6.7% interest in Soilbuild REIT.
• Furthermore, while ESR does not have a stake in Cache Logistics Trust, we note that Cache Logistics Trust manager is 60% owned by real estate fund manager, ARA Asset Management. Global private equity firm, Warburg Pincus, who is the major shareholder of ESR, is also the largest shareholder in ARA Asset Management. It owns 30.7% stake in ARA.
• Looking ahead to the next 12-18 months, in terms of strategic priority, we understand that ESR-REIT manager would focus on successfully integrating Viva Industrial Trust into its portfolio. Management noted that such integrations often take 3-6 months. ESR-REIT manager would also focus on pro-actively managing the enlarged trust’s assets and look at AEI opportunities to unlock value. We identified some of the potential AEIs the REIT could undertake:
  • AEI at 7000 Ang Mo Kio Ave 5 which has untapped c.495k sq ft of GFA
  • AEI at 16 Tai Seng St to maximise its “white” space. Some c.70k sq ft of the building can be used as “white” space. Currently, only c.5k sq ft of space is used as retail
  • AEI at Viva Business Park to extend the land lease
  • AEI at Jackson Square to extend the land lease
• Next, the enlarged trust would continue to evaluate single-asset acquisitions. It could look to acquire S$200m-400m of assets p.a., with its focus in the next 12- 24 months still primarily being Singapore.
• Overseas acquisitions through pipeline from sponsor – ESR manages c.10m sq m of projects owned and under development across China, South Korea, Japan – as well as M&As would be opportunistic in nature. Through it all, ESR-REIT has not guided a hard number for its AUM target.

Benefits of the merger

• Potential re-rating with a larger, stronger and more diversified portfolio.
• Increased exposure to high value-added tenant sectors.
• Lower costs of funding.
• Well supported by a strong and committed developer-sponsor.

YEO Zhi Bin CGS-CIMB Research | LOCK Mun Yee CGS-CIMB Research | https://research.itradecimb.com/ 2018-06-01

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