Keppel DC REIT - CGS-CIMB Research 2019-04-08: Ready 4 More Acquisitions

SGinvestors.io

KEPPEL DC REIT (SGX:AJBU)

Keppel DC REIT - Ready 4 More Acquisitions

• The completion of Keppel Tele & Tran’s privatisation could speed up the injection of SGP 4. This could add 3-6% to FY20-21F DPU, resulting in a 14% total return.
• Organically, demand boost from cloud services and limited spare capacity in the market could mitigate large incoming supply and push rents upwards.
• Maintain ADD with a higher DDM-based Target Price of S$1.54.

Keppel Tele & Tran’s privatisation could catalyse the purchase of SGP 4

• On 2 April 2019, the Scheme shareholders of Keppel Telecommunications & Transportation Ltd (SGX:K11) approved the proposed acquisition by Keppel Corporation Limited (SGX:BN4) of all the issued ordinary shares of Keppel Tele & Tran. Following this, the expected last day of trading of Keppel Tele & Tran shares is on 24 April 2019. We think that the completion of this exercise would serve as a catalyst to speed up the timeline for the acquisition of Keppel DC Singapore 4 (‘SGP 4’) by Keppel DC REIT (SGX:AJBU) from Keppel Tele & Tran.
• During our visit to SGP 4 in 3Q18, the Sponsor mentioned that the asset could reach full occupancy by end-2018. As the only remaining data centre in Singapore from the Sponsor and that it has likely reached full occupancy, we think that the acquisition of SGP 4 would be considered a low-hanging fruit for Keppel DC REIT. We think SGP 4 could be injected into Keppel DC REIT as early as 2H19F upon stabilisation; in our scenario analysis below, we assume it would be completed in FY20.

SGP 4: The last of the Sponsor’s data centres in Singapore

• Keppel DC Singapore 4 (SGP4) has a gross floor area of more than 182,000 sq ft over five floors and is within the vicinity of SGP 2 and SGP 3 in Tampines, which are currently in Keppel DC REIT’s portfolio. SGP 4 was initially acquired by the Sponsor as T20 for S$20m in 2015 from Mapletree Logistics Trust (SGX:M44U) and was redeveloped into a data centre from a warehouse. The facility achieved its temporary occupation permit (TOP) in mid-2017 and is fitted out to Tier 3 concurrent maintainability standards.
• During our visit to SGP 4 last year, the Sponsor mentioned that SGP 4 is a 20MW data centre that could possibly be injected into Keppel DC REIT upon stabilisation; this was targeted to be at end-FY18. Its high specifications allow it to cater to hyperscale cloud providers like Google and Amazon. SGP 3 was selected as a comparable data centre due its similar location at Tampines Street 92, similar ANSI/TIA Tier rating and as both SGP 3 and SGP 4 were developed by the Sponsor.

Acquiring SGP 4 could provide substantial upside

• We derive the possible valuation for SGP 4 at S$418m using SGP 3 rents as a comparable. Similar to SGP 3, SGP 4 is located at Tampines Street 92, has a Tier 3 rating, and was also developed by the Sponsor. SGP 3 was initially acquired by the Sponsor as T27 for S$26.6m in 2013 and subsequently redeveloped at a cost of S$80m-90m, based on our estimates, in 2013. In 2016, it was sold to Keppel DC REIT at a valuation of S$225m.
• As rents for SGP 4 would have been contracted at a later date compared to SGP 3, we think rents would be higher than SGP 3 and applied a 5% increase in rents per sq ft per month based on gross floor area (GFA). Assuming an NPI margin of 93%, which is within the range of other Singapore assets, and a 7.5% NPI yield, we derive a valuation of c.S$418m.
• Based on FY18 figures, we estimate that Keppel DC REIT has a debt headroom of c.S$335m, assuming a 40% gearing level, and c.S$140m assuming a 35% gearing level. We assume the initial NPI yield for our base case scenario at 7.5% with annual rental escalations of 3%. The 7.5% initial NPI yield figure is similar to that of SGP 5 with the effects of a slight cap rate compression and higher Tier rating built in. Our analysis also assumes that SGP 4 is acquired on a fully ramped-up basis or includes a rental top-up from the Sponsor up to a fully ramped-up level.
• Historically, Keppel DC REIT has had low gearing levels of c.31% on average based on the past 10 quarters. We think management would not test the 40% gearing level, and that 35% could serve as a more realistic ceiling. Funding structure for the acquisition base case was assumed to be in line with the existing debt levels of Keppel DC REIT.
• Based on our sensitivity analysis, the possible acquisition of SGP 4 could increase our target price by between 1.66% and 10.79%, with the base case showing a 6% increase in our target price. We do not think Keppel DC REIT would increase its gearing level significantly given that the possible acquisition can be DPU accretive even with no debt funding. We also have not assumed the use of any of Keppel DC REIT’s existing cash balance in our analysis; this could provide additional room for accretion.
• We think a 30% debt funding level would serve as a good base as this implies an equity fund raising of c.S$293m and does not significantly deviate from its current capital structure. Assuming an issue price of S$1.40, this translates to 209m new shares, which is fewer shares than the past two equity fund raisings carried out when c.240m and 224m new shares were issued, respectively.
• In our base case scenario, we expect an equity fund raising of c.S$293m for this acquisition. This amount within the range of the past two equity fund raising exercises carried out for the acquisitions of SGP 3 and SGP 5 in 2016 and 2018 respectively. In 2016, c.S$275m was raised with the issuance of c.242m new units at c.5% discount to volume weighted average price (VWAP) to fund a DPU-accretive acquisition of a 90% stake in SGP 3. In 2018, c.S$303m was raised with the issuance of 224m new units at c.5% discount to VWAP to fund a DPU-accretive acquisition of SGP 5.

Boost in demand comfortably covers supply bump

Supply bump coming up in Singapore

• Over 2015-2018, an average of c.35MW of supply was added to the data centre market p.a. in Singapore, according to 451 Research and BroadGroup Consulting. According to BroadGroup Consulting, the average supply from 2019- 2022F is expected to be c.50MW per year. Based on our checks, we expect > 380MW of new data centre capacity to come onstream over 2019-2022F; this translates to c.95MW per year on average. We think this discrepancy between our average and that of BroadGroup’s could stem from the possible exclusion of owner-occupied data centres like that of Facebook and Google.
• The larger developments are sites owned by end-users such as Google and Facebook while the rest appear to be data centres in the colocation space. The 150MW data centre at Tanjong Kling will be Facebook’s first data centre in the region. Facebook does not have a substantial cloud business like Amazon and Google and so we do not expect its new data centre to displace demand from other colocation providers like Keppel DC REIT. Without the Facebook development, average incoming supply would be c. 58MW per year over 2019-2022F.
• Google has historically built and owned its data centres due to a sizeable cash balance on its books. Hence, we think the impact on displacement from Google’s own demand on other colocation data centres could be limited. Google's data centre development at Jurong West St 23 is its third data centre development in Singapore. However, a growing cloud business could reduce the demand for colocation services if underlying colocation tenants make the business decision to switch their enterprise systems to cloud-based services.
• The actual impact on demand displacement could also be difficult to gauge due to the multi-national nature of Google’s cloud services; cloud services demand from the region could be hosted on a data centre in Singapore. If we assume that 10% of the new capacity would be for Google’s own use and another 30% for overseas cloud demand, then the effective average incoming supply would be c.48MW over 2019-2022F; this figure also excludes Facebook’s development.

Demand to come from hyperscale cloud providers

• According to the Cisco Global Cloud Index, data stored in data centres is expected to grow at a 34% CAGR to reach 1.3 zetabytes by 2021F. Much of this data migration towards data centre storage can be attributed to the rapid adoption of cloud computing services. This trend is also corroborated by data from Synergy Research showing that hyperscale operator capex has been catching up with telcos, which were traditionally the largest users of data centres.
• In 2018, the aggregate capex of the top 5 hyperscale spenders (Google, Amazon, Microsoft, Facebook and Apple) was almost identical to the capex of the top 5 telco spenders (China Mobile, AT&T, Verizon, NTT and Deutsche Telekom). Within the cloud service providers, we note that large scale providers have gained market share over the past four quarters at the expense of small-and medium-sized cloud operators, who have collectively lost 5% pts of market share over the same period.
• As the use of public cloud becomes increasingly prevalent, we expect a shift in data centre demand from the colocation space of individual corporates to the cloud space of cloud service providers. Due to the stronger bargaining power and larger contract sizes from cloud players like Amazon and Microsoft, we do not expect this shift in demand to result in significant rental growth.
• In Singapore, BroadGroup Consulting expects the demand for data centre facilities to follow global trends and be driven by large hyperscale providers which could potentially take up c.40% of Singapore’s colocation space. It expects the bulk of the remaining 60% space to be taken up by telcos, multinational organisations, and banking and fintech services companies. As hyperscale providers increasingly take up greater space, we think that other data centre tenants could face a supply crunch for large space and this also could push rents up. Over 2019-2022F, BroadGroup Consulting expects new demand to average c.50MW p.a. in Singapore.

Improving utilisation to help lift rents

• Overall, we think that the stronger demand will help absorb the large incoming supply. We think the facilities being developed by Google and Facebook will come onstream in phases which will allow time for the excess supply to be absorbed, especially for Google's data centre that could draw some demand from existing colocation tenants. Based on 451 Research and BroadGroup Consulting figures and conclusions from our analysis above, demand and supply are expected to be well-matched with improving utilisation rates. We think this could result in gradual improvements in rental rates.
• Without any new acquisitions in Singapore, we think the benefits for Keppel DC REIT would be limited in the short term due to the average weighted average lease expiry of 3.0 years for its Singapore assets. Additionally, it would be unable to fully benefit from the uptick in demand due to the lack of significant spare capacity at its existing data centres in Singapore. In order to continue achieving the earnings and DPU growth it had in prior years, we think Keppel DC REIT would have to continue its acquisitions to attain greater capacity which would allow it to benefit from expected improvements in rental rates.

Recent acquisitions to boost growth visibility

• FY19F will see full contribution from SGP 5 and maincubes data centres. SGP 5 is a 5-storey purpose-built carrier-neutral data centre in Singapore that was 99.0% acquired by Keppel DC REIT in 2018. The lease was structured as a 1+9 year lease and Jun 2019 will mark the start of the 9-year portion of the lease. We expect this to account for c.12% of NPI in FY19F.
• The acquisition of maincubes data centre in Germany was in Apr 2018. The forward purchase agreement for the data centre was signed in Oct 2015 and the agreed value was €84.0m. The 15-year triple-net master lease agreement for the data centre started upon its completion, with options for renewal for three further periods of five years each. We expect this to account for c.6% of NPI in FY19F.
• The completion of Intellicentre 3 East Data Centre (IC3) will also improve Keppel DC REIT’s earnings. According to the management, the completion of IC3 is expected to be between 2019 and 2020; conservatively, we have factored in earnings from IC3 from FY20F onwards. IC3 will be master leased to Macquarie Telecom, the master lessee of IC2, and will be for 20 years with annual rental escalations. We expect IC3 to account for c.2% of NPI in FY20F.

Valuation & Recommendation

• Following our meetings with the management, we housekeep our model assumptions. In particular, we adjusted NPI margins and growth rates for the Singapore assets as our previous revenue and NPI forecasts for FY18 were below the actual reported figures. This resulted in an increase in revenue and NPI forecasts. Other trust expenses, non-controlling interests and net tax adjustments were also revised to better reflect more recent trends; these were previously based on 3-5 year averages but are now based on 1-3 year averages as the portfolio has grown significantly. Additionally, due to the more dovish interest rate sentiment, we reduce our risk-free rates for the various countries and also lower our terminal growth assumption.
• Our updated target price of S$1.54 offers a 5.30% dividend yield and represents 1.4x P/BV.
• Despite this being above +1 s.d. of its five-year historical average, we believe this reflects the growth potential of the data centre industry and we do not expect a significant correction in current prices.
• Overall, we maintain our ADD call given the positive industry fundamentals and potential for the accretive acquisition of SGP 4 within the next 12 months.
• Organically, we think that the downside is limited due to the long WALE of 8.3 years and less than 5% of leases expiring per year until end-FY20. Further upside catalysts could come from delays in the completion of incoming supply in Singapore.
• Key downside risk could be a significant depreciation in foreign currencies clouding the mid-to long-term growth outlook as c.50% of its portfolio AUM has forex exposure. Keppel DC REIT mitigates this forex exposure by hedging foreign-sourced distributions on two-year forward hedges.

LOCK Mun Yee CGS-CIMB Research | Ervin SEOW CGS-CIMB Research | https://research.itradecimb.com/ 2019-04-08

SGX Stock Analyst Report ADD MAINTAIN ADD 1.54 UP 1.510