Real Estate Sector – Time for a Health Check

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September 7, 2015

Time for a health check

Since our mid-year review of the real estate sector back in June, the sector has continued to recover strongly. Much as we predicted, price growth seems to have accelerated on average across all segments and sales launches are witnessing record absorption rates. Some talk about another bubble building and there are signs that the buying frenzy has also caught the attention of regulators with the government recently reiterating its commitment to ensure that there is no repeat of the 2008 bubble this time around. We felt that it is as opportune a time as any to do a little health check of the real estate players in our coverage universe – we started out purely with the intention of “stress-testing” each real estate player under our coverage on solvency and liquidity metrics. But then we thought we would throw in a few more metrics on the operational front to form a more holistic view of the resilience of each company to future market down-cycles as well as the potential for the company to create value for shareholders. The result is a balanced scorecard on each company which comprises the following 4 quadrants:

– Operational and capital efficiency: This tries to holistically capture how efficiently each company operates and how effectively it creates value for shareholders. Operational efficiency and profitability are not only drivers of return but also the best weapons to mitigate risk both within the company and in the external environment. So, companies with better margins and returns on capital should clearly command a valuation premium.

– Revenue pipeline visibility and quality: Here we assess the company’s future revenue streams, which underpin future earnings. Unlike companies in other industries and their build-to-lease peers, build-to-sell real estate developers cannot rely on recurring revenue; future revenues have to be generated by continuously developing new projects and, hence, visibility into the revenue pipeline based on the current project book is essential. We also look at a way to capture not just the quantity but also the quality of this revenue – expected revenue from unbooked pre-sales is obviously higher certainty revenue than that from sales that have not taken place yet. Similarly, within the latter category, revenue from future sales on projects that have broken ground are obviously less risky or “higher quality” than those from projects that are just “on paper”. Companies that have a “longer” revenue pipeline with a higher proportion of this revenue falling into the “high certainty” category should command a valuation premium.

– Solvency & Financial Liquidity: Given the cyclical nature of real estate and the highly leveraged balance sheets of many developers coming out of the last crisis, it is critical to measure financial resilience. Developers with a greater ability to service their debt obligations pose less risk to their equity investors and hence should trade at a premium. Also, companies with lower leverage are less exposed to the risk of interest rate hikes in the future as inflation ticks-up. Good financial liquidity, meanwhile, ensures that projects are funded and completed on time, which feeds back into revenue / earnings quality.

– Land Bank: No fundamental analysis of a real estate company can be complete without a look at its land bank as land underpins future earnings. An assessment of the unused land bank is also the only way to gauge the long-term potential of a company, beyond the years spanned by its current project pipeline. The long-term earnings potential of companies like KDH and DXG that have relatively limited land bank is more uncertain than that of companies like NLG and NBB which have enough land to sustain revenues at current run-rate levels for the next 30 years, based on current land monetization rates. These companies are also better shielded from near-term risks as land sales can generate cash and revenues, thereby creating a buffer against project execution risk, while also acting as a collateral base for future borrowings. Companies with large and good quality land banks therefore are more resilient to near-term and long-term risks and should therefore command a valuation premium.

We scored each company on each of the KPIs within each of the 4 quadrants mentioned above based on quartile (4 = top performer, 1 = worst performer). We then came up for an average score for each quadrant to rate the companies on each of the 4 main “business resilience” criteria mentioned above. Finally, we aggregated these quartile scores into an overall “business resilience” score for each company. Since our quadrants above collectively evaluate risk and return – the 2 fundamental constituents or drivers of differences in relative valuation – we then decided to be a little more adventurous and plot each company based on its “resilience score” and “relative valuation” index. To come up with the relative valuation index, we used the 1 year, 2 year and 3 year forward P/E, EV/EBITDA and P/B multiples and used the same quartile scoring system to come up with an overall index whereby the higher the index, the more expensive the company on a relative valuation basis.

What therefore started out as an attempt to just test business resilience became more of an exercise in testing to what extent the relative valuation of each company was backed-up by risk and return fundamentals (refer to the balanced scorecard for each of the companies in our coverage universe — we excluded VIC from this analysis since this is not a pure play real estate company anymore). Please note that the conclusions from the relative valuation-to-business resilience comparison are not going to correspond exactly with our current stock ratings for the following reasons:

– Our ratings are based on the gap between market price and absolute valuations of the companies, rather than relative valuations. In other words, a company like HDG might seem to be valued fairly, based on where it is trading relative to our estimated RNAV of the business but the company seems expensive on a relative valuation basis, given its fundamentals.

– The “business resilience versus relative valuation” analysis is not a precise science and is meant to be illustrative; many of the risk factors captured here should, technically, influence how an investor prices the shares of the company but such risk factors do not directly feed into an RNAV valuation – eg. the revenue “quality” criteria such as % of revenue from un-booked presales and revenue “concentration” risk which aims to measure heavy dependence on a select few projects.

– We assign equal weights to each of the KPIs when coming up with the overall “business resilience” score for lack of a concrete basis to do otherwise, but this is obviously a simplification.

Nonetheless, broadly speaking, the analysis splits our coverage universe into 2 distinct camps:

The “bargains”

DXG and KDH are in a league of their own in terms of business fundamentals and, yet, are trading at a discount to peers. Both have limited land banks but score highly in terms of operational efficiency and profitability, revenue visibility and quality as well as solvency and financial liquidity. Both these companies have industry-leading levels of profitability, a robust and relatively low-risk revenue pipeline and low leverage. DXG is further buttressed by its brokerage business, which generates predictable and recurring revenue to act as a buffer for project revenue volatility. We give DXG credit for its 6 new project acquisitions this year by factoring this into its revenue pipeline but the company scores poorly on the land bank criteria since it does not have any spare land beyond what has already been factored into the revenue pipeline. However, DXG’s now demonstrated track record of making acquisitions should provide some comfort that the company can offset its land bank disadvantage (this, being difficult to quantify, is not factored into our business resilience score for the company, thereby constituting further upside). KDH has seen a sharp recent fall in its share price and also looks compelling from both a relative and absolute valuation perspective. These findings corroborate with our RNAV valuation of both companies as both are strong candidates for upgrades to “BUY” in the coming days.

The “doubtfuls”

NBB’s relatively weak fundamentals do not justify its valuation premium to all its peers. It scores well in terms of land assets and the size and quality of its current revenue pipeline but the company’s high leverage, sub-par returns on capital and low working capital efficiency are all major risk factors. NBB’s price has also rallied in recent months most likely on the back of speculative punts on CII’s proposed takeover of the company, resulting in a price that seems out-of-sync with its fundamentals.

PDR’s valuation is only justified if you believe in the company’s turnaround story. PDR, having just come out of a major crisis, has eye-wateringly high leverage and also has poor returns on capital and high inventory levels. PDR, however, is in the midst of a restructuring plan, which if it goes through, should improve its balance sheet substantially. However, the company’s revenue pipeline is also concentrated around just a handful of projects making it relatively risky. The company needs to re-establish its project execution capabilities and ramp-up its project pipeline to catch-up with its peers.

HDG is expensive on a relative valuation basis, given its heavy dependence on the Z756 mega project. While our RNAV valuation suggests that the company is slightly undervalued, this does not capture the risk around further delays or snags in the Z756 project, which accounts for a whopping 26% of its RNAV. Our business resilience score penalizes HDG for this undue risk thereby making the stock seem expensive, relative to peers. This is only fair when you consider the fresh delays to the Z756 project that were announced at the end of Q2, owing to continued negotiations on the LUR fee payment.

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Company “business resilience” scorecards

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VCSC Information

VCSC Rating System & Valuation Methodology

Absolute, long term (fundamental) rating: The recommendation is based on implied total return for the stock defined as (target price – current price)/current price + dividend yield, and is not related to market performance. This structure applies from 27 May 2015.
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Unless otherwise specified, these performance parameters only reflect capital appreciation and are set with a 12-month horizon. Future price volatility may cause temporary mismatch between upside/downside for a stock based on market price and the formal recommendation, thus these performance parameters should be interpreted flexibly.
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Valuation Methodology: To derive the target price, the analyst may use different valuation methods, including, but not limited to, discounted free cash-flow and comparative analysis. The selection of methods depends on the industry, the company, the nature of the stock and other circumstances. Company valuations are based on a single or a combination of one of the following valuation methods: 1) Multiple-based models (P/E, P/cash flow, EV/sales, EV/EBIT, EV/EBITA, EV/EBITDA), peer-group comparisons, and historical valuation approaches; 2) Discount models (DCF, DVMA, DDM); 3)Break-up value approaches or asset-based evaluation methods; and 4) Economic profit approaches (Residual Income, EVA). Valuation models are dependent on macroeconomic factors, such as GDP growth, interest rates, exchange rates, raw materials, on other assumptions about the economy, as well as risks inherent to the company under review. Furthermore, market sentiment may affect the valuation of companies. Valuations are also based on expectations that might change rapidly and without notice, depending on developments specific to individual industries.

Disclaimer

Analyst Certification of Independence
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