gsg_stock discussion

Stockwatch- KLCC Property (Malaysia) JP Morgan initiate coverage 21 Nov 2006 Target Price RM3.30

KLCC Property Holdings
Initiation Overweight

Best of class assets with boost from tourism

• Initiate with OW, PT of M$3.30: We initiate with overweight and a Dec-07 PT of M$3.30, a potential upside of 22%. With premier quality assets in Klang Valley, we believe KLCCP will be a stock hard to ignore given improving trends in commercial properties; its high quality, secured earnings stream from rentals and hotel income; and with an added boost from rising tourist arrivals.

• Share price drivers: We see good upside prospects in the group’s asset values with the positive outlook for commercial properties, a strengthening ringgit, Malaysia’s cheap capital values regionally and increased traffic from new surrounding developments (i.e. KLCC Convention Centre, and high-end condos). KLCCP’s hotel and retail mall operations account for 40% of operating profit and will benefit from rising tourist arrivals spurred further by Visit Malaysia Year 2007. Our forecast is ahead of consensus by 4% for FY07E, and 11-12% for FY08-09E.

• Valuations and risks: Our Dec-07 PT of M$3.30 is a 20% discount to RNAV in line with regional average for property investors. But, KLCCP's asset values are 50% below average capital values for the region and with attractive regional net yields. A 5% rise in asset values raises its RNAV by 7%. Risks to PT are: oversupply of commercial properties (although unlikely for prime assets).

Positive price drivers

High quality, secured earnings, with boost from rising tourist arrivals: This is due to KLCCP’s long-term tenancy agreements expiring no earlier than 2012 for its key office properties (i.e. Petronas Towers, Menara Exxon-Mobil, Menara Maxis) and high occupancy rates of 84-100% for its properties. Rental hikes are locked in at 9% once in three years for Petronas Towers (50% of operating profit) as well as Menara Maxis; and at a base rental plus a profit share with tenants for the Suria KLCC retail mall. Mandarin Oriental Hotel and Suria KLCC mall, together account for 40% of operating profit and should benefit from rising tourist arrivals and Visit Malaysia Year 2007. We forecast a 2-year EPS CAGR of 13% over FY08-09E. Our forecast is ahead of consensus by 4% for FY07E, and 11-12% for FY08-09E.

Discount to RNAV; upside from rising, attractive capital values/yields: KLCCP trades at a discount of 33% to its RNAV/share of M$4.03 versus the regional average of 20%. Malaysia's capital values are 76% cheaper than the regional average (50% cheaper for KLCCP given its prime assets), with attractive net yields of 6-8% for office and 7-10% for retail space. This, rising demand among local and foreign investors from REITs, and recent new and upcoming projects around the KLCC area (i.e. KLCC Convention Centre, high-end condos) will help enhance KLCCP’s asset values. A 5% rise in asset values raises KLCCP's RNAV by 7%.

Long-term growth from future developments or potential acquisitions: The development of Lot C involving the extension of Suria KLCC mall and new office space will raise net lettable area by 16%. Lot C will come on-stream from end-2008 with the full impact on earnings by FY10 estimated at M$24 million pa (13% of FY07E profits). Development of Lot D1 offers growth potential beyond FY10, and existing prime assets of parent, Petronas in the KLCC area and Putrajaya also offers acquisition opportunities for KLCCP, but valuations here would be the key.

Negative price drivers and risks to thesis

Low ROEs and high gearing: KLCCP should generate single digit ROEs of 8-9% for FY07-09E, but this is still slightly ahead of the 2007E regional average of 7% for property investors. KLCCP’s net gearing of 78% may limit ability to grow via asset acquisitions. But, gearing is forecast to decline to 56% by FY09E. Cash flows are also strong with positive FCFs of M$126-164 m pa after M$500m capex for LotC.

Lower yields than REITs: KLCCP’s net yield of 3-4% is lower than the average of 6% for Malaysian REITs. If KLCCP were to raise its pay-out ratio from the current 38% to 90-95% in line with REITs, its yield would work out to 8.5-9.0%, but this is unlikely given its geared balance sheet and development plans. But, KLCCP offers investors a larger and more liquid exposure to the commercial segment. Total market cap of all Malaysian REITs of US$550m is less than KLCCP’s US$689m.

The main risk to our thesis is an oversupply of commercial properties putting pressure on asset values and rentals. However, currently there is a shortage of good quality offices in the Klang Valley, and established retail space and hotels in prime areas like KLCCP’s has and we believe will continue to experience strong demand.

Valuation and rating analysis
Our RNAV of M$4.03/share factors in a rise of 9% in value for KLCCP’s office assets, and 27-40% in value for its retail mall Suria KLCC, and Mandarin Oriental Hotel, relative to the 2004 open market values by independent valuers for the respective assets. These are in line with the overall rise in rentals for KLCCP’s office and retail assets since 2004, and also reflect the value of recent transactions for hotels. Our market values for these assets translate to a net rental yield of 6-8%, in line with the implied yields for recent asset transactions in Klang Valley. We believe key share price catalysts are: 1) Improving commercial property trends which will provide strong support/upside to KLCCP'a asset values. 2) Rising tourist arrivals spurred further by Visit Malaysia Year 2007 as 40% of KLCCP's operating earnings are exposed to tourism. 3) Long-term growth from development of Lot C and Lot D1 to come on-stream from end-2008. We set our PT at M$3.30, a 20% discount to its RNAV in line with the regional average discount for property investors.

Commercial property trends improving, hence strong upside in asset values
Malaysia’s commercial capital values and rental yields remain one of the most attractive regionally (see Table 3). Malaysia's capital values are about 76% cheaper than the regional average (50% cheaper for KLCCP given its higher value prime assets), with attractive net yields of 6-8% for office space and 7-10% for retail malls.

The completion of the KLCC Convention Centre in mid-2005 and Traders Hotel in 2006 under the ownership of parent, Petronas, and new high-end residential developments in the area in the next two to three years will help enhance KLCCP's asset values. In view of this, and the increasing interest/demand among local and foreign property investors as well as from REITS, there is a potential upward pressure in capital values, which augurs well for KLCCP given its prime assets. (As it is, values of recent office and hotel transactions have been on the rise as shown in Table 4). Every 5% rise in asset values would raise KLCCP’s RNAV by 7%.

Boost from tourism
KLCCP should also benefit from rising tourist arrivals, forecast to rise 7% Y/Y to a new record of 17.5 million in 2006. Tourism is expected to be spurred further by Visit Malaysia Year 2007. KLCCP’s operating earnings (40%) are exposed to tourism via its retail mall, Suria KLCC and the Mandarin Oriental Hotel. Suria KLCC has a patronage of 40.8 million per annum, and KLCCP has a profit sharing deal with tenants at 5-15% of revenue above a threshold level on top of the base rent.

The profit sharing portion has risen to 7% of rental revenue versus 2-3% in 2004, and a further 5ppt rise will raise FY08E net profit by 4%. In line with the overall rise for KL hotels (see Figure 2), occupancy rates for Mandarin Oriental have risen from 75-80% in 2004 to 83-85% currently. This is despite rising average room rates (ARR), which will be raised to US$164 by 1Q07, a 25% rise from 1Q06, and a 38% rise from 2005. These rates are cheap when compared regionally i.e. versus ARR of US$200 for 5-star hotels in Philippines and US$240 for 5-star hotels in Singapore. A 5% rise in Mandarin Oriental's ARRs will raise FY08E EPS by 2%.

Long-term growth from Lot C and Lot D1
KLCCP’s development plans for Lot C with a net lettable area of 0.16 million sq ft of retail space and 0.74 million sq ft of office space, will raise its total net lettable area by 16%. The new retail space will first come on-stream by end-2008, followed by the offices by end-2009. Full impact on earnings from Lot C hence is expected by FYE Mar-10E estimated at M$24 million per annum (13% of FY07E profits).

Management indicates that there is a firm interest for 80% of the new office space from a single customer at premium rental rates of 50% to the market. KLCCP may look to sell the remaining 20% of the office space, and if this materializes it will raise an estimated M$144 million (M$0.11/share), which will help reduce FY09E net gearing from 56% to 51%. Total development cost for Lot C is M$500 million. Beyond FY10, growth will come from Lot D1, where there are still no details on development plans. However, in our RNAV, we have assumed the development potential and cost for Lot D1 is similar to Lot C, although the former sits on a larger piece of land at 1.41 acres versus the latter’s 1.01 acres.

Earnings are driven by: 1) High occupancy rates of 85-100% for office properties and 83-85% for hotels. 2) Longterm lease expiring no earlier than 2012 for three key office properties (Petronas Towers, Menara Maxis, Menara Exxon-Mobil). 3) Locked in rental hikes at 9% per annum once in every three years for Petronas Towers and Menara Maxis. Given its prime location, the rental rates of M$6.60-8.50/sqft for KLCCP’s office space is 50-90% higher than the market. Lease tenures for the retail mall are no less than 10 years for anchor tenants (Isetan, Parkson, Cold Storage, Tanjung Golden Village), but are on differing expiry periods of 1.5-3 years for remaining tenants. Overall rental revenue (base rent plus profit share) from Suria KLCC has been rising by 10-12% per annum.

posted by gsg @ 4:29 PM