Lend Lease: Market Overstating The Risk

This story features LENDLEASE GROUP. For more info SHARE ANALYSIS: LLC

– 4.7bn Australian and UK apartment settlements at risk
– Apartment demand appears to be peaking
– Lend Lease underperforming the index as a result
– Management, analysts agree risk overstated
 

By Greg Peel

Global stock markets hit their peaks around six months ago and have corrected ever since, potentially now consolidating at lower levels ahead of a resumption of the longer term bull market. The emphasis is of course on “potentially”.

The major driver of the correction has been fear of a slowing economy in China. As the chart below indicates, the past six months have seen the ASX200 fall by as much as 17% before recovering to around a 10% fall. Shares in property developer and index constituent Lend Lease ((LLC)) have nevertheless fallen by as much as 28% to recover to be around 25% down.

 

Why the underperformance, or if you like, downside outperformance of Lend Lease?

Lend Lease builds apartments. Lots of apartments. The company pre-sells those apartments ahead of construction and takes a deposit. In any economic backdrop there is always a risk buyers will default on their settlement payments.

The economic backdrop in Australia currently is twofold. From the global perspective, China is slowing. From a domestic perspective, Australia has seen a boom in apartment construction as prices have risen substantially, but as supply begins to overwhelm demand, the warning bells have been sounded by everyone from stock analysts to the RBA that the peak may now have been seen.

Lend Lease sells a lot of its apartments in Australia to the Chinese. Thus the market is perceiving a double-whammy risk. Thus Lend Lease shares have de-rated by a greater percentage than the index.

This risk was the primary topic Lend Lease management wanted to address at its recent investor day. The company has never been in the business of issuing specific quantified earnings guidance, but stock analysts attending the briefing came away praising the detail management provided to make its case that the risk is not as ominous as the market appears to believe.

Lend Lease has pre-sold $5.2bn worth of apartments globally and $4.7bn of that total represents Australia and the UK. Of that amount, Chinese buyers represent 20% and other foreign buyers 25%. Lend Lease will attempt to settle on over one thousand pre-sold apartments per annum for the next four years. Therein lies the risk.

But Sydney apartment prices are up 15% in a year and 25% in two years. At the same time, the Aussie dollar has fallen, such that in US dollar terms, 2014 pre-buyers are up as much as 40% ahead of completion. At Barangaroo for example, 12 of the 159 apartments in the first residential stage have already been on-sold, and capital gains on those sales have ranged from 24 to 52%. Lend Lease is holding 10% deposits on the initial sales, and the company’s margin on those initial sales prices averages over 20%.

Lend Lease is thus carrying a solid buffer, and there is very little incentive for buyers, Chinese or otherwise, to default on final settlement. There will always be some buyers who are forced to default of course, and Lend Lease’s long run average default rate is 3%. The company’s current default rate is between 1 and 3%, so no signs of above average default risk at this stage.

Stock analysts have run the numbers based on elevated risk nonetheless, in various different ways. Credit Suisse, for example, calculates Australian apartments represent 17% of Lend Lease forecast earnings for FY16-19. Were 20% of settlements to default, and those apartments are never re-sold, the broker would be forced to cut its earnings forecast by 4.4%.

To put that in perspective, Lend Lease’s worst ever default rate experience occurred just after the GFC hit. A single project saw a default rate of 13%, but all those apartments were later sold at a profit.

Moreover, Lend Lease is not seeing any notable drop-off in demand. Indeed, enquiries are up strongly year on year. The next release of Barangaroo apartments will number 350 and the company has received 1100 expressions of interest, requiring $10,000 registration fees.

All of the above does not mean Lend Lease management is smugly waving off talk of elevated risk as a load of nonsense. Analysts note the company is renowned for its discipline. New apartment releases in the UK will now require a 20%, not 10%, deposit for example, and management is considering the same for the 350 Barangaroo apartments noted above. In Melbourne, Lend Lease will not proceed with new construction unless a 70% pre-sale threshold is reached.

Perhaps the most telling takeaway from Lend Lease investor day, analysts agree, is management’s declaration that it currently holds the highest level of confidence in the earnings outlook for the business in the group’s history.

Having de-rated by a substantial margin beyond that of the ASX200 over the past six months, analysts also agree that Lend Lease shares are undervalued. Six stockbrokers in the FNArena database cover the stock, and all six are carrying Buy or equivalent ratings.

The consensus target is $17.43, suggesting 33% upside.
 

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms