-Competition for assets intensifies
-Office rents remain weakest
-Residential outlook robust
-Opportunities in fund manager A-REITs
 

By Eva Brocklehurst

Insights into the Australian Real Estate Investment Trusts (A-REITs) gleaned from reporting season include JP Morgan's observation that small cap players with a strong earnings outlook for the next year were the top performers. Overall, the sector's pricing now looks full, outperforming the ASX200 more than 12% over the year to date. Other key themes are that the market for transactions is competitive, while debt costs that are close to market will make outperformance on the earnings growth front challenging.

The lack of equity raisings over the period suggests to JP Morgan competition for core retail estate is intensive. Leasing challenges across the three major asset classes - residential, office and retail - mean income growth is benign. Residential stands out as the best placed, with strong sales increases, margin improvements and high pre-sales from developments. JP Morgan's preference remains with the residential A-REITs over pure office and retail landlords. This boils down to Stockland ((SGP)) and Mirvac ((MGR)).

BA-Merrill Lynch echoes the theme, noting domestic concerns over earnings risk across the broader Australian market have driven investors to increase equity allocations to the sector. This broker's preferences are Stockland and Federation Centres ((FDC)), given there is a more positive organic growth outlook for both stocks, coupled with reasonable valuations. Merrills observes the A-REIT sector is now fully valued, particularly given the relatively soft fundamentals in place across the office and retail segments. Negative re-leasing spreads are commonplace among new leases signed up over the last month. While no longer offering compelling value, Merrills considers the sector's 5% yield remains attractive and should be well supported while interest rates remain low.

Credit Suisse was least impressed with office landlords and expects the weak trend to persist. A gradual improvement is expected in Sydney and Melbourne, but off a low base. The broker suspects it may take years to unwind current rental positions. Market incentives of 27% are now materially higher than both average portfolio incentives around 12% and expiring lease incentives around 16%. Any positives? Occupancy levels have stabilised at 94% after two years of decline and lease expiries across FY15-16 have fallen for all office A-REITs, which should be supportive of occupancy rates. Credit Suisse believes Cromwell Property Group ((CMW)) and GDI Property Group ((GDI)) have the greatest risk in this area. Within the sector, Credit Suisse prefers Mirvac and GDI over Investa Office Fund ((IOF)) and Dexus Property Group ((DXS)).

Given the year-to-date outperformance, which has reduced valuation upside and effectively priced in a lower-for-longer yield, Morgan Stanley has downgraded the sector to Cautious from Attractive. Also, earnings momentum is slowing and there is a slight deterioration in earnings quality. The broker believes growth prospects are fully priced and the most attractive stocks in the sector are Goodman Group ((GMG)), Arena REIT  ((ARF)), Lend Lease ((LLC)), Scentre Group ((SCG)) and Stockland, as each can develop its own product rather than compete for assets in a tightening yield environment.

Those A-REITs with a residential exposure are the most constructive in terms of outlook for Goldman Sachs, with NSW having the strongest outlook and Queensland improving. The broker deduces from developer feedback that the hurdle rates of return for residential land site acquisitions are now lower. This is attributed to the robust demand from buyers, particularly in the residential and industrial market, but also from low bond yields which are driving return requirements lower.

Goldman also notes growth is hard to come by. One-year earnings compound growth forecasts are 5.8% for the sector, but this is boosted by a spread of growth for certain stocks in the sector and lack of growth for many others. A recent trend the broker observes is the conversion of existing properties to higher and better use, particularly in residential markets. Those that stand out from a growth perspective are Federation Centres, Goodman, Dexus and Westfield Corp ((WFD)), while CFS Retail ((CFX)), Charter Hall Retail ((CQR)) and Shopping Centres Australasia ((SCP)) are at the opposite end of the scale.

The broker observes the sector is breaking up into three types, not necessarily split along segment lines. These are passive A-REITs, which tend to trade closely around asset values over the longer term. These stock tend to be relatively cheap or expensive versus the longer term average. The broker finds less value in this type of A-REIT than previously was the case, given their current high prices relative to long-term historical averages. The second type is structural recovery A-REITs, generally residential, which have been trading below levels implied by long-term average price/book value on their inventories. In this case, Stockland has reduced its impaired inventory overall, but increased the level of impaired stock to be developed rather than disposed of. Mirvac's key challenge, in Goldman Sachs' view, is how to balance the return on capital employed while delivering earnings growth off its strong base in FY14.

The third type is the fund manager A-REIT. Goldman finds the most opportunities in this type of stock. Charter Hall Group ((CHC)) and Goodman Group are the only two the market views as true fund managers but Goldman thinks Dexus and GPT Group are increasingly worthy of this designation, in the broker's opinion. Following the internalisation of management, CFX is another that has now increased non-rental income - to 8% of revenue. Of this type of A-REIT Goodman is the broker's key Buy call, although Buy ratings are retained for GPT and Dexus.
 

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-Strong distribution growth expected
-Solid suite of assets and growth projects
-Key transport pick for several brokers
 

By Eva Brocklehurst

Transurban ((TCL)) travels from strength to strength. A combination of yield and growth is underpinning its performance and brokers expect the outlook to remain that way, while interest rates are favourable.

CIMB considers the stock should be a top pick in the transport infrastructure arena. Transurban is in the middle of an upgrade cycle and the broker suspects the market is yet to fully appreciate the number of sound projects on the table. Distribution growth over FY14-17 is forecast at around 9.5%, driven by brownfields expansions and acquisitions. Free cash flow was strong in FY14, providing 97% coverage of the distribution. The company reiterated FY15 distribution guidance of 39c per share and expects this to be 100% cash covered, although several brokers consider this expectation may be a little stretched. Deutsche Bank forecasts 97% coverage of 38c per share, highlighting the timing issues and other cash items such as reserve releases which make it difficult to accurately forecast free cash flow.

JP Morgan has upgraded earnings but underlying free cash cover is calculated at 37.5c per share, still short of the company's guidance for distributions. Overall, the result was stronger than expected, both from a bottom line and cash flow perspective. Operating and maintenance expenditure figures seemed too good to be true and JP Morgan suspects they may not be sustainable. Earnings missed BA-Merrill Lynch's forecasts but the difference was in over-estimating fee and other revenue. The broker takes issue with Transurban's assertion that underlying costs increased just 3.7% in FY14. Merrills calculates costs differently, believing they were 10.3% higher. This aside, the broker expects macro factors will drive the stock and total returns should remain similar to the past five years, provided the interest rate environment is favourable.

UBS likes the stock. Transurban offers low risk, 10% per annum, medium-term growth and favourably compares with other Australian yield stocks. Financial close on Sydney's NorthConnex and Melbourne's CityLink-Tulla widening projects are important catalysts as well as the Brisbane AirportLink. The broker does point out that from a portfolio perspective, the share price is highly sensitive to movements in bond yields and increasing volatility is likely. Morgan Stanley finds the resilience of the assets, largely intra-urban roads, and strong growth projects should make the stock appealing to investors but retains an Equal Weight rating, given Transurban appears fairly valued at current prices.

Macquarie also observes dividend growth beyond the current 5-year horizon should be maintained near 10%, as the company remains in an investment phase. Moreover, cost initiatives and the ramp-up of the US assets justify a premium rating for the stock and the broker retains an Outperform call. Macquarie envisages the Brisbane AirportLink will be the next major opportunity as part of the QML acquisition, providing both revenue and cost benefits.

On FNArena's database there are five Buy ratings and one Hold (Deutsche Bank). The consensus target is $8.14, suggesting 5.8% upside to the last share price. Targets range from $7.08 to $8.83. The distribution yield on FY15 and FY16 forecasts is 5.1% and 5.6% respectively.

See also, Transurban Bound For Strong Upside on July 11 2014.
 

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-Attraction in passive rental income across sector
-Housing recovery, low interest rates supportive
-Industrial supported by logistics, infrastructure
-Perth vacancies surge, demand and rent slides
 

By Eva Brocklehurst

Australian Real Estate Investment Trusts (REITs) seem fully priced but there is comfort to be bought from earnings security. The sector, up 17% year to date and outperforming the market by 11%, should deliver on broker expectations at the upcoming earnings reports. BA-Merrill Lynch is upbeat, noting seven of the 19 stocks under coverage beat forecasts in February's reports, with only three missing by more than 1%. The broker believes the sector may continue to outperform the broader market, given the prospect of further downgrades through the earnings season, and the REIT track record.

The sector is attractive to the broker because it offers a 5.2% dividend yield and FY15 earnings and distribution forecast growth of 4.0% and 3.0% respectively. In Merrills' view, the earnings security comes from having over 90% of revenue derived from passive rental income. The broker cites several themes for the August reports. Retail landlords are still likely to be showing signs of pressure, with negative spreads on new leases and incentives remaining elevated. Property developments should receive greater emphasis regarding their future contribution to growth and there are several development projects that will be completed in FY14. The market will be looking for guidance on project starts for FY15.

Residential market volumes are robust, despite reports of a slowing in the housing sector, and market volumes are around 18% above mid-cycle levels. The broker thinks should allow developers to clear impaired stock and achieve near-term targets. Merrills is overweight residential developers going into the results. Several REITs have reported growth in asset values. Continued compression of the cap rate - the ratio of asset value to producing income - is likely to boost forward asset valuations. Another drop in interest rates over the last six months, with A and BBB rated corporate bond yields falling 50% and 70% respectively,  means a continuing tailwind for REITs, which are typically 60-80% hedged.

Merrills expects the sector to deliver earnings growth of 5.5% for FY14, and 12% if it includes Lend Lease ((LLC)) and Peet ((PPC)). The former is benefitting from the sale of the stake in the Bluewater asset while the latter is beneftting from a recovery in the housing market and a ramp-up of development capital expenditure. Specifically, Cromwell Property ((CMW)) is forecast to deliver 11.7% earnings growth following recent accretive acquisitions, while Mirvac's ((MGR)) 9.6% growth forecasts reflect a turnaround in development returns. Merrills expects CFS Retail ((CFX)) earnings will fall 1.2% as the result of the dilution from the capital raising to fund the internalisation of management. In FY15 Merrills expects 2.7% growth. Key stocks expected to deliver robust earnings growth in FY15 are Charter Hall Goup ((CHC)), 8.3%, Goodman Group ((GMG)), 6.5%, and Federation Centres ((FDC)), 5.0%.

Morgans also expects the sector to do well in the upcoming reports. Further improvements in residential markets and low interest rates provide a backing for the broker's confidence, with positive impacts from funds flow for the fund managers. The broker prefers good quality industrial property, with ongoing tenant demand driven by internet retailers and businesses looking to upgrade logistics infrastructure. Office remains challenging but the broker identifies Cromwell Property as one with a strong weighted average lease expiry profile. Among retail exposures Morgans prefers Federation Centres. GPT ((GPT)) and Stockland ((SGP)) are the pick of the diversifieds. Meanwhile, Westfield ((WFD)) after its restructure now offers investors global exposure.

The outlook for the Perth office market has come under JP Morgan's scrutiny. The broker observes moderating levels of tenant demand, resulting from changing fundamentals in global commodity markets and the transition in the domestic mining and resources industry to less labour intensive operations from the construction phase. JP Morgan expects the Perth vacancy rate to peak at 20% in the next two years with a further decline in net effective rents of around 20%. The sector's exposure to Perth is dominated by Dexus (DXS)), Investa Office ((IOF)) and Mirvac. JP Morgan envisages minimal near-term earnings risk based on lease expiry profiles but suggests asset values may be written down to reflect lower sustainable market rents.

Key to Dexus' exposure is 240 St George's Terrace (Woodside Plaza), occupied by Woodside Petroleum ((WPL)), with a book value of $500m. Should Woodside reach a binding agreement over Capital Square and relocate, then JP Morgan estimates Woodside Plaza could fall in value by 15%, resulting in a potential $70m write down.

Perth's vacancy rates are at 13%, up from 6.5% over the last 18 months. JP Morgan estimates incentives have increased to 27% from 10%, while prime net effective rents have declined 25%. New supply under construction comprises 11% of stock, all due for completion by end 2015. The broker notes this would be the highest level of completions since 1991. Looking at the Mirvac and Investa Office portfolios, the broker expects assets that typically fit these profiles to show valuation declines of 5-10%. Should Woodside move, the Dexus portfolio is expected to decline in value by 10-15%.
 

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-Scope for toll revenue growth
-Number of investment options
-Strong distribution, yield
 

By Eva Brocklehurst

A year ago Transurban ((TCL)) attracted two Buy ratings on the FNArena database. There are now five. This signals the toll road operator is a solid, defensive proposition, in broker parlance. The latest quarterly traffic statistics are the launch pad for a re-statement of that confidence.

UBS expects revenue growth rates to moderate to 7% on an organic basis in FY15, with the recent acquisitions of Sydney's Cross City Tunnel (CCT) and Queensland Motorways (QML) boosting the rate of growth to 38% on a proportional basis. The stock's distribution growth and near-term catalysts are underpinning the broker's Buy rating. Highlights for JP Morgan included the NSW toll road assets. Sydney's M2, Lane Cove Tunnel and M7 continued to benefit from the completion of the M2 widening.

Transurban has acquired the Fluor stake after the restructure of the I-495 and I-95 assets in the US and was the only subscriber to the US$280m re-capitalisation. This will take Transurban's stake in I-495 to 94%. The associated equity requirements will be funded from corporate debt but while forecasts have been changed to allow for the increased funding cost, UBS calculates this has been offset by a greater share of asset cash flows. Macquarie notes the performance of I-495 was above expectations in the June quarter and, while revenue still needs to double, the trend is positive.

Closer to home, quarterly traffic was softer in June, reflecting the impact of the timing of Easter and ANZAC Day, but trend growth is on track. Benefits are accruing from the widening of Sydney's M2 which ensures revenue growth for the Australian assets of 11.9% in FY14, in Macquarie's estimates, with 6.2% coming from price and 5.3% from volume. FY15 is the last year Melbourne's CityLink will deliver 4.5%, until the lane widening is completed. As a result price growth drops to 3.6% in FY15 and then 2-3% in FY16 and FY17, on Macquarie's calculations. Offsetting this is expectations from NorthConnex, with financial close at the end of the year, and the re-pricing of trucks on the M7.

Macquarie expects the breadth of investment opportunities open to Transurban is likely to lead to positive revisions to internal rates of return and longer-dated earnings, as they are realised. The company offers multiple growth fronts, with the recent acquisition of QML, NorthConnex, a stage of WestConnex and concession extensions at CityLink all providing scope. Macquarie expects 10% distribution growth over the next five years. After dilution from the issue of equity for QML, Macquarie estimates the acquisition is neutral to slightly positive for investors. Down the track there are latent options which could enhance returns further.

On a slightly more subdued note, BA-Merrill Lynch notes the 0.9% growth on CityLink traffic was at the low end of historical rates, after normalising for the holiday impact, and this is a sign that flows are reaching capacity on that road. Transurban will begin construction on the widening in mid 2015 and over the construction period of two years Merrills forecasts a 2% decline per annum in traffic. Still, CityLink, M2 and M7 were the drivers of tolling revenue growth in FY14 of 12.6% and Merrills expects FY14 proportional earnings to be up 15%, driven mainly by 39% growth for the M2. The broker is comfortable with a Buy thesis and notes the stock's returns compare favourably to Australian long bonds.

Growth is supported by acquisitions and asset enhancements and the stock has an attractive mix of yield and growth, in CIMB's opinion. FY14 was a busy year, the broker observes, and FY15 is shaping up to be another, with the M5 widening and the I-95 express lanes development in the US by the end of 2014 and the integration of QML and CCT, as well as NorthConnex. The broker expects these transactions will drive ongoing earnings growth and underpin forecasts for 9% distribution growth per annum over the three years to FY17. CIMB retains the stock as a top pick in transport infrastructure because of its "unparalleled suite of assets".

UBS notes, following a number of investments to be completed this year, Transurban will enjoy 50-100% of 14 toll road concessions with a weighted average expiry in 2043. Much of the portfolio is mature. Traffic has declined in importance but widening and upgrading of roads remains a catalyst for brokers. On FNArena's database the consensus target price is $7.85, suggesting 3.2% upside to the last share price. The dividend yield on FY14 and FY15 forecasts is 4.6% and 5.1% respectively.
 

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-Higher growth for Westfield
-But more volatility
-Scentre Group low growth
-But quality, high yield
 

By Eva Brocklehurst

After some wrangling over value, the Lowy family has succeeded in delivering the revamped Westfield businesses. The two new entities are Westfield Corp ((WFD)) and Scentre Group ((SCG)). Westfield Corp is now the offshore-focused business, as those Australasian assets previously held by Westfield Group are merged with Westfield Retail to form Scentre Group. In the lead-up to the vote on the proposal, brokers were not so sure Westfield Retail was getting the best end of the bargain. A small adjustment was made as merger terms for the Scentre Group were sweetened. Westfield reduced the net debt attributable to the Australian and New Zealand businesses to $6.8 billion from $7.1 billion.Westfield also clinched approval by suggesting it would spin off its Australasian operations regardless of whether Westfield Retail unit holders agreed.

So, what does the outlook for the two new entities look like?

Westfield Corp's assets are located in UK/Europe with a portfolio of 38 centres in the US and several on the agenda to be sold. The company will now see 70-75% of assets and earnings derived in US dollars, with the remainder primarily in British pounds. The company intends to investigate an appropriate location for its longer-term listing. Westfield Corp has performed strongly since re-listing, with BA-Merrill Lynch observing the stock is trading at a slight discount to the earnings multiples of its US peers and in line with valuation, which incorporates upside from a US$6 billion pipeline of development assets. Having said that, the broker also notes the stock exposes investors to currency volatility. The possibility of an offshore listing is not a catalyst for performance and while the broker thinks the asset quality deserves a premium valuation relative to peers, there are outstanding concerns on how the market will value the extensive development pipeline. All up, Merrills opts for an Underperform call.

UBS thinks development will progress sufficiently to pay for execution over the next 12 months but also acknowledges the added complexity of currency, bond yields, listing destination and register turnover in valuing the stock, which may overshadow real estate fundamentals. Citi likes the exposure to higher growth US/UK markets and notes that Westfield has a good track record of developments. Nevertheless, the broker thinks a favourable outlook is increasingly factored into pricing.

To Goldman Sachs the new Westfield is now a higher growth vehicle. Moreover, the restructure has addressed the issue of an overvalued management business. Project and development earnings are lower now - at 10-11% of earnings - and Goldman thinks this is more appropriate. Now the stock is a more attractive proposition and the reduction in the equity base provides better earnings leverage. Still, Goldman agrees the stock is fairly valued based on peer multiples in the US and UK, and this justifies a Neutral rating.

Macquarie envisages upside risk in a takeover, with a complete exit by the Lowy family a feasible proposition. The family retains an 8.4% stake. The portfolio includes several iconic and irreplaceable assets, for which Macquarie suggests investors would accept low returns. Having said that, the broker suspects US investors value development pipelines more conservatively than Australian investors. In the near term, investors will have to put up with dilutive assets sales. Macquarie does not find the stock a compelling proposition but returns are sufficient to justify an Outperform rating.

Merrills suggests Scentre Group offers the highest quality retail portfolio in Australia, with 15 of the 20 largest shopping centres and occupancy rates over 99% for the past 20 years. Scentre Group currently has $1.9bn in projects under construction and the broker thinks the stock offers the best development capability in the sector as well. There are positive catalysts for Merrills, such as debt restructuring and property divestments. Citi notes operating conditions may be soft at present but they are stabilising and growth, while slow, should be steady. Citi does not think the quality of the portfolio is reflected in market pricing, with the stock trading at a discount to peers.

UBS also believes the stock provides an attractive investment opportunity. There is upside risk to FY14 pro-forma earnings in the broker's view, by as much as 2%. UBS agrees that income from operations is likely to be subdued, given re-leasing spreads are negative, but the company is supported by a reasonable development pipeline. Management has flagged an intention to reduce gearing to 30-35% from 37% by joint venturing on assets to source capital. UBS notes this would be dilutive to earnings, although that could be reduced by selling assets above book value. Help may be at hand, in Goldman's opinion, as near-term cap rates - the ratio comparing book value with income - should compress further and boost the asset base, reducing gearing organically.

Goldman echoes a similar theme to the other brokers, finding Scentre Group screens well for its distribution yield but offers limited growth, while being at risk of earnings dilution through potential asset sales. The broker thinks there will be significant focus from investors on the Lowy family's intentions with its 4% stake. In February 2013 the Lowy family sold a 7.1% stake in Westfield Retail and Goldmans notes this sale acted as an impediment to the share price up until the restructure was announced as many market participants questioned what the family knew or intended.

On FNArena's database Westfield attracts one Buy, two Hold and one Sell rating. The consensus target is $7.32, suggesting 1.6% downside to the last share price. Targets range from $7.15 to $7.45. The distribution yield on FY14 and FY15 forecasts is 3.9% and 3.6% respectively. Scentre Group attracts three Buy ratings and one Sell. The consensus target is $3.35, suggesting 5.3% upside to the last share price. The targets range from $3.13 to $3.55. The distribution yield is 8.6% and 6.6% on FY14 and FY15 forecasts respectively.
 

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-Department stores weaken
-Mall re-leasing spreads flat
-Westfield returns provide support
-National Storage offers growth
 

By Eva Brocklehurst

What is happening with retail sales? How does it reflect on the outlook for Australian shopping centres? JP Morgan observes rolling average annual rates of growth are trending higher but sales remain volatile on a seasonally adjusted, month-on-month, basis - affected by such items as the federal budget blues and a warm start to winter. The broker believes it is important to look at the bigger picture growth metric when measuring retail sales. To this end the June and September quarters should hold up reasonably well. Nevertheless, without a commensurate improvement in consumer sentiment, the broker thinks the December quarter may struggle to maintain the positive trend.

Charting retail growth rates and retail categories suggests to JP Morgan that clothing, footwear & accessories is diverging further from department stores with the former building momentum, while the latter is dipping further into negative. Historically, the two have been strongly related, probably relating to shared exposure to non-discretionary spending. Now, JP Morgan finds this relationship is breaking down.

The analysis suggests that re-leasing spreads for shopping centre landlords will not materially improve over the next 12 months, with a further recovery in sales needed before spreads turn positive. A strong recovery is expected in two to three years time, as very weak sales growth drops out of the calculation and the hoped-for stronger numbers eventuate. In terms of Australian discretionary retailers the outlook is mixed. JP Morgan notes housing remains a strong area, especially hardware, while supermarkets, restaurants and cafes are strengthening. The broker expects the more affluent shopping areas will benefit from housing and equity wealth factors while the less affluent are more likely to be affected by rising unemployment.

On a stock specific basis the broker's analysis show a retail sales tailwind for Scentre Group ((SCG)) of 4.4% on a moving annual growth basis and 4.7% for GPT ((GPT)). CFS Retail ((CFX)) has a less favourable centre sales environment because of its geographic exposure, heavily weighted to Victoria, while the former two are weighted towards NSW where sales growth is stronger.

Australian Real Estate Investment Trusts (A-REITs) are trading in line with BA-Merrill Lynch's valuations and this suggests the sector is fully valued. The broker notes the average distribution yield of 5.3% is 175 basis points ahead of the 10-year bond yield and this is broadly in line with the long-term average. The yield trade has been well supported and the broker expects the sector to continue outperforming through August, given the uncertainty over the earnings outlook compared with the broader market. The capital returns from the restructure of Westfield assets into Scentre Group and Westfield Corp ((WFD)) are likely to support the sector as investors look to reinvest.

The broker has undertaken a review of GPT's industrial development business and thinks there is opportunity for growth in this portfolio as one of the ways to expand the company's asset exposure. Moreover, the establishment of an industrial wholesale fund should add to earnings growth. Mirvac ((MGR)) has announced a number of asset sales recently and Merrills thinks the market is now looking at that company's future capital commitments. With significant commercial and residential projects, capital allocation will be critical to maintaining a healthy balance sheet. The broker thinks the company is well capitalised to execute on the current pipeline. Another stock Merrills thinks is well placed is Peet ((PPC)), as it benefits from improved housing market volumes. The company is expected to announce its first distribution in three years at the August results, highlighting the improved outlook for cash flow from 2015.

National Storage ((NSR)) is the first ASX listed, internally managed, integrated owner of self storage centres. Morgans has initiated coverage with an Add rating and $1.37 target. The company offers investors a leading brand in self storage and a diversified portfolio across Australia. Morgans likes the highly scalable operating platform, conservative gearing and future growth via acquisitions, given the fragmented market. The distribution yield for FY15 forecasts is also attractive, at 6.6%. The biggest drivers of revenue are occupancy, with 74.4% expected by year end, and rental rates, with average growth of 4% per annum over the past 10 years. The company listed last December at 98c, having been established in 2000. National Storage is the second largest group in Australia by number of owned centres and third by number of centres under operation and management. It has a 10% equity interest in a portfolio owned by Southern Cross Storage.
 

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-Question of use of cash
-Leakage of proceeds
-More financial flexibility
-Increased FX risk
-Potential infrastructure catalysts
 

By Eva Brocklehurst

UGL ((UGL)) will dispose of its property services business, DTZ, to a consortium of private equity for around $1.215 billion, guiding to net proceeds of $1-1.05bn. This transaction will now turn UGL into a pure engineering and construction entity.

The company will have a $390m net cash position afterwards, based on UBS' expectations of FY14 net debt of $572m, but the broker remains cautious. Engineering is a more cyclical business than property services and has experienced significant earnings deterioration in the last four years for various reasons. UBS does not think there is much upside for the company and the key question is about the use of the excess cash. Buy-backs and acquisitions are highly accretive but attention needs to be paid to any value accretion in a potential acquisition, rather than focusing on earnings accretion. Hence, the sale does not add value in UBS' view.

Gross proceeds may be in line with expectations but CIMB thinks the net return will disappoint some investors. CIMB suspects many holders of the stock would have expected the difference between the gross and net proceeds would be less. The board, in conjunction with the newly appointed CEO, Ross Taylor, will inform investors later in the year of their intentions, once the transaction has settled. The company has guided to engineering revenue for FY15 of $2.4-2.5bn. However, CIMB cannot find a way to make the standalone business stack up at current prices. On the broker's assumptions, and with the expected proceeds, valuation remains materially below the share price. CIMB thinks the business will only trade on 5-6 times earnings estimates, based on a difficult external operating environment, and a history of poor cash conversion and problem contracts. Hence, CIMB reiterates a Reduce recommendation at a share price above $6.30.

Deutsche Bank thinks the transaction price is fair. The broker describes DTZ as small, less established and with lower exposure to the high growth US commercial real estate market, believing this is reflected in the sale multiples. UGL's high debt levels will now be reduced and the company has the financial flexibility for capital management and/or accretive acquisitions. Deutsche Bank calculates the transaction will be earnings dilutive in FY15, given the company is retaining the proceeds as cash until the board completes a review of the options.

The sale price is below Macquarie's valuation of DTZ at $1.3-1.4bn. This broker also found the net leakage to be larger than expected, reducing cash proceeds for shareholders. Macquarie is not sure if the price justifies selling the business, as opposed to its de-merger. Still, some value must be attributed from the certainty the sale provides for the balance sheet. The broker estimates around $4.06m in surplus funds will be available for a capital return. Acquisition opportunities exist but Macquarie thinks a capital return is the base case. Moreover, the broker thinks the outlook for engineering is improving because of the momentum in infrastructure opportunities. UBS is witnessing an improvement in tenders for the power and infrastructure markets. Macquarie still struggles to envisage much valuation upside at present but an outcome on Sydney's north west rail may be a potential near-term catalyst, perhaps in a consortium with Leighton Holdings ((LEI)).

Morgan Stanley is disappointed. Attention is expected to shift to the quality of the remaining earnings and the broker envisages a weak second half in FY14, continuing a four-year trend where operating cash flow has lagged reported profits. Putting the engineering business on a blended multiple based on peers Downer EDI ((DOW)) and Transfield Services ((TSE)) and the mid point of FY14 net debt guidance implies an equity value of $5.90. UGL will not have a natural US dollar earning hedge now and has not refinanced its US private placement facility, signalling to Morgan Stanley an increased exposure to FX risk. The company may have to either use swaps to remove the FX risk, which increases interest rates on debt, or pay debt holders a break fee. Morgan Stanley remains Underweight on UGL.

BA-Merrill Lynch is more upbeat in the wake of the sale. Management's outlook commentary for the remaining engineering business enhances the broker's conviction that the bottom of the earnings cycle has now been seen. An increased order book over the past six months and lower corporate costs support the broker's more positive view. Merrills has increased forecast earnings for the engineering business by 16% in FY15 and 27% in FY16.

In regard to the sale proceeds, Merrills estimates around $460m will be used for debt reduction and around $590m will be available for a capital return to shareholders. The broker now expects dividend payments to be reinstated next year, one year earlier than previously assumed. While cutting its target to reflect the divestment, the broker retains a Buy rating.

FNArena's database has two Buy ratings, two Hold and four Sell. The consensus price target is $7.00, suggesting 7.5% upside to the last share price. This compares with $7.16 ahead of the announcement.
 

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