Volumes show no signs of picking up

At a Glance

• Generates distributable cash flow of 1.16Scts per unit – down 19% q-o-q – lower than estimates

• Weak water treatment demand at industrial parks compounded by seasonal and one-off factors

• Cut FY10-11 DPU estimates by 6-13%.

• Maintain HOLD, TP revised down slightly to S$0.68

Comment on Results

Downside risks prevailed. Water treatment volumes were weak in 1Q10, falling 12% q-o-q, owing to seasonal weakness caused by the CNY holiday period, a temporary closure at one plant, as well as the lack of any noticeable pick up in activity at the industrial parks despite the broadly improving economic conditions.

Water tariff receipts of S$6.9m (up 3% q-o-q) were somewhat boosted by the minimum offtake payments for the closed plant, but core operating margin dipped further to 35% vs. 37% in 4Q09. Interest expenses were lower in 1Q10 owing to the lower prevailing SOR benchmark, but could increase, going forward. The Trustee Manager is currently negotiating a refinancing agreement for the existing US$66m credit facility (expiring in February 2011), which would carry a higher interest spread.

Outlook & Recommendation

No waivers from Sponsor any more. The DPU subordination period ended in FY09, and as such we expect FY10 DPU to fall significantly short of the 5.42Scts paid out in FY09. Given the continued weakness in volume demand, and the absence of any kickers for the rest of FY09, we cut our FY09-10 DPU estimates by 6-13% respectively to 4.7-5.4Scts. This implies a FY10 DPU yield of 7% at current prices, which we view as fair. Maintain HOLD. Our DDMbased TP (WACC 9.5%) is revised down slightly to S$0.68 to reflect the lower DPU estimates.

Management ruled out any acquisitions over the next 6 months. The strategy now is to acquire completed plants only when they reach a certain level of operating maturity. Expansion works at four plants are ongoing, and should complete in FY11. Till then, treatment volumes and cash flows should remain largely flattish.

1Q10 results review; downgrade sector to NEUTRAL

1Q CY2010 results review. Four out of the eight S-REITs under our coverage reported earnings in line with our estimates. CapitaCommercial Trust (CCT) and Frasers Centrepoint Trust (FCT) beat our DPU estimates by 7.8% and 6.7% respectively. CCT benefited from positive rent reversions and lower property tax that drove a 11% YoY increase in net property income. FCT, meanwhile, beat our estimates (and the manager’s own guidance) on the back of a strong performance from Northpoint post asset enhancement works. Conversely, A-REIT and LMIR Trust missed our earnings expectations for 1Q CY10; with A-REIT missing our DPU estimates because of one-off upfront fees for loans. As a gauge, in 4Q CY09 five REITs reported results in line, three above our expectations and none below.

Guidance was ‘cautiously optimistic’, and growthoriented. Several managers indicated an intention to optimize yield and grow the portfolio both organically (asset enhancement initiatives, including CapitaMall Trust (CMT) and Ascott Residence Trust (ART)) and inorganically (acquisitions, including Mapletree Logistics Trust (MLT)). With this focus on growth, we believe S-REIT’s balance sheet capacity and ability to raise capital will remain key valuation differentiators. It may also be the first time the relatively young S-REIT sector will see REITs refresh their portfolios through divestments and re-developments in a big way (Cambridge Industrial Trust [NOT RATED] has been leading the pack as it de-leverages its balance sheet). Another price differentiator, in our opinion, will be the manager’s skill in optimizing yield through asset works: CMT and FCT, for instance, have a proven track record in this area in our view.

Volatility in the near term. Year-to-date performance of the S-REIT index is slightly negative (-0.7%) at 613.58 points. The recent volatility in the market has led to ~100 basis point movements in yields – we think this volatility will continue as macro-economic concerns, this time in Europe, take a front seat again. In our view, investors may consequently ascribe a higher risk premium (that is, higher yields and lower price-to-book ratios) to the S-REIT sector in the near-term. Nonetheless, we see selective opportunities to pick up strong REITs at attractive valuations (on a longer time horizon), after careful scrutiny of return versus risk. In an uncertain environment, we prefer REITs with a strong earnings outlook and strong balance sheets. We tilt slightly defensive in our top picks and favor FCT, MLT and ART with estimated total returns of 19%, 19.8%, and 21.7% respectively. Downgrade broader sector to NEUTRAL on a more cautious view.

DB Access Asia Conference 2010 Highlights

Improving operating environment; positive outlook. The operating environment for retail has improved amid the strong economic recovery, translating to a 0.9% YoY rise in shopper traffic and 5% increase in gross turnover. Rental renewal rates in 1Q rose 6.2% over preceding rents (vs 3.4% in 4Q09 and 2.3% in 3Q09). More trade categories are doing better, with 9 out of 18 trade categories reporting a YoY rise in gross turnover compared to just 4 in 2009. Mgmt expects CMT to benefit further from the growing trend in tourist arrivals.

Focus on capital management. CMT has been proactive in capital mgmt and is looking to extend and stagger its debt maturity. It has already addressed debt refinancing for 2010 partially through the recent issue of 5-year and 7-year MTNs (S$200m). In April it issued US$500m 5-year MTNs which will fully meet the balance of 2010 refinancing requirements and the acquisition of Clarke Quay. Pro-forma gearing of 34.7% remains conservative.

AEI and acquisition growth engine reignited. Ongoing AEIs are on track with 70% of new NLA in B1 & B2 Raffles City already committed ahead of its completion end this year. For JEC, construction contract has been awarded below initial budget on track for completion in early 2012. CMT is also constructing a new 2-storey F&B annex block in Junction 8 (3,500sf) and will reconfigure some retail units in Tampines Mall, expected to be completed by end this year. The acquisition of Clarke Quay has also been approved, allowing CMT to leverage on the rising trend in discretionary spending with % of revenue from discretionary spending rising from 20.9% t0 25.1%. Gross revenue locked in for FY10 has exceeded 88% of FY09′s.

Dragged back into uncertainty

Vessel re-delivery. FSL Trust’s (FSLT) charterer Groda Shipping recently requested FSLT to take re-delivery of two of its product tankers Verona I and Nika I as Groda does not intend to continue to make full charter payments. To recap, both vessels are under a seven-year bareboat charter agreement fixed at US$20,700/day each until Nov 2014. For the month of May 2010, Groda has made full payment for only one of the two vessels. It has also told FSLT that from June 2010 onwards, full payments should not be expected for either vessel. The charter agreement was structured with a cash security deposit of US$3m/vessel (covering about five months of charter revenue) and an assignment of the long-term Contract of Affreightment (CoA) between Groda and OJSC Rosneft Oil Company, a Russian state-controlled energy company.

What happens to DPU? FSLT said it was exploring legal and commercial options, and that “best efforts will be made to ensure the uninterrupted operation of the vessels”. FSLT has the option to either continue the CoA with Rosneft (terms not disclosed) or re-deploy the two vessels elsewhere. The end result could potentially be at a lower rate than before. The two vessels contribute roughly 15% of total revenue. In our view, FSLT may be able to meet its DPU guidance for 2Q10 with cash reserves and the vessel deposits. However, DPU guidance for further quarters will depend on where the two vessels are employed and at what terms. Note that FSLT has to pay out US$32m (roughly 50% of cash earnings) in loan repayments every year during the covenant waiver period. The balance is utilized towards distributions.

Contagion key concern. Our key concern is what the redelivery means for the rest of FSLT’s product tanker portfolio (26% of total revenue including Groda). While Groda’s thought process is unknown, it seems to have found it more profitable to walk away from the deal (and the US$6m deposits) than to continue with the charter agreements. FSLT has always touted its focus on risk management and current events may be a good test of that focus. On a positive note, we understand from the manager that this development does not impact FSLT’s loans. Still, any reduction in revenue could affect FSLT’s plans to raise unsecured debt. We reduce our fair value estimate from S$0.59 to S$0.48 (which assumes a slight negative drag on cash earnings from the two vessels and increases our discount to FCFE value from 20% to 25%). Maintain HOLD.

1Q10 misses the mark as rental guarantees expire

1Q10 results below expectations. LMIR Trust reported 15.7% YoY and 3.4% QoQ gains in 1Q revenue and net property income to S$21.6m and S$20.3m respectively, primarily due to the strong Indonesian Rupiah (IDR) against the Singapore Dollar (SGD). By our estimates, revenue and NPI were slightly negative to flat YoY and QoQ in IDR terms. Revenue and NPI missed our estimates by 8.9% and 7.6% respectively. Meanwhile, distributed income fell 11.5% YoY but rose 3.5% QoQ to S$12.9m or 1.20 S cents per unit. We believe this is due to the appreciation in the IDR, as the hedged rate on distributions is significantly higher than the physical rate. Consequently, LMIR booked a realized (cash) forex loss this quarter of S$1.7m versus a loss of S$0.9m in 4Q09. DPU was within 5% of our expectation of 1.26 S cents.

Mall occupancy falls 2.2ppt versus 31 Dec to 93.8%. Malls such as The Plaza Semanggi (the second largest income contributor among the retail malls), Bandung Indah Plaza (third largest contributor) and Ekalokasari Plaza recorded occupancy declines of 600 basis points, 470 bps, and 820 bps respectively. The manager attributed the occupancy declines (-220 bps overall) mainly to the expiry of rental guarantees, granted by the vendor at the time of LMIR’s IPO, on spaces that had undergone extensive asset enhancement. After including temporary leasing and new leases committed by way of signed letters of intent, occupancy at Mar 2010 is 96% (flat). The manager said that with improving sentiment, it continues to receive various leasing enquires for vacant space. It is also re-mixing its tenant profile as it positions the portfolio for a more favorable retail climate.

Easing earnings estimates slightly. LMIR re-iterated that while the retail property market might start to benefit from a strong macro environment, LMIR will not see any “material benefit” in 2010 as “the portfolio has a very defensive position with very low upcoming expiries and already high occupancy levels”. The REIT manager said it continues to source for new acquisitions to take advantage of its low leverage of 10.2% debt-to-assets. We are now factoring in lower occupancy assumptions for FY10 and FY11. Our revenue estimates decline 2.7% and 3.7% for FY10-FY11F. In line, we adjust our DPU estimates for FY10-FY11F down by 3.3% and 4.3% to 5.0 S cents and 5.2 S cents respectively. Our fair value estimate, at a 20% discount to SOTP value, declines to S$0.55 from S$0.59 previously. With a 23% estimated total return, we maintain our BUY rating.