ART – OCBC

Compelling earnings story

Guidance hopeful but cautious. At 3Q09 results, Ascott Residence Trust (ART)’s manager said that while it remained cautious of the pace and extent of the economic recovery, it was “confident of the longer-term growth in the markets” in which ART operates. Our view is that the worst is behind ART – we believe Pan-Asian markets, where ART operates, will continue to be attractive FDI destinations. We think ART may shine in the year ahead as corporate spend and travel gradually return. The challenge now is increasing, and sustaining, occupancy at levels that allow for a successful increase in unit rates. Note that we are currently estimating flat RevPAU growth in FY10, which is fairly conservative.

Valuation picture is mixed. ART has re-rated 37% since our July upgrade and is now trading close to our previous S$1.19 fair value estimate. We use pre-crisis valuation levels as a sanity check on current pricing. The current price to book value of 0.87x already exceeds the 0.75x averaged in 2H 2006 but still offers 22% upside to the 1.06x book averaged in 2007. Distribution yields present a different picture. Using consensus estimates, the current forward yield of 6.35% already outperforms the 7.01% consensus yield averaged in 2007. We believe this could be because ART is at the trough (in our opinion) of a tough earnings cycle and the market may be pricing in significant earnings recovery, which is justified. Nevertheless, current pricing is more attractive than that of peer CDL-Hospitality Trusts [NOT RATED], which is trading at 4.7% consensus forward yield and 1.19x book value.

What next? ART is geared at 41.5% debt-to-assets and is due for asset revaluations in 4Q09. While we don’t expect significant downward revaluations, ART’s gearing is one of the highest in the S-REIT sector in a climate where the concept of leverage above 35% is now outmoded (in our opinion). So far, the manager has been remarkably disciplined about protecting value and has not raised equity since FY07. In 2010, fresh equity, likely raised through a private placement, could be used to fund asset enhancement works or yield-accretive acquisitions. A virtuous cycle of cheap acquisitions at cheaper capital is achievable if the manager maintains its focus on value protection and creation. Maintain BUY with fair value increased from S$1.19 to S$1.25 (14.9% total return). Key risk to our thesis is heightened regional economic risk, which could dampen investor sentiment towards diversified REITs.