Results above expectations; Maintain BUY

2Q11 results above expectations. Ascott Residence Trust (ART) announced a 2Q11 distribution of S$26.3m, up 127% YoY. This came in above our expectations as 2Q11 distribution income made up 30% of our FY11 forecast. As a result, we increase our FY11 revenue and distribution income forecasts by 5.0% and 11.3% respectively. 2Q11 revenue improved 65% YoY mainly due to the contributions from 28 properties acquired in Oct10. Gross margin expansion to 56% in 2Q11 further boosted the YoY gross profit growth to 98%, fueled by higher margins on master leases, higher rental rates and better cost management. Revaluation gains of S$82.8m were also recognized.

Steady performance across portfolio. Master leases on 20 properties constituted about 25% of ART’s 2Q11 gross profit, boosting performance YoY given the higher margins from these leases. These leases have an average weighted remaining tenure of seven years and are expected to underpin performance going forward. We saw improved YoY performance across countries, except for China, Indonesia and Japan. In China, this was due to the divestment of Ascott Beijing in Oct10 and poorer performance at Tianjin and Shanghai, offset by Beijing. In Indonesia, this was due to the divestment of Country Woods in Oct 10 and the strengthening of the SGD versus USD. The poorer performance in Japan was mainly due to the effects of the earthquake. 2Q11 REVPAR across the portfolio increased 17% YoY to $147, mostly due to Singapore and UK. Occupancy remained stable at 81%.

Healthy balance sheet. ART continued to show a healthy balance sheet with gearing at 40.1% and cash at S$112.7m. 59% of debt have fixed-rate terms, with the remaining 22% and 19% under floating with interest rate caps and floating rates, respectively. 11% or S$119.4m of total outstanding borrowings fall due in 2011, of which S$110.0m has been refinanced in Jul 11. The remaining S$9.4m is expected to be paid down according to scheduled terms.

Maintain BUY. We see further upside to ART’s unit price due to continued good execution from management. Its diversified portfolio across geographical regions would also buffer earnings somewhat against region-specific weaknesses. (28.3% Europe ex. UK, 45.1% Asia ex. Japan, 16.6% UK, 10% Japan, by asset values end 2Q11) Moreover, we expect a significant portion of profits (44% of gross profit 2011 YTD) to be underpinned by master leases and guaranteed income management contracts going forward. Maintain BUY with a revised fair value estimate of S$1.35 ($1.30 previously).

Potential headwinds may tamper growth

Global air travel softening. The IATA has recently revised its yearly profit outlook for the global airline industry with a 54% cut from US$8.6b three months ago to US$4.9b. This represents an almost 80% nose-dive from last year’s US$18b profit. Total passenger traffic is also expected to grow by just 4.4% this year compared to last year – slower than the 5.6% forecast three months ago. Asia Pacific is expected to be the most profitable while Africa is deemed the worst performer. Airlines also continued to be plagued by high taxes imposed by European governments and exorbitant charges imposed by some airports and service providers. We think ART’s hospitality growth, with its 43.2% and 10.7% exposure (asset values) in Europe and Japan respectively as of 31 Mar, may be tampered by the easing of air travellers ahead.

Euro Debt Woes. In Europe, business sentiments continue to be plagued by lingering debt crisis. Moody downgraded Greece credit rating from B1 to Caa1 (on par with Cuba). Italy and Belgium’s rating outlook were also cut from stable to negative by S&P. In UK and France where ART has the largest exposure in Europe (16.6% and 21% respectively), inflation and unemployment rates remain stubbornly high. The British recorded an inflation of 4.5% in Apr and unemployment of 7.7% for 1Q11. In France, inflation is 2.1% in Apr while unemployment is 9.7%, only slightly lower than the peak of 9.9% registered during the financial crisis. We noted that ART’s Citadines properties in France are on master leases and this provides some form of safeguards against deteriorating economic conditions. However, we remain wary of the prospects of ART’s properties in UK, Belgium and Spain, on the back of further fiscal tightening and rising inflationary pressures. The performance of the service residences industry has historically been correlated to GDP growth and FDI inflows, and the current state of affairs in UK, France, Belgium and Spain certainly suggests a less positive outlook.

Singapore’s prospects better. According to STB, international visitor arrivals reached 3.12m in 1Q11, representing a 15.7% YoY growth. RevPau also increased 15.7% YoY to S$191, on the back of robust performance in both room rates and occupancy rates. ART, with its largest asset exposure in Singapore (21.5%), looks poised to benefit from the uplift in its home country. Nonetheless, given ART’s exposure in Europe and Japan, its share price may face further secular headwinds in the form of weakening demand and continued inflationary worries. Maintain BUY albeit with a reduced fair value of S$1.30 (prev: S$1.34).

Journey to the West

• It is all about location – a visit to Ascott REIT’s prime properties in Paris/London

• Tapping the low hanging fruits, planned refurbishment to underpin earnings growth

• Maintain BUY and S$1.38 TP

It’s all about location. In our recent site visit to selected Ascott REIT’s serviced residences (or “apart’ hotels”) in Paris/London, we note a distinct feature – properties are strategically positioned in key business districts or major tourist attractions in London and Paris with good access to public transportation (most properties are within walking distance to the Metro in Paris and The Tube in London). Hence, these apart’ hotels attract a sustainable flow of guests – we understand that the Paris/London properties enjoy a healthy annual occupancy rate of between 75-85%.

Upgrading works at selected properties to underpin stronger operational performance. Ascott REIT has embarked on a refurbishment exercise for its European portfolio. We visited selected properties in Paris/London, which are currently undergoing renovation. We understand that Ascott REIT will be able to fetch average room rates in excess of 20% higher when the newly renovated rooms are re-opened, impressive given the competitive landscape in London/Paris. The manager targets an average payback period of 4-5 years on renovation capex spent in London.

DPU Growth of 8% expected. We project Ascott REIT to deliver a DPU growth of 8% in 2011, one of the strongest amongst its SREIT peers. Growth is expected to continue to be driven from a turnaround in its Asian operations, led by Singapore (contributing c19% of EBITDA in 2011) while London properties (29% of European EBITDA, 12% of EBITDA on a portfolio basis) are poised to be the strongest performer after its planned refurbishment exercise towards the run-up of the London Olympics in 2012, on top of a projected +2% adjustment in master leases in FY11.

BUY, DCF-based TP of S$1.38 maintained. Ascott REIT continues to offer an attractive above sector average FY11-12F yield of c7.0%-7.1%, which is unwarranted in our view, given its capable management track record, sponsor links and a portfolio of largely freehold properties. There is potential for further earnings upside if the manager executes on acquisitions.

Boosted by European portfolio

• In line; upgrade to Neutral from Underperform. FY10 results met Street and our expectations, at 102% of the respective full-year forecasts. Stronger REVPAU assumptions for Singapore, stronger assumptions for gross operating profit margins and moderate growth expectations for its European portfolio raise our FY11-12 DPU estimates by 2-4%. We also introduce FY13 estimates. Following our upgrade, our DDM-based target price climbs to S$1.32 from S$1.22 (discount rate 8.3%). Upgrade to Neutral as we see re-rating catalysts from stronger-than-anticipated REVPAU growth in Singapore due to MICE and tourism growth, and in the UK in the lead-up to the 2012 London Olympics.

• FY10 DPU of 7.54cts (our forecast 7.43cts) grew 2.7% yoy. Gross profit of S$39.3m in 4Q10 grew 80% yoy on full contributions from 28 properties acquired in 3Q10, offset by the divestment of Ascott Bejing and Country Woods, and strong performances in Singapore, the UK and Australia. However, 4Q10 DPU growth of 15.6% yoy to 2.16cts paled in comparison due to dilution from equity fund-raising. Europe now contributes 43% of ART’s gross profit, with the top-3 contributing countries being France, Vietnam and Singapore.

• Singapore and UK could grow stronger. Singapore is one of ART’s biggest growth markets, where gross profit grew 14% qoq and REVPAU, 15% yoy to S$219. Although qoq REVPAU was down 10%, we believe this was due to seasonality. YTD REVPAU of S$208 has grown 25% from a year ago. That said, this is still 15% below peak levels of S$249. We believe ART can achieve or even surpass peak levels in 2011, backed by strong visitor arrivals and MICE growth. Surprising us this quarter was gross profit in the four UK properties which grew 31%, above management’s forecast. REVPAU was also 9% above forecast at S$174. This was attributed to the successful refurbishment and rebranding of “Citadines Prestige” in two properties, which enabled higher pricing. Management will start to rebrand Citadines Trafalgar Square this year, and we anticipate improved pricing thereafter. The lead-up to the 2012 London Olympics is also likely to boost performance.