Strategic review takes a twist. The new management has decided to ditch the divestment plan of the Australian assets. Previous asset enhancement projects at Keypoint and China Square Central were put on hold. It has also dropped plans for a hotel development at China Square Central with a view of rising construction cost and lower tourist arrivals. It will instead focus on recapitalizing the balance sheet and active asset management to retain tenants and maximizes lease renewals.

No catalyst in sight. Fraser Commercial Trust (FCOT) faces significant headwind and sees some pressing issues it needs to address.

Key issue 1: Asset revaluation a risk to breaching gearing limit. FCOT latest valuation of its properties recorded an S$126.2million (-6.6%) loss to its asset value. NAV per unit is cut from $1.39 to 1.21. We see further risk in cap rate expansion resulting in lower property values, which might increase the gearing ratio. It has one of the highest gearing ratio among the SREIT. FCOT current gearing is 48.6%. We think it is stuck in a difficult position to reduce the gearing, as the plausible ways are not favorable. Judging by the strategic review outcome, an asset sale was already ruled out. An equity fund raising (EFR) might not be able to raise the expected amount due to the weak equity market climate. At the current price level, a pure EFR would be highly dilutive as well.

Key issue 2: FCOT has S$70 million debt due on 22nd Nov 2008. This is supposed to be repaid with the redemption proceeds from AWPF, however management has mentioned there will be no redemption. We believe FCOT should be able to secure refinancing given its sponsor relationship. However we have also assumed a higher interest margin along with the refinancing.

Valuation and recommendation. FCOT is trading at approximately 80% discount to its NAV. Although cheap on a relative basis, we are of the view that sentiments may not pick up in the short term. Our concern stem from the following points; 1) high gearing ratio, 2) probable dilution from EFR, 3) high borrowing cost, 4) worsening rental outlook and asset value. We are downgrading our call to Hold with a fair value of $0.21.

A Catch-22 Situation for F&N (& a possible solution)

Key points:

♦ FCOT is the cheapest REIT in the S-REIT space on P/Book basis.
♦ Implicit backing of F&N reduces re-financing risk.
♦ A potential privatization candidate for F&N, we see a possible takeout price at $0.42, implying 82% upside.

Analysis:

1) Back in July 2008, F&N bought a 17.7% stake in Allco Commercial REIT (Allco) and 100% of Allco’s REIT manager, paying an aggregate purchase price of S$180m.

2) The S$104m price tag for 17.7% in Allco translated to a price of $0.83/unit and was at a 42% discount to Allco’s Net Asset Value, valuing the whole REIT at S$588m.

3) F&N’s game-plan was to use Allco REIT as its commercial REIT vehicle and eventually inject its pipeline assets (Alexandra Point, Alexandra Technopark and Valley Point) into Allco. Allco was subsequently renamed Fraser Commercial Trust (FCOT).

4) Today, amid a full blown financial crisis, and company-specific refinancing issues, FCOT’s share price has plunged to $0.23, implying P/NAV of 0.18x and a market capitalization of $164m. Distribution yield is in excess of 20%. F&N is currently sitting on a paper loss of $75m based on the last trade price.

5) In the short term, FCOT faced the daunting task of re-financing S$460m of short termT loan. Given the implicit backing of F&N, we believe the company would be able to resolve this, abeit with a higher cost of funds.

6) F&N currently faces a challenging situation: given the huge discount to Net Asset Value (78%) and high distribution yield, any asset acquisition would not be accretive and also involve massive unit earnings dilution. The designated pipeline assets for the REIT would have to be deferred infinitely in the current environment.

7) One potential solution would be for F&N to privatize the FCOT to resolve the deadlock. Post privatisation, F&N would have greater flexibility to carry out an asset restructuring exercise, getting rid of under-performing assets and re-packaging the REIT for a future re-listing when market conditions improve. Under current market conditions, a privatization offer would be a cheap way of acquiring physical assets.

8) While we are cautious of industrial REITs in general given a supply glut in a slowing economy and potential tenancy risk, we believe FCOT’s low valuation has priced in much of the negatives and has limited downside risk at this level. We also see it as a potential M&A target.
9) Assuming a takeout price of 0.35x P/Book, that will translate to a target of $0.42, 82% upside from current level. Buy.