Switch to PREH

PCRT’s 3Q and 9MFY14 DPUs were in line, at 26% and 77% of our full-year forecast, respectively, largely coming from the earn-out in place. While operations improved marginally in terms of occupancy, core net profit was affected by one-off losses. We believe investors will be better off switching to the new vehicle PREHL which offers greater value as PCRT’s fundamentals are expected to remain anaemic. We maintain our Hold rating, with an unchanged RNAV-based target price (30% discount to RNAV).

Marginal operational performance offset by one-off losses

The commencement of operations at Jihua Mall, Foshan and Qingyang Mall, Chengdu in Aug 2013 and Apr 2014 increased both PCRT’s revenue and NPI. However, the improvements in underlying earnings was offset by one-off losses from impairment loss on receivables from master lease tenant of Shengyang Red Star Macaline Furniture mall (Guangcai Group), higher finance cost and net foreign exchange loss. As the earn-out for PCRT is set to expire at end-2014, we believe operational performance will be the key to PCRT’s share price performance. With overall occupancy at 80.3% and rental reversion anaemic given the challenging situation facing retailers, we believe investors could be better off by switching to PREHL.

Switch to PREHL

The voluntary conditional general offer to acquire PCRT shares using PREHL shares has commenced and is expected to have its first closing date on 8 Dec 2014. Current PCRT shares allow investors to get exposure to PREH at a 51-56% discount to RNAV. So essentially, PREHL allows investors to get greater value at the expense of lower dividend yield. Over the long term, we believe PREHL could re-rate in 3-steps: i) strata sales of up to 50% of the units in Chengdu and Beijing will be realised in 2015, ii) most China assets in PREHL will be completed in 2016/17, following which recurring rental income for the remaining 50% of the assets will commence and PREHL should record significant revaluation gains, and iii) stabilisation of investment properties in 2019/2020.

Maintain Hold

We keep our Hold rating on PCRT. While downside is limited by the value in PREHL, re-rating catalysts could take a while to materialise.

Limited downside

Two key pieces of information in the PREHL circular warrant a relook at PCRT 1) the value within PREHL, and 2) the plan for strata sales of up to 50% of PREHL’s China assets, which will reduce funding risks. We upgrade PCRT from reduce to Hold, with a slightly higher target price (still at 30% discount to RNAV) as we adjust our rental estimates.

We cut FY15-16 DPS by 11-15% for the delayed opening of Chengdu Dongzhan Mall and potentially higher pre-opening expenses.

Cheaper entry via PCRT

Our preliminary estimates show that PREHL could be valued at an RNAV of $2.11-2.25/share assuming a 50.1-100% acceptance level for its voluntary offer for PCRT. This RNAV is supported by growth and value creation in its development assets in China, which make up almost 70% of PREHL’s GAV. These assets will be purchased by PREHL at a 25% discount to their residual land value and development margin is estimated at 20-25% on completion. While peer comparison studies show that PREHL could trade up to a fair 40% discount to RNAV, entry via PCRT (and subsequent acceptance of VO of PREHL shares) implies an entry point at 53-56% discount to PREHL’s RNAV, indicating that any downside has been fully priced into the trust.

Potential 3-step re-rating for PREHL

In the longer run, by swapping PCRT units for PREHL shares, investors can look forward to a re-rating of PREHL when i) strata sales of up to 50% of units in Chengdu and Beijing are realised in 2015, ii) China assets in are completed in 2016/17, where recurring rental income for the remaining 50% of the assets will commence and PREHL should record significant revaluation gains, and iii) stabilisation of investment properties in 2019/2020.

Upgrade to Hold

We raise PCRT from reduce to Hold. PCRT’s share price is 5.5% below the level prior to the PREHL-related announcement and is trading at an implied 53-56% discount to PREHL’s RNAV. Post the VO, investors in PCRT will have exposure to a larger portfolio of Singapore and China investment and development properties, which will enable them to benefit from both recurrent income in Singapore and development and revaluation upside from China projects. In the meantime, while downside risk is limited, near-term upside for PCRT may be capped by higher perceived risks for development exposure and income vacuum from the cessation of earn-out support in 2015.

Is it worth the wait?

If St James’ reverse takeover of Perennial goes through, PCRT’s shareholders will be offered an option to swap their shares for those of a bigger real estate company with presence in Singapore and China. We do not like the deal as: 1) investors will probably have to compromise on yield; 2) investors will gain access to a portfolio with higher gearing and proportion of assets under development, thus higher risk, in our view; and 3) while we believe the S$0.70 offer price is fair, the issue price of PREHL at 0.9x NTA is expensive compared to Singapore developers at an average 0.74x P/BV. We downgrade our rating to Reduce from Hold and cut our RNAV-based target price by 13% as we increase our discount rate from 20% to 30%.

What Happened

Trading in both Catalist-listed St James Holdings (SJH) and PCRT was halted on 14 Mar for the announcement of: 1) the reverse takeover of Perennial Real Estate Holdings Pte Ltd (PREH) (incl. 27% stake in PCRT), after which SJH will be renamed Perennial Real Estate Holdings Ltd (PREHL) and transformed into a real estate owner, developer and manager in Singapore and China, and 2) voluntary conditional offer of S$0.70/unit for PCRT in exchange for PREHL shares issued at S$1.1756/share, conditional upon the completion of (1) above.

What We Think

Rationale. We believe the rationale of the proposed acquisition and offer is to gain better access to funding. Also, the consolidation of PREH and PCRT’s assets positions the company as a mixed development developer and clears the confusion on whether PCRT should be regarded as a yield play.

We view the deal negatively. While we believe the offer of S$0.70 at 1x RNAV and 0.9x P/BV is fair, payment in PREHL shares complicates the issue. The issue price of PREHL translates to 0.9x P/NTA and 24x P/E, pricey in our view. Existing shareholders converting into PREHL would compromise on yield, accept higher development risks, higher gearing and wait a much longer time for the portfolio to complete development. While investors can buy PCRT at 0.7x P/BV to be exchanged for PREHL shares at 0.9x P/NTA, we believe PREHL’s shares may de-rate to an average 0.74x P/BV as well. CMA is trading at 0.87x P/BV, but 75% of its assets are operational, while 77% of PREHL’s assets are under development.

What You Should Do

Reduce exposure on potential overhang post the announcement.

Maiden contribution from Jihua

With the opening of Jihua Mall came its maiden revenue contribution of S$1.3m and pre-operating expense of S$2.7m. While pre-operating expenses may drag down earningsinFY13-14, the effect on distributions should be mitigated by the earn-out funds.

3Q/9M13 DPU accounted for 24%/71% of our FY13 forecast, in line with our and consensus expectations. Our target price, still based on 20% discount to RNAV, is unchanged at S$0.57 as we roll over estimates to FY14. We maintain a Neutral rating.

Maiden revenue contribution from Jihua Mall, Foshan

The Jihua Mall officially started operations in Aug 2013 and contributed revenue of S$1.3m in 3Q2013. While committed lease for the mall currently stands at 95%, only c.70% of the mall are currently operational and some tenants are in their rent-free fit-out period. We expect operational and rent-paying leases to reach the committed level and stabilise by 2-3Q2014.

Pre-operational cost weighs

S$2.7m out of S$3.1m property operating expenses was incurred for Jihua, mainly for marketing and pre-operational costs. Increased marketing expenses will be beneficial if it translates into higher shopper traffic and tenant sales growth, and consequently rental income. However, we believe that the unoccupied residential/office units in the vicinity remains a concern for Jihua and Qingyang. Given our expectation of longer gestation period for these two malls, we expect pre-operational costs to drag down earnings in FY13-14.

Dividend buffer buys time

3Q2013 shopper traffic for Shenyang Longemont increase 183% yoy on the back of shift in tenant mix and aggressive marketing campaigns. We believe the management will be able to fulfil their aim of growing tenant sales, and consequently rental revenue, in time to come. The earn-out fund, which lasts till end 2014, provides the much-needed time for its assets to stabilise. Upon its expiration, the management has not rule out the possibility of monetising completed assets to unlock value.

Occupancy ramped up in line with expectation

Company Overview

Perennial China Retail Trust (“PCRT”) is Singapore’s first pureplay PRC retail development trust. Listed on the main board of SGX on 9 June 2011. PCRT’s key investment lies mainly in major 2nd tier cities of China, including Shenyang, Foshan and Chengdu. PCRT also holds 10% in predominantly retail Bejing Tongzhou integrated development.

• Reported 1Q13 JV net operating income (from Shenyang properties) at $0.55mn (-41.4%y-y), distributable amount at $10.9mn (+2.7%y-y), DPU at $0.95 (+1.1%y-y).
  
• Overall occupancy improved in operational Shenyang properties and preleasing activities in Foshan Jihua and Chengdu Qingyang malls are progressing well.
  
• Sponsor secured for PCRT right of first refusal to acquire block retail component in Beijing Tongzhou Integrated Development Phase2, adding to PCRT’s potential pipeline.
  
• Maintain Accumulate with unchanged target price at $0.67.
  

What is the news?

Operating profit from Shenyang Properties fell by 41.4% y-y to $0.553mn, mainly attributable to seasonally higher utilities expenses from additional heating during the harsh winter as well as increased marketing expenses to improve sales in Longemont Mall. The management has strategically negotiated another master lease agreement with an antique wholesaler for Red Star Macalline Mall, raising occupancy rate from 60% to 93%. Occupancy (including committed leases) for Longemont Offices rose from 16% to 32.0%. Occupancy in Longemont Mall stayed at 70%, the same as from 4q12, but shopper traffic improve significantly by 136% over the same period last year. Committed occupancy for Foshan Jihua and Chengdu Qingyang Malls rose to 77% and 63% respectively as compared to 60% and 33% in 4q12. Operation commencement of Foshan Jihua Mall is delayed to 3q13 from 2q13. Sponsor secured for PCRT the right of first refusal to acquire the block retail component of Beijing Tongzhou Integrated Development Phase2 (~70,000 to 100,000 GFA).

How do we view this?

The pace of ramping up occupancies is generally in line with our expectation. Temporary shortfall in earnings due to an effort to ramp up leases does not affect our valuation because any shortfall in the FY2013 and FY2014 would be fully covered by the negotiated earn-out amount, a source of income support. Nevertheless, the overall portfolio has to be stabilized by the end of FY2014 to avoid a major decline in distribution.

Investment Actions?

We maintain our ‘ACCUMULATE’ rating with FY2013 target price at S$0.67 (35% discount to RNAV), equivalent to an upside potential of 5.5% on top of an above 6% dividend yield.