Kenanga Research: ‘Trading buy’ for Eastern & Oriental

A more exciting future lies ahead

We visited Eastern & Oriental (EOB) recently and took away the following points;

We felt positive after meeting EOB as the company is still committed to strengthening balance sheet and long-term sustainability. It is focused on garnering high take-ups for its ongoing projects (e.g. St Mary and Quayside Resort) to build strong warchest of cash. Also, the company will sell its KL niche landbank to focus on developing STP2 if offered price is right.

Landbank sales could raise another RM344m in the near term, on top of its current cash pile of RM519m at 31/12/09. We think niche land banks on Jalan Yap Kwan Seng, Jalan Teruntung @ Damansara Heights, Jalan Conlay and Jalan Gallagher @ Bukit Tunku are most saleable in the short term given scarcity of land in the mentioned prime locations. If so, it potentially lowers current net gearing of 0.50x at 31/12/09 to 0.13x (see Note1).

Note 1: Our net gearing includes interest bearing ICULS and ICSLS.

Comforted by quick sales for St Mary Residences and Quayside Resort (Block 1 of Phase 1); current take -ups are 65% and 60%, respectively (see ‘On-going project progress’ for further details). Project take-ups at c.65% imply construction cost “break-even” point or comfortable project cash-flow levels. It allows EOB to confidently embark on new projects, like reclamation of Phase 2, Seri Tanjung Pinang (STP2) which could add up to 740 acre new land.

Recall EOB owns concession to reclaim up to 980 acre in Seri Tanjung Pinang, of which 240 acre has already been reclaimed and is an on-going development i.e. Seri Tanjung Pinang 1 (STP1). STP1’s final phases include the RM1.8 billion GDV Quayside Resort (Phase 1 and 2).

Scarcity of developable land in Penang is a push factor to develop Seri Tanjung Pinang 2 (STP2). We view STP developments as EOB’s crown jewel given prime location while providing the group with long-term sustainable income. Advantages of integrated (e.g. STP) vs niche (e.g. Dua Residence) projects are; 1) flexibility in launching various products to match demand whilst preserving development margins 2) maintain high market visibility 3) maximum value extraction via pricing-up as developers add value whilst population size grows. Enjoy premium pricing by leveraging on growing population size and added value.

Masterplan approvals for STP2 to be obtained by end-2010, according to management. If so, reclamation works can commence as early as 1QCY2011.

Cost and timeline hurdles. STP2 land cost is hefty given magnitude of reclamation works. It begs the question of whether EOB can stomach such costs. The full 740 acre can be reclaimed in several parcels over a period of time; although this may not be as cost effective as reclaiming 740 acre at once (due to multiple mobilisations of machines and labour force as well as exposure to material cost escalation risks e.g. sand), it allows EOB to better manage its cash-flow. EOB is also constrained by 2017 dateline or when the reclamation concession expires. It takes an average of three to four years to complete reclamation in deep waters (e.g. Tanjung Bungah area), implying reclamation must commence in 2014-15 at the latest.

Estimating reclamation cost of RM3.2 billion to RM3.5 billion (including infrastructure cost), assuming full 740 acre is reclaimed at RM100psf-RM110psf (STP1 reclamation cost is c.RM90psf including infrastructure ). Note reclamation cost is more expensive in Tanjung Bungah area given deeper waters vs. The Light which are at shallower waters (c.RM50psf).

Net gearing could be as low at 0.03x in CYE2012. We assume 1) RM344 million cash is raised from landbank sales 2) St Mary Residence is completed and fully sold 3) Quayside Resort Phase 1 (GDV RM900m) is 80% sold and 80% completed 4) ICSLS/ICULS fully converted (see Note2). Even so, additional gearing could add RM791 million to RM1.1 billion to cash-pile , assuming EOB’s internal net gearing of 0.60x-0.80x, which comes short of estimated reclamation cost of entire STP2.

Note2: We assume 8% ICULS 2006/11 and 8% ICSLS 2009/19 full converted. Recall EOB can mandatorily convert ICSLS to EOB shares on 1:1 basis after 2 years of issuance if traded EOB shares are more than RM1 each on a three-month VWAP basis.

Financing options to reclaim 740 acre. EOB is considering the following options in order to quickly realize full 740ac of STP2;

1) Bank guarantees, similar to STP1, which help defer payment of reclamation costs.

2) Joint development. Balance sheet risk is shared between EOB and JV partner(s) while providing greater financing avenues for reclamation of STP2.

3) Reclamation undertaken by another party in return for a portion of STP2 land. Theoretically, no balance sheets risks and hence, zero financing costs for land.

We prefer Option 3. This way EOB can quickly reclaim and realise STP2 or full 740 acre although share of land and GDV is reduced. Margins should be better given theoretical zero financing cost for land. EOB can only decide on appropriate option when STP2 masterplan approvals have been secured.

We think property development at project management’s level could be another business avenue. The Eastern & Oriental brand carries a premium in the market and EOB should leverage on it. It opens opportunities for EOB to develop project at a project management level implying no balance sheet risk while earning project management and performance fees. Foreign partners or those lacking visible branding in local markets may find EOB an appealing candidate.

On-going project progress

St Mary Residence has achieved overall 65% take-up rates. Tower C and A sales were driven by the 10/90 promotional scheme at an average price of RM1,000psf and RM1,300psf, respectively. St Mary project “breaks-even” on construction costs basis these take-up levels. Hence, EOB can confidently price-up on future sales (expected at average of RM1,350psf for remaining units of Tower C and A) as the project is at comfortable cash-flow levels; short term financing (e.g. bridging loans, revolving credits, etc) repayments become a surety post completion of the project. EOB plans to market remaining units of Tower C and A will be marketed to Singapore and Hong Kong.

Overall construction progress is at c.30% implying significant billings in 4Q2010; targeted completion is in 2 years time.

EOB’s Singapore sales office should be open early April 2010, featuring St Mary Residence project. It will aide in drumming-up foreign interests. Locals make-up majority of existing sales.

Potential recurring income from managing St Mary’s Tower B service suites. EOB has the first right of refusal to manage Tower B; recall Tower B is a repayment in kind to the land owners (St Mary Church) with no attached rental guarantees. If EOB chooses to manage Tower B, they will consider the following options close to project completion ; 1) entitled to a percentage of rental revenue (c.1.5%-2.0%) and profits (c.20%) 2) agreed annual rental return to the land owners while EOB enjoys excess or bears deficit. We prefer Option 1 as it minimises cash-flow risks, particularly during volatile economic conditions.

Nearing break-even level for Quayside Resort Block 1 (298 units; RM252 million GDV) of Phase 1 at 60% take-up rate; this does not include additional 10%-15% bookings sales which are likely to be converted to SPA sales. Construction cost ‘break-even’ point is likely at 65%. Sales were also driven by 10/90 promotional schemes with locals as main constituents (c.80% Malaysians of which c.50% are Penangites). Average selling price is RM650psf.

Targeting April 2010 launch of Quayside Resort Block 2 (298 units) of Phase 1, given strong response for Block 1. Pricings will be stepped-up 10%-15% higher than Block 1 at average price of RM715psf-RM748psf. We believe the market can stomach higher prices as the last tower of Waterside Suites carried an average selling price of RM820psf.

Quayside Resort earnings contributions to be felt from FY11 onwards, based on current 10% completion rate for Phase 1; recall foundation works commenced much earlier than launch. Superstructure works were awarded in early 2010.

Earnings and valuations

No changes to FY10E recurring net profit of RM35.3 million. 9M2010 net profit already makes up 77% of our estimates and 4Q2010 should be driven by stronger contributions from St Mary’s Residences, as well as, billings from previously launched STP1 projects (e.g. Waterside Suites). We are also expecting RM31 million gain on disposal from Jalan Tengah land (Lot 595) in 4Q2010, implying FY10E reported net profit of RM58.6 million. RM466 million unbilled sales provides 1.5 years visibility.

Raising FY2011-2012E recurring net profit by 27%-28% to RM48.7 million-RM73.3 million by factoring for 1) launch of Quayside Resort Block 2 (298 units; estimating GDV RM290 million) of Phase 1 for launch in April 2010 2) better than expected take-up rates for Quayside Resort Block 1.

Fair value maintained at RM1.26 based on 0.9x peer PBV on BV/share of RM1.40. At current price, EOB is attractive at 0.7x PBV vs 0.8x historical averages. Although earnings needs time to play catch-up based on FY2010, 2011, 2012E recurring PER of 23x, 16x, 10x, we reiterate our Trading BUY on EOB given 1) strong y-o-y earnings growth from on-going projects (three-year CAGR of 41%) 2) positive news flow from upcoming reclamation of STP2 provides strong share price catalyst 3) intention to convert ICSLS to EOB shares.

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