Investment Highlights

• We upgrade Pavilion REIT (PREIT) to BUY from HOLD with a higher fair value (FV) of RM1.56 (from RM1.43) based on the dividend discount model (DDM).

• The increase in our FV is based on the lower risk-free rate due to decline in the 10-year Malaysian Government Securities (MGS) to 3.9% from 4.3%. We also take into account higher rental income and minimal rental rebates from FY22F onwards. No changes to our neutral 3- star ESG rating (Exhibits 6, 7).

• PREIT’s distributable income of RM125mil in 1HFY22 (Exhibit 1) came in slightly above our and consensus' expectations. It accounted for 56% of both our and consensus’ FY22F earnings.

• The variance to our forecast was mainly due to the betterthan-expected rental revenue and income from advertising coupled with lower rental rebates offered to tenants. A strong pick-up in retail footfall and tenant sales for the Raya festive season also contributed to higher rental revenue as rentals collected are derived on either the higher of base rental rate or a portion of the tenant’s sales.

• We raise our distributable income estimates by 6% for FY22F–FY24F, after taking into account higher rental income from both Pavilion Kuala Lumpur and Elite Pavilion malls. We do not expect rental waivers to be offered to tenants going forward as all businesses are now allowed to operate after the reopening of the economy and international borders.

• In 2QFY22, PREIT’s gross revenue rose 13% YoY due to higher rental revenue and income from advertising. Net property income (NPI) surged 75% YoY to RM83mil. This was supported by lower operating expenses (-24% YoY) given the lower rental assistance offered to tenants. As a result, distributable income jumped 2.5x YoY to RM57mil.

• On a QoQ comparison, PREIT’s 2QFY22 gross revenue expanded 2% while NPI fell 12%. This was attributed by higher provision for doubtful debts and higher utility cost due to the imposition of electricity tariff surcharge of 3.7 sen per kilowatt hour to the non-domestic sector starting from 1 February 2022, which increased the property operating cost.

• PREIT’s debt-to-asset ratio stayed at 35%, well below the 60% statutory threshold required by the Securities Commission (SC).

• PREIT proposed a first interim gross DPU of 1.9 sen in 2QFY22, which represented a distribution payout ratio of 100%. It was 1.6x the 0.7 sen declared in 2QFY21 and 8% lower than the pre-pandemic level (2QFY19) of 2 sen.

• QoQ, the average occupancy rate fell to 79% from 82%. The decline was mainly attributed to the drop in the occupancy rates of all its retail malls except Intermark Mall. Nevertheless, the occupancy rate for office in Pavilion Tower remained stable at 74% (Exhibit 4).

• 52% of its tenancies in Pavilion Kuala Lumpur are set to expire in FY22F (Exhibit 2). We understand from management that 50% of lease renewals have been completed. With footfalls recovering to 85% of the pre-pandemic (2QFY19) level in 2QFY22, management is optimistic about the renewal of the remaining tenancies that will expire in FY22. Based on the latest briefing, we understand from management that PREIT has secured 92–93% of the occupancy rate in 2HFY22 with the entry of new tenants and expansion of existing tenants. Meanwhile, the current rental reversion rate is mildly positive for the mall with increments ranging from 2% to 3%.

• Despite the decline in Da Men Mall’s occupancy rate to 59%, we expect the rate to recover in 2HFY22 as PREIT has secured new tenants including A&W, Subway and Big Pharmacy. With the new tenants, we expect the occupancy rate in Da Men Mall to rise to over 70% by end of FY22.

• Since the beginning of 2022, the yield spread between PREIT and 10-year MGS has been narrowing. This was contributed by the surge in 10-year MGS yield which followed closely the rising trend of 10-year US Treasury yield (UST). However, we see a stabilisation in 10-year MGS yield with a decline to 3.9% from the peak of 4.4% following heavy foreign selling in June 2022 and also tapering in inflationary pressures with the retreat in commodity prices from their high levels. FY23F distribution yield is estimated at 6%. We expect PREIT to be appealing to yield-seeking investors with its higher yield spread against 10-year MGS (Exhibit 5).

• PREIT currently trades at a compelling FY23F PE of 17x vs. its 2-year average (pre-pandemic, FY18-19) of 19x. Meanwhile, distribution yield for FY23F of 6% is attractive vs. 10-year MGS yield of 4%. We also like the stock due to its key assets which are strategically located in the capital of Malaysia, providing a good platform for new international brands to establish footholds for expansion into the Malaysian market while supporting demand for retail space at the malls. Looking forward, we foresee a gradual pick-up in retail footfall and tenant sales with the reopening of international borders and further relaxation of SOPs.

Source: AmInvest Research - 29 Jul 2022