1QCY16 reporting season was weaker than last quarter with earnings disappointment ratio rising to 33% from 17% previously. Cracks in dividend payout were observed, particularly for small-mid cap players in the affordable space which were previously positioned as relatively stable considering their above-average dividend yields. Majority of developers (67%) were behind their sales target and worse-off than last quarter (4QCY15: 25%); this is mainly due to timing of launches, which are skewed towards 2Q-2HCY16. The underperformance pattern sounds similar to the tune sung by industry players last year, which also did not pan out. Margin compressions were also observed. Meanwhile, our adjustments in CALLs/TPs during this reporting season were more negatively bias compared to last quarter. Developers have started to roll out new launches in 2QCY16 with innovative schemes to tackle the issue of tight lending liquidity. While indications of bookings have been good, the real test is converting them to SPA sales. We also note some of these schemes, which help developers secure sales, may cause cash-flow issues in the future. We will monitor two key indicators, namely 1H sales and unbilled sales visibility (average has dropped to 1.3 years’ visibility from 1.5 years YoY); if these conditions are met by most developers during the next reporting season, we would likely UPGRADE the sector to NEUTRAL. If the majority of developers fail to meet these conditions, we would likely to MAINTAIN a NEGATIVELY bias call because our main concern is that the sector’s earnings risks, which may de-rate valuations further. For the sector to see a sharp re-rating, positive monetary policy or administrative measures relating to the sector or a sharp improvement in the economy are prerequisite. Until then, we advise investors to stay away from the sector on potential sector de-rating. Reiterate UNDERWEIGHT on Developers.

Nothing exciting about 1QCY16 result season. Out of 12 developers under coverage; (i) 33% (UEMS, HUAYANG, CRESNDO, MRCB) disappointed largely on weaker-than-expected billings and margin compressions on higher marketing costs and lower margin projects, (ii) 17% (IOIPG, MATRIX) came above on better-than-expected billings, (iii) the remaining 50% were within to broadly within expectations. This season was just worse-off than the last quarter (17% disappointments and positive surprises from 8% of our coverage). Cracks appearing in dividends. Dividend-wise, we note that small-mid cap developers have disappointed in terms of payout ratio (e.g. HUAYANG) and are also expected to reduce or even remove dividend even though they have official dividend policy in place (e.g. MATRIX, KSL) as developers seek to reserve cash during such challenging times. At this juncture, this is done on the premise of conserving cash for future landbanking and on-going working capital as take-up rates are marginally weaker. We also believe this could be indications of an extended challenging period for the property sector. It is noteworthy that these small-mid cap players in the affordable space were previously positioned as relatively stable plays considering their above-average dividend yields. With dividend payout under threat, we believe these stocks may de-rate further.

Headline sales deteriorated with (i) 67% of developers were proportionately behind sales targets (MAHSING, UOADEV, UEMS, SPSETIA, ECOWLD, HUAYANG, SUNWAY, KSL) mainly on lack of new launches as timing of these new launches are skewed towards 2Q16 to 2HCY16, (ii) 8% (CRESNDO) exceeded expectations due to pick-up in sales at Bandar Cemerlang township, (iii) the remaining 34% was on schedule. It is clearly a weaker quarter compared to the previous one where 25% missed while 33% exceeded sales targets; having said that, last quarter was buoyed by heavy marketing campaigns by developers to clear WIPs/inventories. Note that this is a similar tune as last year where industry players kept citing the same mantra of ‘a better 2H’ which did not pan out as we had to trim sales targets for 70% of our property coverage last year.

Margins sizzling off? We observed YoY and/or QoQ margin compressions from most developers (exceptions were UOADEV and ECOWLD), which do not surprise us. Developers have been offering incentives/freebies and launching marketing campaigns, which cannot be fully factored into their selling prices due to weak sector sentiment. Additionally, the rollout of ‘affordable housings’ would mean lower margins, particularly for developers which were previously selling properties above RM600k/unit. We expect margin compressions to continue throughout the year; we have yet to fully factor for this effect as we are unable to ascertain the full impact at this juncture.

Property RNAV discounts widen further. Based on last price, 1QCY16 average property RNAV discount has widened slightly to 54.0% from last quarter’s 53.4% (1QCY15: 49.3%). Small-mid cap developers (<RM3b market cap) led the discount expansion at an average of 56.8% vs. last quarter’s 54.6%, while big-cap average (>RM3b market cap) improved slightly to 51.9% from 52.6%. Note that the sector’s historical high RNAV discount was at 64.1% (big cap: 61.7%, small-mid caps: 67.4%).

Earnings adjustments mainly done last quarter. Earnings revisions-wise, we reduced earnings for UEMS (FY16-17E: -30% to -23%) and MRCB (FY16-17E: -20% to -11%) while MATRIX’s earnings were adjusted slightly higher (FY17E: +5%); the rest were unchanged. This is not surprising since we trimmed and raise earnings for 42% and 25% of developers last quarter, respectively. This quarter, while many developers are proportionately behind targets, we have decided to maintain sales targets (except UEMS which we reduce and MATRIX which we increased) until we get further indication of whether 1H sales can make-up at least 40% of full year targets; failing which, we are likely to trim targets, and hence earnings. Negative bias on recommendations as out of developers under our coverage, we have; (i) trim 33% of TPs on weaker prospects (UEMS, HUAYANG, KSL, MRCB) and dilutions from cash-calls (ECOWLD), (ii) upped 17% of TPs (e.g. MAHSING, SUNWAY) as we updated their SoPs. Most CALLs were maintained except for HUAYANG, which was downgraded. Last quarter, we only trimmed TPs for 25% of developers with 1 upgrade and 1 downgrade in CALLs.

Developers are testing the market. Since Apr-16, developers have been rolling out new launches and so far, bookings, i.e. demand, is healthy. Incentives (e.g. i. developers deferring interest and/or instalment payments, including the traditional 10-90 program, ii. low upfront deposits, iii. alternative financing options) is spurring interests on the ground. Nonetheless, while bookings look good for the recently launched project, the key issue remains with tighter lending liquidity, which we believe will not abate any time soon. The test of conversion of booking to SPA sales remains elusive at this juncture. We will monitor two key indicators, namely 1H sales and unbilled sales visibility. If these conditions are met by most developers during the next reporting season, we would likely UPGRADE the sector to NEUTRAL. If the majority of developers does not meet these conditions, we would then likely MAINTAIN a NEGATIVELY bias call because our main concern is that the sector’s earnings risks, which may de-rate valuations further.

Key indicators:- (i) 1H16 sales must meet at least 40% of full-year target, else we would likely trim targets if it is below 40%, and hence earnings, which may result in further downgrades, (ii) We are also monitoring unbilled sales and our coverage’s simple average, which has dropped to 1.3 years’ earnings visibility from 1.5 years YoY. Developers with unbilled sales closer or above 2 years’ visibility (e.g. UEMS, SPSETIA) are driven by their overseas projects or earnings normalizations (e.g. ECOWLD). However, if sales targets are further trimmed this year, we can expect our average visibility to drop to below 1- year, i.e. higher risks of earnings volatility. Notably, developers with less than 1-year visibility are: IOIPG, UOADEV, MATRIX, CRESNDO, HUAYANG.

Cash flow under threat? In general, developers’ average net gearing remains healthy at 0.3x (below threshold of 0.5-0.6x). However, we note that the bigger boys are adopting more aggressive selling strategies, including the traditional 10-90 (10% deposit and no loans/payments until completion) and “move-in, pay later” schemes, developer’s financing (shorter tenure with higher than bank interest rate), deferment of interest/instalment period and low upfront payments, rebates/freebies, to name a few. Most of these incentives will either translate to higher ASPs or margin compressions for the developers. More importantly, some of these incentives mean developers get to secure sales but will be cash-flow taxing during the construction stage; as a result, we believe this will only be offered by the big-boys with much stronger balance sheet. Nonetheless, we will be monitoring this closely because such modus operandi may worsen ‘unbilled sales’ quality, and hence, valuations.

Reiterate UNDERWEIGHT on Developers. For the sector to see sharp re-rating, it will require positive monetary policy relating to the sector or a sharp improvement in the economy. Until then, we advise investors to stay away from the sector on potential sector de-rating.

Source: Kenanga Research - 2 Jun 2016