We reiterate UNDERWEIGHT on Developers. Post our sector downgrade last quarter, the KLPRP Index decline (-4.6% QoQ) was more severe than the FBMKLCI’s drop (-3.7% QoQ). We also saw lower dividend pay-outs among small-mid caps, unexpected cashcalls by some big-boys while a few land deals were rescinded. Valuations weakened but at a slower rate as the market ‘wait-and-see’. Property loans data continued to weaken in terms of approval rates while LDR makes new highs, indicating that the current tight lending liquidity to the sector is unlikely to change. Our studies show that a 25bps cut in OPR rates is unlikely to cause a significant improvement in demand. Meanwhile structural change in the sector is becoming evident as the Malaysia Property Transacted Values to Nominal GDP (PGDP) Ratio is making new lows indicating that the sector is becoming a lesser proxy to the economy; it also implies that property prices could weaken further. We think more cash-calls maybe announced in the next 12 months. Budget-2017 is expected to be ‘rakyat-centric” and hence likely to be muted for developers. Earnings risks are prevalent with margin compressions arising from heavy A&Ps, LADs and switch towards volume-based mass-market housing products. We will monitor two key indicators, namely 1H16 sales and unbilled sales visibility (1.3 years currently); if certain conditions are met by most developers during the next reporting season, we are likely to UPGRADE the sector to NEUTRAL. If the majority of developers fail to meet these conditions, we would likely MAINTAIN a NEGATIVELY bias call because our main concern is 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 prerequisites. Until then, we advise investors to stay away from the sector on potential sector de-rating. Our only Preferred Pick for 3QCY16 is UOADEV (OP; TP: RM2.22) for its defensive qualities and strong yields of 6.5%.

Property stocks weakened over 2QCY16. After downgrading the sector to UNDERWEIGHT on 25/3/16, the FBMKLCI slid by 3.7% QoQ, the KLPRP Index declined 4.6% while our universe of developers saw 7.1% fall, which was significantly worse off compared to 1QCY16. This was amidst the unexciting-toweak 1QCY16 reporting season which saw more earnings disappointments compared to the last quarter.

The quarter also saw deterioration in headline sales with 67% of developers under our coverage being proportionately behind their sales targets; most developers are banking on a stronger 2HCY16. Big-cap developers (>RM3b market cap) fared better than small-mid cap players (<RM3b market cap) with 4.0% and 11.4% declined QoQ, respectively. It was unnerving to see small-mid cap developers lowering dividend pay-outs (e.g. HUAYANG) with some failing to honour their dividend policies while others may not be able to do so in the future (e.g. KSL, MATRIX). Adding to that are margin compressions observed from several factors: (i) heavy A&P costs arising from incentives/freebies, (ii) late deliveries (LAD). Meanwhile, average unbilled sales have dropped to 1.3 years YoY visibility from 1.5 years, which is still considered healthy. (Refer to “Not Quite Ripe for Bottom Picking”, 2/6/16 report for details on 2QCY16 result review). We also saw unexpected cash calls from ECOWLD and SPSETIA while landbanking newsflow was relatively quiet, save for: (i) ECOWLD’s rescinding the Eco Marina deal and signing its Eco Ardence deal shortly after, and (ii) UEMS and WCT mutually rescinding the Serendah land JV deal.

Big caps fared better than small-mid cap developers so far. YTD, the KLPRP has declined by 3.5%, which was steeper than the FBMKLCI (-0.1%). Big-cap developers (>RM3b market cap) fared better at -0.4% YTD vs. small-mid caps (<RM3b market cap) -7.3% as investors move back to the big-boys for stability while the small-mid caps were affected by higher earnings volatility and potential reduction in dividend pay-outs (Refer to Appendix for YTD return charts).

Valuations weakened but at a slower rate as the market adopts a ‘wait-and-see’ stance. We highlighted some concerns in our 2QCY16 Strategy (“Make Hay While the Sun Shines”, 25/3/16) regarding: (i) developers' ability to meet their sales targets and the potential unbilled sales risks if targets are not met, and (ii) compression in valuations if unbilled sales, and hence, earnings continue to weaken. Back then, we were reluctant to call a bottom on the sector’s valuations as we felt there still have more earnings risks in the near horizon and now, our negatively bias views remain unchanged because we are still waiting for 1H16 sales confirmations.

Developer’s average Fwd PER/PBV has compressed from 12.0x to 11.5x / 0.87x to 0.83x QoQ, respectively. YoY, average Fwd PER/ PBV has fallen from 11.7x to 11.5x / 0.98x to 0.83x, respectively, vs. its 6-year mean of 17.4x and trough of 7.9x. While this appears closer to the bottom, many developers’ Fwd PERs may be a misleading barometer at this juncture as sales and earnings risks still loom. On another note, stocks like UEMS and MRCB have seen significant Fwd PER expansions.

We observe that UEMS and MRCB have experienced higher than average earnings volatility/disappointments but their share prices appear sticky, possibly due to shareholding structure. However, we still see further earnings risks with these two stocks and would not be surprised if some forms of cash call announcements are made within the next 12 months. (Refer to Appendix for Peak/Trough levels). The sector’s average Property RNAV discount is down by 2.1ppt YoY to 53.5% vs. the sector’s 6-year mean of 49.6%, and was relatively flat over the quarter at (-0.1ppt QoQ). However, against the sector’s peak historical RNAV discount of 64.2%, can we truly say that valuations have bottomed if earnings risks still looms? (*Note that Property RNAV discounts and our SOP discounts may vary depending on the stock).

Property loans data offers no reprieve. YoY, 5M16 Residential Loans Applied was marginally higher at+1% while corresponding Loans Approved was sharply down by 21%. Residential Loans Approved data has been on a declining trend for the last consecutive 15 months, while Loans Applied is showing some improvement after 28 months of consecutive decline. 5M16 Non-Residential Loans Applied and Approved was down by 21% and 33%, respectively.

We are aware there is still demand on the ground for genuine buyers but given weak sentiment, investors/speculators demand remains relatively tamed as seen by the Loans Applied data. Nonetheless, what is evident is the banking system still not favouring the sector at the moment considering that the Loans Approved data is much weaker than Loans Applied. Loan-to- Deposit Ratio (LDR) made a new high at 88.3% in May 2016, indicating that lending liquidity is likely to remain tight while lending to the sector is unlikely to see significant improvement as the banking system appears to be reducing the property loan exposures as a proportion of total banking system loan approvals with May 2016 at 31% vs. CY14-15 average rate of 43%- 36%. Our Banking Analyst believes the current tight lending situation will remain for the year. This supports our view that the sector is going through a structural change, as we highlighted in our earlier sector reports.

Is an interest rate cut enough to spur the property market? Unlikely! Back in Sep-14 when BNM raised the OPR by 25bps to 3.25%, Average Lending Rates (ALR) was relatively unchanged. Similarly, we believe that a 25bps cut in the OPR is unlikely to swing demand significantly. As it is, property demand has declined even with current low lending rate environment, as seen in the chart below. We reckon the issue of lending is not with buyers’ demand but rather lending liquidity. While we admit that an OPR cut may warrant better consumer sentiment, we take the view that it will not change the property demand landscape significantly. If the OPR cut is 50bps or more, this may change our view.

Structural change becoming evident. We have been tracking Malaysia Property Transacted Values to Nominal GDP Ratio (PGDP Ratio) because real estate forms one of the major pillars of this country or most economies; note that the Malaysia Property Transacted Values has a 92% correlation with Nominal GDP. We observe the KLPRP Index and the PGDP ratio have similar cycles, although the market or the KLPRP Index tends to peak first before PGDP ratio, which is expected as the market tends to ‘price-forward’. It appears that real estate is becoming a lesser proxy to the economy as the PGDP ratio has been on a declining trend for the last three years to a current 10-year low of 4.3% (1Q16) vs. its 10-year average of 6.6% while the KLPRP Index has yet to de-rate in a similar manner.

Interestingly, the KLPRP Index has a relatively high correlation to the Malaysia House Price Index (HPI) at 86% and Nominal GDP at 83%. If the KLPRP Index or share prices of developers are expected to see further weakness given the trends indicated by the PGDP ratio, property prices could weaken further. The House Price Index (HPI) data for 1Q16 and 2Q16 have not been released yet. As at 4Q15, Malaysia HPI grew at 5.8%, which is below its 10-year average of 6.5%, indicating that the sector has cooled down. However, we gather that HPI data is derived based on the gross prices stated on the transacted SPA. Over the last 1-2 years, new launches do come with variations of rebates/freebies/incentives with many amounting up to 20%- 30% of the SPA prices, implying the increasing disparity between gross and net house prices, so house price growth rates could be much weaker than the official HPI. Additionally, residential supply is worsening on the back of weaker demand, i.e. absorption rates have worsened.

Cash calls... The average FY16-17E net gearings of developers remain at 0.24-0.26x which is below our comfort threshold of 0.50-0.60x. Even then, SPSETIA recently did a cash-call albeit having a healthy FY16E net gearing of 0.28x. ECOWLD’s recent cash call, while not a surprise, came earlier than expected. Meanwhile in the small-mid cap space, developers have either: (i) reduced dividend pay-outs (e.g. HUAYANG), (ii) and may reconsider their minimum pay-out dividend policies (e.g. MATRIX) or (iii) forgo their dividend policies (e.g. KSL). With weak demand while developers seeking to capitalise on good land deals amidst weak sentiment, we would not be surprised if there are more cash-calls and further dividend risks. These events do cause earnings dilution and affect investors’ returns, which may weigh down valuations.

…and more to come? We think the following developers have high odds of doing some form of cash calls in the next 12 months; (i) UEMS has a few Australian projects, which are extremely capital intensive while local billings are thinning very quickly - the group aspires to diversify out of Johor, which may entail landbanking and hence, new funding, (ii) HUAYANG due to their higher-than-average net gearing and potential landbanking as the group is still looking for affordable housing landbanks, (iii) ECOWLD may consider non-dilutive fund raising options as current landbanking momentum is expected to continue. Developers that are less likely to do another one for the next 12 months are MAHSING and IOIPG as they still have unutilized rights proceeds. For the other developers (e.g. SUNWAY, CRESNDO, MATRIX, KSL), it is not so clear if they may attempt cash-calls because it depends on their landbanking deals. However, we are confident that UOADEV will not do cash calls given their strong net cash position while almost a third of their market cap is cash.

We were extremely surprised to see SPSETIA’s recent IRCPS cash-call (RM1.07b) because of their strong balance sheet, bullet deliveries from overseas projects and perpetual bond put in place. We believe a big land deal will likely follow shortly after. However, we are concerned on the longer term implications of this cash call. The IRCPS dividend rate of 6.49% works out to be an 8% pay-out. As it is, SPSETIA has the highest minimum dividend pay-out policy of 50% amongst our coverage, while over the last three years, its average pay-out was 64%; assuming ordinary dividend pay-out are not affected, the group will be paying out c.74%. We reckon such pay-outs are not sustainable for a developer like SPSETIA, which has cash-flow intensive projects in the UK (i.e. Battersea) while the group has started to adopt the traditional ‘10-90 financing scheme’ for some of its newer projects (e.g. Eco Templer) and is also on an aggressive expansion mode in both Australia and Malaysia. We believe one of two things may happen to the stock over the next 12-24 months; (i) ordinary dividend pay-out maybe reduced to make room for the IRCPS dividends, or (ii) another round of cash-call.

BREXIT risks. With BREXIT, we can expect volatility in currencies and equity markets. While we maintain that cities like London are largely ‘ever-green’ in the long-run, the nearer term may see an adjustment period in demand and prices. However, a quick channel check indicates many investors are looking at this as an opportunity to invest in London, especially if the GBP depreciates against the MYR. We think the market and developers may take a short breather to assess the situation, but we expect news-flow/launches to resume next year.

SPSETIA has the largest exposure (c.20% of Total Remaining GDV) under our coverage. For SPSETIA, their 40% owned Battersea Ph 1 and 2 have been sold while Ph 3 is between 60%-70% take-up rate. The risk for SPSETIA is more on the earnings front; if the combined property value and currency depreciation effect amounts to more than 20% of the property value upon completion (Note that Phase 1 delivery is over 4Q16-1Q17), buyers may not go through with the remaining 80% payment and forgo the purchase; however, judging from the GBP-MYR movement from Battersea Ph1 launch and today, the dynamics remain favourable and we reckon earnings from Battersea remain intact. Currently, SPSETIA is not launching new phases of Battersea pending the completion of the Northern Line extension. Battersea makes up 10% of SPSETIA’s FD RNAV.

As for ECOWLD, the listing of EWI is coming during volatile times, but management remains unfazed. Post listing of EWI, ECOWLD’s exposure is estimated to be c.10% of their enlarged effective remaining GDV. The listing of EWI has been delayed slightly to Sep/Oct 2016 from July 2016, due to SC’s approval process for entry of a strategic partner, which apparently is taking a ‘co-anchor’ position rather than a cornerstone position. While the strategic partner has not been revealed by management, it was reported in several media sources that it could be one of Tan Sri Quek Leng Chan’s vehicles. It appears the group is unperturbed by BREXIT; according to EWI management, it appears overseas investors are looking at BREXIT as an opportunity to enter into the London property market at discounted prices. In fact, BREXIT could bring about more attractive land deals for EWI. Note that EWI will have a light balance sheet post IPO. We have imputed for EWI in our estimates based on a 30% stake, which makes up 7% of our FD SoP (including funding).

Budget-2017...anything to look forward to? At this juncture, we believe Budget-2017 will still be very ‘rakyat-centric’ where goodies will be given out under government housing schemes (e.g. PR1MA) and if we are lucky, additional subsidies for government affordable housings. However, this will not have any significant impacts for our universe of developers. In terms of monetary measures, (i) our Economist is of the view that Malaysia’s OPR will remain unchanged, (ii) we believe that adjustments to the 70% LTV cap on third home purchases is also unlikely as those who are buying third homes are investors/speculators rather than genuine home buyers, so increasing the LTV cap may send the wrong message to the ‘rakyat’. Fiscal measure-wise, we believe lowering or removing the RPGT will be detrimental for the property market as it may cause a panic-sell which further exacerbates the oversupply situation. We reckon if there is an increase in withdrawal limit from EPF Account 2 (30% of EPF account), this will help increase home ownership substantially but such actions may require longterm studies by EPF due to long-term repercussions on future retirees. All in, we expect a relatively muted Budget-2017 for developers.

RECOMMENDATIONS

1Q sales are not good indicators. Recall last year when industry players stated they expected a stronger 2H during the first half of 2015, which was subsequently met with huge sales targets and earnings cuts during the 2QCY15 reporting season in Aug 2015. As mentioned earlier, most developers are proportionately behind their targets premised on new launches being skewed to 2H16. Since Apr 2016, developers have been rolling out new launches and so far, bookings appear healthy although the real test is the conversion of booking sales into SPAs. We also noticed more roll-outs of very small apartment unit launches, i.e. RM300k-400k/unit, in 1H16; while this bodes well to beef up developers’ sales numbers, it will definitely be a margin drag. Developers are becoming very aggressive with incentives (e.g. i. developers deferring interest and/or instalment payments, including the traditional 10-90 program, ii. low upfront deposits or rebates, iii. alternative financing options) to spur interests on the ground, but again, will be another factor for margin compressions.

Aug 2016 reporting season will be important for developers. So, we will monitor two key indicators, namely 1H16 sales and unbilled sales visibility. If certain conditions as stated below are met by most developers during the next reporting season (Aug 2015), we are likely to UPGRADE the sector to NEUTRAL. If the majority of developers do not meet these conditions, we would then likely to MAINTAIN a NEGATIVELY bias call because our main concern is the sector's earnings risk, which may de-rate valuations further.

1. 1H16 sales must meet at least 40% of full-year target, else we would likely trim targets if sales fall below 40%, and hence earnings, which may result in further downgrades in earnings.

2. Average unbilled sales visibility has dropped to 1.3 years’ earnings visibility from 1.5 years YoY. Developers with unbilled sales closer or above 2-year 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 below 1-year, i.e. higher risks of earnings volatility. Notably, developers with less than 1-year earnings visibility are: IOIPG, UOADEV, MATRIX, CRESNDO, HUAYANG. If unbilled sales drop below 1 year, this is usually alarming as it means the next 2-3 years’ earnings trajectory will likely see a declining trend.

Reiterate UNDERWEIGHT on Developers. We are maintaining most of our calls and TPs save for the following; (i) UOADEV upgraded to OUTPERFORM from MARKET PERFORM on unchanged TP of RM2.22 as its share price has corrected post dividends while we continue to like the stock for its defensive qualities and strong yields of 6.5%, (ii) lower TP for HUAYANG to RM1.83 but maintain MARKET PERFORM due to wider discount applied given its higher than average net gearing, lower than average dividend pay-out and weak earnings trajectory. ECOWLD’s (OP; TP: RM1.58) listing of its associate overseas arm, EWI, should take place by Sep/Oct 2016, which should lend strength to its share price. Our other recommendations are maintained and largely MARKET PERFORM to UNDERPERFORM calls. Overall, we advise investors to stay away from the sector for now or remain nimble for trading plays. Our Preferred Pick currently is UOADEV.

Source: Kenanga Research - 8 Jul 2016