1H17 realised net income (RNI) of RM111.4m came in below both consensus and our expectations at 43% and 40%, respectively. 1H17 dividend of 3.96 sen was also below expectations (42%) on weaker margins. As such, we lower FY17-18E earnings by 14-4%, post accounting for Elite Pavilion acquisition, 7.2% placement and higher operating expenses. Maintain OUTPERFORM on lower TP of RM1.85 (from RM2.02).

1H17 realised net income (RNI) of RM111.4m came in below both consensus and our expectations at 43% and 40%, respectively. 1H17 GDPU of 3.96 sen per unit (which includes a non-taxable portion of 0.13 sen) was also below expectation at 42% of our FY17E GDPU of 9.4 sen (4.9% dividend yield). Although top-line came in within our expectations at 46%, results missed due to margin compressions from higher operating and financing cost.

Results Highlights. YoY-Ytd, GRI was up by 6% on acquisitions of Damen Mall and Intermark Mall (in Mar 2016), and positive rental growth from other assets on mid-single digit reversions. However, RNI declined by 8% on: (i) higher operating cost (+23%) on maintenance cost for the air-conditioning system and upgrading work, air chillers rewinding, replacement of escalator handrails and broken combs at Pavilion Mall, replacement of lift and escalator parts and improvement of light fittings at Intermark Mall, and tenancy costs incurred for landlord provisions at Damen Mall, (ii) higher expenditure (+4%), and (iii) higher financing cost (+30%) incurred for the acquisition of the new malls. QoQ, 2Q17 RNI declined by 5% on the back of a marginal top line growth (1%) from positive reversions, but bottom-line succumbed to margin pressure due to higher operating cost (+9%) on reasons mentioned above.

Acquisition of Elite Pavilion Mall positive in FY18E. PAVREIT also announced the proposed acquisition of Elite Pavilion with Urusharta Cemerlang (KL) Sdn Bhd (UCKL) and a vesting agreement with Urusharta Cemerlang Sdn Bhd (UCSB) and UCKL for the Extension Connections for RM580m purchase consideration. Additionally, PAVREIT also announced a conditional SPA with UCSB for disposal of 10 car park bays for RM880k. We believe asset NPI yield is decent at 6.1% considering tough market conditions vs. PAVREIT’s intended target of 6.5%, while Pavilion Mall NPI yield is 6.0% (at FY16). The acquisition is expected to be completed in 4Q17 and will be funded by a combination of borrowings and 7.2% placement (refer overleaf). All in, we are positive on this acquisition as it contributes c.8% to FY18E earnings, and 7.6% to DPU (post placement).

We trim FY17-18E earnings by 14-4% post accounting for the net negative impact from: (i) declining margins - we lowered our net margins closer to current levels of 45-46% in FY17-18E (from 53-52%) on higher operating expenses and financing cost, and (ii) post accounting for positives from incremental earnings from the acquisition of Elite Pavilion Mall in FY18.

Maintain OUTPERFORM but lower TP to RM1.85 (from RM2.02). We lower our TP post trimming our earnings estimates and after accounting for the dilution from the 7.2% placement, lowering GDPS/NDPS to 8.9 sen/8.0 sen (from 9.7 sen/8.7 sen), on an unchanged spread of +0.8ppt to our 10-year MGS target of 4.00%. We have applied the thinnest yield spread among MREITs under our coverage (between +0.8ppt to +2.0ppt) as we believe PAVREIT should be traded at thinner spreads on strong catalyst from expectations of asset injections. As such, we believe PAVREIT warrants an OUTPERFORM call, with attractive total returns of 11% at current levels.

Outlook. FY17-18 will see minimal expiries c. 24-22% of NLA on modest single digit reversions. Fahrenheit88 acquisition is still on the table, pending the sponsor’s intention to sell, while we believe PAVREIT is eyeing a cap rate closer to 6.5%. Additionally, as we had highlighted previously, we reckon PAVREIT could potentially acquire 3rd party assets from WCT (which owns Paradigm Mall and AEON Bukit Tinggi) as Tan Sri Desmond Lim is now a major shareholder. With a low gearing of 0.27x (from 0.26x in FY18) post the placement and acquisition of Elite Pavilion Mall, PAVREIT could gear up by an additional RM800m before reaching its internal gearing limit of 0.35x.

Risks to our call include: (i) bond yield expansion vs. our target 10-year MGS yield, and (ii) weakening rental income

Source: Kenanga Research - 28 Jul 2017