New horizons

Maintain HOLD. We cut Pavilion REIT?s (PavREIT) FY17F/18F earnings by 3%/3% as NPI margins were lower than expected, with 4Q16 net property income (NPI) margin of 65.5% vs. our estimate of 68.5%. This was due to the higher operating expenses allocated towards promotional and marketing initiatives for da:men and Intermark Mall. We expect operating expenses to remain high in FY17 for maintenance work of Pavilion. We believe NPI margins will improve once management has rebranded and realigned the assets.

Potential upside in new acquisition plan. PavREIT?s core asset is Pavilion KL mall. The premium tenant profile and location have led to strong average rental rates of above RM20psf. In FY16, PavREIT has opened the door to two new acquired assets which are da:men USJ mall and Intermark Mall. Two remaining right of first refusal (ROFR) assets are the 250k sq ft Pavilion Elite and 300k sq ft Fahrenheit88 mall, currently held by PavREIT?s major shareholder. We expect to see valuations around or above the RM600-700m range due to their prime location near Pavilion KL, which can support rental rates of >RM20psf/mth.

WCT is another source of acquisition pipeline. Tan Sri Desmond Lim, major shareholder of PavREIT, has recently acquired a controlling stake in WCT. Given an existing vehicle in PavREIT, WCT?s aspiration to list its retail malls via a REIT will likely be abandoned by the new management of WCT. Instead, these assets comprising BBT mall and Paradigm mall with a combined market value of c.RM1.2bn will likely be injected into PavREIT. If this materialises, an equity raising exercise via placement and/or right issues will need to be undertaken to finance the acquisitions.

Valuation

After rolling forward our assumptions, our DDM-derived TP is RM1.85, with 7% cost of equity and 1.50% terminal growth.

Key Risks to Our View

Underperformance of new assets. We based our assumptions on the positive performance of the acquisitions (da:men USJ and Intermark Mall) and we forecast both to be immediately accretive. In the event the new assets underperform due to lower-than-expected occupancy levels and rental reversions, its earnings may come in below our expectations.

Source: Alliance Research - 20 Jan 2017