SP Setia : INITIATING COVERAGE – For the long term but not now

December 1, 2008 at 6:35 am Leave a comment

• Proxy to the Malaysian property sector.
SP Setia is a developer of distinction with an impeccable track record. Based on its 18 projects in Malaysia and 1 in Vietnam, it has 4,783 acres of undeveloped landbank with remaining gross development value of
RM16.3bn. It is not a coincidence that SP Setia is regarded as a proxy to the Malaysian property sector.
• Charting the next stage of growth.
As a township developer, SP Setia has achieved net profit CAGR of 14% since 1999. However, going forward organic growth from township may be difficult to match historical growth rate due to a higher base now. To chart the next stage of growth, SP Setia adopts a 2-prong strategy i.e. (1) broadening its product offerings with more commercial developments, and (2) venturing overseas with its maiden residential project in Vietnam.
• But challenging times ahead.
Rising building materials prices have resulted in margin erosion in FY2008 but we believe further margin downside risk is limited as prices of commodities such as crude oil, steel bar and copper have eased.
However, going forward, risk of declining sales may be heightened. Launches of new phases within existing townships have slowed down while new projects have been scaled back unless sufficient pre-launched
bookings are procured. Against such a backdrop, we expect sales growth to be flat in FY2009 while recovery is expected in FY2010. Earnings wise, FY2009 is still expected to be strong due to unbilled sales of RM2.2bn as well as recognition of a net gain from land sold to Lend Lease, which we estimate to be about RM27m. Although we expect sales growth recovery in FY2010, earnings growth will only come in post-FY2010 due to lag effect.
• Fairly valued with limited upside in the near term.
We initiate coverage with a HOLD call and target price of RM2.62 which is derived by ascribing a 25% discount to RNAV of RM3.50. SP Setia is currently trading at P/E of 12.2x based on FY2009 earnings which is
almost at parity to its 15-year historical P/E of 12.8x as well as our expected market P/E of 12.5x for FY2009. Although there is limited upside for now, SP Setia remains the best proxy to Malaysia property sector and we recommend accumulation on price weakness.

Impeccable track record
SP Setia came a long way since its formation in 1974 as a building contractor. It was listed on the Second Board in 1993 before being transferred to the Main Board in 1996. Following its foray into property development, SP Setia was re-classified into the Property Sector in 1999. Over the next 8 years, SP Setia transformed itself to be the largest listed property developer in Malaysia with its net profit growing at CAGR of 14% since then.

Established branding
SP Setia has established itself as a township developer of distinction having won many accolades over the years including FIABCI International Prix d’Excellence Award, The Edge Malaysia Top Property Developers Award, Euromoney Real Estate Awards, Forbes Asia Best Under US$1 Billion Award and Cityscape Real Estate Awards. It has built a distinctive brand name among Malaysian households with its bread and butter
“Setia” brand townships in the Klang Valley and Johor. Although it started only with the Setia brand for the mass housing township, over the years, it has rolled out more products with differentiated branding strategy to enhance its product offering as well as profile e.g. the highly acclaimed Duta series for high-end properties.

Institutionalised shareholding structure
SP Setia’s meteoric rise to be the leading property developer has attracted many investors over the years as it is regarded as the proxy to the Malaysian property sector. Today, its shareholding structure is very much institutionalised with Skim Amanah Saham Bumputra and Employees Provident Fund among its major shareholders with 18.8% and 11.8% interest respectively while its group managing director, Tan Sri Dato’ Sri Liew Kee Sin, holds a 10.2% stake.
Besides property development, SP Setia also has construction and manufacturing businesses, which are complementary to its principal activities. Its construction arm acts as its project manager for its in-house developments which are undertaken by sub-contractors. In addition, SP Setia also manages the construction of certain government residential projects in Putrajaya as well as infrastructure jobs such as the upgrading work of a 3.5km stretch of the Pasir Gudang Highway from the Perling Interchange to the Skudai Interchange. It has also secured a RM190m contract to build the new Home Affairs Ministry Complex and Quarters in Setia Tropika, Johor. The group’s manufacturing business, via its wholly-owned Setia-Wood Industries Sdn Bhd,
supplies timber doors, roof trusses and timber flooring boards to the local construction industry and produces custom-made timber frames and doors for the export market. Today, Setia-Wood assumes the main role as the manufacturing arm of SP Setia, supporting the operations of the Group. Its operations are housed in a 7-acre factory covering a total area of 60,000 square-feet in Taman Industry Rawang Indah, Rawang, Selangor.

Massive landbank in diversified locations
SP Setia has a diverse exposure to the top 3 property hotspots in Malaysia i.e. Klang Valley, Johor and Penang, which collectively account for 76% of the nation’s total residential property transactions in 2007. Besides these 3 locations, SP Setia has also ventured into Sabah (Aeropod @ Tanjung Aru) and Vietnam (Eco Lakes My Phuoc). Its massive landbank of 4,783 acres with remaining gross development value (GDV) of RM16.3bn will provide earnings visibility over the next 10 years, at the very least.
Unbilled sales, which currently stand at RM2.2bn, provide further support to its earnings visibility over the next 2 years.


Limited growth from domestic township developments
While its tried and tested business model of buying large tracts of land cheaply and developing it into award-wining townships has served SP Setia well over the years, it has become increasingly difficult to maintain its historical net profit CAGR of 14% at a higher base now. Organic growth from same projects may face demand resistance while securing new landbank in good locations and at low prices is becoming a daunting task. Furthermore, by virtue of its already dominant market share in Klang Valley and Johor, there is a limit on the number of new township projects it can add to each location without cannibalising its other existing township projects in the vicinity.

Duplicating its township business model in Vietnam
Due to limited opportunities domestically, SP Setia has turned to overseas markets in search of greener pastures. Its first port of call is Vietnam where it plans to duplicate its successful township business model.
Although the Vietnamese economy is in the doldrums now due to high inflationary pressure, lack of access to credit and impact of softening U.S. economy on its export demand, the underlying fundamental of its property sector remains intact in the long-term. This is due to its large population of 85m, lack of modern housing supply and increasing trend of urbanisation as workers seek better paying jobs in urban areas. Nevertheless, we expect sales take-up for its maiden project in Vietnam i.e. Eco Lakes My Phuoc to be lacklustre in the near term and would not be surprised if launches are deferred until sentiment improves.
We are however not overly concerned with SP Setia’s exposure to the Vietnamese property market as the current lull is expected to be short-term. Furthermore, land use right premium for the Eco Lakes My Phuoc project amounting to US$51m (RM173.4m) is only paid as and when the various parcels of land are ready to be developed. SP Setia’s main capital outlay so far is its 55% contribution for the charter capital of the said project amounting to US$20m (SP Setia’s share is US$11m). Its other project in District 9 of Ho Chi Minh City is still pending the signing of joint venture agreement and its only capital outlay will be in the form of charter capital amounting to US$20m (SP Setia’s share is US$13.4m).

Broadening product offerings
Besides expanding into overseas market, SP Setia has also broadened its product offerings by venturing into commercial and high-end condominium projects, which have shorter turnaround time.
Traditionally, SP Setia’s commercial projects are confined to the development of shopoffices and other commercial components within its existing townships. Besides being another source of earnings, these commercial developments also complement its core residential developments as the appeal of its townships will be enhanced with the presence of commercial activities. In addition to shopoffices, SP Setia sells commercial land parcels or enters into joint venture for the development of retail malls. Over the years, it has
established a proven track record in attracting reputable retail mall operators such as Aeon, Tesco and Lend Lease to its townships. Besides commercial developments which enhance the value of its existing townships, SP Setia has now ventured into niche standalone commercial projects comprising retail malls, office suites and purpose-built office buildings. Typically, these projects have shorter turnaround time (3 – 5 years).


Margin under pressure but further downside is limited Escalating building material prices at unprecedented pace over the past year has resulted in many developers facing margin pressure. Developers are in a bind as properties which have been pre-sold will now have to be built with lower profit margin, or in a worst case scenario, even at a loss. While developers now strive to pass on higher cost to home buyers for their new launches, resistance may be encountered especially for mass housing properties due to deteriorating economic conditions as well as declining disposable income due to high inflation. Against such a backdrop, SP Setia has seen its EBIT margin from property development shrinking from 36.3% in 4QFY07 to 17.2% in 3QFY08.
However, we believe further downside risk to margin is limited. Crude oil price has corrected significantly from its high of over US$140 per barrel in July 2008 to under US$60 per barrel now. Prices of other commodities such as steel bar and copper have also declined. However, it is too early to expect overall construction costs to decline as other than steel bar, price escalation of other building materials has merely eased but remained firm, for now at least. To mitigate higher construction costs, SP Setia has raised prices by 10% – 15%. However, in view of a soft property market, SP Setia’s ability to fully pass-on additional costs
to buyers may be limited without affecting demand.
Overall, we expect margin to stabilise in the near term. Margin may only recover to previous level once the global economic conditions as well as consumer sentiment improve.

Heightened risk of declining sales
Against a backdrop of global economic outlook uncertainty and poor consumer sentiment, the property sector is exposed to the risk of declining sales. Although SP Setia has achieved sales of RM1,340m for the first 11 months of FY2008 which has surpassed the RM1,235m sales for the whole of FY2007, going forward sales may slow down. The risk of slowdown is particularly evident in Setia Alam, Setia Indah, Setia Tropika and Setia Pearl Island which experienced waning sales momentum over the first 11 months of FY2008.

Scaling back launches
In view of declining demand and poor sentiment, launches of new phases within existing townships have been slower as compared to FY2007. For the first 11 months of FY2008, SP Setia has launched 2,148 units as compared to 3,727 units for FY2007. Launches of new projects have also been scaled back as management turned cautious by ensuring sufficient pre-launched bookings before committing its resources to launch. Nexus 1, a niche commercial project in Klang which comprise of office tower, retail space and serviced
apartments, has been deferred despite being launched in the early part of the year. Deposits were returned to buyers as the company looks forward to a better time to re-launch the project. Its high-profile Kenny Hills Grande project which comprises of 15 units of bungalows in Kenny Hills also failed to get off the ground as pre-launched bookings have so far failed to hit its targeted 50% threshold. SP Setia’s maiden launch in Vietnam has also not been smooth sailing. The preview of its first phase of 71 units terrace houses priced at
US$120,000 – US$130,000 per unit has so far garnered only 17 bookings. In the meantime, the company has deferred the official launch until the show units are completed by end 2008.
Although management has set a RM1.8bn sales target for FY2008, we do not expect this to be achieved as actual sales for the first 11 months of FY2008 was only at RM1.3bn. We expect RM1.5bn sales for FY2008 which include RM120m sale of a 30.5-acre commercial land to Lend Lease on which a retail mall will be built in Setia Alam. FY2009’s sales are expected to be flat while recovery is expected in FY2010. This is premise on a soft landing of the global economy instead of a deep recession.
Full year earnings for FY2008 is expected to be 22.5% lower mainly due to contraction in margins as building materials prices soared. Going forward, we expect FY2009 to register a 5.6% earnings growth despite a flat sales expectation. This is on the premise of a large unbilled sales of RM2.2bn as of 30 September 2008 and the delay recognition of about RM27m net gain from land sold to Lend Lease as we expect the conditions precedent to be fulfilled only in FY2009. Net earnings for FY2009 would have been RM186m without the
gain on land sale.
What we have not factored into our earnings estimate is the possibility SP Setia may sell more commercial land within its township projects which will provide immediate earnings contribution to its bottomline.

SP Setia is currently trading at P/E of 12.2x based on FY2009 earnings which is at a premium to property sector average of 5.3x. The premium is justified given SP Setia’s position as the de facto proxy to the Malaysian property sector as well as being the most liquid property stock. However, SP Setia is fairly valued at current level with limited upside as it is almost trading at parity to its 15-year historical P/E of 12.8x.
We initiate coverage on SP Setia with a HOLD call and target price of RM2.62 which is derived by ascribing a 25% discount to RNAV of RM3.50. At the target price, the implied P/E of 12.5x is in line with our expected market P/E for FY2009. Despite limited upside for now, we recommend accumulation on price weakness.


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