This article first appeared in The Edge Financial Daily on June 28, 2017

S P Setia Bhd
(June 23, RM3.40)
Maintain hold with an unchanged target price of RM3.65: After two months of negotiations with Permodalan Nasional Bhd (PNB) to acquire I&P Group Sdn Bhd, S P Setia Bhd is proceeding with the deal for a price of RM3.65 billion.

Based on independent property valuers’ reports, the market value of I&P’s properties is at RM7.4 billion while its fair value is RM6 billion, after adjusting for the deferred tax liabilities arising from land revaluations. We believe the acquisition price, at 39% discount to I&P’s revalued net asset value (RNAV), is fair as a majority of developers under our coverage trades at around 30% to 50% discount to their RNAVs.

S P Setia will borrow RM1.5 billion to partly fund the acquisition. The balance will be mainly funded by two rights issues, one each for ordinary and preference shares that may raise up to RM1.2 billion each. S P Setia also plans for a private placement exercise to raise another RM1.2 billion after the rights issues to fund the development of I&P’s land bank. The prices and entitlement basis of the cash calls will be determined at a later date, but the rights issue of ordinary shares will be priced at a 20% discount to the theoretical ex-rights price.

We are not surprised by the plan to raise equity but the size of the cash calls is a negative surprise. Based on S P Setia’s latest closing price and shares outstanding, a 20% discount to the theoretical ex-rights price for the rights shares, and a hypothetical 10% discount to the price of placement shares would increase its shares outstanding by 26%. Our calculation excludes the dilution impact from the rights issue of preference shares as their conversion price will be higher than S P Setia’s share price at the price-fixing date.

Assuming that I&P’s core net profit in its financial year ending Dec 31, 2018 (FY18) is the same as our estimate of a core net profit of just RM69 million in FY16, we believe the additional earnings contribution from I&P will not fully offset the interest cost and dividends for preference shares related to the financing of its acquisition, let alone the dilutive impact on earnings per share (EPS) due to the enlarged share base. If I&P delivers only RM69 million of core net profit in FY18, there is a 33% downside to our FY18 EPS forecast.

Nonetheless, the acquisition holds great promise if S P Setia manages to replicate its success stories on I&P’s land bank. Compared with I&P, S P Setia has a much stronger brand name and a better track record in developing property projects. We expect S P Setia to take up to one year to integrate the two companies and draw up new plans for I&P’s land bank. S P Setia is confident that I&P’s assets will boost its sales in FY18. However, we think the sales will only translate into meaningful earnings starting FY19.

While we like the long-term prospects of the acquisition, it is offset by the downside risk to FY18 forecasted EPS, due mainly to the massive cash calls. S P Setia remains a “hold” with stronger-than-expected sales as the key upside risk while high integration cost is the key downside risk. — CIMB Research, June 23