Pavilion Real Estate Investment Trust
(Oct 31, RM1.50)
Downgrade to “underperform” from “market perform” with target price (TP) of RM1.48. The ninth month of financial year 2014’s (9MFY14) realised net income (RNI) of RM175.3 million came in within expectations, making up 77% of the street consensus and 78% of our estimate. As expected, there are no dividends.

Quarter-on-quarter, the gross rental income increased by 3% to RM101.4 million, possibly due to positive rental reversions on 14% of net lettable area (NLA) up for expiry and normalised occupancy, with 97% compared with 95% in the second quarter of 2014 (2Q14) as refurbishment nears completion.

On the flip side, operating cost decreased by 16% due to reversal of over provision of assessment charges and overcharging of electricity charges as well as increasing net property income (NPI) by 11% to RM75.5 million. As a result, RNI increased by 13% to RM63 million.

Year-on-year, the top line grew by 8% to RM301.3 million from renewal of tenancies with strong rental reversions in Pavilion Kuala Lumpur shopping mall (PSM).

The 9M14 is seeing the full impact of a major rental reversion year (71% of PSM’s NLA) which was implemented last year.

This, coupled with slight improvement in NPI margins at 0.4 percentage points (ppts) from lower utility expenses due to similar reasons mentioned above, and higher interest income up 2%, allowed for RNI to increase by 10% to RM175.3 million.

Capital expenditure commitment to date is RM17.7 million, which is mainly used for the refurbishment of PSM.

We expect Pavilion Office Tower’s occupancy to remain relatively weak due to the supply glut of office spaces in the Klang Valley.

The asset acquisition environment remains challenging due to the low cap rate environment of 5% to 6% at present, and we believe Pavilion Real Estate Investment Trust (PavREIT) is unlikely to make any acquisitions in the near term, despite their low gearing level of 0.16 times.

We make no changes to our financial year 2014 (FY14) and FY15 RNIs.

PavREIT’s share price has increased by 8.1% in the third quarter of 2014 (3Q14) and 15.6% year-to-date. As such, total returns to our TP is down 0.3% at current levels.

We downgrade our call to “underperform” (from “market perform”) as we have already factored in potential positive rerating catalysts such as the European quantitative easing, while we believe the stock, and sector, does not warrant any further rerating catalyst at this juncture.

We believe our FY15E earnings is acceptable as PavREIT’s organic growth of 4.2% is stretched as FY15 will see minimal area up for expiry (15% of NLA) on optimistic reversions of 6%.

We maintain our TP at RM1.41 based on our target FY15 gross dividend yield of 5.6% (net: 5%) or an increase of 1.8 ppts spread to calendar year’s 10-year Malaysia government securities (MGS) of 3.8%.

The risks to our call are bond yield expansion compared with our target 10-year MGS yield and weakening rental income. — Kenanga Research, Oct 31

This article first appeared in The Edge Financial Daily, on November 3, 2014.