Analysts' Recommendation

JP Morgan Initiates Coverage of Starhill REIT with 'Overweight' Recommendation & Target Price of RM1.30

Asia Pacific Equity Research, 20 June 2007

Most liquid but lacking aggressive growth strategy relative to peers

Initiate with OW: We initiate coverage on Starhill REIT with an OW rating and a Dec-07 price target of M$1.30. With an asset size of M$1.28B, Starhill REIT consists of 4 properties in the Golden Triangle—Starhill Gallery, Lot 10 (both retail malls), the JW Marriott Hotel, and 'The Residences' service apartments.

Share price drivers: (1) As the most liquid proxy to the sector (market cap is 2.6x the next biggest M-REIT), Starhill will benefit from any withholding tax cuts on dividends. (2) Slight upward rental rate revision in FY08 is expected as sub-leases, which account for 67% of Starhill Gallery's total NLA, initially signed with Autodome are novated back to the REIT. (3) The group's unique/niche mid- to high-end retail malls will benefit from rising tourist arrivals and consumption spending, as well as potential long-term upside in turnover rents (1% of revenue currently) as rentals for more new tenancies are being fixed based on a base rent plus profit share.

PT, risks: The stock is trading at a 17% discount to our DDM-based Dec-07 PT of M$1.30 (implying a 4.2% FY08E yield vs. the 10-year government bond yield of 3.6%). Key risks to our PT: unexpected fluctuations in interest rates, which could significantly affect cost of capital, and unexpected deterioration in Malaysia's retail/hospitality sector environment.

Positive price drivers

Starhill, as the most liquid proxy to the M-REIT market, will benefit from the strong possibility of withholding tax cuts on dividends in the upcoming Budget. Starhill REIT's market cap currently stands at US$364 million versus the industry average of US$121 million while its average daily trading value of US$0.3 million is superior to the industry average of US$0.1 million. If the government reduces withholding taxes for foreigners to 10% from 20% currently, Starhill REIT's FY07E net dividend yield will be 5.8%, representing a 220bp spread over the risk free rate.

Most contracts initially signed with Autodome will expire in November 2007; tenancies novated to Starhill REIT should boost rental rates. About 67% of the total NLAs, which were based on sub-leases with Autodome (related party, which underwrote rentals for Starhill at cheaper rates during its IPO in 2005), will expire in November 2007. Now that the right tenant mix has been achieved and vacant lots filled, novation of these tenancy agreements to Starhill REIT will be at rates that are slightly higher.

Unique properties, good brand name, and prime location for its retail malls (and hotels) to benefit from rising consumption spend and tourist arrivals. All the four properties in the REIT are located within the Bintang Walk area in the Golden Triangle (which is also popular among tourists) and cater to their respective niche target markets. The jewel in its crown, Starhill Gallery, caters to the high-end, high net worth consumers, including tourists. Recent rental revisions for the group's retail malls have seen rates rising by 10-15%. Moreover, increasingly, the group's new tenancies are being fixed based on a base rent plus profit share. These turnover rents currently constitute 1% of the total rental revenue.

Negative price drivers and risks to thesis

Keener competition for Lot 10 with an upcoming 1.37 million sq ft The Pavillion by end-2007/early-2008. The Pavillion retail mall (situated across the road from Starhill's assets) may pose as a threat to Lot 10 given its size (NLA of 1.37 million sq ft versus Lot 10's 0.17 million sq ft) and its similar mid- to high-end target market. The Pavillion is less likely to pose as competition to Starhill Gallery given the latter's niche in the very high-end segment, in our view. Lot 10 accounts for 30% of the REIT's rental revenue, while the remaining is accounted for by Starhill Gallery and the hotels.

Starhill REIT lacks an aggressive growth strategy. This despite having the capacity to raise additional debt of up to M$500 million for acquisitions, based on a maximum gearing ratio of 50% for REITs. Moreover, the low cost of debt of 5% should facilitate earnings accretive acquisitions. The REIT, however, has acquired only one asset post its listing, i.e., "The Residences" service apartments, a related party acquisition in late-2006, through the issuance of new units.

The main risk to our thesis is unexpected fluctuations in interest rates. While we expect Malaysian interest rates to remain stable, unexpected movements could result in volatility of the share price in the short term. A 1 percentage point rise in the riskfree rate (current assumption = 4%) will reduce our price target by 15% from M$1.30 to M$1.11.

Valuation and rating analysis

We set a Dec-07 price target of M$1.30 for Starhill REIT, using a DDM model (assumptions: 4% risk free rate; 5.5% market risk premium; beta of 0.72, and longterm growth rate of 3%).

At our price target, Starhill's stock trades at an FY07E net dividend yield of 4.0% versus the 10-year bond yield of 3.6%. This compares to the M-REIT average of 5.4%, with the premium accorded to Starhill being backed largely by its size, liquidity, and decent assets. This also compares to 2.9% for Quill Capita, which has the lowest yield among M-REITs.

At our price target, Starhill's net yield spread (assuming 20% with-holding tax) over the 10-year government bond yield for FY07E and FY08E stands at 0bp and 20bp, respectively. For a 100bp increase in 10-year government bond yields, Starhill's price target will decrease by 15% to M$1.11.