Pouncing on downtrodden developers

In July 2001 Forrester Kurts became The Intelligent Investor’s first ever Strong Buy recommendation at 81 cents per share. At the time shares in the Queensland property developer (now known as FKP) were trading at a hefty discount to their net tangible asset backing and we had reason to believe that those assets were worth every cent of their stated value.
Less than two years after purchase, we recommended owners lock in their handsome gains at $1.48 per share. Adding in 15 cents per share in fully franked dividends, the total return was north of 100%. It was a happy chapter in our value investing history and, in preview, we’re now aiming to perform a similar feat.
This investment theme is based on a view that property prices and, importantly, sales volumes are on the rise in key Australian property markets (see discussion at our recent blog post Understanding today's property market).
The risk is if the current run peters out, or the market is hit by a shock. Perhaps interest rates will rise further than most people expect over the coming year or two, or problems might develop in China which then flow through to the Australian economy.
So we must be careful in our portfolio allocation, exposing no more than 6% or 8% to this theme (and perhaps much less if you have direct exposure to residential property through home ownership or investment properties).

Good money to be made

To be clear, ‘this theme’ is the idea that there might be good money to be made in buying certain property development stocks at this point in the cycle. Stock selection will be crucial, though, as there are wide discrepancies in both financial strength and valuations across the sector.
Several listed property developers are currently trading at steep discounts to their stated net tangible assets, just as FKP was eight and a half years ago. These are the ones we’re going to focus on, with the idea that a cheap price should offer two attractive benefits.
Firstly, there's the potential for a double-dip gain as the value itself rises and investors close the gap between the share price and that value (as was our experience with FKP).
Secondly, a discounted share price should afford a degree of protection if market conditions turn sour and absorb ‘the effect of miscalculations or worse than average luck’, in the words of the great Benjamin Graham.
So, with the idea of buying discounted property developers in a (hopefully) improving property market, let’s sally forth and see what the investing landscape holds for us.

Australand

Our main recommendation is blue chip developer Australand. We’ve ridden the property cycle before with this one, commencing a string of positive recommendations on 27 July 01 (Buy for Yield – $1.60) and selling out profitably on 19 Sep 03 (Sell – $1.75) after collecting 27 cents per security in largely franked distributions.
Those who bought and sold at those points banked total returns of more than 26% plus franking credits in just over two years. We’re hopeful of an even better result this time around, though Australand is a different animal today.
The group’s move to a safer business model that includes developing and owning commercial property means it doesn’t offer pure exposure to the residential sector.
Australand’s commercial portfolio boasts 70 office and industrial properties currently valued at $2bn, though we expect the full-year result (released on 4 February) will usher in lower property values. Despite an absence of trophy assets, the reliable rental stream provides a level of comfort.
Its residential development operations consist of a pipeline worth almost $1bn at cost (with an expected completion value north of $3bn). Victoria and Western Australia represent the group’s largest exposures, each accounting for around 35% of the development pipeline.
As you can see in chart one, the profits thrown off by the property portfolio have recently dwarfed the earnings from the development divisions. However, it also contrasts the cyclical decay of development profits against the stability of rental property; the pie will increase significantly if development profits recover, as we believe they are set to.
Australand’s high-density building expertise is particularly valuable in Australia’s crowded cities, where land is scarce and expensive. Stockland’s recent retreat from the apartment sector reflects the fact that an aspirational brand is often necessary for apartment owners to sign lifelong mortgages. Though Australand fits the bill, profits collapsed in the first half of 2009, as some lousy projects were written off and management hoarded capital to shore up its balance sheet, rather than recycle the cash into new projects.
It wasn’t enough to mollify its lenders, though. Australand has raised nearly $1bn in fresh equity; a large amount for a group with a market capitalisation of $1.4bn. A $950m syndicated loan, the group’s major source of funds, has also been extended until June 2011.
Australand is majority owned by CapitaLand, which is sponsored by Singapore sovereign wealth fund Temasek Holdings. This Singaporean sugar daddy repeatedly stepped into the breach in the depths of the crisis and appears to have successfully shepherded its Australian vehicle through the darkest days.
Apart from strong financial support in the toughest of times, CapitaLand may also ride to the aid of Australand investors by lobbing a bid for the stock it doesn’t already own. This would be cream on the cake for today’s buyer – we’re not counting on it but it remains a possibility.
Australand’s current price tag is rather pessimistic. To justify it, property values would have to fall by around 9% (the equivalent of a 0.75% increase in capitalisation rates) and its existing development stock would have to be liquidated at 50 cents on the dollar (this spreadsheet shows how Australand’s value shifts under various scenarios).
Though the former appears probable, our thesis is that the latter is not, particularly after the company marked down inventory values by around 10% ($134m) in the half year to 30 June 2009.
If Australand’s development inventory is fairly valued and profits recover, it’s not hard to imagine Mr Market paying a premium to NTA and Australand’s stock price moving north of 70 cents and delivering us a 50% profit in the process. But if that happy scenario doesn’t come to pass (and assuming another economic calamity doesn’t eventuate), the consolation is a forecast 8.4% yield.
In short, while Australand’s fundamentals have clearly improved over the past six months, its security price has barely budged since 30 Jun 09 (Avoid – $0.47). It’s now time to get on the front foot. LONG TERM BUY.

Sunland

The property collapse in Dubai has been a nightmare for many, including luxury Queensland developer Sunland. Its share price collapsed from a high of $4.58 at Christmas in 2007 to a low of 29 cents on 6 March 2009, before staging a recovery. But as US investor and Columbia Business School professor Paul Sonkin suggests, ‘The margin of safety lies on a bed of broken dreams’.
Though famous for trophy developments such as the Gold Coast’s Palazzo Versace Hotel and Q1, the world’s tallest residential skyscraper, Sunland is equally at home building residential communities on the fringes of Australia’s capitals.
It’s done this successfully since 1983, but the company’s disastrous Dubai foray has left sand on management’s face and tarnished the company’s reputation, forcing write offs totalling $209m. Yet Sunland’s financial position was never in doubt.
By good luck or good management, the company boasted net cash on its balance sheet throughout the downturn. Unlike Australia, aspiring property owners in Dubai fund developments in stages. This, and the fact Sunland wasn’t on the hook for the project debt (the debt was ‘non-recourse’), helped shield the company from Dubai’s property market collapse; the company also completed several projects. Having been embarrassed, though, we expect management to stick closer to home from here on.
Unlike its contemporaries which have been dishing out new securities like confetti, Sunland has been buying back shares at a discount to NTA; it’s an efficient use of shareholder funds and perhaps reflects management’s large stake in the business. But alternative uses for the cash are now on the agenda.
Sunland recently paid Devine $25m for a prime CBD site in Brisbane, Thakral Holdings $23.4m for land on the Gold Coast and $4m for a parcel of land to expand an existing development. With all guns blazing, Sunland also recently announced ‘its largest project release in the Group’s 26-year history’; nine new residential developments with an end value of $511m.
Right now Sunland boasts a huge pile of cash, has plenty of product on the market and has dusted itself off in Dubai. It also trades at a 35% discount to its net tangible asset backing per share of $1.20 (eight cents of that is in Dubai). Don’t let the glossy annual reports fool you, there’s substance beneath the surface.
The stock is up 20% since 30 Jun 09 (No View – $0.65) and we’re upgrading to LONG TERM BUY. Though any weighting to Sunland should be perhaps half or less of that allocated to the larger and more diversified Australand.

Other options

Speaking of smaller weightings, there are a few stocks even further up the risk curve in which you might consider a small investment. Bear in mind that even a blue chip developer like Australand carries a medium level of risk, so by the time you hit the development sector’s tiddlers, you’re getting into rather dangerous territory.
These three are too small for us to provide regular coverage on, so you’ll have to conduct your own due diligence. But we feel they’re worth mentioning for those with the requisite appetite for risk and research.

AVJennings

The largest of the three is the economically labelled AVJennings. Unlike our previous pleasant experiences with other property development stocks, we got AVJennings wrong when we followed Guinness Peat Group’s lead and recommended it on 29 Mar 06 (Speculative Buy – $1.31).
We recommended a tactical retreat a little over two and a half years later on 14 Nov 08 (Sell – $0.45) nursing a hefty 66% loss, which illustrates the pain potentially awaiting those playing at the pointy end of this sector. But the fundamentals seem much brighter today than they were 14 months ago and the share price is only moderately higher.
In its most recent annual report AVJennings spruiked ‘a land bank of some 9,825 lots under control or management, equivalent to approximately 5 years supply.’ By funds employed, the company’s largest state exposure is to New South Wales (47%), followed by Victoria (28%). The remainder is split between Queensland and South Australia.
Stated net tangible assets per share are $1.04, or $0.82 if you exclude interest payments capitalised in inventory – a common practice in the industry (but one that’s not particularly conservative). The current share price represents a 38% discount to the more conservative figure, leaving upside of 62%.
There was also some positive commentary at the group’s annual meeting in November with chairman (and major shareholder) Simon Cheong reporting that ‘the company is tracking ahead of its forecasts and plans.’ Though presumably those forecasts and plans were fairly muted given the gloomy economic backdrop when they would have been drawn up.
AVJennings could be worth a look for those comfortable with the risks implicit in a developer currently valued at $140m by investors which was shouldering more than $100m in net debt at 30 June 2009 (though that figure was down from a more imposing $169m a year before).

Devine

Devine is next on the list. This Queensland-based group is 43.7% owned by construction and contracting giant Leighton, which might clean up the remainder at some point now founder David Devine has elected to step back from day-to-day operations (he remains a director).
At its annual meeting in October, Devine reported a land bank of 7,577 equivalent lots (as at 30 June). The lion’s share (around 80%) of those were split fairly equally between Queensland and Victoria, with South Australia filling in the remaining 20% or so.
The group’s balance sheet at 30 June wasn’t strong, sporting more debt ($267m) than equity ($265m) and the annual report revealed that the company had ‘received a waiver from its principal financier, the ANZ, in respect to a technical breach of two banking covenants.’
Those are hardly confidence-inspiring words but Devine soldiers on for now. And if the property market is moving, then it should be able to squeak through and perhaps close the gap between its current share price and its net tangible assets of 79 cents per share (or 70 cents, excluding capitalised interest).
Devine is even higher risk than the rather risky AVJennings, but not as risky as our final tiddler.

Becton

Once a darling stock with a market capitalisation of more than half a billion dollars, Melbourne-focused Becton still has a debtload to match; $355m. That towers over the group’s tiny current market capitalisation of just $23m and Becton only exists today at the mercy of its lenders.
The group’s auditor, PricewaterhouseCoopers, drew attention to this fact in its audit of the latest annual report; ‘there is significant uncertainty about whether the Group will continue as a going concern’.
The auditor also shone a light on ‘significant uncertainty regarding the carrying value of the investments in the Funds managed by Becton.’ Becton’s investments in its own funds, at $139m, represent the group’s second largest asset. If these are worth much less than their carrying value, the impact would be seriously deleterious to Becton’s stated net assets of $98.8m ($65.2m excluding tax assets which would likely be worth very little in any liquidation).
In just one example of the many Byzantine issues Becton owners must grapple with, there are some listed convertible notes (BECG) due to mature this year. This is real rocket fuel, with the possibility of sending investors to the moon, or painfully blowing up in their faces.

Putting it together

Recommendation guide

	Australand	Sunland
Buy	Below $0.40	Below $0.65
Long Term Buy	Up to $0.55	Up to $0.85
Hold	Up to $0.75	Up to $1.20
Take Profits	Above $0.75	Above $1.20

While a number of our analysts have been negative on direct residential property as an investment for several years, even the grouches are interested in a portfolio approach to discounted property development stocks at this point. While there are never any guarantees, the property cycle and share prices seem weighted in favour of today’s buyer.
We are issuing official recommendations on Australand, the lynchpin of this portfolio, and Sunland. The other three stocks are included for those interested in conducting their own research on these higher risk situations. We don’t intend to cover them on an ongoing basis.
Overall, we’d limit purchases of such stocks to an absolute maximum of 8%, in aggregate, of your portfolio. Australand might account for 4% or 5% and the much smaller Sunland perhaps 2% or 3% at the most.