We reiterate our Buy rating on Hang Lung Properties （HLP） as wethink both FY18 results and management guidance provided at itsbriefing reaffirm our view that its resilient fundamentals andpathway to earnings growth are underappreciated by the marketbased on current valuations due to concerns about the macroenvironment and the Hangzhou project acquisition last May.
Management is optimistic on China rental operations amiduncertain macro backdrop
China rental growth pace accelerated into 2H2018
Amid uncertain macro backdrop, HLP’s 2H18’s rentalrevenue growth in China accelerated to 6% yoy on RMBbasis, faster than 1H18’s 2%, driven by betterperformance across both malls in and out of Shanghai（with the exception their Tianjin Riverside 66 mall）。Management is optimistic on their China operations, onthe back growth and underlying consumption and alsopositive policy tailwinds as authority continues to redirectmore spending back to onshore.
We see their relatively strong performance asdifferentiated against broader consumer related names, aspointed out in our China Consumer team’s recent note（China Consumer Connections: Pulse Check:Premiumization and desire for experiences lead thegrowth）， within discretionary spending trades: big ticketitems, luxury, and travel retail are facing greater pressure,while affordable categories remain stable. We attributethis relative outperformance partly to -
AEI: After the completion of Plaza 66 mall’s AEIs in 2017, the mallperformed well on the back of upswing in luxury sales.
Operations for projects outside Shanghai continue to mature （i.e.entering into 2nd or 3rd lease terms）
More pragmatic approach （when compared to earlier years） thatrecognizes the need for different shopping malls depending on projectparticulars and the city tier in China, and this likely reflects the shifttowards a focus on rental income, rather than purely on branding andpositioning.
Serviced apartments as an under-appreciated unknown in the longer term.
According to management, roughly one-third of their 27mn sq ft GFA of spaceunder development in China are designated for apartment usage （mainly inprojects in Wuhan, Wuxi, Kunming and Shenyang, altogether valued at c.6%of our FY19E NAV）， which management would have the flexibility to eitherretain for rental use or to sell individually.
Given the backdrop on higher residential property prices in recent years andpotentially higher gearing （max out around 20-ish% considering payment ofHangzhou land premium and peak of construction capex of various projects），they have also started planning/construction of these serviced apartmentportions.
Management sees that their earliest time for serviced apartment projects tobe available for pre-sale would be around 2021E （with completions from2022E onwards）， with Wuhan and Wuxi as higher likelihood at the moment.
FY2018 results shows China NPI margins improvement
China rental revenue growth pace is ahead of that in HK portfolio. In spite of theongoing AEIs in Grand Gateway 66, China rental revenue was still +4% yoy in Rmbterms and +7% yoy in HKD terms.
NPI margin improved by 1% yoy mainly driven by the 3% yoy growth of China rentalmargin. For China rentals, NPI up 3pp yoy to 64.5%, or up 5pp yoy if impact ofGrand Gateway AEI was excluded.
Underlying profit was down 26% due to lack of property sales, while operating profitfrom rentals was up 7%.
DPS stayed flat yoy at HK$0.75, in line with our forecast.
BVPS grew by 1% yoy partially contributed by overall revaluation gain of HK$4.17mn（+3% yoy in valuation）。 HK and China properties recorded HK$3,815mn andHK$318mn respectively.
Key push back from investors and our take
Since upgrading the stock to Buy on Jan 17 （link to our upgrade note）， we met withinvestors across Hong Kong and Singapore, and while we think in general investorsagree on the rental pick-up amid organic growth and new openings, their key push backsare:
If one were to expect a DPS hike in 2H19E （i.e. to be announced in Jan 2020E），why buy now? We think this is a valid question, but our view is that from anoperational point of view, except Tianjin, all other projects are already registeringsequential improvement in revenue suggesting the weaker part of their operationsare already behind, thus risk of worse-than-expected operations would be relativelylow. From a stock valuation point of view, entry point is attractive, as the HLP is nowat near-trough-level valuation—56% discount to FY19E NAV, versus 5-year averageof 44%, with its discount being widened to 14pp more than that of the sector（PropCos ex-REIT）， which is close to the widest in recent years.
Would another potential major land acquisition in China bring concerns onreturns drag? We note that after HLP bought Hangzhou Project back in May 2018,their stock saw c.10pp underperformance against the FTSE E/N Hong Kong in thefollowing month, which we view as reflecting investors’ concern on potentially lowinitial yield for the project. We also highlighted this in our upgrade note that potentialNAV-dilutive M&As as one of the risks to watch out for. However, in yesterday’s （Jan30） results briefing, the company commented that amid uncertain macro, they haveturned more cautious on the land banking front and see relatively low likelihood toembark on a fast-pace M&A spree in the near term.
Reiterate our positive view on HLP
Internal growth drivers—HLP is about to embark on another period of active projectcompletions with a substantial increase in rental floor space in the next two yearsvs. flat GFA since 2015. In our view, this will help drive its rental revenue to a 12%CAGR in 2018-2020E （from 4% in 2013-2017）。
Positive tailwinds from government policies—A new e-commerce law in Chinashould lower import tariffs and restrict the activities of daigou, and therefore lookssupportive for the types of onshore shopping malls that HLP develops.
Near-term catalyst—As HLP enters a year with a higher level of rental growth, wesee scope for HLP to raise DPS and we are still upholding our expectation for this,which compares to a flat DPS since the last cut in FY15.
We revise our 2019E-20E EPS by -5%/+2% on the back the latest financials andupdate to property sales schedule, and introduce FY21E EPS. We keep our12-month NAV-based target price HK$20.0 unchanged, at the same 45% targetdiscount versus the stock’s NAV discount levels of 49% （post-QE average） and 57%（-1SD）。
Risks
Slower-than-expected Chinese macro growth leading to weaker-than-expectedconsumption spending, which could affect HLP’s shopping malls in both China andHong Kong.
Weaker-than-expected RMB leading to lower HKD translation for China rentals, andalso outbound spending in Hong Kong.
NAV - dilutive acquisitions.
Project delays and slower-than-expected ramp-up of newly completed projects.