Palm Hills Developments — Update 16 November 2016

Demand in the upper and middle income brackets of the Egyptian residential property market in which Palm Hills operates remains strong. The company says its own prices have continued to rise, with Q316 land prices up 27% year-on-year and buildings up by 44% for villas and 38% for apartments. Against this favourable background, Palm Hills continues to make strong operational progress, with 9M16 gross sales up 18% (to EGP5.4bn) on the same period last year, reflecting continued strong demand for housing across all regions. Changes in accounting rules (both Egyptian GAAP and IFRS) for revenue recognition have complicated the financial results, although there is no impact on ultimate profitability over time. In addition, shifts in the sales mix meant a greater proportion of deliveries in 9M16 were of units sold at lower prices and margins due to the weak market following the 2011 revolution in Egypt. The changes to our estimates (on an IFRS basis) are modest and we continue to see considerable value to be realised as the company works through its pipeline of developments. In this section, we summarise the underlying trends and operational progress of the group during Q316, leaving a detailed discussion of the financial reporting, complicated by accounting changes, for the financial section.

The Egyptian Central Bank announced on 3 November that it would allow the Egyptian pound to float, having previously pegged it to the US$. The immediate effect was for exchange rates offered by major banks to jump by c 45%, from EGP8.88 to around EGP13.00 to the dollar. The decision had been anticipated to some extent, as one of the conditions of a $12bn IMF loan which was granted on 11 November 2016, with $2.75bn to be disbursed immediately. Other conditions included securing $6bn of bilateral loans, reductions in fuel subsidies, introduction of VAT and optimisation of the public sector wage bill, with the aim of reducing fiscal deficits. In the medium and long term a floating currency should be beneficial to the wider Egyptian economy, relieving constraints on international capital flows, allowing importers to buy foreign goods, making Egyptian exports more competitive and bringing currency trading back into the formal banking sector from the black market (Al Jazeera reports that the black market value of the US$ dropped from EGP18.25 to EGP13.00 overnight following the news). In the short term there will be a considerable rise in inflation as energy subsidies are being cut as part of the same reform package. In anticipation of that, the central bank simultaneously raised interest rates by 3% to 14.75%. Other measures include the abolition of a priority list for imports and phasing out monetary funding of the budget deficit.

The rise in inflation, which was already running at 11%, will affect poorer Egyptians the most, although the IMF has pointed out that many prices already reflected black market exchange rates. The impact on Palm Hills’ customers (who are typically in a higher income bracket) will be less, and may potentially reduce the cancellation rate as payment instalments effectively become cheaper. Palm Hills has taken steps to mitigate the effects of inflation on construction costs:

The increase in interest rates will have a more direct effect on Palm Hills by making its debt more expensive. Our forecasts anticipate a rise in finance costs by increasing the average cost of debt from 3.5% to 10%. This takes into account the end of the grace period on the EGP2.1bn Arab International Bank loan, as well as the 3% increase in Egypt’s key interest rates. Our forecasts do not yet take into account any refinancing using proceeds from the securitisation of receivables. Funds from the securitisation will be used to pay down the company’s more expensive debt and we will revisit our forecasts once the first tranche has been securitised.

Management has indicated that in the past, c 20-25% of demand for Palm Hill’s units has come from buyers using real estate as a hedge against inflation. Before the currency floated, periodic devaluations were liable to cause sharp inflation shocks. The floating exchange rate will smooth these and potentially reduce pure investment demand for residential housing. However, with 75-80% of demand coming from underlying population trends and an improved outlook for the economy, we do not expect any negative impact on long term demand.

Overall, we expect the floating of the pound to be of benefit to the Egyptian economy and therefore to Palm Hills as well. The share price rose 1.3% after an initial spike (against 3% for the EGX 30 index, in which the largest sector is banking), possibly reflecting the positive nature of the news, but no market expectation of a large immediate impact.

A look through the accounting noise

As indicated above, operational progress in the period has been partly masked by changes to Egyptian GAAP and the IFRS basis on which our forecasts are based.

The most significant change affecting both IFRS and GAAP is that revenues from the sale of standalone units, including the associated land (typically 50% of the contract value), are recognised on a percentage of completion method; land revenues and profits had previously been recognised up front. The treatment of apartments is essentially the same, although as a practical matter there is a 100% completion hurdle, meaning that all revenue and cost is recognised when the unit is delivered to the customer. It is very important to note that the changes have no impact on cash flows or ultimate profits, but have deferred some profit recognition into the future. The company has provided a full comparison of the 9M16 results under both old and new GAAP for 9M16 and 9M15, which is replicated below. The effects on IFRS numbers will be similar and we await publication of the IFRS accounts in the next few weeks.

As indicated above, our estimates are on an IFRS basis (the main difference with GAAP is that provisions are taken as part of general and administrative expenses, reducing EBITDA; the PBT and net profit figures are the same under both regimes) and we are now taking the opportunity to shift these from an old to a new IFRS basis. Although a comparison of old and new IFRS similar to the GAAP analysis above is not available for 9M16, we believe the accounting revenue deferral effects will be similar.

Estimate revisions (new IFRS basis)

Looking forward, we have adjusted our estimates for the new accounting method and for the mix of deliveries in 9M16, which is a temporary effect that management expects to finish before 2017. This has reduced our 2016 EBIT and earnings forecasts, reducing cash, with a concomitant effect on NAV. Our new estimates, on the new IFRS basis, are shown in Exhibit 2. We have not yet included the effects of the securitisation of receivables, meaning that the interest rate rise has increased the cost of borrowing in our estimate for 2017, reducing EPS. Once the pricing and quantum of the first tranche of the securitisation are known we will seek to take it into account.

Cash flow and balance sheet

Having accelerated construction and delivery over the past couple of years, management still aims to complete all construction projects that had been started before 2016 by the end of 2017. In addition to faster recognition of revenues and profits (although, as seen in 9M16, some older projects have slimmer margins) this will free management resources to focus on new projects. In cash terms, having paid a c 10% deposit when reserving a property (a sale for Palm Hills), customers typically pay an additional 10% of the value at contract and the balance in instalments over four to seven years. Accelerated construction increases the outflow of cash (to fund construction and land purchases) relative to inflows and has been the main driver for negative operational cash flow at Palm Hills over the past couple of years, despite (or because of) the strong growth in sales.

In the nine months to October, Palm Hills spent EGP1.5bn on construction and received EGP2.3bn in customer payments. However, there was an operating cash outflow as a result of land payments and general and administrative expenses. The cash balance ended the period at EGP929m, similar to the 2015 year-end position of EGP966m. While we await the IFRS figures, the exact net debt number cannot be determined from the GAAP accounts (because the definitions of various balance sheet items differ between the two sets of accounting standards), but we expect it to be in the region of EGP2.8bn (47% of shareholder equity) compared with EGP2,145m (34%) at the end of FY15. Obviously the dividend distribution is a significant factor, but so was the EGP0.5bn increase in working capital to fund construction, which came from a drawdown of credit. We expect positive operating cash flow to emerge in 2017, in line with our previous forecasts.

To improve gearing and bring forward positive cash flow, Palm Hills plans to securitise up to EGP2.5bn of customer receivables attached to units that have already been delivered, beginning with an EGP350-450m bond in Q416. The bond will be without recourse to Palm Hills and is secured on the delivered properties, so there is no construction risk and some security against default for bondholders. From Palm Hills’ perspective, it is a low-risk source of capital and makes use of what is now its largest balance sheet asset (Exhibit 3).

We have not yet included the securitisation programme in our estimates, but we believe the likely cost will be in line with our assumed weighted average cost of capital (21%); this is in line with management indications.

As set out in our initiation note of 28 April 2016, we look at the valuation of Palm Hills in three stages:

Reported NAV per share has reduced by EGP0.15 in 9M16, driven largely by the EGP0.15 dividend paid in April. The potential uplift to the carried value of land and hotels as guided by management is given in Exhibit 4, and is unchanged since our initiation note. For undeveloped land we have compared management guidance with recent transactions near each plot to give an estimated market value per square metre and the hotels are valued at replacement cost per room, again using management guidance corroborated with publicly available transaction information.

Our method for estimating the NPV of future profits remains unchanged but we have increased our discount rate from 18% to 21% to reflect the rise in interest rates. Future profits are not affected by the new accounting treatment as explained above, but the parameters of the calculation have evolved over the period: the scope of the 500 feddan project, Palm Hills largest planned development, has been reduced as the masterplan has been finalised to take account of site topography, reducing the overall value of the project by EGP3.7bn, equivalent to c 12% of estimated future residential construction revenues. Our construction costs are reduced by an equivalent amount, but because the project’s footprint remains the same, our infrastructure cost estimate has not been reduced, so the overall project margin has come down slightly. The much smaller Smart Village Residence will no longer go ahead because the Ministry for Telecommunications has decided it will be exclusively commercial in usage. Hacienda Beach has also been reduced slightly in scope. These effects and the increase in the discount rate used to calculate the NPV to 21% from 18% brings our NPV of future profits to EGP1.33 per share, an overall reduction of 16.8% from EGP1.60 previously. Therefore, our updated value per share including all the components discussed above decreases to EGP5.73 from EGP6.14 (Exhibit 5).

Exhibit 6 illustrates the sensitivity of our valuation to different discount rates. For example, if we were to keep our discount rate unchanged at 18%, the corresponding NPV would have been EGP1.42 per share, resulting in an overall valuation of EGP5.81. We note that Bloomberg shows a weighted average cost of capital for Palm Hills of 18.6% as at 8 November 2016.

No updated NAV data has been published for most of Palm Hills’ peer group since our initiation, so comparison of price to book values is difficult. In Exhibit 7 we show Palm Hills’ share price compared to its four most liquid peers: TMG, 6 October, Madinet Nasr and Amer Group.

Palm Hills’ sensitivities have changed little since our initiation note although some possible factors are now more immediate, including the launches of new projects, the signing of an agreement with NUCA and the sale of the Saudi land. The successful securitisation of the first tranche of receivables can be added to these. All those factors could see Palm Hills break the close correlation shown to peers in Exhibit 7.

The wider outlook for the Egyptian economy has brightened with the floating of the pound and associated reform measures. That decision also brings closer the potential loan from the IMF announced in August. A staff-level agreement has been reached, which is contingent on IMF board approval and Egypt raising up to $6bn from bilateral partners. The Governor of the Egyptian Central Bank expects to be able to present the reforms to the IMF in the near future and hopes to secure the loan package soon. A successful closure of the deal would likely increase the longer-term benefit to the economy and to Palm Hills.