Palm Hills Developments — Update 15 February 2017

A strong final quarter contributed to record annual reservations and revenues, driven by high demand in the run up to and immediately after the flotation of the Egyptian pound, higher selling prices and an accelerated construction programme. The successful securitisation of the first three tranches of customer receivables post the period end will help reduce debt levels, and the land bank has been partially replenished with the acquisition of 190 feddans (c 200 acres) of land adjacent to two existing projects in West Cairo. We summarise the main points from the results below.

Palm Hills will maintain its focus on construction to accelerate revenues and contain costs in the current inflationary environment; a construction spending target of EGP2.3bn has been set for 2017. The company also intends to securitise and sell up to a further EGP1bn of receivables in the year to accelerate positive cash flow and to help reduce debt. From a cost point of view, the market is likely to be challenging in 2017 as high inflation follows the change in monetary policy, although the longer-term effect on the economy should be positive, and inflation has in the past encouraged homebuyers. Palm Hills has several project launches coming up, which should help maintain a high rate of new reservations, and the success of recent launches provides some confidence. The company’s position as a major buyer of construction services may also help it to mitigate some of the cost increases its suppliers will seek to pass on.

The company has also given guidance that it will target EGP8.5bn of new sales in FY17, and a strong January gives management confidence that this is achievable. Management expects the EBITDA margin to improve from the 18% seen in FY15 and FY16 towards a longer-term level of 30%. The likely range given for FY17 is 22-28%. The reason for the expected margin increase is that units sold at low prices in 2011 and 2012 are now being delivered and their associated revenues and costs will therefore have a decreasing impact on profitability. The level of margin recovery will depend to some extent on cost control in an inflationary environment: Palm Hills currently has EGP3.2bn of planned construction spending (of which EGP2.3bn will be in FY17). The large majority of that (EGP2.8bn) has already been contracted at fixed costs. The only elements of the company’s typical construction contracts that are not fixed are cement and steel costs. To help mitigate the rise in prices of those materials, Palm Hills buys in bulk and in advance.

We believe it is reasonable to assume that prices can be raised more than costs and that the FY17 EBITDA margin of 22-28% is achievable. As annual sales have continued to rise and increase the company’s stock of receivables, it is also reasonable to expect that revenues will increase. Even if revenues remained the same, the margin improvement would drive increased EBITDA and net profit. Without being able to issue updated forecasts we would expect consensus earnings estimates to be increased.

We have dealt with the recent changes to accounting methods in previous notes; these have no long-term impact on profitability: they defer some revenue recognition, and therefore profit, to future reporting periods. Of greater significance is the conversion of reservations into contracted sales and the development of the balance sheet. The recent results provide the first whole year-on-year comparison under the new regime and we examine them in more detail below. We note that the cancellation rate has returned to a more normal 12% in Q4 after a spike in Q2, discussed in our November update note (page 2).

Exhibit 1 shows the 2015 and 2016 profit and loss account as reported under new Egyptian GAAP. While the net increases in costs of revenue and administrative costs are in line with revenue growth, below the EBITDA line there are some significant differences: the one-off gain on the sale of investment property in 2015 and the increases in tax and minority interests. These last two are persistent, in that the company’s tax holiday has ended and over the next two years we will continue to see deliveries of units in projects where other investors have significant stakes. As the EBITDA margin increases, we would expect the net margin to rise as well. A range of 22-28% at the EBITDA level would feed through to 14-18% at the bottom line.

The securitisation of receivables did not finally occur until after the year end, meaning that its effect is not yet fully clear. However, the rises in advances from customers and notes receivable reflect strong sales in the year.

Receivables have now reached EGP11.3bn, up from EGP8bn at the half year; however, they have fallen to 47% of total assets from over 50%. This is significant, because although they are an asset, they are unrealised until customers actually pay, meaning that inflation erodes their value. The securitisation programme therefore effectively brings cash flow and profits forward, which the company indicates will be at a higher NPV than otherwise. This also allows the repayment of more expensive debt and helps to fund an accelerated construction programme, in turn bringing profits forward.

Net debt rose over the year, from EGP2.1bn to EGP2.8bn as cash inflows of EGP3bn were offset by EGP2.3bn of construction spending, plus administrative expenses and payments of land liabilities. Net debt to equity grew from 33% to 42% as a result, but this should be reduced by the securitisation programme.

The cash flow statement shows positive operating cash flow, helped in part by changes in investments held to maturity and an increase in payables. There has been a significant reduction in new borrowing and given 2015’s one-off land sale, significant equity fund raise and the payment of a dividend in 2016, the direction of travel appears to be positive. The acceleration of positive cash flows from notes receivable should contribute further to this trend.

Palm Hills trades at around EGP0.19 above stated NAV of EGP2.69/share. We would continue to value Palm Hills on the basis of NAV plus the NPV of future profits and the potential uplift to the values of its fixed assets, principally its land bank. While we have not been able to update our NPV calculation pending publication of the IFRS accounts, management continues to guide the potential uplift to the hotels and land bank at EGP1.81/share, implying significant upside to the current valuation.

Management does not expect the board to recommend a dividend in FY17, preferring to reduce debt, but there may be a distribution in the form of a share buyback.

The principal factors that may affect Palm Hills remain the health of the Egyptian economy, the ability to plan, sell, build and deliver high-quality projects and the replenishment of the land bank. We would also draw attention to the company’s commercial developments and other sources of recurring revenue, which should start to make a higher contribution to net profits as projects are completed and membership of the Palm Club continues to grow. The continuation of the securitisation programme and the reduction of debt will also be important in the coming months. Specific and foreseeable events to monitor in FY17 include:

More generally, the company will be affected by growth of the Egyptian economy and population, inflation and the value of the Egyptian pound. The anticipation of inflation has in the past encouraged domestic buyers and the company reports that in FY16 the number of Egyptians earning salaries in other currencies abroad and buying units in Egypt from Palm Hills rose from 10% of the customer base to 25%.