After running a negative recommendation on DLF for over two years, during which period the stock underperformed by 63%, we now turn positive?strength of demand and pricing in DLF?s core market Gurgaon being the key reason. We believe that net debt has now peaked at the current level of Rs 225 billion and expect it to come down to Rs 201 billion by Mar?11 driven by higher FCF (free cash flows?operating cash flows minus capex.)

REIT (Real Estate Investment Trust?which issues stock-like security) yields in the Singapore market have corrected by 100 bps (percentage points) to 6% over the last three months, raising the probability of DAL (DLF Assets Ltd) listing and yield compression. We raise benchmark NAV (net asset value?gross value of assets minus liabilities) by 22% to Rs 404/share as we roll forward to Mar?12 and also build in better pricing.

Pricing in DLF?s home market Gurgaon has improved materially. After Mumbai, Gurgaon has become the second micro market where physical property prices are now beyond the previous peak. Despite the prices moving up, sales volumes have been steady at 11-13 million sf/ quarter. Developers (Unitech, Anantraj) beginning to buy land in Gurgaon adds to our confidence. Strength of pricing and demand in Gurgaon helps DLF?it accounts for 42% of its NAV. We raise NAV by 7% to factor in better property prices. With DLF?s unsold inventory from January 2008 now sold, DLF?s new project launch activity in Gurgaon should improve.

DLF?s office leasing volumes have steadily improved from a negative in H1FY10 to now 1m sf/quarter. Overall industry volumes have stabilised at 7-8m sf/quarter for the last three quarters. Given the pick-up in hiring, we expect leasing volumes to improve further though pricing recovery is unlikely before H2,2011 due to oversupply. DLF is restarting capex on adjourned retail projects?highlighting rising developer confidence.

The continuous increase in net debt (from Rs 152 bn in Sep?09 to Rs 225 bn now) has been a source of worry but this was largely associated with DAL consolidation. We believe the debt level has now peaked. Improved project level cash flows would bring down the net debt to Rs 201 bn by Mar?11.

Since our downgrade in July08, DLF stock has corrected by 38% as against the market up move of 27%. During this time, DLF has emerged stronger (improved focus on cash flows) and cleaner (DAL consolidation). Increased leasing volumes and falling REIT yields in Singapore improve visibility on DAL listing and a potential listing will bring down debt materially. Launch of the long-awaited Mumbai project launch could be another near-term trigger as the project offers visibility on 15-20% of FY11-14 earnings.

A key volume driver for DLF is its core Gurgaon market where there has been no new mid-income/affordable segment launch in last two years. The sales in FY10 were led by new inventory launched in existing high-value Phase-V location. Also about 1m sf of the mid-income product at New-Gurgaon was sold in FY10 as leftover inventory of launches done in early-08.

We expect DLF to restart the new launch process in its higher volume, New-Gurgaon segment from late FY11/early FY12 as old inventory is whittled down and a few notifications related to change in density norms leading to launch of affordable housing product come through.

DLF?s impending launch of its 4m sf hi-end residential property in Central Mumbai has gained importance given the lack of new launches by the company. While pre-launch activities have been ongoing for 4-6 months now, DLF has decided to be extra cautious in seeking all approvals before it launches the project, as it comes in a significant new territory. At Rs 20,000/sf+ of expected realisations, the project?s total revenues can exceed $2 bn. The project is estimated to be 15-20% of DLF?s FY11-14 profits. A potential strong performance of the Mumbai project may also help accelerate the deleveraging process in H2FY11.

While real estate industry has seen a steady deleveraging over the past two-three quarters, either through operational surplus or through fund raisings, DLF has consistently posted higher net debt QoQ (quarter-on-quarter), largely on account of DAL consolidation and purchasing of residual stake in certain SPVs (special purpose vehicles.) With debt expected to peak in the Sep?10 quarter, we expect operational cash flows to turn substantially positive, leading to a debt reduction of Rs 24 billion from now till March?11.

While low residential sales/ launches in FY11 YTD (year-to-date) [about 3m sf of sales in the first five months of FY11] has been an issue for DLF, the situation is likely to ease in H2FY11 as inventory of its ongoing projects whittles down and the company is able to do fresh launches. The company guides for a 15m sf of new sales in FY11, which implies that the new project launch/sales activity to substantially pick up, going forward. A key volume-driver for DLF is its core Gurgaon market where there has been no new mid-income/affordable segment launch in the last two years. However, we expect the trend to reverse as its inventory in older projects is now nearly fully absorbed.

?CLSA

*Expected to outperform the local market by 0-10%, a grade below Buy.