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  1. Rental asset ownership restructuring to change fortunes

Rental asset ownership restructuring to change fortunes

Sale of co-founders’ 40% stake in DLF Cyber City Developers via institutional investors will improve corporate governance standards

By: | Published: April 11, 2016 6:02 AM

DLF co-founders’ stake sale in rental assets—the big catalyst: We believe DLF board’s strategy to restructure rental asset ownership by monetising its co-founders’ 40% stake in rental asset-owning subsidiary DLF Cyber City Developers (DCCDL) via institutional investors soon would change DLF’s fortunes. We think the sale would materially improve corporate governance standards and better align the cofounders’ interests with those of DLF minority shareholders. Based on our DCCDL valuation of $2.2 bn (assuming a 10% cap rate), a 40% stake sale could yield nearly $900m. With the recent government tax incentives to facilitate REITs in India further increasing demand for DLF’s strong rental asset portfolio in Tier-I cities, we see a good likelihood of stake monetisation over the next 2-3 months at a lower cap rate of 9%. This could re-rate our rental asset valuations of R70/share for DLF by approximately 30%. We reiterate our Buy rating on the stock.

DLF is best-positioned for a leasing market recovery among its peers
India’s office leasing market is witnessing strong growth, with leasing volume up 10% y-o-y in 2015, vacancy rates at a 7-year low, and rentals firming up amid limited supply. We believe DLF is best-positioned to benefit from a leasing recovery and increased demand given its superior leased assets and largest rental income among its peers. We forecast a 14% rental income CAGR over FY15-18, driven by (i) 2-3msf of office space at CyberCity, Gurgaon will likely see rental revisions of 15-20% over the next two years; (ii) Noida mall (about 2msf) became operational in December 2015 and will likely start rental contributions in FY17e; and (iii) an additional 2msf of inventory will be leased over the next two years.

High net debt levels, but pressures could ease
DLF’s consistent increase in net debt over the last few years, weak pre-sales, and negative operational cash flow from the development business have concerned most investors. However, we believe pressures will ease materially over the medium term from strong rental income growth, improved cash flow from land/project sales, and management’s efforts to infuse a large part of the proceeds from the co-founders’ rental asset stake sale in DLF.

Valuation: trading near historical troughs; stock looks compelling
With DLF trading at distressed levels (65% discount to NAV; 0.7x FY16E P/BV) and near our downside case valuation of
Rs 90.00/share, the risk-reward looks compelling. We base our
Rs 210 price target on a 35% discount to NAV of R320/share.

PIVOTAL QUESTIONS
Is the Indian office leasing market witnessing strong growth trends?
Yes. We believe the Indian office leasing market is witnessing strong growth in leasing volume, with rentals firming up, vacancy rates at 7-year lows, and capital constraints limiting new supply. With REITs likely to be a reality soon in India following the governments’ tax concessions, commercial markets could outperform the residential segments over the next 1-2 years.

What are the implications of rental ownership restructuring for DLF?
We think the restructuring and asset monetisation exercise would have significant positive implications for DLF as it could materially improve corporate governance standards, better align co-founders’ interests with those of DLF minority shareholders, potentially re-rate its rental asset valuations by ~30%, and reduce DLF’s high debt levels. The market has been sceptical of the rentalHi team, Pl asset sale, but the Supreme Court’s decision to allow monetisation has removed the regulatory uncertainty.

Can DLF’s cash flow pressures ease given $3.2 bn in debt and weak residential sales?
Very likely. Although weak residential sales and negative cash flow from the development business could remain near-term overhangs, pressures could ease with a 14% rental income CAGR over FY15-18e, land/project monetisation, and the co-founders’ capital infusion post-stake sale.

UBS VIEW
We think DLF’s strategy to restructure its rental asset ownership amid a growing preference for commercial assets could change its fortunes. We see a good likelihood of the 40% stake in DCCDL being monetised shortly at lower cap rates, which could re-rate our rental asset valuations for DLF of R70/share and act as a significant catalyst for the stock. Further more, an infusion of the co-founders’ stake sale proceeds into DLF will considerably reduce its development business debt and ease investor concerns on its high debt levels over the medium term.

EVIDENCE
Capitalisation (cap) rates have fallen 200bp to 10% over the past one year. This is on the back of record investments of $1.5 bn in Indian commercial assets in 2015. Leasing volume rose 10% y-o-y in 2015 to record levels of 37.7 msf across six key cities, with firming rentals, vacancy rates of 8-14% (from 20-30% highs in 2008), and inventory close to 8-year lows. Furthermore, DLF has already started its due diligence process for the strategic stake sale with clearance from the Supreme Court. Recent residential project monetisation has also reduced its net debt in Q3 FY16.

WHAT’S PRICED IN?
The market seems to be offsetting a large part of the development business value with rising debt levels as it remains sceptical of DLF’s ability to monetise the stake sale in its rental assets and deleverage. We believe DLF’s share price largely reflects value for its 60% holdings in rental assets, with a significant discount to its developmental assets
(R45/share compared to our fair value estimate of R140/share). The stock is trading below its 10-year historical P/BV and at a discount to NAV trends, underlining the market’s strong scepticism.

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