E&O facing strong headwinds

Eastern & Oriental Bhd (Nov 18, RM1.48)

Maintain hold with a lower target price of RM1.65: Eastern & Oriental Bhd (E&O) reported a core net profit of RM5 million in the second quarter of financial year 2017 (2QFY17). This was a turnaround for the group as it recorded a core net loss of RM7 million in 2QFY16, thanks to higher property development profit margin and lower operating expenses. Its gross profit margin grew from 35% in 2QFY16 to 44% in 2QFY17 while other operating expenses (administration and sales) dropped 14% year-on-year to RM25 million. End-2QFY17 unbilled sales declined 5% quarter-on-quarter (q-o-q) to RM980 million.

E&O inventory level rose 17% q-o-q to RM537 million as at end-2QFY17. We understand that the higher inventory was due to the completion of its Andaman project in Penang, where 150 units remain unsold. These units have a total carrying value of about RM400 million in E&O’s book. In 2HFY17, the group will hold back its new launches and focus its efforts on clearing the inventory. It expects its 2HFY17 sales to be no less than the RM152 million achieved in 1HFY17 (sales in 1HFY16 were RM635 million).

On top of that, the group will also keep a close eye on the progress of its Seri Tanjung Pinang (STP) 2A land reclamation project in Penang. The land reclamation is about 15% completed and management believes that the target completion date of June 2018 remains achievable.

E&O is also in talks with several potential partners to acquire a minority stake in the development of STP 2A. We understand that E&O could form a joint venture with the potential partners and acquire the land plots in STP 2A via the joint venture.

If this happens, E&O’s earnings could be boosted by the gain arising from the land sale.

The securing of a strategic investor in STP 2A is also crucial for the survival of E&O as the project cost alone is RM1.8 billion. The cost is 70% funded by debt and based on a 5% interest rate; the interest cost of RM63 million per annum could more than wipe out E&O’s entire projected net profit in the next three years, based on our estimates.

We still have high hopes that it will eventually secure strategic investors for its STP 2A project. The strategic investors’ entry price should set the benchmark for the valuation of the bigger STP 2B and 2C projects, which currently account for 54% of its total revalued net asset valuation (RNAV), based on our estimates.

However, the uncertainty surrounding the timing of securing a partner and concerns about the high inventory level could overshadow the potential of the entire STP 2 project.

Although E&O currently trades at nearly 70% discount to its RNAV, the widest among all the developers that we cover, there is no visible rerating catalyst for its share price. The upside risk to our call is the securing of a strategic investor for STP 2A while the downside risk is further deterioration in property market sentiment. — CIMB Investment Research, Nov 17

This article first appeared in The Edge Financial Daily, on Nov 21, 2016. Subscribe to The Edge Financial Daily here.