Idea of the week: Lendlease bond yielding 5.9% amid strategy change.

Lendlease Group is an Australian integrated real estate business operating 3 core business segments of Investments, Development and Construction.

The investment segment involves the funds management, asset management platform and the group’s property investments. The funds segment involves Lendlease acting as a fund manager for wholesale, direct real estate funds which are sold to investors and generate a recurring revenue from the management fee charged for the Funds under Management (FUM). On the other hand, Lendlease also acts as a property manager for a portfolio of assets which also generates a recurring fee from their Assets under Management (AUM). Lastly, the group also holds an investment portfolio totaling AUD 3.7 billion, consisting of equity invested in Lendlease managed funds and direct investment in property and property related assets. Currently, FUM for the group is AUD 48 billion while Assets under Management is AUD 34 billion.

The group was established in 1958 and was successfully listed in the Australian Stock Exchange in 1962 and has since then achieved a market cap of AUD 4.2 billion. Currently, the Group is one of the largest real estate developers in Australia and has since expanded internationally, with presence in Asia, Americas and Europe. The group also has a presence in Malaysia with the development of Setia City Mall and The Exchange TRX.

Earnings yet to recover to pre-covid highs

Table 1: Profitability (AUD million)

The past years have proven difficult for the group, facing headwinds from project disruptions, higher overall cost and further impairments from revaluation of assets. Their core operating profit after tax (OPAT) for HY24 dipped 42% against HY23 and can be attributed to lower earnings in the investment segment of 39% and a 25% dip in earnings in the construction segment. Adjusting for the sale of the second tranche of the Military Housing Asset Management income stream, investment earnings in HY24 increased by 1 percent.

Chart 1: Investment segment performance in AUD Billion

Operating EBITDA from Management fee have continued to be weighed down in the past years from increased cost from building out their overseas fund platform and lower performance fees on funds and asset management. Historically, the base management revenue excluding performance fees from FUM hovered around 0.5% of FUM with EBITDA margins of around 40%. Given that, with AUD 50 billion in FUM and growing, we are positive that the investment segment will contribute a positive recurring income for the group.

For FY24 the group has provided a guidance for OPAT to be at around AUD 260 million, primarily driven by higher completions and recognition of backlog revenue from the development and construction segment in 2H24.

Change of business strategy – refocusing on Australia

The continued poor performance from the group in the past years saw the share price shedding 60% of its value in the past 5 years. This had led to pressure from investors for a change in strategy, eventually pushing Lendlease to restructure its business.

In the strategy update in May 2024, Lendlease has committed to focus on its market-leading Australian business and international investments platform by exiting its international construction business in the US and UK, further accelerate capital release to recycle up to AUD 4.5 billion in capital and to lower cost by simplifying its organizational structure. The move is seen as Lendlease’s effort to shrink and simplify their operations, focusing on their core development market in Australia.

The strategy also involves a cost cutting initiative paired with their planned exit from construction in the UK and US to be positive, as it will provide savings from lower employee overhead expenses. So far, AUD 125 million p.a. pre-tax savings associated with the restructuring are anticipated to be realised within 12 months. Additional cost reduction is expected from the 35% reduction in Full-time Equivalent (FTE) within the next 18 months through their divestment initiatives.

However, in the short-term, the strategy has proven costly, with an estimated impairment cost of AUD 1.4 billion for FY24. The impairments include write down of goodwill in the US and UK construction business and impairments in overseas development projects where their intended use has changed. The impairments on the overseas development project of AUD 450 – AUD 550 million will effectively lower their tangible assets and increase gearing by ~0.7% in FY24.

Nevertheless, the group is well on track to deliver on its strategy, with AUD 1.3 billion sales of its 12 communities project in Australia awaiting regulatory approval, a further AUD 0.4 billion in sales of its US Military Housing and AUD 147 million sale of its Life Sciences joint venture. These transactions are estimated to contribute up to AUD 335 million of OPAT in FY25 and bring in cash to allow them to effectively execute their deleveraging targets.

Increase in target capital allocation to the investment segment to drive recurring income

The shift in strategy also involves a change in the targeted reallocation of capital to Australia of around 40-60% of capital which has historically in the past 5 years averaged at around 37%. Furthermore, the group is targeting to lower the capital allocation in the development segment to 40% from 60% and an increase of 20% to the investment segment.

The growth in FUM will largely be supported by the current development work in progress of AUD 18 billion, of which the group has indicated AUD 6 billion of future secured FUM from the current development pipeline. The group’s internal target to achieve AUD 70 billion by FY26 seems overly optimistic, we instead expect FUM to hit AUD 60 billion by FY26 based on a conservative 10% growth rate, which is around their 5Y average growth in FUM. Taking historical management revenue as their base management fee, the group’s management revenue derived from fees have been at around 0.5% of total FUM, netting them circa AUD 300 million in revenue (not inclusive of performance fees) and an EBITDA of AUD 120 million, assuming EBITDA margins of 40% and FUM of AUD 60 billion.

All in all, we expect the investment segment to contribute a bigger proportion to the EBITDA of the group as they work towards increasing their co-investments and achieving their target FUM of AUD 70 billion. However, we expect these targets to be achieved upon the completion of their capital recycling efforts, as they work towards bringing back the capital invested in US and UK.

Credit profile

Table 2: Selected credit metrics (in AUD millions unless stated otherwise)

Lendlease credit profile has deteriorated slightly in HY24, as development capital has reached its peak with an 18% increase to AUD 7.2 billion in HY24 leading to an increased in borrowings and lower cash balances. We expect their leverage levels to remain elevated throughout FY24 and to peak at an estimated Net debt to EBITDA of 6.3x. The key assumptions behind the 6.3x net debt to EBITDA includes an OPAT of AUD 260 million with EBITDA of AUD 550 million, and net debt to reduce to AUD 3.5 billion from expected net cash inflows of AUD 900 million from settlements from the completion of Residences One.

On the other hand, interest coverage has deteriorated owing to an increase in debt and interest rates. However, at a cover of 2.2x the group is still capable to service their debt, considering that the recurring revenue and earnings from the investment segments is enough to cover the interest cost, at around 1.4x.

Completion pipeline and asset sales to support 2026 debt reduction target

The capital release from targeted asset sales is a positive for bondholders, especially investors in the shorter maturity bonds. The group has committed to reducing their debt by AUD 1 billion by 2026 in an effort to achieve their targeted net debt to tangible assets of 5%-15%. To achieve this, the group has an anticipated AUD 2.8 billion assets on the market, with announced sales of AUD 1.9 billion in FY25. Further asset sales are expected, which includes their international construction business in the US and UK, The Exchange TRX in Malaysia, and Ardor Gardens in China.

We are optimistic on their ability to execute these sales, considering their current financial flexibility in the short-term given their available liquidity of AUD 1.6 billion comprising AUD 600 million in cash and AUD 1 billion in available credit facilities. This is also further supported by expected cash receipts from their completion of development in the coming years from an expected completion of AUD 2.4 billion in 2H24 expecting net cash proceeds of AUD 900 million, and a expected completion pipeline of AUD 3.0 billion in FY25.

Overall, we believe that investment in development capital is likely to have peaked and will moderate in the coming years as more than 50% of their development work in progress is expected to be completed in the by FY25. Therefore, cash receipts from the total expected completion of AUD 5.4 billion up to FY25 together with announced asset sales of AUD 1.9 billion and undrawn credit facilities of AUD 1 billion will provide them sufficient liquidity to repay their total AUD1.8 billion of debt in FY25 and FY26.

Chart 2: Debt maturity profile

Risks

The group’s future success in implementing the announced strategy is underpinned by their ability to complete their divestments and asset sales successfully to recycle the targeted capital. Out of the AUD1.9 billion announced, AUD1.3 billion sales of the Australian Communities project is still under scrutiny by the Australian Competition and Consumer Commission (ACCC) with a targeted final decision of 12 September 2024. Additionally, their divestment out of the construction business in the US and UK are also currently in progress and is dependent on them successfully finding a buyer for the business.

Recommendation

Despite declining revenue and operating profit, we believe Lendlease’s new strategy is positive for its future outlook, especially for debtholders, considering the group has made a commitment of reducing net debt to tangible assets to 5%- 15% from its current 22% by 2026 through their announced asset sales expected to be realised in 2025, which we believe includes redeeming the bond maturing in 2026 to achieve the target. As such investors can consider investing in LLCAU 4.500% 26May2026 Corp (USD) currently yielding 5.97%. The bond issued by Lendlease Capital is guaranteed by Lendlease Corporation Limited.

Table 4: Lendlease Bond Information