Amid unprecedented political strife in Hong Kong, ESR Cayman Limited (“ESR”) in June pulled plug on its HKEX listing application, citing market conditions. Fast forward five months later, the company successfully raised HKD4.4 billion via a second IPO attempt, which was Hong Kong’s second-largest initial public offering (“IPO”) this year before Alibaba Group Holding completed its secondary listing in November. In this article, we find out more about this rapidly growing logistics developer and manager.
About ESR Cayman
In 2016, a merger between e-Shang Cayman Limited (“e-Shang”) and the Redwood Group gave birth to ESR. The company is a logistics real estate developer and operator focused on building and managing logistics properties such as warehouses and distribution centres. The company also manages a broad range of funds and investment vehicles specializing in those assets.
According to its IPO prospectus, ESR is one of the largest Asia Pacific-focused logistics real estate company by gross floor area (“GFA”), value of portfolio assets, and development pipeline as measured by GFA. The firm has business interests across China, Japan, South Korea, Singapore, Australia, and India. As at 30 Jun 19, the group had total assets under management (“AUM”) of USD20.2 billion, with a portfolio of 213 properties covering a total GFA of 10.9m square metres (including properties under construction and land held for future developments).
By geography, most of ESR’s AUM were held in Japan, China, and South Korea, which constituted 37.3%, 21.7%, and 17.9% of the group’s total AUM. The company’s biggest geographical exposure in terms of portfolio assets directly held (51%) and land held for future development (42%) is China.
E-Shang was co-founded by an affiliate of Warburg Pincus and Mr Jeffrey Shen Jinchu in 2011, while the Redwood Group was established by Mr Stuart Gibson and Mr Charles Alexander Portes in 2006. Today, Mr Shen, Mr Gibson and Mr Portes continue to lead ESR’s senior management team as co-founders and executive directors.
Strong shareholder support
ESR’s rapid growth came with the financial backing of a group of strategic and prominent shareholders. The group’s major shareholders include Warburg Pincus, the Redwood group, APG Asset Management, The Shen Trust (controlled by Mr Shen), SK Holdings, JD.com, and OMERS Administration Corporation. Among the aforementioned names, Warburg Pincus, the Redwood group, and SK Holdings hold the biggest stakes, with equity interest of approximately 19%, 13%, and 11% in ESR respectively.
Since ESR’s inception, the company’s strong shareholder base has been supportive of its capabilities in originating deals, access to capital markets, land acquisitions, and tenant relationships. For example, JD.com is not only a substantial shareholder of ESR with an equity stake of ~7.7%, but also a key tenant leasing more than 1m square metres (“sqm”) of logistics space from ESR as of June 2019.
More importantly, we like that ESR has been self-sustainable in many aspects, and does not place undue reliance on its substantial shareholders including Warburg Pincus. ESR has its own operational and financial system independent of Warburg Pincus and there is no outstanding financial aid (in any form including loans and current account balances).
The business model: how do ESR make money?
Unlike the traditional build-to-rent type of developers, ESR adopts a highly scalable business model that has enabled it to grow rapidly over the years. The company scales its business by deploying both its own capital and funds gathered from pooled funds and investment vehicles, achieving economies of scale efficiently and better diversification of investment risks.
ESR gathers development funds to finance the initial development phase of land sourcing, design, construction, and leasing of the logistics properties, which typically take around one to two years (see Figure 1). Subsequently, ESR will divest stabilized assets to its core funds or other platforms such as REITs. By doing so, the company can continue to earn recurring management fees and its share of rental income.
Figure 1: ESR’s business model
Source: Company, iFAST compilation
This model allows ESR to monetise the assets and at the same time retain an interest in those assets. If and when the underlying assets or platforms outperform a target return, ESR may also be entitled to additional share of profits.
We like the simplicity of ESR’s design and construction processes in its logistics developments, which have allowed the company to complete its development cycles in relatively short timeframes (1-2 years), from land sourcing to leasing. This enables ESR to monetise matured assets quickly and free up capital for growth deployment.
To sum up, ESR’s has 3 major revenue streams. Firstly, the company earns development profits through the building and sale of logistics properties. Secondly, it earns recurring fee income from managing properties held by the funds and investment vehicles that are managed by the company. Thirdly, it earns rental income and capital appreciation on properties directly held, and dividend income and share of earnings and value appreciation from REITs that it manages.
As shown in Figure 2, all 3 segments described above—development, fund management, and investment—are major revenue contributors. Over the years, we see that the fund management segment has grown at a quicker pace than the investment segment. Given recent developments (see the next section), such as projects in India and acquisitions in Japan, we are likely to see top-line improvements in the immediate quarters ahead. Particularly, the development and investment segments will likely see substantial growth as their 1H19 results have already almost outpaced those of full-year 2018.
Figure 2: revenue by business segment
Recent transactions and growth pipeline
Following recent transactions including the acquisition of the remaining 80.1% interest in ASX-listed Propertylink for AUD398m, ESR has stayed on its ambitious expansion trajectory. In June 2019, ESR completed the acquisition of an additional 51% interest in Sabana Real Estate Investment Management Pte Ltd (“Sabana Manager”), the manager of SGX-listed Sabana Shariah Compliant Industrial REIT (“Sabana REIT”).
ESR also acquired additional units in Sabana REIT to increase its stake. Upon completion of the deal, ESR now holds about 93.8% equity interest in Sabana Manager and 21.2% of the total issued units in Sabana REIT.
The abovementioned transactions gave control to ESR of another Singapore industrial REIT, in addition to ESR-REIT. As an aside, market watchers have been speculating that there would be more corporate activities within the Singapore industrial REIT sector. We will continue to monitor for significant corporate developments in the group and provide updates when necessary.
In July, ESR entered into a partnership with Future Group, an India-listed conglomerate. The partners will jointly develop two industrial warehouses in India for a total planned GFA of approximately 122,000 sqm. These developments are expected to be completed by September 2020. ESR is expected to hold about 51% interest in the partnership at the development stage and to acquire the remaining interest following the completion of the project.
In August, ESR entered into an umbrella agreement with managed vehicles of China Merchant Capital Fund to establish a new joint venture in Australia. ESR is expected to hold a 20% interest in the joint venture, which is to be managed by the company’s Australia unit and hold 11 of Propertylink’s wholly-owned properties.
Also in August, ESR acquired a logistics property in Kawajima, near Tokyo, Japan for a price tag of JPY8.74 billion (~USD80.5m) from one of its development funds. The property will ultimately be transferred to a new Japan fund. This new fund will serve as a vehicle for the acquisition of smaller and stabilised assets in Japan that are not part of the mandate of the group’s Japan core fund.
All told, ESR has been aggressive in growing its presence and scale in the Asia Pacific region via acquisitions and collaborations. A wider geographical coverage should bring about diversification benefits to offset ESR’s substantial concentration risk in the logistics sector.
Financial highlights
Boosted by the recent acquisition of Propertylink, ESR’s revenue in the first half of 2019 rose 66.3% YoY to USD155.8m. Revenue also increased because of an increase in management fee income, in line with the growth in AUM, and the inclusion of construction income following the consolidation of CIP. In August 2018, ESR acquired the Australia property construction company CIP, having plans for CIP to act as the seed platform to launch the group’s business in Australia.
The consolidation of CIP also brought a significant jump in ESR’s cost of sales from USD2.1m in 1H18 to USD41.8m in 1H19. Gross profit margin (“GPM”) as a result fell from 97.8% to 73.2% over the same period. We are unperturbed by the sharp fall in GPM as CIP operates a construction business that has a different margin profile, and the current level of GPM remains healthy in our opinion.
Meanwhile, other income and gains more than doubled from USD75.7m in 1H18 to USD165.4m in 1H19. We note that other income and gains have been a significant contributor to ESR’s bottom line. This financial item primarily consisted of changes in fair value of investment properties and financial assets, as well as dividend income received from property platforms that the company held interest in.
In 1H19, the significant jump in other income and gains was primarily driven by fair value gains on investment properties under construction from the RW Higashi-Ogishima DC property, in tandem with the company’s plan to convert the property into a modern logistics facility. Gains from Japan properties held through funds and investment vehicles and an increase in dividends received from equity investments in listed securities (likely REITs) also helped lift other income and gains.
ESR reported adjusted earnings before interests, taxes, depreciation, and amortisation (“EBITDA”) of USD125.2m in 1H19, up 29.8% YoY. Nonetheless, interest cover (adjusted EBITDA over interest expense) weakened to 1.5x (1H18: 2.1x), as the jump in earnings was insufficient to offset a bigger jump in interest expenses (+81.4% YoY). Besides the consolidation of Propertylink’s finance costs, an increase in debt load also led to the higher interest expense.
We think the current level of interest cover is relatively weak and warrants closer monitoring. On the other hand, we note that ESR’s interest cover averaged around 2.1x between 2016 and 2018, which was a manageable level in our view.
Credit highlights
As at 31 Aug 19, ESR Cayman had total borrowings of USD3.04 billion, of which USD589.5m (19.4%) were short-term debt. Total borrowings doubled from USD1.46 billion at the end of December 2018, following the drawdown of debt for the Propertylink acquisition and consolidation of Propertylink’s balance sheet.
The company also had outstanding around USD288m in notional amount of redeemable convertible preference shares—USD60m of these preference shares were expected to be converted to ordinary shares upon completion of ESR Cayman’s IPO—and USD100m of perpetual securities. On 7 Nov 19, ESR announced that it has redeemed in full preference shares that were not converted into equity.
Net gearing (net debt over equity) was 74% at the end of June, while we estimated adjusted net gearing (including preference shares and perpetual securities in debt) at 93%. Meanwhile, ESR’s gross debt over total assets stood at 47.2% in 2Q19 (4Q18: 33.0%).
ESR had a comfortable liquidity position with USD1.16 billion of cash and bank balances and USD85.4m of unutilized banking facilities in August. The liquidity reserve was more than enough to cover near-term obligations of USD589.5m and USD100m of perpetual securities (assuming that they would be redeemed on the first call date of 7 Jun 2020)
ESR’s financial flexibility was also adequate in our view. As at 30 Jun 19, secured debt (excluding “Hana” notes1) was USD1.7 billion, while investment properties totalled USD2.7 billion. On the other hand, the company faced a higher refinancing wall in the medium term, with both the S$350m ESRCAY 6.750% 01Feb2022 Corp (SGD) and USD425m ESRCAY 7.875% 04Apr2022 Corp (USD) maturing in 2022.
ESR had a market capitalisation of HKD51.1 billion (~USD6.6 billion) as at 16 Dec 19, which provided ample equity cushion behind its USD3.04 billion of debt. Furthermore, based on the disclosed intended use of proceeds from the share offering, we estimated pro forma adjusted net gearing to fall significantly to approximately 61% post-IPO.
According to its share listing prospectus, ESR expected to incur hefty capital expenditures (“capex”) of USD1.23 billion and USD424.7m for 2019 and 2020 respectively. As such, while we expect ESR’s leverage to fall significantly post-IPO, the company is likely to continue to deploy significant investments to support its growth trajectory, which may push gearing higher subsequently. In addition, we noted that ESR’s free cash flow had remained negative since 2016, signalling the need for external funding sources to meet capex needs.
Key risks
Lack of information regarding managed private funds and investment vehicles
After achieving its HKEX listing, ESR will have to comply with additional disclosure requirements, bringing much higher transparency and timely updates of its financials and business. While this is a plus for investors, we note that terms and conditions of ESR’s management agreements with the many private funds and investment vehicles it manages are not disclosed. That said, we take comfort that according to ESR’s IPO prospectus, the company does not have any significant contingent liabilities as at 31 Aug 19.
High dependency on capital partners
A substantial part of ESR’s income is derived from fund management. Therefore, ESR’s business depends to a large extent on its ability to achieve and maintain a good relationship with capital partners. ESR also relies on such relationships to source funding for property acquisitions and developments, and an inability to obtain such funding could have an adverse impact on its AUM.
The funds and investment vehicles ESR manages rely heavily on capital investments from its capital partners. A default of any major capital partners on their funding commitments may jeopardise the operation and performance of those funds and investment vehicles, which may in turn have an adverse impact on ESR’s operating results.
On the bright side, there are several possible mechanisms in place to discourage capital partners from reneging on their obligations, such as forfeiture of existing investments. Also, we take comfort that ESR has not had any capital partners failing to honour a capital call to date.
Business model entails heavy capex
Based on ESR’s IPO prospectus, the group has the largest development pipeline in aggregate across key Asia Pacific markets, as measured by GFA, from 1 Jul 19 to 31 Dec 20. As at 30 Jun 19, the group had approximately 4.4m sqm of GFA of properties under construction (both directly owned and those held in funds and investment vehicles managed by the company) that were expected to be completed over the next two to five years.
The pipeline of properties under construction represented more than half of the GFA of ESR’s current completed properties. In addition, ESR had about 2.4m sqm of GFA to be built on land held for future developments. Altogether, ESR’s development pipeline added up to 15.3m sqm of GFA.
To reiterate, ESR’s aggressive expansion plans translated to a projected capex of USD1.23 billion in 2019. This is likely to weigh on the company’s cash position and increase its leverage. We will continue to monitor the group’s credit profile but for now, we are comfortable with ESR’s moderate leverage post-IPO (based on our estimations), decent liquidity position, and strong shareholder base.
Industry considerations
Another potential risk, which at this juncture delivers more opportunities than challenges in our view, is ESR’s high portfolio concentration in logistics properties. ESR builds and manages a portfolio of properties that are mainly used for logistics and distribution services by tenants such as e-commerce companies, third-party logistics (“3PL”) providers, retailers, manufacturers, and cold-chain logistics providers.
We think the growth in these sectors—and ultimately economic growth and rising income levels in APAC—should continue to drive demand for logistics spaces. On the other hand, in an adverse scenario of an economic downturn in Asia Pacific, ESR’s operations can be adversely impacted. For instance, demand for logistics space would naturally fall if growth in the e-commerce industry slows down. Logistics assets may then become idle, followed by a fall in rentals and market value of those properties.
That said, we think the likelihood of the above scenario is low. Taking China as an example (where most of ESR’s stabilised assets are located in), our stocks research team pointed out that the healthy pace of growth in the country’s e-commerce industry should continue in the upcoming years. (See “EC World REIT: Leverage On China’s Burgeoning E-Commerce Industry With This REIT!”) Robust growth in the volumes of parcel deliveries in China (see Figure 3) should spur a higher need for logistics space, which bodes well for ESR.
Figure 3: express delivery volume in China
The rapid growth in China’s postal sector is a natural outcome of the country’s similarly fast-growing e-commerce industry. As shown in Figure 4, advancement in technology has boosted online retail activities, with both the e-commerce transaction value and business-to-consumer gross merchandise volume displaying healthy growth trends. According to China’s tech giant Alibaba Group, total gross merchandise volume settled through Alipay (Alibaba Group’s online payment system) rose 26% YoY to USD38.4 billion during the Singles’ Day sale in November. The record-breaking performance indicated healthy consumer sentiment, which we think should support the logistics value chain.
Figure 4: China’s growing e-commerce sector
While we are encouraged by the rosy outlook that some of the macro statistics suggested for the logistics sector, we acknowledge the difficulty in predicting how much longer the up-cycle can continue. We are also cognisant of the macroeconomic uncertainty presented by China’s slowing economic growth.
That said, we think the impact from a slowdown in China’s e-commerce sector should be manageable for ESR. Besides having a short development timeframe, ESR’s logistics assets also have a relatively simple building structure, which allows room for modifications to suit other uses besides logistics. More importantly, we like that these facilities are situated at strategic locations, such as near key logistics hubs and industrial zones.
Furthermore, we think the group’s well-diversified tenant base provides good earnings stability. The group’s assets are let out to tenants in a broad range of industry sectors including retail, wholesale, transportation, and 3PL providers. Its tenants include leading e-commerce players and renowned retailers such as JD.com, H&M, Amazon, and Cainiao.com (a member of Alibaba Group). As of 30 Jun 19, ESR’s stabilised assets2 have an occupancy rate of 92%.
Recommendation
The ESRCAY curve is made up of the S$350m ESRCAY 6.750% 01Feb2022 Corp (SGD), USD425m ESRCAY 7.875% 04Apr2022 Corp (USD), and USD100m ESRCAY 8.250% Perpetual Corp (USD).
The ESRCAY 6.75% ’22s have an ask YTM of 4.88% (Z-spread: 335bps), while its USD counterpart with similar maturity, the ESRCAY 7.875% ’22s carry an ask YTM of 6.14% on a post-swap basis. We think the sizeable yield pick-up from the ESRCAY 7.875% ‘22s makes the USD note a better investment choice.
Nonetheless, we think the ask YTM of 4.88% (Z-spread: 335bps) on the ESRCAY 6.750% 01Feb2022 Corp (SGD) provides a generous compensation to SGD investors for taking on ESR’s credit risk. As a pricing reference, the ARASP 4.15% ‘24s of ARA Asset Management Limited (“ARA”) are indicating at an ask YTM of 3.47% (Z-spread: 189bps).
ARA is a global real assets fund manager with AUM of S$44 billion. It operates with a similar business model as ESR and also has most of its portfolio assets in the APAC region. A major difference between ARA and ESR is that the former’s portfolio of assets comprises mainly of office and commercial properties. The company recorded an adjusted net gearing ratio (including perpetual securities in debt) of 1.0x as of 30 Jun 19.
The ESR curve also compares attractively with other peers. For instance, Global Logistic Properties Ltd’s GLPSP 3.875% USD notes due 2025 have an ask YTM of 3.52%, representing a spread of 182bps above US Treasuries. A switch from the GLPSP 3.875% ’25s to the ESRCAY 7.875% ’22s would give a yield pick-up of a significant ~302bps, which is attractive even if we take into consideration ESR’s unrated status and smaller asset base.
GLP is a direct competitor of ESR with a much bigger AUM of USD66.0 billion (as at 30 Jun 19). GLP also specialises in logistics assets, operating primarily in China and Japan. The company reported a debt-to-assets ratio of 43.8% as at 30 Sep 19 and carry triple-B credit ratings.
At its indicative offer price of 102.4, the ESRCAY 8.25% perp has a YTW of 3.07% (Z-spread: 145bps). The perp is first callable on 7 Jun 20. If not called, its coupon rate will reset in June 2020 (and very three years thereafter) to the sum of the prevailing three-year US Treasury yields, the initial spread of 6.815%, and a step-up margin of 5%. The hefty reset spread as compared to the current spread on the ESRCAY 8.25% perp indicates a low likelihood of a non-call event. Assuming the ESRCAY 8.25 perp will be redeemed on 7 Jun 20, the 3.07% YTC (2.61% in SGD terms) is not too shabby for a short remaining maturity of ~6 months.
Footnotes
1 The Hana Notes were USD300m of notes issued in November 2016, bearing a fixed interest rate of 6.3% per annum and have a maturity date on 18 Nov 19. On 7 Nov 19, ESR announced that it had fully redeemed the outstanding Hana notes using IPO proceeds.
2Stabilised assets refer to assets that were completed for more than a year or that have reached an occupancy rate of over 90%.
Declaration:
For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) has a principal position in ESRCAY 6.750% 01Feb2022 Corp (SGD). The analyst who produced this report hold a NIL position in the abovementioned securities.
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