Key Characteristics. Product Type. Fixed/Floating. Payment Frequency Current Distribution** Issue Margin / Coupon** Franking Credits Incl.

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1 Issuer Name Peet Limited Security Name Peet Bonds Key Characteristics Product Type Corporate Bonds Issue Size* [$75,000,000.00] Par Value $ Fixed/Floating Fixed Research Report Report Created on 2 May 2016 Last Price $ Accrued - Capital Price $ Running Yield** 7.50% Security Recommendation Subscribe Security Risk High Payment Frequency Current Distribution** Issue Margin / Coupon** Franking Credits Incl. ASX Listed Semi Annual 7.50% 7.50% No Yes (Prospective ASX Code: PPCHA) Yield to Maturity*** 7.50% Trading Margin 5.14% Optional Call Date - Legal Final Maturity 7 June 2021 (5 Year) Next Ex-Date - Issuer Outlook Convertible No Next Payment Date 16 December 2016 Improving Stable Deteriorating GICS Sector Real Estate Next Cash Distribution**** $3.75 * Size is subject to change. The issuer has guided to a size of $75 million. ** Based on a prospective issue margin of 5.14%. Actual margin to be set at bookbuild. *** Based on a prospective issue margin of 5.14% and interpolated swap rate to maturity of 2.36%. Actual margin to be set at bookbuild. **** Actual cash amount based on $100 face value. Summary On the 2nd of May 2016 Peet Limited (ASX Code: PPC) announced a new issue, Peet Bonds (Prospective ASX Code: PPCHA). The size of the offer is indicated at $75 million but will change based on demand. The purpose of this transaction is to help refinance the existing Peet 9.5% Convertible Notes (ASX Code: PPCG) while further diversifying and increasing the average maturity of Peet s debt profile. The proceeds will also be used for general corporate purposes. The bonds are structured as simple corporate bonds meaning they have no optionality and interest payments are mandatory. To qualify as a simple corporate bond this security has met specific legal eligibility requirements on the issuer and the security. The bonds are protected by event of default conditions which give the holder the right to recover any unpaid principal or interest subject to issuer solvency. The simple corporate bond regime does not allow noteholders to be subordinated to unsecured creditors. The notes are guaranteed by the issuer and all wholly-owned subsidiaries of the issuer. The bonds pay a fixed rate coupon (to be set at bookbuild but guided at 7.50%) payable on a semi-annual basis in arrears on the 16th of June and December each year. The bond may only be redeemed on its legal final maturity date (7 June 2021) or when a Tax Event, Change of Control Event or a Clean Up Condition exists. Bond holders are protected by a series of covenants such as a negative pledge (net secured debt cannot be more of 40% of total adjusted assets) and restrictions on indebtedness (net total debt cannot be more than 50% of total adjusted assets). More information can be found in section 2.1 of the Base Prospectus. Figure 1: Capital Structure 1 Figure 2: Relative Value % Senior Secured 16.0% Senior Unsecured 16.0% Other liabilities 51.0% Common Equity 2 May 2016 Page 1

2 Security Recommendation - Subscribe as at 28 April 2016 We initiate coverage on the proposed Peet Bonds (ASX: PPCHA) with a Subscribe recommendation. Our valuation assumptions are based on the security being redeemed (in full) on the legal final maturity date (7 June 2021) and all interest payments being made in a timely manner. There are a number of comparable issues within the Real Estate Sector including Mirvac, Stockland and Lendlease. There is a difference in credit risk between these issuers. From an operational perspective, Peet is focussed on land banking and arguably has greater project risk than its competitors. Our relative value analysis suggests the notes are offered to investors at a margin that is considered fair and commensurate with the risk of the security. The sensitivity to our valuation assumptions can be found in the relative value section. In our opinion the overall credit risk of the issuer has improved significantly since the last issue (2011). In comparison, net debt has been reduced by almost a third, revenue streams have evolved and a lower cost base has been achieved. We acknowledge that the gearing covenant has been maintained but we expect the company will prudently manage the group s balance sheet within these covenants. At the current stage of the property cycle we believe Peet is positioned well. The group took the opportunity to strengthen its balance sheet during the recent growth phase of the residential market while investing in and managing projects with low capital intensity. This strategy has paid off and with a sales pipeline valued at $12 billion targeted at low to middle income owner occupiers we expect the group s strategy will be able to sustain margins while limiting the negative impact of earnings cyclicality. Peet has a strong history of successful land development while maintaining strict controls on its balance sheet. The performance of the PPCG notes during a period of uncertainty is a testament to the group s performance and strategy. For this reason, we expect the notes to perform well through the property cycle. Positive / Negative Risk Factors What factors would change the Recommendation UP Recently, Peet Limited began development on the University of Canberra's Belconnen campus into an academic and social hub, including a residential community. Student housing continues to be a strong growth driver in Australian property and may present new opportunities for the group; A history of prudent capital management and stable polices is a credit positive. Further reduction of net debt (to target less than 25% gearing) through organic sales growth and strategic land acquisitions; Funds Management business continues to grow resulting in higher margins for the group as a whole through projects with low capital intensity; Development spend is expected to be self-funded through operating cashflows, reducing the possibility of further indebtedness. Peet has minimal exposure to medium density residential property (apartments and units) and investor driven demand. This allows the group to avoid leglisation regarding restrictions on investor demand and the potential oversupply in Sydney and Melbourne apartment markets; Strong track record, management expertise and sound strategy will prevail despite turns in the property cycle; Ability to scale back development in unfavourable market conditions. Peet derive most of their value through land rather than housing enabling the group to retain more stable land assets; Well positioned for coming years with pipeline valued at $12 billion. This will generate sufficient cashflow, decreasing the possibility of liquidity pressure. What factors would change the Recommendation DOWN Potential for prolonged sales risk associated with the group s Flagstone project which is expected to continue for 30 years. This project (valued at $3 billion) makes up 25% of the group's pipeline and any threat to its value will significantly impact earnings growth; Further increases in residential mortgage interest rates as a result of tighter bank regulation. This will have adverse impact on owner-occupier demand, especially in Peet s target customer bracket of low to middle income earners; Negative economic impacts. This includes reduced consumer confidence, increases in the unemployment rate, declining wage growth and low levels of migration (both inter-state and internationally); Changes to government legislation that reduce the affordability of house and land packages including taxation (land tax, stamp duty) or incentives (first home owner grant); Peet is subject to settlement risk. This is often higher with lower income earners and can result in cashflow volatility and subsequent liquidity pressure; Project forecasts miss targets in Western Australia and the Northern Territory could be a drag on earnings. These states have performed poorly post the mining boom and this is expected to persist for some time; Deterioration in investor demand for syndicates in the Funds Management business. Given the increased weighting of total projects to this segment, a slowdown in demand would cause a sharp reduction in revenue. 2 May 2016 Page 2

3 Issuer Outlook - Stable as at 28 April 2016 Earnings The Australian residential property market has performed strongly over the past 5 years and this is reflective in the earnings of land developers. As a result, Peet has provided average Revenue and EBITDA growth of 36% and 26% respectively over the past 3 years. This has been fuelled by demand from both owner-occupiers and investors forcing an upward trend in property prices which in turn created material earnings growth for the group. The underlying driver of this success has been Peet s ability to correctly time projects enabling the group to ride the property cycle accordingly (i.e. selling land lots when the demand is strong and holding off when demand is subdued) while always maintaining a low cost base. The group s most recent results (first half 2016), shows a slight reduction in demand in the weaker states (namely Western Australia and the Northern Territory) resulting in a 12% decrease in lot settlements. This was partially offset by stronger conditions in Victoria demonstrating the strong diversification of the group s portfolio. This resulted in a 26% decrease in revenue to $135 million and 12% decrease in EBITDA to $40 million over the 6-month period. Operating profit increased by 8% to $19 million due to a reduction of the group s finance costs (lower debt levels). Consensus estimates for the 2016 full year are slightly down on 2015 with revenue of $ million and EBITDA of $80-90 million reflecting expectations of demand moderation. Due to the nature of the group s operations, earnings mirror the residential property market and wider economic landscape. However, this is a known fact to Peet and the group continually improves the efficiency of their operations to reduce the cyclical impact on earnings. The group s EBITDA margin has increased by 7% since 2013 and now sits at 29%. This has been a strategic move by management as Peet s once traditional business model focusing on company-owned projects has evolved to incorporate funds management related activities. This relatively new segment generates excess of 60% EBITDA margin (40% higher than company owned projects) and it is no surprise that the group has strategically weighted its $12 billion pipeline towards this type of business (60%). As a result, Peet has been able to substantially lower its cost base while reducing the capital intensity of its operations. At the end of 2011, each dollar of net debt yielded 20 cents of EBITDA while at the end of 2015, for each dollar of net debt Peet was able to produce 47 cents of EBITDA. This reflects strong balance sheet management and clear execution of strategy. From an economic point of view, key indicators are displaying mixed results. Population growth appears to be sustainable and labour markets continue to improve but political uncertainty and further credit tightening by banks should have adverse implications for property markets in the medium term. However, we take comfort in Peet s pro-active management approach to identifying and extracting value from land (which is much more stable) rather than construction and housing as well as the group's minimal exposure to the potentially over-supplied apartment market in Melbourne and Sydney. Given the strong position of Peet s balance sheet, a decline in land prices may even lead to fresh acquisitions at discounted prices. With 48,000 lots in the pipeline, strategically weighted to the east coast states (reducing exposure to a struggling Western Australia) we take comfort Peet s track record of successfully syncing projects with economic trends and changes in the property cycle. Cashflow Due to timing differentials between land acquisition, development and sales there can be pressure on cashflow at certain periods of the property cycle. However, Peet has been able to successfully manage this cyclical influence with operating cash flow turning negative only once in the last 3 years (half year results 2014). Operating cashflow for the half year 2016 remained positive at $14 million but declined by $51 million in the prior corresponding period due to reduced lot settlements. This is expected to improve in the second half of 2016 as more settlements are scheduled. Although free cash flow was partially impacted by this result, a 34% increase in dividends paid was the major contributor to negative free cash flow (-$1.6 million) for the half year ended. However, management have indicated that without any further actions/decisions, Peet would still remain cash positive until the end of Capital Management Due to unexpected turns in the property cycle, strict capital management is imperative to success in land banking. When the market is trending upwards, developers tend to strengthen their balance sheets in expectation that excess capital will provide a safety net when demand softens. This includes investing in riskier areas when the residential property market is growing in sync with the economy and becoming more risk averse when things start to cool off and adjusting the capital mix accordingly. Peet have followed this strategy over the last few years. The mining boom and subsequent surge in the residential property market allowed the group to increase its exposure to Western Australia (54% of pipeline in 2011) resulting in large revenue growth. However, given the current economic landscape the group have adjusted their strategy and allocated capital to more low-risk areas along the east coast of Australia (60% of pipeline in 2016). Instead of continuing to chase growth at the expense of the balance sheet, the group used its strong financial position to considerably reduce its net debt from $291 million in 2011 to $177 million in This has increased slightly to $186 million following the acquisition of Tarneit residential estate in Victoria. As a result, Peet s debt-to-capital ratio has improved significantly declining from 52% in 2011 to 27%. We also take comfort in management actively raising new equity ($51 million in 2015) to manage capital. In turn this has reduced the group s finance costs and interest cover remains strong at 4.0x. To further reiterate Peet s disciplined capital management, the group targets a gearing range of 20-30%. Although gearing has increased from 23% to 31% in the last 12 months, management have indicated this will decline within the target range by the end of the 2016 financial year. For the purposes of this calculation we include land vendor liabilities as debt and a sharp increase in these obligations is the primary reason for the higher gearing ratio. Land vendor liabilities refer to obligated future payments to land vendors for the purchase of properties with deferred payment terms and are unsecured. Following the refinancing of the existing convertible notes, the remaining funds will be used to pay down secured debt. Our calculations suggest that this will leave Peet credit neutral and we expect additional cash will be utilised to reach the group s gearing target range. This will leave sufficient headroom on the covenant level of 50%. Peet s secured debt comprises a $250 million 3-year secured facility with NAB and ANZ which has been drawn down to $186 million at the end of 2015 resulting in secured debt ratio of 13.5% (note land vendor liabilities are excluded as they as unsecured obligations). We expect this to reduce slightly to 11.5% (subject to the market value of inventory adjustments) at financial year end as the excess proceeds of the new note issue will be used to pay down drawn funds. Given the covenant level of 40%, this gives Peet sufficient headroom to explore growth opportunities as they appear. Although dividends increased slightly over the 2015 the group s payout ratio of 50% was maintained. This increase is 2 May 2016 Page 3

4 mitigated by the group s dividend reinvestment plan. This remains deactivated which is a credit negative but can be utilised in the future to further enhance Peet s balance sheet. Outlook Peet s success is attributable to its ability to adapt. Historically a direct land bank investor primarily utilising its own capital, Peet has expanded its revenue base (while lowering its cost base) enabling the group to diversify project risk through differing ownership structures in its funds management and joint venture businesses. These projects allow the group to generate substantial margins with minimal exposure to company capital. Therefore, it is no surprise that Peet will continue to grow its Funds Management division to take advantage of its capital efficient nature. Management have forecasted Funds Management EBITDA to be $55 million for the 2016 financial year (up 94% on 2015) with a maintained EBITDA margin of 65-70%. 12 projects are expected to commence in 2016 (including the group s 12,000 lot Flagstone project in Queensland) and 80% of the Peet s land bank is expected to be in development by the end of 2017 driving sales momentum in coming years. Although we have some concerns regarding the Australian residential property market, Peet have clearly demonstrated their ability to efficiently manage their balance sheet at all stages of the property cycle reflecting the seasoned expertise of management. Given the strength of the group s current balance sheet and pro-active management of its pipeline, we expect Peet to continue this strategy and capitalise on the next residential property market upswing. Next Event: Peet Limited Full Year Results to be published in August May 2016 Page 4

5 Figure 3: Credit Curve (Comparable Securities) 2 Figure 4: Historical Trading Margins of Comparable Securities 1 The balance sheet structure diagram represents a measure of liabilities and captial in order of seniority of the overall cash balance sheet. 2 Pricing as at close of business 28 April 2016 Source: BondAdviser 2 May 2016 Page 5

6 Relative Value Peet Limited is Australia s largest pure-play residential land developer. In terms of size smaller groups include AVJennings (ASX Code: AVJ), Sunland (ASX: SDP) and Villa World (ASX Code: VLW) while the larger participants are Lendlease (ASX: LLC), Stockland (ASX: SGP) and Mirvac (ASX: MGR). Lendlease Corporation is a multinational property and infrastructure group. The group focuses on commercial, residential, retail, retirement and industrial property and has an integrated business model consisting of development, construction and investment management. This includes residential land banking. Stockland is a diversified property group that manages, owns and develops shopping centres, industrial property, residential communities and retirement villages. The majority of the group s earnings is derived from retail and residential real estate assets. In 2015, the group owned 64 residential communities. Mirvac Group creates, owns and manages real estate assets in Australia across office, retail, industrial and residential sectors. The group s development business has exposure to residential projects. AVJennings Limited is a residential property developer that is listed on the Australian Securities Exchange (ASX) and Singapore Exchange (SGX). The group operates in Australia and New Zealand and purely operates in the residential sub-sector of the property market. Sunland Group is primarily involved in the development and sale of land of medium-density residential housing projects but has some interests in high rise apartment projects. The group operates on the east coast of Australia. Villa World Limited is residential property development and construction group that operates on the eastern coast of Australia. The company comprises two business segments, Queensland/NSW and Victoria and offers ready-to-live house packages, townhouses and land. Figure 1: Relative Value Credit Curve as at 22 nd of April % 5.00% Peet 7.50% % 3.00% 2.00% 1.00% Stockland 7.50% 2016 Mirvac 8.00% 2016 Lendlease 6.00% 2020 Stockland 4.50% 2022 Lendlease 5.50% 2018 Mirvac 5.75% Stockland 8.25% 2020 Mirvac 5.50% 2017 Stockland 5.50% % Term (Years) Source: BondAdviser 2 May 2016 Page 6

7 While Peet s smaller competitors offer no debt securities for relative value analysis, we utilise the credit profiles of Mirvac, Stockland and Lendlease to support our thesis. The diverse operations of these larger industry participants are not directly comparable to the pure-play strategy of Peet and the risk premium illustrated by the credit curve reflects this difference. In terms of similar maturities, Lendlease 6.00% 2020 offers the smallest risk premium of 2.70% while Stockland 8.25% 2020 offers the largest risk premium at 3.71%. This risk premium is primarily a function of diversification. Although these companies have interests in land banking, their operations span over many other activities and sub-sectors: Lendlease is a multinational corporation that develops, constructs and manages industrial, residential, residential and retail real estate assets. Mirvac comprises an investment portfolio and development business across office, retail, industrial and residential property. Stockland is Australia s largest diversified property group and is involved in retail centres, business parks, office buildings, residential communities and retirement villages. In comparison, the risk inherent in Peet is more concentrated due to the nature of its projects. However, due to the group s long history of managing projects over many cycles we believe the premium offered compared to its peers is justified per unit of risk. Peet's current ASX-listed senior unsecured convertible bond ($50 million issue) has performed well over its life (with the exception of margin volatility leading up to redemption) providing buy and hold investors a ~65% return over life of the security. Figure 2: Historical Trading Margin for Peet 9.50% Convertible Notes (ASX Code: PPCG) 12.00% 11.00% 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% Source: BondAdviser 2 May 2016 Page 7

8 Lots Research Report Who are the Key Competitors? Table 1: Residential Land Development Industry Market Share Sales ($million) FY15 Market Share Lendlease (ASX Code: LLC) Stockland (ASX Code: SGP) Mirvac (ASX Code: MGR) Peet (ASX: Code PPC) AVJennings (ASX Code: AVJ) Sunland (ASX Code: SDG) Villa World (ASX Code: VLW) % 14.1% 12.9% 4.0% 3.6% 3.3% 3.7% Source: Company Reports, BondAdviser Estimates Figure 3: Residential Land Bank Pipeline of Key ASX-listed Competitors Stockland Lend Lease Peet Mirvac AVJennings Sunland Villa World Source: Company Reports Banks are the primary provider of funding to land bankers and generally enforce gearing limits in the range of 45% 50%. Peet expect gearing to drop back into its 20% - 30% target range and towards the industry average of 23%. (Note: Peet Limited gearing for the 2015 Financial Year was 23.8% showing that this reduction is achievable). Table 2: Key Credit Metrics of Competitors (as at December 2015) Interest Coverage (LTM) Gearing (1H16) Peet Limited (PPC) 4.0x 30.6% Lendlease (LLC) 7.7x 12.10% Stockland (SGP) 4.2x 23.1% Mirvac (MGR) 4.5x 28.3% AVJennings (AVJ) 4.9x 24.1% Sunland (SDG) 3.4x 33.6% Villa World (VLW) 5.8x 9.9% Source: BondAdviser, Bloomberg 2 May 2016 Page 8

9 Sep-2011 Nov-2011 Jan-2012 Mar-2012 May-2012 Jul-2012 Sep-2012 Nov-2012 Jan-2013 Mar-2013 May-2013 Jul-2013 Sep-2013 Nov-2013 Jan-2014 Mar-2014 May-2014 Jul-2014 Sep-2014 Nov-2014 Jan-2015 Mar-2015 May-2015 Jul-2015 Sep-2015 Nov-2015 Mar-2000 Sep-2000 Mar-2001 Sep-2001 Mar-2002 Sep-2002 Mar-2003 Sep-2003 Mar-2004 Sep-2004 Mar-2005 Sep-2005 Mar-2006 Sep-2006 Mar-2007 Sep-2007 Mar-2008 Sep-2008 Mar-2009 Sep-2009 Mar-2010 Sep-2010 Mar-2011 Sep-2011 Mar-2012 Sep-2012 Mar-2013 Sep-2013 Mar-2014 Sep-2014 Mar-2015 Sep-2015 Research Report Market Size The residential land development and subdivision industry generated approximately $8.8 billion in revenue for the 2014/15 financial year and is expected to grow by 5.4% p.a. in the 2015/16 financial year (this is expected to moderate to 1.5% p.a. in coming years). Low density residential owner occupiers (Peet s target customer base) accounts for 60% of industry revenue. In the market experienced a slowdown caused by a number of factors including restrictions on first home buyer subsidies. This was followed by a period of significant growth with excess demand driving house prices upwards. As a result, construction activity has increased and we are now in a position where supply is beginning to catch up with demand and hence we expect growth to moderate in coming years. There has been some speculation of oversupply in apartment and unit markets but this is not the focus of our analysis. The primary drivers supporting land development and subdivision, measured by housing starts, will inevitably experience a short-term slow down but continuing trends (i.e. migration and household income) will support it over the medium term. Figure 4: Value of Residential Building Work Done and Commenced ($millions) $18,000 $16,000 $14,000 Value of Residential Building Work Commenced Value of Residential Building Work Done $12,000 $10,000 $8,000 $6,000 Source: Australian Bureau of Statistics Figure 5. Value of Residential Dwelling Stock as multiple of Rolling 12 month GDP Value of Dwelling Stock ($billions) (RHS) Value of Dwelling Stock/Rolling 12 month Real GDP (LHS) Source: Australian Bureau of Statistics 2 May 2016 Page 9

10 Industry Drivers The revenue and profitability of residential developers and land bankers are generally highly correlated to the state of the overall economy. Therefore, the industry is predominantly driven by macroeconomic themes, consumer expectations and government policy/incentives. Understanding how these key drivers influence demand is key to understanding the sector. Figure 6: Peet Limited Total Revenue Vs Total Dwelling Units Approved $200 $180 $160 $140 $120 $100 $80 $60 $40 $20 $0 Peet Limited Revenue ($millions) (LHS) New House Dwellings (millions) (RHS) Source: Australian Bureau of Statistics, Bloomberg Macroeconomic Themes Peet is ultimately a beneficiary of the Australian residential property market and is impacted by macroeconomic trends that are linked to this sector. Population Growth continues to be at historically high levels driven by increased overseas migration. This now accounts for 60% of Australian population growth. On a state level, Western Australia and Queensland are still experiencing a cooling off period post the mining boom and is set to continue given subdued global commodities markets. This has improved housing affordability. On the other hand, New South Wales and Victoria are growing at a constant pace and affordability levels continue to deteriorate. The Australian Bureau of Statistics (ABS) forecasts annual population growth of 1.5%. Economic Growth has moderated from its last peak in 2012 and has remained in the 2-3% range over the last 2 years. However, this is expected to increase as Australia s services sector continues to strengthen (currently 65% of GDP). This growth rate is relatively stronger in comparison to other OECD countries. Labour markets continue to improve. The unemployment rate has gradually declined from its high in 2015 at 6.3% to 5.7% in March This follows the downward trend in unemployment since mid RBA, Government Policy and Regulation Peet is subject to changes to legalisation (potential tax reform), monetary policy and bank regulation. There is uncertainty regarding this year s budget in May and this will be a major contributor to the direction of the residential property market. This is reflective in current consumer sentiment as many potential buyers and existing residents are taking a more cautious approach. 2 May 2016 Page 10

11 Index Level Jan-2010 Apr-2010 Jul-2010 Oct-2010 Jan-2011 Apr-2011 Jul-2011 Oct-2011 Jan-2012 Apr-2012 Jul-2012 Oct-2012 Jan-2013 Apr-2013 Jul-2013 Oct-2013 Jan-2014 Apr-2014 Jul-2014 Oct-2014 Jan-2015 Apr-2015 Jul-2015 Oct-2015 Jan-2016 Variable Lending Rate for Housing Loans RBA Cash Rate Research Report In historical terms, interest rates remain low. However, recent regulatory changes (made by APRA) have forced the banks to increase their capital levels which has in turn meant they have passed the cost onto consumers through higher mortgages rates. Further credit tightening may result in a softer residential property market in the medium term. Figure 7: Variable Lending Rate for Housing Loans Vs Cash Rate 8.00% 5.00% 7.50% Variable Mortgage Lending Rate 4.50% 7.00% Cash Rate 4.00% 3.50% 6.50% 3.00% 6.00% 2.50% 5.50% 2.00% 5.00% 1.50% Source: Australian Bureau of Statistics, Reserve Bank of Australia Figure 8: Consumer Sentiment Index Source: Westpac, Melbourne Institute 2 May 2016 Page 11

12 Land Banking Land banking is a relatively simple process. Companies acquire and develop land for future housing communities. Peet predominantly develops land to be built into housing but these projects can also be retirement villages or medium density residential buildings such as units or apartments. Land developers generally either sell land directly to owner-occupiers or partner with third party builders (i.e. Metricon, Simonds Homes) to arrange house and land packages. What makes operating in this sector difficult is timing. Land banking is subject to the sales cycle whereby timing differences between the purchase of land and cash flow generation will test the balance sheet during periods of unfavourable market conditions. As a result, industry success is highly correlated to the health of the overall economy. Therefore, the key to land development is being able to sync the stages of planning, development, marketing and sales to the correct periods of the economic cycle while ensuring the strength of the underlying balance sheet is maintained. In other words, land developers ride the property cycle. Although this will result in some earnings volatility, this allows the developer to prosper in strong markets while surviving in weaker ones. Projects Peet currently owns and manages a diversified pipeline of approximately 48,000 lots valued at around $12 billion. This has been strategically positioned away from struggling states, namely Western Australia and new projects being considered are primarily on the east coast. The group has 2,318 contracts on hand. The group plans its developments based on market conditions and currently expects to have 80% of its land bank in development by the end of The ability to quickly adjust development plans to market conditions is a key feature of the group. The group will able to start pre-selling their projects when the property market enters a phase of growth to capitalise on its strategy. This ensures sustained EBITDA over the medium term. In 2015, Peet embarked on one of their largest projects to date (Flagstone City in Queensland). The project value is estimated at $3.2 billion (25% of the group s current pipeline) and consists of 11,749 lots. First sales for Flagstone are expected to be taken in the current period and the project is expected to run for 30+ years. This project is a joint venture owned equally with MTAA Super. Land lots are expected to sell for between $125,000 and $160,000 which reiterates the group s target low to middle income earning customer base. This price point allows affordability and enables Peet to sell the project primarily to the owner occupier market. On average, Peet bought Flagstone for $7,000 a lot and expects to generate strong margins on the project. Table 3: Flagstone Project Sales Forecast FY16-FY19 Financial Year Lots Revenue: Worst Case Revenue: Best Case $10m $16m 2017 ~180 $22.5m $28.8m $27.5m $38.4m $37.5m $48m+ Source: Company & BondAdviser Estimates 2 May 2016 Page 12

13 Other prominent projects include Aston / Craigieburn in Victoria (1729 of 2479 lots remain available) set for completion in 2024 and Googoing in the ACT (4904 of 6000 lots remain available) set for completion in The latter is a joint venture with Mirvac Group. Business Model Peet Limited follows a staged business model whereby it acquires, manages, develops, markets and finally, sells land estates. The group is involved in the residential sub-sector and has very limited exposure to the medium density apartment market (less than 3.5%). This includes no exposure to the Sydney and Melbourne unit/apartment market. The key to the group s success is acting on growth opportunities subject to timing of favourable market conditions. This has developed into a strong track record. Projects are targeted at low and middle market segments and funded by either external investors equity (syndicated or joint venture projects) or by the group s own capital and credit lines. Peet currently manages 70 projects across three succinct business segments: Funds Management: Primarily involves syndication whereby projects are offered to retail (generally $20-30 million) and/or institutional investors (generally $50 million or more). The project is then managed by Peet who earns underwriting fees, ongoing fees and performance fees. This business segment enables Peet to utilise various land ownership structures. Company-Owned Projects: Direct acquisition of land for residential development purposes. Peet generates profit through the sale of lots. Joint Arrangements: Relates to the development of land on behalf of or co-owned with government, statutory authorities and private landowners. Peet earns predominantly management fees from these arrangements. The growth engine of Peet is its highly capital efficient funds management business. All debt funding is project specific and not guaranteed by Peet Limited or any of its subsidiaries. The group rarely deploys company capital to these types of projects and as a result, the low-cost base of these projects allows Peet to realise a 60% EBITDA margin. Peet s customer base primarily consists of owner-occupiers to ensure its projects do not become vacant lots owned by investors. Generally, the group s customer base consists of 80% owner-occupiers, 15-20% investors and less than 5% foreign buyers. This ensures that the group limits the impact of any changes to legalisation that restrict investor-driven demand in the residential property market while also achieving the goal of building sustainable communities. Following the recent decision of Peet to acquire the remaining shares of CIC Australia Limited in 2015 (now a subsidiary of Peet Limited), the group now has a project in every mainland state. This has allowed the group to diversify its portfolio, reducing its vulnerability to state-specific risks while also capitalising on regional growth opportunities as they appear. As a result, the group has been able to somewhat combat the full impact of the sluggish WA market. Additionally, the group s land bank is spread across its three business segments and reduces the overall inherent risk to Peet through various ownership structures. Traditionally Peet primarily focused on company-owned projects but its evolving business model now allows less capital intensive ownership structures through its Funds Management and Joint Venture divisions. 2 May 2016 Page 13

14 Figure 8: Divisional and Geographical EBITDA Contribution for the Half Year 2016 Source: Company Reports Stress Testing The obvious risk to any Real Estate business is a sharp and protracted period of negative house price growth. Although we do not expect this type of event for the sake of our analysis we assume a scenario whereby house prices drop 15-20% over a 24-month period. The obvious result of this is that land value will decrease. However, it will not decrease at the same rate as housing (i.e. we assume ~12-16% for land values). This is a key consideration for Peet relative to construction companies. This assumption will affect all residential land developers but as one of the lowest cost producers in Australia, Peet is well positioned to handle a correction. For example, the average cost base per lot at Flagstaff is ~$7k compared with a sales value of ~$120k. This provides Peet with the ability to discount sales to maintain volumes (a key risk mitigant of this type of event). Ultimately this will have a negative effect on the tangible asset base but operating cash flow should be sustained. In this scenario operating cash flow should remain relatively stable as a large proportion of cash outflow is discretionary whereas cash inflow is contracted in pre-sales. There is no doubt this scenario would cause short term stress on the balance sheet (including banking covenants) but we remain confident that management has in place sufficient levers to offset this risk. 2 May 2016 Page 14

15 Peet Limited: Financial Summary Peet Limited: Financial Summary Recommendation Summary Subscribe 2 May 2016 Profit or Loss Balance Sheet Revenue from Land Sales ($m) Management/Performance Fees ($m) Other Revenue ($m) Total Revenue ($m) Land & Development Cost ($m) Depreciation & Amortisation ($m) Other Expenses ($m) Total Expenses ($m) Finance Costs ($m) Share of JV Profit ($m) Other ($m) Pre-Tax Profit ($m) Taxation ($m) Non-Controlling Interest ($m) Net Profit ($m) Cash & Liquids ($m) Receivables ($m) Inventories ($m) Equity Acc. Inv ($m) Intangibles ($m) Other ($m) Total Assets ($m) Payables ($m) Current Borrowings ($m) Non-Current Borrowings ($m) Provisions ($m) Other ($m) Total Liabilities ($m) Net Assets ($m) Net Debt ($m) Credit Metrics Credit Metrics Net Leverage (x) Interest Cover (x) Revenue Growth (%) EBITDA Growth (%) EBITDA Margin (%) Covenant Gearing (%) EBITDA Composition Development (%) Funds Management (%) Joint Ventures (%) EBITDA Geography SA (%) NT (%) WA (%) VIC (%) NSW/ACT (%) QLD (%) Cashflow Cash from Operations ($m) Purchase of Land ($m) Finance Costs ($m) Dividends Received ($m) Taxation ($m) Net Operating Cashflow ($m) Payments for PPE ($m) Payments for Intangibles ($m) Payments for Invesments ($m) Other ($m) Net Investing Cashflow ($m) Change in Borrowings ($m) Equity Issuance ($m) Dividends Paid ($m) Other ($m) Net Financing Cashflow ($m) Change in Cash ($m) Free Cashflow ($m) Operational Performance Lot Sales (#) 3, , ,308.0 Lot Settlements (#) 3, , ,091.0 Contracts on Hand by Lots (#) 2, , ,990.0 Contracts on Hand by Value ($m) Total Pipeline ($m) 11, , ,523.0 Source: Company data, BondAdviser estimates. 2 May 2016 Page 15

16 Research Methodology Every research report issued by BondAdviser includes a clear recommendation - Buy, Hold or Sell - on the security. This recommendation framework is designed to help investors navigate different investment opportunities by identifying the market price, yield, term to maturity, liquidity, volatility and risk. The guide below may help you understand our research opinions. For further information on our research approach, you can refer to our RG79 statement by clicking here. Research Opinions key Buy - Over the next 12 months, the analyst expects the security to outperform the current yield due to credit spread tightening or favourable movements in the underlying yield curve. Hold - Over the next 12 months, the analyst expects the security to provide stable returns broadly inline with the current yield but with little credit spread tightening. Sell - Over the next 12 months, the analyst expects the security to underperform the current yield due to credit spread widening or adverse movements in the underlying yield curve. Suspended - The recommendation has been suspended temporarily due to the disclosure of new information or market events that may have a significant impact on our recommendation. This also includes situations where we have been given non-public information and we need to temporarily suspend our coverage in order to comply with applicable regulations and/or internal policies. Not Rated - A security that has not been assigned a formal recommendation. Analyst Jack Pobjoy Credit Research jack.pobjoy@bondadviser.com.au About BondAdviser BondAdviser is an independent research company that specialises in bonds and fixed income securities. We provide investors, advisers, brokers and institutions with research, data, education and tools to help them invest intelligently. 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