Lendlease (LLC) is Australia’s global property developer. LLC has significant global reach and specialist expertise in developing large-scale, complex mixed-use urban developments. Many of LLC’s projects have project lives > 7 years, whilst its development pipeline currently exceeds A$120bn.
Restructuring in recent years has refocused LLC onto core property functions of construction, development and investment management. Despite the strategic re-positioning, LLC currently earning less than half its potential, with the Group still perceived by investors as a property behemoth in a conglomerate structure. Further asset sales remain a distinct possibility, including the Residential Communities business (Australia) which we estimate to be worth ~$A1bn.
CEO Tony Lombardo in November 2022 lowered LLC ROE target to 8-10%, which some may argue is insufficient for a global property business with numerous sources of construction and execution risk. The market currently assumes LLC only gets to the bottom end of the target range by 2025. Tony’s short-term performance incentives are based on earnings, not ROE.
To meet LLC’s target ROE lift balance sheet gearing from ~7% to mid-teens by 2024/25. The target dividend payout ratio has been reduced by 10% points to 30-50% (Nov 2022). The re-gearing of the balance sheet creates another uncertainty in terms of recovery in earnings.
LLC trades at PER 9x FY24E and 0.75x book value. Within the S&P/ASX 100 Industrials, only Qantas (QAN) trades on a lower PER multiple. Investors are not pricing in any of the earnings recovery LLC is guiding for FY24E.
We rate LLC a Hold. Clear evidence of earnings improvement is not likely until 2023/24. We resist the urge to have a more constructive view on LLC despite emerging valuation appeal. The macro backdrop of rising interest rates/cost inflation creates a layer of uncertainty around LLC's FY24e targets.
Key catalysts to drive a rerating in the share price include 1) evidence of new project starts; 2) higher rate of development completions; 3) the potential sale of the Residential Communities business; 4) new capital (including third party) onto the investment management platform.
Business Overview
Lendlease is an Australian REIT manager and developer which operates globally. The group operates in three key segments: Development, Investment Management and Construction.
LLC is targeting a group return on equity (ROE) of 8%-10% for FY24E, driven by ~A$8bn of development completions, a normalisation in fee revenue for investment management and continued progression in the construction pipeline.
The key driver of a recovery in earnings growth is the property development business which has a A$117bn pipeline stretching out to FY40+. ~13% of this pipeline is exposed to Australian regional residential developments which are likely to face headwinds into FY23/24. The development pipeline has key major urban projects across global gateway cities like Kuala Lumpur, London, Seattle, San Francisco, and Sydney.
Figure 1: LLC FY23e earnings mix across three divisions
Source: Refinitiv, Sandstone Insights.
Non-core strategic reset
Divestment of non-core assets in recent years has distracted investors from the core property development and investment management business. The Engineering business was sold for $180m in 2019, and Services $310m in 2021 with proceeds going back to the balance sheet.
LLC is exploring the potential selldown of the Residential Communities business. This division develops master-planned housing subdivisions on the suburban fringes. The housing product is very similar to what Mirvac (MGR) and Stockland (SGP) develop.
A 100% selldown of the Communities business could be valued at ~A$1bn, with the likely added benefit of a working capital release. Proceeds from any sale or partial sell-down would likely to be deployed to the balance sheet, to help fund the scale-up of the development business in FY24/25E business.
In addition, there is press speculation that the Construction division becomes the next area of divestment given historically low margins and volatility of earnings. We would be surprised if LLC moves down this path near-term, given the challenges of removing the Construction arm from the Group.
Earnings Split
LLC’s earnings are split between three segments of the business: Development (~40%), Investment Management (40%) and Construction (~20%). Historically, Development and Construction businesses have produced significant earnings volatility (whilst almost consuming large amounts of capital).
The geographic split of the earnings base is Australia (62%), America (21%), Asia (14%) and Europe (3%). Australian exposure is expected to fall as developments in London and Seattle gets underway.
Development earnings historically have been volatile, driven by the completion rate of projects and the profitability of each project. The pandemic period created difficult operating conditions for the development pipeline which compressed the earnings base. The market is forecasting a rapid recovery to pre-pandemic levels by FY25.
Figure 2: LLC earnings are expected to recover strongly from 2024e
Valuation considerations
To the frustration of shareholders, LLC over the last decade has failed to deliver consistency of earnings from Development. Timetable slippage and margin volatility have resulted in Group ROE slipping from early/mid-teens to just 6% in FY22.
The inability of LLC to monetise with any degree of consistency its development pipeline sees the share price trading at the cheapest levels for over a decade on a price-to-book basis.
Figure 3: LLC price to book at a decade low of 0.75x. REIT sector trades at 0.8x book.
Figure 4: LLC EPS has fallen >40% since 2018, dragging the share price down. Earnings improvement is not visible until FY24e.
Figure 5: LLC PER 1 standard deviation below the long-term average at 9x.
Figure 6: LLC PER relative vs industrials index. 1 standard deviation below the long-term average at 0.6x
Peer Comparisons
Investors have struggled to value LLC given the conglomerate structure and historical volatility of earnings.
When looking at global peers across Construction, and domestic peers in Investment Management and Property Development, it's clear that the market is significantly discounting the higher margin and higher multiple divisions of LLC – namely the Investment Management and Property Development.
The case can be made that the market is valuing the entire LLC business on just a construction multiple. This is arguably too harsh, given the qualities of Investment Management and Property Development business.
Figure 7: LLC global valuation comparisons
What could LLC be worth?
We have constructed a valuation scenario, using a Sum of the Parts (SOTP) valuation methodology on LLC which implies a valuation over A$10.50 per share, or >40% upside to the current share price.
LLC has no direct competitor on the ASX to benchmark financial metrics too. We have used global peers for Construction, and domestic peers for Property Construction and Investment Management.
To build in conservatism to the valuation, we have applied several discounts to both the earnings and valuation multiples. These include;
1) lower Development FY1 market consensus EBITDA estimates by 10% (given ongoing cost prices/potential for ongoing weather issues), discount the EV/EBITDA multiple by 30% to account for LLC’s poor track record;
2) 30% discount to Investment Management multiple to account for lack of scale, limited third party capital and lower performance fee leverage vs peers;
3) 20% discount for Construction given poor track record. We also factor in a doubling of the net debt from A$1.5bn to A$3.0bn as LLC needs to deploy additional capital over 2023/24 new projects.
Relaxing these assumptions would imply a valuation over $18.50 per share.
Figure 8: Sandstone Insights Lendlease valuation scenario *
Can development earnings double by Fy25?
This is the pivotal question for investors looking at LLC. Development earnings are dramatically undershooting what they should be. The recovery in Development earnings underpins >80% of markets earnings improvement estimates for LLC into FY25E.
Development earnings should be the largest component of LLC earnings mix, generating A$700-800m pa consistency.
In recent years, a combination of COVID-19, construction delays (weather, supply chain issues) and lack of products to sell, have seen development earnings fall to as low as A$181m in 2022. Key projects to be delayed include, The Exchange (Kuala Lumpur, Malaysia) retail development has been pushed back to FY24. Alongside this, Barangaroo Residential Tower 2 (Sydney, NSW) is pushed back to FY25.
LLC’s medium-term guidance is derived from a A$120bn development pipeline generating ~A$8bn per year of development completions or finished projects. At a 10% margin that generates A$800m of EBITDA, or over 4x more earnings than in 2022.
Figure 9: LLC EBITDA is expected to recover from FY24E.
Figure 10: LLC development earnings are key to any recovery in the share price
The key question is just when do these earnings and cash flows drop?
At the November 2022 investor day, LLC talked down expectations of a quick uplift in development earnings given project delays through 2022, which will impact completions across 2023/24. The market currently has just under A$800m of EBITDA forecast for FY25E.
A Development lead earnings recovery would dramatically change the ROE profile for LLC, with the potential to lift Group ROE from 6% to 8% by 2025E. LLC is targeting Group ROE at 8-11% medium term, which would be dependent on stronger Development margins. The possibility remains for Group ROE to lift above the target range if development margins lift to the upper end of its historical range (11-26%). The market is giving no benefit of LLC achieving ROE greater than 8% by 2026E.
Figure 11: ROE is expected to increase to >8% over 2024-25E
LLC Development Pipeline
LLC’s project pipeline is focused on 15 global cities across master-planned urban developments, offices, luxury apartments, build-to-rent units, and residential land estates. The key project completions needed to deliver this earnings improvement are listed below.
Figure 12: LLC development pipeline to 2026. X4 larger than last three years
The sheer magnitude of the Development pipeline feeds the bull case for investors in LLC. Over the last 3 years, ~A$10bn of projects were started. Looking forward into FY25, almost A$40bn of projects are expected to commence. That provides 5 years of recurring earnings at LLC’s target completion rate of A$8bn per year. In our view, this is likely to be the rerating catalyst for the LLC share price over 2023/24.
Whilst investors have been frustrated at the pace of completions over the last 2-3 years, the delays of the last 2 years imply we should start to see to a material improvement in completions given the higher backlog. FY23E earnings should show material improvement over FY22, whilst FY24E should be approaching >A$750m of earnings.
Complicating the outlook for Development earnings is the margin assumption. Margins have swung around significantly over the last 5 years from low teens to a peak of 25%.
The market is currently assuming margins land in the 11-13% range over FY23-25E. A more bullish assumption requires a leap of faith on; 1) LLC can hold margin given industry-wide cost inflation; 2) development delays have not eaten into margins; and 3) several large ‘big ticket’ projects being delivered on time and on budget.
Investment Management
Investment management historically has had the most consistent earnings base. The investment management platform includes ~A$75bn of FUM and AUM. Group AUM is ~A$30bn and includes commercial asset management as well as residential asset management. Group FUM is ~A$45bn representing the funds from Lendlease’s 6 core wholesale funds. FUM growth has remained strong through the pandemic period growing at a CAGR of ~10.2% since FY18.
The funds' management platform operates in Asia, Australia, Europe, and the US. The segment includes wholesale funds in Retail, Commercial and Industrials. The funds include; 1) Australian Prime Property Fund Retail; 2) Australian Prime Property Fund Commercial; 3) Australia Prime Property Fund Industrial; 4) LLC Sub-regional Retail Fund; 5); LLC International Towers Sydney Trust; and 6) LLC One International Towers Sydney Trust.
Investment management earnings have recovered quickly to pre-COVID levels due to the benefit of (strong) performance fees generated in FY22. Fees are expected to normalise from FY23 onwards as COVID-19 distortions unwind. At the November 2022 Investor Day, LLC downgraded FY23E ROIC to 6-7.5%, below the 6-9% medium-term target.
The potential for opening to additional third-party capital is a positive initiative and should help grow FUM moving forward. The model of establishing relationships with capital partners earlier in the process is very similar to what Charter Hall Group (CHC), Goodman Group (GMG) and HMC Capital (HMC) currently do. This opens the door for additional fee income streams.
Figure 13: LLC Investment Management EBITDA are expected to recover from 2024e
Construction Business
Construction is the smallest division for Lendlease, representing 12% of Group earnings. Construction is focused on social infrastructure, defence, and commercial projects.
The earnings base from the construction segment is notably volatile which makes it difficult for the market to value it. Historically the EBITDA margin has landed between a 1-3% range. Management guided to an FY23 EBITDA margin of 1.5-2.5% due to project overruns and legal disagreements before returning to the 2-3% target range.
The Construction business has a ~A$10.5bn backlog of work. Notable projects include the USFPI Airfield works (US), Frankston Hospital Redeployment (VIC), Sydney Metro Martin Place (NSW), US Privatised Army Lodging (US) and Manchester Town Hall (United Kingdom).
Strategically there remains a question mark on the strategic fit of the Construction business within LLC. Are the financial benefits of owning a construction operation enough to offset the perception of low-margin volatile earnings that Construction earnings streams generate? The market also prescribes a much lower valuation for Construction earnings. In our view, any move to jettison the Construction business is unlikely in the short/medium term. We also suspect it would incredibly difficult and complicated process. The Group continues to see itself as offering vertically integrated property solution to clients.
Balance sheet
Balance sheet gearing is currently ~7% (net debt to total assets), sitting below the Board’s target range of 10-20%. LLC has guided to gearing reaching the midpoint of the target range as further capital is deployed.
We estimate gearing will lift towards ~15-18% through FY23/24E as LLC commits additional capital to both Development and Investment Management. We estimate committed capital will increase by A$3bn taking total capital deployed to A$12bn (split 40% to Development and 60% to Investment Management).
The balance sheet is therefore tighter than it appears. The recent cut to the dividend payout ratio from 40-60% to 30-50%, saves around A$30m p.a., which is a relatively marginal for the Group. Additional flexibility could be sorted via asset sales, Residential Communities or Construction business, although we doubt either business would achieve a sale price of book value at present.
Press speculation in early December flagged the possibility of A$0.5bn to A$1.0bn equity capital raising to provide further balance sheet flexibility. LLC has “categorically denied” the suggestion. The share price has fallen ~20% since the November investor day.
Equity raising remains an outside risk but would require the precursor of a project/asset write-down to occur. Operating cash flow should dramatically improve in FY23 given the absence of restructuring programs relative to FY22.
Risks To Investment View
Upside Risks
1. Strong construction earnings
2. Property values don't fall as far as we are expecting.
3. Faster than anticipated development of key projects
4. Construction margins hold up better than anticipated
5. New large project/masterplan commencements
6. New third-party capital mandates in Investment Management
Downside Risk
1. Softer conditions in the US residential market
2. Larger than expected price falls in property, leading to less demand for property assets (capital partners, lower AUM).
3. Larger than expected Melbourne Metro impairment
4. Difficulty in obtaining further capital to pursue development opportunities
5. Construction margins fall/difficulty in moving projects into the delivery phase
6. Equity capital raising to increase balance flexibility
Investment View
The strategic repositioning of LLC over the last few years has been frustrated by a long list of disruptions, many of them not directly in LLC’s control (COVID-19, weather, supply chains). As a result, LLC is currently underearning by close to half. Return on capital is less than half what it should be.
Rising interest rates through 2022, and the revelation of project slippage at November’s investor day further weighed on the share price. As a result, LLC share price has underperformed the market significantly over the last 3 years, generating a total return -55% vs S&P/ASX 200 +19%.
This leaves LLC trading at PER 9x FY24E and 0.75x book value. LLC is one of the cheapest industrial companies in the S&P/ASX 100. Investors are not pricing in any of the earnings recovery LLC is guiding for FY24E.
We rate LLC a Hold. Clear evidence of earnings improvement is not likely until 2023/24. We resist the urge to have a more constructive view of LLC. The macro backdrop of rising interest rates/cost inflation creates a layer of uncertainty around LLC's FY24e targets.
Key catalysts to drive a rerating in the share price include 1) evidence of new project starts; 2) higher rate of development completions; 3) the potential sale of the Residential Communities business; 4) new capital (including third party) onto the investment management platform.
Figure 14: LLC PER fwd remains elevated, earnings recovery not until FY24e
Figure 15: LLC 1 year forward PER relative to industrials index.
Figure 16: LLC dividend yield remains below market, DPS will grow below eps into FY25e.
Figure 17: ROE is currently half the long-term average.
