Hongkong Land - Expect further re-rating on potential bottoming of Hong Kong office rents

Rental reversion was in line: Hongkong Land (HKL) posted 16% Y/Y growth in core net profit to US$281 million, up 16% Y/Y. The results were 15% below our estimates and were at the mid-range of consensus. Core EPS rose 19% Y/Y to US$0.125. The lower earnings were due to lower-than-expected development earnings originating from MCL Land, while positive rental reversion of 25% Y/Y and 7% H/H in 1H09 was in line with estimates. The board proposed an interim dividend of US$0.06, same as 1H08. HKL’s self appraised NAV (adjusted for deferred tax) was US$5.64/sh, down 5% from end Dec-08 levels (US$5.92/sh).

Office market is getting better: We are more bullish on the office market as rental decline is decelerating and rents beat our expectation, while capital value has recovered from the 1Q09 lows due to substantial cap rate compression. We upgrade our Dec-09 NAV by 38% to US$6.1 based on office and retail cap rates of 4.5% and 5.25%, respectively, and expect rental to stabilize from now though upside is capped by the spaces to be surrendered from upcoming relocations.

Upgrade to OW, Jun-10 PT US$4.6: The stock is trading at 0.7x end Jun-09 P/BV and 35% discount to NAV. This compared to 0.7-0.8x P/BV when office rental was on the rising trend, and 27% long-term mean NAV discount. We expect the stock’s NAV discount to revert to the long-term average as we believe there are clearer signs of office rental bottoming out. We thus set our Jun-10 PT at US$4.6 based on 25% discount to Dec-09/10 NAV, which translates into 0.77x end FY09E P/BV. Given the 16% upside potential, we upgrade the rating of the stock from Neutral to Overweight. Major risks to PT are weaker-than-expected office/retail demand and hence rental rates, delay of economic recovery as well as interest rate risks and hence cap rate fluctuations.

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