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Morningstar | Aveo’s FVE Cut to AUD 2.30 on Risk of Slowing Sales and Development Trajectory

We reduce our fair value estimate for Aveo to AUD 2.30 after making further downward adjustments to our assumptions for the company’s build rate on increased concerns for the domestic residential property market. Long-term low auction clearance rates of about 45% on a national level and even lower in some cities combined with faster than anticipated falls in property prices have driven this revision. Meanwhile, credit growth is falling rapidly as funding is becoming increasingly difficult to obtain. The sharp slowdown in dwelling turnover is negative for residential developers and retirement village operators as the it significantly extends the settlement period, sales rate and hence the rate at which capital can be redeployed. The valuations of retirement operations like Aveo are highly sensitive to the build rate of new retirement units. Consequently, the cut to Aveo’s development rate reduces our fair value estimate by 18% to AUD 2.30. With Aveo trading around AUD 1.85, the stock continues to screen as undervalued.

After cutting our fiscal 2019 build rate assumptions following management guidance in June 2018, we now make further cuts. In June 2018, Aveo cut its build rate for fiscal 2019 from over 500 to 418 units, as we reduced our assumption to 400. Since then, house prices and auction clearance rates have deteriorated further, making it harder for Aveo and peers to sell both new and existing individual living units, or ILUs. We expect continued weakness in the Australian housing market and subsequently cut our forecast for the annual number of new retirement units Aveo develops and sells over the next three years by 25%. We now reduce our fiscal 2019 sales expectations by 100 units to 300 units.

Over the four months to mid-August, Aveo has been selling 22 ILUs per week, roughly 1,100 per year. These sales are the sum of resales of existing units, of roughly 800, with the balance of 300 comprising newly built units. Given around 10% of existing residents depart each year, the resales of 800 units equates to Aveo reselling circa 8% of the existing ILUs, which means the backlog of unsold units is creeping higher. This is evidenced by the occupancy rate falling from 93% to 90% over the 12 months to June 2018. As Aveo sometimes buys back units from outgoing residents, we expect the firm to have a preference to sell these bought-back units rather than further increasing the number of new units it is holding for sale. Until market conditions improve, clearing the backlog of unsold units and raising the occupancy rate towards longer-term average of 95% is expected to weigh on the number of new units Aveo develops and sells each year.

We are forecasting sales of new ILUs to very slowly increase beyond fiscal 2019. The drivers behind this being a fast-growing pool of Australian retirees and increased discounting by Aveo. We have trimmed expected margins for new developments on the assumption Aveo will need to discount ILU prices to secure sales.

The key potential share price catalyst ahead includes a recovery in the rate at which the firm sells new and existing units. After a sharp drop 16 months ago following negative press on the retirement living sector, weekly sales enquiry leads are nearly back to previous levels of about 170. This is positive, but management still needs to lift the conversion rates from around 22 per week to closer to 30 in order to lift the develop rate back to the former level of 500 new units annually.

The other prospective share price catalyst could be from the strategic review that is currently underway by the company’s investment bank, Merrill Lynch. Merrill Lynch’s objective is to close the value gap between Aveo’s share price and the net tangible assets, or NTA, per Aveo share of AUD 3.92. We don’t see actions by the bankers closing the gap with NTA as we believe the assumption underpinning valuation of the retirement assets are unrealistic, premised on medium-term price appreciation of 3.5%-4.0% and long-term price growth of 3.5%-4.25%. It would appear all options are on the table but the focus appears to be on the introduction of potential capital partners into the retirement business. It is still early days, however, but we expect an update on this and the firm’s sales progress at Aveo’s annual general meeting on Wednesday, Nov. 14.