EUR 850.00 For Business Accounts Only

Morningstar | Transferring Coverage of No-Moat Aveo Group; AUD 2.10 FVE Unchanged. See Updated Analyst Note from 24 May 2019

We reiterate our AUD 2.10 fair value estimate for retirement operator Aveo Group following transfer of coverage to a new analyst. Our no-moat, medium fair value uncertainty, and Standard stewardship ratings are retained. Negative media attention since June 2017 and near-term earnings risk centred on slower unit sale rates have weighed on sentiment, but the firm’s escalation in development activity could provide some upside earnings potential. The shares currently screen as fairly valued, trading around 10% higher than a month ago.

Aveo’s income is sourced predominantly from its established business segment, which derives deferred management fees and shares in capital gains when retirement units are resold. The firm also has a retirement development pipeline, involving the redevelopment and greenfield development of independent-living units. We expect established business to account for more than 80% of earnings over the next five years, owing to Australia’s ageing demographic. Development profits are likely to remain a smaller income driver unless we see a material improvement in domestic housing conditions.

Aveo’s earnings are likely to remain lumpy over the immediate future, but we do see possible earnings catalysts ahead. Negative press focused on legacy resident freehold contracts in villages acquired in 2016 tarnished its reputation. We expect another 12-18 months for Aveo to restore its reputation. Regardless, this has no bearing on Aveo’s main business, where the majority of residents stay under leasehold contracts. On the other hand, a softer housing market has seen Aveo cut its build rate for fiscal 2019 from over 500 to 418 units just as occupancy levels fell from 92% to 87% over the 12 months to December 2018. Aveo is tackling this by increasing buying protection on its leasehold contracts, which, coupled with guaranteed buyback and simplified terms, should allay residual concerns of prospective buyers.

We forecast around 300 unit sales in fiscal 2019 before increasing by 2% per annum. Long-term industry drivers are positive, with the firm well positioned to benefit from the ageing population that drives demand for retirement living units and serviced apartments.

We like the firm’s high-growth strategy of upgrading legacy units and adding to resident amenities. The firm estimates it can deliver at least AUD 0.70 per share of value accretion to the portfolio from these higher-margin activities over the next three years, but we exclude this blue sky from our valuation unless there is evidence of a material improvement in margins. Redevelopment of units is currently a small part of the business, and there is more uncertainty around the value that may come. Until housing market conditions improve, our long-term average assumption on development margins sits intact around 21% (versus a three-year historical average of 24%). In the meantime, we expect the upside from redevelopments to be offset by the discounting of retirement units (to clear the backlog of unsold units), which will weigh on operating margins.

At this stage, we have not factored in a housing market improvement in our forecasts. We note that there may be upside to the housing market with the recent federal election result, the Australian Prudential Regulation Authority's loosening of the borrowing stress test, and potential for reserve bank rate cuts. The coalition government policy generally favours house price appreciation.

The current strategic review is important as it could result in the sale of the Aveo business. Aveo originally engaged with its investment banker to close the gap between its share price and net tangible assets of AUD 3.83 per share (versus a share price of AUD 2.10 at time of writing). No further specifics were disclosed apart from there being interest from both domestic and international investors. A number of indicative and nonbinding offers were received in January, with shortlisted parties currently involved in the next stage of due diligence. We think there is no guarantee that a transaction will occur, as the sheer (45%) difference between price and net tangible assets illustrates the uncertainty around long-term cash generation prospects of existing assets and pipeline initiatives.