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Morningstar | Charter Hall's Planned Purchase of Folkestone Overshadows FY18 Result. FVE Increased to AUD 5.80

Growth in narrow-moat-rated Charter Hall Group's fiscal 2018 operating earnings of 5% to AUD 37.7 cents per security, or cps, was in line with guidance and expectations. Charter Hall used the result to announce its proposed AUD 205 million acquisition of listed competitor Folkestone. The acquisition will be funded from existing cash and unused debt facilities. On the assumption the proposal will receive the necessary shareholder support, Charter Hall has guided for fiscal 2019 post-tax earnings to grow by 8% to 10% (equivalent to AUD 40.7 cps to 41.5 cps), but slightly lower growth of 5% to 7% should the Folkestone transaction gain necessary shareholder approvals.

Given the Folkestone board has endorsed the transaction and will vote their shares in favour--barring a superior offer--we've assumed the transaction will gain the necessary support to proceed. Our fiscal 2019 forecasts incorporate a likely performance fee from the Charter Hall Office Trust, or CHOT, of AUD 90 million less tax, adding a further AUD 13.5 cps. All up, we forecast fiscal 2019 earnings of AUD 54.4 cps implying growth towards the bottom of the 8%-10% guidance range. Folkestone's earnings are volatile, with their fiscal 2018 earnings buoyed by AUD 6 million in performance fees and a further AUD 3 million in acquisition fees. We've assumed this fee income falls going forward, but Charter Hall is able to strip out AUD 4 million of ongoing costs post the acquisition, which provides much of the guided accretion. Our fair value estimate increases 3% to AUD 5.80 from AUD 5.60. At current levels, Charter Hall continues to screen as overvalued, currently trading around AUD 6.80.

We think the main reason for the divergence between our valuation of Charter Hall and the share price is the outlook for high margin transaction and performance fees. These have been rising strongly in recent years, but we forecast the growth rate to moderate over the longer term as competition increases in the sector and demand for property assets abates. We see the gradual rise in bond yields as the trigger for a fall in demand for property funds managed by Charter Hall and others.

The Folkestone proposal is being progressed by a scheme implementation agreement, requiring support of 75% of Folkestone's shareholders. The proposal involves 100% cash consideration, with the price of AUD 139 cps, a 25% premium to Folkestone's previous closing price. Based on Folkestone's fiscal 2018 results, the AUD 205 million purchase price represents a 10.2 times EBITDA multiple, a 14.8 times price/earnings multiple, and a 29% premium to Folkestone's net tangible assets. The scheme meeting in anticipated for mid-October.

Details on the proposal are scant until the Scheme Implementation Agreement is released in mid-September. However, at a high level, the merger of the two entities makes strategic sense. Folkestone operates a series of investment vehicles that would benefit by leveraging Charter Hall's considerable distribution capabilities. There is also considerable overlap in operational parts of the business, so a merger will remove cost duplication in areas of listing fees, board and executive costs (of AUD 3 to 4 million) plus saving in core functions for finance, technology, occupancy, and governance.