Echo Investment: Sounds good (BUY - initiation of coverage)

Echo is a pure commercial (office and retail) and residential developer, with a clear focus on Poland. Its portfolio of projects, comprised of a number of offices, mid- to upmarket residential projects and three shopping centres, should secure sound returns over the next three-to-four years, in our view. A large number of the developments are subject to a right of first offer (ROFO) or a forward sale agreement – this helps to secure a timely exit, which enhances the returns. On our estimates, Echo’s projects are generating around 20-40% equity IRRs, substantially above its cost of equity, which we pencil in at around 10%. With its targeted 20-30% net debt to assets, the current projects should generate enough cash flow to allow Echo to pay around EUR 50-60m in dividends annually over our forecast horizon. The sound bottom-up case is enhanced by the top-down, in our view. Growing wages, low interest rates and what appears to be a shortage of mid- and upper-market apartments are boosting the demand for residential. As for commercial, strong investment volumes are beneficial for pricing, as the sound economic backdrop drives demand for office space, and growing wages and consumer confidence at the 2007 levels bode well for retail. We initiate coverage of Echo with a BUY rating, setting our 12M price target (PT) at PLN 6.80/share, offering 39% upside from current levels.
Attractive project portfolio should help to secure strong margins. From land acquisitions, design and permitting to construction, leasing and sales, all is done in-house, without general contractors. This allows Echo to exercise significant control over both the cost and quality of its projects. Historically, even during the post-crisis years, Echo has been achieving a gross profit margin of well over 20% on its developments.
We estimate IRR in excess of 20% across projects, well above the cost of equity of around 10%, on our estimates. This is driven by a high-profitability, capital-light business model and a short holding period.
We see the potential for dividends of around EUR 50-60m annually throughout our forecast horizon, implying a cumulative dividend yield in excess of 30% over the next three years. The sale of the remaining 7% stake in EPP (valued at around PLN 230m, on our estimates) could generate a special dividend, doubling the dividend yield from c.10% to c.20% next year.
We set our 12M PT at PLN 6.80/share, offering 39% upside. We base our valuation range on two valuation tools: SOTP-based DCF model (implying PLN 6.35/share) and a comparative valuation (implying PLN 7.24/share).
Key risks: a weakening of demand (once the cycle turns); margin compression (due to growth in land and labour costs); tightening-induced growth in the cost of capital (exacerbated by the potential expansion of property yields); delays and cost overruns; oversupply; and legal risks.