Capitaland: Why I am selling

DISCLAIMER: This article does not constitute advice to buy or sell any specific security. You should do your own research and exercise caution when dealing in securities.

I recently purchased shares in Capitaland Limited (SGX: C31) on two occasions: October 2020 and February 2021. Back then, I found Capitaland to be best-in-class, led by capable management, and undervalued by the market. On 22 March 2021, Capitaland announced a proposed restructuring that will separate the property development business (which will then be privatised) and the investment management business (which will continue to be listed). Since then, I have been looking for an opportunity to offload my shares in Capitaland.

Background

I highly doubt that any of you have not heard of Capitaland. It is the largest real estate company in Singapore and one of the largest in Asia. Capitaland was formed by the merger of DBS Land and Pidemco Land in 2000 (source here) following MAS’s new regulations requiring the separation of financial and non-financial activities of Singapore banks (read more here).

Capitaland operates in three main areas of business – property development, fund management, and lodging.

In the property development segment, Capitaland buys land and builds buildings to sell. Well-known properties in Singapore developed by Capitaland include ION Orchard, Raffles City, Funan, The Interlace, d’Leedon, and One Pearl Bank. Apart from Singapore, Capitaland also has a significant property development business in China.

In the fund management segment, also known as real estate investment management, Capitaland manages six real estate investment trusts and numerous real estate private funds. Capitaland makes investment decisions, ensures that the properties well-maintained, and gets tenants for the real estate in exchange for a management fee.

In the lodging segment, Capitaland provides serviced apartment, co-living, and hotel management services under brands including Ascott The Residence, lyf, and Citadines.

Quite recently, when I was on the lookout for quality companies with strong operating results ready to bounce back from the pandemic, Capitaland caught my eye. By analysing operating results (that is, ignoring fair value swings induced by the pandemic), I found Capitaland severely undervalued by the market in October 2020 and bought some shares. I subsequently bought even more shares at a slightly higher price in February 2021 as I believed in the long-term prospects of the company given how well it is run.

Then everything changed when the Fire Nation attacked

On 22 March 2021, Capitaland management announced a proposed major restructuring exercise (‘proposed restructuring’). This will be voted on by shareholders in 3Q2021 and is intended to be completed by 4Q2021. You can read the official announcement here.

Just after the proposed restructuring was announced, Capitaland’s share price jumped to a high of $4.01, before slowly sinking back to $3.66 as of today. (For reference, Capitaland’s shares closed at $3.31 just before the announcement.)

Proposed restructuring

What exactly was proposed? In gist, Capitaland’s three main business units of (i) property development; (ii) fund management; and (iii) lodging will be split up. The property development unit will be privatised and fully owned by CLA Real Estate Holdings (the majority shareholder of Capitaland), while the fund management and lodging units will be re-listed under Capitaland Investment Management (CLIM).

Here is a diagram provided by Capitaland:

You can think of this as CLA Real Estate Holdings privatising Capitaland’s property development business from existing Capitaland shareholders while leaving them with Capitaland’s fund management and lodging business.

For each existing Capitaland share that an investor has, they will receive:

• One CLIM share;
• 0.143 to 0.155 Capitaland Integrated Commercial Trust (CICT) units; and
• $0.951 in cash.

Capitaland’s management has provided some calculations claiming that existing C31 shareholders are getting $4.102 worth of value for each C31 shares, which is 24% higher than the last close before the announcement of $3.31.

I do not quite agree with this calculation of ‘implied consideration’. My main point of contention is the ‘value per share’ of each CLIM share. This has been stated as $2.823 (or $2.715) which is the post-restructured Net Asset Value (NAV) of CLIM. Management argued that post-restructuring, the price-to-NAV ratio, or P/NAV, should rise to levels comparable to other global Real Estate Investment Managers (REIMs). For comparison, management showed that the historical P/NAV of some of the largest REIMs is about 2.6 times, whereas the historical P/NAV of some Asian property developers is about 0.6 times. Currently, Capitaland’s historical P/NAV stands at about 0.8 times.

If investors will really assign CLIM a P/NAV of 2.6 times post-restructuring, why are they not already doing so, given that the majority of Capitaland’s existing assets are already being operated as if operated by a REIM? Let us do some simple calculations. Capitaland’s NAV per share is about $4.30 currently. The announcement stated that one share of CLIM (which will result from one existing Capitaland share) will have NAV of $2.823. Therefore, about 66% of Capitaland’s current book value is being operated as under a REIM. If REIMs in Singapore really get a historical P/NAV of 2.6 times, then Capitaland’s P/NAV should be about 1.92 (66%×2.6 + 34%×0.6). The fact that Capitaland’s current historical P/NAV of about 0.8 (note that this is even after the proposed restructuring was announced leading to a jump in share price) is not even half of 1.92, tells us that investors are unlikely to value CLIM at anywhere near 2.6 times P/NAV post-restructuring.

If we assume that CLIM’s P/NAV will be about the same as Capitaland’s currently, at about 0.8 times, that would value one share of CLIM at about $2.258 (0.8×$2.823). Then, the implied consideration would be $3.537 ($2.258+$0.158+$0.170+$0.951). And this is assuming no drop in CICT share price when all the CICT units are distributed to Capitaland shareholders resulting in greater supply of CICT shares.

Loss of valuable property development business

As mentioned above, we can think of this proposed restructuring as, CLA buying over Capitaland’s property development business from existing Capitaland shareholders for $0.951 in cash and 0.143 to 0.155 CICT units. We will take the mid-point and assume that 0.149 CICT units are eventually paid out to existing Capitaland shareholders. The 200-day moving average of CICT is $2.1211, so the total amount that CLA is paying for Capitaland’s property development business is about $1.267 ($0.951+0.149×$2.1211) per share, giving it a valuation of $8.2B. Is this a fair price? Let us do some analysis.

We can use the information above, extracted from Capitaland’s annual reports, to determine the earnings before interest and taxes (EBIT) of Capitaland’s property development business in 2020 and 2019.

FY2020 development EBIT	$1.510B
FY2019 development EBIT	$1.000B
Average annual EBIT from development business (2019-2020)	$1.255B

What price-to-earnings (P/E) ratio should we assign? Management’s slides for the proposed restructuring gave an average of 9.3 times P/E for Singapore, Hong Kong, and Chinese property developers. To be on the conservative side as well as to account for interest and taxes, let us use just 8 times EBIT. This would give Capitaland’s development business a valuation of $10.04B, significantly more than the $8.2B valuation assigned by this proposed restructuring.

Therefore, I do feel that Capitaland’s existing shareholders will be selling the property development business for less than it is worth. Furthermore, it is known that property development is highly lucrative in land-starved Singapore. Removing the property development from Capitaland just makes it a much less exciting investment opportunity.

Issuance of CICT shares

Another aspect of the proposed restructuring that I do not like is the distribution of shares in Capitaland Integrated Commercial Trust (CICT) (SGX: C38U) as part of the payout to current Capitaland shareholders. If I had wanted to invest in CICT, I would have bought CICT shares. For Capitaland investors who do not want to hold CICT units, they would have to then sell the CICT units distributed to them, incurring an additional layer of transaction cost and market risk, as CICT’s unit price may plunge when many of Capitaland’s shareholders try to sell the CICT units distributed to them.

To make matters worse, for small-time investors like ourselves, the number of CICT units will not be in multiples of 100. I am not a fan of SGX’s minimum lot size rule. I do not understand why they cannot instead require companies to maintain a reasonable share price via share consolidation exercises (e.g. minimum $5 per share) and then allow shares to be traded in any quantity. Why must the stock exchange mandate that trades can only be done in ‘lots’ of 100 units? With the removal of minimum trading price (MTP) in 2016 (which used to be $0.20), the minimum lot size rule seems woefully ineffective for any plausible objective. For example, Advanced Systems (SGX: 5TY) last traded at $0.001. That is 0.1 cents per share. Even with the minimum lot size rule, a trade can be done at $0.10, or ten Singapore cents (which is for 100 shares in Advanced Systems). Why not just require the company to consolidate their shares to a reasonable price like $5, and then allow shares to be traded individually? For comparison, the London Stock Exchange and New York Stock Exchange do not have any minimum lot sizes.

Back to the Capitaland story, Capitaland shareholders will be paid 0.143 to 0.155 CICT units per Capitaland share. This will almost certainly not be in multiples of 100 units as I do not have that many Capitaland shares, so I will incur additional losses trying to sell the remainder (when divided by 100) on the odd lot market.

What I am hoping for

Personally, I find this situation less than ideal. I would much rather have no proposed restructuring and the share price of Capitaland hover around $3.14 (the price at which I last bought Capitaland shares), than for this restructuring to be announced and the share price jump a little bit. This is because as a value investor, we invest in businesses that we believe in and want to hold for a long time to come.

Here are two positive improvements that I am hoping for (but not that hopeful for).

CLA to improve offer

Without the proposed restructuring, I had previously valued Capitaland shares at at least $3.80. At the current share price of $3.66 (albeit post-dividend of $0.09), which indicates what investors think the proposed offer is worth, it is still lower than what I feel is Capitaland’s intrinsic value. I hope that CLA and Capitaland’s managements will recognise investors’ views of this proposed scheme (as evident in the share price) and raise their offer. I will still sell before the scheme is implemented, however, as I do not wish to end up with odd units of CICT.

Shareholders to reject the proposed scheme of arrangement

I would be quite pleased if Capitaland shareholders vote to reject the proposed restructuring. Adhering to a buy-and-hold approach, I do think that Capitaland (as it is now, without restructuring) will give pretty nice returns over the next ten years or so. Unfortunately, I do think that the proposed scheme will almost-surely be approved.

The future

I may consider investing in Capitaland Investment Management (CLIM) in the near future, although I find CLIM a much less compelling investment proposition than Capitaland as a whole. This is because real estate investment management can be done at various scales and does not experience the same depth of economies of scale as property development.

My transactions

These are all the trades that I have done in shares of Capitaland (SGX: C31), as of 9^th May 2021:

• 29 October 2020: BUY at $2.61
• 8 February 2021: BUY at $3.14

As long as it appears that the proposed restructuring will occur, I intend to sell all my Capitaland shares by the end of 3Q2021.