Situation overview

Perennial China Retail Trust (PCRT) is a money-losing, value-destroying Chinese real estate company with misleading ‘disclosures’ and horrendous corporate governance. Regardless of what happens to the Chinese macroeconomy, PCRT’s current business will continue to deteriorate and the company’s acquisition plans will benefit corporate insiders at the expense of shareholders. While shares look expensive (>40x P/E) in a ‘best case’ scenario , if the Chinese real-estate bears are proven right then PCRT will likely be one of the first dominos to topple. Debt-funded acquisitions and an unsustainable divided provide catalysts for the thesis to play out. Borrow is available in reasonable size at a current rate of about 3.5%.

Business description and history

PCRT is an externally managed holding company formed in early 2011 for the purpose of acquiring equity in certain real estate projects from Summit Property. The company completed an IPO in Singapore in June 2011. The only current operating assets are 50% of the equity in two unlevered shopping malls in Shenyang, China: the Shenyang Red Star Macalline Furniture Mall (“Red Star”) and the Shenyang Longemont Shopping Mall (“Longemont”).

Red Star is a furniture-focused shopping mall that opened in September 2010. With 182k sq m of net floor space it is “one of the largest furniture malls in the PRC.”  Longemont is adjacent to Red Star and at 209k sq m NLA is slightly larger. Longemont’s largest tenant by rent and floor space is a theme park on the top two levels; however, nearly 50% of the mall’s sales derive from a supermarket in the basement that occupies only 14% of the floor space. This would seem to confirm my research, which suggests that aside from the basement/supermarket, Longemont is lightly trafficked and the theme park is not a major draw. Some have suggested that Red Star/Longemont’s slow foot traffic is due to an availability of more affordable shopping options, despite the malls’ good location.

PCRT also owns (or owns an option to purchase) four “development projects” that are in various stages of construction:

Shenyang Longemont Offices – Two 56-story grade-A office towers located directly above the Longemont Mall. Total leasable area is 177k sq m and opening is scheduled for the end of the year. Fifty percent owned by PCRT.

Foshan Yicui Shijia Shopping Mall – This 47k sq m shopping mall is part of a new suburban development in the city of Foshan. This project will be 100% owned by PCRT and is scheduled to open in Q1 2013.

Chengdu Qingyang Guanghua Shopping Mall – 59k sq m suburban mall that is part of a larger new development. One hundred percent owned by PCRT and scheduled to open in Q2 2013.

Chengdu Longemont Shopping Mall – Part of a large mixed-use development at the Chengdu high-speed rail station. Approximately 185k sq m of net space and 80% owned by PCRT. Both the high-speed rail line and the mall are expected to open in 3Q 2014.

Company disclosures are misleading

There are several places where the company’s disclosures are vague/incomplete/misleading. In the interest of brevity, I’ll limit this discussion to three specific instances:

Operating Metrics – PCRT reports average rent and occupancy at the operating assets quarterly. In the IPO prospectus, the company reported occupancy of 91.6% for the Red Star mall inclusive of “committed” leases and projected 2H2011 rent of RMB 3.85 sq m/day. The prospectus states that “The Trustee-Manager has used rents and turnover rents receivable under the Committed Leases as at 31 December 2010 to forecast and project the Gross Rental Income.” Although occupancy at Red Star fell in the second half of 2011 to as low as 49.1% in 4Q, based on these same “committed leases,” rental rates met or exceeded projections.

As part of its annual segment reporting requirement, PCRT reported that from February 2011 (the day PCRT was founded) to the end of the year, Red Star generated revenue of S$8.22MM (or RMB 42.43 at the average SGD/RMB). With this information, it’s not hard to calculate what the true occupancy was over this period. As shown in figure 1 below, if we assume an average rent of RMB 3.85 sq m/day, this would imply an average occupancy of 19% – much lower than management-provided metrics. When I asked the company about this massive discrepancy, I received an unintelligible answer.

Figure 1: Red Star operating metrics do not match financial statements

Appraisals – I recently purchased wedding bands for me and my wife for about $1,000. After the sale, the jeweler handed me an appraisal for $2,500. This of course is ridiculous, but at least it is a harmless, accepted practice. For PCRT however, this is standard procedure and it’s the common unit holders who are harmed.  

PCRT holds its assets on the books at values derived from “independent appraisals.” These appraisals are done on an “as if complete and fully leased” basis, meaning the appraiser has valued the properties assuming 95% occupancy. Given the performance of PCRT’s operating assets since the IPO, this produces some wacky conclusions – even though 2H2011 profit from the assets (excluding gains resulting from increased appraisal values) was 69% below forecast, valuation increased by 4%. Now according to the appraisals, the malls are worth over 100x trailing earnings as of Q1.

This alone might not be so bad except that the management fee PCRT pays is calculated based on a percentage of appraised value. Accordingly, these inflated appraisals help transfer company cash into the pockets of corporate insiders.

Opening dates – PCRT appears to be fabricating excuses for poor operating performance. The text below is from the International Appraiser blog (internationalappraiser.com) describing a visit to the mall that management claimed was closed at the time.

“One surprising claim, though, was that the slow leasing performance of the Longemont Mall was due to a 3-month delay in the opening of the mall until October due to fire department regulations. My visit occurred in September and was instigated by the news that the mall had opened on July 1st. Furthermore, DBS (one of the IPO underwriters) published a favorable report on PCRT on November 14, 2011, with the title ‘Perennial China Retail Trust – Execution on Track,’ also informing the readers that the mall had opened in July.”

It is impossible to know for sure, but these disclosure issues could explain the CFO’s abrupt departure for a “sabbatical” in June.

Corporate governance is poor and management incentives are not aligned with shareholders

PCRT is externally managed by an entity called Perennial China Retail Trust Management Pte. Ltd (trustee), and the properties are managed by Perennial (China) Retail Management Pte. Ltd. PCRT needs six pages in the prospectus to explain the fee arrangement with these entities – but here are the highlights:

-          Base fee (trustee-manager) – 0.35% of total assets

-          Performance fee (trustee-manager) – 4.5% of net income

-          Trustee fee (trustee-manager) – 0.03% of total assets

-          Acquisition fee (trustee-manager) – 1.35% of transaction amount

-          Divestiture fee (trustee-manager) – 0.5% of transaction amount

-          Development fee  (trustee-manager) – 3.5% of development costs

-          Property management fee (property manager) – 2% of revenue + 2.5% of net income

-          Leasing fee (property manager) – 2 months’ rent for leases on new buildings

Besides being excessive, this structure creates obvious perverse incentives. Management is incentivized to grow assets and earnings regardless of the impact on shareholders. This would help explain the PCRT’s appetite for debt-fueled acquisitions. Via various vehicles, CEO Pua Seck Guan owns 50% of the trustee and 20% of the property manager, despite owning only 42MM units (3.8% of outstanding).

Performance of the operating assets will continue to deteriorate

Without any apparent irony, the first line of the Goldman Sachs Q1 earnings note titled “In line with expectations: Raise TP/earnings on additional earn-out” is “PCRT’s 1Q12 distributable income of S$0.074mn was 99% below guidance.” Keep in mind that this is guidance for an unlevered shopping mall that was made less than a year ago. In the first quarter, PCRT’s share in the two malls managed to earn only S$910k (before management fees of S$908k and G&A of $516k), which is a sharp deceleration from previous quarters.

There is good reason to believe that things will only get worse. The company’s 2011 annual report contains third-party research predicting that shopping center and department store floor space in Shenyang will double over the next four years despite Shenyang already having the highest vacancy rate in China and more retail space than Beijing or Shanghai (source: Prudential Real Estate Investors, The Case for China Retail: Issues and Opportunities, March 2012, p. 20).

The situation does not look any better for the development projects. Chengdu, PCRT’s main expansion market, has the second highest retail vacancy rate behind Shenyang and the annual report predicts retail space in the next 3 years will almost triple from 1.9MM to 5.2MM Sqm. Furthermore, a recent report for Jones Lang LaSalle predicts class A office space in Shenyang will increase 400% through 2014 (Source:China 50, Fifty Real Estate Markets that Matter p. 22).  Of course, it’s entirely possible that some of these planned projects will be canceled or scaled back, but it appears that for at least for the next several years the supply-demand balance will deteriorate further.

Acquisitions will destroy value for shareholders (but benefit insiders)

Conversations with people close to these markets indicate that even if the expansion projects are able to achieve operating performance in line with their markets, returns will be low. Given the supply-demand dynamics in the planned expansion areas and the performance of the current assets, I view achieving market-level performance as something of a “best case” outcome. Regardless of performance or returns to unit holders, expansion will certainly result in increased fees for management since “base fees” are paid as a % of appraised asset values and all debt rests at the corporate level meaning the malls themselves are “unlevered” and as such even if performance is poor management should still collect a “performance fee”. 

Figure 2: Economics of planned acquisitions

Valuation

So let’s say everything goes right for PCRT; the Chinese macroeconomy is stable, the new assets open on time and are filled at market prices/vacancy levels, and the performance of the Shenyang malls does not deteriorate further. As shown in figure 3 below, even in this “best case” scenario, the current stock price would imply a greater than 40x multiple on future earnings.

Figure 3: Best-case future earnings power

How you win

Dividend Cut – PCRT pays a current dividend of S$0.0386/unit. Given the lack of operating cash flow, this payment is funded via an “earn out” whereby a portion of the acquisition price is held in escrow and used to pay dividends if operating cash flow is insufficient. This structure allows PCRT to take on debt to pay dividends while not having to reduce the nominal amount paid to acquire assets (thus increasing management fees). While this earn-out structure will allow the company to maintain the current dividend through 2014, it cannot continue forever. As shown in figure 3 above, even the “best case” scenario earnings post-expansion would support a dividend of only about one-third of the current payment.

Debt Covenants/Refinancing – PCRT is funding its expansion entirely with new short-dated debt. Management estimates that after the current expansion is completed (excluding Chengdu Longemont) the company will have S$325MM in debt. All of the company’s assets are pledged as collateral and minimum interest coverage is 175%. As shown in figure 3 above, even the “best case” scenario interest coverage is only 235%. The current facility expires at the end of 2015, and if the rate on the new facility rises only 150bps to 4.5%, then PCRT would be in violation of the debt covenants. Furthermore, should any of the development projects underperform their market (as the current assets have done), then PCRT could have a difficult time servicing or refinancing its debt.

How you lose

Cost of Carry – Between the “dividend” and cost to borrow, this position has a negative carry of about 10%. If PCRT is somehow able to continue to add debt to pay dividends before the market realizes what’s going on, the total return on this position could prove less than compelling even if the thesis eventually plays out. However, given PCRT’s leverage/cash needs, I doubt banks will continue to allow payments to shareholders indefinitely.

Operating Performance – PCRT has underutilized assets with very high operating leverage. Accordingly, if rents or occupancy is significantly higher than expected, the current valuation could be justified. Given the supply-demand dynamics and the company’s history of massive underperformance, I view this as unlikely.

Appendix A: Historical income statement