Between 2010 and 2018 San Francisco has been one of the fastest growing regions of America with an ~36% increase in jobs created, fuelled by the Silicon Valley boom. This compares to ~14% increase in total number of jobs in the US across the same period .
As Tony Montana taught us “first you get the money, then you get the power, then you get the woman (or man)” Which generally requires a place to live. The problem however, as highlighted in the 2hr Google commercial, the Internship, is that Silicon Valley housing is expensive and in short supply leading some employees to secretly live in motor homes behind their workplaces. It is estimated that despite the 750,000 new jobs created within the Bay Area of California (San Jose, San Francisco and Oakland) from 2010 to 2018 only 100,000 new homes had been built.
In June 2019 Google pledged USD1bn to help fix this crisis and one month later announced it had entered an agreement with Lend Lease (LLC) to develop 3 major areas in the San Francisco Bay Area into mixed use communities (San Jose, Sunnyvale and Mountain View). It is our understanding that Google had tendered the 3 district developments as separate contracts and LLC had bid on and won all 3. LLC estimates that it will develop ~1.4 million sqm of residential, retail, hospitality and associated community uses (Google will develop the commercial) with an estimated end development value of USD15bn, AUD20bn. The work would commence as early as 2021 and include at least 15,000 (to 20,000) new homes on Google land over a 10 to 15-year period. It appears the median house price in San Francisco is currently USD1.3m. Based on the contract value and reported details the apartment prices would need to be below that (USD700k-1.0m) but it supports as much as AUD2bn of gross revenue to LLC per annum from this contract alone.
We further note “In recent years, urbanisation development activity has averaged AUD4bn per annum. There is scope for activity to accelerate materially over the medium term given the significant growth in the pipeline”. With the addition of Google, we take this to mean >AUD6bn gross Development revenue per annum. LLC has historically targeted between 15-25% margin on cost for apartment developments. We would expect the Google contract to be at the lower to mid-point of this range (15-20%). Below we assess what the expanded pipeline could mean for future earnings of LLC and how we believe the sell-side is yet to fully factor this in.
Increased Development Pipeline = Increased Development Earnings
Although obviously material it is more than just Google that has elevated LLC’s Development pipeline to ~AUD100bn. Google, combined with other projects, has taken the build to rent pipeline to ~AUD20bn by June 30, 2019, providing significant scope for growth.
Now we need to make several assumptions but if we assume:
- The lifespan of Development projects hasn’t differed too much over the past 5 years, and will remain similar into the future
- As can be seen below in the past 4 years LLC has delivered ~8% gross urbanisation pipeline Revenue per annum (implies 12.5 years run rate)
- The margin profile doesn’t differ too much going forward to history
- As can be seen in our table below however we have assumed 100bpts lower margin to account for increased 3rd party funding of projects
- The market continuing valuing Development consistently to history
- ~AUD17bn of UK projects where LLC is currently preferred convert
- Work secured approximates work completed in FY20 and FY21
- Completions represent a reasonable proxy for gross revenue
- (Commercial) completions don’t equal revenue in a given year however should approximate over the longer term
We see a case on these assumptions for projected Development EBITDA for FY22 onwards (once Google contract kicks in) being as high as AUD1,200m p.a.
Lend Lease Development Division Summary – Historic and projected FY22
Source: Lend Lease Annual Reports and Chester Asset Management
As evidenced below this is considerably higher than that assumed by the sell-side and would lead to a materially higher assessment of value. Most analysts value LLC using a SOTP methodology. We present a survey of these below (but have chosen to keep the analysts surveyed anonymous).
Lend Lease Development Division Summary – Historic and projected FY22
Source: Various unspecified analysts and Chester Asset Management
Obviously, there are several reasons why this may not transpire to be the case including:
- The pipeline having a longer gestation period than the past
- However, the Google contract is reported as “10 to 15 years” which is in line with our 12.5-year assumption
- The Google Contract/ pipeline ramp-up taking longer than 24 months
- Whether it is FY22 or FY23 the point of the analysis doesn’t change; i.e. we have reviewed sell side estimates beyond FY22 (where available) and don’t see a discernible increase in FY23 projections
- The Google announcement comments that development work could start as early as 2021
- Margins being lower than history
- We believe the Google contract is 15-20% on cost vs Management historically targeting 15-25% of cost on projects
- Fixed Development overheads may increase due to increased geographic reach, but we would assume that operating leverage would provide some support to the assumption of 14% on gross revenue
- Analysts changing valuation methodologies i.e. reducing the multiple applied to Development earnings
- This could occur but we would contend that a large part of the uplift in Development earnings comes from this Google contract which is arguably lower risk than other Development contracts
- Our survey misrepresenting consensus
- We have chosen 4 brokers (at random) that cover the stock
- In IRESS we note 7 analysts covering the company
- The other 3 analysts could potentially have higher Development earnings than those included within our sample
- Completions being a poor proxy for Gross revenue
Engineering and Services Issues still linger
In November 2018 management took a provision of AUD500m on 3 projects excluding the likely cost to exit the business (another AUD500m at the mid-point in estimated exit costs). We provide the summarised update on these 3 projects from 30 June below.
- Gateway Upgrade North: Operational Since March 2019
- Kingsford Smith Drive: >85% complete – expected completion CY20
- North Connex M1/M2 Tunnel: >85% completed – expected completion CY20
At the 30 June 2019 LLC had chosen to present the Engineering and Services subsegment of Construction as non-Core. Despite being presented as non-core and the provisions raised LLC has continued to operate the segment as a going concern (as divestment is progressed). This has included commencing new contracts including:
- Melbourne Metro Tunnel Project: <20% complete
- WestConnex 3A M4-M5 Link Tunnels: <20% complete
There remain no guarantees we won’t see further provisions, particularly against these 2 projects so continue to see this as the biggest risk investing in LLC. As evident in the table below, ex the Engineering and Services businesses, Construction earnings have remained relatively steady over the past 5 years.
Construction 5 year historic earnings
Source: Lend Lease Annual reports
Going forward we aren’t projecting any material changes from history.
We note LLC are said to be making good progress on the exit of Engineering and Services. We expect to have some clarity in the December Quarter.
Investments Earnings will also benefit from the Development Pipeline
Funds Under Management has doubled over the past 5 years and with the increase seen in the Development pipeline it is likely that it will double again in the medium term, as LLC take more developments on balance sheet including Residential (apartments) for Rent.
Although not explicitly disclosed how much LLC earns from each of the subsegments we estimate the following amounts in FY2019.
Lend Lease Investments Division Summary – FY19 Chester Estimates
Source: Chester Asset Management and Lend Lease Annual Results Material
Most of the Funds Management business is in Australia (71% year end FY19) where FUM typically has minimal performance fees. We see Investment Management as the key growth driver of the segment with in our minds other subsegments not expected to materially differ from their FY19 levels in the near term. We assume it takes 5 years for the FUM to double again from current levels so by FY22 we expect Investment Management Fees to be ~50% higher than current levels.
Potential for a Re-rate
Although a previous holding of Chester we had chosen to exit in August 2018 at ~AUD20.00/share on valuation and earnings insight grounds. We chose to re-enter the position in August 2019 at ~AUD15.00/share on valuation and earnings insight grounds. Now trading on ~12x consensus FY21 earnings with a 4% dividend and potential material upward analyst revisions in FY22 and beyond we feel the stock could rerate, particularly with the exit of the Engineering and Services business and some guidance by Management on the medium-term earnings trajectory.
LLC Sum of the Parts Valuation Analysis
Source: Chester Asset Management
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 By Metropolitan Transportation Commission
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