We remain confident Lendlease’s (ASX: LLC) earnings should improve, but we think the balance sheet is one of the concerns that depressed Lendlease’s security price to new depths in calendar 2024.

Lendlease’s 23% gearing, revealed in February, breached its target of 10%-20% gearing, and interest cover worsened to 2.2 times, down from 3.0 times in June 2023. Management declined to disclose the covenant minimum, but 2.2 times would be a low ratio for a property trust, let alone Lendlease’s huge development and construction commitments.

Nevertheless, management’s expectation of gearing near the midpoint of its target by June looks reasonable to us. This is based on expected net cash proceeds of $1.5 billion from settlements at Residences One Sydney Harbour, which is 98% sold, and the sale of its residential communities business.

Execution of these transactions is critical, but the inflows look probable and would be meaningful compared with Lendlease’s $4.4 billion debt. We don’t envisage many settlement defaults at Residences One at Barangaroo, given record house prices, meager rival supply, and the necessarily wealthy purchasers in that building.

Stockland and its capital partner Supalai have contracted to buy Lendlease’s communities business, and we think they have the balance sheet to complete. Stockland appears enthusiastic about the deal, notably highlighting the acquisition at its results presentation in February and discussing it repeatedly.

The communities deal was priced at an approximately 20% premium to its book value, more evidence Lendlease securities’ 15% discount to net tangible assets of $7.39 per security, is too pessimistic. The remaining development inventory of about $1.5 billion is on the balance sheet at cost, but should sell for more than that. Further, much of Lendlease’s value is intangible funds management and development.

We reaffirm our $13.30 fair value for no-moat Lendlease and the securities screen as substantially undervalued as they are currently trading at a discount of 51% to fair value.

Business strategy and outlook

Lendlease is a diversified global property developer, landlord, property manager, fund manager, and builder on a range of development projects, funds, and completed properties around the world. Interests have included include apartments, offices, retail property, aged care facilities, retirement and military accommodation, roads, and rail tunnels.

The group is evolving on numerous fronts: exiting noncore businesses; seeking better returns on capital; accelerating its development pipeline; and advancing projects outside its homebase of Australia.

Lendlease sold its risky engineering business in calendar 2020, though it retained liability for engineering/construction projects with several years to run. Lendlease found a buyer for its engineering services business after two years of marketing, and the price was respectable. Lendlease is also gradually reducing its exposure to retirement living and military housing. Lendlease’s project mix will then predominantly comprise residential and commercial property.

The group’s ongoing business comprises three segments: development, investments, and construction. We don’t expect much growth in construction earnings, that business is primarily to preserve scale and construction expertise in support of Lendlease’s development business. The investments division houses a wide range of businesses including, military housing, property asset management and funds management. We expect the latter two business lines to grow substantially as Lendlease sells stakes in its development projects.

This is a trade-off, relinquishing potential development profits in return for lower risk management fees, performance fees, and capital to accelerate its development pipeline.

Moat rating

Read more about how identifying a company with a moat impacts investment results.

We do not ascribe a moat to Lendlease due to the competitive industries in which it operates. Development accounted for more than half of earnings before interest, taxes, depreciation and amortisation (“EBITDA”) in 2019 and 2020 and we estimate it will grow to more than two thirds of EBITDA over the next decade, based on a large pipeline of work.

We assume attractive margins on this pipeline, but there are risks that are largely outside of Lendlease’s control, including market demand, rival developments, construction costs and potential delays, and political risk.

That said, we think the projects in its pipeline look attractive for Lendlease, and give it some moat-like characteristics. The planning approvals, development contracts and preferred developer agreements Lendlease has with municipalities, landowners, and planning bodies are valuable intangible assets. They allow Lendlease the right to develop a large area, over a long period of time, thereby minimizing nearby competition and the risk of localized property gluts.

In December 2023 Lendlease had an estimated end value in its development pipeline of $103 billion. Of this, about $87 billion are urbanization projects. Most of the targeted development production from 2023 to 2026 already has masterplanning approval, bestowing a high likelihood that the projects will proceed.

There are risks to this, including community opposition to projects, construction cost blowouts, rising interest rates, and myriad others, and we factor these into our estimated development margins. Ultimately the final number and value of assets is unknown even to Lendlease, and development margins are subject to a variety of execution and market risks, precluding us from awarding a moat.

The group benefits from switching costs in its investments business. Wholesale investment vehicles only allow withdrawals at predetermined windows, roughly every five years depending on the fund. This protects clients who want long-term investments alongside similarly minded co-investors, minimizing transaction costs and asset churn in the funds.

Lendlease benefits as it makes it unlikely that large swathes of investors will exit at once, given the staggered nature of redemption windows. Other switching costs include the significant transaction costs and tax consequences of selling property, and the time lag in exiting a fund. Lendlease can apply a waiting period on large redemptions for up to two years in some funds, providing time to liquidate assets, which we think deters impulsive sell decisions. Where possible, Lendlease will replace departing investors with incoming ones, retaining funds and negating the need to sell assets.

By contrast most equity or bond fund managers have no lock-up, with redemptions often processed within 24-48 hours. They also face competition from passive fund managers and ETFs, which do not generally exist in the direct property market. That said, Lendlease is not immune to withdrawals. For example pressure on retail property values from e-commerce prompted substantial redemption requests from clients over the course of 2018/19, exacerbated by covid-19 in 2020.

We expect some clients will ultimately leave, and that Lendlease will likely offer fee discounts for clients that choose to remain. Fortunately Lendlease’s investments business is well diversified, including approximately 20 different funds and mandates, meaning that funds under management has continued to rise despite these challenges.

We don’t see any moaty characteristics in other parts of the investments business such as military housing, retirement accommodation, or property management. Likewise, the construction business has a large number of competitors and razor thin margins that typically vary from 0 – 4%. Lendlease retains its construction business primarily to maintain expertise and scale to support its development business. We expect Lendlease to bid on construction projects in the gateway cities that it wants to maintain a development presence, which include Sydney, Kuala Lumpur, San Francisco, New York, Chicago, London, Milan and others.