Wednesday 21 January 2015 by Justin McCarthy Company updates

PAYCE update – East Village site visit and share buy-back

This article provides an update on the East Village shopping and commercial centre, including observations from a recent site visit. We also discuss the developments with PAYCE’s proposed share buy-back and possible implications

Key points:

1. The East Village shopping and commercial centre that forms the security for the PAYCE 9.5% fixed rate bonds appears vibrant and well patronised from a recent site visit.

2. On 9 December 2014 PAYCE announced a proposed share buy-back which last week was put on hold at the request of ASIC.

3. With the guarantee from East Village now in place the PAYCE bonds have significantly de-risked and given the solid asset backing, any additional risks from potential changes in ownership structure or disclosure requirements are considered relatively minor.

4. The PAYCE bonds have early call options in December 2016 and December 2017 and we expect PAYCE to be able to refinance at cheaper rates should existing financial conditions continue.

East Village update

East Village, located in Victoria Park, Sydney, was developed by PAYCE and completed in October 2014. PAYCE sold and settled all of the residential units in late 2014 (for circa $130m) and now fully owns the shopping and commercial centre having refinanced all of the remaining project debt with an investment loan (i.e. senior secured bank facility).

PAYCE bondholders will recall that the 9.5% fixed rate bonds are guaranteed by the East Village retail shopping and commercial rental assets (ranking after the senior secured bank facility) thus providing ‘hard asset’ security backing.

The centre was previously valued at $210m and while not disclosed, we believe it would have been re-valued for the investment loan late last year at around $230m, given improvements in property valuations over the past 12 months (FIIG estimate only).

PAYCE has confirmed the refinance was within the terms of the bonds, including that the bonds are now guaranteed by the East Village owner (Joynton North Pty Ltd as trustee for Joynton North Property Trust, which is 100% owned by PAYCE).

Under the terms of the bonds, PAYCE cannot leverage East Village by more than 70% of its value (including the $50m bond issue) until December 2016 and 60% thereafter. Assuming a valuation of $230m, that would limit the senior secured investment loan to $111m until December 2016 and $88m thereafter, providing significant residual value to support the bonds (i.e. $111m bank debt + $50m bonds / $230m value = 70% and $88m bank debt + $50m bonds / $230m value = 60%). This would equate to a senior secured debt loan-to-value ratio (LVR) of 48.3% until December 2016 and 38.3% after that date, assuming the valuation remains constant at $230m.

The bonds have a maturity date of 3 December 2018 but are able to be called early at $102 in December 2016 or $101 in December 2017. Assuming current financial conditions remain steady over the next two years (particularly interest rates and credit margins), PAYCE would likely be able to refinance East Village at a substantially lower cost than the bonds (9.5% coupon) even taking into account the 2% premium payout for early call.

East Village site visit

One of my colleagues in FIIG’s debt capital markets team was last week given a tour of the East Village shopping and commercial centre by PAYCE management and provided the following update:

Most tenants were well prepared and were able to commence their operations shortly after the centre was completed in October 2014, including the key tenants such as Coles, Audi and Virgin Active. The Coles supermarket is one of the largest in Sydney (>4,000sqm) and incorporates the latest Coles format (bakery, café, butcher and deli surrounding the grocery aisles) all to a very high quality. The Audi service centre is similarly impressive with the latest technology enabling fast and efficient car servicing in a pristine environment.

Virgin Active also encompassed the latest Virgin Active format being introduced around the world including yoga, dance, boxing and cycling rooms, swimming pool and spa, as well as the usual gym equipment. Their membership has already reached 3,000 people, well ahead of budget.

The Phoenix yum cha restaurant with seating for over 450 people has reportedly also been trading well while the childcare and medical centres have also commenced operations. Many other shops are also trading including the fruit and vegetable market, Westpac bank branch, Optus shop and cafes.

The only disappointment was the restaurants – evidently many had not got started on their fit-outs before Christmas so elected to delay commencement until the new year. These are expected to open in February / March 2015. Two shops are also vacant but represent a small proportion of the entire centre income (<1%). Reports from locals who use the centre are that in peak times (after 4pm) the place is full of people which is understandable given it’s the only shopping centre with many kilometres and is surrounded by thousands of apartments in close proximity.

Share buy-back

On 9 December 2014 PAYCE announced a proposed share buy-back whereby shareholders are being asked to approve an offer to all shareholders to convert all or some of their ordinary shares to preference shares (plus some cash payments), valuing the ordinary shares at $8.50 (versus a pre-announcement share price of around $4). From a bondholder perspective, their security position is unchanged with one form of equity (ordinary) being replaced by another form (preference equity). However, ASIC has held up the shareholder approval / meeting and forced PAYCE to obtain an independent expert report, presumably to confirm the offer is fair and reasonable. The shareholder meeting was scheduled for 13 January 2015 but has now been postponed to allow time for the independent experts report to be completed. This proposal replaces the previous proposal to swap ordinary equity for subordinated debt that was voted down by bondholders last year.

The proposed offer to shareholders to sell their shares (and take up preference shares) is not expected to be taken up by all shareholders and a full takeover / privatisation is not the intention of the major shareholder and CEO (Brian Boyd) as far as we are aware. PAYCE want to remain listed for the same reason they listed in the first place: banks view them favourably because of the governance and disclosure that comes with ASX listing and this allows them to get better debt funding for their residential projects and investment properties. We understand that many of their approximately 300 shareholders are inactive and unable to be located and consequently are unlikely to take up the offer (if it proceeds).

With the 29.6% ownership held via Lanox Pty Ltd (an associate of Brian Boyd) not participating in the offer, the buy-back is most likely directed at the other major shareholders who have limited ability to sell their shares on market – given the large size of their holdings, small free float and thinly traded market (<$100k traded last year).

The company has been and will continue to be effectively controlled by Brian Boyd and as such no change is expected in this regard. While we do not envisage the company will be privatised, if this does happen there is a risk that PAYCE reduce their disclosure / financial reporting not being compelled to do so.

Conclusion

PAYCE successfully completed their $230m Platinum residential project (also in Victoria Park, Sydney) late last year with all but one of the 322 units settling and has sold their Hurstville development site at a substantial profit. Their other projects in Kirrawee, Ermington, Riverwood and Brisbane are also going generally to plan and at various stages of development and completion. Project completions and sales in the December 2014 half year added $100m to retained earnings and increased net assets to $234m (based on the pro-forma balance sheet provided in their 9 December 2014 ASX announcement regarding the share buy-back).

Consequently, we view PAYCE’s credit standing as being substantially stronger now than when the PAYCE bonds were issued in December 2013 and this is reflected in their current market price.

With the guarantee from East Village now in place the PAYCE bonds have significantly de-risked. Given the solid asset backing, additional risks from changes in ownership structure or disclosure requirements are considered relatively minor.

The PAYCE 9.5% fixed rate bond with a maturity date of 3 December 2018 is indicatively offered at a yield to maturity of 6.52% or a yield of 4.82% if called at first opportunity on 3 December 2016. The PAYCE bonds are available to wholesale and retail clients in minimum parcels from $10,000.

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities. For more information, please call your FIIG representative.

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