D.M. WENCESLAO AND ASSOCIATES INCORPORATED INITIAL PUBLIC OFFERING

On June 11, 2018, some troubling news was released about D.M. Wenceslao and Associates Incorporated (DMW), a Philippine-based integrated property developer that was embarking on an initial public offering (IPO). DMW's IPO price had been reduced to ?12.00,¹ after initially being promoted at up to ?22.90.² The company cited market conditions as the reason behind the reduction, as the Philippine Stock Exchange Index (PSEi) had registered a year-to-date drop of 9.6 per cent as of the previous trading day.³ The offer period was set to run from June 18-22, 2018, while the listing was due to take place on June 29, 2018.⁴ Jake Veluz, a

portfolio manager at the Trust and Investments Group of BDO Unibank, Inc. (BDO), pondered whether he should buy DMW shares on behalf of the fund he managed. He needed to prepare an internal memorandum detailing the merits, risks, and fair value estimate associated with the company's stock.

There appeared to be mixed opinions regarding the offering, with some brokers announcing valuations of over ?20. However, Veluz knew that there were concerns about the overall stock market performance, with the PSEi having declined to 7,740.74 on the previous trading day after hitting an all-time high of 9,058 (see

Exhibit 1) on January 20, 2018.⁵ This was the first IPO of 2018 for the Philippine Stock Exchange (PSE). When speaking to the Philippine press in May 2018, the president of the PSE, Ramon Monzon, commented that the PSE's target was eight IPOs in 2018, double the number seen in 2017, although, "unfortunately up

to May, there's still zero."⁶

As Veluz studied the prospectus provided by DMW, he wondered about the valuation and the prospects of the IPO. He needed to come up with a recommendation before the offer period ended.

PORTFOLIO MANAGEMENT AT THE TRUST AND INVESTMENTS GROUP OF BDO

With over ?1,032 billion in assets under its management, BDO was one of the largest fund management providers in the Philippines.⁷ BDO assisted clients in achieving their financial goals by creating, managing, and maintaining a portfolio tailored to their needs. BDO's clients included high-net-worth individuals, pension trusts, retirement funds, and endowments.

Veluz was considering an investment in DMW as part of a small pooled portfolio of institutional clients with P10 billion under management. The goal of this fund was to provide consistent capital growth in order to meet the research and expenditure needs of the client institutions.

For these specific clients, BDO was managing a large capitalization equity fund benchmarked against the PSEi. The PSEi was a fixed basket of 30 common stocks carefully selected to represent the general movement of the stock market.9 Out of more than 260 stocks listed on the PSE, the PSEi constituents had the largest market capitalization, were subject to a minimum free-float market capitalization of 12 per cent, and exhibited consistently high daily trading activity. The market capitalization of the PSEi constituents ranged from P70 billion to P765 billion.'

Aside from the PSEi, the PSE published the volumes and values of six sectoral indices, which were then used by BDO as portfolio allocation benchmarks As of April 2018, there were 2 dominant sectors? namely, holding firms, which had a value weight of 37.4 per cent, and financials, which had a value weight of 27.8 per cent. The remainder of the PSE sectors were industrial, property, services, and mining and oil, which had value weights of 18.7 per cent, 8.2 per cent, 6.5 per cent, and 1.3 per cent, respectively.11

At BDO, a "neutral" sector allocation was considered to be in line with the PSE sector index weight, while "overweight" implied a heavier allocation and "underweight" a lighter allocation. Based on BDO' s reading of the market prospects in 2018 and beyond, as well as on the existing sector weights, Veluz aimed to be overweight in relation to property, banks, and conglomerates; underweight in relation to industrial and mining; and neutral in relation to the services sector. The property sector was assigned a 10 per cent tilt, or a total allocation of 9 per cent, which was calculated as 8.2 per cent multiplied by 110 per cent (or 100 per cent plus a 10 per cent tilt). In addition, the portfolio investment guidelines allowed for an allocation of up to 10 per cent to non-index stocks, under which a DMW investment bet would also fall.

THE PSE

The PSE was the only stock exchange in the Philippines. It was one of the oldest stock exchanges in Asia, having been in continuous operation since its initial establishment as the Manila Stock Exchange in 1927. In 2001, one year after the enactment of the Securities Regulations Code, the PSE transformed from a non-

stock, non-profit, member-governed organization into a shareholder-based, revenue-earning corporation headed by a president and a 15-seat board of directors.12

In May 2018, with more than 260 listed stocks, the total market capitalization of the PSE stood at P16.41 billion.13 The investment magazine Alpha Southeast Asia had named the PSE the best stock exchange in four out of the last five years leading up to the end of 2017.14

THE PHILIPPINE ECONOMY

In terms of its gross domestic product (GDP), the Philippine economy grew at an average rate of 6.3 per cent annually between 2010 and 2017. The GDP growth was primarily driven by manufacturing, trade and real estate, and business activities. In 2017, the Philippine economy was ranked second in Asia with regard to GDP growth, behind Vietnam and ahead of China. The services sector was the main contributor, with an annual growth rate of 9.6 per cent, followed by industry, with a growth rate of 8.2 per cent. Low interest rates also contributed to the growth of the Philippine economy. Additionally, lending rates had decreased, thereby allowing businesses to access capital at very low rates. However, the country reported growth in inflation of 3.4 per cent during the last quarter of 2017, which resulted from an increase in prices and the depreciation of the peso!'

Two significant factors drove the stock market down: inflation and the weaker peso. The 4.4 per cent inflation experienced during the first quarter of 2018 exceeded the central bank's forecast of 2 per cent to 4 per cent. The peso also suffered a 4 per cent decline (relative to the United States dollar [US$]) due to the country's current account shift from surplus to deficit!' Higher inflation occurred due to the passage of the Tax Reform for Acceleration and Inclusion (TRAIN) Act in December 2017, which resulted in price increases in relation to several consumer goods. Meanwhile, the peso weakened due to the increased importation of capital goods, which supported the government's focus on infrastructure development. These initiatives were instituted with the aim of boosting the overall Philippine economy!' Median corporate earnings growth stood at 5.9 per cent, which was lower than that of the previous quarter, due to the higher commodity prices and the weaker peso. Additionally, oil became more expensive as a result of the weaker peso.18 The earnings of both gaming and property companies registered the highest median growth, standing at 53 per cent and 12 per cent, respectively. This occurred due to the rise of Philippine offshore gaming operators (POGOs) and the influx of foreign nationals, mostly from China!'

THE REAL ESTATE INDUSTRY

In 2017, the real estate industry in the Philippines had a gross value of P501.5 billion, with a growth rate of

12 per cent over 2016. The sector had an output-multiplier effect (or impact) of 1.2 times on the rest of the economy. This meant that a P1.00 increase in investment spending in relation to the real estate industry generated P1.20 of additional output into the economy? In December 2017, Colliers International Philippines (Colliers) made a forecast for the real estate market in 2018. Colliers encouraged various companies to take advantage of the opportunities created by the implementation of government policies such as the Comprehensive Tax Reform Package, the relaxation of foreign ownership restrictions in the retail and construction sectors, and amendments made to the existing procurement law and business registration systems. The report also encouraged the infrastructure units of developers to explore operation and maintenance opportunities involving transportation projects both inside and outside of Manila. Colliers further suggested that developers be more innovative, given the proliferation of townships and the expansion of opportunities in alternative markets such as Cebu due to its strategic location and skilled workforce.'

The residential property market in the Philippines continuously performed well due to the country's robust economic growth. The price of property in the Makati Central Business District had risen by around 132 per cent from 2010 to 2018.22 In September 2017, the consultancy firm Knight Frank LLP projected that Manila would record 19.1 per cent growth in prime office rents by 2020. This growth would primarily be driven by the expansion of business process outsourcing (BPO) and POGOs.23 Colliers estimated a strong demand for office space in Metro Manila, accompanied by a vacancy rate of around 7.6 per cent. The retail market in the Philippines exhibited strong fundamentals. It was projected to grow continuously due to the growing population, rising purchasing power, improved employment opportunities, and significant remittances from overseas workers. All these factors were expected to have a positive impact on retail property in the country.²⁴

Major Players

Ayala Land, Inc.

Ayala Land, Inc. (Ayala Land) was one of the major real estate developers in the Philippines. In fact, in 2016, it was the second-largest developer in the country, with revenues of P142.9 billion. The company was involved in land bank management as well as in the building and management of shopping centres, hotels, and resorts. Additionally, the company engaged in the construction of residential buildings, with a particular focus on condominiums and housing projects.25

SM Prime Holdings, Inc.

Founded in 1958, SM Prime Holdings, Inc., was one of the biggest property developers in the Philippines, with revenues of P93.8 million over the 12 months leading up to June 2018. It primarily focused on building and managing shopping malls in the Philippines, China, and the Pacific Islands. Additionally, the company built hotels, resorts, housing and condominium projects, offices, convention centres, and more."

Megaworld Corporation

Megaworld Corporation (Megaworld) was one of the biggest developers in the Philippines in terms of its annual revenues. The company won the Best Developer Award in both 2016 and 2017, and it was also nominated in 25 categories in the 2017 PropertyGuru Philippines Property Awards. The company was in the business of constructing housing projects, condominiums, and commercial buildings, primarily offices. It was reported to be planning to spend over P60 billion on new projects in the coming years, mostly townships and a few office towers.'

Filinvest Land, Inc.

Founded in 1955, Filinvest Land, Inc., was one of the oldest real estate developers in the Philippines. The company developed properties such as residential, leisure, office, and other commercial buildings, as well as townscapes.28 Reporting revenues of P18.7 billion during the 12 months leading up to June 2018, the company operated through real estate and leasing segments. The real estate segment engaged in the acquisition of land; the planning and development of integrated residential communities; and the development and sale of residential lots, housing units, medium-rise residential buildings, farm estates, industrial parks, residential resort projects, private membership clubs, and condominium buildings. The leasing segment was involved in the operation of Festival Supermall, including its management and theater operations, as well as in the leasing of commercial and office spaces in Makati City, Alabang, Muntinlupa City, Pasay City, Cebu City, and Tagaytay City.29

Vista Land & Lifescapes, Inc.

Reporting approximately P35.9 billion in revenues during the 12 months leading up to June 2018, Vista Land & Lifescapes, Inc., a Philippine investment holding company, was involved in the development and sale of residential lots and units as well as residential high-rise condominiums. It also engaged in the development, leasing, and management of shopping malls and commercial centres, as well as in the operation of hotels. Further, it developed, leased, and marketed retail malls. It also developed and operated BPO commercial centres."

THE COMPANY

Profile

DMW was an integrated property developer with an established track record in land reclamation, construction, and real estate development. It possessed, on aggregate, one of the largest landholdings in Metro Manila. Aseana City, DMW's largest landholding within Metro Manila, covered 569,121.2 square metres and was strategically located next to Entertainment City and the Mall of Asia complex in the Manila Bay Area. Aseana City was positioned as the next major mixed-use central business district (CBD) within Metro Manila, comprising recreational and entertainment outlets, commercial and retail developments, prime office space, and residential condominiums. Due to the strategic location of its landholdings, DMW was a direct beneficiary of a number of fast-growing sectors within the Philippines, including BPO, POGOs, gaming, and tourism."

Aseana City was connected to key transport linkages, such as the Ninoy Aquino International Airport (NAIA) Expressway and the Southwest Integrated Bus Terminal Exchange ("SWITex") station. Further, the upcoming Manila Light Rail Transit Line 1 (LRT 1) extension would likely improve urban connectivity and access to Aseana City from major transport hubs and rapidly growing population centres outside of Metro Manila, which would facilitate the further development of Aseana

As one of the country's leading providers of land reclamation, DMW had assisted the Philippine government in reclaiming the land underlying Aseana City. According to the reclamation agreement with the Philippine Reclamation Authority (PRA), DMW and its controlling shareholder, Wendel Holdings Co., Inc. (WHI), obtained title to a portion of the total reclaimed lands (2,040,000 square metres) amounting to approximately 1,074,714 square metres, including DMW's existing landholdings in Aseana City (569,121.2 square metres) (see Exhibit 2).33

As the owner of substantial landholdings prior to the escalation of land prices in Metro Manila, DMW's land costs were relatively low when compared with the current market prices, which had appreciated substantially since the time it reclaimed the land (1993-2008). Out of DMW' s landholdings in Aseana City (569,121.2 square metres), 327,034.5 square metres of land reserves remained and were available for development (see Exhibit 2). This differentiated the company from other property developers, which had to rely on locating and acquiring suitable land at significantly higher costs for their developments. This meant that DMW had a premium margin advantage over its competitors."

DMW had a strong track record with regard to completing infrastructure projects. Indeed, as of December 31, 2017, the company had completed more than 100 construction and infrastructure projects throughout the Philippines, including ports, bridges, and expressways. It offered a full range of construction-related services, including surveying and planning, condition works, engineering, and architectural and project management services.35

DMW's real estate business was comprised of land and commercial building leasing, land sales of non-core plots, property development, and residential unit sales. As of December 31, 2017, DMW had seven investment properties, six of which were located in Aseana City, with a total land area of 42,464.6 square metres and a total leasable floor area of approximately 59,000.1 square metres. Its nine forthcoming real estate projects, which would all be completed within the next five years, consisted of three residential developments and six commercial developments, which represented a total gross saleable floor area of approximately 88,315.6 square metres and a total gross leasable floor area of approximately 264,574.6 square metres. Further, DMW's first residential development, Pixel Residences, which was expected to be completed in October 2019, was 100 per cent pre-sold as of June 2017.36

The scope of DMW's offerings in the areas of land reclamation, construction, and real estate enabled it to provide integrated, one-stop solutions to its customers as well as to effectively compete in large-scale and complex projects.'

Recent Financial Performance

For the years ending December 31, 2015, 2016, and 2017, DMW's revenues amounted to P1,641.3 million, P2,180.4 million, and P3,011.2 million, respectively. Its net income had increased from P871.7 million in 2015 to P1,559.8 million in 2017, representing a compound annual growth rate of 34 per cent during that period (see Exhibits 3 and 4).38

DMW's interest-bearing loans amounted to P2.48 billion by the end of 2017, while the company claimed a low borrowing rate of approximately 3.25 per cent. More than 70 per cent of the company's credit facilities remained undrawn. DMW's completed construction projects and real estate developments were funded through a combination of existing cash balances and cash flow from operations.39

Business Strategies

DMW had two major goals. First, the company sought to become a leading property developer with complete capabilities and expertise in real estate, land reclamation, and construction. Second, the company sought to ensure the smooth development of Aseana City, in line with its master concept and planning guidelines, in order to realize the full revenue potential of its business investments.'

DMW planned to implement the following business strategies:

Grow Aseana City into a "next-generation" CBD within Metro Manila

DMW expected more middle-class families, middle-income executives, and BPO and POGO workers to seek out self-contained communities wherein residences, office buildings, facilities, retail outlets, and even schools were located in close proximity to one another to allow for ease of access. The master plan for DMW's Aseana City developments was expected to reflect this trend. 41

Develop a portfolio of high-quality real estate projects

The company planned to continue to develop commercial spaces for the BPO and POGO industries as well as to target the mid- to higher-end consumer market for its residential projects. DMW wanted to continue to capitalize on the proximity of Aseana City to existing retail, gaming, and hotel facilities in nearby developments.' For example, Ayala Land, one of the largest real estate companies in the Philippines, was constructing a flagship mall on a 102-hectare lot leased from DMW.43

Apply a multi-pronged approach to grow its land bank

DMW had the option to pursue strategic acquisitions of land assets from its controlling shareholder, WHL⁴⁴ The company could enter into a joint venture or a long-term lease agreement with its parent company for the use of 14 hectares of land in Aseana City.' The company also considered acquiring land outside of Aseana City in the future.'

Enhance its earnings base, grow recurring income streams, and adhere to prudent financial management

DMW's forthcoming real estate projects were designed to capitalize on the development of Aseana City as well as to increase the recurring revenue stream stemming from the leasing of land and commercial space. The company also planned to grow its construction and reclamation business further. In addition, DMW expected to continue its prudent approach to cost control and the management of its capital and cash position.'

Risks

Highly concentrated holdings in Aseana City

COL Financial Group (COL Financial), one of the leading equity research companies in the Philippines, noted that much of DMW's value stemmed from Aseana City. Although DMW had a land bank of 308,429 square metres in other areas of Metro Manila as well as in other provinces, the development of those sites was not a priority, while the value of the properties was minimal when compared with the value of the land bank in Aseana City. Lower land prices and weaker overall demand in Aseana City would negatively impact DMW, although this was not considered likely to occur in the near future.48

Land reclamation could stifle asset prices

The land reclamation project proposed by a competing company in the nearby cities of Pasay and Paranaque was expected to increase the land supply in the Metro Manila Bay Area. However, the project had not yet received approval from the government. Further, it would take at least seven years for the land reclamation project to be completed.49

DMW was entering the residential property market for the first time

DMW's first residential project, Pixel Residences, was expected to be completed in October 2019, although all the units were pre-sold by June 2017. The company also had three new residential projects in the pipeline, which might not be finished on time or which might not be completely sold."

Government policies regarding loan-to-value ratios and bank exposure to real estate loans

The Bangko Sentral ng Pilipinas (BSP) was closely monitoring banks' loan exposure to the real estate industry, as it did not want a property bubble to hurt the overall national economy. This affected DMW's ability to generate fresh funding from banks to develop new projects further.'

Regulatory and political risks

These risks included the need to acquire various permits from myriad government agencies in order to develop real estate projects, particularly reclamation projects.

Natural disasters

The Philippines was located in the Ring of Fire, and "The Big One," or a major earthquake with at least a

7.2 intensity level, had long been expected.' Aseana City's proximity to a body of water and the fact of it being a reclaimed land project added extra layers of concern.

IPO

IPO Background and Pricing

The Philippine press reported that family-owned DMW had first filed its application for an IPO with the Philippine Securities and Exchange Commission (SEC) in 2015, although it had deferred its plans due to volatile market conditions." From the time DMW first announced its IPO plans until the end of 2017, the PSEi had increased by 17.61 per cent, although it subsequently declined in 2018.54

DMW again filed an IPO application with the SEC in March 2018. It obtained approval in mid-May 2018 at a reported price of up to P22.90. The DMW IPO was intended to raise P15.55 billion, with 679.17 million in newly issued primary shares and an overallotment option of 101.87 million shares.' The overallotment option gave a stabilizing agent, ATR Kim Eng Capital Partners, Inc., the option to purchase up to 101.87 million shares from the controlling shareholder (WHI) to cover overallotments to other shareholders within the first

30 days of the listing date according to the same terms and conditions as the first 679.17 million shares.'

On June 11, 2018, the DMW IPO price was reduced by 47.6 per cent to P12, with the same number of offered shares and the same overallotment option." An analyst report by the Manila-based SB Securities indicated that the reduced price was "fair" and that "it is not justifiable in our view if the issue is priced beyond P14 per share simply because well-established peers are currently trading at bargain levels."'

The total number of outstanding shares in DMW was expected to stand at 3,395,864,100 after the IPO.⁵⁹

Use of Proceeds

With an IPO price of P12, DMW was expected to raise a net amount of P7,599.2 million (from the newly issued primary shares) after deducting the underwriting fees, commissions, and expenses.' Almost half of the IPO proceeds (or P3,731.2 million) would be used for 9 forthcoming projects?namely, the construction of 6 office buildings and 3 residential buildings.' Another P2,880 1 million would be used to obtain land assets by purchasing the 50 per cent of shares it did not already own in a joint venture company that owned

6 hectares of land close to Aseana City." Of the remaining balance, P524.4 million would be used for the development of the infrastructure in Aseana City, including public amenities and underground utilities, while P463.5 million would be used for other general corporate purposes, such as the purchase and repair of construction equipment, and working capita1.63

VALUATION

Discounted Cash Flow and Land Bank

To evaluate the new IPO price of P12 per share and to determine whether there was still a potential upside to the investment, Veluz considered various valuation methods. He decided to use those methods that would be most suited to each business segment based on the business characteristics and the amount of publicly disclosed information. The company's real estate business covered (1) land and commercial building rentals, (2) land sales of non-core plots, and (3) property development and the resulting residential unit sales. Additionally, DMW had construction and land reclamation businesses.

In relation to DMW's existing land and commercial building rentals as well as its construction business, a discounted cash flow (DCF) valuation seemed to be most appropriate, given that the future income tended to be recurring. Veluz wanted to forecast the future cash flows of the rentals and construction business separately and then to discount those cash flows to the present day using DMW's weighted average cost of capital.

With regard to the land sales and property development, he planned to calculate the market value of DMW's remaining land reserves (see Exhibit 2) and then, consistent with the BDO approach to land banks, to assign a discount in order to calculate the intrinsic value of the remaining land reserves. He wondered about the most appropriate treatment for the land intended for use in the nine forthcoming projects as well as the new land to be acquired based on the IPO.

Finally, Veluz planned to add the DCF value of the rentals and construction business to the intrinsic value of the remaining land reserves. Then, he would deduct the net debt and divide by the number of shares (including the new IPO shares) to arrive at the price per share of DMW. This price per share was also referred to as the "net asset value" of DMW.

DCF for Recurring Cash Flows in Leasing and Construction

In terms of the revenue growth of the existing land and commercial building (and other) rental businesses, Veluz considered using the midpoint of the rent escalation provisions in DMW's properties, ranging from

5 per cent to 10 per cent per year. The cost forecasts for the land and building leasing businesses would be estimated based on the 2017 percentage of these cost items in relation to 2017 revenues. Veluz decided to make explicit cash flow forecasts for five years starting from 2018 and then to calculate a terminal value.

With regard to DMW's construction businesses, Veluz decided to use the nominal growth of the construction industry in the Philippines from 2016 to 2017 (amounting to 7.9 per cent), as reported by the Philippine Statistics Authority.64

To simplify his valuation of the cash flows from the existing rentals and construction business, Veluz assumed that the capital expenditures were equal to depreciation. He believed that depreciation, as included within the cost of goods sold, amounted to 7 per cent of revenues. The net working capital was calculated based on the days receivable and days payable from 2017, while the operating cash was assumed to be 40 per cent of the revenues.

Veluz decided to use the capital asset pricing model (CAPM) to determine the weighted average cost of capital for the cash flows of DMW. He gathered comparable competitor information relating to historical beta and leverage ratios (see Exhibit 5) as well as information about government bond rates (see Exhibit 6). He assumed a market risk premium of 7.27 per cent' and a target debt-to-capital structure of 10 per cent. The corporate tax rate in the Philippines was 30 per cent, which was adopted by Veluz for simplicity.

Intrinsic Value of Remaining Land Reserves

As for DMW's land sales and property development business, Veluz considered using Collier's appraised market value of DMW's entire land and property inventory (see Exhibit 7), although doing so seemed to result in an overly large value, which double counted the land used for rental streams. A 2017 study by Colliers showed that the value of the reclaimed land in the Manila Bay Area ranged from P150,000 to P250,000 per square metre.' Veluz decided to apply the midpoint value of P200,000 to the remaining land reserves of DMW. He was aware of the BDO and industry practice of applying a straight price cut or discount to the market value of the land bank in order to come up with an intrinsic value for the remaining land reserves. In the case of DMW, the discount was applied because it was uncertain whether all of DMW's significant and concentrated landholdings could be sold in the future at current prices. Competing land development projects were expected to begin in subsequent years. In addition, DMW's competitors' landholdings were likewise subjected to a discount by stock market and equity analysts. To establish a benchmark for the discount to be applied to the market value of DMW's remaining land reserves, Veluz looked at a specific competitor of DMW, Megaworld. With a market capitalization of P147.1 billion as of May 2018, Megaworld was an integrated real estate developer with core businesses in office space leasing and the development of residences, commercial centres, offices, and hotels. COL Financial had a fair value estimate, which represented a 40 per cent discount on the market price of Megaworld.67

Land Reclamation

There seemed to have been no revenue generated by the reclamation business over the last three years, so Veluz excluded it from his valuation.

Comparable Company Valuation

Finally, to firm up his valuation estimate, Veluz wanted to look at comparable companies to determine the attractiveness of the DMW offering relative to its peers. He gathered data and relevant forward-looking ratios such as the next 12 months total enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA) and the price to earnings multiple on major Philippine players in the property industry (see Exhibit 5). He knew that he needed to estimate the normalized 2018 net income and EBITDA for DMW in order to come up with the appropriate forward-looking ratios.

THE DECISION

Based on the information available to him, Veluz believed that he would be able to make the right decision regarding whether his fund should invest in DMW. He took a tasty sip of coffee and opened his spreadsheet.

Estimate the fair value price of the DMW share using the discounted cash flow and CAPM method.

Determine the market value of the land that has not been allocated.

Compare the fair value price with the IPO price to determine whether or not to buy the stock.