ab Global Equity Research Israel Real Estate UBS Investment Research 12-month rating Buy Azrieli Group Prior: Not Rated 12m price target NIS105.00/US$29.12 - Get real in Israel Price NIS85.00/US$23.57 Initiating on Israel’s leading commercial real estate group RIC: AZRG.TA BBG: AZRG IT We initiate coverage on Israeli real estate group Azrieli with a Buy rating and 6 September 2011 NIS105 price target. Azrieli has occupied a strong position in property development and management since it was founded in 1983, offering exposure to Trading data (local/US$) Israeli shopping centres (60% of its portfolio) and office property (38%). The 52-wk range NIS104.70-84.41/US$29.82-23.37 outlook for Israeli commercial property remains bright overall, but we prefer retail Market cap. NIS10.3bn/US$2.86bn to offices as we expect performance here to be less volatile in the longer term. Shares o/s 121m (ORD) Free float 25% Well placed for growth, with a sound financial base Avg. daily volume ('000) 73 We estimate 13% EPS CAGR from 2011, driven by market demand, indexation Avg. daily value (m) NIS6.5 and high development exposure, though re-financing and a shift to higher-yielding assets could drive it as high as 18%, in our view. Azrieli is relatively strong Balance sheet data 12/11E financially. We estimate current NAV gearing is 55%, rising to c70% on Shareholders' equity NIS11.8bn completion of the group’s NIS2.9 billion development programme (one recent mall purchase remains conditional). Prem (discount) to NAV/Share -23.3% Net Cash (debt) (NIS6.60bn) Non-core holdings add volatility and diminish focus Forecast returns Opportunistic acquisitions have led to non-core investments representing c38% of the consolidated balance sheet. The value of these holdings is currently depressed Forecast price appreciation +23.5% and has created an additional source of NAV volatility. Besides facing regulatory Forecast dividend yield 2.5% and other risks, we believe these investments lower the group’s appeal for property Forecast stock return +26.0% specialists. Market return assumption 9.9% Forecast excess return +16.1% Valuation: Initiating with a Buy at a price target of NIS105 Our Buy rating and PT are based on a 12% discount to our 2012 NAV estimate. On EPS (UBS adj, NIS) this basis the prospective EPS yield is 4.1% and the DPS yield is 2%. The latter 12/11E 12/10 measures are relatively low, but we think the group’s earnings growth potential is From To Cons. Actual attractive. The shares currently trade at a 22% discount to our NAV estimate. Q1 - 1.19 - 1.56 Q2 - 0.77 - 0.63 Q3E - 0.98 - 1.13 Highlights (NISm) 12/09 12/10 12/11E 12/12E 12/13E Q4E - 0.99 - 1.59 Net rental income 785 882 980 1,092 1,151 12/11E - 3.93 7.20 EBITDA 925 1,041 1,211 1,251 1,296 12/12E - 4.48 5.26 EPS (UBS adj, NIS) 4.55 4.94 3.93 4.48 4.81 fd NAV/share (UBS, NIS) 93.60 103.08 110.84 119.41 128.72 Performance (NIS) Stock Price (NIS) Rel. TA 100 DPS (UBS, NIS) 0.00 1.98 2.16 2.42 2.60 120 120 Profitability & Valuation 5-yr hist av. 12/10 12/11E 12/12E 12/13E 100 100 DPS yield (UBS) % - 2.2 2.5 2.8 3.1 80 80 Prem/disc to NAV % - -11.5 -23.3 -28.8 -34.0 60 60 CEPS yield (UBS) % - 5.4 4.5 5.1 5.4 40 40 EV/EBITDA x - 15.7 15.3 14.4 14.0 20 20 0 0 PE (UBS) x - 18.5 21.7 19.0 17.7 8 8 9 9 9 9 0 0 0 0 1 1 1 /0 /0 /0 /0 /0 /0 /1 /1 /1 /1 /1 /1 /1 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 0 0 0 1 0 0 0 1 0 0 0 Source: Company accounts, Thomson Reuters, UBS estimates. (UBS) valuations are stated before goodwill, exceptionals and other special items. Stock Price (NIS) (LHS) Rel. TA 100 (RHS) Valuations: based on an average share price that year, (E): based on a share price of NIS85.00 on 05 Sep 2011 07:34 BST Source: UBS www.ubs.com/investmentresearch Ziv Tal Quentin Freeman Darren Shaw Analyst Analyst Analyst [email protected] [email protected] [email protected] +972-99-600 115 +44-20-7568 4414 +972-99 600113 This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 48. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Azrieli Group 6 September 2011 Contents page Ziv Tal Analyst Investment Thesis 3 [email protected] +972-99-600 115 — Israel’s leading property company........................................................................3 Quentin Freeman — The Azrieli family holding .....................................................................................4 Analyst — Strategy ...............................................................................................................5 [email protected] Valuation & price target basis 7 +44-20-7568 4414 Darren Shaw — Real estate business............................................................................................7 Analyst — Non-core businesses ...........................................................................................8 [email protected] +972-99 600113 — Sum-of-the-parts valuation ...................................................................................8 Howard Lesser — Price target ..........................................................................................................8 Analyst — Peer comparisons ................................................................................................9 [email protected] Management 14 +44-20-7568 4415 Revenue estimates 16 Reinhard Cluse Economist — Real estate business..........................................................................................16 [email protected] — Other businesses ...............................................................................................20 +44-20-7568 6722 — Dividend policy...................................................................................................21 Property portfolio 23 — Israel shopping centres ......................................................................................24 — Israel offices.......................................................................................................27 — Foreign investments...........................................................................................29 — Developments....................................................................................................29 Other holdings 31 Debt structure 34 Net asset value 35 Appendix 37 — Israeli property market........................................................................................37 — Rents .................................................................................................................39 Azrieli Group overview 41 Israeli economy 43 — Macroeconomic data and forecasts....................................................................46 We would like thank Naveen Mahajan, an employee of Cognizant group, for his assistance in preparing this research report. Cognizant staff provide research support services to UBS. UBS 2 Azrieli Group 6 September 2011 Investment Thesis Israel’s leading property company We initiate coverage on Israeli real estate group Azrieli with a Buy rating and NIS105 price target. Azrieli is the major listed Israeli property company, occupying a very strong position in shopping centres. Its assets are seeing good tenant demand from a relatively strong Israeli economy and new international entrants. The assets are still valued on relatively high net operating income yields (average 7.9%), which we believe are likely to decline over the next few years, supporting potential asset growth. The group is implementing a significant development programme, potentially representing 25% of the portfolio, of which 45% is retail. All retail projects are due for completion before 2015; the office element has a later completion timetable (2016). Expected cash returns are 12% on retail and 10% on offices. This income represents an important driver of relatively high expected earnings and capital gains growth. We expect consolidated EPS to post 13% CAGR from 2011, driven by demand, indexation and development. Over time, EPS should also benefit from a reduction in interest costs (some debt is at historically high levels), and a shift from low-yielding, non-core and financial (cash) assets into higher-yielding property. We estimate this could raise EPS CAGR to 18%. Acquisitions should also prove accretive. The group is relatively strong financially, with interest cover at 2x and dividend cover 1.8x, on our estimates. We estimate current NAV gearing is 55% (consolidated), rising to 70% proforma on completion of the development programme and assuming no change in values. However, investors should be aware that the Israeli economy is facing some consumer resistance to pricing currently, and that the group has substantial other activities, including offices in Houston, and investments in holding group Granite, Bank Leumi and Leumi Card. Together these represent 44% of group assets. There is also a minority interest controlled by the Azrieli family. Finally, Israel faces a number of well-known geopolitical risks. The shares currently trade at a c22% discount to our NAV estimate, or an implied property yield of c9% (global sector averages are 4% and 6%). We estimate the earnings yield is 4.1% and the dividend yield 1.9% (global sector averages 6% and 5%). Although the shares look expensive