Income and NAV growth in H1

Palace Capital 4 December 2017 Update
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Palace Capital

Income and NAV growth in H1

Interim results

Real estate

4 December 2017

Price

335p

Market cap

£154m

Net debt (£m) as at 30 September 2017

86

Net LTV as at 30 September 2017

41.9%

Shares in issue

45.8m

Free float

94.5%

Code

PCA

Primary exchange

AIM

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(1.5)

(12.5)

(7.1)

Rel (local)

1.0

(11.3)

(15.0)

52-week high/low

387.8p

330.0p

Business description

Palace Capital is an AIM-listed UK property investment company. It is not sector-specific and looks for opportunities where it can enhance the long-term income and capital value through asset management and strategic capital development in locations outside London.

Next events

Payment of interim dividend

29 December

Analysts

Martyn King

+44 (0)20 3077 5745

Andrew Mitchell

+44 (0)20 3681 2500

Palace Capital is a research client of Edison Investment Research Limited

Palace Capital has announced its interim results for the six months ended 30 September 2017. These show good progress in income, earnings, and NAV. The interim dividend had been previously announced, showing growth of 5.6% to 9.5p per share. The significant acquisition of the RT Warren portfolio and accompanying capital increase came after the period under review and is not reflected in the results. Our forecasts reflect the near-term dilution from the acquisition but not the upside from asset management, due to uncertainty as to the timing and impact. Despite that, Palace offers a highly attractive yield and discount to NAV, while the increased market capitalisation and intention to seek a Main Market listing are likely to broaden Palace’s appeal to a wider investor base.

Year end

Net rental income (£m)

Adj. EPRA earnings* (£m)

Adj. EPRA EPS* (p)

EPRA NAV/
share (p)

Price/EPRA NAV/share (x)

DPS
(p)

Yield
(%)

03/16

13.0

4.6

18.9

414

0.81

16.0

4.8

03/17

12.2

5.7

22.2

443

0.76

18.5

5.5

03/18e

14.3

7.0

19.8

395

0.85

19.0

5.7

03/19e

17.9

9.5

20.6

396

0.85

19.5

5.8

Note: *Adjusted EPRA earnings exclude revaluation gains, profits or losses on disposals of investment properties and surrender gains on early lease terminations.

Interim progress; yet to reflect RT Warren

Management remains very positive about prospects for Palace. While occupier and investor demand for commercial property outside of Central London remains good, the company cites progress with some of its strategic assets and the prospective upside from asset management of the recently acquired RT Warren assets. These have increased Palace’s asset base by 35% since end-H118 but the potential is clear in the smaller immediate income uplift of c 26%. Management plans to increase income from the commercial assets acquired and recycle capital from the lower-yielding residential assets into further commercial investment.

Small changes to forecasts

The end-H118 gross rent roll increased to £14.1m (£12.7m at end-FY17), reflecting the £20m Newcastle acquisition on an 8.6% net initial yield, as well as rental growth and leasing initiatives, but was slightly below the level we had forecast. This feeds through into our H218/FY19 rental income forecast and together with an increased cost assumption generates a 0.7% reduction in our adjusted earnings forecast for FY18 and 3.7% in FY19. Our EPRA NAV per share forecasts rise slightly and forecast DPS is unchanged and remains fully covered.

Valuation: Attractively priced with upside potential

With a fully covered prospective yield of 5.7% and a 15% discount to FY18e NAV per share, Palace shares appear to have factored in the near-term dilution from the recent capital increase but not the potential benefits to emerge from the acquisition and increased scale.

Company description

Palace Capital is a property investment company listed on the Alternative Investment Market (AIM) of the London Stock Exchange (LSE) and registered in the UK. It focuses on commercial property, mainly outside London. Its strategy seeks to enhance capital values and provide a sustainable and growing income stream by acquiring assets with potential for rent increases through the reduction of void costs, refurbishment and, in some cases, redevelopment or refurbishment. Most properties are held for long-term rental income, but the company also realises capital value through selective disposals where opportunities arise.

On a spectrum with very low-risk buy-and-hold REITs at one end and speculative developers at the other, Palace is in the middle: it has the flexibility to invest earnings in capital-enhancing asset management projects, unconstrained by the REIT property income distribution requirement (albeit the payout ratio is currently similar to a REIT’s), and is willing to assume some development risk where the potential returns are attractive, but also has a stable core portfolio producing sustainable rental income as well as providing opportunities for capital growth.

The company was given its current form in 2010 when Neil Sinclair (the current CEO) and others acquired an AIM-listed vehicle for the purpose of property investment. The current portfolio has been built by acquisition since late 2011, the most recent being the corporate acquisition of RT Warren, which completed in October and therefore does not have an impact on the interim results but is covered in detail in our last update note. The RT Warren portfolio was valued, on an open market and fair value basis, by Cushman & Wakefield at £71.8m and represents a substantial 35% increase on the £202.8m value of Palace’s pre-acquisition portfolio value as at 30 September. It brings an immediate £3.7m in annual gross rental income, which also represents a significant, but smaller, 26% uplift on the pre-acquisition contracted gross rental income. The smaller contribution to income highlights the opportunity for Palace management to grow the newly acquired commercial rents over time through more active management, while most likely disposing of the residential assets, subject to price. The capital freed up will then be available for recycling into higher-yielding commercial property assets, which remain the company’s focus.

Following the completion of this acquisition, Palace has commenced preparations to apply to join the Official List of the London Stock Exchange, a move that should broaden the appeal of its shares to a wider group of investors.

FY18 interim results

The interim results covering the six months that ended 30 September 2017 show continued growth in income, earnings, and net asset value. But importantly, the results do not reflect the impact of the recent significant RT Warren acquisition and accompanying capital increase. This was covered in detail in our last published note. We have made only small adjustments to our forecasts, increasing NAV per share, slightly reducing forecast earnings but with DPS unchanged and remaining fully covered.

Key features of the interim results were:

IFRS net profit of £4.4m was up 26% on H117 but included £1.4m of revaluation gains, slightly offset by £0.2m of losses on disposal.

Adjusted net earnings, which like EPRA earnings excludes revaluation movements and disposal gains/losses, and deferred tax expense on property revaluation but further adjusts for share-based payment charges, increased 16% on H117 and 11% on H217. Diluted adjusted EPS per share was 12.8p.

As previously announced, the interim dividend is up 5.6% to 9.5p per share and will be paid on 29 December to shareholders on the register as at 8 December. Quarterly dividend payments will commence in April.

The external portfolio revaluation represents a 1.5% gain on a like for like basis and contributed to NAV per share growth of 1.8% compared with end-FY17, to 451p per share on an EPRA basis.

The RT Warren acquisition completed shortly after the period under review, on 9 October, but is in our previously published forecasts.

Exhibit 1: Summary of H118 financials

£000s

H118

H117

FY17

Net rental income

6,463

5,936

12,211

Administrative expenses

(1,487)

(1,369)

(2,915)

Operating profit before gains on investment properties

4,976

4,567

9,296

Gain on revaluation

1,396

32

3,101

Gain/(loss) on disposal

(159)

873

3,191

Operating profit

6,213

5,472

15,588

Net finance expense

(1,354)

(1,562)

(3,011)

PBT

4,859

3,910

12,577

Tax

(507)

(464)

(3,191)

IFRS net profit

4,352

3,446

9,386

Adjusted earnings

3,215

2,779

5,686

Basic IFRS EPS (p)

17.3

13.4

36.6

Diluted EPRA EPS (p)

12.4

10.4

21.2

Diluted adjusted EPS (p)

12.8

10.8

22.1

DPS declared (p)

9.5

9.0

18.5

IFRS NAV per share (p)

442

419

436

EPRA NAV per share (p)

451

419

443

Net LTV

41.9%

39.5%

36.9%

Source: Palace Capital

Financials

Our existing forecasts were made at the completion of the RT Warren acquisition and accompanying capital increase and thus require only modest adjustment now. NAV per share is increased, despite a slight cut in earnings, while the DPS forecast is unchanged and remains fully covered.

Gross rental income was slightly ahead of where we expected it to be in H118 and void costs were lower. However, the period end gross contracted rent roll fell slightly short of our forecast with a knock-on into H218 and FY19. We continue to assume that the remaining c 44,000sq ft of refurbished office space in Manchester, Leeds, and Milton Keynes will be let over the next year, with a positive impact on FY19 rental income. At an assumed £17.25 per sq ft (similar to the recently agreed let on 5,200sq ft of space at the Manchester property (Boulton House), the positive impact on our gross rent roll going into FY19 is c £760k.

Recognising the expanded scale and continuing ambitions of the business, we have also slightly increased our expectations for administrative costs through H218 and FY19.

Our revised forecasts are shown in Exhibit 2.

Exhibit 2: Forecast changes

Net rental income (£m)

Adjusted EPRA EPS (p)

EPRA NAV per share (p)

Dividend per share (p)

Old

New

Change (%)

Old

New

Change (%)

Old

New

Change (%)

Old

New

Change (%)

03/18e

14.4

14.3

-0.7

19.9

19.8

-0.7

392

395

0.8

19.0

19.0

0.0

03/19e

18.3

17.9

-2.2

21.5

20.6

-3.8

394

396

0.6

19.5

19.5

0.0

Source: Edison Investment Research

Valuation

We have noted above that strategically, Palace sits somewhere between the income-focused REITs and the more development-focused companies, giving it flexibility to invest earnings in capital-enhancing asset management projects. While our forecasting has built in c £5m pa of general capex spend we still expect the high payout ratio of the past two years (an average 84%) to continue over the next couple of years.

Hence, although Palace Capital is not a REIT, this current level of payout is at a similar level to the UK REIT sector and the prospective dividend yield of 5.7% is towards the upper end of prospective yields offered by the broad universe of property investment companies and REITs shown in Exhibit 4, below. The 9.5p per share dividend, announced on 30 November 2017, will be paid on 29 December 2017 to shareholders on the register as at 8 December 2017. In combination with the move to quarterly dividend payments from April 2018, we estimate that shareholders entitled to this most recently announced dividend will see dividend payments of 24.125p over the next 12 months (9.5p plus the first three quarterly dividends in respect of FY19, which we estimate at 4.875p each), representing c 7% of the share price.

Exhibit 3: Universe by prospective dividend yield

Source: Bloomberg, Edison Investment Research. Note: Data as at 4 December 2017

But Palace’s strategy is about more than income returns and the company has built a strong track record of value creation since its first major portfolio acquisition, the Sequel portfolio, in October 2013. In the three and a half years to the end of the last financial year (March 2017), it grew NAV per share by 103% and while still increasing dividends per share strongly: from the 4.5p per share declared in respect of the year ending 31 March 2014 to 19.0p declared for the current year.

To capture both income returns and capital returns we show the NAV total return since end-FY14 in Exhibit 3. Including the 4.1% NAV total return generated in the first six months of the current year (8.2% annualised), Palace has generated a 46.8% NAV total return over the entire 3.5 years shown. This represents a compound annual return of 11.6% pa.

Exhibit 4: NAV total return

FY15

FY16

FY17

H118

FY15-H118

Opening EPRA NAVPS (p)

341

388

414

443

341

Closing NAVPS (p)

388

414

443

451

451

Dividend per share paid (p)

8.5

14.0

18.0

9.5

50

NAV total return (p)

54.7

40.8

46.4

18.0

159.9

NAV total return (%)

16.0%

10.5%

11.2%

4.1%

46.8%

Source: Palace Capital, Edison Investment Research

The shares have retreated from a 12-month high of 395p before the announced RT Warren acquisition and capital increase, a downward move of c 10%, somewhat less than the 14% near-term dilution of our FY19 NAV per share forecast prior to the transaction. Our estimates imply that taking account of that near-term dilution, the four-year NAV total return to the end of FY18 will drop to a compound 7.4% pa but that is before taking account of any of the asset management upside that management anticipated from RT Warren. Given the difficulty in credibly forecasting this ahead of events, it is not reflected in our forecasts.

The 15% discount to our forecast end-FY18 NAV per share that Palace now trades on positions it in the lower half of the universe (Exhibit 5).

Exhibit 5: Universe by P/NAV

Source: Bloomberg, Edison Investment Research. Note: Data as at 4 December 2017

We would argue that the current valuation has built in no anticipation of such progress from the newly acquired assets or ongoing portfolio initiatives, particularly the Hudson House development in York. Furthermore, as Palace Capital is now a larger and potentially more liquid company, we would expect the shares to appeal to a wider group of investors especially as Palace makes preparations to apply to join the Official List of the London Stock Exchange.

Exhibit 6: Financial summary

Year end 31 March

£000s

2014

2015

2016

2017

2018e

2019e

IFRS

IFRS

IFRS

IFRS

IFRS

IFRS

PROFIT & LOSS

Rental & other income

 

 

3,252

8,637

14,593

14,266

16,055

18,898

Non-recoverable property costs

(648)

(1,200)

(1,624)

(2,055)

(1,715)

(1,000)

Net rental income

 

 

2,604

7,437

12,969

12,211

14,340

17,898

Administrative expenses

(649)

(1,439)

(2,048)

(2,915)

(3,187)

(3,400)

Operating Profit (before amort. and except).

 

 

1,955

5,998

10,921

9,296

11,153

14,498

Revaluation of investment properties

19,501

9,769

3,620

3,101

2,396

0

Costs of acquisitions/profits on disposals

270

(461)

(525)

3,191

(1,176)

0

Operating Profit

21,725

15,306

14,016

15,588

12,373

14,498

Net Interest expense

(573)

(1,398)

(2,264)

(3,011)

(3,175)

(3,600)

Profit Before Tax

 

 

21,153

13,909

11,752

12,577

9,198

10,898

Taxation

81

107

(953)

(3,191)

(1,158)

(1,635)

Profit After Tax (FRS 3)

21,234

14,015

10,799

9,386

8,040

9,263

EPRA adjustments:

Revaluation of investment properties

(19,501)

(9,769)

(3,620)

(3,101)

(2,396)

0

Costs of acquisitions/profits on disposals

(270)

461

525

(3,191)

1,176

0

Deferred tax charge

0

0

0

2,200

0

0

Debt termination cost

0

0

0

155

0

0

EPRA earnings

1,463

4,707

7,704

5,449

6,820

9,263

Adjusted for:

Surrender premium

0

0

(3,172)

0

0

0

Share-based payments

12

114

110

237

200

200

Adjusted EPRA earnings

1,475

4,821

4,642

5,686

7,020

9,463

Company adjusted PBT

1,394

4,714

5,595

6,677

8,178

11,098

Average fully diluted number of shares outstanding (000s)

5,264.3

17,488.9

24,618.0

25,737.7

35,534.1

45,875.2

Basic EPS - FRS 3 (p)

 

 

403.4

80.1

43.9

36.5

22.6

20.2

Fully diluted normalised (p)

 

 

31.4

28.3

18.9

22.2

19.8

20.6

Fully diluted EPRA EPS (p)

 

 

29.1

26.9

31.3

21.2

19.2

20.2

Dividend per share declared (p)

4.5

13.0

16.0

18.5

19.0

19.5

Dividend cover (x)

6.47

2.07

1.96

1.14

1.01

1.04

BALANCE SHEET

Fixed Assets

 

 

60,086

104,470

175,738

183,959

274,277

279,277

Investment properties

59,440

102,988

174,542

183,916

274,148

279,148

Goodwill

6

6

0

0

0

0

Other non-current assets

640

1,475

1,196

43

129

129

Current Assets

 

 

7,060

15,653

11,903

13,692

24,397

21,563

Debtors

1,937

3,375

3,327

2,511

4,726

5,396

Cash

5,123

12,279

8,576

11,181

19,670

16,167

Current Liabilities

 

 

(4,171)

(3,487)

(9,048)

(8,197)

(10,851)

(12,078)

Creditors

(2,971)

(3,087)

(6,815)

(6,161)

(8,665)

(9,892)

Short term borrowings

(1,200)

(400)

(2,233)

(2,036)

(2,186)

(2,186)

Long Term Liabilities

 

 

(18,599)

(36,620)

(71,778)

(79,895)

(109,217)

(109,517)

Long term borrowings

(17,384)

(35,407)

(69,711)

(75,758)

(105,130)

(105,430)

Deferred tax

0

0

0

(2,187)

(1,588)

(1,588)

Other long term liabilities

(1,215)

(1,214)

(2,067)

(1,950)

(2,499)

(2,499)

Net Assets

 

 

44,376

80,016

106,815

109,559

178,605

179,245

EPRA net assets

 

 

44,370

80,010

106,924

111,759

181,104

181,744

Basic NAV/share (p)

357

396

414

436

390

391

EPRA NAV/share (p)

341

388

414

443

395

396

CASH FLOW

Operating Cash Flow

 

 

1,297

4,388

12,287

10,294

10,123

15,256

Net Interest

(390)

(1,593)

(3,421)

(2,516)

(2,584)

(3,300)

Tax

(13)

(15)

(158)

(1,047)

(762)

(1,635)

Preference share dividends paid

(18)

0

0

0

0

0

Net cash from investing activities

2,532

(2,922)

(50,012)

(3,108)

(73,596)

(5,000)

Ordinary dividends paid

0

(1,766)

(3,221)

(4,617)

(6,744)

(8,824)

Debt drawn/(repaid)

(21,266)

(10,600)

21,272

5,861

14,863

0

Proceeds from shares issued

23,009

19,664

19,114

29

67,550

0

Other cash flow from financing activities

(66)

(2)

(2)

(2,291)

(361)

0

Net Cash Flow

5,085

7,155

(4,141)

2,605

8,489

(3,503)

Opening cash

 

 

39

5,123

12,278

8,576

11,181

19,670

Other items (including cash assumed on acquisition)

0

0

439

0

0

0

Closing cash

 

 

5,123

12,278

8,576

11,181

19,670

16,167

Closing debt

19,509

37,021

74,011

79,744

109,815

110,115

Closing net debt/(cash)

 

 

14,385

24,742

65,435

68,563

90,144

93,947

Net LTV

23.0%

23.3%

37.0%

36.9%

32.4%

33.1%

Source: Palace Capital accounts, Edison Investment Research

Edison is an investment research and advisory company, with offices in North America, Europe, the Middle East and AsiaPac. The heart of Edison is our world-renowned equity research platform and deep multi-sector expertise. At Edison Investment Research, our research is widely read by international investors, advisers and stakeholders. Edison Advisors leverages our core research platform to provide differentiated services including investor relations and strategic consulting. Edison is authorised and regulated by the Financial Conduct Authority. Edison Investment Research (NZ) Limited (Edison NZ) is the New Zealand subsidiary of Edison. Edison NZ is registered on the New Zealand Financial Service Providers Register (FSP number 247505) and is registered to provide wholesale and/or generic financial adviser services only. Edison Investment Research Inc (Edison US) is the US subsidiary of Edison and is regulated by the Securities and Exchange Commission. Edison Investment Research Pty Limited (Edison Aus) [46085869] is the Australian subsidiary of Edison. Edison Germany is a branch entity of Edison Investment Research Limited [4794244]. www.edisongroup.com

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Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

295 Madison Avenue, 18th Floor

10017, New York

US

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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