Logistics growth amid the pandemic

This note provides a detailed update on our strategic report published in September 2020.

With the majority of Raven’s warehouse space used to support essential sectors such as supermarket chains, all of its warehouse properties continued to operate during FY20 despite a COVID-19 lockdown in the first half of the year. As restrictions were eased, and a second lockdown avoided, the demand for space increased. Following a similar trend to other markets, Russian e-commerce activity saw strong growth, although it remains some way behind and has much further to go. Occupancy increased to 94% (FY19: 90%) and more than 99% of rents were collected. Although the pandemic continues to cloud the general economic outlook, warehouse market demand-supply fundamentals continue to be strong, with low vacancy, a lack of new supply and increased construction costs all indicating the potential for accelerated rental growth.

However, despite the strong operational performance and cash collection in rouble terms, weakness of the rouble continued to weigh on the results as presented in sterling.

To a very large extent, Raven is now a rouble-denominated operating business that reports in sterling and makes shareholder distributions (ordinary and preference share) in sterling at group level. At the level of the rouble-based operating subsidiaries, the main exceptions to this are the residual US dollar-denominated leases (now down to 8% of total warehouse space, but 18% of warehouse net rental income/NOI) and euro-denominated secured debt (40% of total secured debt), both of which we expect to decline further. As a result, changes in the value of the rouble impact on reported earnings and net asset value as reported in sterling.

Against sterling, the end-FY20 closing rate was c 24% below end FY19, while the FY20 average rate was c 12% lower. Compared with the euro, the end-FY20 closing rate was slightly more than 30% lower than end FY19. We are not currency forecasters and despite a number of positive indicators for the Russian economy and rouble (see below), including the recent strong recovery in oil prices, in our forecasting we assume a continuation of FX rates around current levels.

In the income statement, the impact of rouble weakness was:

In the balance sheet, the main impact is on the translation into sterling value of rouble-denominated net assets, primarily the investment property portfolio and rouble-denominated debt.

The rouble mismatch in the local operating units arises from the managed transition from US dollars to roubles. Before the decline in Russian interest rates through 2019–20, real rates were unattractively high. Over time, we expect the euro debt to be replaced by rouble debt, matching the income base of the group, through debt amortisation and through refinancing when the terms are appropriate.

Exhibit 2 provides a summary of financial performance in FY20, including a reconciliation from IFRS reporting to the group’s measure of ‘underlying earnings’, which approximates to recurring ‘cash earnings’ that support shareholder distributions. Raven has also published earnings and net asset value (NAV) on an EPRA basis for the first time. EPRA net reinstatement value (NRV) and net tangible assets (NTA) are both 49p, well ahead of the IFRS diluted NAV per share of 40p. We will continue to review the EPRA earnings disclosure, but for now consider underlying earnings, as a closer proxy for distribution potential, to be the more useful measure to focus on.

The key features of the FY20 income statement in underlying terms were:

Compared with IFRS earnings, the main adjustments to underlying earnings relate to depreciation, unrealised valuation movements in respect of properties and derivative instruments, amortisation of the convertible preference share redemption premium (historically), long-term incentive payments that are settled in shares and other non-recurring items (including the £45.7m accounting profit on the redesignation of the convertible preference shares into new ordinary and preference shares).

Leasing strategy continues to focus on maintaining high occupancy with high quality tenants for the long term, while keeping a diversified tenant mix across sectors and business types. Short term lets are used to minimise voids. Raven also targets tenants who require significant capital investment into their premises and seek to ‘rentalise’ these improvements over the term of the lease, creating enhanced returns. The growth of the e-commerce activities of tenants is also providing an opportunity to invest in higher specification fit-outs including specialised racking.

Both the warehouse and office markets in which Raven operates are now effectively rouble markets and Raven’s remaining US dollar leases will fully unwind over the next two to three years. Average US dollar rent is more than double the average rouble-denominated rent, partly reflecting the high-spec nature of much of the space (eg cold store units), and making a direct comparison difficult. However, it remains the case that Raven’s remaining US dollar leases are above current market rents and their unwinding continues to act as a drag on revenues. Void reduction, rouble indexation and reversion to market rents in respect of rouble leases signed over the past two to three years are positive offsetting factors, while market conditions offer potential for a general recovery in market rents.

Management notes that continued reductions in market vacancy, a lack of new supply and increased construction costs are creating classic conditions for rental growth. While economic uncertainty remains (although forecasters expect a recovery in Russian GDP in 2021), the warehouse sector nevertheless seems ideally set to benefit from an accelerated structural shift driven by e-commerce, with all the major retailers developing their strategies to reflect this. Moreover, on a comparative European measure, rents are very low and for the majority of end-users, form a very small percentage of their total cost base. Raven anticipates market rents rising to R4,500 per sqm during the year, and growth continuing thereafter.

Russian GDP declined by 3.1% in 2020 due to the direct and indirect impacts of the COVID-19 pandemic. This was the sharpest correction since the global financial crisis 11 years ago, but compared with many other economies represented a relatively resilient performance and was around half the rate of decline seen across the eurozone area. The Russian Central Bank recently indicated that the economy is on track to grow 3–4% in 2021. With consumer price inflation running at c 5%, the prospect of a reversal in some of the past two years’ decline in interest rates may provide support to the rouble, along with the recent strength in oil prices after last year’s sharp fall.

With continuing strong demand for warehouse space relative to supply, market vacancy has continued to fall in both Moscow and St Petersburg.

JLL estimates end-2020 vacancy of 2.8% in Moscow, which represents 70.5% of Raven’s warehouse portfolio, and even slightly lower in St Petersburg. Despite the tightness in the market, rents did not grow as fast as expected during 2020 and this held back valuations. However, Raven indicates that it is now seeing evidence of rents firming at a faster pace and expects this to continue, moving towards RUB4,500 by year-end.

Raven estimates that the cost of constructing a Grade A warehouse has risen by at least 15% in the last 12 months, which may further restrict new development activity unless rents increase further. Costs have been affected by the impact of the weak rouble on imported materials and a reduction in the foreign labour force due to Covid-19 lockdowns and the closing of Russia’s international borders. Many foreign temporary construction workers returned to their homes in the middle of 2020 and are as yet either unwilling or unable to return.

Compared with the wider European market, Russian warehouse rents remain at relatively low levels, while yields are significantly higher. Notwithstanding the relative lack of development of the Russian property investment market, this is a positive indicator for value creation over the medium to longer term. In the near term, against a positive fundamental sector backdrop and compared with international markets and local interest rates, Russian warehouse valuations appear very well underpinned with upside potential.

During FY20, Raven significantly simplified its capital structure and since the year end has agreed a solution to the overhang of shares owned by Invesco, subject to shareholder approval at a forthcoming general meeting.

In July 2020, shareholders approved the re-designation of the company’s convertible preference shares and this became effective on 30 September 2020. Holders of the convertible preference shares each received a mix of new ordinary shares and new preference share. In financial terms, the redesignation increased IFRS earnings on a recurring basis was slightly accretive of both basic IFRS EPS and NAV per share. The impact on underlying earnings was modest as non-cash amortisation of the redemption premium on the convertible bonds was already excluded. Additionally, the company noted the following benefits to shareholders resulting from re-designation:

IFRS accounting allocated a part of the uplift in equity resulting from the issue of new ordinary shares to the FY20 income statement as a one-off accounting gain (£45.7m net of costs). The recurring benefit to the income statement is c £6m pa, representing the net benefit of the convertible preference share finance costs saved (c £19.7m including c £7.2m of redemption premium amortisation) less additional interest expense on the new preference shares issued.

In 2019, with shareholder approval, Raven repurchased and immediately cancelled 99.1m ordinary shares (16% of the outstanding number at the time) from funds managed by Woodford Investment Management and Invesco Asset Management (IAML). The shares were acquired using the company’s existing cash resources, at a significant discount to net asset value, materially enhancing NAV per share. An agreement to acquire IAML’s remaining ordinary and preference shareholding lapsed during H120 due to the market uncertainty created by the pandemic, but talks aimed at removing the overhang continued and a new agreement was reached in January 2021. A conclusion of the transaction requires approval by ordinary and preference shareholders at a general meeting, ahead of which circulars will soon be issued. In respect of the IAML holdings, under the transaction:

The transaction prices are 21.6p for the ordinary shares and 90.8p for the preference shares.

To capitalise RH, management participants will transfer up to c 53.0m Raven ordinary shares, already owned, and Raven will provide an equal amount of cash. At the transaction prices above, the cost of the ordinary share purchase (c £21.6m) and preference share purchase (c £30.2m) amounts to c £51.8m. In addition to its cash capital contribution, Raven has indicated an intention to assist the JV with additional funding and has recently entered into a €60m corporate loan through its Cypriot holding company.

Further details are not yet available, including the accounting treatment of the JV (consolidated or equity accounted). However, given the significant discount of the transaction prices to market prices, the existing significant discount to NAV on which the ordinary shares trade and the high yield on the preference shares, we would expect the transaction to be accretive for the company. We would also anticipate that distribution income to RH on its Raven share investments will exceed the funding cost. Most likely in our view is that any surplus will be used to amortise the debt funding such that the JV is neutral to Raven’s recurring cash flow.

If approved by shareholders, post-completion the Invesco interest in both ordinary shares and preference shares will fall to zero, and the RH JV will own c 27% of the group’s ordinary shares and c 15% of the preference shares. Ahead of the shareholder vote and completion of the transaction, we have not included it in forecasts.

Raven has not historically reported supplementary information on an EPRA basis but has now taken the opportunity of recent changes to the EPRA methodology to do so. A key issue was the EPRA NAV adjustment (add-back) for deferred tax provisions in respect of unrealised property gains. In Russia these are payable whether the property is sold (and the gain realised) directly or as part of a corporate vehicle, and conservatively Raven has quoted IFRS net assets (after deducting deferred tax) even as a long-term investor. EPRA NAV has been replaced with three new measures: net reinstatement value (NRV), net tangible assets (NTA) and net disposal value (NDV). The EPRA NRV and NTA values include a deferred tax add-back, even where this may become payable. NRV in particular is aimed at highlighting the value of net assets on a long-term basis, reflecting the investment that would be needed to recreate the company.

EPRA NRV and EPRA NTA were both 49p at end-FY20 (Exhibit 15), well above the diluted IFRS NAV of 40p. EPRA NDV of 42p was much closer to the IFRS value, reflecting the crystallisation of deferred tax liabilities that would occur on sale. We have included EPRA NRV as our main asset value benchmark for Raven.

On an EPRA basis, the FY20 loss was reported as £49.7m compared with £34.7m on an underlying basis and £14.2m on an IFRS basis. Both EPRA and underlying earnings included an adjustment for the £45.7m gain on resignation of the convertible bonds, property and interest rate derivative valuation movements, and both include FX movements in the income statement, adding volatility to the results. However, underlying earnings, as a proxy for cash earnings, makes additional adjustments. These include for depreciation, long-term incentives not paid in cash, and amortisation of the issue premium and issue costs on preference and (historically) convertible preference shares. We will continue to monitor the EPRA earnings disclosure, but for now we consider underlying earnings, adjusted for FX, as the more useful measure.

Our forecasts are based on FX rates at around current levels as shown in Exhibit 1. Although the rouble is only slightly weaker versus sterling compared with end-FY20, we estimate that a continuation of the current rates would represent a c 10% reduction in the average FY21 level compared with FY20, reflecting rouble weakness in H220.

At the level of the rouble-based subsidiaries, the slight strengthening of the rouble versus the euro since the end-FY20 level suggests a positive translation of euro-denominated debt (reported in the income statement) in FY21 (c £10m versus a negative c £53m in FY20). However, at current rates we forecast this to be more than offset at the group level by the negative impact on the sterling presentation of the rouble earnings. We also forecast a negative translation impact on NAV (c £21m versus c £147m in FY20), taken within other comprehensive income, in respect of the reduction in the sterling-equivalent value of the rouble net assets.

For the core property investment business, our forecasts allow for a continued run-off of the remaining US dollar-denominated warehouse rents offset by indexation of rouble-denominated rents and improving occupancy. For warehouse occupancy, we assume a further improvement to c 96% from 94% at end FY20 and for this level to be maintained during FY22. We expect little change in the office portfolio and in rouble terms, we expect total net property rental income to be broadly flat (c RUB10bn) over FY21/22. At our assumed FX rates, there is a downward trend in the sterling presentation due to rouble weakness.

There is a similar FX effect on our forecasts for RosLogistics, masking the slight improvement in net rental and related income (c 2%) we forecast for FY21 (increasing to 5% growth in FY22).

The changes to our underlying earnings forecasts are significantly driven by FX and, as noted above, we have not at this stage incorporated the proposed Invesco share repurchase via a newly formed JV. Our revised forecast for underlying profit before tax and FX gains/(losses) is £20.5m, down from £24.9m previously.

Our IFRS earnings forecasts are shown in Exhibit 19 at the back of this report and also include a relatively small amount of depreciation, unrealised valuation movements in respect of properties and derivative instruments (we assume none prospectively), and long-term incentive payments that are settled in shares (none assumed prospectively).

Our forecasts indicate a continuing healthy cash position and a stable LTV in respect of the secured debt despite the further negative FX impact on the sterling presentation of portfolio values and NAV. We expect continuing distributions per share at the rate of 2.5p pa.

Although we have not assumed any change in the rouble value of the portfolio, as we note on page 13 there are several supportive positive factors that point towards potential valuation increases. The structure of Raven’s balance sheet, with assets funded primarily by secured debt and fixed-charge preference shares, provides the ordinary shares with significant gearing to asset value. We estimate that a 1% increase/(decrease) in the value of the portfolio (at constant FX) is equivalent to a c 4% increase/(decrease) in NAV per share after allowing for deferred tax.

Investors in the ordinary shares are fully exposed to share distributions and NAV movements, and would benefit from any narrowing of the wide discount to NAV.

Despite sometimes volatile economic and market conditions, Raven has consistently made distributions to ordinary shareholders. These are made through share repurchases effected by way of tender offers, providing shareholders with a choice of receiving cash (in return for shares tendered) or retaining their shareholding and benefiting from increased ownership share in the company. Since listing, it has repurchased and cancelled more than 300m ordinary shares. COVID-19 uncertainty delayed the FY19 final distribution (2.25p) until September 2020, resulting in just one distribution in respect of FY20 (1.25p declared with the final results) but the company indicates that it will return to biannual distribution in FY21.

Our forecast 2.5p distribution for FY21 represents a yield that is approaching 9%, while the shares are trading at a more than 40% discount to EPRA NRV per share.

At a price of 113p, the yield on the cumulative non-redeemable preference shares is a little more than 10% based on the fixed yield of 12% on the nominal value of 100p. The preference shares have the added security of ranking ahead of the ordinary shares for distributions, but do not provide the upside exposure to underlying income, property valuations and a recovery in the rouble versus sterling.