Raven Property Group — Positive developments obscured by FX

Raven Property Group, founded in 2005, is a self-managed investor in modern, Grade A, Russian warehouse assets through acquisition and development. At 30 June 2020, the portfolio comprised c 1.9m sqm of logistics warehouse property (of which c 70% is in the Moscow region) and c 50k sqm of office property in St Petersburg and is valued at £1.3bn. At end H120, the portfolio was 93% let to predominantly large Russian or international companies operating mainly across the retail, distribution, manufacturing and third-party logistics sectors, with e-commerce growing quickly from a small base and representing an increasing share (6% at H120 v 4% at end-FY19). The group comprises the core investment property division, a third-party logistics business in Russia (RosLogistics) and an immaterial UK residential property developer (Raven Mount).

The ordinary shares are listed on the main market of the London Stock Exchange (LSE), with secondary listings on the Moscow and Johannesburg stock exchanges. The group also has preference shares and redeemable convertible preference shares listed on the LSE. Shareholders recently voted to re-designate the convertible preference shares into new ordinary and new preference shares, effective 30 September 2020. This simplification of the capital base should be positive for liquidity in the ordinary and preference shares, and removes uncertainty surrounding conversion.

Raven is the leading long-term investor in Grade A logistics warehouses with the aim of growing rental income and progressive shareholder distributions. Warehouse space per capita in the large Russian market remains relatively low by European standards, while logistics demand is benefiting from similar modern retailing trends that have been seen globally, with e-commerce demand continuing to expand. The property investment market in Russia is fragmented and immature, but the total value of transactions increased by 41% to $4.1bn in 2019. Domestic buyers remained the largest part of the market, with western capital almost non-existent, foreign investment instead coming from China and the Middle East. A broadening and deepening of the investment market would be a welcome development that could be expected to support valuations. Prime Russian warehouse yields of 11–12% are well above more developed international markets and compare favourably with Russian official interest rates at 4.25% and on a declining trend. The company’s income-focused strategy has remained constant since IPO, but in recent years has adapted to meet the challenges of volatile economic and currency/oil market conditions as well as sanctions. Most significantly, the group has effectively completed its transition to a rouble-denominated business model with legacy US dollar leases accounting for just 14% of warehouse space at end FY19 and US dollar-denominated debt completely refinanced.

While headline figures are again affected by FX movements, underlying performance was robust in H120 against the backdrop of a challenging operating environment. As a growing and essential part of the supply chain, all of Raven’s warehouse properties continued to operate during COVID-19, occupancy increased and more than 99% of rents were collected. Although the pandemic continues to cloud the economic outlook, warehouse demand-supply fundamentals continue to be robust.

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 (14% of the warehouse total by space, but more by gross rental income; we estimate c 25%) and euro-denominated secured debt (41% 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. During FY19, the strength of the rouble versus sterling had a positive impact on income and NAV, but the subsequent COVID-19 inspired financial market volatility, oil price weakness and continuing geopolitical tensions have seen the rouble weaken significantly, during H120 and since.

Against sterling, the end-H120 closing rate was c 6% below end FY19, while the H120 average rate was c 3% below H119. Compared with the euro, the end-H120 closing rate was c 12% lower than end FY19, while the average rate was c 3% below H119.

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.

On the company’s underlying earnings basis, H120 performance was robust before the negative year-on-year impact of unrealised foreign exchange movements, comprising:

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, long-term incentive payments that are settled in shares (no impact in H120), and other non-recurring items.

Raven Property’s portfolio of 1.89m sqm of Grade A warehouse space (and 40,000 sqm of office space) operated successfully in H120 despite the COVID-19 pandemic and lockdown. With logistics networks being an essential part of the supply chain, all the warehouse assets remained in operation and, as noted above, cash rent collection was not significantly affected. Portfolio occupancy and average occupancy improved further during the half, with occupier demand benefiting from the shift towards e-commerce, while speculative development activity has in many cases been deferred.

Both the warehouse and office markets in which Raven operates are now effectively rouble markets and we expect Raven’s remaining US dollar leases to fully unwind over the next three years (1.6 years is an average of longer and shorter maturities). At the period-end exchange rate, the average US dollar rent is equivalent to c RUB11,200, more than double the average rouble-denominated rent. In part, this premium reflects the high-spec nature of much of the space (eg cold store units) and so a direct comparison is not entirely valid. Nevertheless, the continued unwinding of long-term dollar contracts will act as a drag on revenues which management seeks to mitigate through void reduction and indexation of rouble leases, and possibly acquisitions, with the potential for market rent growth to provide additional support. Rouble leases are indexed to Russian CPI, but may also specify a minimum level. The average indexation of Raven’s rouble-denominated leases at end FY19 was c 5% pa, above the c 3.4% year-on-year increase in CPI reported in July 2020.

Although Russian GDP growth was a modest 1.3% in 2019 (2018: 2.5%) it was accelerating towards year end. Q120 growth was 1.6%, reinforcing hopes that 2020 would see a revival on the back of large infrastructure modernisation projects. Those hopes were dashed by the COVID-19 pandemic, which first affected the economy in February/March through a sharp reduction in the value of Russian exports, particularly linked to the collapse in oil prices. This was followed in April/May by the domestic shutdown in an effort to control the spread of the virus. Preliminary reports indicate an 8.5% contraction in Q220 GDP, within the range of official expectations. Compared with the last oil price crash, the Russian financial position appears to be in a significantly better position, entering the pandemic with twin budget and external surpluses, and foreign exchange and gold reserves at multi-year highs. While the floating rouble has seen the currency decline to mitigate the effects of the external economic shock, strong internal and external financial balances have provided room for fiscal stimulus and for interest rates to decline. Inflation has picked up a little from a year-on-year low of 2.3% in February to 3.6% in August, but the key policy interest rate has fallen 3.25% over a year to the current 4.25%.

Russia is a large economy with good potential for long-term growth. In that context, warehouse space per capita remains relatively low by European standards, while logistics demand is benefiting from similar modern retailing trends that have been seen globally, with e-commerce demand continuing to expand.

After continuing to improve through 2019 and into the early part of 2020, demand-supply conditions in the warehouse market appear to have remained robust, despite the impact of the pandemic, with a good level of occupier demand and an increasingly tight supply of good-quality, modern logistics and warehouse space. In both the Moscow and St Petersburg markets, vacancy has reduced and prime warehouse rents have improved over the past three years. Prime rents sit at around the RUB4,000–4,100 per sqm level, while prime yields remain in the region of 11–12%. Despite the economic shock of the pandemic, occupier demand for warehouse space appears to have remained robust, while speculative developments have in many cases been deferred.

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.

On 31 July 2020, shareholders approved the re-designation of the company’s convertible preference shares into new ordinary shares and preference shares, and this will take effect on 30 September 2020. Holders of the 198.2m convertible preference shares will for each receive 0.6108 new ordinary share and 0.5849 new preference share. This will result in the issue of c 121.0m new ordinary shares (c 26% of the existing number), and c 115,9m new preference shares (c 16% of the existing number).

In financial terms, the re-designation is slightly accretive of the H120 basic IFRS NAV per share, will increase IFRS earnings on a recurring basis, and is slightly accretive to basic IFRS EPS. Because the company’s underlying earnings measure excludes non-cash amortisation of the redemption premium on the convertible bonds (but includes interest payments), there is only a small uplift.

The company notes the following benefits to shareholders resulting from re-designation:

The financial effects of the re-designation on the FY19 financial statements are set out in detail in the prospectus. The partial replacement of the convertible preference liability with new equity generates an uplift in group equity. Compared with the H120 balance sheet, we expect a slightly larger uplift in equity, primarily because the convertible preference share liability to be retired has increased with H120 amortisation of the redemption premium, resulting in c 4% accretion to H120 basic IFRS NAV per share.

IFRS accounting sees a part of the uplift in equity pass through the income statement as a one-off accounting gain (based on the H120 balance sheet and recent share prices, we estimate c £47.8m), partly offset by transaction costs of c £1m. 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.

On a pro forma basis, as a result of existing investment in the convertible preference shares, the composition of the ordinary shareholder base is expected to change as shown in Exhibit 15.

Invesco Asset Management (IAML), which owns c 42.1m convertible preference shares, will continue to be the largest ordinary shareholder with a stake of c 27%. On a pro forma basis, its holding of preference shares will also increase by c 24.6m to 63.6m shares (29.4% of the total). Due to market volatility, a conditional agreement between the company and IAML for the off-market repurchase by the company of IAML’s ordinary and preference shares, entered into in December 2019, was not executed and has now lapsed. Raven says that it remains in dialogue with IAML and is still keen to find a solution to the perceived stock overhang.

In a similar exercise, during FY19, with shareholder approval, Raven repurchased and immediately cancelled 99.1m ordinary shares (16% of the outstanding from funds managed by Woodford Investment Management and IAML. The shares were acquired using the company’s existing cash resources, for an average 36.4p per share, a significant discount to net asset value, materially enhancing NAV per share.

As noted above, changes in the value of the rouble impact on reported earnings and net asset value as reported in sterling, and the continuing rouble weakness since end H120 is substantially allowed for in our forecasts. Despite the Russian national balance sheet being relatively well positioned, with internal and external debt levels among the lowest globally and financial reserves at an historically high level, we have not assumed any meaningful recovery and have based our estimates on current rates (£/RUB98 at the time of writing compared with £/RUB86.4 at the end of H120). We estimate an average H220 rate of £/RUB97 compared with a H120 average of £/RUB87.3.

As a result we expect a further unrealised negative impact on the income statement NAV in H220, relating to the translation of euro-denominated debt into roubles within the operating subsidiaries, and also at group level, within other comprehensive income, in respect of the reduction in the sterling-equivalent value of the rouble net assets. We estimate the aggregate effect of these at c £102m compared with end-H120 net assets of £279.3m. This is substantially offset by the gain that will be recorded on cancellation of the convertible preferred shares and including retained earnings.

We estimate that a 1% strengthening/(weakening) of the rouble versus sterling compared with our forecast increases/(decreases) net assets by c 1.7%.

For the core property investment business our forecasts allow for a continued run-off of the remaining US dollar-denominated rents offset by indexation of rouble-denominated rents and improving occupancy. For occupancy, we assume a further slight improvement in H220 (to c 94% from 93% at end H120) with a further increase to 96% in FY21. In rouble terms, we expect net rental income to be broadly flat (c RUB9.7bn) over FY20/21, at a similar level to FY19, but 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. In rouble terms, we expect a relatively modest 4% decline in net rental and related income in FY20, with some impact on logistics shipping volumes from the pandemic, with modest c 2% growth in FY21.

A c 10% improvement in the value of the rouble would add c £10m to group net rental and related income (with a similar impact from a further rouble decline), while each 1% change in occupancy compared with our assumptions affects net rental and related income and underlying earnings by c £1m.

Exhibit 17 shows our revised forecasts for FY20 and FY21. Due to the pandemic and capital activity, our last forecasts were published in August 2019 and reflect a rouble exchange rate of £/RUB80. If we were to apply a similar £/RUB80 on a full-year basis to our FY21 revised forecast for underlying profit before tax excluding FX, this would increase to £42.2m. The underlying (ex-FX) improvement in our FY21 forecast in sterling terms is driven by lower expenses and finance costs, the latter reflecting significantly reduced interest rates.

In part, the underlying increase in our forecast PBT is offset by an increase in assumed tax. We have applied the standard 20% Russian tax rate to underlying PBT excluding FX movements and preference share interest, the former being non-tax deductible (until realised) and the latter reflecting the distribution nature of the preference share payment (rather than a tax-deductible cost), subject to local withholding tax, At the (unadjusted) group level, on an IFRS basis, the tax charge also includes deferred tax in respect of the investment property valuation movement. Our forecasts do not assume an underlying movement other than to factor in FX effects. Raven is registered in Guernsey, where it is tax exempt, but is liable for tax on its operations in Russia (its main operating subsidiaries) and the UK, as well as in its Cyprus (holding company). Russia is a relatively low tax jurisdiction, but changes to the tax code in respect of certain overseas tax treaties are possible and the group structure is designed to deal with the commercial risks of operating in Russia rather than to take advantage of tax benefits offshore.

As noted above, our IFRS earnings forecasts shown in Exhibit 22 on page 16 of this note also include a relatively small amount of depreciation, unrealised valuation movements in respect of properties and derivative instruments, amortisation of the convertible preference share redemption premium (until re-designation on 30 September), and long-term incentive payments that are settled in shares (no impact in H120).

We have not assumed any changes in the value of interest rate derivatives used to manage interest rate exposure, nor do we assume any underlying change in the value of investment properties, denominated in roubles. Given the positive fundamentals in the Russian warehouse market and the wide gap between valuation yields and interest rates, especially compared with more developed markets elsewhere, the prospects for valuation gains appear favourable. We estimate that a 1% increase/(decrease) in the value of the portfolio is equivalent to c 1.8p increase/(decrease) in our forecast end-FY20 NAV per share, assuming no change in the £/RUB exchange rate and after deferred tax.

Raven currently operates two share schemes to reward and incentivise executives and senior staff in addition to discretionary bonus payments. While no accruals were made in H120, the FY19 charge was £5.5m. The annual performance incentive (API) is payable in cash or shares (ordinary and preference) based on performance against a range of financial and operating targets set annually. The maximum amount payable to an individual is capped at 50% of basic salary if paid in cash or 175% of basic salary if paid in shares, which are required to be held for three years. As a condition of the scheme there was no API payable for 2018. The FY19 API accrual was £4.3m, representing 89.5% of the total potential award. The five-year performance plan (FYPP) is a long-term incentive scheme which is open to the executive directors and other senior managers, allowing participants to invest into the FYPP a number of existing holdings in the company. These must continue to be retained for five years from the commencement of the plan (until 31 March 2023), at which point the company will match the investment with up to three times the value of the shares held based on annual compound total shareholder returns (‘TSR’) of between 4% and 12% over the period. Any award under the plan will be settled by the issue of ordinary shares. No accrual was made in FY19 or H120.

The FY19 charge also included £0.6m of other staff bonuses and £0.5m in respect of the now lapsed 2016 retention scheme. FY19 underlying earnings included a charge of £4.9m in respect of assumed cash settlements and the IFRS charge also included the non-cash settlement of the 2016 retention scheme.

In our forecasts we have allowed for bonus payments of £0.3m in H220 and £1.0m in FY21, all within underlying earnings.

At the end of H120, FY19 secured borrowing amounted to £703m (FY19: £689m), including c £6m of unamortised loan arrangement fees carried within payables. The borrowings comprised 17 different debt facilities, with an average cost of 5.7%. The weighted average term to maturity was 4.3 years, with only 4% (two facilities) maturing before 2023. Compared with the investment property portfolio value (including properties under development) of £1,253m, the gross loan to value ratio (LTV) was 54.3%.

Historically, the portfolio had been funded by US dollar debt to match US dollar-denominated rents. With the market-led move to rouble-denominated leases, Raven has been transitioning its funding towards rouble-denominated debt, removing a structural FX mismatch. US dollar debt has been replaced initially with a mix of rouble- and euro-denominated debt, the latter recognising the slow decline in rouble borrowing rates despite falling inflation. The end-H120 mix was 59% rouble debt and 41% euro debt compared with 58%:42% at end FY19. Given the significant reduction in rouble interest rates over the past year, we expect a further significant shift towards rouble debt. Secured debt amortisation (£16.2m in H120) is focused on the euro-denominated debt and represents an ongoing shift away from euro debt as it is refinanced.

The secured bank debt is floating rate, but Raven has entered a series of interest rate derivative financial instruments that cap its interest rate exposure to the underlying benchmark borrowing rates (before the lending margin) at a weighted average 5.36%, leaving the group positively exposed to the decline in market rates.

Exhibit 19 shows our forecasts for net operating income/cash flow after interest on secured and unsecured debt. We forecast c £11m pa in FY20 and FY21, supporting our distribution per share assumption of 2.25p in each year. From September 2020, the permanent capital structure will comprise the enlarged base of ordinary shares and preference shares, while the redeemable convertible preference shares will disappear. The (non-convertible) preference shares earn a cumulative 12% dividend on the fixed issue amount per share of 100p and rank ahead of the ordinary shares. This fixed charge in respect of preference and convertible preference shares provides ordinary shareholders with significant asset and income gearing. The total ‘fixed’ charge on cash flows from preference shares will not change materially following the re-designation of the convertible preference share element, and the prospects for ordinary share distributions will remain sensitive to sterling movements in net cash generated from operations, and the £/RUB exchange rate. A c 1% increase/(decrease) in operating cash flow increases/(decreases) total net operating income after interest (and ordinary shareholder distribution capacity) by more than 5%. Using H120 exchange rates, we estimate that net operating income/cash flow after interest would be c £16m in FY20 and c £22m in FY21.

Although the convertible preference share re-designation increases the equity base, at current exchange rates this is more than offset by unrealised FX losses. As a result, we expect the gearing of ordinary shareholders to changes in asset values to remain relatively high. We estimate that a 1% increase/(decrease) in the sterling value of the portfolio is equivalent to a c 1.8p increase/(decrease) in NAV per share after allowance for deferred tax.

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

Despite sometimes volatile economic and market conditions, Raven has consistently made distributions to shareholders through share repurchases effected by way of tender offers. Since listing, it has repurchased and cancelled more than 280m ordinary shares. After a delay during the uncertainty created by the COVID-19 pandemic, Raven will now proceed with the final distribution in respect of FY19 of 2.25p (making 3.5p for the year). Because of the delay, rather than two distributions in respect of FY20, management says it will make one payment to be determined at the end of the year.

Our forecast 2.25p distribution for FY20 represents a yield of c 7.6%, while the shares are trading at a c 40% discount to FY20e NAV per share.

At a price of 124p, the yield on the (non-convertible) preference shares is just under 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 underlying income, property valuations and a recovery in the rouble versus sterling.

The global economy has entered a highly uncertain stage, triggered by the spread of COVID-19. The Russian economy faces specific challenges from its sensitivity to oil prices, and continuing political and economic tension with the US resulting in continuing economic sanctions. However, there has been a significant adaptation to sanctions and this may mitigate the effects of external economic events. These country-specific risks have the impact of reinforcing normal sector risks including occupancy and rent levels, funding access and cost, and property valuations. We highlight the following: