Palace Capital — Confidently reinstating DPS

Palace Capital (LSE: PCA)

Last close As at 02/03/2024

210.00

4.00 (1.94%)

Market capitalisation

GBP92m

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Research: Real Estate

Palace Capital — Confidently reinstating DPS

Palace Capital (PCA) reported FY20 adjusted PBT in line with expectations while COVID-19 contributed to end-year negative unrealised valuation movements. With robust rent collection to date, PCA has shown its confidence by re-instating DPS payments. While market conditions are challenging, PCA benefits from refurbished properties that are available to let and continued progress at Hudson Quarter where 25% of apartments have been pre-sold ahead of the expected March 2021 completion.

Martyn King

Written by

Martyn King

Director, Financials

Real Estate

Palace Capital

Confidently reinstating DPS

FY20 results

Real estate

16 July 2020

Price

200p

Market cap

£92m

Net debt (£m) at 31 March 2020

105.8

Net LTV at 31 March 2020

38.1%

Shares in issue

46.1m

Free float

95%

Code

PCA

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

11.2

(5.4)

(30.5)

Rel (local)

7.6

(16.0)

(17.8)

52-week high/low

345p

171p

Business description

Palace Capital is a UK property investment company listed on the Main Market of the LSE. It is not sector-specific and looks for properties that provide opportunities to enhance the long-term income and capital value through asset management and strategic capital development in locations outside London.

Next events

AGM

7 August 2020

Analyst

Martyn King

+44 (0)20 3077 5745

Palace Capital is a research client of Edison Investment Research Limited

Palace Capital (PCA) reported FY20 adjusted PBT in line with expectations while COVID-19 contributed to end-year negative unrealised valuation movements. With robust rent collection to date, PCA has shown its confidence by re-instating DPS payments. While market conditions are challenging, PCA benefits from refurbished properties that are available to let and continued progress at Hudson Quarter where 25% of apartments have been pre-sold ahead of the expected March 2021 completion.

Year end

Adj. PBT*
(£m)

Adj. EPS**
(p)

EPRA NAV/
share (p)**

P/NAV
(x)

DPS
(p)

Yield
(%)

03/19

8.9

17.3

407

0.49

19.0

9.5

03/20

8.0

17.5

364

0.55

12.0

6.0

03/21 central scenario***

6.6

14.4

339

0.59

13.0

6.5

Note: *Adjusted PBT is adjusted for realised and unrealised revaluation movements, non-recurring items, and share-based payments. **Adj EPS and EPRA NAV per share are fully diluted. ***Figures shown are for a mid-point in a range of scenarios: see page 7.

Adjusted PBT in line and robust rent collection

FY20 adjusted PBT of £8.0m (FY19: £8.9m) excludes a £2.9m one-off lease surrender premium included in the EPRA earnings definition. Underlying the performance was a positive property level total return of 1.1%, ahead of the MSCI UK Quarterly benchmark (-0.5%) for a third year running. Lower adjusted PBT mainly reflects refurbishment and development activity as the company invests for medium-term total returns. Valuation losses of £17.9m reflected COVID-19 and the lag in capex recognition until completion and letting. EPRA NAV per share fell to 364p. PCA has collected 93% of March quarter rents billed and 84% to date for the June quarter. It says the Q420 DPS of 2.5p is the minimum quarterly payout that it expects during FY21. In the absence of earnings guidance and a continuing high level of market uncertainty we have provided a range of scenarios (page 7) with the central scenario outcome shown above indicating scope for DPS of 13p.

Medium-term opportunities for optimising value

While market conditions remain highly uncertain, PCA has a range of opportunities to optimise both income and capital values in various market conditions over the medium term. The end-FY20 estimated rental value (ERV) of the portfolio (including Hudson Quarter) was 23% ahead of passing rent. Management expects Hudson Quarter (HQ) to add c £1m to annual rental income and generate development gains of at least 20p per share when complete and let/sold in FY22. HQ apartment sales should generate c £50m in proceeds to reduce debt and invest in yielding acquisitions and in a range of further refurbishment and development initiatives that can be phased in over time to provide counter-cyclical value-add opportunities.

Valuation: High yield and significant discount to NAV

Based on our central scenario, the FY21 DPS indication of 13p represents a yield of 6.5% (5.0% at the indicated minimum 10p payout) while the discount to end-FY21 NAV is c 40%.

Investment summary

Regional investor targeting total returns

Palace Capital is an internally managed UK REIT that operates a total return strategy focused on the regions, supported by a diversified portfolio of mainly office and industrial assets (c 60% combined) and balanced between income-producing assets and opportunities for capital growth through refurbishment and development.

Palace has a proven long-term track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. Since its first major post-IPO transaction in H214 until end-FY20 PCA’s total return strategy has generated cumulative EPRA NAV total returns of 113.1% or a compound annual average return of 12.3%.

An active refurbishment and development programme weighed on income in FY20 but will improve the quality of the portfolio and should enhance future income and capital value prospects. The existing portfolio contains strong reversionary potential, while completion of the flagship Hudson Quarter development in York in March 2021 should add meaningfully to portfolio income and capital value.

The COVID-19 pandemic and lockdown has created a challenging and highly uncertain economic and market backdrop. The lockdown’s timing was too late to significantly impact FY20 income earnings, but year-end property valuations and capital returns were negatively affected. In common with peers across the sector, rent collection has slowed although Palace reports a robust performance to date supported by a proactive approach with tenants. As at 7 July 2020 (the date of reporting FY20 results) 93% of rents that had been billed in relation to the March quarter advance billing date had already been collected, with 91% in cash and 2% subject to an agreed near-term collection plan, with the remaining 7% outstanding. For the June quarter advance billing date, 84% of rents that had been billed had been collected in cash (64%) or were subject to agreed near-term collection plans (20%), with 16% outstanding.

A final DPS of 2.5p was declared (bringing the total for the year to 12p) and the company says that this has been set very conservatively and is the minimum level of dividend that it expects to pay in each quarter of FY21; it hopes to lift dividends as the year progresses. We estimate that to fully cover the £4.6m dividend payment after all expenses and financing costs requires £12.3m of net rental income to be generated compared with the £15.9m reported (as adjusted) in FY20 (excluding the one-off lease surrender premium), which would represent a reduction of more than 20%. Upside potential to this base level DPS comes from an improvement in market conditions as the lockdown eases and progress with capturing the significant reversionary potential embedded in the portfolio.

With total drawn debt of £120.8m at 31 March 2020, Palace has undrawn debt resources available of £32.9m, including £21.5m of the Barclays development facility to fully fund the remaining construction cost, in addition to cash resources of £14.9m.

We briefly review the FY20 results below before providing an update on the near-term outlook and potential impact of COVID-19, as well as the medium-term prospects driven by the significant embedded income and capital potential in the portfolio, including Hudson Quarter, providing Palace with a wide range of opportunities despite more challenging markets.

FY20 results in brief

As Palace had previously indicated, FY20 adjusted profit before tax of £8.0m (FY19: £8.9m) was in line with expectations, while COVID-19 contributed to end-year negative unrealised valuation movements. Adjusted profit before tax excludes a one-off £2.9m lease surrender premium which is included in the EPRA definition of earnings. EPRA earnings increased to £10.8m (FY19: £7.6m). Underlying the results was a positive property level total return (income and capital) of 1.1%, driven primarily by sector positioning, outperforming the MSCI UK Quarterly Benchmark return of -0.5%, for the third year in a row.

Lower underlying net rental income (excluding the surrender premium) reflected the ongoing refurbishment and development programme. Increased administrative costs primarily reflected the investment in growing the property management team, partly offset by lower share-based payment expenses. On an underlying basis, excluding refinancing costs and fair value movements in debt hedging instruments, finance expenses were little changed.

With the Q320 DPS of 4.75p cancelled to conserve liquidity going into the pandemic, the 2.5p final DPS took the total to 12p for the year, 1.5x covered by adjusted EPS of 17.5p.

Unrealised revaluation losses of £17.9m in FY20 (5.7% fall in valuation adjusted for disposals) include the year-end impact of COVID-19 and some timing effects that management expects to unwind as newly developed or refurbished assets are completed and let or sold.

EPRA NAV per share reduced to 364p (FY19: 407p), partly offset by the 19.0p of DPS that was actually paid in the year the EPRA NAV total return was -5.8%. DPS declared for the year was 12.0p including Q120 and Q220 DPS of 4.75p each and a final DPS of 2.5p.

Exhibit 1: Summary of FY20 financial performance

FY20

FY19

FY20/FY19

£m unless stated otherwise

IFRS

Adj.

Adj. earnings

IFRS

Adj.

Adj. earnings

Adj. earnings

Rental & other income

21.1

(2.9)

18.3

18.8

0.0

18.8

Non-recoverable property costs

(2.4)

(2.4)

(2.3)

(2.3)

Net rental income

18.8

(2.9)

15.9

16.4

0.0

16.4

-3.2%

Dividend on listed equity investment

0.1

0.1

0.0

0.0

Share based payments

(0.1)

0.1

0.0

(0.3)

0.3

0.0

Other administrative expenses

(4.2)

(4.2)

(3.8)

(3.8)

9.6%

Operating profit before gains/(losses) on property assets

14.6

(2.7)

11.9

12.4

0.3

12.7

-6.5%

Unrealised gains/(loss) on revaluation of investment properties

(17.9)

17.9

0.0

(5.9)

5.9

0.0

Profit/(loss) on disposal of investment properties

(0.1)

0.1

0.0

(0.4)

0.4

0.0

Unrealised gain/(loss) on listed investments

(0.4)

0.4

0.0

(0.2)

0.2

0.0

Operating profit

(3.9)

15.8

11.9

11.1

1.6

12.7

-6.5%

Net finance costs

(4.3)

0.5

(3.8)

(3.7)

0.0

(3.7)

2.2%

Change in value of interest rate derivatives

(0.8)

0.8

0.0

(0.9)

0.9

0.0

Profit before tax

(9.1)

17.1

8.0

6.4

2.5

8.9

-10.2%

Taxation

3.6

(3.6)

0.0

(1.3)

0.2

(1.0)

Profit after tax

(5.4)

13.5

8.1

5.2

2.8

7.9

1.7%

OTHER DATA

Basic EPS (p)

(11.8)

11.3

Fully diluted EPRA EPS (p)

23.4

16.5

41.7%

Fully diluted adjusted EPS (p)

17.5

17.3

1.5%

DPS (p)

12.0

19.0

-36.8%

EPRA NAV per share (p)

364

407

-10.4%

EPRA NAV total return (%)

-5.8%

2.8%

Fair value of investment properties

277.8

286.3

Gross debt

120.8

119.4

Net debt

105.8

96.5

Net LTV (%)

38.1%

33.7%

Source: Palace Capital data, Edison Investment Research

Funding and debt

End-FY20 gross outstanding debt was c £120.8m (including unamortised debt facility fees) and the cash balance was c £14.9m. Net debt of c £105.8m represented a net loan to value ratio (LTV) of 38.1%. The debt was well spread across lenders with an average cost of 3.1% with no maturities for the next two years. Of the total debt facilities, 56% of the was either fixed rate or hedged to mitigate interest rate risk and 44% was floating rate. The debt facilities shown in Exhibit 2 include the £26.5m Barclays Bank development facility that was arranged to substantially fund the Hudson Quarter construction costs. The £21.5m undrawn from this facility at end-FY20 is sufficient to cover the remaining Hudson Quarter development costs. During FY20 the revolving credit facility (RCF) with NatWest was increased from £30m to £40m and extended for a further five years at lower cost.

Exhibit 2: Debt portfolio as at 31 March 2020

Lender

Facility (£m)

Drawn (£m)

Maturity

Hedging

Barclays

40.9

40.9

Jun-24

£34.8m fixed

NatWest (RCF)

40.0

28.6

Aug-24

100% floating*

Santander

25.8

25.8

Aug-22

£19.3m fixed

Lloyds

6.8

6.8

Mar-23

100% floating

Scottish Widows

13.7

13.7

Jul-26

100% floating

Barclays (development facility)

26.5

5.0

Oct-21

100% floating**

Total

153.7

120.8

56% fixed/44% floating

Source: Palace Capital. Note: *Facility fee on undrawn balances 1.05%. **Facility fee on undrawn balances 1.3%.

Each of the facilities has its own agreed banking covenants in respect of minim levels of LTV and interest cover (ICR) or debt service cover (DSCR, including loan amortisation). Overall, Palace states that rental income would need to fall by more than 40% on average and asset values by 18% on average for all the ICR and LTV covenants to be challenged, respectively. However, two facilities in particular (Scottish Widows and Santander), are under more pressure due to their funding of the leisure assets in the portfolio, where rent receipts have been particularly affected by the pandemic lockdown. Post the year end, the ICR covenants for these two facilities were breached as part of the quarterly April test. Both banks provided temporary covenant waivers in response to this unusual situation and PCA expects to return to compliance this month.

Focus on regional office and industrial with embedded potential

The portfolio was externally valued at £277.8m at the end of FY20, with a contractual rental income of £17.6m reflected in a net initial yield of 6.0%. It comprised 53 assets (51 completed and two development assets) let to more than 200 individual tenants. The weighted average unexpired lease term (WAULT) to first break increased to 4.8 years (6.5 years to expiry) from 4.5 years during FY20 and the EPRA occupancy rate (which excludes development assets) increased to 87.3% (FY19: 86.9%). The estimated rental value (ERV) of the void space is £2.6m), the majority of which relates to completed refurbishment projects or assets that have been identified for strategic refurbishment or development. Total ERV of £20.6m (including lease incentives at expiry and upside reversion to market rents) is £3.0m or 17.6% above current contractual income, representing significant upside potential. Additional to this is the income potential from the Hudson Quarter commercial space when completed which Palace estimates will add c £1.0m to ERV (and generate a pre-tax development gain of at least £10m).

Exhibit 3: Portfolio summary

FY20

FY19

Portfolio value

£277.8m

£286.3m

Net initial yield

6.0%

5.7%

Reversionary yield

6.6%

7.0%

Contractual rental income

£17.6m

£17.7m

Estimated rental value

£20.6m

£21.5m

Weighted average unexpired lease term to first break

4.8 years

4.5 years

EPRA occupancy rate

88.3%

86.7%

Source: Palace Capital

Focus on regional offices and industrial

The portfolio is regional (ie not Central London) and 60% (by value) is invested in offices and industrial assets, both sectors that at a market level were performing well going into the pandemic and which are expected to continue to outperform the retail sector. Regional offices account for c 46% of the portfolio by value, including city centre buildings in Liverpool, Manchester, Leeds, Newcastle and York (on completion of Hudson Quarter), all within the domain of the ‘Northern Powerhouse’ and set to benefit from the government’s ‘levelling up’ agenda which aims to drive growth in the north. Business relocations away from London, limited new supply and the past conversion of office space to residential, are all factors that should continue to provide support to the market going forward despite a more uncertain economic environment. With an ERV of £2.1m, office voids represent a significant share of the upside from letting vacant space. Industrial property (14% by value) has similarly been benefitting from firm occupier demand, particularly by retailers requiring ‘last mile’ distribution space to meet increased customer demand from e-commerce, limited new supply and rental growth. Two large leisure assets in Halifax and Northampton account for 13.7% of the portfolio by value. The sector has faced similar challenges to the retail sector and has been significantly affected by the lockdown. However, the properties are substantially let (93%) to solid covenants with an average 9.5-year WAULT and management is confident of collecting all rents outstanding as a result of the lockdown in coming months. The portfolio’s exposure to retail is relatively low with two retail warehouses let to Booker (a subsidiary of Tesco), Wickes (part of Travis Perkins) and Pets at Home, and a supermarket let to Aldi on a long lease. The range of other retail tenants is diverse with no exposure to problem areas like mid-market fashion or department stores.

Exhibit 4: Portfolio by sector

% by
value

Value
(£m)

No. of
assets

WAULT to first break
(yrs)

Contractual income (£m)

ERV
(£m)

Office

46.3%

128.5

28

3.0

8.8

11.5

Industrial

14.0%

38.8

10

3.9

2.4

2.8

Leisure

13.7%

37.9

2

9.5

3.6

3.3

Development

13.6%

37.8

2

N/A

N/A

N/A

Retail

8.6%

23.9

8

7.3

2.0

2.2

Retail warehouse

3.8%

10.5

2

6.8

0.8

0.7

Other

0.0%

0.4

1

3.3

0.1

0.1

Total portfolio

100.0%

277.8

53

4.8

17.6

20.6

Source: Palace Capital

Embedded potential and further opportunities from asset management and development

The upside potential embedded within the portfolio is represented by:

the significant £3.0m upside from current contracted rent for the completed assets and the estimated full occupancy rental value at market rents;

the potential £1.0m uplift from the completion and letting of Hudson Quarter;

and several additional medium-term refurbishment and development opportunities for which detailed asset management plans have been identified.

Exhibit 5: Current rent roll to ERV bridge as at 31 March 2020

Source: Palace Capital

Of the £3.0m (18%) end-FY20 reversionary potential from the completed assets, the single largest opportunity comes from void reduction (£2.5m), the majority of which relates to completed refurbishment projects (£1.8m). Additional potential (£0.7m) comes from assets where vacant possession has been strategically obtained with a view to refurbishment or development activity, some of which could meanwhile be offered on short lets. Including Hudson Quarter, end FY20 potential ERV (£21.6m) was 23% ahead of the end FY20 contracted rent.

Palace has also identified several medium-term asset management opportunities that it plans to phase in over a number of years, potentially providing counter-cyclical opportunities to add value to the portfolio should market-wide rents and capital returns stall.

Hudson Quarter progressing well

Hudson Quarter is a key development for Palace and with positive conditions in both the commercial and residential markets in York management has not changed its expectations for rental values or gross development value. Construction activity continued through the lockdown, and although it slowed slightly due to social distancing measures and materials supply chain issues, it has again begun to pick up with completion now expected in March 2021, about two months later than previously expected.

Hudson Quarter occupies a two-acre site in York, within the city walls and just a minute’s walk from York railway station. The scheme comprises three residential buildings and a commercial building. The 127 flats will be sold and the commercial element, comprising 39, 500 sq ft of grade A offices, of which 4,500 sq ft has been pre-let, will be retained for income.

Although the marketing suite was closed during the lockdown contracts have been exchanged on 32 of the 127 apartments with a value of £8.5m; a further five are under offer (value of £1.6m). Palace says that it has detected no weakness in the market as a result of the pandemic lockdown and has had no need to discount prices to maintain sales. In February, 4,500 sq ft of office space, on the ground floor of one of the residential buildings was pre-let to Knights, the quoted law firm, at a record rent for York of £25 per sq ft.

Financials

Forecasting in the current environment is highly uncertain, from the perspective of accounting income, cash collected income and capital values. In that context we have opted to consider a range of potential outcomes in respect of the current financial year only while noting that completion of the Hudson Quarter development in March 2021 should, all else being equal, provide a significant uplift to contracted rental income and NAV, as well as releasing c £50m of capital (from completion of residential sales in full) for debt reduction and/or reinvestment in yielding assets.

Palace has yet to provide any guidance in respect of the full year financial performance but has indicated that it sees the payment of quarterly dividends amounting to 10p for the year as a very conservative objective that it hopes to improve upon. We estimate that to fully cover the £4.6m dividend cost after all expenses and financing costs requires £12.3m of net rental income to be generated. Compared with the £15.9m reported in FY20 (excluding the one-off lease surrender premium) this represents a reduction of more than 20%.

Exhibit 6: We estimate full cover of a 10p annual DPS requires £12.3m of net rental income compared with £18.8m

£m unless stated

DPS (p)

10.0

Number of shares (m)

46.0

Total dividend paid

4.6

Edison estimated administrative expenses

(4.4)

Edison estimated net finance expense

(3.6)

Edison estimated other income

0.3

Required net rental income

12.3

£m unless stated

DPS (p)

Number of shares (m)

Total dividend paid

Edison estimated administrative expenses

Edison estimated net finance expense

Edison estimated other income

Required net rental income

10.0

46.0

4.6

(4.4)

(3.6)

0.3

12.3

Source: Edison Investment Research

Income statement and cash flow

For the income statement we have modelled three scenarios in order to indicate a range of potential outcomes. We have deliberately not labelled these as base case, lower case and upper case given the uncertainty and because outcomes that fall outside of our scenarios are entirely possible. A summary is shown in Exhibit 7.

Exhibit 7: Scenario summary for FY21

£m unless stated otherwise

Lower scenario

Central scenario

Upper scenario

Gross rental and other income

16.1

16.8

17.5

Property costs

(2.9)

(2.5)

(2.3)

Net property income

13.2

14.3

15.2

Admin expenses

(4.1)

(4.1)

(4.1)

EBITDA

9.1

10.2

11.1

Finance costs

(3.6)

(3.6)

(3.6)

Adjusted pre-tax earnings

5.5

6.6

7.5

Tax

0.0

0.0

0.0

Adjusted earnings

5.5

6.6

7.5

Share-based payments

(0.3)

(0.3)

(0.3)

EPRA earnings

5.2

6.3

7.2

Fully diluted number of shares (m)

46.1

46.1

46.1

Adjusted EPS (p)

12.0

14.4

16.3

EPRA EPS (p)

11.3

13.7

15.7

Source: Edison Investment Research

Resulting from the pandemic, lockdown and weakness of economic activity, the key area of uncertainty with regards to the recurring income statement ie before property valuation movements, is in respect of rental income. There are several factors that will contribute to the outcome including:

The extent and pace of recovery in rental collections. Although the government has restricted the ability of landlords to act against tenants in arrears until the end of September, ultimately tenants will have to become compliant with existing (or possibly revised) lease terms. Rents in arrears may become irrecoverable and even tenants who are currently paying rents may fail and voids could increase.

Market conditions may make it more difficult to renew leases maturing during the year (or subject to break clauses) and may slow the letting of vacant space, a significant source of potential income upside.

Although portfolio office and industrial rents are generally low compared with market levels and ERV is significantly above contracted rent for the portfolio as a whole, in the leisure and retail warehouse sectors contracted rents are slightly above market rents. In some cases, it could be necessary to agree lower rents to protect long-term occupancy.

Cash rental collection may fall below accounting rental income if rent collections are delayed or where rent-free periods are provided in return for lease extensions, easing near-term tenant cash flow while securing long-term occupancy. Accor has been granted a six-month rent-free period on its annual rent of £510k in return for a five-year extension in its lease to 2032.

At present we do not know how these factors will play out, but we expect the position to become clearer as the economy continues to re-open. Our three scenarios each focus on:

How much of the expected contracted rent, based on the opening level, is ultimately collected and included within accounting income. Our starting point is to assume that the Q121 (93%) and Q221 (84%) collection rates remain as currently reported with no further improvement (conservative in respect of Q221 as collections are continuing) but (more optimistically) that in H221 collection normalises.

Uncollected rents become voids with a negative impact on income and irrecoverable property costs.

Each scenario assumes a £0.5m drop in start-year passing rent of £17.6m in respect of expiring leases not renewed (after IFRS smoothing adjustment the Accor rent-free period has only a small impact on accounting rental income) and very conservatively we have assumed no benefit from letting start-year vacant space.

Our central scenario assumes that all rents on agreed monthly payment plans are received during FY21 but that only 90% of Q1–Q2 outstanding rents are ultimately collected, reducing rent roll going into H221 by c £0.4m. The resulting accounting gross rental income of £16.8m compares with the opening rent roll of £17.6m (but closing FY21 rent roll of £16.7m). With adjusted EPS of 14.4p we assume aggregate DPS of 13p for the year.

In the upper scenario we assume that 100% of outstanding Q1–Q2 rents are collected during FY21 and that rent roll ends FY21 at £17.1m, with accounting gross rental income of £17.5m reported and slightly lower non-recoverable property costs. With no contribution assumed from the letting of vacant space, this should not be interpreted as a best-case scenario. Adjusted EPS of 16.3p would indicate a higher DPS than for the central scenario.

In the lower scenario we assume that just 80% of Q1–Q2 outstanding rents are collected and that rent roll closes FY21 at £16.3m. Reported accounting gross rental income for the year is £16.1m and non-recoverable property costs are higher at £2.9m. With adjusted EPS of 12.0p the lower scenario has Palace’s base level annual DPS target of 10p well covered, although this should not be interpreted as a worst-case scenario.

As we have assumed that rents are either collected during the year or not paid at all the only difference between accounting rental income and cash received rental income implied by our scenario analysis is in respect of rent-free/lease incentive adjustments which smooth the impact through the income statement with a non-cash adjustment. In our analysis the IFRS smoothing impact is relatively small (c 5%) but would increase if rent deferrals extend beyond the end of FY21 or if there are more rent-free agreements with tenants, deferring near-term income but extending occupancy.

Property valuations and net asset value

MSCI UK Property Index monthly return data show that across the UK commercial property sector as a whole, positive total returns were recorded until March 2020, with a positive performance from the industrial and office sectors offsetting weakness in retail and leisure. From March through May, due to the pandemic and lockdown, all main sectors experienced weakening capital values and negative total returns, while the weakness of retail and leisure accelerated. Total market capital returns were -2.3% in the month of March 2020, -1.7% in April and -1.1% in May. Data for June from CBRE suggests that industrial and office values may be in the process of stabilising (-0.1% and -0.2% respectively) while the decline in retail values continued (-1.4%).

Office rental value growth was broadly stable through May, but capital values weakened and there is much debate as to whether the pandemic and remote working will have a negative long-term impact on the demand for office space. Home working has probably received an enduring boost but the case for full-time office working is less clear. When in the office, it is likely each worker will require an increased amount of space. Well-appointed offices, with good transport links, good IT infrastructure and environmental credentials are likely to retain a premium. The industrial sector should continue to find support from a general tightness of supply relative to demand and has continued to see rental growth through May. The structural weakness in the retail sector seems set to continue. Based on recent trends, Exhibit 8 shows our best guess at capital value movements across the market for FY21 and applied to the PCA portfolio as at end-FY21. We have allowed for PCA’s leisure assets to do a little better than the market, reflecting the end-FY20 negative valuation adjustment and the recent asset management/lease extension initiatives. We also expect PCA’s retail exposures to outperform the wider retail market, but we have made no allowance for the possibility that letting void space may have a positive valuation impact. Given the level of uncertainty this is best treated as an illustration.

Although we have included none of the development gain that management expects from the completion and letting/sale of Hudson Quarter, with scheduled completion in March 2021 it is possible that some of this may fall into FY21.

Exhibit 8: Portfolio valuation assumptions for FY21

End-FY20 value
(£m)

Assumed FY21 valuation movement

FY21 valuation movement (£m)

Office

128.5

-6%

(7.7)

Leisure

37.9

-8%

(3.0)

Industrial

38.8

-4%

(1.6)

Retail

23.9

-8%

(1.9)

Retail warehouse

10.5

-8%

(0.8)

Other

0.4

0%

0.0

Total completed portfolio

239.9

6.3%

(15.0)

Development

37.8

N/A

N/A

Total portfolio

277.8

5.4%

(15.0)

Source: Edison Investment Research

Including these property valuation movements into our central scenario for income returns suggests an end-FY21 EPRA NAV per share of 339p (FY20: 364p). Alternatively, each 1% increase/decrease in the total portfolio value (including the development assets) is equivalent to an increase/decrease in EPRA NAV per share of c 6p. For the end-FY20 EPRA NAV (364p) to fall to match the current share price (200p) would require a c 27% reduction in the portfolio value.

Cash and gearing

With Hudson Quarter construction spending funded by the Barclays development facility, and including £3m of capex in respect of completed assets, our central scenario indicates a broadly stable cash position and an increase in net debt to £125.0m (end-FY20: £105.8m) and an increase in LTV to 43.9%. If capital values are stronger than we allow for the LTV would be lower. For the upper and lower scenarios, the impact on debt and gearing should be smoothed out by higher or lower dividend payments, respectively. If adjusted for the post-completion sales of the Hudson Quarter apartments (c £50m) and including the development gain that management expects (at least £10m), the end-FY21 LTV would be c 30%.

Valuation

Since its first major post-IPO transaction in H214 until end-FY20 Palace’s total return strategy has generated cumulative EPRA NAV total returns of 125.3% or a compound annual average return of 13.3%. Our central scenario indicates a negative total return in FY21 (-7.6%) driven by the market-driven property valuation movements that we assume, but we note that FY22 (for which we provide no forecast at this stage) should benefit from completion of the Hudson Quarter development (at the end of FY21) with management expecting an increase in rental income of c £1m pa and generating a pre-tax development gain of at least c 20p per share at completion and full letting (or sale). Some of the development gain may be recognised by the independent valuers in FY21 but we assume not at this stage.

Exhibit 9: NAV total return history

H214

FY15

FY16

FY17

FY18

FY19

FY20

Cumulative return H214–FY20

Opening EPRA NAV per share (p)

218

341

388

414

443

414

407

218

Closing NAV per share (p)

341

388

414

443

414

407

364

364

Dividend per share paid (p)

2.5

8.50

14.00

18.00

19.00

19.00

19.00

100

Income return (%)

1.1%

2.5%

3.6%

4.3%

4.3%

4.6%

4.7%

45.9%

Capital return (%)

56.6%

13.5%

6.9%

6.9%

-6.4%

-1.8%

-10.4%

67.2%

NAV total return (%)

57.8%

16.0%

10.5%

11.2%

-2.1%

2.8%

-5.8%

113.1%

Average annual compound return (%)

12.3%

Source: Palace Capital data, Edison Investment Research

The company indicates that it targets quarterly DPS payments for FY21 amounting to at least 10p per share (a 5.0% yield on the current share price), with the potential for this to be higher. Recognising Palace’s REIT status and the requirement that it distribute at least 90% of its rental profits, we have assumed aggregate DPS of 13p (a yield of 6.5%) or c 90% of our ‘central scenario’ adjusted earnings. The shares trade at a significant discount to EPRA NAV, around half the end-FY20 EPRA NAV per share of 364p and a still large discount of c 40% to our central scenario FY21 EPRA NAV per share of 339p.

In Exhibit 10 we show a summary performance and valuation comparison of Palace and a peer group of UK commercial real estate investment companies with a strong regional focus.

Palace shares have declined over 12 months, broadly in line with the peer average. However, the peer group performance is below that of the broad UK property sector where some of the long-income-focused specialist REITs and industrial-focused REITs have been outperformers. In terms of valuation we show the trailing yield based on aggregate declared DPS over the past 12 months as well as the forward-looking yield based on the most recently declared DPS annualised. Neither is entirely satisfactory as the sector remains in a state of flux, with some companies having indicated a reduced DPS payout for the time being and some postponing DPS payments altogether until later in the year. It will take some time before the full-year prospective DPS outlook becomes clearer and a true comparison can be made. With that said, PCA’s annualised yield of more than 5% based on the minimum (10p) annual dividend that management expects is above the peer average and compares favourably to the risk-free yield on offer (10-year UK gilt yields are less than 0.2%). Given the strong track record of total return generation, the prospect of Hudson Quarter completion in FY21, and the potential to drive further returns from the existing portfolio, the Palace valuation appears undemanding with material upside if economic and market prospects become clear in the coming months.

Exhibit 10: Peer comparison

Price (p)

Market cap. (£m)

P/NAV (x)*

Trailing yield (%)**

Annualised Yield (%)***

Share price performance

1 month

3 months

12 months

From 12M high

Circle Property

158

45

0.57

4.2

4.2

-7%

-14%

-19%

-33%

Custodian

85

355

0.83

7.9

3.5

-9%

-9%

-29%

-29%

Picton

72

392

0.77

4.5

3.5

9%

-1%

-25%

-34%

Real Estate Investors

32

60

0.47

11.9

6.3

-3%

-25%

-43%

-45%

Regional REIT

72

310

0.64

11.5

10.6

-6%

-7%

-32%

-41%

Schroder REIT

33

172

0.55

6.3

0.0

-3%

-16%

-41%

-43%

UK Commercial Property REIT

65

842

0.75

5.7

2.8

0%

-3%

-26%

-29%

BMO Commercial Property Trust

59

472

0.48

7.6

0.0

-20%

-12%

-50%

-52%

BMO Real Estate Investments

61

147

0.61

7.2

4.1

11%

21%

-27%

-32%

Average

0.63

7.4

3.9

-3%

-7%

-33%

-38%

Palace Capital

200

92

0.55

6.0

5.0

15%

-1%

-30%

-42%

UK property index

1,466

3.1

-4%

4%

-13%

-26%

FTSE All-Share Index

3,456

3.5

0%

11%

-16%

-19%

Source: Company data, Refinitiv. Note: Prices at 14 July 2020. *Based on last reported EPRA NAV per share. **Based on trailing 12-month DPS declared. ***Based on last reported DPS annualised.

Exhibit 11: Financial summary

Year end 31 March (£000's)

2017

2018

2019

2020

2021e*

PROFIT & LOSS

Rental & other income

14,266

16,733

18,750

21,147

16,838

Non-recoverable property costs

(2,055)

(1,824)

(2,318)

(2,392)

(2,500)

Net rental income

12,211

14,909

16,432

18,755

14,338

Dividend income from listed equity investments

43

105

0

Administrative expenses before share-based payments

(2,678)

(4,011)

(3,790)

(4,154)

(4,100)

Share-based payments

(237)

(174)

(332)

(130)

(300)

Operating Profit (before capital items)

9,296

10,724

12,353

14,576

9,938

Revaluation/impairment of properties

3,101

5,738

(673)

(17,917)

(15,044)

Gains/(losses) on disposal of properties

3,191

274

(361)

(131)

0

Loss on revaluation of listed equity investments

(214)

(425)

0

Operating Profit

15,588

16,736

11,105

(3,897)

(5,107)

Net finance expense

(3,011)

(3,432)

(4,672)

(5,174)

(3,622)

Profit Before Tax

12,577

13,304

6,433

(9,071)

(8,729)

Taxation

(3,191)

(773)

(1,263)

3,632

0

Profit After Tax (FRS 3)

9,386

12,531

5,170

(5,439)

(8,729)

EPRA adjustments:

Revaluation/impairment of properties

(3,101)

(5,738)

382

17,154

15,044

Gains/(losses) on disposal of properties

(3,191)

(274)

652

(138)

0

Deferred tax charge

2,200

(299)

243

0

0

Other adjustments

155

308

1,143

(6,242)

0

EPRA earnings

5,449

6,528

7,590

10,774

6,316

Adjusted for:

Non-recurring items

0

698

0

(2,850)

0

Share-based payments

237

174

332

130

300

Adjusted earnings

5,686

7,400

7,922

8,054

6,616

Company adjusted PBT

6,677

8,472

8,942

8,029

6,616

Average fully diluted number of shares outstanding (000s)

25,738

34,980

45,898

45,988

46,069

Basic EPS - FRS 3 (p)

36.5

35.8

11.3

(11.8)

(18.9)

Fully diluted EPRA EPS (p)

21.2

18.7

16.5

23.4

13.7

Fully diluted adjusted EPS (p)

22.2

21.2

17.3

17.5

14.4

Dividend per share declared (p)

18.5

19.0

19.0

12.0

13.0

EPRA dividend cover (x)

1.14

0.98

0.87

1.95

1.05

BALANCE SHEET

Fixed Assets

183,959

253,984

261,064

251,653

242,931

Investment properties

183,916

253,863

258,331

248,699

239,977

Goodwill

0

0

0

0

0

Other non-current assets

43

121

2,733

2,954

2,954

Current Assets

13,692

46,292

55,256

51,799

69,358

Trading properties

0

0

14,367

27,557

43,436

Assets held for sale

0

21,708

11,756

0

0

Cash

11,181

19,033

22,890

14,919

16,600

Other current assets

2,511

5,551

6,243

9,323

9,323

Current Liabilities

(8,197)

(11,520)

(16,000)

(16,053)

(14,829)

Creditors

(6,161)

(8,834)

(10,001)

(14,053)

(12,829)

Short term borrowings

(2,036)

(2,686)

(5,999)

(1,836)

(1,836)

Long Term Liabilities

(79,895)

(105,457)

(119,997)

(121,051)

(142,995)

Long term borrowings

(75,758)

(97,157)

(112,017)

(117,520)

(139,464)

Deferred tax

(2,187)

(6,531)

(5,580)

(228)

(228)

Other long-term liabilities

(1,950)

(1,769)

(2,400)

(3,303)

(3,303)

Net Assets

109,559

183,299

180,323

166,348

154,465

EPRA net assets

111,759

190,011

186,968

167,919

156,036

Basic NAV/share (p)

436

400

393

361

336

Diluted EPRA NAV/share (p)

443

414

407

364

339

CASH FLOW

Operating Cash Flow

10,294

9,899

11,877

15,746

9,013

Net Interest

(2,516)

(2,704)

(3,385)

(3,662)

(3,222)

Tax

(1,047)

(395)

(1,639)

(2,173)

0

Net cash from investing activities

(3,352)

(67,725)

(11,517)

(10,097)

(21,511)

Ordinary dividends paid

(4,617)

(6,744)

(8,718)

(8,743)

(3,454)

Debt drawn/(repaid)

6,467

8,151

17,954

1,411

20,854

Proceeds from shares issued

29

70,000

0

0

0

Other cash flow from financing activities

(2,897)

(3,434)

(162)

(978)

0

Net Cash Flow

2,361

7,048

4,410

(8,496)

1,681

Opening cash

8,576

10,937

17,985

22,395

13,899

Closing cash

10,937

17,985

22,395

13,899

15,580

Restricted cash

244

1,048

495

1,020

1,020

Closing balance sheet cash

11,181

19,033

22,890

14,919

16,600

Closing balance sheet debt

(77,794)

(99,843)

(118,016)

(119,356)

(140,774)

Unamortised debt costs

(936)

(1,552)

(1,334)

(1,405)

(841)

Closing net (debt)/cash

(67,549)

(82,362)

(96,460)

(105,842)

(125,015)

Net LTV (exc restricted cash & adjusted for unamortised debt costs)

36.9%

29.8%

33.7%

38.1%

43.9%

Source: Palace Capital historical data, Edison Investment Research. Note: Central scenario as described in this report


General disclaimer and copyright

This report has been commissioned by Palace Capital and prepared and issued by Edison, in consideration of a fee payable by Palace Capital. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2020 Edison Investment Research Limited (Edison).

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Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

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Frankfurt +49 (0)69 78 8076 960

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London, WC1V 7EE

United Kingdom

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1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

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General disclaimer and copyright

This report has been commissioned by Palace Capital and prepared and issued by Edison, in consideration of a fee payable by Palace Capital. Edison Investment Research standard fees are £49,500 pa for the production and broad dissemination of a detailed note (Outlook) following by regular (typically quarterly) update notes. Fees are paid upfront in cash without recourse. Edison may seek additional fees for the provision of roadshows and related IR services for the client but does not get remunerated for any investment banking services. We never take payment in stock, options or warrants for any of our services.

Accuracy of content: All information used in the publication of this report has been compiled from publicly available sources that are believed to be reliable, however we do not guarantee the accuracy or completeness of this report and have not sought for this information to be independently verified. Opinions contained in this report represent those of the research department of Edison at the time of publication. Forward-looking information or statements in this report contain information that is based on assumptions, forecasts of future results, estimates of amounts not yet determinable, and therefore involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of their subject matter to be materially different from current expectations.

Exclusion of Liability: To the fullest extent allowed by law, Edison shall not be liable for any direct, indirect or consequential losses, loss of profits, damages, costs or expenses incurred or suffered by you arising out or in connection with the access to, use of or reliance on any information contained on this note.

No personalised advice: The information that we provide should not be construed in any manner whatsoever as, personalised advice. Also, the information provided by us should not be construed by any subscriber or prospective subscriber as Edison’s solicitation to effect, or attempt to effect, any transaction in a security. The securities described in the report may not be eligible for sale in all jurisdictions or to certain categories of investors.

Investment in securities mentioned: Edison has a restrictive policy relating to personal dealing and conflicts of interest. Edison Group does not conduct any investment business and, accordingly, does not itself hold any positions in the securities mentioned in this report. However, the respective directors, officers, employees and contractors of Edison may have a position in any or related securities mentioned in this report, subject to Edison's policies on personal dealing and conflicts of interest.

Copyright: Copyright 2020 Edison Investment Research Limited (Edison).

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Edison Investment Research Pty Ltd (Edison AU) is the Australian subsidiary of Edison. Edison AU is a Corporate Authorised Representative (1252501) of Crown Wealth Group Pty Ltd who holds an Australian Financial Services Licence (Number: 494274). This research is issued in Australia by Edison AU and any access to it, is intended only for "wholesale clients" within the meaning of the Corporations Act 2001 of Australia. Any advice given by Edison AU is general advice only and does not take into account your personal circumstances, needs or objectives. You should, before acting on this advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If our advice relates to the acquisition, or possible acquisition, of a particular financial product you should read any relevant Product Disclosure Statement or like instrument.

New Zealand

The research in this document is intended for New Zealand resident professional financial advisers or brokers (for use in their roles as financial advisers or brokers) and habitual investors who are “wholesale clients” for the purpose of the Financial Advisers Act 2008 (FAA) (as described in sections 5(c) (1)(a), (b) and (c) of the FAA). This is not a solicitation or inducement to buy, sell, subscribe, or underwrite any securities mentioned or in the topic of this document. For the purpose of the FAA, the content of this report is of a general nature, is intended as a source of general information only and is not intended to constitute a recommendation or opinion in relation to acquiring or disposing (including refraining from acquiring or disposing) of securities. The distribution of this document is not a “personalised service” and, to the extent that it contains any financial advice, is intended only as a “class service” provided by Edison within the meaning of the FAA (i.e. without taking into account the particular financial situation or goals of any person). As such, it should not be relied upon in making an investment decision.

United Kingdom

This document is prepared and provided by Edison for information purposes only and should not be construed as an offer or solicitation for investment in any securities mentioned or in the topic of this document. A marketing communication under FCA Rules, this document has not been prepared in accordance with the legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This Communication is being distributed in the United Kingdom and is directed only at (i) persons having professional experience in matters relating to investments, i.e. investment professionals within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005, as amended (the "FPO") (ii) high net-worth companies, unincorporated associations or other bodies within the meaning of Article 49 of the FPO and (iii) persons to whom it is otherwise lawful to distribute it. The investment or investment activity to which this document relates is available only to such persons. It is not intended that this document be distributed or passed on, directly or indirectly, to any other class of persons and in any event and under no circumstances should persons of any other description rely on or act upon the contents of this document.

This Communication is being supplied to you solely for your information and may not be reproduced by, further distributed to or published in whole or in part by, any other person.

United States

Edison relies upon the "publishers' exclusion" from the definition of investment adviser under Section 202(a)(11) of the Investment Advisers Act of 1940 and corresponding state securities laws. This report is a bona fide publication of general and regular circulation offering impersonal investment-related advice, not tailored to a specific investment portfolio or the needs of current and/or prospective subscribers. As such, Edison does not offer or provide personal advice and the research provided is for informational purposes only. No mention of a particular security in this report constitutes a recommendation to buy, sell or hold that or any security, or that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

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Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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

1,185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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Research: TMT

Nanoco — Fundraising extends cash runway further

In May Nanoco announced it had taken actions to extend the cash runway from July this year to calendar year Q221. Since then it has signed a five-year framework agreement with STMicroelectronics covering multiple infrared sensing applications, won a development contract for a new technology application in the display sector and secured third-party funding for its patent infringement lawsuit against Samsung. Having achieved these key goals, the company has now raised £3.4m to extend the cash runway to at least the end of calendar year 2022. While our estimates remain under review, we hope to see fresh guidance from management in the new financial year.

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