Raven Russia — Emerging opportunities

Management was clear at the beginning of 2016 that it expected trading conditions to be difficult, but identified several positive factors: that the quality of the investment property assets remained excellent, despite the write-down in valuation; that new supply into the market was very limited, with vacancy rates expected to fall over the 18 months ahead; and that any improvement in the rouble–US dollar exchange rate would be of benefit to Raven. The FY16 results bear out all three: the property assets’ valuation was more resilient in FY16; occupancy was roughly flat and should rise following the acquisitions in February; and the rouble strengthened along with the price of oil and more positive economic indicators in Russia, contributing $18.1m to earnings. The FY16 results represent a considerable stabilisation after the steep declines in FY15, which stemmed from a sharp fall in the oil price and economic sanctions imposed on Russia in 2014. We will briefly describe the main points from the results before looking at the market outlook and our forecasts in more detail.

The results show that despite challenging conditions, Raven, with shareholder support, is emerging from the Russian recession in good shape: the balance sheet is strong, the portfolio has grown in FY17 and market conditions are improving, which is encouraging for occupancy and rent levels. Raven has continued to make distributions to shareholders and our forecasts, explained on pages six to nine, indicate rising revenues and profits, underpinned by the high-quality portfolio. We will now look at the wider market in more detail.

Raven was founded and admitted to AIM in 2005, with the intention of building a portfolio of Class A Russian warehouse assets through acquisition and development. It internalised its property advisor in 2008 and took over Raven Mount in 2009, which participates in a JV developing a luxury private residential estate in the Cotswolds. The ordinary shares (RUS) and warrants (RUSW) issued in 2009 moved to the main market of the LSE in 2010, followed by the preference shares (RUSP) in 2011. In 2016 Raven issued 109m convertible preference shares which trade on the official list of the Channel Islands Stock Exchange (TISEA). Apart from Raven Mount, Raven Russia also owns RosLogistics, a third-party logistics business in Russia. Tenants in its 1.5m sqm of investment property tend to be large Russian or international companies providing strong tenant covenants.

As demonstrated by the conditional deal announced earlier in the year (see our January note for details), Raven continues to expand its portfolio of Grade A logistics warehouses in Russia and has added two office buildings which came as part of that deal. The portfolio is chiefly made up of warehouses near Moscow and the regional assets are in Novosibirsk and Rostov-on-Don. The recession put severe pressure on many occupiers, and over the last two years Raven has successfully defended several of its leases in Russian courts, while negotiating with other occupiers in order to maintain occupancy. A dispute with Dixy, a major occupier at Noginsk, was resolved and a new lease for eight years for 43,000sqm of space has been signed at market rent.

The company also has a land bank of 263ha of which 84ha are adjacent to existing completed assets, mostly near Moscow. The remainder is in other regional cities where Raven does not have other assets, there are all on the route from Moscow to Novosibirsk, one of Russia’s main transport arteries. Although ERVs have now steadied, as discussed above, they remain at levels where development would provide only marginal returns (if any). Therefore no development is currently planned at any of these sites, although there is permission to add 134k sqm of space at Noginsk and 130k sqm at Nova Riga.

The charts below show the sector and currency exposures of the warehouse portfolio excluding the Gorigo asset acquired this year. The weighted average lease term to maturity of the warehouse leases was four years at 31 December 2016. Average dollar denominated rents were $125 per sqm per year and the average rouble or capped rent was R5,120. Overall, long term, dollar denominated leases still make up the bulk of net operating income (NOI) and underpin Raven’s cash flows, but for the sake of expediency in the recent environment, Raven has signed some shorter leases with smaller local operators with purely domestic businesses. This has partly driven the shift towards rouble rents (which moved from 21% to 26% of GLA over the year). These leases tend to be under five years and have breaks, providing the tenant with flexibility and insulating them from currency risk. On the other hand, Raven is able to index-link these rents to CPI, supporting NOI, and is not tied to the tenants for an extended period, meaning that space can potentially be re-let more easily to larger, international occupiers in future. The tactic has enabled Raven to manage its expiry profile and keep occupancy above 80%.

In the year, Raven renegotiated leases on 157k sqm of space. 187k sqm of space was vacated on maturity or early termination and new leases on 167k sqm were signed. The total gross lettable area of the portfolio at year end was 1,499k sqm, so new and extended leases were signed in respect of c 22% of the portfolio by area. The lease maturity profile of the portfolio and changes to it in 2016 are shown in Exhibit 4. As of 31 December 2016, no single tenant accounted for more than 11% of GLA and the top 10 accounted for 46% (58% of NOI).

The Russian warehouse market is still dominated by large retailers that are seeking to make their supply chains across Russia more efficient. The recession from which Russia is now emerging has subdued new supply, although it did increase vacancy rates across the sector, especially around Moscow where they remain over 12%. Near Raven’s regional assets the rate is under 10%, and rents there are now similar to rents in Moscow. Property investment is concentrated in the office sector and is 90% Russian-funded, with only c 6% of capital going to the warehouse market. This leaves it relatively immature and potentially attractive to specialist investors such as Raven. We examine the Moscow market, where Raven’s portfolio is concentrated, in more detail below.

Exhibit 5 shows the completion and take-up of grade A warehouse space around Moscow over the last three years as well as the vacancy rate. This shows severe oversupply in the first half of the period as Russia went into recession, and a recovery in the second half, with take-up in Q315 and in Q416 noticeably affecting vacancy. It does not show the area of previously let space where leases expired, and although since mid-2015, there has been 1.2m sqm more space taken up than built, a further 0.9m sqm of oversupply from the previous 18 months remains, before allowing for lease expiries.

This is a likely contributor to rents remaining low compared with historical levels, although the recent slight reduction in vacancy may be associated with a stabilisation of rental rates visible in Exhibit 7. We have estimated rents using JLL’s quarterly reports on the Moscow warehouse market. JLL switched from reporting rent levels in dollars only in Q115, and now only gives rouble figures. This in itself reflects a change in market dynamics, and for consistency of presentation we have chosen to extrapolate dollar figures from the movements in rouble rents and the exchange rate for the last two quarters. We note, however, that dollar and rouble rents did not move in tandem when both were being reported, and exchange rate changes did not match the variance. However, the recent strength of the rouble should increase the dollar value of rouble rents, and reflects economic conditions, which may also be conducive to higher rents.

The smaller St Petersburg warehouse market has shown similar trends, with vacancy down over 2016 from 7.6% to 5.5% and rents steady as take-up outstripped new supply. The office market also performed well, with vacancy rates down in class A and B offices. The construction of a major office, leisure and retail plaza to the north-west of the city (referred to in our last note) is expected to increase demand for other office space in the vicinity, which includes the Primium building conditionally acquired by Raven in February. Raven’s St Petersburg assets are 99% let on average and market commentators expect vacancy rates generally to fall in the area, supporting rents.

We therefore share management’s view that the outlook is better than a year ago, but that the market is in the early stages of recovery. We would also note that the move from dollar-denominated rents to rouble-denominated rents changes the sensitivity of the market to exchange rates. It is likely to be beneficial to occupiers whose Russian business works in roubles, aligning their costs more closely with their revenues, which may make occupancy levels more resilient to economic headwinds in future. For a foreign owner of Russian property, the shift increases direct exposure to the rouble. In the near term this may be beneficial for a business reporting in dollars or sterling, given the rouble’s recent strength and falling Russian inflation. Forward rates imply that in the medium term the rouble is expected to weaken against the dollar, however, reflecting the recent interest rate increase by the Federal Open Market Committee (FOMC) and expectations of further increases in 2017.

We have reviewed our estimates in the light of the published results and recent acquisitions, leading us to raise them slightly, as shown in Exhibit 10. The 2016 results were better than our forecasts in terms of NOI and EBIT, the latter helped by FX gains of $18m in the year. However, revaluation losses were above our forecast, leading to lower IFRS earnings and slightly lower NAV per share than we had expected. Cash earnings were ahead of our forecasts and the board intends to distribute a further 2p per share via a tender offer for one share in every 26 at 52p per share, also ahead of our forecast. We have introduced a 2018 forecast and explain our assumptions in detail below.

The principal drivers of changes to our net operating income forecast have been the increase in rents from the new St Petersburg assets (c $13m per annum, with a c eight-month contribution in 2017) and improvements in the rouble to dollar exchange rate. We continue to forecast on the assumption that vacancy across the existing portfolio will fall from 19% at the year-end to 15% at H117, 13% in H217, 10% in H118 and 7% in H218. This outlook is based on the improvements in the economic conditions in Russia and the rapid reduction in vacancy seen in the wider warehouse market following the financial crisis in 2009: market-wide vacancies dropped from c 12% to 4% in a year and to 1% the year after that. Raven’s performance in the recession, limiting the falling occupancy and NOI, encourages us that this can be achieved. We have also adjusted our tax expectations upwards to allow for new legislation coming into effect in FY17.

We also assume that new leases are at a lower rent than before the recession. In a year that saw 11% of GLA re-let, rouble rents went from 21% to 26% of the portfolio, implying that around half of new rents are denominated in the local currency. We assume that those start at RUB4,000 in H117 and grow 5% per annum, roughly in line with inflation and at the lower end of Raven’s range of indexed annual lease uplifts. For the half of rents in dollars, we apply the current exchange rate of RUB57.789/US$. At the moment, we do not assume that this will change, but, for illustration, if we were to apply the current forward rates, our dollar NOI in FY18 would be c $4m lower.

For RosLogistics, we apply 5% annual cost and revenue growth in roubles half-by-half (ie H117 is 5% above H116), and then apply the current exchange rate to future periods. Rouble strength therefore magnifies growth in dollar terms. For the smaller Raven Mount operations, we assume flat revenues of $2m and NOI of $1m (Exhibit 11).

We do not assume any FX gains or property valuation changes and our model uses operating costs of 25% of NOI, administrative expenses flat at $14m, depreciation in line with the last reported period and share-based payments of $1m per year. We allow for a distribution of 1p per year in FY17 and FY18, expecting that the board will wish to continue making one while preserving balance sheet strength as the market improves. As before, we model this as a cash payment but would expect further tender offers to be more likely. Our earnings and balance sheet estimates suggest higher distributions would be possible should the board deem them appropriate.

As mentioned above, the balance sheet was strengthened significantly in FY16. Management believes that valuation losses have now washed through, and, as ever, we do not forecast investment property valuation changes (this applies to derivatives and other assets carried at fair or market value as well). The conditional acquisition of the three St Petersburg assets will lift the value of the investment property portfolio if it is successful and contributes the most to the cash reduction we expect in FY17.

We expect management to continue reducing debt levels and for gross and net debt to continue to fall in relation to property assets (Exhibit 14). The sale of part of HSH Nordbank’s debt book in FY16 gave Raven the opportunity to repay most of one of its facilities for $16m and be released from the other, generating a profit of $15m. Since the year end another high-amortisation loan has been refinanced, extending it from $75m to $80m maturing in 2024 and with a reduced amortisation rate and similar interest. There are now no major debt maturities before 2019 other than scheduled amortisation. The average cost of debt is now 7.5% and the weighted average maturity is 4.7 years.

Cash flow movements are largely explained above and we show our cash flow forecast in Exhibit 16. The acquisition causes net debt to increase in FY17 compared to FY16, but we expect it to fall thereafter. NOI was 2.2x bank interest in FY16 as expected in our previous estimates, and the debt reduction measures should cause this multiple to rise to 2.6x in FY17 and 2.7x in FY18 on our forecasts.

Occupancy, rent levels, valuation yields and foreign exchange movements all affect Raven’s business and are key assumptions in our forecasts. We assume the last two remain at current levels, which we believe to be a conservatively naïve stance; we base our rent assumptions on the pattern of recent new leases and the profile of upcoming lease expiries and we forecast improving occupancy based on the general outlook for the wider Russian economy.

As noted earlier, and illustrated in Exhibit 17, the rouble has performed well recently and Russia appears to be coming out of recession, with falling inflation and a recovery in the oil price since the lows of early 2016. Our oil and gas team continues to expect a long-term oil price of $70 per barrel, above the current level of c $50/bbl. The OECD forecasts Russian GDP growth in 2017 and 2018 of 0.8% and 1.0%, respectively, after falls of 3.7% and 0.8% in 2015 and 2016 (last updated on 28 November 2016).

An improvement along the lines expected by the OECD and other commentators would be of benefit to Raven, and, like management, we look for evidence of better trading conditions in 2017.

Raven’s strategy is to grow income and shareholder distributions and although the Russian recession made a reduction in the dividend necessary, a distribution has been maintained, with 2.5p exceeding our forecast for 2016. We maintain our conservative forecast of 1p per share for FY17 and FY18, noting that the current strategy is defensive (although opportunistic as demonstrated by the recent acquisition). However, we have raised our EPS forecast from 5.5p to 5.8p in FY17, which may leave room for a higher level of distributions than we have assumed.

With the company well placed to benefit from a stabilising economy, cash flow and distributions will continue to be the underlying attraction of a long-term investment in Raven, and the current discount to NAV of c 1% may be reduced.

Our forecast distribution of 1p per ordinary share equates to a yield of 1.9% on the current price and reflects our view that Raven remains prudent, is still reducing debt and wishes to maintain its cash balance. Below we show net operating income after tax and all interest payments using the US$/£ exchange rate as at 17 March 2017 (and historic rates for historic periods). These have increased from our old forecasts (see page 10 of our update note from 31 August 2016).

The preference shares (RUSP) earn a cumulative 12% dividend on the fixed issue amount per share of 100p. These shares currently trade at 143p, for a yield of 8.4%. The convertible preference shares (RUSC), which rank above other shares, receive a cumulative 6.5% preferential dividend on the subscription amount of 100p, a yield of 5.7% on the current price of 114p.

Diluted IFRS NAV per share at 31 December 2016 was 71c, slightly lower than 72c a year earlier. Fully diluted and adjusted and using an exchange rate of $1.2361/£ gives 54p for a discount of c 5%, a considerable reduction over the last six months, reflecting greater optimism on the economic outlook and adjustment for FX movements.