Town Centre Securities — FY18 earnings in line and DPS increased

TCS is a UK real estate investment trust (REIT) operating across the UK with a regional focus, primarily in Leeds and Manchester, where management is able to exploit its strong and detailed knowledge of the local markets, Scotland and (mainly suburban) London. The company is a family-run business with strong income focus and a 58-year record of increased or maintained DPS. It owns a mixed-use portfolio, valued at c £403.5m as at 30 June 2018, including key development sites in Leeds and Manchester. It also has a car parking operation (CitiPark), which provides a growing and complementary revenue and earnings stream, while monetising what would in some cases be empty, non-income producing development assets. Intensive asset management and active capital recycling are used to drive income growth and capital returns, and the company has a substantial pipeline of continuing development opportunities. For an in-depth overview of TCS, please see our April 2018 initiation note.

The underlying FY18 results (EPRA earnings and NAV) were very much in line with our expectations and those of the market, as flagged in the company’s trading update in mid-July. The increase in the full-year dividend per share to 11.75p was a positive surprise for us and reflects management’s confidence about the development of its portfolio and the company’s future prospects. The year saw continued progress in reshaping the portfolio through capital recycling and new developments coming on stream, targeted at ensuring a resilient income stream while unlocking growth for the future. Retail and leisure exposure has now reduced to 55% compared with 70% two years ago and 80% 10 years ago. Strong property returns contributed to a 10.0% NAV total return during the year, and the group completed a comprehensive refinancing of its bank debt. The loan to value ratio fell to 47.5% (FY17: 49.3%) and following the innovative refinancing of Merrion House had fallen further in July, to a pro forma 45.3%. The Merrion House refinancing saw TCS receive £26.4m in cash in July, providing additional resources to selectively fund the development pipeline.

The key financial highlights of the FY18 results were:

TCS has a diverse, mixed-use portfolio with a 30 June 2018 value, including investment properties, developments, joint ventures, and car parks, of £403.5m (FY17: £381.1m). The investment properties were valued at £331.3m, reflecting a net initial yield of 5.7%, with a passing rent of £20.0m, and 95% occupancy. The full occupancy estimated rental value (ERV) was £22.6m. Including the car parking assets and car parking income on development assets, the end-year passing rent increases to £23.4m.

Retail and leisure remains the single largest sector weight in the portfolio but has been actively reduced to 55% (from 70% two years ago) in line with the strategy of repositioning the portfolio for future income and growth. Geographically, Leeds and Manchester combined represent 75% of the portfolio by value and remain core to that strategy.

The significant, and ongoing, repositioning of the portfolio can be clearly seen in Exhibit 6, and this has been driven by capital recycling as well as the group’s development programme (e.g. the recently completed ibis Styles and Premier Inn hotels in Leeds, and the Merrion House redevelopment). Since the beginning of FY17, TCS has disposed of an aggregate £33.2m of properties with acquisitions amounting to £29.0m. Within this, net divestment from retail and leisure assets has been a little more than £24m.

TCS is not exiting retail, and while it has reduced the overall exposure it remains committed to investing the appropriate formats in the right locations. Of the retail exposure retained by TCS, a little more than 80% (of the 55%) represents the Merrion Centre. The Merrion Centre mostly comprises convenience and discount retailing, well suited to its location in the heart of the Leeds student quarter, and this has provided protection against much of the disruption being seen in the high street. Occupancy levels remain high (97%), and footfall and rental income remain strong, with like-for-like rents up 2.0% (increasing to 13.4% including Merrion House office development completion).

The retail tenant base is diversified (the top 10 tenants represent 29% of property income, almost half of which is represented by Waitrose and Morrisons, along with many other good-quality covenants. Rents are mostly collected a quarter in advance and across the portfolio 97% of collections typically occur within four days of the quarter start.

Well placed in the centre of Leeds, the Merrion Center, which remains the group’s largest single asset, has been transformed over the past 10 years from a shopping centre to truly mixed-use destination. Delivery of the Merrion House office development (February 2018) and the ibis Styles hotel with restaurant (April 2017) have continued the process, with reliance on traditional ‘mall’ retail falling to less than 25%. As noted above, the problems in the high street have had no material impact on the Merrion Centre, and although Poundworld, now in administration, was a tenant, the store is one of a small number that have been sold to Iceland, with the lease being assigned with no change in terms. TCS is developing plans that would potentially see the building of a new office tower above part of the centre, providing further diversification.

Since year-end, TCS has completed the acquisition of The Cube, a high yielding mixed use property situated opposite the Merrion Centre. The £12m purchase price represents an immediate yield of 12.5% on the passing income and the yield is expected to remain above 9.0% after lease expiries in 2019 and 2020. TCS plans future capex of £5m.

The group is also entering a JV with Leeds City Council for development of an aparthotel on George Street alongside Victoria Gate and Leeds City Market, and is developing plans for the Vicar Lane island site where TCS increased its ownership to 100% in June 2017.

In Manchester, TCS has acquired Ducie House for £9m, a 33,000 sqft multi-let office, including a 63-space surface car park, with future development potential. The asset was included in the year-end portfolio, adding gross annual income of £675k to rent roll, with the cash payment appearing in H119 on completion.

Construction of the 91 unit Burlington House residential development, a JV with Highgrove Group, is proceeding on time and to budget. TCS has confirmed that post-completion (scheduled for May 2019) its investment will be held for private rental sector (PRS) use, an area where it is keen to diversify portfolio income. Full planning approval has been received for the 128 unit Eider House residential development that is expected to follow the completion of Burlington House.

Elsewhere, during the FY18 year TCS sold three properties in Scotland for an aggregate £10.1m, ahead of valuation, and since year-end has acquired a mixed residential/retail property in Chiswick High Road in London for £1.6m (net initial yield of 4.6% and a potential reversionary yield of more than 5%), and a retail unit on Gordon Street in Glasgow, let to Mountain Warehouse for £2.4m (5.25% net initial yield).

With the addition of the development opportunity at Ducie House (yet to be scoped), the pipeline of development opportunities available to TCS has increased to an estimated gross development value (GDV) of £588m. All of this pipeline is owned by TCS already and much of it is already part of relevant local government approved strategic planning frameworks, or has already been granted detailed planning permission. The main components of the pipeline are represented by the key development assets in Leeds and Manchester:

This pipeline, and the capital required to develop it, is very significant in relation to the size of the group and has the potential to be transformational, although little of it is included in our estimates. TCS continues to explore how best to fund these investments, which will most likely involve ongoing capital recycling and potential access to new capital resources, including further JV developments.

As can be seen from Exhibit 2, the underlying performance in FY18 (EPRA EPS and NAV) was very close to our forecasts, while the increase in DPS was a positive surprise. In this section we will focus on the changes in our multi-year forecasts driven by recent portfolio transactions and the evolution of the development pipeline, as well as update on the funding position, including the refinancing of existing facilities and the innovative Merrion House refinancing that was completed in July.

A summary of our earnings forecasts for the property rental segment is shown in Exhibit 8. Our assumptions include:

The JV contribution included within the property segment forecast includes Merrion House, the on-site development at Burlington House, and planned developments at George Street and Eider House (although TCS is yet to confirm that this will be a JV). We also expect TCS to proceed with redevelopment of the Leeds car park, but commencing later than we had previously assumed. Our detailed assumptions for these developments are set out in our initiation note and are little changed.

The main change to our JV forecast is in respect of the innovative refinancing of Merrion House, a 50:50 JV with Leeds City Council (LCC), the tenant. The transaction was discussed in detail in our July update note, but to briefly recap, LCC agreed to advance to the JV vehicle (Merrion House (MH) LLP) all of the base rent that would be due until lease expiry in 2043, discounted at an equivalent rate of 3.5% plus costs. As a result, TCS was able to unlock the value created by the JV development for reinvestment, while maintaining control of a key asset, and received £26.4m in cash in July. MH LLP will continue to recognise the contracted rent with LLC on a quarterly basis, but this will be partly offset by an interest charge calculated on an effective interest rate basis. We estimate that the 50% TCS share of MH LLP net income will reduce from an annualised c £1.7m to an annualised c £0.8m, effective for nine months in the current year.

Management expects the Burlington House development to complete in May 2019, which is then expected to generate c £1.1m pa of rental income for the JV (TCS share 50%), a yield on cost of c 6.0%. With confirmation that Burlington House will be retained for PRS use, we have adjusted our forecasts for the interest cost in respect of the debt that we expect the JV to retain at completion (c £13.0m, at an assumed 5%, or an LTV of 50%). We expect the TCS share of earnings to be an annualised c £275k from FY20 with a development gain on completion (TCS share) of £2m in FY19.

Construction of the George Street development is expected to start in January 2019 with a scheduled 18-month build time. We have conservatively pushed back completion by 6 months to end-H121. The development is expected to generate £1.2m pa of rental income for the JV, an estimated 6.5% yield on cost. Assuming no debt within the JV, we expect the TCS share of earnings to be an annualised c £600k (FY22 being the first full year), with a development gain on completion (TCS share) of £900k in FY21.

Although no firm decision has been taken by TCS, we continue to assume the Eider House residential scheme will be undertaken as a JV, with a TCS share of 50%, and that it will be for PRS use at completion. Management expects a March 2019 start date with an 18-month build programme. The estimated rental income is £1.6m pa, a return on the £28m build cost of 5.5%. We now assume completion at end-H121 and a first time contribution in H221, six months earlier than previously. We assume that 50% of the build cost will be debt financed (at 5.0%) and including the c £2m land value the estimated £40m value at completion implies a development gain for the JV of c £10m. We expect the TCS share of recurring JV net income after financing costs to be c £450k pa (FY22 the first full year) and its share of the development gain to be £5.0m in FY21.

Exhibit 9 summarises our updated forecasts for the JV capital, income and valuation movements in respect of the developments contained in our forecasts.

The ibis Styles hotel, within the Merrion Centre, and operated under management contract, opened in April 2017. Management says that the hotel operations have traded strongly and exceeded its expectations, but that the restaurant incorporated within the scheme has lagged and is in the process of being repositioned. Positively, the success of competing local independent restaurants indicates that there is local demand for the right offering. FY18 income fell slightly short of the £600k target and our forward looking estimates are reduced, especially for FY19 as the restaurant changes take effect.

We have made little change to our CitiPark estimates other than to defer redevelopment of the Leeds car park site. We had previously assumed the temporary loss of £500k pa of revenue for 12 months (H219–H120) while the site was partly decommissioned in order to construct a new multi-storey car park, for which we assumed revenue of £600k pa at completion. In our new forecasts, decommissioning is deferred until the beginning of FY21 and we now assume a reduction in income in that year of £560k with completion of the new multi-storey car park, and associated income uplift, now falling outside of the forecast period. Otherwise, we continue to expect further steady underlying organic growth in gross revenue and operating profit before valuation movements, with an underlying improvement in efficiency ratios.

End-FY18 financial liabilities were £198.1m, comprising £105.9m of 5.275% fixed rate debentures due 2031, secured bank borrowings of £87.8m, and £4.5m of finance lease liabilities. Adjusting for cash balances, the net debt position was £192.6m (FY17: £188.8m) and the LTV was 47.5% (FY17: 49.3%).

The three bank debt facilities, c £103m in aggregate, were all recently extended or renewed with no material impact on the cost of borrowing but with improved and more flexible terms, providing TCS with certainty over its debt funding for the next three to five years. The weighted average maturity of the debt was 8.6 years at end-FY18 compared with 8.2 years 12 months previously. The weighted average cost of debt was 3.9% at end-FY18.

The end-FY18 LTV ratio of 47.5% was distorted by the acquisition of Ducie House and Sale of Princes St straddling the year end, and is impacted by the subsequent refinancing of Merrion House. Management indicates that post the Merrion House financing in July, the pro forma LTV drops to 45.3%.

The £26.4m net inflow from the Merrion House refinancing has a significant impact on the TCS funding position as summarised in Exhibit 10. Our forecasts include £47.4m of investment in wholly owned assets over the next three years, higher than previously forecast as a result of the recent transactions that have been announced. This includes £3m pa of refurbishment capex and £6m development spending on the Leeds car park in FY21). We also forecast £16.1m investment in the JVs (TCS share), partly offset by proceeds from disposal of £16.1m. The FY19 movements include the £9.5m payment for Ducie House, and £3.3m proceeds from the sale of Princes St, although the end-FY19 property portfolio is adjusted for both transactions. The Merrion House refinancing proceeds are shown as other cash flow from investing.

After dividend payments, our forecasts point to a net cumulative funding requirement of £16.6m over the next three years. Our model assumes £15.0m of additional borrowing and a small reduction in the cash balance. This additional borrowing takes forecast financial liabilities to £213.1m by end FY21, utilising existing debt facilities, and the LTV to 48.0%.

Bringing all of the above together, Exhibit 13 shows a summary of the changes in our group forecasts.

The changes to the assumed timing of developments discussed above have an impact during the forecast period but substantially work themselves through by FY21 with the exception of the temporary loss of c £0.6m net revenue and EPRA earnings (c 1.1p per share, roughly half the forecast reduction) in relation to the Leeds car park redevelopment. The balance of the reduction in FY21e EPRA earnings is explained by the higher financing costs within the JVs, only partly offset by increased net rental income from the larger wholly owned portfolio. It is also worth noting that Eider House and George Street only contribute to FY21 for six months post the assumed completion dates and would add an additional £0.75m of EPRA earnings (c 1.4p per share) on a full-year basis.

TCS has a strong focus on growing portfolio income to support its long-term progressive dividend policy, although its active asset management strategy, aimed at enhancing long-term total return, means it is not focused on yield maximisation over the shorter term. In this context we think it informative to examine NAV total return performance (the change in NAV per share plus dividends paid). The aggregate five year NAV total return is now 64.0%, or a compound annual total return of 10.0%.

The investment in portfolio repositioning and development required to generate these returns is a limiting factor on immediate dividend distributions, but TCS has a long and consistent track record of dividend payments, increasing or at least maintaining DPS in each of the past 58 years, including during the last downturn in 2008. The FY18 increase to 11.75p (FY17: 11.5p) represents a dividend yield of 4.7%, with the dividend 1.11x covered by earnings, and is above the c 4.4% yield for the UK property index and the c 4.3% yield for the FTSE All Share Index. The TCS share price discount to NAV of more than 30% is well above the median for the broad UK sector (c 10%).

The broad UK property sector is encompasses a wide range of companies with differing strategies and includes a number of investors in specialist asset types. In Exhibit 15 we show a summary valuation comparison of TCS with what we consider to be a closer group of peers, including companies focused on regional property and those with retail exposure.

As a whole, the peer group yield is higher than for TCS but so too is the P/NAV. Breaking this down, the retail focused stocks (and some other stocks with relatively low dividend cover) tend to have the higher yields and lower P/NAVs. Those stocks most reliant on income returns and less reliant on refurbishment/development to generate returns (eg Picton or Custodian) have above-median P/NAVs. To some extent the relative market valuation of TCS to some degree reflects its portfolio balance (increasingly diversified but still relatively ‘overweight’ retail and leisure) and strategy (income focused but an active asset manager and re-cycler of capital). However, in terms of P/NAV the TCS valuation appears to more closely resemble that of the pure retail focused stocks despite it having a more diversified revenue stream. A similar picture can be seen in relative share price performance over the past 12 months.

It is difficult to describe the current TCS valuation as anything other than modest, while the share price performance does not appear to be reflecting some of the specific characteristics of TCS or the progress that has been made in the past 12 months. As discussed throughout this report, we would highlight: