Raven Property Group — Good underlying progress

Raven Property Group (formerly Raven Russia) was founded in 2005 to build a portfolio of modern, Grade A Russian warehouse assets through acquisition and development. The company has been self-managed since 2008 and has built a substantial portfolio which, at 30 June 2018, comprised c 1.77m sqm of logistics warehouse property (of which c 72% is in the Moscow region), and c 50k sqm of fully let office property in St Petersburg. Total portfolio occupancy is 87% and the warehouse portfolio is 86 let to mainly large Russian or international companies operating mainly across the retail, distribution, manufacturing and third-party logistics (3PL) sectors. In addition to the core investment property division, group subsidiaries include Raven Mount, a UK residential development company, and RosLogistics, a third-party logistics business in Russia.

The ordinary shares are listed on the main market of the London Stock Exchange (LSE) and the group intends to seek a broader investor audience by pursuing secondary listing on both the Moscow and Johannesburg (JSE) stock exchanges. The JSE has formally approved the secondary listing, classified as “domestic” for exchange control purposes, and a full pre-listing announcement is expected to be posted soon.

Although as we discuss below, market conditions are now improving, warehouse rents are currently much lower than they were three or four years ago and, to a large degree in response to rouble weakness, the market has switched to rouble rather than US dollar-denominated lease terms. Raven has adapted its strategy to these changes but remains focused on maintaining and growing its core portfolio of Grade A logistics warehouses in Russia, with the aim of producing rental income that delivers progressive distributions to shareholders. With high acquisition yields available (c 12%), acquisitions are an important element in replacing the reduction in market rents, which have yet to fully feed through to income given the multi-year nature of lease contracts. Grade A logistics warehouses are the most likely assets to be acquired, but Raven will consider other types of property asset classes if the property and financial metrics are sufficiently attractive. Prior to the market changes, Raven had operated a US dollar model, matching US dollar income with US dollar property debt. However, as new leases are signed, Raven’s income mix is becoming increasingly rouble denominated and a balance sheet restructure is underway, shifting from US dollar debt to rouble debt, so as to limit the currency mismatch. A first stage of the strategy was to issue convertible preference shares, in 2016 and in 2017. Although sterling denominated, these provided a significant boost to capital resources and liquidity, to mitigate risks and take advantage of acquisition opportunities.

Against the backdrop of a Russian economy that has returned to growth despite continuing economic sanctions, and an improving supply-demand balance in the warehouse market, acquisitions and letting activity generated an increase in H118 net operating income (NOI) compared with both H117 and H217. Robust cash flow has maintained a strong cash position, supporting continuing distributions and acquisition growth. However, with the company still reporting in US dollars, unrealised FX effects continue to affect both IFRS and company reported underlying earnings. Excluding FX effects, underlying earnings grew 12.3% to $11.9m.

After a period of relative calm in the rouble/US$ exchange rate during FY17, the weaker rouble in H118 had a negative translation effect on the rouble-denominated cash balances held by the group. Unrealised foreign exchange movements in the p&l, included within the company’s underlying earnings measure (see below), were $-8.7m in H118, a negative swing of $13.6m compared with H117. The decline in sterling versus the US dollar over the same period also increased the cost of the preferred and convertible preferred shares. There was a similar effect on property valuations, which increased by 7% in rouble terms compared with December 2017, but which translated into a $34.4m revaluation loss in US dollar terms. Recognised in other comprehensive income, which saw a H118 gain of $13.0m, was the positive impact of sterling weakness versus the US dollar, with the sterling-denominated preference share liabilities translating into a lower amount in US dollars.

In Exhibit 4 we summarise the income statement performance on both a reported IFRS basis and on the underlying basis provided by management, a key internal performance measure. Underlying earnings excludes investment property revaluations, gains or losses on the disposal of investment property, intangible asset movements, gains and losses on derivative financial instruments, share-based payments and other long-term incentives (to the extent not settled in cash), the accretion of premiums payable on redemption of preference shares and convertible preference shares, material non-recurring items, depreciation and amortisation of loan origination costs, together with any related tax.

Management describes operating fundamentals in the Russian market as strong, with many economic indicators moving in its favour and supply-demand conditions in the warehouse market improving.

The rouble enjoyed a period of relative stability versus the US dollar during 2017 and the early months of 2018, trading in a range of c $50-60, but has weakened to c $67 as a result of a further tightening in economic sanctions and generalised volatility in FX markets, especially for emerging markets currencies. More positively, oil prices have continued to trend upwards, with Brent crude recently trading at close to $80 per barrel.

Compared with the Moscow region, conditions in St Petersburg and the regions, which account for the balance of Raven’s warehouse stock, have been less challenging, exhibiting similar but less volatile development.

New warehouse lettings in the period totalled 153,000 sqm (8.7% of the total warehouse space), while a further 116,000 sqm of existing leases were renegotiated and extended. Tenants vacated 54,000 sqm of space.

At the end of H118 132,000 sqm of warehouse space was due to mature in H2, plus an additional 62,000 sqm of potential lease breaks. Management expects tenants to vacate 39,000 sqm of the maturing space, and for 15,000 sqm of the breaks to be exercised. However, since the end of H118 it has so far let a further 38,000 sqm of vacant space and has already renegotiated and extended 23,000 sqm of maturing leases.

Both the warehouse and office markets in which Raven operates are now effectively rouble markets and Raven’s remaining US dollar leases should therefore be expected to unwind over the next three years. Rouble leases are generally shorter at inception than US dollar leases and contain lease break clauses (c three years on average or five years with a three-year break option, compared with an average c five years previously for dollar leases). Rouble leases do have the advantage of having annual indexation which is linked to Russian CPI but may also specify a minim level. The current average indexation of Raven’s rouble-denominated leases at 30 June was 6.1% pa. At current market rent levels, this unwinding of long-term dollar contracts will be a negative drag on revenue, for which acquisitions and void reductions are providing an off-set. Raven indicates an average rent for new lettings in roubles during H118 at c RUB3,800 per sqm (2017:RUB3,870 per sqm) while lease renewals benefit from tenants wanting to avoid the frictional cost of moving. Management indicates an average level of RUB4,500-5,000 per sqm (2017:RUB5,250).

The St Petersburg office portfolio continues to perform well with no significant changes in occupancy or tenant mix.

Given the improvement in market conditions, Raven is also planning to speculatively build c 70,000 sqm of warehouse space on development land that is already owned at Nova Riga. At current construction costs and rents it expects to generate a c 12% return on the marginal cost of investment, although no additional rent is likely until 2020. The Nova Riga land plot (25 hectares) is one of a number of land plots owned by Raven, totalling 156 hectares, of which 84 hectares (including Nova Riga) represents potential additional phases of existing assets.

The key forecasting judgement is how quickly Raven can grow income through void reduction and the acquisition of income producing assets to offset the drag of older, primarily US dollar-denominated leases maturing and the rents reverting to market. It is also possible that market rents may begin to recover, although we do not allow for this in our forecasts.

Exhibit 13 shows the breakdown of historical and forecast group net operating income (NOI). The key driver of our NOI forecasts is the property investment division that we expect to generate c 92% of NOI in FY18.

Our key forecasting assumptions for the investment property division NOI are:

Our revised estimates are shown in Exhibit 14. Although we expect slightly higher NOI than previously, this is more than offset (in underlying earnings) by higher administrative costs and higher net finance costs and, in FY18, negative FX revaluation effects not previously forecast.

Management indicates that the H118 growth in the cost base will support Raven’s ongoing growth policy and that future warehouse acquisition or development should be expected to increase income without having any marked impact on overheads. Our forecasts allow for lower bonus costs.

The increase in our forecast for net finance expense is driven by lower forecast interest income, resulting from lower balances as cash is invested, lower interest rates and FX effects. We have assumed an unchanged 7.4% cost of bank debt.

Our estimates are based on exchange rates of £1-US$1.31 and $1=RUB67.

Please note that Exhibit 14 is presented on the company’s underlying basis which differs from the IFRS-based financial summary in Exhibit 17.

As noted above, utilising a strong cash position to fund high quality income producing acquisitions is a key element of Raven’s strategy to offset the effects of rent reversion and return the company to growth. We estimate that the remaining US dollar-denominated leases are generating NOI that is c $35-45m above spot market levels for Rouble denominated leases at the current exchange rate, although indexation of Rouble leases may narrow the difference by the time that the US dollar leases expire, and a good level of renewal by existing tenants would be beneficial. To plug the gap, management targets adding c $10m pa to annualised NOI through acquisitions over the next two to three years, as well as further reducing voids.

At an assumed 12% yield, an aggregate $30m addition to NOI would require investment of around $250m. Assuming gearing of 60%, the cash/equity investment requirement is c $100m. Our forecasts already assume completion of the recently agreed acquisition at Sever. It is a corporate acquisition and will include an undisclosed amount of debt that Raven intends to refinance. For now, our model allows for a cash outlay of $36.2m, with no debt assumed on acquisition. If refinanced at 60% gearing, this will increase our forecast cash balance by c $22m. We would additionally anticipate that Raven may look to refinance its existing amortising secured debt in order to release any over-collateralisation. Amortisation is running at c $30m pa and in our illustration of how Raven may finance the targeted acquisitions (Exhibit 15) we assume that $60m may be released by refinancing existing debt. On this basis, our analysis indicated potential end-FY19 cash resources of $156m (or $96m without refinancing existing secured debt) compared with a net cash requirement of $85.5m.

While the illustration in Exhibit 15 indicates that a high cash balance would remain after the acquisition spend, it is lower than the c $100m that we have previously assumed that management would wish to maintain. We suspect that given the improving operating environment and the likelihood that by the end of FY19 Raven will have completed the repositioning of its balance sheet, substantially matching rouble income with rouble-denominated debt and thereby de-risking cash flows, management would be comfortable with a reduced cash buffer.

Operating cash flow remained robust in H118 and after interest payments it was at a similar level to H117 ($7.5m versus $7.4m). The full year 2017 benefitted from a one-off gain of c $20m on the sale of non-core development land within the UK subsidiary, while in 2018 convertible preference share dividends have increased as a result of the further issuance of shares in 2017. The end-H118 cash balance also remains strong at $198.1m.

As noted above, our forecasts assume completion of the $36.2m agreed acquisition at Sever and that it is settled in cash, although in reality this will include the assumption of debt and less cash outlay. We also factor in a modest amount of ongoing capex plus $30m of development spend at Nova Riga in 2019. We have also assumed shareholder distributions in the form of tender offer buy backs and that sufficient shares will be tendered for a full distribution (similar to H118 but higher than in previous periods).

Investors in Raven can choose between ordinary shares, preference shares, convertible preference shares and warrants. The ordinary shares, warrants, and preference shares are traded on the LSE while the convertible preference shares trade on the official list of the International Stock Exchange Authority Limited (TISEA). As noted above, the group is pursuing secondary listings of the ordinary shares on both the Moscow and Johannesburg stock exchanges.

The ordinary shares offer a good level of yield and provide investors will full upside to NAV growth or discount narrowing. Based on our forecast distribution of 2.5p for FY18, the yield is 6.3% and the discount to fully diluted adjusted NAV is c 26%. Distributions are variable and are normally made via tender offer buy backs. Our assumed distribution is relatively high compared with forecast earnings but as noted above, a full deployment of cash resources on cash-generative acquisitions has the potential to substantially lift earnings and cash flow above the forecast levels.

The convertible preference shares (RAVC) rank ahead of other share classes in terms of dividend payments and receive a cumulative 6.5% preferential dividend on the subscription amount of 100p, a cash yield of 5.5% on the current price of 118.5p. The convertible preference shares are redeemable by the company on 26 July 2026 at 1.35, and can be converted into ordinary shares at the holders request at any time prior to redemption, currently at a rate of 1.759 (equivalent to c 67p per ordinary share at the current price), a premium of c 69%.

The (non-convertible) preference shares (RAVP) earn a cumulative 12% dividend on the fixed issue amount per share of 100p, ranking ahead of the ordinary shares. At a current price of 144.5p, the yield is 8.3%.

As noted above, although NAV per share declined in H118, the main driver was the translation of the investment portfolio value from roubles to US dollars. The portfolio value increased by 7% in rouble terms. If the market continues to improve, as we expect, there should be room for valuation yields to decline over the medium to long term, further increasing rouble-denominated asset values. However, the investment market in Russia is relatively thin compared with the size of the economy, making valuation movements less predictable.

Diluted IFRS NAV per ordinary share at end-H18 was 76c and on a fully diluted adjusted basis (adjusted for goodwill, deferred tax on valuation gains, fair value movements on derivative contracts and cumulative FX movements on preference shares) it was 71c. At an exchange rate of $1.31/£, this represents c 54p for a P/NAV discount of c 26%.

Political and economic tension between the US, EU and Russia, resulting in continuing economic sanctions against Russia, and volatility in foreign exchange markets, continue to create uncertainty and risks for Raven. However, as noted above, the Russian economy is again growing and local market operators appear to have accepted the inevitability of long-term economic sanctions and are adapting accordingly. The local risks have the impact of reinforcing normal sector risks including occupancy and rent levels, funding access and cost, and property valuations. We highlight the following: