Raven Russia — Growing into an improving market

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 became self-managed in 2008. 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 a first tranche (109m) of convertible preference shares, followed by a second tranche (90m shares) in July 2017. These shares trade on the official list of the International Stock Exchange Authority Limited (TISEA). At 30 June 2017, the investment portfolio comprised c 1.6m sqm of predominantly logistics warehouse property (c 70% in the Moscow region), let 79% to mainly large Russian or international companies, providing strong tenant covenants. Group subsidiaries include Raven Mount, a UK residential development company, and RosLogistics, a third-party logistics business in Russia.

Russia has a low density of warehouse space, which suggests plenty of room for growth. However, the Russian recession through 2015-16 coincided with cyclical pick-up in new building and saw vacancies increase and rents fall. Market conditions have since improved, with the US$/rouble rate relatively stable, oil prices improving, inflation and interest rates declining, and economic recovery taking hold. Against this background, demand/supply conditions in the warehouse are improving, with declining new supply and good levels of occupier demand for logistics warehouse space. Raven has a strongly liquid balance sheet, ending H117 with a cash balance of $108m, to which it added $102m with the July issue of convertible preference shares, and seeks acquisitions to take advantage of market recovery.

Following on from the April 2017 acquisition of a three-asset portfolio (a warehouse and two offices in St Petersburg) for $86.6m, management indicated with the interim results that it hoped to complete a second significant acquisition in the Moscow region before year-end, continuing the investment of proceeds from recent convertible preference share issues. Through one of its operating subsidiaries, it has now conditionally agreed the acquisition of a logistics park in the Moscow region. The property consists of a modern Grade A warehouse complex, built in stages between 2014 and 2017, to the north of Moscow centre. The property is large, with a gross lettable floor area (GLA) of 195,132sqm, similar to Raven’s existing properties at Pushkino (c 214,000sqm), Noginsk (204,000sqm) and Istra (206,000sqm), and adds c 18% to Raven’s Moscow warehouse GLA and c 12% to overall portfolio GLA. It is currently 73% let to a number of local and international tenants including OBI (Germany-based international DIY retailer), O’KEY Retail Group (large Russian food retailer), Major Logistics Group (Moscow-based logistics services provider), Miratorg (leading Russian meat producer and supplier) and R-Pharm (one of Russia’s largest pharmaceuticals producers). Leases are denominated in roubles and the current annualised income is RUB616m ($10.4m) with a current weighted average lease term of four years. Rental income rises to RUB886m ($15.0m) on a fully let ERV basis.

The property is to be acquired from a Russian incorporated company (Industrialniy Park “Sever” Limited Liability Company) for an initial consideration of RUB5.119bn (or a US dollar equivalent of $86.58m using the RUB59.1/$ exchange rate implied in the announcement). Additionally, deferred consideration of between RUB1.51bn ($25.5m) and RUB1.97bn ($33.3m) is due within 18 months of completion, with payments dependent upon and triggered by progress in letting vacant space. The total consideration is equivalent to RUB34,000-36,300 ($600-625) per sqm, which we believe is below replacement cost, including build costs at RUB25,000-30,000 ($400-500) per sqm and land costs at RUB2,000-4,000 ($35-70) per sqm. Raven expects a full occupancy yield of 11.38% on the maximum consideration, with a reversionary yield of 12.51%.

Raven is acquiring the property with cash, although discussions over partial debt funding have commenced. This would boost the return on equity from the acquisition and free up resources for additional investment. Given the increasing share of rouble-denominated rents within Raven’s portfolio, we would expect Raven to diversify its existing US dollar-denominated debt funding into roubles as Russian inflation and interest rates reduce. Official lending rates were reduced by a further 25bp on 27 October to 8.25%, but with the central bank forecasting inflation at c 3.0% by year-end there is scope for further reductions.

The acquisition agreement is expected to complete in early December, conditional upon the satisfaction of certain escrow arrangements.

We have adjusted our estimates, assuming that the agreed transaction completes as planned. The spread between the immediate yield on the assets to be acquired and the loss of interest on the cash invested has a positive impact on our forecast for adjusted earnings. Adjusted earnings after tax increases by just over 11% on a full-year basis in 2018, while the increase in fully diluted adjusted EPS, from a higher base, is c 8%. For now, we have made no changes to our forecast distributions per share, which we raised following the interim results.

We have conservatively assumed only the current annualised rental income on the newly acquired assets at this stage, making no assumptions about the potential for occupancy improvement or rent reversion and will reassess this, along with the existing portfolio, with future earnings releases. We do not anticipate any impact on recurring administrative costs and only an insignificant one-off expense in relation to transaction-related professional fees. Our existing forecasts assume a c 5% rouble-based return on cash assets and our interest income forecast is reduced accordingly. We have allowed for an $87.78m initial payment at completion (assumed 1 December, with a one-month impact on the current year) and have assumed payment of the minimum deferred consideration in three equal instalments over the following 18 months (with the effect that c $105m of the minimum total consideration of c $112m is reflected in our published forecasts to end-2018). If letting progress is made, then our income forecasts are likely to rise to more than compensate for the additional deferred consideration that may be triggered.

We have not assumed any new debt funding in our forecasts, but even without this our forecast end-2018 cash balance, adjusted to take account of deferred consideration, remains a little above $100m.

In the note that we published after the interim results, we explored in depth the potential upside to our base case forecasts from the deployment of cash balances in the acquisition of yielding investment properties. We update that analysis below, taking account of the Sever acquisition and its impact on our forecasts.

Our starting point remains our revised estimate for end-2018 cash, adjusted for the remaining deferred consideration on the Sever acquisition at that time, and assumes a gearing of both the Sever acquisition and the cash acquisitions made in April 2017. We would not expect management to commit all of the available cash resources to investment and assume that it will continue to prudently hold c $100m. Allowing for this, we estimated that post-completion of the Sever acquisition Raven will still have capacity to invest c $128m over the next 18 months, most likely in further initially un-geared acquisitions, which are then geared to recycle equity into further projects. Assuming a 60% LTV again this implies a remaining potential for cash-generating asset additions of more than $300m.

The additional potential upside to our base case forecasts remains substantial as we show in Exhibit 3. Noting that JLL recently put prime yields in the Moscow warehouse market at 11-12.5% (Russian Warehouse Markets, dated 26 July 2017), we show the outcome based on a range of property yields. We assume no significant acquisition or additional administrative costs and have applied a 7.8% interest cost to additional borrowings, similar to the existing average cost of secured debt – although management hopes to be able to lower this.

On this basis, full deployment of resources in the way described (at an 11% net initial yield) has the potential to lift underlying earnings and net operating income after interest costs by an additional 36%, compared with our revised FY18 base case forecast. On a fully diluted basis (allowing for preference share conversion) the increases, from a higher base, are 25% and 26%, respectively. In both cases, the percentages are the same in per-share terms. To the extent that market conditions continue to improve, as management anticipates, this would be a strong contributor to earnings growth. Alternatively, should market conditions remain weak for an extended period, it is a useful offset to medium-term NOI attrition, which is likely on the current portfolio as rents gradually revert to the lower levels recently established. Full reversion of warehouse portfolio rents to current market levels would require several years with no market improvement, which seems an unlikely scenario but would represent an eventual reduction in NOI of $35-40m pa.

With the company well placed to benefit from a stabilising economy, the potential for cash flow and distributions will continue to be the underlying driver of investment in Raven. Over the longer term we believe there is room for valuation yields (c 11-12.5%) in the Russian market to decline, but there is no immediate prospect of any material shift.

Based on our distribution per share forecast of 2p, the prospective yield on the ordinary shares is 3.8%. The Sever acquisition is accretive to earnings and cash flow without assuming the occupancy and rental income improvements that management expects. Although we have not revised our distribution forecast at this stage, earnings cover is improved and the positive potential from further acquisitions is material. As noted above, a full deployment of cash resources on cash-generative acquisitions has the potential to further lift cash flow (net operating income after interest) substantially above the revised forecast levels. At an 11% net initial yield on acquisitions, net operating income after interest and after a full deduction for annual debt amortisation (estimated $30m) would still leave distributable cash per share of more than 3p pa. This would represent a potential yield on the ordinary shares in excess of 6%, with the ability to benefit fully from any growth in NAV or discount narrowing.

Giving up some of the potential for upside benefit in return for a higher yield, an investment in Raven may also be made through non-convertible or convertible preferred shares.

The convertible preference shares (RUSC) 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 yield of 5.2% on the current price of 124p. The convertible preference shares can be converted into ordinary shares at any time up to July 2026, currently at a rate of 1.759 (equivalent to 70.5p per ordinary share at the current price). The (non-convertible) preference shares (RUSP) 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 148p, the yield is 8.1%.