Medicx Fund — Update 7 June 2016

MedicX Fund continued to selectively add assets in H116, despite a highly competitive UK investment market, and maintains a strong investment pipeline in both the UK and Republic of Ireland. Profit progression during the period was limited by the time gap between drawing on funding and income generation from investment but as this unwinds earnings growth should pick up, supported by the new management fee structure that fixes payments until assets grow by an additional c £193m from the H1 level. The fund sees good prospects for growth in Ireland, where yield differentials are materially ahead of those that can be earned in the UK, and anticipates an increase in the pace of UK open market rental growth as the pace of NHS approved new developments accelerates to meet growing GP demand.

Demand for attractive primary healthcare properties has remained strong, with valuation yields further compressed in H116. While this is a positive for NAV, it does make it more expensive to acquire assets and new income streams, particularly in the UK. This is especially the case for larger assets and portfolios and in this environment the fund has continued to be selective, taking a disciplined approach focused on single assets and forward funding developments. As we show in Exhibit 1 below, positive funding conditions have maintained a healthy spread between income and long term funding costs.

There are growing indications that NHS demand for new, purpose built, primary healthcare facilities will soon accelerate, and MedicX believes that its close working relationships with preferred developers and provider groups leave it well positioned to benefit.

Meanwhile, the fund’s entry into the Irish market offers additional opportunities at an increased yield. For a description of the Irish market opportunity please see our note of February 2016. Two development funding investments have been made so far and two are in solicitors’ hands and going through the legal process. Although there was a small positive currency impact in H116, MedicX continues to negotiate local euro funding, which will provide a significant hedge for future Irish values and returns.

The UK will remain the core of the portfolio, with Irish investment not intended to exceed 15% of the portfolio value.

While cross-political backing for NHS planning (which puts increasing focus on primary care) is very positive for long-term growth, more immediately the Investment Adviser identifies the response of GPs as a strong impetus for change. With many existing GP practices operating out of cramped, unsuitable premises, too small to provide the extended services, hours, training and education that is being demanded, the trend towards merging and forming federations or provider groups appears to be accelerating. With this and government plans to add some 10,000 additional clinical staff, including c 5,000 additional GPs, comes increased demand for large, modern, purpose-built facilities. All clinical commissioning groups have been tasked with preparing local estates strategies. Not all have been published yet but these evolving strategies promise to underpin this expansion of service delivery and provide strong opportunities for long-term investors in required facilities such as MedicX.

In FY15, EPRA NAV total return (the increase in NAV plus dividends) was 17.2%, although total shareholder return (dividends plus share price movement) was -0.4%, affected by a low share price towards the end of the year. In H116 the share price has fully recovered, with a total shareholder return of 16.9% in the six months to 31 March 2016 (of which 3.5% was attributable to dividends). EPRA NAV per share, adjusted for dividends, increased by 4.7% in H116. Whereas conditions in the mainstream commercial property market have become a little less certain in recent months, with the UK EU referendum and a slowdown in inwards property investment clouding the outlook, the primary care sector enjoys high income visibility and security. The sector benefits from effectively full occupancy, long leases and the UK government as the de-facto tenant of c 90% of properties (in Ireland government income will be 60-75%). Income forms a higher proportion of returns than for the commercial sector in general and both income and capital returns are less volatile in primary healthcare than other sectors. The fund’s costs are relatively certain because it uses an external manger and does not have the risks associated with being an operator or developer of property. The rising dividend, supported by the security of income, despite not being fully covered by EPRA earnings, forms a substantial part of the total return and there is a scrip dividend alternative for shareholders who prefer to take their returns in new shares.

MedicX pays a high proportion of total return in the form of quarterly dividends and has indicated that it expects to pay an aggregate 5.95p per share for the current year, barring unexpected circumstances. At c 6.8% prospective, the dividend yield is a key attraction of the stock. The dividend policy is progressive (19% aggregate, unbroken dividend growth since the fund was launched in 2006).

FY15 saw cover increase to 63.3%, up from 53.6% in FY14. H116 was 63% and the Investment Adviser is indicating that full-year cover will be slightly below 2015 level as the funds received from the recent loan note issue are deployed into income-generating assets. We are now forecasting 62.4% cover in FY16 and 66.8% in FY17. Underlying dividend cover as calculated by the Investment Adviser adjusts to reflect the completion of properties under construction, assuming full rent, incremental interest costs and other expenses. This was 71% in H116 compared with 67% in H115 and 68% for 2015 as a whole.

We forecast underlying EPRS earnings in FY16 to represent a return of 5.3% on average. This measure excludes valuation movements from earnings, but revaluation does increase the asset base to which they are compared.

In April the directors approved a quarterly dividend of 1.4875p per share in respect of the three months to 31 March, which will be paid on 30 June.

H116 EPRA NAV per share, which adjusts the IFRS net assets to exclude the impact of deferred tax not expected to crystallise, was 71.2p, up from 70.8p at the year end. At a price of 87.0p, this puts the shares on a P/NAV of 1.22x.

Our forecasts do not assume any further valuation yield compression beyond the 5.36% net initial yield as at 31 March. Although yields have already fallen from c 6% in 2009 (see Exhibit 1), given continuing investor enthusiasm for primary care assets and the expectation that rental growth will accelerate over time a further decline is entirely possible. The Investment Adviser estimates that if valuation yields were to decline by 50bp, the EPRA NAV would increase by c 16p per share, to 87.2p.

The Investment Adviser undertakes a regular DCF valuation of the portfolio (see the Investment Adviser’s report in the annual report for full details). The DCFs assume a long-term average 2.5% per year increase in individual property rents at their respective review dates. Residual values are based on capital growth at 1% a year from the current valuation until the expiry of leases (when the properties are notionally assumed to be sold), and assuming the current level of borrowing facilities. The DCF uses a discount rate of 7% for completed occupied properties and 8% for those under construction, giving a weighted average 7.06% (a premium to the 31 March 2016 20-year gilt yield of 2.32%).

At the end of H116 the DCF valuation was £359.8m or 95.8p per share.

The long-term rent growth assumption in the DCF is above the current average level of increases being achieved, although as explained above these are expected to increase as new development activity picks up. The Investment Adviser calculates that for the DCF calculation to equal the 31 March 2016 share price of 87.5p, it would be necessary to assume 1% pa rental growth or a weighted average discount rate of 8.0%, or no capital growth over the forecast period.

It is worth noting that the stated NAV and EPRA basis NAV both capture the deduction for purchasers’ costs that is applied by the external valuer in its portfolio valuation. This amounted to £38.7m at 31 March 2016 or 10.3p per share. This is a notional deduction from the fully appraised value of the properties to allow for costs such as stamp duty that a buyer of any property would potentially face on full or part liquidation of the portfolio.

Adding this 10.3p back to the 71.5p EPRA NAV takes the latter much closer to the DCF value per share.

H116 revenues were consistent with our forecasts and we have made only minor adjustments to this year and next. Despite fixing management fees at the current level until portfolio assets exceed £782m, other administrative expenses were ahead of our assumptions in H1 and, along with slightly more shares than we had assumed (through ongoing treasury share sales), this leads to a small reduction in the FY16 EPS estimate, which largely flows through to FY17.

Our practice is to anticipate only the revaluation gains that are likely to arise from rental growth, with no assumption for changes in valuation yields. The continued H116 compression in yields produced valuation gains in excess of our assumption and this drives the increase in NAV per share estimates in both FY16 and FY17.

Our forecasts are based on £60m of new commitments in FY16 (H116 £27.4m) and £75m in FY17. We have assumed c 200bp of additional yield spread after financing on Irish investments versus those in the UK. Average rental growth is assumed to increase to 1.5% in FY17 after 1.2% in FY16.

Our balance sheet projections assume that portfolio growth is funded by additional debt, taking forecast net debt to £343m by the end of FY16 at an assumed similar average cost to the existing debt. This would take the ratio of net debt to portfolio value to 54.8% in FY16 and 59.8% in FY17. Both are below the board’s upper limit of 65% but above the longer-term target of c 50%. Our forecasts do not include additional sales of treasury stock beyond the 2.5m shares sold at 86p on 1 June 2016, although these are highly likely. We estimate that there are around 14m treasury shares remaining in excess of likely scrip dividend requirements through to the end of 2017. At the current share price, these could raise an additional c £15m in cash for investment and would reduce the FY16 net debt to portfolio value to 52.8%. Given the improving outlook for asset acquisition it is possible that MedicX will seek additional equity funding during our forecast period. Given the premium to NAV at which the shares trade it would seem reasonable to assume NAV accretion from such a move and we expect MedicX to pay careful attention to managing the potential drag on cash earnings from any time lag in investing proceeds.