Raven Russia — Update 31 August 2016

Coming into 2016 management was realistic about the harsh environment that the company was facing; the financial results for the six months to 30 June 2016 have met its expectations, and have beaten our own on costs and finance expense, with FX gains in addition. Market conditions, echoing economic developments, appear to be stabilising, and occupancy levels have held at 82% over the period, in line with our expectations. The company’s active leasing efforts, aimed at defending income and cash flow, have dealt with the majority of the lease maturities due in 2016. Cost containment measures are bearing fruit, and defensive management of the balance sheet saw strong cash balances maintained ($183m at 30 June compared with $202m at 31 December 2015, despite ongoing debt repayments of more than $30m in the half year). Following the issue of c £109m of new convertible preference shares in early July, the cash balance at the date of the interim report has increased to $331m, providing considerable flexibility for liability management in the coming months, and providing scope to benefit as the market recovers, rebuilding the company’s top line through acquisitions and development as and when opportunities arise.

We have made little change to our assumptions for portfolio rental income as a result of these results, but our estimates are increased to reflect lower costs and financing charges, incorporating the recently issued convertible preference shares.

The Russian economy saw its slowest pace of contraction in Q2 of this year since the crisis began. Preliminary estimates released by the government in early August show a better than expected 0.6% year-on-year decline, half the rate recorded in Q1. There are indications that investment spending may be reaching a turning point after a severe contraction, although household consumption remains weak. The data support the general trend of economic forecasts for the economy to stabilise during 2016 and begin to grow again in 2017, despite ongoing international sanctions. The Russian Central Bank looks for a positive GDP reading in Q3 and for a 0.3-0.7% contraction for the year as a whole, before growing 1.1-1.4% in 2017. In its January 2016 update, before the recent improvement in oil prices, the World Bank forecast a 0.7% decline this year and growth of 1.3% next; the IMF World Economic Outlook update (also from January) follows a similar pattern of expectations (-1% and then +1%).

There are signs that the worst effects of the rouble devaluation have fed through to inflation, with annual CPI inflation at the lowest level for more than two years in July at 7.2%. The decline in inflation suggests growing room for the Central Bank to reduce policy interest rates from the current 10.5%.

The Brent crude oil price has recently been trading at around $50 per barrel compared with less than $30 in January, while the rouble has recovered to around 65 roubles per US$ from more than 80 earlier in the year.

The weakness of the economy (GDP shrank by 3.7% during 2015) had the effect of reducing the demand for new lettings and the opportunities to renew existing leases, and has put downward pressure on market rents. The rouble weakness (it remains at almost half its mid-2014 level versus the US dollar) put enormous pressure on tenants with US dollar-pegged leases, with some simply unable to cope and others opting for rouble-denominated rents at levels where the US dollar equivalent is well below the levels previously seen in the market, albeit indexed to Russian inflation.

These negative effects of economic weakness were exacerbated by a significant amount of new supply during 2014, already in development when the crisis hit, being delivered to market. The majority of this space was developed speculatively with no end-tenant in place. In 2014, c 1.6m sqm of new modern warehouse space was completed in the Moscow region (75% of the Raven portfolio), according to JLL. This 16% increase on the 9.6m sqm opening stock had been planned in the context of a structurally undersupplied market with persistent low vacancy and a low ratio of warehouse space per capita relative to other major European locations. New supply continued at a high level into 2015 as projects that could not be shelved were completed, adding an additional c 800k sqm. The market vacancy rate increased from 7.9% at the end of 2014 to an estimated 10.5% at the end of 2015 according to JLL.

Although new supply in H116 has slowed to roughly half the level of H115, JLL estimates that for 2016 as a whole supply will actually increase on 2015 (by c 18%), although much has either been leased or sold at an early stage of construction. Take-up of space has continued (JLL estimates c 800,000 sqm for 2016), with large retailers in particular seeking to improve their supply chains.
E-commerce is expanding with traditional retailers reporting strong growth in online sales, which should support demand for well-located warehouses around the major cities. Nevertheless, JLL forecasts the vacancy rate to end the year higher than 2015 at 11.0-11.5%.

Rent pressure has been greatest in the market for new tenants, where developers are forced to compete aggressively so as to be able to let space. For existing tenants, contractual lease terms provide some friction to the adjustment process and in lease renegotiations any decision to move rather than renew must include the consideration of the costs and difficulties involved in moving and re-training staff, and possible disruptions to supply chains and existing business.

Across all sectors rents are for now rouble-denominated for new lettings, although the majority include indexation to Russian CPI. JLL estimates that the average level of Class A prime rents on existing leases was c $80 per sqm at 30 June 2016, down from c $100 at the end of 2015. It estimates that new rouble rents have been fairly stable at c RUB4,200 per sqm, and that rents will be similar through H216.

When the Russian economic crisis hit, management turned its focus to defending occupancy and cash receipts by aggressively renegotiating near-term maturing leases, and this has continued into 2016. 2016 contractual lease maturities at 1 January 2016 were 228k sqm, or c 19% of the let space. The majority of these have already been dealt with during H116 and overall contractual occupancy has remained unchanged since year end at 82%. 82k sqm of the 2016 maturities have been renegotiated or extended and 119k sqm in total across all maturities. 78k sqm of 2016 maturing space has been vacated by the tenants or terminated by Raven (usually because it is unhappy with the strength of the tenant covenant). A small amount of maturities for later years have similarly been terminated. 85k sqm of space has been newly let for various maturities, but 75k sqm of this is for a term of two years or more. 75k sqm of 2016 maturities remain to be dealt with in H216.

73% of the let warehouse space remained on US$ denominated leases as at 30 June, with an average warehouse rental level of $124 per sqm, and a weighted average term to maturity of 3.4 years. The 27% of let space that is now on rouble rents is at an average RUB5,000 per sqm with a weighted average term to maturity of two years, and an average annual indexation of a minimum 7% pa. The recent strengthening of the rouble versus the US$ is beneficial to Raven.

In our note of 4 April 2016 we set out our estimates for future rents and NOI in detail. Our starting point was the end-2015 portfolio contracted NOI of $162m and we modelled the potential future direction of NOI according to assumptions about Raven’s ability to extend, renegotiate, or re-let maturing space at maturity and at what level of rent. Raven has not provided a portfolio NOI update for the half year, but we note that H1 NOI recorded in the P&L was very close to our estimates ($77.0m versus a forecast $76.3m), that period-end occupancy of 82% matches that assumed in our modelling and that evidence on the level of new rents appears consistent with our assumptions. For this reason, we are making no changes to our Investment Property NOI forecasts for H216 or 2017. For convenience, we repeat our forecast framework below.

By way of illustration, we extended this analysis beyond our earnings forecast period (2016-17) and out to 2020, by which time an implied c 86% of the portfolio would have transitioned to the assumed new rent levels. We called this an illustration rather than a forecast because we were conscious that, this far out, the actual outcome may well differ materially, either positively or negatively. The key downside sensitivities are a faster migration to the new lower market rent level than we have assumed, lower market rents than assumed, or higher vacancy. As a result of the assumption of improving occupancy from H117, the illustration showed NOI increasing from 2018 despite continued migration of the portfolio from higher, historic contracted rent levels to the lower levels assumed. We will look to refresh the analysis as new portfolio NOI data become available.

The underlying interim results are very much in line with our expectations at this stage from an operating point of view, although costs are somewhat lower and our forecasts had not assumed the positive FX movement. Financial expenses were also lower than we had allowed for (a larger positive debt cost amortisation adjustment) such that overall underlying operating earnings were well ahead of our forecasts. The details are shown in Exhibit 4 below.

As discussed above, the cost improvement is partly explained by the move from bad debt provisions to recovery, but expenses were nonetheless better than we had thought and we have reduced these quite significantly (by c $5m for FY17) in our full year estimates, as shown below. We have also reduced our future full year financial expenses, adjusting for the convertible preference issue, part of which will be used to repay more expensive bank debt; underlying finance costs also benefit from an increased adjustment for debt cost amortisation. In combination with the H1 FX gain, the change to our underlying EPS is material.

As the conversion terms for the newly issued convertible preference shares are above the current NAV per share, there is no dilution on NAV level.

As indicated above, the changes to our NOI estimates are immaterial. For property investment, we allow for the small H1 beat versus our forecast, but future periods are unchanged. Roslogistics NOI is slightly increased by a strong underlying rouble performance and a slightly improved assumed translation rate into US$.

As usual, our forecasts assume no future revaluation movements on the property assets and no FX impacts.

We continue to allow for a small income distribution of 1p per year (0.5p in H216), anticipating that management will wish to maintain a distribution while continuing to focus on maintaining a strong balance sheet until a clearer market picture emerges. As always, we model this as a cash payment, although we would anticipate that continuing distributions by way of tender offer are more likely.

The balance sheet shows no material moves during H1. Property revaluation was small, cash balances remained high and debt amortisation continued ($33.7m repaid in the period). In 2015 significant negative property revaluation pushed up the ratio of debt to portfolio value, with gross bank debt (excluding preference shares) increasing to 66.9% of property assets versus 54.4% in 2014. Total net debt (including unencumbered preference shares and cash) also increased, but was lower due to the high cash balance. Exhibit 8 shows the improvement in H116, with continuing positive cash flow to finance debt amortisation, and also shows our estimate for the H216 position, assuming that $100m of the £109m raised from the convertible preference share issue is used to refinance existing bank debt. By the end of 2016, the ratio of gross bank debt to property assets should be back to more comfortable levels, similar to 2014.

Our cash flow analysis in Exhibit 10 shows forecast net debt declining further through 2017 despite the continued pressure on NOI that we have factored in.

Our forecasts indicate a stabilisation in the ratio of period-end contracted NOI to bank interest expense in 2016 at c 2.2x (2015: 2.3x) and an improvement to c 2.5x in 2017.

Raven’s strategy has focused on growing income and shareholder distributions. The Russian financial crisis has necessitated a reduction in distributions per share from a peak of 6p per share in 2014 to 2p in 2015 and we forecast 1p in 2016 and 2017. The current strategy remains highly defensive, focused on maximising cash flow, with a greater emphasis on long-term security and debt reduction. This strategy, and the support of shareholders in funding the convertible preference share issue, leave Raven well placed to navigate current market conditions and seize opportunities in an upturn. As a result, we believe that a long-term investment in Raven will remain very much about cash flow and yield.

As discussed above, we forecast ordinary share distributions of 1p per share for 2016 and 2017. In part, the forecast decline reflects our expectation of lower profitability and cash flow, but it also reflects prudence as Raven continues to target debt reduction and a healthy cash balance.

Exhibit 11 shows our expectations for operating cash flow net of tax and after interest payments (both bank debt and fixed preference share coupons). These have increased slightly with our earnings forecast increase. Our expectation is that it will remain healthily positive and well in excess of the modest distribution that we forecast. However, this is before debt amortisation, which has been running at c $60m pa but which we expect to reduce to c $40m pa as a result of the convertible preference share issue bank debt refinancing. As a result, it would be possible for Raven to increase the payout of free cash flow, making distributions ahead of our forecast, without eating into its high cash balance. At the current share price, this forecast 1p distribution would represent a yield of c 2.1%.

The preference shares earn a cumulative dividend of 12% pa payable on the fixed-issue amount per share of 100p. These illiquid shares last traded at a price of 130p, which represents a prospective yield of a little more than 9%.

The NAV per share, on a diluted IFRS basis at 30 June, was $0.72, up from $0.70 at the year end. On a fully diluted adjusted basis it was $0.70. Using a £/$ exchange rate of 1.3150, the equivalent fully diluted adjusted NAV in sterling is 54p and the P/NAV 0.67x. However, we do not consider P/NAV to be the main driver of share price or best indicator of value. The investment market in Russia remains relatively immature, making portfolio values more volatile.