Raven Russia — Strong results with improving outlook

Raven Russia (Raven), listed on the main market of the London Stock Exchange (LSE). It was founded in 2005, with the intention of building 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 31 December 2017, comprised c 1.8m sqm of predominantly logistics warehouse property (of which c 72% is in the Moscow region). At end-2017 the portfolio was 81% let, to mainly large Russian or international companies. International comparisons show Russia to have a relatively low density of warehouse space, a positive indicator for long-term growth. In the near term, the Russian recession through 2015-16 coincided with a cyclical pick-up in new building, causing vacancies to increase and rents to fall, with the market converting almost completely to rouble-denominated lease terms in contrast to longer-term US dollar-denominated leases that Raven has historically targeted. However, with economic recovery taking hold, the US$/rouble rate relatively stable, oil prices improving, and inflation and interest rates declining, warehouse market conditions are improving.

New Grade A development completions in the Moscow region in 2017 were the lowest since 2006 (source: JLL), and well below improving levels of take-up, with vacancy across the market reducing. Market rents have stabilised. Raven has a strongly liquid balance sheet, ending 2017 with a cash balance of $266.7m, which supports a continuing acquisition strategy (four properties acquired in 2017) aimed at high-quality, attractively yielding assets to support income through the transition from maturing, dollar leases. Acquisitions are not included in our base forecasts, but a sensitivity analysis is provided on page 7.

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.

Raven warrants (RUSW) and preference shares (RUSP) are traded on the LSE in addition to the ordinary shares (RUS), while convertible preference shares (RUSC) trade on the official list of the International Stock Exchange Authority Limited (TISEA).

The full year results were a positive surprise, with strong growth in net operating income, statutory and underlying earnings, NAV per share, and an increased distribution. We had not anticipated the disposal gains on the legacy UK land bank, and stripping this out of underlying earnings leaves them pretty much where we had expected. Market conditions are improving, and this is reflected in a gain on revaluation of investment properties (not in our forecast) and contributing to NAV growth. With management sounding increasingly confident about the outlook, in addition to the land sale gain, the increase in distributions was also not in our forecast.

With both the warehouse and office markets in which Raven operates now being effectively rouble only, the remaining long-term US dollar contracts should therefore be expected to unwind over the next three years. New lease terms, in roubles, are shorter and generally 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). They do have the advantage of having annual indexation linked to Russian CPI. At current market rent levels, this unwinding of long-term dollar contracts will be a negative drag on revenue, for which acquisitions are providing an off-set. Average rents for new lettings in roubles during 2017 were RUB3,870 per sqm (c $65) while lease renewals benefit from tenants wanting to avoid the frictional cost of moving and averaged RUB5,250 (c $87.5) for rouble leases.

We would expect a continuation of the market recovery to improve occupancy and support market rents, while further acquisitions are also likely. Raven made two accretive acquisitions (four properties) in 2017, expects to complete more in 2018 and has the balance sheet to finance them. Together, these have the potential to offset the further drag on revenues from the unwinding of long-term dollar lease contracts. We estimate that dollar rents contributed c 50% of total NOI in 2017 and with a three-year maturity, the unwind into rouble contracts at current rents would see half of this erode. Our forecasts allow for this and include an occupancy improvement (by 4% in each of 2018 and 2019), to reflect the improved market supply-demand balance, but no acquisitions, as we have no way to know when they may happen and on what terms. We can however illustrate the potential impact and we present a sensitivity analysis below.

The 2017 underlying result was very much in line with our forecast, with the exception of the unexpected land sale gain at Raven Mount (Exhibit 5).

For 2018, our forecast is reduced although the extent of the reduction is exaggerated by our reluctance to include the likely acquisitive activity. We have reduced our NOI expectation by 3% which primarily reflects a lower assumed rent level on new and extended leases. On average, these are now forecast at $70 per sqm versus $75 per sqm previously, reflecting current market levels. We nevertheless expect warehouse NOI to increase in 2018 with the full year impact of the 2017 acquisitions adding at least $14m. The other factor suppressing our revised 2018 forecast is higher net finance charges, resulting from the additional debt taken on in H217 as part of the company’s refinancing operations. The reality is that the debt has boosted cash levels, and the cash is likely to find a home in accretive acquisitions, the subject of the sensitivity analysis. For 2019, we expect much of the same, with the further increase in occupancy only partly off-setting the dollar lease unwind, in the absence of forecast acquisitions.

Raven is continuing to seek high quality income producing acquisitions and expects distressed sellers or mature funds exiting the market to provide further opportunities over the coming months, despite improving market conditions and the falling cost of local funding.

As noted above, the cash position was $266.7m at end 2017, although 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, our revised analysis suggests that Raven has capacity to invest c $120m by the end of 2019, most likely in initially ungeared acquisitions, which are then geared to recycle equity into further projects. Assuming a 60% LTV again, this implies potential cash-generating asset additions of more than $300m (end-2017 investment portfolio: $1.6bn). This is a similar figure to our previous estimate, although we have moved to a 2019 basis (from 2018) and no longer assume re-gearing of the 2017 acquisitions following the debt raised in H217. By the end of 2019, any deferred consideration for the Sever acquisition will have been paid and has no impact on the calculation.

The additional potential upside to our base case forecasts remains substantial as we show below. JLL estimates prime yields in the Moscow warehouse market at 11-12.5% (Moscow Warehouse Market Indicators, 2017), with St Petersburg c 100bp above this. In Exhibit 8, we illustrate the potential uplift to NOI and underlying earnings from investing the $301m estimated in Exhibit 7, at a range of property yields between 10-12%. We assume no significant acquisition costs or additional administrative costs and have applied a 7.8% interest cost to additional borrowings, similar to the existing average cost of secured US dollar debt – although management hopes to be able to lower this, especially with local borrowing costs falling.

On this basis, full deployment of resources in the way described (at an 11% net initial yield) has the potential, on an annualised basis, to increase NOI by $33m and lift underlying earnings and net operating income after interest costs by an additional 35%, compared with our FY19 base case forecast. On a fully diluted basis (allowing for preference share conversion) the increases, from a higher base, is 23%. In both cases, the percentages are the same in per-share terms.

We are now more confident that market conditions will continue to improve (as management anticipates, and partly reflected in our forecasts, which include improving occupancy but no uplift in market rents), acquired NOI has the potential to offset the un-wind of long-term dollar contracts and generate earnings growth. Alternatively, assuming no improvement in market rents or occupancy, acquired NOI would materially offset an eventual reversion to marke- level NOI of $35-40m pa, albeit spread over a number of years.

An investment in Raven can be made via ordinary shares, preference shares, convertible preference shares and warrants. The ordinary shares receive variable distributions and would benefit fully from any growth in NAV or discount narrowing (c 27% currently). The 4p distribution declared for 2017 represents a yield of 9.3% on the ordinary shares. We believe this partly reflects the non-recurring gains at Raven Mount and we assume a lower distribution for 2018 and 2019 of 3p per share in each year, a yield of 7.0%. Our assumed distribution is relatively high compared with forecast earnings, more so in 2019, 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 (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 5.4% on the current price of 120.5p. The convertible preference shares can be converted into ordinary shares at any time up to July 2026, currently at a rate of 1.779 (equivalent to 67.7p 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 147.0p, the yield is 8.2%.

The growth in NAV per share in 2017 was supported by investment portfolio valuation gains, reflecting the stabilisation of the market and falling interest rates. If the market continues to improve, as we expect, we believe there is room for valuation yields to decline further over the medium to long term, but would not anticipate a material near-term shift. 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-2017 was 80c and on an adjusted basis (adjusted for goodwill, deferred tax on valuation gains, fair value movements on derivative contracts and cumulative FX movements on preference shares) and fully diluted (including cumulative preference shares), at 78c. At an exchange rate of $1.3550/£, this represents 60p for a discount of c 27%.