Bonmarche (BON:LSE)

Bonmarché is a clothing and accessories retailer catering to women over 50 years old in the UK. After a good couple of years since listing in the AIM at 213p a share in Nov 2013, its shares hit a high of 318p a year ago, returning 49% over the two years. The company moved from AIM to the main market (LSE) in October 2015, owing largely to its growth story and performance in AIM. Since then it has lost over 72% of its market cap and the shares now trade at 87.5p. The latest fall of ~24% in the share price came just after the company reported like-for-like sales falling by 8% for the first half of FY17. At a LTM price to earnings ratio of just 5.6, the shares may appear dirt cheap, but the LTM P/E is deceptive. In my opinion Bonmarche is a falling knife.

Enterprise value calculation

Faltering sales

The company’s pitch as a growth story is faltering with like-for-like sales showing a downward trend since.

The extremely intense competition in the sector doesn’t show any signs of abating and it is difficult to see Bonmarche return to its glory year of double digit growth. With thin margins, the declining sales trend spells disaster down the line. 

Operating leases

Bonmarche was bought in 2012 by the private equity house – Sun European Partners – when its parent company Peacocks went bust. Sun used the standard private equity playbook, shutting down 130 worst performing stores and renegotiating the leases on the remaining 265 stores to get rents down by 28%. Spend on operating lease rents fell from £23.3m to £16.9m between FY13 and FY14. Approximately 30 per cent of the leases expire in 2017, this exposes the company to a high risk of substantially higher rents from FY17. The already thin margins will come under severe pressure if the rents go up. The alternative of stores closing doesn’t sound good as the stores where rents increase are likely to be the ones with good sales.

I calculate the off balance sheet operating lease liability to be £118m even without a significant rent increase in FY17. Any material increase will significantly add to the off balance sheet debt.

The falling pound will significantly erode margins

As per the prospectus filed in Sep15 when the group entered the main market, £47.6m of its costs were in USD for FY15; with total COGS of just over £135m for FY15, USD costs represent 35% of COGS. The pound has fallen close to 20% against USD since Brexit and all indications are that the pound could call further. Moreover, Brexit represents a permanent fall in value, representing a permanent increase in Bonmarche’s cost base. Running the numbers, allowing a 20% increase to 35% of its COGS represents a 5% fall in gross profit margins from the current ~24% to ~19%. With EBIT margins at under 6% even before the fall in pound, I estimate EBIT margins to fall to just over 1% in FY17, and continue to remain low. This doesn’t account for any increase in operating lease rentals, which could trip the company to a loss.

Significant capex plan for FY17

The group has been growing stores each year with capex averaging at roughly 3% of sales (averaging £5.7m over last 3 years). For FY17, the group is embarking on a major capex programme with a planned £14m expenditure which includes implementation of an ERP system. Even without any increase in operating lease rentals, I predict this will mean the group burns through ~£5m of cash in FY17.

Liquidity and viability

If sales continue to falter, operating lease rents increase significantly in FY17 and margins fall as expected, the group’s viability will be under threat. My cash flow projections indicate that expected fall in margins, a 28% increase in rents from FY17, and the planned capex spend, could lead to a severe liquidity crisis if sales continue to falter. The group has current cash balance of £13m with a £10m revolving facility. However, the revolving facility expires in Nov17 and may not get renewed if the business deteriorates further, or the terms of renewal may be more onerous.

Valuation

Even a fairly optimistic DCF valuation predicts a 100% downside. The below DCF assumes what I believe to be a fairly optimistic scenario where FY17 sales fall is arrested over the holiday period and sales begin to grow by 2% from FY18, gross margins improve gradually to 21% after the immediate fall in FY17 and no increase in operating lease rents.

Conclusion

As value investors, we love a bargain; and one of my favorite hunting grounds is a stock screen showing the fallen ones. But such a screen tends to be a mix of falling knifes and value buys (more of the former in my opinion). Bonmarche looks like a falling knife.

VMWare Tracker offers a decent upside potential

The Dell – EMC merger has been well covered in the financial press since the merger was announced last year. I have written on it in March this year. As there is a whole host of information in the public domain I will keep the background very brief and focus on the specifics – i.e., analyse if VMWare tracking share offers a value opportunity now.

A very brief summary of the story so far

Dell and EMC have now merged, resulting in EMC being taken private. Dell paid cash consideration for EMC’s core business, but issued a tracking stock for most of EMC’s stake in the publicly listed VMWare. Broadly, EMC holds 81% of VMWare, and the tracking stock issued by Dell tracks 53% of the VMWare economics with 28% of the economics retained by Dell. The public hold the remaining 19% in VMWare common.

The VMWare tracking stock has now been listed and trades under the ticker: DMVT.

What’s the point of raising this now given the merger is all done and dusted?

Just look up the VMWare stock price and compare it to the VMWare tracker. When I last checked, VMWare tracker was trading at a 35% discount to VMWare common. As each VMWare tracker tracks a VMWare common, the 35% discount appears steep. It makes sense to check this situation out to see if the VMWare tracker is mispriced.  

Is the VMWare tracker mispriced?

To identify if the VMWare tracker is mispriced, two questions need answering:

1.      What is the value of VMWare common? – as the tracker tracks the underlying VMWare common stock, its value needs to be based of the intrinsic value of VMWare common. One needs to have some sense of the value of VMWare common and the comfort that it is not overpriced.

2.      What is the right discount for the VMWare tracker? – tracker’s like this one always trade at a discount to the underlying common. Based on comparables identified by Evercore (see the Merger Agreement), it appears that the discount on other trackers have been ~10%. But one needs to check the details for this tracker, identify key risks & terms, and get a feel for quality.

Broadly, the aim is to assess if the market’s current pricing of the VMWare tracker gives rise to a situation where the probability of upside significantly outweighs the probability of downside.

VMWare value

VMWare is currently trading at ~$73 a share. I think the price is about right.

·         Morgan Stanley & Evercore, who acted as EMC’s financial advisors for the merger, estimated VMWare’s intrinsic value in the range of $71 - $88 under various scenarios. (see the Merger Agreement for the detailed financial opinion and valuation)

·         Using the 5 year Free Cash Flow to equity projections for VMWare as disclosed in the Merger Agreement, and applying a discount rate of 11% for VMWare’s cost of equity (which is on the higher side), I get a DCF value per share of $77.

·         For a company forecast to grow at ~9%-10%, VMWare doesn’t trade at a too steep a multiple:

o    12.2x FY17 forecast FCF & 11X FY18 forecast FCF;

o    15x FY17 forecast P/E and 13.4x FY18 forecast P/E;

o    8.4x FY17 forecast EV/EBITDA and 7.6x FY18 forecast EV/EBITDA.

Overall, I am comfortable that the current share price is not excessive and there is some potential for upside if some of the projected merger synergies discussed in the Merger Agreement come true. 

What is a reasonable discount for the VMWare tracker?

Although the VMWare tracker tracks 53% of the underlying VMWare economics, its value cannot equate to 53% of VMWare common. Trackers always trade at a discount, and if you believe Evercore per the Merger Agreement, comparables trade at a discount of 10%. So why the 35% discount on this one?

I have set out both the negatives (reasons for a steeper than 10% discount) & positives (reasons why the discount could narrow from the current 35%) below.

Principal reasons for a steeper than 10% discount

1.      Lack of alignment of interest – To me this is the biggest and most concerning of all the risks. When I look at situations like this, I like to see management being personally exposed to the newly created merger security and having a material amount of personal wealth riding on its success. If you flip through the Merger Agreement, you struggle to find reasons why the Dell common stock owners (principally Michael Dell & Silver Lake) need to care for the VMWare tracker. None seem to hold any of the VMWare tracker – they do have a lot of personal wealth riding in the newly merged Dell-EMC business via their ownership of the Dell common stock, but that is not the same as owning and being directly exposed to the VMWare tracker. You could argue that as Dell is directly exposed to 28% of the VMWare economics, control’s VMWare, and expects a lot of benefits for the newly merged Dell-EMC business by being connected with VMWare, they have a lot riding in ensuring that VMWare as a business succeeds. However, for reasons listed below, I feel that VMWare as a business could succeed without the VMWare tracker getting the upside from this success. Personally, I would have liked it better if Michael Dell and Silver Lake were personally exposed to the success of the VMWare tracker.

2.      VMWare tracker will be exposed to the Dell-EMC credit risk. Dell has borrowed shedload to fund this deal (in excess of $50bln). Post deal, the group is expected to have a debt to free cash flow ratio of about 6x, resulting in junk-grade status. However, the group will generate a decent amount of free cash to be able to service the debt and deleverage. They have a stated aim of getting back to investment grade status in 18-24 months and given historic and forecast cash flows, this should be achievable. However, if the group goes under, the VMWare tracker will be worthless as the creditors enforce on Dell’s 81% VMWare stake. Broadly, you could find the VMWare business doing well, but still lose out on the VMWare tracker if Dell-EMC don’t succeed.

3.      The VMWare tracker only has 4% of the votes in the merged group. Basically, the tracker has no control or say. This pretty much kills the possibility of an activist taking a significant position in the tracker and fighting the case for the tracker holders. 

4.      Dell is allowed to move assets around, including the VMWare stake belonging to the VMWare tracker – for example, it looks like they are able to take away/transfer all or part of the VMWare stock from the tracker by replacing it with an equal value asset. This obviously is not what the VMWare tracker holders are buying into in the first instance.

5.      VMWare currently don’t pay a dividend. But even if they did, Dell are not obliged to pass this one to the VMWare tracker holders. However, they do need to ensure that any dividends attributable to the VMWare tracker is assigned to the tracker’s value – my reading of this is that if they use the cash from any dividends, they will owe the VMWare tracker an equal amount as a payable. However, this is not the same as the VMWare tracker holders being guaranteed their share of any dividends declared by VMWare.

6.      If Dell buy out the 19% VMWare common, effectively taking VMWare private, VMWare tracker would have no market comparable, and could effectively be left in a limbo.

      

      For the above reasons, I feel that the VMWare tracker merits a higher discount than the 10% seen for other trackers / comparables. However, I don’t think that the discount needs to be as high as 35% for the reasons listed below.

Positives for the VMWare tracker

1.      It is possible that a lot of the downward pressure on the VMWare tracker at present, given it only just got listed, is being exerted due to forced selling by institutions (former EMC holders who got handed over a bunch of tracker shares which they don’t want or cannot hold or don’t understand). It is not uncommon for institutions to be restricted from holding something like this and spin-offs / mergers do often create forced selling. To the extent there are forced sellers out there, it obviously creates an opportunity for a value buyer and one would expect the discount to narrow once things settle down.  

2.      Some of the governance risks I have listed in the negatives above are offset in part by the Capital Stock Committee whose main objective is to look after the interests of the VMWare tracker holders. Broadly, Dell has created a committee of directors known as the Capital Stock Committee, and the Dell board of directors will not be permitted to take certain actions with respect to the VMWare tracker without the approval of the Capital Stock Committee, including with respect to any changes to the policies governing the relationship between the Dell-EMC group and the VMWare tracker group. The Capital Stock Committee will consist of at least three members, and be independent under the rules of the NYSE. For these independent directors approximately half of the value of any equity compensation will consist of VMWare tracker or options to purchase VMWare tracker. The existence of an independent Capital Stock Committee, with some alignment of interests with the VMWare tracker holders, offers a degree of protection from governance risks listed above.

3.      If Dell do manage to deleverage and get to investment grade rating in 18-24 months as stated, and if no governance concerns come up in the meantime, this will be a net positive for the VMWare Tracker and should narrow the discount quite a bit. At least the credit risk is much reduced.

4.      Dell’s debt facilities permit up to $3 billion of repurchases of VMWare tracker, this amount may increase over time based on Dell’s net income and other factors. Dell has stated its interest in pursuing a repurchase of the VMWare tracker once it achieves its stated objective of reducing indebtedness and achieving investment-grade rating over the next 18-24 months. This augurs well for the VMWare tracker.

5.      Finally, VMWare tracker should create substantial liquidity and increase the ability to gain exposure to the underlying VMWare business. Currently there are 80m VMWare common held by public. The listing of 223m VMWare tracker increase liquidity substantially.

      In summary, I think that the VMware tracker doesn’t merit a narrow 10% discount seen for comparables but neither does it merit the steep 35% discount priced by market. I think a ~20% discount seems more reasonable.

      

     How to trade the situation?

     Given this is a new issue, and there is still quite a bit of uncertainty attached, I don’t think buying VMWare tracker direct is the way to go. Options offer a better much better risk/reward. Buying call options over VMWare tracker puts lower amount of capital at risk and adds a tone of gearing to amplify the return in the event the discount narrows and/or VMWare common increases in price.For example, a April 2017 call option on the VMWare Tracker with a strike price of $50 can be purchased for a $3.90 premium. If the discount on the tracker narrows to 20% by April 2017, assuming VMWare common stays at current levels, the VMWare tracker would be up at $58.4, giving a 115% return and 2.15x multiple on capital for a six month hold (364% return annualised). Even if the discount only narrows to 25%, the return would be 22% for a six month hold (49% return annualised).

      

      As discussed above, there are clearly downsides to the trade but I think that the probability of an upside outweighs the downside. Buying long-dated call options over the VMWare tracker offer a decent play with lower levels of capital at risk given you are only exposed to the option premium. 

      Afterword

      I wrote of the arbitrage opportunity offered by the VMware tracker back in March17. Back then, the VMWare tracker was priced at an implied discount of ~53% against the underlying VMware common. A simple strategy of going long EMC share then would have resulted in a return of 10% over 6 months (21% annualised); and a strategy of buying Oct 16 EMC calls at a $24 strike price which were selling for a $3.65 premium would have resulted in a return of 47.5% over 6 months (117% annualised). The beauty of this situation is that it still has the potential for a decent upside, which is not unusual for special situations like this.

     As I write this blog, I am reminded of Joel Greenblatt (one of my favourite value investors) and his fantastic book - You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits. Joel wrote this book back in the late 90s and it is as relevant today as it was back then and will continue to be so for a long time yet. In it, Joel peppers us with real life examples of special situations (spin-offs, mergers, reorgs etc in which he invested) and provides practical advice to profit from them. Joel is a great investor and I highly recommend this book if special situations are of interest to you. Joel is better remembered for another one of his book – The Little Book That Beats The Market. But to me, You Can Be a Stock Market Genius is even better, and that is saying something given that The Little Book is also a fabulous book. 

      

Sports Direct International Plc (SPD:LSE)

Sports Direct, a UK based discount sportswear retailer, has had nearly 58% of wiped off its share price in the last year and invites attention. Doubly so, given that it is a business that has long-term viability. Shopping at Sports Direct may not be the best of experiences – its shops are jam packed with stock and a real challenge on one’s patience – but as long as there are bargain hunters looking for their next bargain trainer, there will be Sports Direct. It is a business that is here to stay.

Hence when the market votes so dramatically against Sports Direct, it is worth a look to see if there has been an overreaction to short-term bad news. So the question is – are the shares today a bargain like a Sports Direct clearance where goods go for up to 90% off?

Key Stats

The company had already had a disappointing FY15 – where EBITDA, PBT, and EPS all fell substantially – when it was hit by the twin strikes of Brexit and a major controversy surrounding the company’s employment practices. Brexit will hit the company’s gross margins for sure – it generates ~80% of its revenues in the UK and buys its stock from outside, with a major chunk in USD and the company did not bother to hedge currency risk pre-Brexit. As for its employment practices, the company continues to bear the brunt of negative press to this day; firstly, its CEO Mike Ashley, who holds 55% of the company, got a right royal telling off from the UK’s parliamentary committee, and now institutional shareholders are up in arm’s demanding a full and thorough enquiry and change of ways. The end result is going to be an increase in SG&A as the company mends its way and treats its people more fairly. Both results, hit to gross profit margin and increase in SG&A, don’t augur well for the shareholders and it is only right that the share price fell. The question is, has it fallen by too much, or is it fair?

Using the company’s own prediction for FY17, I get a forecast FY17 P/E of 10.7, and forecast FY17 EV / EBITA of 8.8. This might look cheap, but the company projects a revenue growth of 8% for FY17, a decline in gross margin of not more than 275bps from 44.21%, and an increase in operating costs of not more than 8%. Whilst one could accept the gross margin and operating costs targets, the revenue growth target of 8% looks particularly optimistic given that it suffered a like-for-like fall in sales, and group revenues only increased by 2.5% in FY15. By its own admission, foot fall was low post Brexit.

Adopting management’s forecast numbers, I estimate intrinsic value per share of £3.44 - £3.65, for a return of between 5% and 11%. But if one were to use a 2.5% revenue growth projection - same as was achieved last year - leaving gross margin and operating cost as predicted by management, value per share drops to between £2.18 - £2.51 for a return of between negative 33% and negative 23%. In my opinion, there is more downside potential than upside potential at present - for example the gross margin could fall by much more than the 2.75% projected by management (the company does not disclose details around its purchases) given the fall in Pound and no hedge.

Valuation summary

The market may have voted down Sport Direct for a valid reason. This stock is a wait and watch for now; it may yet become a bargain one day, like a Sports Direct footwear on sale.

Charles Taylor PLC (CTR:LSE)

Charles Taylor offers a range of management and professional services to the global insurance market; in addition, it also owns a small life insurance business. The company derives most of its revenues from its professional services businesses (~97%) which operate on a fee-based model, with the rest coming from its owned life insurance business.

This is an attractive business – it has a strong and durable moat; it has been in existence since 1884 and has developed deep connections with its client base in the global insurance market; its services are an essential part of its client's business, very technical and bespoke in nature and delivered by a highly skilled and varied workforce; it is very difficult to switch providers for these services; the company has a solid management team; and its financials look - with a strong balance sheet and a track record of revenue, EBITDA, and earnings growth. Moreover, I believe that the business is headed in the right direction at present.

At 11.4 times my forecast FY17 EPS, and with good growth prospects, I believe the stock offers good value. I calculate intrinsic value per share in the range of £3.35 - £3.65, which implies a 22% - 33% upside to the current share price of £2.745. The stock also offers a decent dividend yield of 4% based on my forecast for FY17.

Overview of the business & investment case

Charles Taylor’s professional services businesses operate through three main divisions:

·         Management Services provides end-to-end management for insurance companies covering every aspect of an insurance business from management of underwriting claims to regulatory and accounting services. The division has a solid client list consisting of – The Standard Club, which provides liability insurance to 10% of world shipping; Signal Mutual, the largest provider of Longshore workers’ compensation insurance in the US maritime industry; SCALA, which provides workers’ compensation to the majority of Canada’s ship owners; and it also provides administration services to The Offshore Pollution Liability Association (OPOL), a mutual insurance association established to meet offshore pollution claims under the Offshore Pollution Liability Agreement 1974. The division has been a solid performer contributing ~35% of the group’s revenues, and ~55% of group’s EBITDA. It is highly cash generative, reliable, and has shown decent growth (FY15 EBITDA of £10.3m with a ~7% EBITDA growth over the last 5 years).

·         Adjusting Services provides loss adjusting services across the aviation, energy, marine, property & casualty and special risks sectors. The division specialises in resolution of larger and more complex losses arising from major incidents. This is a cyclical business which does well at times of natural catastrophes and man-made disasters, when insured losses are high and specialist adjusting services are in demand. Based on stats, this has not been the case over the last few years, with insured losses running 30% - 40% below their 10 year average. The positive sign here is the fact that the company has grown revenues at over 4% in the last 5 years and has invested in opening new offices in new geographies, and recruited senior loss adjusters. The investment has meant that EBITDA has remained flat at ~£3.5m over the last two years. However, given the resilience shown by the division during a benign claims environment, and the investment the company has made in growing the business, the future looks good as and when the claims environment picks up.

·         Insurance Support Services business provides a range of professional and technology services wherein insurance clients can select specific stand-alone services of their choice, including - outsourced insurance support services, technology services, investment management, captive management and specialty risk management. Management also view this division as the Group’s business incubator where they can develop and test new business initiatives. Financially, this division has been a growth story, with sales growth of ~48% over the last four years, and EBITDA growth of ~60% in the same period. FY15 EBITDA stood at £5.15m. I see continued growth prospect for this business line, and particularly like the technology offering and turn-key managing agency offering. And given the deep relationships with clients across other business divisions, there is tremendous scope for cross selling .

·         Recent acquisitions add value to the business. Charles Taylor raised ~£30m through a rights issue in March 2015, following which it has made two significant acquisitions which I believe add good value to its professional services offerings. In July 2016 it acquired CEGA, a specialist provider of technical medical assistance and travel claims management services with over a 40 year track record and good growth. CEGA had FY15 revenues of £31m (equates to ~22% of Charles Taylor’s FY15 revenues of £138.6m from its professional services divisions) and FY15 EBITDA of £3.3m (equates ~17% of Charles Taylor’s FY15 EBITDA from its professional services divisions). According to management presentation, CEGA’s EBITDA has grown at 7.5% over the last previous two years. The acquisition has a maximum consideration of £29.8m, with £23.8m paid upfront & £6m deferred and payable subject to future performance hurdles being met. Assuming full deferred consideration is paid, the price equates to 8x CEGA’s FY15 EBITDA, which appears fair given growth prospects. The other significant acquisition was a 25% investment in Fadata, a specialist software solutions provider to insurance businesses for a consideration of £3.7m. Both acquisitions are a good fit; CEGA should contribute meaningfully to revenues and EBITDA from FY17 onwards in addition to providing a new, technical, high value-add professional service business line which is closely-related to Charles Taylor’s existing core businesses; and the Fatada stake is already being exploited by the company - business plans to be an implementation partner of Fadata, and is already undertaking joint marketing initiatives with Fadata, which it anticipates will lead to projects to implement its end-to-end policy administration system

In sum, Charles Taylor’s professional services divisions enjoy a strong moat across business lines, and offer tremendous ability to cross sell within its sphere of its competitive advantage – e.g. the ability to develop and sell bespoke insurance technology services given its knowledge and experience of the insurance markets. This reminds me of what Pat Dorsey, author of The Little Book that Builds Wealth states: “The way I think about the linkage between moats (competitive advantages) and intrinsic value is that moats add the most value to businesses that have lots of reinvestment opportunities within their moats. A business that has a large set of investment opportunities “inside the moat” has a much higher intrinsic value than a business without competitively advantaged reinvestment opportunities because the former compounds cash flow at a very high rate, whereas the latter is forced to use cash for sub-optimal opportunities.”

·        Finally, there is the owned insurance companies business which are primarily in run-off (i.e., an insurance policy provision that provides liability coverage against claims made against companies that have been acquired, merged, or have ceased operations and indemnifies the acquiring company from lawsuits against the directors and officers of the acquired company). Here, the group aims to deliver value through operational efficiencies. The division contributes ~3% of the group revenues, and EBITDA and has a net book/equity value of £11.8m as at FY15.

Valuation

I forecast FY17 earnings from operations of £16.12m, or £0.24 earnings per share (EPS); this equates to Forecast FY17 P/E of just 11.45. And based on FY15’s adjusted EPS of £0.1998, the company currently trades at P/E of 13.75. Even assuming the company continues to trade at the 13.75 P/E multiple, this would equate to value per share of £3.3 based on my FY17 forecast EPS, implying a 20% return to the current share price of £2.745. However, given the growth prospect, low downside risk and the resilience of the business, I believe that the stock merits at least a P/E multiple of 15, equating to value per share of £3.6 based on my FY17 forecast EPS, and implies a 31% return to current share price.

I have cross checked my P/E multiple with a DCF valuation. My DCF valuation gives me a value per share of £3.63, implying a 32% return to current share price which is consistent with my 15x P/E multiple. I have made the following assumptions for my DCF:

-         EBITDA growth of 2% for the professional services businesses (which is conservative given recent growth and prospects for future); WACC of 7%;  ROIC of 8% (which has been the average over last 4 years); and an effective tax rate of 15% (last 5 year effective tax rate has average 12%).

-         Note that I have valued the insurance business at its FY15 book value of £11.8m which I think is conservative.

The result of my DCF valuation is shown below.

*Liabilities attributable include - pensions obligations (£40m), deferred consideration (£9.6m), debt (£22m), non-controlling interest (£2.1m), projected cash & equivalents after allowing for CEGA consideration and cash attributable to insurance business (£30m). 

In summary, I believe that Charles Taylor is a great business priced attractively and offers an attractive good return prospect with limited downside risks. 

NorthStar Realty Europe Corp (NRE:NYQ)

NRE is a NYSE listed REIT with a focus on European commercial real estate; its portfolio predominantly consists of prime office properties in Germany, UK and France; and it is the only NYSE listed REIT with a European focus. I believe that at current share price of $8.70, NRE trades at a significant discount to my estimated NAV of $15 per share.

Key stats

The key stats above assume a 15% drop in cash flow per share and a 5%-10% fall in value of NRE's property portfolio owing to currency risk further to recent events in the UK (see discussion on currency risk & NAV calc below). It is worth bearing in mind that only ~22% of NRE's in place rents come from the UK. 
   
Investment case

My investment case for NRE is as follows:

1.       NRE’s portfolio comprises mainly of prime office properties in key cities of Germany, UK and France (represents 76% of the total portfolio); the overall portfolio has a weighted average lease term of 6.2 years and is 88% occupied; tenant quality is solid with the top tenants being blue chip and creditworthy. See below for more details on the portfolio.

2.       At current price the stock offers a solid 6% dividend yield compared to 1.38% paid by the 10-year U.S. Treasury note and the 2.1% yield for the Standard & Poor’s 500. NRE’s dividend yield compares well with comparable European REITs where continental office focused REITs offer a 4.8% dividend yield and UK REITs offer a 2.85% dividend yield.

3.       My conservative NAV per share forecast for NRE is $13 - $15 per share, implying a 50% - 70% upside to current share price.

4.       The current economic outlook in Europe should prolong the low interest rate environment and a continued period of quantitative easing by both ECB and BOE is likely. This should continue to support cap rates.

5.       I acknowledge that the outlook for rental growth, particularly in the UK, may be negative following Brexit; my valuation assumes no rental growth. It is worth bearing in mind that only ~22% of NRE’s in-place rents come from UK; and that too consists of prime office properties leased to quality tenants. Bar a disastrous economic situation, the portfolio & current rents should hold. In summary, NRE’s 6% dividend yield along with current significant discount to intrinsic value offers a buying opportunity. The market appears to have overreacted to the current uncertainties in the UK, and seems to have failed to acknowledge the quality and geographic mix of NRE’s real estate portfolio.

Currency Risk

Given the recent big drop in GBP against USD, currency is a risk area. ~22% of in place rents come from the UK which will be negatively impacted given the fall in GBP against USD. Assuming the GBP depreciation results in a 30% drop in income from the UK, and allowing for a 10% drop in income from Europe due to EUR risk, cash flow per share would fall from $0.90 per share to ~$0.77 per share, giving a cash flow yield of ~9%. If NRE maintains its dividend payout of 70%, this would give a dividend per share of $0.54 with a dividend yield of 6%. This should still support my NAV per share estimate of $13 - $15 per share. 

Valuation

NAV

Below is my NAV per share estimate for a range of valuation of NRE’s portfolio – starting with the most recent valuation undertaken by Cushman & Wakefield and ending with the implied portfolio value based on current share price. 

The current share price of $8.70 implies a ~20% discount to the most recent valuation undertaken by C&W. I believe this to be overdone and think that a more realistic NAV in the range of $13 - $15 per share is a better reflection of intrinsic value. My estimate is supported by both comparables.

Comparables

In the below table I have shown the Price / NAV and dividend yield for comparable European REITs – both continental office focused REITs and UK office focused REITS.

As can be seen, UK REITs currently trade at a significant discount to NAV following the UK’s vote to leave the EU. Continental European REITs continue to trade at close to NAV. NRE’s portfolio is split 75:25 between continental Europe and UK; applying this split to the comparable P/NAV, I get an implied NAV per share for NRE of $15 per share.

Further, using NRE’s portfolio split, the comparable universe offers a dividend yield of 4.3% compared to NRE’s dividend yield of 6%. Applying the comparable universe’ dividend yield to NRE would support a price per share of $14.

Cash flow

I forecast cash flow per share for NRE of $0.90, implying a cash flow yield of 10% based on current share price. My range for intrinsic value per share of $13 - $15 implies a cash flow yield of between 6% - 7% and a Price / Cash flow of between 14x - 17x (both reasonable).

Implied Cap rate

My forecast FY16 NOI for NRE of $129.4m implies a cap rate of 6.35% based on Enterprise Value of $2bln. My intrinsic value per share of $13 - $15 would give a cap rate in the range of 5.4% to 5.7%. Given NRE’s portfolio mix and quality and the anticipated prolonged low rate environment in Europe, I believe these cap rates are supportable.

 NRE’s real estate portfolio quality and mix

The below tables and graphs are taken from NRE’s financial statements and presentations to market and provide a snapshot of NRE’s portfolio mix and quality.

Portfolio overview

Portfolio overview by geography

Rent concentration by geography

Major tenants

Source for portfolio information shown above - NRE's financials and management presentation

Other considerations

·         NRE is a newly created REIT, having listed in NYSE in November 2015 when it was spun off from NorthStar Realty Finance Corp. It have limited analyst coverage and it is the only US listed REIT with a focus on European real estate. I believe that due to these reasons, it has traded at a discount to its peers in Europe; the recent fall in European markets has broadened this discount. I think this is overdone and at some point down the line, may be as analyst coverage improves, this disconnect between NRE and its peers should narrow.

·         NRE pays a fixed management fee of $14m per annum to NorthStar Asset Management which, per my calculation, equates to a PV of $233m or $3.84 per share (applying a 6% discount in perpetuity to the $14m). The NAV needs to be perpetually discounted for this management fee.

·         In addition to the $14m fixed management fee, NRE is obliged to pay additional management fee of 1.5% of any new equity issuance. NRE currently has $187m of stock settable notes which are due to mature at the end of FY2016; it can either pay down the notes at maturity, or convert them to equity. If the notes convert to equity then NRE’s management fee will increase by $2.8m per annum (1.5% * $187m), implying an additional discount to NAV of $47m (or $.77 a share). Such a scenario should still support a NAV per share of $13 - $14. However, I see the risk of the stock settable notes being converted to equity being low on the basis that NRE started off with $340m of stock settable notes and has bought back $150m of the notes from open market purchases so far. Given NRE’s cash flow generation, I believe that the company continue to buy back the notes or repay it at maturity. Further, management are incentivised to increase cash flow per share more than they are incentivised to increase the management fee (management fee reduces cash flow per share and the higher incentive fee payable to NSAM).

·         The company has repurchased 4.3m shares from November 2015 for a total of ~$50m. If the current discount to NAV persists, I expect the company to continue to repurchase shares.