We have used December to commence the cleaning of house. When EGPCVF was created, a number of our smaller holdings carried over from EGP Fund No. 1 became redundant in light of our enlarged capital base. We eliminated a few of these this month.
First was the disposal of a small holding in US Residential Fund (USR.AX). We only acquired the holding in January this year as part of a capital raising to acquire an asset (Patriots Point in North Carolina) we really liked the look of. It was my understanding that provided further suitable assets could be found, that more capital would be raised in order to grow the fund into a scale more appropriate for a listed property owner/manager. This strategy seems to have changed recently, with the decision to return about a quarter of the capital. To my way of thinking, this will leave listing costs etc as too high for the size of the listed vehicle. The investment turned out a respectable result which crossed over both funds, with EGPCVF doing the better. Our IRR over the nearly 12 months was a respectable 32.6% after all costs. Unfortunately, only 0.5% of the current fund was in it, so it didn’t really move the needle in terms of results, but every little bit counts…
The second disposal was our holding in RFM Poultry (RFP.NSX). RFP was the sort of quirky idea we had more capability of doing when our capital base was much smaller. Over an 11 month period from September 2014 to August 2015, we accumulated a holding in the NSX listed chicken farmer that was large enough to be meaningful to the fund at the time. Our average all-in cost was just under 84.3cps. The stock from the time we acquired it paid us a quarterly yield that grossed up to 17.03% annually on our cost base. Unfortunately, even if we’d never sold a single share, the position would only equate to under 0.5% of the assets of the present fund. Along with our substantial yield, meaningful capital gains were made along the way, enabling a lifetime IRR for the investment of 37.2%.
Finally we disposed of a holding in Steamships (SST.AX) that we have held since early 2013. In hindsight, SST was a mistake. I overestimated the positive economic effects of the activation of the LNG plant on the Papuan economy (it was reputed to lift GDP by around 25% the day it was commissioned). SST is very cheap at present in my estimation, but the position spoke for less than 0.1% of fund assets and is so illiquid as to be impossible to add to in any meaningful way. The buyer of our SST holding is likely to do well, but our return was abysmal, an IRR loss of 7.0% annually was recorded out of a (thankfully) very small position.
The above 3 positions aptly describe how we expect our investment program to roughly look over time, with 2 out of 3 holdings working more or less as expected, and the one we got wrong being sized in such a way that not too much harm was caused. The lifetime IRR for the above 3 investments was 23.8% annually, which would be a truly outstanding result if it could be maintained over any reasonable length of time.
We are also using this month’s blog and report to reveal another of our top-5 holdings. Blackwall Limited (BWF.AX) is our fourth largest holding, accounting for 4.7% of the invested portion of the portfolio. In setting out the work below, I posit a fair value range of between $1.39 and $1.97 per share. As always, I would warn against the apparent precision of giving such values to the cent, but you will see below, it is the outworking of our thinking on how the business should be valued.
BWF is primarily a property fund manager, but inside the stock is an operating business known as WOTSO, which is a co-working or shared workspace business, not dissimilar (except for the scale of the operation) to what WeWork do.
In terms of thinking about the valuation of BWF, we will start first with the balance sheet. At June 30 2017, there was just a shade over $22m of tangible assets on the BWF balance sheet. Of this $22m, $3.18m was attributable to the Adelaide WOTSO building, which was announced as syndicated out for $4.2m in September (.PDF). That announcement is well worth reading for a flavour of the type of entrepreneurial deal Stuart Brown (CEO) and the BWF team do. NTA was increased by almost $1m post the Adelaide transaction (and a considerable amount of cash freed up to seek out other interesting opportunities).
In the announcement released 30 November 2017 (.PDF), a further blockbuster outcome was realised for BWF owners with a $7.9m performance fee being crystallised and taken as units in the asset at 55 Pyrmont Bridge Road. There have been good tailwinds for property in the Sydney market over the 3 years since that asset was syndicated, but a return in excess of 30% per annum after all fees and costs is a spectacular outcome to date for the unitholders.
Along with the profits the operating businesses should add to the balance sheet in the first half of FY2018, the NTA should be at least $32m. Subtract roughly a $1m dividend paid in October and perhaps it’s more like $31m or so. At 90cps (price at time of drafting the blog), BWF is capped at $53.7m. So what this tells us is that the funds management and WOTSO businesses are implicitly being valued at less than $23m.
To think of the $31m of tangible assets as some fixed unmoving sum is a mistake by the way, despite paying out 62% of earnings as dividends over the 3 years from FY14-FY17, NTA has grown from 27cps to 37cps, or over 11% per annum.
To my view, the most exciting part of the business is WOTSO. We attended the AGM in November, held in one of the original WOTSO Work Spaces in Neutral Bay. For a sense of how the WOTSO business has unfolded, I present the following:
|Financial Year||Revenues||Expenses||EBTDA||PBT||PBT Margin|
Particularly in FY2017, you can see the acceleration of the business into profitable scale. I estimate the WOTSO business exited FY2017 on a revenue run-rate exceeding $7.5m per annum, which if the operating leverage implicit in the table above should have the business operating on a PBT run rate approaching $1m (and growing very fast). The only limiting factor for BWF in the rollout of WOTSO is that management have shown an intention to expand profitably (unlike WeWork…). This is quite severely limiting because the median WOTSO from the time capital is first deployed into a new premises takes around 15 months to reach breakeven and over 2 years to begin to fully mature in terms of the profitability.
This means that rather than “growth at all cost”, the capital is selectively applied where the return is highest. To someone like myself who values lifetime return on capital over most any other investment metric, I find this slower, more deliberate approach pleasing. Many a business with the capacity for exceptionally fast growth has blown itself up by focusing on speed rather than execution… They seem to be trying to grow at a rate that maintains a PBT margin of almost 10%. Management have shown an ability to do deals that provide growth but limit risk.
Where third party deals (which introduce “lease leverage” risk into the business) are done, they are done in way that shares risk with the landlord rather than taking full operational leasing risk and hoping occupancy builds to a sufficient level before incentives run off. The Bondi Junction deal (.PDF) is a good example of this, with WOTSO membership including a membership to the East Leagues club in which the WOTSO has been located.
CEO Stuart Brown once remarked to me at his surprise at the scant regard the implicit valuation for WeWork gave to the enormous lease risk which provides the real leverage in the model, the importance of this cannot be overstated.
The WOTSO business is exceptional for its ability to take space in city fringe locations where the rent is meaningfully cheaper than in prime CBD sites, but then through entrepreneurial fit-out and leasing practices, command rates per square metre that are roughly what are being achieved in prime locations. The outworking of this important dynamic is that mature WOTSO sites are earning exceptional EBITDA margins of at least 25% and as high as 35%.
WOTSO is a very fast growing business with FY2017 revenues growing by almost 84% and operating profit roughly doubling. As I mentioned in last month’s blog, pinning down a valuation on an extremely fast growing business is very tricky and a range of likely outcomes is best used. Given what has been achieved so far with WOTSO, I find it hard to imagine less than about a 33% growth in revenues annually over the next 3 years (just shy of 2.5% per month). PBT margins have been maintained at almost 10% while revenues have grown by more than 70% annually over the past 3 years. Keep in mind that in terms of square meterage, WOTSO has already grown nearly 40% with the Bondi Junction announcement and the financial year is only halfway complete.
I estimate that if revenue growth slowed to 33% annually over the next 3 years that by FY2020, PBT margin would be at least 15% and probably approaching 20%. 33% annual revenue growth and a PBT margin of 17.5% would put the WOTSO business on a FY2020 PBT of around $2.5m. This is my base case for the WOTSO business. This outcome would have the PBT of the WOTSO business growing almost 350% over 3 years. A business exhibiting growth rates like that in my view is likely to trade at least at 15x PBT, which implies a valuation 3 years hence for WOTSO of $37.5m.
The more ambitious valuation case for the WOTSO business might see the revenue growth rate over the next 3 years annualise at 50% (just shy of 3.5% per month). Should this happen, PBT margin would likely be lower than in the slower growth example in the previous paragraph, perhaps only getting as high as 15% as a preponderance of the sites would remain immature due to the very rapid growth. Such an outcome would see FY2020 WOTSO revenue exceeding $20m and would likely see PBT of over $3m. The much higher growth would presumably be starting to draw growth focused investors who I would hazard would happily pay 20x PBT for a business that has a long runway and has grown PBT from $360k to >$3m in 4 years. This of course implies a WOTSO valuation of more like $60m+ in FY2020.
So it is entirely possible that if the execution of the WOTSO opportunity is done well, the entire current market capitalisation can be explained by WOTSO, with the remainder thrown in for free. More practically, we need to discount the expected valuation in 3 years’ time back to today’s price. Using a 10% discount rate, today’s valuation as described by the 2 preceding paragraphs would range from $28m-$45m.
In fact, using the same valuation metrics that have WeWork valued at $20 billion, WOTSO would already be worth $120m… Don’t put too much stock in the WeWork comparison valuation. As I often point out to CEO’s when they come to my office and try to use company comparison metrics to explain why their company is more valuable than its present market value, just because one company achieved an insane valuation, does not mean your company also deserves an insane valuation…
As for the property fund management business, like WOTSO, I will show the last 4 financial years:
|Financial Year||Management Fees||Performance/Transaction Fees|
The management fees generated have been growing at double-digit rates on average. Like virtually all fund-management businesses, the other side of the income statement is tricky to model as transaction and performance fees are very lumpy.
The management fees over the last 4 years have been roughly matched by the expenses of the fund management business and it is not unreasonable to expect that this will approximately continue to be the case, though hopefully costs grow more slowly than management fees as scale improves.
Effectively, we expect the fund management business to break even on its growing pool of management fees. Management explain that their vertically integrated (i.e. they don’t outsource property management) model is more efficient than similar businesses. They have also indicated the management fees in future years will likely be greater than operating expenses and that the swing factor over the past few years has been the start-up cost for the WOTSO business. As WOTSO matures, the numbers will be broken out with greater clarity which will assist analysis.
The upside in the fund management business therefore primarily comes from the generation of performance and transaction fees. Over the past 4 years, these fees have averaged $2.4m annually. With the $7.9m performance fee already generated in FY2018, if we assume no other fees for performance in FY2018, the 5 year average is closer to $3.5m.
The fund management business could be reasonably valued on about 10-12x the 5-year average for PBT, so effectively we imply a valuation between $24m (10x the $2.4m average) and $42m (12x the $3.5m average).
I am generally leery of “sum of the parts” valuations, but think in this case it is not unreasonable.
At the bottom end of the range, BWF would be valued at $31m (NTA) + $28m (low valuation for WOTSO) + $24m (low valuation for the funds management business) = $83m. At the top end of the range, BWF would be valued at $31m (NTA) + $45m (high valuation for WOTSO) + $42m (high valuation for the funds management business) = $118m. This implies BWF at 90cps has equity upside of between 54% ($1.39) and 118% ($1.97), with a mid-point valuation of $1.68 implying 86% upside. Not quite as good as buying $1’s for 50 cents, but if the future works roughly as we hope, then pretty close.
To be clear, I’d be exceedingly surprised if even the lower end of the above range were achieved in the next 12 months. What we hope for all of our larger investments is that they grow their intrinsic valuation at a rate that approximates the growth in the share price, that way we never need to contemplate selling.
So an ideal situation in the case of our investment in a business like BWF is that in 12 months’ time, the share price is perhaps $1.05, we have been paid perhaps 4cps in dividends and our assessment of the mid-point for intrinsic valuation has moved to perhaps $1.80 and we have to do nothing.
We consider an investment in BWF as similar to betting on a three sided die where two sides say “win big” and the third side says “don’t lose much”. That’s the type of investment asymmetry that makes coming to work pretty exciting (to me anyway). It is this type of low downside investment that customarily becomes a larger position for EGP.
Speaking of downside, I should be clear that like any fund manager, a severe downturn in the asset class they manage (in this case property) would be harmful in the short term (to share price, if not to the underlying business). With that said, we consider the management to be of a most excellent and entrepreneurial quality and given their track record of buying distressed assets and generating excellent returns, would actually expect a property down cycle to be helpful to the business longer term. BWF now have a large investor base that has had an excellent experience across a number of different assets and funds.
I already described the 30+% IRR of 55 Pyrmont Bridge Road. The Bakehouse Quarter asset which dates back around 20 years has an IRR assuming the current option is exercised that will exceed 15% (i.e. had distributions been reinvested, each original dollar invested would now be worth $17.50). The Blackwall Storage Fund commenced in 2006 is another good example of the type of asset Blackwall specialise in. Investors received average annualised cash dividends of 11.4% over the life of the fund and were handed back $1.34 in cash for every original dollar invested when the fund was wound up in 2013, after sailing through the GFC without missing a beat. The directors have now been in business together for almost 20 years and in that time have never structured an investment that has not grown NTA.
Investors who have experienced returns such as those described above will no doubt be most enthusiastic about hearing about new opportunities as and when they arise. In the event the Bakehouse Quarter deal settles, the investor group will have liquid cash of around $200 million. These investors are not by and large individuals that will need that money and are highly likely to be very keen to redeploy into new investments Blackwall structures.
I trust you all had an enjoyable Christmas with your family and wish each and every one of you a prosperous 2018. Here at EGP, we’ll be doing everything in our power to ensure we are a big contributor to any prosperity you experience in 2018 (and beyond) – Tony Hansen (04/01/2018)
|August 15th 2017||Current Price||FYTD||Annualised|
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