Description

Investment Overview: Balwin Properties is a 22-year old, JSE-listed, South African residential homebuilder with the highest profit margins of any worldwide builder, a demand tailwind, large multi-year pipeline and significant insider ownership. However, its stock is valued at only 2.7x trailing-12 month EPS,

Global homebuilders over time generally trade for 10-15x earnings, and 1-2x book value. Worldwide homebuilder valuations are currently depressed, but we believe this is temporary as valuations for homebuilders are well below historical averages. Balwin earns the highest ROE’s and gross margins of any global homebuilder we have seen; yet the business trades for less than 3x earnings and 0.6x book value. This is one of the least sensible valuations we have ever seen. If Balwin traded for only 10x trough earnings, it would be 230% higher than today's’ price.

The opportunity exists due to recent temporary slowing in Balwin’s growth and the location of the company in South Africa. We note that Balwin IPO’ed at 10x earnings, and its closest comp on the JSE, Calgro M3 Holdings, at one point traded for 20x earnings. So we believe a multiple greater than 10x for a homebuilder in South Africa is reasonable, and is supported by historical data.

We believe a resumption of growth aided by a recently announced rental partnership agreement (which will provide additional demand, while increasing earnings stability) should be a catalyst for a significant re-rating of the shares. We believe the multiple can re-rate back up to a P/E of 8x (still below its IPO valuation of 10x and worldwide comp’s), which on our estimate of $1.65 in near-term earnings power, would translate into a share price of ~R13-R16 /share vs. the current share price of ~R3/share, or a +4x increase. Thus, we believe the shares offer an asymmetric opportunity for value investors who look at out of favor industries and like to fish in less crowded ponds. Noteworthy, the South African stock market has been the best performing worldwide market over an extended period.

Note: All financial data are presented in Rand, unless otherwise indicated.

Company Overview: With roots dating back to 1996, Balwin Properties has established itself as one of the largest turnkey residential apartment development homebuilders in South Africa, with a portfolio of over 70 developments constructed or currently in development. The company was listed on the JSE in October 2015 at R10/share. Balwin’s focus is on the mid-market 1,2 & 3 bedroom apartments, with an ASP currently at ~R1 million (~$70,000 USD’s), on high density developments in the 4 largest metro areas (Johannesburg, Pretoria, Durban & Cape Town). Balwin has a growing pipeline, worth ~R40 billion, or over 14x the trailing-12 month revenues of R2.7 billion, which should support growth over the next decade. Based on our research and site visits, the company has established an excellent brand reputation as a high quality builder offering a lifestyle product at a value price. Helping to differentiate Balwin from smaller developers, the company’s new and larger developments all include “lifestyle centers”, which include a: swimming pool, gym, sports facilities, concierge and food & dining services. Additionally, the company has an exclusive license with Crystal Lagoons, to incorporate their unique lagoons in some of Balwin’s developments, further differentiating its product portfolio.

The following illustrate the company’s developments:

The following is a sample layout of one of its developments:

Key Investment Points:

Housing Shortage, Rise Of The Middle Class & Demographics In South Africa: Demand Tailwinds: Fueled by a rapidly growing middle class and urban migration trends, South Africa currently has a ~4M home shortage of low-cost houses to accommodate 15 million citizens. This social problem has its roots in the country’s pre-1994 apartheid regime. There is supportive government policy for urban densification. With the population growth of 1.6% per annum, this is adding over 200,000 units to this shortfall per year. Exacerbated by urban migration, the rise of an affluent middle class, slow housing delivery as well as the lack of sufficient rental opportunities in the metropolitan areas. From a cultural perspective, home ownership in South Africa has been viewed as a traditional means of wealth preservation.

The following charts illustrate these points:

South African Population

Another tailwind for housing demand in South Africa is the rise of the middle class since apartheid. As illustrated in the chart on the left below, since the end of apartheid in ~1993, South African GDP per capita has seen strong growth. The chart on the right shows the steady rise in South African disposable income. This growth has been driven by the rise of the middle class in the country. The African National Congress stated in January 2018 that the black middle class had grown from 1.7 to 6.0 million in the previous five years. With an ASP for its apartments at ~R1 million ($70,000 USD’s), Balwin has positioned its product offering to target the growing South African middle class customer.

              GDP Per Capita                                                     Disposable Income

Additionally, Balwin is well positioned from a changing demographics perspective. South Africa has a relatively young population, (as illustrated below) with about two-thirds aged 34 years or younger. Moreover about 20% of the population is within the prime 1st time buyer segment age of 25-34 years old (vs. 13.9% in the US and 13.7% in Western Europe), and this figure will grow in the next few years. Thus, with an ASP of ~R1 million, and given its location in the prime metro markets of the country, Balwin is well positioned in the sweet spot of the market from a demand perspective.

Secure Residential Pipeline - Healthy Supply: Balwin has a growing project pipeline diversified across 13 developments currently active. Based on ASP’s of about R 1million, this pipeline is worth ~R40 billion, or over 14x ttm revenues of R2.7 billion, which should support growth over the next decade. This pipeline provides Balwin a competitive advantage as land ownership in South Africa is often concentrated and typically not easy to obtain, especially at a reasonable price. Having secured an adequate supply of land, currently Balwin has shifted its focus to accelerating the development of its land bank. Thus it is likely that the number of developments running at any given time will increase. Also, Balwin’s just announced rental partnership (which will be discussed later in the report), is another example of this. All of the land in Balwin’s project pipeline is owned by the company, with the exception of its large Waterfall development, which the company has an exclusive lease agreement to develop.

The following is the company’s current project pipeline:

Turnkey Business Model Results In Industry High Profit Margins: All elements of the sourcing, financing, planning, construction management, development and sales processes are performed in-house, with the exception of certain professional services, which are outsourced to approved vendors with whom Balwin has long-standing relationships. Balwin benefits from a cost perspective from the relatively high unemployment rate in the country, which combined with its training program, provides the company an adequate source of relatively cheap labor. The design of Balwin’s units are standardized to allow “cookie-cutter” construction, and offer flexibility to meet market demand in the number of bedrooms required by customers. For example, recently Balwin reacted to the challenging economy by redesigning its buildings to accommodate more 1-bedroom units, and has seen an improved unit uptake from customers.

The company strives to keep a constant rate of construction to retain contractors, maintain quality, and keep costs low. Also helping to keep costs down is Balwin’s in-house sales operations, which eliminates the expense of paying large outside agent commissions. The company has a pre-sale business model, targeting selling 20 - 25 apartments per location, per month. Development finance is secured against the pre-sales of the specific phase being developed.

Based on our discussions with local industry sources, Balwin has a reputation for constructing its developments rapidly, while maintaining a high degree of quality and craftsmanship. The company’s fully integrated turnkey model, which coupled with its scale of size, allows Balwin to delivers a high quality, good value home to customers at above average industry profitability and returns. Balwin targets gross margins of 30%-35% over the life of a development, which places its returns above most US & UK homebuilders. During early phase development (of which many of its larger developments are in) margins are lower and then tend to rise during future phases.

We believe Balwin has a number of healthy competitive barriers, including:

•       Brand: The Balwin brand (Lifestyle & Quality) has been established over the last 22 years.

•       Scale of size: As one of the largest homebuilders in the country, to keep costs low and offer good value to consumers.

•       Turnkey business model: A major differentiator in using in-house staff and capabilities to help keep costs low.

•       Key relationships: With major suppliers and sub-contractors (aided by continuous building strategy) as well as local government bodies to obtain necessary approvals.

•       Financing: Obtaining the required financing from local banks to both purchase land and fund construction (without the benefit of pre-sales income).

New Rental Strategy Provides A Number Of Benefits: To date Balwin’s sole focus has been selling apartments in its developments to customers. In a move to diversify its business model, management began constructing and negotiating with various investor groups to establish a rental partnership. In December 2018, the company announced the first phase of it rental partnership under the name Balwin Rentals. Under the agreement, which Balwin Properties will own a 25% interest and an outside consortium will own 75%, the company will construct unique developments to be sold to the partnership. In the first phase, 156 units will be sold to Balwin Rentals, with a medium term goal of 4-6 developments in 2-3 years. Balwin will receive a ~30% gross margin on sales to the partnership and 25% of the rental income stream. The agreement provides a number of benefits to Balwin, including: no burden on its balance sheet, regular sales in early phases of new developments, increasing the pace of land bank development and the on-going annuity recurring annuity rental revenue stream, which should help smooth its financial results over time. Longer-term the end goal is to build up to scale (~5,000 apartments) and spin off the partnership holders as a JSE listed REIT.

We believe Balwin Rentals is well positioned to grow its rental portfolio by capitalizing on the growing need for rental apartments in and around the major metro areas of the country. Part of the housing problem in South Africa is an estimated 1.5 million shortage of rental units in the country. Noteworthy, global exposure to residential rentals through the REIT market is 17.1%, compared to less than 2% in South Africa. Clearly, there is a large opportunity for residential rentals in South Africa. By comparison, the percentage of residential rental exposure in the REIT market in some other economies are outlined below:

Aligned Owner/Operator Management & Knowledgeable Board :  Founder & CEO Stephen Brookes has been with the company for 21 years and owns ~35% of the outstand stock while MD Rodney Gray, has 19 years tenure and owns 10%. Well respected, Buffet Investments, headed by knowledgeable real estate investor Jonathan Beare, has been a large shareholder since 2011, has a seat on the Board, brought in a new CFO and owns 9.2% of the shares. Noteworthy, CEO Brookes has stated that at current prices, the share price is so compelling that he will purchase additional shares when not restricted.

From a capital allocation perspective, the company has used its cash flow to purchase new parcels of land to grow its project pipeline and for capital expenditures to build infrastructure in its developments. The company recently temporarily curtailed its dividend to use the cash for expenditures tied to starting a number of new developments (i.e. roads, gatehouse, lifestyle centers and its lagoon). We expect the dividend will be reestablished after the company passes thru the heavy cap-ex phase associated with its new developments.

Healthy Growth Slowed By Some Temporary Issues, Improvement Beginning: After re-focusing on its core residential development business in 2011, the company has been on a healthy growth trajectory, including meeting its FY16 & 17 IPO forecasts, until FY18 (February), when a number of temporary issues impacted growth and profitability.

In 2H FY17 & FY18 Balwin saw a temporary slowing in growth tied to:

·         delays in beginning construction due to permitting issues at 4 new developments which impacted revenues,

·         lower early phase margins at a number of its new developments, and

·         Presidential election macro-economic uncertainty.

Despite the recent slowing, as illustrated in the table below, the company has recorded strong growth over a multi-year period relative to the number of apartments delivered as well as in profitability. Noteworthy, Balwin’s growth post shown below has occurred despite challenging economic conditions, leading to declining GDP, during the tenure of scandal ridden former President Jacob Zuma, who was recalled by his party (ANC) in February 2018.

However, we believe the slowdown in growth will be temporary. The good news is that:

·         construction at all four new developments now underway and back on track,

·         margins will mean revert back to targeted range as new development construction ages,

·         sales have remained healthy; with the current order backlog of 1,789 apartments sold (as per August 2018), but not delivered (see Project Pipeline chart),

·         post the election of Cyril Ramaphosa to head the ANC (replacing Jacob Zuma), business confidence has improved and,

·         the new rental partnership will help unit sales growth.

As a result, we believe that beginning in the new fiscal year (February), earnings will rebound from the weakness in period a year earlier as a result of some of the above issues reversing. We believe this will serve as a catalyst in restoring investor confidence in the stock and the beginning of a re-rating of the stocks valuation to more appropriate levels.

The Company’s EPS Are Understated; Especially Relative To Near-term EPS Power: We believe Balwin’s EPS are currently understated relate to its potential near-term earnings power. The company has a target of selling 20 - 25 apartments per location, per month, which at 13 developments, equals ~3,500 apartments/year. Noteworthy, this is current below capacity of ~5,000 apartments/year. At current ASP of ~R1 million, equates to about R3.5B revenue. At targeted gross margins of 30%-35% over development life cycle this equals ~R1.65/share in near-term EPS power. We believe the company is capable of achieving this level of earnings in the FY22 (calendar 21) time frame. The following is the historical and our future earning model for the company. Our forecasts assume gross profit margins at the lower end of the targeted range.

The Shares Are Very Attractively Priced On Both An Absolute Basis & Compared With Worldwide Home Builders; Significant Upside On Re-rating: Relative to Balwin’s trailing-12 month EPS of R1.04, the shares are valued at a P/E of only 2.7x. Relative to the company’s EPS power, the shares are currently valued at only a P/E of

As illustrated in the following table, relative to other worldwide homebuilders, Balwin has the highest profit margins and among the highest returns on assets and equity. However, despite these attractive financial/business model attributes, the shares of Balwin have by far the lowest valuation of any of the leading worldwide home builders, with a P/E of only 35% the average US and UK comp’s (which are also selling at depressed valuations) respectively. Noteworthy, the current P/E of

At a P/E of 8x our FY22 estimate (below comp’s), the shares could trade at ~R13-R16 /share vs. the current share price of ~R3/share, or a 4x increase.

Off-The-Radar Screen Investment Opportunity: Given the location of the company in South Africa, this is a company that is not on the radar screens of most investors and should be appealing to those investors who like to fish in less crowded ponds. We note the following:

•       Investors should not be put off by a potential investment in South Africa, given the countries strong banking, accounting and financial regulations standards, which are among the highest of any country in the world. The Global Competitiveness Report (2015-2016) by the World Economic Forum ranks South Africa as:

      • #2 in the world for Securities Market Regulation (U.S. ranked 24th)

      • #1 for Auditing Standards (U.S. ranked 23rd)

      • #8 in Soundness of Banks (U.S. ranked 39th)

      • #3 for Efficacy of corporate boards (U.S. ranked 15th)

•       Incoming South African President, Cyril Ramaphosa, has a more pro-business mentality, vs. his scandal plagued predecessor, leading to an increase in business confidence.

•       Both UBS and Goldman Sachs recently adopted a more favorable tone on the country from an investment perspective; the latter stating “A New Dawn Awaits South Africa”.

•       As illustrated below, the South African stock market (JSE) has been the best performing worldwide market over an extended period.

Risks/Issues:

Macro-economic: For any worldwide home builder the company’s sales are normally influenced by macro-economic factors, including economic growth, interest rates and disposable income. As illustrated below, over its history, South Africa has seen healthy GDP growth. However, in the 2012-16 period, economic growth and business confidence declined under the anti-business policies of former scandal-ridden President Jacob Zuma leading to a downgrading in the country’s debt rating.

South African GDP (1990-2017)

With the election of Cyril Ramaphosa as the new President, he brings more of a pro-business mentality to the office. This has already paid off, with Q3 2018 growth at 2.2%, and economic forecasts for 2019 at 2%. Therefore, we believe South Africa is at an inflection point. Additionally, as illustrated below, after a multi-year period of declining housing prices in the country, it appears things may have bottomed earlier in 2018 and are improving.

While macro-economic factors do impact Baldwin’s growth prospects, what gives us some comfort in this regard is the success that the company has already demonstrated during the last few years in a challenging economy when GDP was declining and interest rates rising. This highlights the strength of the tailwind created by the growing middle class in the country and the rise in disposable income, which is fueling housing demand among the middle class.

Permitting/Registrations: Recently Balwin has had delays in receiving all the necessary permits/zoning needed to begin construction at new developments and to register new sales (mostly from local government regulatory agencies due to staffing/administration issues). While these delays are now behind the company, this could be an issue in the future. In order to help mitigate the issue of permitting, Balwin has chosen to purchase and develop new land in parcels which have already been previously zoned for residential construction.

Dividend Policy: When Balwin reported 1H FY19 results (in which EPS was up 9%) in October, they announced that they would be temporary suspending the company’s dividend. Management indicated they were doing this due to the expected cash usage needed in the near future tied to expenditures (roads gatehouses, lifestyle centers, etc.) associated with beginning new developments and they expect to resume dividends at some time in the future. We believe this decision has been somewhat disconcerting and misunderstood by local South African investors who have grouped Balwin in a similar light with a number of the local South African traded real estate REITS, where dividend yield is most paramount to their ownership. Given Balwin’s orphan status on the South African JSE as a growth oriented (non-REIT) home builder (as opposed to the roughly 10 stocks in the US or UK) and the timing of where the company is in its development cycle, we believe this has contributed to the sell-off in the share price from these yield centric investors.

Land expropriation: We extensively highlighted by the media, we note that even if it passes into law, it would have no impact on Balwin, and would only relate to farmland that is not being used.

Water Shortage: last summer certain regions, especially the Western Cape, we faced with a critical water shortage due to a couple of years of well below average rainfall leading to a significant decline in the countries reservoirs. During this period, when water rationing was instituted in the Cape Town area, Balwin saw only minimal impact in its construction activity due to the use of water from wells and alternative sources. While this issue may remain an issue in the future, a significant amount of rainfall during the winter season has helped fill up the major reservoirs to more adequate levels.

Related Party Transactions: Members of management, especially CEO Steven Brooks have historically made meaningful purchases of apartments in most of Balwin’s new developments for investment purposes. CEO Brooks owns about ~500 units currently. While these type of transactions always need to be looked into, our discussions with management on the subject leave us comfortable with the issue.  CEO Brooks has historically always purchased apartments in phase 1 in every development and has indicated he is likely to continue doing so in the future. His logic is that he already owns ~35% of the shares, wants to diversify and increase his ownership in the company without constricting the float and wants to get the sales going and create excitement for other buyers who see that others have already purchased. Noteworthy, CEO Brooks has stated that at current prices, the share price is so compelling that he may consider purchasing additional shares when not restricted.

Catalyst

• A resumption in earnings growth.
• The benefits from the new rental agreement or the announcement of additional agreements/partnerships.
• Expanded investor interest outside of South Africa.