Description

Please note that all figures below are in £ terms.

Thesis

As we are combing through UK stocks following the general market fall and Brexit complications a few names are beginning to look more compelling. Here we are presenting Capital and Counties (“CapCo”), a midcap UK real estate company going through a reorganisation process that could unlock value in the near term via selling non-core (and distracting) assets. The process is aimed at closing the 30% discount to NAV, which is the highest since 2010 despite the near-term catalyst.

Background

CapCo is a London (LSE; part of FTSE 250) and Johannesburg (JSE) listed real estate company that owns two assets: the Covent Garden estate (“CG”), which is cash flow generating, and Earls Court (“EC”), a re-development project mired in politics. The company has been in existence since the 1930s and been an independent company since 2010 following the demerger from Liberty International (now Intu Properties).

CapCo shares are closely held with roughly 60% on the LSE and 40% on the JSE. The top 10 holders make up over 50% of the shares outstanding, dominated by institutional investors, Norges Bank (c. 8%) as well as the Gordon family of South Africa (c. 9%; founders of the predecessor of Intu).

Properties

The difficulty when it comes to CapCo is the difference in risk profile of the two major assets and the distraction that EC presents. The total value of the portfolio as of H1 2018 is £3.3bn, of which CG is £2.6bn (c. 80%), while EC is £0.7bn (c. 20%), however the majority of the (rather negative) newsflow is provided by EC.

CG

The portfolio has been built over the decades through acquisitions and currently consists of 78 buildings, 514 lettable units with a total of 1.2m sqft. area that’s at 97% utilisation. The current gross income (as of H1’18) is £64m and the estimated rental value (ERV) is £107m, with a path laid out by the company to £125m by 2020 (the delta is expected to be realised from developments / refurbishments, rent reversions etc). Anecdotally, anyone who has visited CG over the past 10+ years encountered vast numbers of tourists that made the area less attractive for locals to visit. However, management has done a good job in repositioning the estate that’s beginning to bear fruit, by introducing a variety of new brands, restaurants and tenants and CG is becoming a more attractive to place to visit (e.g. 20+ new brands contracted in 2017, and 100+ retailers and dining concepts introduced since 2006). This positive progress meant that CG has become a larger portion of the overall portfolio from around 50% or so 5 years ago to the current 80% (granted some was self-inflicted following the reduction in EC valuation and asset sales but more on this below). CG currently trades on a 2.3% initial yield and 3.6% equivalent yield.

EC

Despite the positive development of CG the mess around EC has detracted significantly from performance and market perspective on the name. To recap briefly, CapCo got involved in EC first in 2007 and the development consists of two main assets: 63% interest in Earl’s Court Partnership Ltd (ECPL), a masterplan that is ready for development of 7,500+ new homes following the demolition process, and a 50% stake in Lillie Square (LSQ), a 1m sqft. two-phase residential development near the ECPL project. The total valuation of these two projects (prop. to CapCo) is £707m (£519m ECPL, £148m LSQ and £40m others). Note, to management’s credit they’ve sold some assets around this property, for instance the Empress State office building for £250m, which was a positive outcome. As mentioned above, the relative share of EC has declined due to asset sales but also due to valuation reduction given the decline in gross developmental value, increase in cost of delivery and comparable land transactions. The market for high-end homes in London has been impacted by tax hikes and uncertainty around Brexit, which pushed down land values. Note also that disclosure on EC declined partially as it has a reduced relative share and also because of the political sensitivity, so it has been harder to properly evaluate this side of the portfolio.

While we’d save the readers of this post from the intricacies of UK politics (probably Brexit provides sufficient “entertainment” for this purpose) it is safe to say that this part of CapCo’s portfolio is mired in a political mess. To quote one article from 2015 (link: https://londonist.com/2015/09/earls-court; it’s very easy to find many similar in nature…): “Ever since it [ECPL] emerged into the public domain in 2009, the project has divided opinion. For its champions, basically local Conservatives and its developer Capital and Counties (Capco), it is, in Boris Johnson’s [former mayor] words, “a landmark scheme” which will transform an untidy and rather dowdy patch of inner west London into a dazzling new district. For its various critics […] it is a greedy colonisation that will turn an area alive with cultural and economic activity populated by a wide range of London residents and visitors into a sterile, over-priced one, through a process that has demonstrated at every stage how to do “regeneration” badly.”.

To conclude here, development (definitely on such large scale) is very different from CapCo’s bread and butter of acquisition and management of prime property in Central London. The company has shown a level of incompetence here that lead to significant value destruction and detraction from the core story.

Next steps

The reason why we think CapCo is compelling, despite the above mess, is because of management’s announcement in May 2018.

After a decade of growing CG successfully and getting EC ready for the redevelopment it seems that they finally admitted defeat and announced the potential split of the two assets into separate vehicles. CG would be put into a REIT while EC into a separate development vehicle. There were no further announcements about the exact process e.g. specific timelines (did note formalisation by year end but nothing further), if this involves a capital raise at either vehicle (likely at EC), doing away with the dual-listing etc. As part of this, CapCo announced that (i) the current CEO would continue leading the CG vehicle while the EC vehicle would be run by the MD/CIO of the project and (ii) retirement of the current chairman as of May, who has been replaced by an existing board member. 

Further to this announcement, CapCo recently also noted that besides the split they are also considering the sale of EC and confirmed that CK Asset Holding  (Li Ka-shing’s company) is currently conducting DD on substantially all of these assets apart from LSQ, which is a JV with Kwok family of Hong Kong. 

Valuation

As of 24 December 2018 CapCo is trading at just over 30% discount to NAV, which is as high as it has ever been since 2010. In subsequent years it actually traded at a premium, however post Brexit referendum the discount widened to the 10-20% territory. In fact, the average figure since 2010 is actually a slight premium to NAV.

As of 30 June 2018, the gross value of the assets is £3.3bn, of which £2.6bn CG and £0.7bn EC. After accounting for net debt (£0.5bn) and other adjustments the EPRA NAV is £2.9bn or 335p/sh vs the 227p current share price. Leverage is modest at 17% LTV following the asset sales, with 2.9% weighted avg. cost and 6.5 years to maturity.

The closest comp to CapCo is Shaftesbury (ticker SHB in London), which up until the summer of this year traded at a premium but now at a 15% discount (which we account in majority to the general market sell off and political developments in the UK). SHB has a market cap of £2.6bn and NAV of £3.1bn (as of 30 September 2018) and it owns Carnaby Street, part of Covent Garden, Chinatown and to a smaller extent Soho and Fitzrovia estates. The relative lower discount is attributed to the fact that SHB is a pure-play REIT, as well as being further along the repositioning phase of its properties. Part of the reason the premium held up so well this year could also be due to the stake building of Samuel Tak Lee (HK property billionaire with significant UK property investments) and Norges Bank (also shareholders of CapCo), who between them now control just over 50% of the company.

One could make the argument that an investment in SHB is more desirable to take direct exposure to prime Central London property, however the reason why we are more inclined to go with CapCo is because of the catalyst that would result in the split of the assets, clearing up the “equity story” and making it more appealing to income oriented investors. Assuming the closing of the discount to 15% (implied share price of 285p/sh), where roughly SHB is trading, would imply an upside of 25% and going to 0% discount would be a 47% upside (this is where SHB traded before, granted it’s a very bullish case scenario from here).

Another way to look at it is backing out the value of EC. Assuming 0% discount on CG and adjusting for net debt and other assets the implied NAV is £2.1bn i.e. £200m negative value on EC.

A number of UK analysts cover CapCo and the current target price is 290/sh (c. 13% discount to NAV) or 28% upside.

CapCo does pay a dividend but it is anemic with 1.5p/sh for 0.7% yield vs SHB’s 2%. Now, this 1.5p/sh payout has been in place since 2010, we think due to the cash requirements for EC and property acquisitions. In the case of SHB the dividend has grown by 7% CAGR over the past 10 years and as it’s a REIT it is required to distribute 90% of qualifying income. We believe that as the cash requirement for EC reduces and CG rental income closes the delta vs ERV there is scope for a dividend increase over time.

While we have no visibility into the outcome of the Brexit process, that will no doubt have an impact on the share price in the near term, we believe that CapCo with its ownership of prime Central London property and potential catalyst in the split/sale of EC and conversion of CG into a REIT presents an opportunistic short-term idea. Beyond this having an exposure to the CG estate, and assuming continued work on the repositioning, at a meaningful discount, could provide further upside over the long term.

Risks

Execution of the split or sale of EC

London property prices – The investment is taking 100% exposure to UK property prices, which are impacted by Brexit

FX – the £ hasn’t found bottom yet vs the $ and with the Brexit uncertainty it might even dip further. Perhaps for this reason this idea might be more suitable for £ investors or might require hedging, at least until there is more clarity

Catalyst

Split or sale of EC and simplification of the corporate strategy

Further positive developments on the repositioning of CG

Clarity on the Brexit process outcome (not specific to the name, but broader UK market)