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Grainger's road to recovery

Grainger should win investors' affections as it pays down debt and becomes a more conventional property company
February 28, 2013

Grainger calls itself "the UK's largest quoted residential property owner". That makes its business seem a simple buy-to-let operation. If only. In practice, Grainger could also be dubbed 'the UK's most complex quoted property owner'.

IC TIP: Buy at 136p
Tip style
Value
Risk rating
Medium
Timescale
Long Term
Bull points
  • Company in the process of simplifying itself
  • Private rented sector is expanding
  • Shares trade at big discount to book value
Bear points
  • Big debt pile
  • Business model in transition

But that, paradoxically, is a reason to buy its shares. Management is overhauling the business to create a more conventional, dividend-paying property company. This will take years. Yet as Grainger gradually changes, investors should become receptive, causing the discount to book value at which its shares trade to narrow.

The other reason to buy Grainger's shares is its focus on the private rented sector. The latest English Housing Survey shows how private renting is gaining market share at the expense of owner occupation and social renting. Even the government recognises this and has announced subsidised development finance to boost the nascent build-to-let industry. Having agreed this month to buy 100 rental flats being built above a new Asda in east London, Grainger is well placed to benefit.

Yet two-thirds of the company's 18,960 tenanted homes are subject to so-called regulated tenancies where landlords do not have the right to eject tenants, who pay less than the market rent. As a result, regulated tenancy homes are less valuable than identical homes subject to modern tenancies.

Grainger's plan was to buy regulated tenancies, wait for ageing tenants to die and sell at a profit. But this model has two flaws. The number of regulated tenancies available is dwindling. Second, it makes Grainger more reliant on volatile transaction revenues than recurring rents. That appeals neither to investors, who receive paltry dividends, nor to banks, who offset the cash flow risk with higher interest rates.

Banks also dislike Grainger's balance sheet. Marking its trading property to market, its loan-to-value ratio is about 55 per cent. When that ratio falls to 50 per cent or below - the arbitrary level the City finds acceptable - the stock market will reward it, reckons analyst Robbie Duncan at broker Jefferies.

GRAINGER (GRI)

ORD PRICE:136pMARKET VALUE:£566m
TOUCH:135-136p12-MONTH HIGH:140pLOW: 81p
DIVIDEND YIELD:1.5%TRADING PROP:£1.02bn
DISCOUNT TO NAV:14%
INVESTMENT PROP:£586mNET DEBT:305%

Year to 30 SepNet asset value** (p)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
2009141-170.0-29.51.3
2010140-20.8-2.91.7
201115326.19.51.8
2012157-1.70.11.9
2013*1598.80.52.0
% change+1+400+6

Normal market size: 4,000

Matched bargain trading

Beta: 1.0

*Jefferies estimates **Triple NAV (see text)

Chief executive Andrew Cunningham gave an unambiguous commitment to addressing these problems in November. He will sell assets to get debt below £1bn this year and - longer term - he will reinvent Grainger as a private rented sector expert, boosting rental income.

And it's encouraging that Grainger's track record in property management is impressive. Helped by a bias towards south-east England, the value of its UK portfolio has substantially outperformed the usual house price indices, and sales are invariably above book value. Second, the past few months have brought some promising deals, notably the formation of funds that Grainger will manage in exchange for fee income.