As one would expect, the constant news flow from all these companies is throwing up numerous investment opportunities in this ongoing bull market, albeit one undergoing a correction phase at the moment. As I have stated in my columns this week, the current market weakness should be seen as a chance to buy into good quality companies at favourable valuations. It should also enable us to pick up shares in companies that have yet to react to positive trading updates that were released during the market fall-out. And one this week that took my notice was from Aim-traded property fund manager First Property Group (FPO: 25p).
To recap, I advised buying shares in the company in my 2011 Bargain share portfolio when the price was 18.5p and I made a strong case in November 2012 when the price was still around that level ('Hidden value', 20 November 2012). Since then, we have picked up interim dividends of 0.33p a share and a final payout of 0.75p a share. Combined, this gives an annual dividend of 1.08p, so at the current price of 25p the shares still offer a decent yield of 4.3 per cent. The payout was well covered by EPS of 2.3p in the 12 months to March 2013, and with EPS set to double to 4.6p in the current financial year it’s fair to say that the final dividend of 0.75p is pretty safe too.
But despite the significant progress the company has been making since my last update (‘Hot property plays’, 12 November 2013), the share price is little changed. That is not only unwarranted, but means that we have a great opportunity to buy in ahead of what will be a bumper pre-close trading update in mid-April.
Smart move into residential property
The main reason for the expected surge in profits is due to First Property’s astute decision to make a move into residential property last summer.
Last July, the company splashed out £3.4m of its £13m cash pile buying seven largely vacant offices, one in Bracknell in the Thames Valley and the others in Woking, Surrey, which it planned to convert into housing. It was a pretty smart deal since the company was exploiting the oversupply of offices in the regions in order to sell these properties as residential units into what is clearly a buoyant housing market in the south east of England. It is also one well underpinned by a housing shortage. Moreover, priced at only £62 per sq ft, First Property negotiated a good price too.
In fact, it was such a good deal that, having secured planning permission in September, the company managed to sell on the Woking property at the end of last year for £6m, resulting in a thumping profit of £3.1m. And only last week, the company announced that it has sold the Bracknell property for £2.05m. Net of purchase, holding and selling costs, this property will make a £770,000 contribution to First Property’s profits this year.
Combined, this means that the company has achieved almost £3.9m of profit on its original investment in little over six months, highlighting the entrepreneurial skill of chief executive Ben Habib and his management team. Furthermore, this augurs well for the earnings potential from the partnership First Property formed a few months back with clients to invest in office buildings in the UK with a view to converting these to residential use. The partnership, which is closed ended, has a life until May 2018.
So far clients have committed £12m to the venture, with an intention to increase this to £40m, and First Property has committed 5 per cent of the equity raised subject to a limit of £2m. The company will manage the partnership, but will not levy any fees for its services. Instead it will be paid 20 per cent of the profits earned, subject to claw back in the event of losses.
But even without factoring in any contribution from this new partnership, analysts at Arden Partners predict that First Property will report full-year pre-tax profits of £6.5m and EPS of 2.6p in the financial year to March 2014, up from £3.5m and 2.3p, respectively, last year. This represents a chunky £500,000 profit upgrade on previous forecasts following this week's property sale, and one that has gone largely unnoticed by investors. The broking house also calculates that the company’s underlying net asset value is currently around 26.5p a share. That’s well in excess of my estimates and ensures some very positive newsflow when First Property issues its pre-close trading statement in mid-April ahead of financial results in June.
The move into residential property also puts to good use the company's cash. Factoring in the proceeds from the aforementioned property sales, cash on the balance sheet should be around £16.7m including £7.5m held by Fprop Opportunities, the company's 76 per cent-owned Polish-focused fund. This means that First Property has ample funds available to build up a replacement income stream through its UK residential activities to replace the income earned on its USS Fprop Managed Property Fund which expires in a couple of years time.
That fund was established eight years ago on behalf of The Universities Superannuation Scheme (USS) to invest in commercial property in the UK and central Europe. Assuming the company can maintain its 15 per cent hurdle rate on invested capital, then the current cash pile should easily generate the fee income needed to replace the earnings from the USS fund.
Top performing funds
It’s also worth noting that First Property has other substantial sources of recurring revenue including its UK Pension Portfolio fund. This is fully invested and has £88.5m of assets under management, mainly retail warehousing and properties in the retail sector. That fund is producing an ungeared return of 6.3 per cent and has a minuscule vacancy rate of 0.6 per cent on a portfolio of 21 properties acquired since 2010 and which have a weighted average unexpired lease term of 10.2 years.
In addition, Fprop Opportunities has £21.4m of assets under management consisting of two investments that are generating rates of return on equity in excess of 25 per cent per year. Backed by £8.5m of cash available for new investments, following the raising of an additional £3.7m last April, Fprop Opportunities is currently in negotiations to acquire further similarly high-yielding investments.
The fee income from these funds aside, there is hidden value in First Property's balance sheet worth highlighting.
Uncovering value in the balance sheet
First Property has one remaining directly owned property holding, Blue Tower, an office tower in the central business district of Warsaw. The initial 28.3 per cent interest in Blue Tower was acquired in December 2008 for £8.3m and is now valued at £12.85m, so has been appreciated sharply in the past five years. In addition, Blue Tower contributed almost £1m to First Property’s profit before tax and unallocated central overhead costs in the last financial year, equating to an annualised return on equity invested of 49 per cent. This highlights the very high returns achievable in the Polish commercial property market.
Indeed, First Property acquired an additional 19.7 per cent interest in Blue Tower for €5.2m (£4.3m) last November funded by €1.7m in cash and a €3.5m bank loan. This will generate an additional €460,000 of earnings for the company, equating to an impressive pre-tax return of 27 per cent on equity.
Interestingly, First Property conservatively holds Blue Tower at cost in its accounts, which means that the reported net asset value of the company - £19.5m at the end of September, or 17.5p a share - understates its true worth significantly. In fact, mark the Warsaw property to market value and First Property's book value rises a further 3.3p to 20.8p a share.
It's worth flagging up that First Property values its interests in all the funds at cost too. If these were marked to market value the carrying value of these investments would be £12.8m, rather than the £10m stated in the company's latest accounts. The additional £2.8m equates to 2.6p a share, and means that when combined with the hidden value of the Blue Tower Property, the company's net asset value rises to 23.4p a share. Add to that sum the bumper 3.26p a share of net earnings First Property is forecast to make in the second half of the financial year to March 2014, and you can see how Arden Partners arrive at a net asset value of 26.5p.
Anomalous valuation
To put the favourable valuation into some perspective, with First Property’s share price around 25p, valuing the company at £27.8m, a profitable fund management business with £338m funds under management is being ungenerously valued given the substantial asset backing on the balance sheet.
Or look at it another way, once you strip out the bumper gains from the Woking and Bracknell properties, First Property’s shares are trading on little over 11 times earnings and yield a solid 4.3 per cent. That valuation is not only attractive, but is low enough to offer realistic scope for the share price to return to the 2000 high of 29.5p if the company continues to pull off further smart deals targeting the residential property market as seems highly likely.
Needless to say, I continue to rate First Property a decent medium-term buy on a bid-offer spread of 24p to 25p ahead of the April pre-close trading statement.
