Equity commitments made by the colleges amount to £14.25m, and First Property is committing £725,000 to the fund. Once fully invested, analyst Chris Thomas at Arden Partners believes the new fund will contribute “a few hundred thousand pounds to First Property’s profits, providing modest upside to [Arden’s estimate of] annual recurring profits of £9.4m in the current year to end March 2017”. Moreover, the fund can gear up its investments by 50 per cent, implying it could acquire £30m worth of property, so generating even more profit for First Property.
The other point worth noting is that Mr Thomas at Arden Partners is factoring in an average exchange rate of £1:€1.217 for First Property’s overseas income in his forecasts for the financial year to end March 2017. That’s important because the company owns a portfolio of 11 high-yielding commercial properties in Poland and Romania worth £170m and yielding around 9.8 per cent, the recurring profits from which account for a chunk of Mr Thomas’ forecast. Bearing this in mind, the average exchange rate in the first 10 months of the financial year is actually £1:€1.195, and the current spot rate is around 2 cents below that, so offering scope for First Property to post a currency driven earnings beat.
So, having first recommended buying at 18.5p in my 2011 Bargain Shares Portfolio, and banked total dividends of 7.265p a share, the operational back drop is certainly compelling enough to maintain my positive stance ahead of the pre-close trading update in early April. I last updated my view after the company announced a 13 per cent rise in assets under management to £457m in the final quarter last year ('A quartet of small-cap value plays', 28 December 2016). The latest mandate suggests that it’s well on the way to hitting the £500m mark, and beyond.
And the valuation is pretty compelling too with the shares trading on a slight premium to book value per share of 45.9p, rated on less than 8.5 times EPS estimates of 5.6p, and offering a 3.3 per cent prospective dividend yield. Buy.
LMS Capital portfolio write-down
To put it mildly, the trading update from small-cap private equity fund LMS Capital (LMS:47p), a company I last rated shares in a buy at 60p ('New mandate for LMS', 17 August 2016), was not what I was expecting.
Last summer, Gresham House (GHE:305p), a specialist asset manager and a constituent of my 2016 Bargain shares portfolio, took over the mandate to run LMS’s portfolio with the aim of maximising shareholder value through the sale of legacy assets in the near-term, some of which will be returned to shareholders through tender offers, and redeploying the balance of the cash proceeds on new investments in the smaller quoted company and private equity space. At the time, LMS returned £6m by purchasing 7.14m shares at 84p each from shareholders through a tender offer. I advised tendering 10.45 per cent of your holdings which lowered your entry price to 57p.
So, adjusting for the cost of the tender offer, this implies a pro-forma figure around £85.2m, or 88p a share. However, the company has just reported that its likely year-end net asset value will be £67m, or 69.5p a share, reflecting a deterioration in the performance of some of the legacy investments in LMS’ portfolio. Even taking into account one-off costs which will deliver annual costs savings of £1m, this is a massive hit and one that is hard to explain.
Firstly, around two thirds of LMS’ portfolio is invested in the US, so the sterling value of these investments should have benefited from a very positive currency tailwind since the end of June last year. LMS does not hedge its currency risk, so was a beneficiary of the 7 per cent weakening of sterling against the greenback in the second half of last year.
Secondly, equity markets on both sides of the Atlantic have been riding high and mergers & acquisition activity has hardly been subdued, so the financial back drop is favourable even for unlisted investments.
Thirdly, £10.5m of the £91m net asset value of LMS’ portfolio at the end of June 2016 was in cash, and Gresham House has since made realisations of £6.9m, so even after allowing for the £6m tender offer, then this implies the portfolio of legacy investments has effectively lost a quarter of its value in constant currencies in the second half last year. That’s truly remarkable, and raises serious question over the valuations attributed to these investments by the previous fund managers.
So, although the investment managers of Gresham House are in no way to blame for the write-downs on LMS’ legacy investments, and their investment strategy is clearly working at Gresham House Strategic (GHS) as I noted in my column earlier this week (‘Value opportunities’, 30 January 2016), the valuation downgrades has weakened the investment case for LMS as well as wiping 15 per cent of its share price.
It’s a company I have covered for almost six years, having originally recommending buying the shares at 54.5p ('Capital returns', 11 February 2011). Longer term holders will have made hefty gains because the company has made substantial capital returns in the past six years through tender offers pitched at net asset value per share: a buyback of 17.4 per cent of the share capital at 84p in December 2012; a buyback of 17.2 per cent of the share capital at 90p in July 2013; a buyback of 22.5 per cent of the share capital at 95p in May 2014; a buyback of 28.7 per cent of the share capital at 96p in December 2015; and last summer’s buy back of 10.45 per cent of the share capital at 84p. This means that if you bought 10,000 shares at 54.5p when I initiated coverage six years ago, you retain a holding of 3,383 shares, worth £1,590, and have received total cash proceeds of £5,991. That cash return is more than the initial investment and it’s time to crystallise profits on the residual holding.
Elegant still worth checking out
I have been casting a close eye over the full-year results from Elegant Hotels (EHG:83p), the largest hotel operator in Barbados, having upgraded my recommendation on the shares to a speculative buy a fortnight before Christmas (‘Investments worth checking into, 12 December 2016). I am not the only one who believes there is upside here as entrepreneur Luke Johnson accumulated a 12.5 per cent stake in the company in the final quarter of last year.
The key attraction is the hidden value in the company’s balance sheet. That’s because the luxury hotel operator owns six high end hotels along the prestigious west and south coastlines on the island: Colony Club, Tamarind, The House, Crystal Cove, Turtle Beach and Waves Hotel & Spa. These properties have a combined valuation of $257m (£202m), or about US$87m above their carrying value at the end of September 2016. Using the current exchange rate of £1:$1.25, this implies an adjusted net asset value of around 179p per share and means Elegant Hotels’ share price is trading at less than half book value.
Sceptics will rightly point out that hotels are illiquid assets, and the top-end of the hotel market in Barbados has come under pressure which negatively impacts the operator’s profits and hotel property valuations. However, when a share price is only half book value then there is a hefty ‘margin of safety’ built into the valuation to start with. Moreover, even if Elegant Hotel’s underlying operating profit in the new financial year declines to US$13.6m on slightly higher revenues of US$58.4m, down from profits of US$16.3m in the year just ended, and a peak of US$19.1m in the 2015 financial year, as predicted by analyst Mike Allen at house broker Zeus Capital, then this is still a very profitable business, one able to trade through these tougher times.
The major reason for the reversal in profits is due to softer demand for luxury holidays from the key UK market, a segment accounting for 70 per cent of the company’s bookings, reflecting a combination of the slide in sterling since the EU Referendum which has impacted affordability and a move by holidaymakers generally towards the lower cost villa market. Another contributory factor has been a change in the mix of tourists with US visitors, a growth segment, going on vacation for shorter breaks compared with holidaymakers from the UK. This also impacts food and beverage revenue for hoteliers as well as occupancy rates.
True, the company has taken steps to mitigate the decline in demand through promotional activity and has expanded sales teams both in the UK and US, but as the results for the 2016 financial year highlighted – occupancy rates were down by more than five percentage points to 62.9 per cent, so driving revenue per available room down too – profits still took a hit, and are forecast to fall further in the current year. However, I believe that the bad news is fully discounted into the valuation for a number of reasons.
Firstly, the board have been sensibly targeting management contracts of hotels located outside Barbados and a few months ago signed its first management contract to bring Hodges Bay, a 122-room luxury hotel in Antigua into Elegant Hotels’ portfolio. The hotel is currently under construction, is scheduled to open its doors in mid to late 2017, and is expected to be earnings enhancing in the 2018 financial year. The directors believes that management contracts of this nature represent a “compelling opportunity to expand beyond Barbados, given they require far less capital investment than full ownership, and is considering a number of other similar targets”. I agree and the extra income from this revenue stream should support expectations of a rebound in profits in the 2018 financial year.
Secondly, tight control of working capital means that a high percentage of Elegant Hotels’ operating cash flow is being converted into cash profits, so enabling the board to continue investing in hotel refurbishments, service borrowings and maintain a 7p a share dividend (at a cost of £6.2m). Not that finances are stretched as net debt of US$61.8m represents little over three times cash profits of just under US$20m in the financial year just ended and equates to less than a quarter of the value of the hotel portfolio. The 8 per cent plus dividend yield is clearly supportive even if cover is thin.
Thirdly, even if Elegant Hotels’ EPS declines from 13.7c to 10.1c this year as analysts predict, then this still equates to 8.2p at current exchange rates, implying the shares are rated on a modest 10 times potentially trough earnings, a deep discount to peers. Add to that an attractive price-to-book value ratio, and I feel the valuation is attractive enough to act as a catalyst for M&A activity.
So, having first advised buying at 105p at the time of the Aim listing ('Checking into an elegant investment', 15 June 2015), since when the company has declared total dividends of 10.5p, and last recommended buying the shares at 76p before the shares went ex-dividend the 3.5p final payout (‘Investments worth checking into, 12 December 2016), I feel a return to my original 105p entry level is not unreasonable. Trading on a bid-offer spread of 80p to 83p, I continue to rate Elegant Hotels’ shares a buy.
Please note my 2017 Bargain share portfolio goes live online before the market opens on Friday this week and I will be updating all the constituents of my 2016 Bargain Shares Portfolio alongside that article.
MORE FROM SIMON THOMPSON...
A comprehensive list of all the investment columns I have written in 2017 is available here.
The archive of all the share recommendations I made in 2016 is available here
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