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A trio of small-cap value plays

Simon Thompson’s highlights two hot property investments, and sees value in a cash-rich technology-focused merchant bank too
August 22, 2017

In yesterday’s column I noted that student accommodation construction company Watkin Jones Group (WJG:203p) has just secured planning permission for a 322-unit residential build-to-rent scheme on a site in Leicester, increasing its pipeline in this niche market to six schemes which will be delivered between 2019 and 2021. It’s not the only company on my watchlist targeting the growing institutional appetite for private rental sector housing as Alpha Real Trust (ARTL:122.75p), an investor in high-yielding property and asset-backed debt and equity investments in western Europe, is investing in two large schemes in the UK.

In Leeds, Alpha’s Monks Bridge project has been granted detailed planning consent for 300 residential units plus 140,000 sq ft of commercial development with a gross development value of £55m. In addition, the site has outline planning consent for a further 300 residential units. The site is carried in the accounts at £6.1m, representing 5.4 per cent of Alpha’s portfolio value. The second scheme is located in central Birmingham where Alpha owns Unity and Armouries, a development with planning consent for 162 residential apartments with ground floor commercial areas, and which has a gross development value of £33m.  Clearly, these are chunky developments in relation to the company’s £113m investment portfolio, which is why discussions are ongoing with potential joint venture funding partners to shoulder some of the costs.

That’s not to say Alpha isn’t cashed up to maintain a serious equity interest in both schemes as it has realised £50m of investments in the year to date, including £37m realised earlier this month from the sale of a 70 per cent stake in its wholly owned H2O shopping centre in Madrid to CBRE European Co-Investment Fund; and a further £5.3m by selling off a 18.7 per cent stake in small-listed property company Industrial Multi Property Trust (IMPT:330p) to FTSE 250 property group Hansteen (HSTN:126p). Alpha’s cash pile was boosted by a further £10.9m after a subordinated loan to Industrial Multi Property Trust was redeemed in full. The directors’ plan to invest around £30m in total over the next 12 months in on its build-to-rent schemes, a sum that’s fully covered by the proceeds from the H20 stake sell down. It makes sense to do so as there is obvious potential to generate a solid rising income and at an attractive yield by gearing up these developments, not to mention scope for capital growth too.

 

High yielding assets

Alpha’s investment managers are also focussed on creating a diversified portfolio of high yielding smaller mezzanine loans secured on real estate assets. For instance, the company has provided a £1.7m mezzanine loan secured on a Staybridge Suites hotel located in central Newcastle which is operated under a franchise agreement from international hotel group, Intercontinental Hotels Group. The three-year facility matures in October 2019 and generates an annualised return in excess of 15 per cent for Alpha, plus some fees too.

Alpha also provides a £3.4m two-year mezzanine facility to Active UK Real Estate, a company listed on the Channel Islands stock exchange (www.cisx.com), which matures in November 2018 and earns a coupon of 9 per cent annum. It’s pretty safe too. That’s because after taking into account the balance of Active UK Real Estate’s bank finance of £14.8m, Alpha’s loan is positioned between a 45.7 per cent and 55.9 per cent loan-to-value on the £32.4m value of that company’s portfolio. Alpha has some equity interest here too because a couple of years ago it invested £3.2m in exchange for a 20.5 per cent stake to increase its exposure to the high yielding UK commercial real estate sector. The shareholding has done well, increasing by £1m in value.

I would flag up too that UK freehold ground rent investments account for £26.7m, or 23.6 per cent of Alpha’s total portfolio, and are held through a freehold income authorised fund (FIAF). These rock solid investments are held with a view to achieving steady and predictable returns, a consistent income stream and prospects for growth. The FIAF is ungeared, has an unbroken 24-year track record of positive inflation beating returns, and generated a total annual return of 7.9 per cent for Alpha in the 12 months to end June 2017. There are reasons to expect this record to be maintained given that 85 per cent of the fund’s 65,000 freeholds owned have a form of inflation protection through periodic uplifts linked to the Retail Price Index (RPI), property values or fixed uplifts.

 

Potential for one-off gains

The other interesting take for me in Alpha’s first quarter results to end June 2017, which were released last Friday and showed a 2.2 per cent rise in net asset value per share to yet another record high of 162.4p, was the update on Alpha’s investment in the Galaxia project, a development site located in NOIDA, an established suburb of Delhi that is one of the principal office micro-markets in India. Having initiated arbitration proceedings against its joint venture development partner Logix Group in order to protect its Galaxia investment, and subsequently won a judgement in the Delhi High Court, the award and interest accrued now stands at £13.9m, massively above the £5.4m carrying value in Alpha’s accounts.

The Delhi High Court has issued a warrant of attachment against the primary residential homes owned by the promoters of Logix. Alpha has had these properties independently valued at £6m. Moreover, the Logix promoters have been directed by the court to furnish a statement of their assets and bank statements at the next court hearing later this month, so this will give some insight into the amount Alpha is likely to recover. In the meantime, interest continues to accrue at the rate of 15 per cent per year until the award is paid in full. The difference between the £5.4m carrying value of the award in Alpha’s accounts, and the £13.9m required by the directors of Logix to settle it in full, is now worth over 12p per Alpha share based on 69.3m shares in issue.

I would also flag up that between Alpha’s end June 2017 first quarter accounting period end and the completion of the sale of 70 per cent interest in the H2O shopping complex on Monday, 7 August 2017, the value of sterling declined from £1:€1.138 to £1:€1.105. It has since fallen to £1:€1.09, the full impact of which is to add £2m to Alpha’s end June 2017 net asset value, a sum worth almost 2.9p a share.

So, having initiated coverage on Alpha’s at 80p ('High-yield property play', 10 Feb 2016), banked six quarterly dividends of 0.6p a share since then, and last advised running profits at 127p ('Check into small-cap value plays', 20 Jun 2017), I feel that the 26 per cent share price discount to spot net asset value is still too deep. In fact, I rate Alpha’s shares a buy at the current offer price of 122.75p and have a 12-month target price of 145p. Buy.

 

Palace lords the planners

Earlier this month, I suggested it was a pretty good time to buy the Aim-traded shares of property investment company Palace Capital (PCA:395p) ('High-yielding opportunities', 8 Aug 2017), noting that success on the planning front was a likely catalyst for a higher rating.

Bearing this in mind, the company has just announced that the planners have given their consent for the redevelopment of Hudson House in York, a 103,000 sq ft office block located close to the city’s railway station, into 127 apartments covering 95,000 sq ft, 34,000 sq ft of offices, 5,000 sq ft of retail space and car parking. The sales market in the York and Harrogate area is buoyant as buyers move from the outskirts to the town centres, so it shouldn’t be difficult to find buyers for the units as has been the case with the nearby Terry’s Chocolate Factory in York. This property has been converted into residential by another favourite company of mine, property investment and construction company Henry Boot (BOOT:301p). Interestingly, Henry Boot reports interim results this Friday, so expect a further update on how sales in York are progressing.

The directors of Palace Capital believe that the Hudson House scheme will cost around £35m to develop which gives a total cost of the project of £50m after accounting for the £14.9m carrying value of the site in the company’s accounts, albeit it’s already showing a hefty profit as it was acquired for only £3.8m as part of the Signal Portfolio acquisition from Quintain in 2013. To put the potential redevelopment profit upside into some perspective, property analyst Tim Dainton at brokerage Arden Partners believes the value of the scheme “will be no less than £60m, but this could prove conservative given the proximity of Hudson House to the railway station and less than a two hour journey to London.”

He notes that apartments in a similar sized scheme in Harrogate achieved valuations of around £650 per sq ft, and though it’s difficult to quantify the exact prices the Hudson House scheme will achieve, if the units went for a similar price per sq ft then the implication is that the residential element could achieve the £60m sale values by itself. Moreover, although there has been no new office space in York for the past 20 years, and “while it’s difficult to prove that rents are higher than £18 per sq ft”, brand new office space in Leeds is going for around £30 per sq ft, according to Mr Dainton. This leads me to believe that a valuation for the office space could be anything between £10m to £14m based on an annual rent roll between £600,000 to £1m to a quality tenant.

So, although analysts at both Arden and Edison Investment Research have held their full-year net asset value estimates at 445p and 449p, respectively, I would be very surprised if we don’t see a decent valuation uplift on this development when the company reports its interim results later this year. I would also point out that the Hudson House development is unencumbered, so the directors have the flexibility of either putting it into a joint venture if a partner can be found, or alternatively redevelop the scheme themselves using Palace Capital’s lowly geared balance sheet. Either way, there is upside potential here for a company which had a last reported net asset value of £110m.

Ahead of the first half results to end September 2017 which will be announced in November, I continue to rate shares in Palace Capital attractively. Please note that I initiated coverage last autumn at 335p ('A royal investment', 17 Oct 2016), since when the board has declared dividends of 18.5p a share for the 2016/17 financial year, with prospects for a 19p a share payout this year, according to analysts from both firms. Trading on a 12 per cent discount to conservative looking net asset value estimates, and offering a solid looking 4.8 per cent prospective dividend yield, I continue to rate the shares a buy.

 

MXC’s unloved shares undervalued

Aim-traded shares of MXC Capital (MXCP:1.25p), a technology-focused merchant bank run by a management team that backs investee companies they represent, have drifted down to an all-time low of 1.25p, so are well adrift of the 1.65p level at which I last rated them a buy ('Check into small-cap value plays', 20 Jun 2017), and less than half the price at which I first advised buying at ('Dealmakers', 31 May 2016).

This is despite the fact that MXC’s board committed to a £300,000 share buy back in December, and extended it by the same amount again in early April. To date, the company has purchased 21.1m of the 3.372bn shares issue at prices as low as 1.42p. Moreover, it’s not as if the portfolio of investee companies have performed poorly since the February half year-end. 

In fact, MXC’s three largest listed small-cap holdings have actually increased in value by £6.45m since the February half year-end, including its investment in Tax Systems (TAX:80p), a leading supplier of corporation tax software to the large corporate sector and the accounting profession in the UK and Ireland. MXC subscribed for £8.7m-worth of new shares as a cornerstone investor in a £45m placing last summer and still holds warrants over 6 per cent of the 76m shares in issue, the majority exercisable at 67p, but some at 61p. These warrants are currently showing a paper profit of over £650,000 and MXC's holding of 15.2m Tax Systems' shares is now worth £12.2m. A pre-close trading update last month confirmed confirmed that Tax Systems is trading in line with finnCap's expectations which point to the company delivering a near third rise in EPS to 4.2p this year, implying the shares are rated on a forward PE ratio of 19. Assuming the company delivers a 16 per cent rise in EPS to 4.8p next year, as finnCap predicts, then the forward PE ratio falls to 16.6. 

MXC has two other major equity investments: a holding worth £13m in Castleton Technology (CTP:69p), a leading provider of technology products and services to the social housing and not-for-profit sectors; and a £14.5m investment in Aim-traded Coretx (COR:33.5p), a provider of IT solutions, cloud and network services, and data centre hosting. Shares in Castleton are rated on 14 times finnCap's earnings estimates for the financial year to end March 2018, falling to 13 times forecasts for the year after, while shares in Coretx are rated on 20 times N+1 Singer's earnings estimates for calendar 2017, falling to 15 times 2018 earnings estimates after factoring in upgrades and the contribution from acquisitions made. The combined value of these three investments is around £40.4m, or just £1m below MXC’s own market capitalisation.

Or put it another way, MXC’s current share price fails to attribute any value whatsoever to the rest of its investments which include a private equity portfolio worth £7.1m; a net cash pile of around £6.5m when MXC reported its interim results in May; the £3m holding in Adept4 (AD4:4.8p), a small cap Aim-traded company that provides 'IT as a service' to small and medium sized businesses across the UK; and the value of 7m call options in Redcentric (RCN:81p), a leading UK IT managed services provider. True, these options have a strike price of 80p, or just below Redcentric’s share price, but they still have time value, albeit it’s going to take time for Redcentric’s new management team to restore credibility amongst investors after last year’s revelation of accounting issues.

The point being that even if you attribute nil value to MXC’s intangible assets of £11.5m on its balance sheet, by my reckoning the company’s pro-forma net tangible asset value is still around £56.5m, or 1.7p a share. So, although MXC’s share price has performed poorly since the emergence of accounting issues at Redcentric last autumn, which led to a £8m diminution of value on MXC’s warrants in Redcentric as well as a on its shareholding too (subsequently sold), I feel the sell-off in MXC’s shares has gone too far.

So, having taken into account the operational performance of the aforementioned three major investee companies, the cash on MXC's balance sheet, and the value of the private equity portfolio, I believe next month's pre-close trading update should highlight the value on offer here. Recovery buy.