A rock-solid property pick?
Shoppers and tenants return to Eastern European malls with a vengeance, pushing operating income to record highs
Should South African investors, who have had something of an on-again, offagain relationship with Eastern Europe, still be exposed to the region’s real estate market?
It certainly seems so, given the stellar set of results released last week by Nepi Rockcastle the largest mall owner in Central and Eastern Europe (CEE) and the JSE’s biggest property stock, with a market cap of R66bn.
The company declared a 47% year-onyear uplift in dividend payouts for the 12 months to December, which comes on the back of what CEO Rüdiger Dany describes as the “best operating performance in the group’s history’’.
Nepi Rockcastle’s more than 50 shopping centres are spread across nine countries: Romania (the country in which the company was co-founded in 2007 by South Africa’s Resilient group), Poland, Bulgaria, Hungary, Slovakia, Croatia, Lithuania, the Czech Republic and Serbia.
Like many other real estate investment trusts
(Reits), Nepi Rockcastle’s earnings came under pressure in 2020/2021 due to Covid’s crippling trading restrictions.
Russia’s invasion of
Ukraine last year and the subsequent spike in
European interest rates, food and energy costs were further cause for concern. There were also important management changes to contend with last year in the appointment of a new CEO and
CFO. Yet Nepi’s business bounced back strongly from the second quarter of 2022 when pandemic-related measures were finally lifted.
Dany says last year’s surge in net operating income was driven by record-breaking sales growth and strong rental increases across the portfolio, underpinned by the resilience of CEE consumers.
“It’s amazing how shoppers have returned to malls coming out of the pandemic, with spend per visitor going up dramatically from the second quarter.”
He initially thought the spending boom would be short-lived as pent-up demand faded. But the rebound in tenant turnovers has continued into 2023 and is now comfortably ahead of the record levels achieved in 2019.
Dany says the performance is particularly remarkable given that it was achieved against a “challenging economic background, marked by high inflation, rising interest rates and the energy crisis triggered by the war in Ukraine”.
He notes that Eastern European consumers have a far greater preference for enclosed malls compared with their Western European counterparts. Not only because there is a lack of “high street” shopping facilities in the region but also because malls are typically regarded as important entertainment and community centres.
That’s especially true during the dreary winter months: many Eastern Europeans still live in cramped flats dating from the communist era.
Dany says there’s been a strong resurgence of demand for space from international tenants, with the war forcing many big brands to leave Ukraine and Russia and open stores in neighbouring countries instead.
Referring to apparel brands including Zara, Primark, Nike, JD Sports and LPP, he says: “These retailers are coming to us as we are the biggest player in the region. Profit margins for retailers are higher in Romania and Poland than if they opened a store in Germany, France or the Netherlands.”
The trend has cut the vacancy rate in Nepi Rockcastle’s mall portfolio from 4% to just 2.7% in the 12 months to December. Earnings for the year to December were supported by the reversal of €21m that was held back last year as a provision for a litigation case.
To some extent, Nepi’s share performance this year reflects the company’s bumper performance. Its shares are up almost 6% since January and they’re 18% ahead over six months, against the
JSE property index’s 6% rise over the same period. But analysts believe there’s further upside in store for Nepi Rockcastle shareholders.
Liliane Barnard, CEO of Metope Group, says Nepi Rockcastle remains a preferred stock given the strong results posted last week.
She argues that the company’s sizeable development pipeline will ensure continued good growth in earnings over the next few years.
About €677m worth of extensions and new developments are under way. Two Polish acquisitions made late last year — the Forum Gdansk and Copernicus shopping centres — will further boost income.
Barnard says higher inflation is also starting to support higher indexation (inflation-linked rental increases), more of which will be seen in the next financial year.
In addition, the CEE region as a whole should continue to have higher GDP growth rates than Western Europe, the US and UK. “An investment in Nepi Rockcastle enables South Africans to gain access to these higher growth markets,” she says.
In an Anchor Stockbrokers sales note, equity research analyst Francois du Toit says Nepi Rockcastle’s stronger than expected results mean that the distributable earnings per share guidance for 2023 is 10% ahead of analyst consensus.
He adds that
Nepi’s Romanian assets have performed particularly well. Rentals in Romania were 12% higher in the second half of 2022 against the first half of the year. Also, 61% of the full-year profits came from Romania though the country accounts for only 39% of total rental income.
Du Toit says the unusually high property operating and corporate costs seen in the first half of 2022 also appear to be normalising.
“Overall, we like the strong Romanian results and that costs are getting back under control, probably reflecting lower oil and utility costs, a more benign European winter and one-off costs incurred by the new management team in the first half of 2022.”
Zaid Paruk, investment analyst and portfolio manager at Aeon Investment Management, says Nepi Rockcastle trades at a 9.5% forward yield and a 19% discount to net realisable value.
“This is attractive for South African investors looking for a rand hedge opportunity and stacks up well against local property counters.”
Paruk says unlike CEE-focused companies, South African Reits still face a poor consumer backdrop and rising costs due to increased loadshedding.
“Local property companies will also have to absorb the capital expenditure to introduce renewable energy solutions to their buildings.”
But as ugly as things are, there still might be a few reasons to buy KAP as a sturdy recovery play.
The diversified industrial group spans timber, specialist chemicals, logistics, bedding, automotive components and niche technology, and can be viewed as a proxy for the local economy.
So it’s been hit hard by disruptive loadshedding, waning consumer demand, higher inflation, currency fluctuations and higher interest rates. Group margins took a fair beating in the six months to endDecember, settling at 9.3%.
Adding to KAP’s woes was a serious breakdown at its sprawling chemicals business, Safripol, which saw a chunk of production lost at a time when demand was strong and margins thick. Then there is the group’s substantial debt, which happened to coincide with a 90% slump in cash flow from operations to just R100m on the back of markedly higher working capital demands.
Yet Graeme Körner, director at Körner Perspective, praises KAP for its convincing longer-term strategy and good underlying businesses. “I like a business that is positive and constructive. These guys don’t cry into their beer … they just get on with it and invest in their future capacity. KAP is a better business than the market gives them credit for.”
Körner says if KAP can manage 60c a share in earnings for the full financial year to June then, on a 10 times earnings multiple, there could be considerable upside to the stock.
“In the past they have proved that their capex does generate good returns. There are enough good ingredients here for
KAP to be a new Bidvest,” says Körner.
Essentially KAP — which in its distant past incorporated listed businesses including Glodina, Kolossus and Silveroaks — now revolves around three large profit contributors: timber specialist PG Bison (34% of operating profits), polymers business Safripol (32%) and logistics hub Unitrans (23%). Bed manufacturer Restonic, automotive trimming specialist Feltex and fledgling transport technology group Drive Risk are much smaller, but each has compelling longerterm attributes.
In the first six months of the 2023 financial year PG Bison saw robust demand across most market segments, which allowed the raw board plants to operate at planned capacity.
Its performance was hampered by the value-added timber production being hit by unscheduled maintenance on three of the melamine faced board presses and a delayed commissioning of a seventh press (due to semiconductor chip shortages). It partly explains the margin squeeze from 20.6% to 18.4%.
Safripol, which manufacturers polyethylene terephthalate (PET) for use mainly in soft-drink bottling, benefited from an R80m profit kicker courtesy of higher rand-based raw material margins. But this was offset by lower sales volumes which, Chaplin says, was due to lower consumer demand and reduced offtake due to stage 6 load-shedding. What’s more, Safripol had to contend with a “major breakdown” at the PET plant. It lost 38 days of production, which was reflected in a sales volume drop of 11%.
Chaplin explains: “Electricity failures are not good for a polymer plant, which operates at high temperatures and high pressure.” Safripol’s interim operating profit was down 26% to R450m with margins melting to 8.7% (previously 12.7%).
Unitrans held up despite a weak showing in Africa, with revenue rising 12% to R5.5bn and operating profit down only 3% to R334m. Feltex was the star performer with solid operating profit of R97m (earned on an 8.9% margin), but Restonic reported operating profit down 57% to R41m with “lots of retail time lost to load-shedding”.
It’s still early days for Drive Risk, but a R10m operating profit from revenue of R288m will increase enthusiasm for a decent slug of annuity income in years to come.
The second half looks better — especially for the key timber and PET hubs. Chaplin expects high demand, due in part to export markets. And he’s banking on a stable operational performance at Safripol — also with the development of export markets to supplement local demand.
At current levels KAP’s shares hardly look expensive. That said, the market’s enthusiasm for local industrial counters (Hudaco being the exception) is on the wane, and there seems no need to rush into KAP at this point.
Dividends might even be open to question, with Chaplin placing considerable emphasis on the need to ease KAP’s debt load with interest rates at 10.5% — even if the group is predicting a significant improvement in working capital and a reduction in net debt expected during the second half.
Investors able to focus on the long-term horizon would do well to watch KAP for further weakness. It could be a rare opportunity to grab shares in a quality business at a knock-down price. x