Ovaro - New name, new tricks?

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Question to @Jesse_Kinnunen regarding the scenario section of the recent company report (23.11.2018):

The NAV-based valuation of real estate investment companies on the stock exchange is typically dependent on the company’s return on capital and risk profile. Listed real estate investment companies in Finland have been valued at an average discount of 20% to EPRA NAV over the past 20 years. Based on this, Ovaro’s fair value could be approximately 7.2 euros at the end of 2018 or 6.5 euros per share after restructuring, if the sale of the residential portfolio intended for sale is realized with 10% costs.

Does this, however, refer to the fair value at the end of 2020? :slight_smile:

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Am I understanding the strategy correctly if I say this: sell large apartments because they generate cash and eliminate interest and amortization payments, etc. This is good because the share price is at such a terrible level. Cheaper rental apartments remain, generating positive operating income.

Large apartments can be sold even at a somewhat poor price, as it is still good relative to the share price? In this case, value losses are recorded, but in reality, more money is obtained relative to the current valuation?

Does it go something like this? :wink:

Apparently, if needed, own shares will be bought back, which will provide better cash flow for Investorshouse (and others).

26

Best regards, I joined Orava again for the 3rd time.

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27

This referred to the end of 2018. It’s important to note with Ovaro that the fair value of the share is not the same as our target price. Our target price is the level we believe (based on analysis) the share will settle at within the next 12 months. With Ovaro, profitability is currently so weak and investor confidence so low (rightfully so) that the share is unlikely to reach this fair value we estimated within 12 months. You can read about the differences between target price and fair value, for example, here: https://www.inderes.fi/fi/sijoituskoulu-inderesin-tavoitehinnat

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28

In the big picture, this is exactly how it is. There are two angles to sales. Firstly, due to family apartments, Ovaro’s relative profitability is weak, and when/if they are sold, the profitability and cash flow of the remaining entity will be healthy. After the sales, Ovaro’s expensive parent company loans (interest rate 4.3-5%) can also be renegotiated, which will further improve profitability. The second perspective relates to capital allocation and shareholder value. The stock is at a significant discount to its per-share NAV. In theory, the company should sell apartments even at a clear loss and use these funds to buy back its own shares, as this significantly increases the per-share NAV and, consequently, leads to a better per-share profit for all shareholders.

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29

Yep. Based on this, I opened a position in Ovaro again. In principle, it should work out.

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30

I have noted with great pleasure that Inderes’ comments on Ovaro have recently become a degree more cautious.

The hype has been replaced by slightly more realistic comments. This is a good thing.

Inderes has also understood in its latest report to revise the 2019 dividend forecast to zero.

As late as August, a dividend of 0.19 euros was forecast for 2019. This, considering the company’s financial situation as a whole, is something so incomprehensible that it’s better if I don’t say anything about it.

In the latest update, the 2019 EPS forecast is now 0.16€. In the August update, it was 0.64€. So, 75% was cut from the forecast based on one quarter. Well, that’s good. That 0.64€ forecast was also something that it’s better if I don’t say anything about.

I would politely ask if you are, so to speak, a bit at sea with this company?

With all friendliness.

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31

I apologize for my outburst. I promise to write something constructive next, and not just be a jerk.

Let’s continue the discussion in a more civil manner.

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32

Thanks for your feedback and question. I try to answer questions, and constructive criticism is always welcome. Generally, visibility into Ovaro’s future direction and the year 2019 has been unclear and subject to change for almost the entire year. As a result, our forecast models and forecasts have also changed. In practice, proper information about the new strategic direction was only received at the CMD in October, at which point visibility became clearer. It is true that the reported earnings forecasts, which include fair value changes, have completely changed, but if you look at the cash flow-based operating profit, its forecasts have not changed much since August (2019e: EUR 2.3 million => EUR 2.0 million). This is only a EUR 300,000 change in revenue in relation to a company with a real estate portfolio value of EUR 192 million. A dividend of EUR 0.19 corresponds to approximately EUR 1.8 million, which was clearly below the operating profit we were forecasting at the time. This dividend forecast does not look reasonable now that we are looking at it. However, it was not theoretically impossible, assuming that the company would have reached that level of operating profit and also achieved its apartment sales targets that we predicted and managed to renegotiate its loans.

We have clarified the company’s financial situation very thoroughly. We have discussed directly with debt financiers about the terms and conditions under which they would be willing to finance Ovaro. The old Orava did not receive debt financing on attractive terms, and in our understanding, several different financiers refused to finance the company at all. Based on our investigations, this situation has changed after the change in ownership structure and management, and Ovaro (in our understanding) already has better opportunities to obtain debt financing.

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33

Really great background work!
Perhaps I haven’t read carefully enough, but I haven’t come across such a sentence before. This kind of information should be presented more often in reports. Was this known already during the time of the previous management?

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34

The challenges of external capital financing were known even during the time of the previous management. Of course, their interest was also to get external capital as cheaply as possible, and to our understanding, they genuinely and vigorously tried to secure loans on the most favorable terms possible. Although the situation is now better in our understanding, it is by no means a foregone conclusion that capital could be obtained on significantly better terms, at least currently. Significantly better terms would likely first require a turnaround in profitability and a track record.

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35

Thanks for your factual reply.

By the company’s financial situation, I didn’t mean whether the company can renew its loans or not. Surely, with new management at the helm, the conditions for this are better than during the old management’s time.

I mean the financial situation as a whole and the company’s operational profitability:

The company’s real estate portfolio of just under €200M currently generates a cash flow (after financing items) of roughly €1.5M annually. (information from page 20 of the interim report, cash flow statement) If this can be improved by, for example, €1M next year, it doesn’t change the big picture much yet.

Even currently, the company cannot cover its financing costs for newer apartments with its operational cash flow but is forced to sell apartments to pay them off. See page 47 of the interim report, section on liquidity risk.

In other words, the company currently has to sell its apartments simply to stay afloat.

Cash on hand is now about €3M.

Bullet loans totaling €38M are maturing within approximately 2 years and must be repaid.

Somehow, it would still be necessary to either build or acquire those higher-yielding properties to get closer to a normal real estate investment company and a normal real estate investment company’s return level (but with what money?)

Own shares should also still be bought (but with what money?)

The company’s LTV is now 52.5%, so there isn’t much upward flexibility.

Given this situation, it would make no sense to distribute money from the company as dividends, even if loans could be renewed. Ovaro’s new board would not do anything so foolish, and I believe they will act responsibly. The old management, of course, distributed as much money from the company as they could.

For this reason, I have never believed Ovaro would pay a dividend in 2019.

Then, a prediction for the future:

You now believe Ovaro will pay a dividend of €0.19 in 2020.

I, on the other hand, believe that Ovaro will not pay a dividend in 2020 either.

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36

The company’s operational and cash flow-generating capabilities are indeed currently weak. However, Ovaro is not in an acute crisis because its business cash flow is positive, and its cash reserves of EUR 3 million at the end of September exceeded short-term interest-bearing debts of EUR 1.7 million. Additionally, cash flow profitability will improve from December 18, when the agreement with the management company ends.

It is important to look ahead now and recognize that the company will almost completely transform if the ongoing restructuring succeeds. The company’s strategy is to sell EUR 79.3 million, or 41%, of its housing portfolio, consisting of poorly performing new family apartments. The funds obtained from these sales are intended to be invested in new real estate investment properties. If this is successful, the company’s cash flow profit will improve significantly. Critical variables here are the price and timeline for divesting these family apartments, and what properties will replace them. The new CEO told the CMD that he believes most of these could be sold already in 2019. In our last analysis report scenario (here: Odotamme saneerauksen onnistuvan - Inderes), we assumed that these properties could be sold (considering all transaction costs) at a 10% discount to their Q3’18 balance sheet values, which would yield approximately EUR 27 million net after payment of corporate loans. If these could be invested in commercial properties and financing subsequently renegotiated, Ovaro’s annual operational profit could rise to the level of EUR 4-5 million. If this were achieved, there would fundamentally be no further problems with dividend payments or share buybacks.

To clarify, the company has not specified how it will allocate capital between share buybacks, dividends, and new property acquisitions. I specifically asked HPJ Roininen about this at the CMD, and the answer was that they prioritize shareholder value. At the current share valuation level, the company fundamentally favors share buybacks over dividends, as these increase shareholder value more. The company officially states its goal is to achieve at least 10% total returns for shareholders, consisting of share price appreciation and profit distribution. Profit distribution can occur either as dividends or share buybacks.

There were many challenging assumptions behind this, and the restructuring will certainly not be easy. However, I consider it likely that the restructuring will succeed. Ultimately, for investors, this is currently partly a matter of trust. Do investors trust that the current board and management can implement the restructuring?

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37

Thanks again for your good response.

I would like to bring up one more point regarding the company’s financial situation:

The company will switch to a valuation carried out by an external appraiser in the 2018 financial statements.
If it is assumed that the values of the properties remain the same during Q4 2018, then a write-down of €5.0M will be made to the property portfolio.

With my math, this 5 million write-down reduces the equity ratio to about 42-43% and at the same time increases the LTV to about 54-55%. At the same time, EPRA NAV falls to about 9 euros, as you have predicted.

We note that after this, we do not have much room to sell those large, low-yield properties, at least not at a very large discount, because this directly further weakens the financial key figures.

The company’s new management is good and they are doing the right things.

However, looking at the financial situation as a whole, I come to the following conclusion:

A SHARE ISSUE OR HYBRID LOAN IN 2019 - 2020 SEEMS VERY LIKELY

In order to properly restructure the company, its equity must somehow be strengthened. Otherwise, we are just kicking the can down the road. The situation is not satisfactory for the company itself or for investors: The result remains poor, the terms of financing remain weak, and the company constantly has to explain to investors why the restructuring is not progressing faster.

The interest rate on a possible hybrid loan would be really high, in which case we would again be in a situation where financing costs eat up the operating profit.

A share issue, on the other hand, would be psychologically painful for investors and would have a diluting effect on per-share key figures.

Of these, I consider some kind of directed issue to be the most probable, the size or timing of which I will not try to guess here.

However, I have now stated aloud that this possibility exists, and time will tell if it materializes. By share issue, I mean any measure that results in an increase in the number of outstanding shares of the company. This also includes the acquisition of new properties through a directed issue, where the company’s own shares (contribution in kind) serve as payment.

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38

Thanks for your point. I completely disagree with you on this. Your estimates for the equity ratio and LTV seem correct after the assumed 5 MEUR write-down. However, when family apartments are sold, solvency improves, it does not weaken, and thus there is more room for maneuver. Family apartments totaling 79.3 MEUR are subject to housing company loans of 44.6 MEUR. Their LTV% is therefore higher than Ovaro’s overall LTV, and even if they were sold at a 10% loss to book value, the equity ratio would increase and the LTV% would decrease after the transaction, meaning that financial key figures would improve. The equity ratio could even rise to a healthy level of 53% with that 10% sales loss assumption, if one assumes that no capital gains taxes are realized (uncertain). A lot would have to go wrong if hybrid loans or share issues had to be relied upon. If this were to happen, shareholder value would inevitably be destroyed. I don’t see that reconstruction would require so much capital; it’s now about the management’s actions.

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That 0.4% is pretty small - if I recall correctly, the authorization is about 9% of the share capital… it will require an improvement in the financial situation.

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Buying back own shares when the stock market price is below the per-share net asset value is like printing money, isn’t it? I made a calculation.

Q3 2018:
€86,765,000 equity
9,598,910 shares
equity per share: €9.039

40,000 shares acquired, cost €198,780 (share price €4.9695):
€86,571,220 equity
9,558,910 shares
equity per share: €9.056 (+0.19%)

A patient owner is rewarded with an increase in per-share wealth, but the payment goes to those leaving the company. Changes in property values (€-3.165 million Q1-Q3 2018) erode value faster than the cash flow used for share buybacks increases it. For the first three quarters, this value erosion was -1.6% calculated from the fair value of the property portfolio (199617 - 3165) / 199617 - 1 = -0.016.

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The share repurchases should be more than 10 times the amount announced now to have a significant impact. Nevertheless, I see it as a small positive sign that the current management is doing the right things and focusing on shareholder value. The changes in value of owned properties have been truly dismal this year and, in fact, throughout the entire period since listing. The new management has a huge task ahead to transform the real estate portfolio into a profitable one.

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42

This share buyback situation is quite interesting. It’s time for a thought experiment! Theoretically, if share buybacks continue indefinitely with all available cash flow, the company’s last shareholder, with a P/B value remaining at 0.5, would own the company’s entire equity, which would be half of the current amount. On the other hand, the company’s earnings performance has been so weak that a price-to-book valuation below 1 is justified. Thus, the company’s return on equity does not meet investors’ required rate of return. Share buybacks do not improve operating profit, but they do increase all per-share metrics, including net asset value per share, even though a share buyback reduces its absolute amount.

Let’s confirm this with an illustrative calculation. Assume that the company liquidates its assets, pays off its debts, and buys back its own shares so that half of its equity is used up. Also, assume that the company’s market value is always half of its equity in super-efficient markets. Thus, the share price rises after each buyback. I wrote a code snippet that calculated the final result.

Before:
€86,765,000 equity
9,598,910 shares
Market capitalization €43,382,500
Share price €4.52
Equity per share €9.039

After:
€43,382,495 equity (-50.0%)
2,666,363 shares (-72.2%)
Market capitalization €21,691,247 (-50.0%)
Share price €8.135 (+80.0%)
Equity per share €16.259 (+80.0%)

*The calculation shows that I underestimated. The last shareholder’s ownership amount is not half of the current, but less than that.

This hypothetical situation seems paradoxical. The P/B ratio becomes unusable, and therefore the only reasonable price for the share is to relate the price to the cash flow per share, which share buybacks increase, provided that the cash flow remains at the same level. Upon liquidation of the company, the P/B should approach one.

The entire calculation, of course, goes haywire if the company makes a loss and the markets are correct in their assessment that the true selling prices of properties are lower than what has been recorded in the balance sheet.

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@Jesse_Kinnunen, is this view on Ovaro accurate?

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