Description

**Metrics presented above are in SEK. 2023/’24 estimates are consensus sourced from Bloomberg**

Castellum (CAST SS) is a Swedish real estate company trading at nearly 40x my estimate of 2024 FCF. I think there is at least 20% downside to consensus earnings estimates over the next couple of years, and any rational assessment of value in this business (e.g., DCF) would imply 80%+ downside to the equity.

Business Overview

Castellum owns and leases commercial real estate properties across Sweden. Offices account for ~60% of owned property value per the chart below, while public sector (government tenants) and ‘other’ property types account for the remaining 40%. Relative to other listed peers, Castellum’s property portfolio is more regional in nature without much, if any, exposure to high quality CBD assets. Most readers will likely be familiar with the ‘polarization’ dynamic which has impacted office and retail space in the United States. While not yet observable in Castellum’s financial results, we believe the same polarization headwind is likely to materialize in Sweden.

Castellum’s average lease term is approximately 4 years with minimal tenant concentration. Contracted lease rates with tenants are indexed to inflation each year between renewal periods, which has supported revenue and EBITDA growth YTD with CPI in Sweden running +LDD in early 2023. Indexation provisions have driven Castellum’s top-line growth of +8% YoY through 1H’23, with EBITDA growing +9% YoY over the same period.

Thesis Overview

Bullish investors cite indexation provisions to argue that Swedish real estate is more attractive than U.S. real estate, where rent agreements typically include fixed escalators rather than an inflation peg. The argument goes that property values in Sweden are protected from significant declines in a high cost of capital environment, because nominal rents increase in lockstep with CPI.

Our view is that inflation is a headwind, rather than a tailwind, for the value of stocks such as CAST SS. You can see this in CAST’s reported net earnings, including interest expense, which declined (11%) YoY in 1H’23 despite the +9% EBITDA growth referenced above. Castellum’s YTD earnings declines have been driven by short-dated debt maturities which have been re-priced as the Swedish Riksbank has taken repo rates from 0% in early 2022 to 4% (and rising) today.

We believe Castellum’s balance sheet is not viable in an environment with non-zero costs of capital. A cursory forecast of EBITDA and capital expenditures over the NTM implies that this business can only generate positive free cash flow at a ~5% break-even cost of debt (defining FCF in this simple analysis as EBITDA – CapEx – Interest Expense). Castellum’s marginal cost of short-dated debt is 5.9% today as shown in the table above from the Company’s latest earnings report.

Why does this opportunity exist?

• Unlike many of its peers, Castellum has already undertaken an equity raise to re-capitalize the balance sheet. The Company raised SEK 10Bn through a rights issue completed in late May 2023. The bullish narrative is that CAST SS has already ‘taken its medicine’ to alleviate the pain of higher interest rates. However, the 10Bn capital raise (25% of market cap at the time) represented only 12% of outstanding debt. We believe Castellum’s rights issue has delayed the need for a larger balance sheet restructuring, rather than fixed the problem as bulls seem to suggest
• Massive behavioral biases among Nordic real estate investors, many of whom have become conditioned to the notion that property cap rates only go down – in other words, valuation of real estate only goes up. The graphic below – again from Castellum’s latest earnings report -- is a good depiction of the Swedish real estate environment since 2010. At a 3% Swedish 10Y rate (current), property cap rates in Sweden were 7-8% in the early 2010s. There is virtually no value to equity holders if we mark Castellum’s properties at these historic capitalization rates.

Risks

• This stock is clearly sensitive to interest rates, with daily news flow driving large swings in sentiment and market prices. The pendulum has swung back in favor of the bears recently as interest rates in Sweden and Europe more broadly continue to make new highs. I would not be surprised to see a near-term reversal in sentiment, as has occurred several times over the past year
• Related to the first point above, there is a clear risk that short-term costs of capital decline to alleviate balance sheet risks which are well known by the market today. We think path dependency is important here, as a decline in ST costs of capital is likely to be accompanied by a recession in Sweden (already starting per latest macro datapoints). Our analysis also suggests a fairly manageable upside branch of +25% or so from the current stock price, assuming this unlikely ‘goldilocks’ scenario of lower rates + no fundamental weakness + return to ZIRP earnings multiples materializes

Catalyst

Rating agency downgradesFurther balance sheet re-structuringTime