Value Investors Club / LXB Retail Properties (LXB LN)

Description

There will be no need for coffee to keep you awake during the write-up. It’s not a write-up on how Tesla and

Solarcity will take over the world. There will be no boring debates on whether the Apple 7 is better than the

Apple 6 which is better than the Apple 5 or whether the next Apple will still be made from boring old

aluminium. No, this is an exciting write-up on the weaknesses of IFRS and how to make money

exploiting these weaknesses.

I am recommending LXB Retail Properties as a long. LXB, which owns mostly retail properties in the UK,

is currently in a process of selling these properties and returning cash to shareholders. At the recent AGM

shareholders instructed management to complete the disposals by March 2017.

The current share price is GBP1.00. My best guess valuation is GBP1.16p resulting in a 16p

profit. But, it gets much better. LXB will return 38p to shareholders on May, 26 2016. So the real return

on investment is actually 16p on 62p, implying a 26% return over 10 months. A more optimistic

possibility is a 38p profit on a 62p investment. It does not get much better than that.

Business Description

Price GBP1.00

#shares 168.3 (adjusted for buybacks in jan2016)

Mcap GBP168.3mil

LXB raised money in an IPO in October 2009 to take advantage of opportunities in a distressed property

market following the GFC. LXB focused on acquiring and developing retail properties on the edge of towns. The plan was

to acquire the properties, gain planning approval, develop the property, find tenants and then sell.

The listing was originally supposed to last for 5 years. However, due to delays in getting planning

approvals, LXB has had to ask shareholders to extend the life of the company in 2014 and 2015.

Today, all the planning permissions on the remaining properties have been received and many of the

developments will be completed this year. Management have committed to an orderly realization of the

properties “with substantially the whole of the value being returned in cash by 31 March 2017”.

LXB is listed in Jersey and there are no taxes to be concerned about.

It is important to note that while delays in planning permissions delayed some developments, other

projects went ahead very successfully and LXB has already started to return the proceeds from these

disposals to shareholders.

The table below has been extracted from the cash flow statement and shows the initial equity raised

and the subsequent return of equity in the form of buy backs, capital returns and dividends.

Equity Equity

Raised Returned Dividend

Sep-10 147,583

Sep-11 109,917

Sep-12

Sep-13 (44,900)

Sep-14 (39,946)

Sep-15 (51,317) (31,460)

Total 257,500 (136,163) (31,460)

The table shows that LXB initially raised GBP257mil and by Sep2015 returned GBP167mil. As

mentioned above, shareholders are about to receive an additional GBP64mil (38p per share) in May. LXB

also bought back 15.28mil shares for GBP14.7mil (96p per share) in Jan 2016.

Following the May distribution, GBP126mil will be left on the balance sheet. If the GBP126mil is returned to

shareholders, then, the total cash returned will equal GBP357mil which implies a 39% return on the

original R257mil equity investment.

In the valuation section below I will make the argument that the remaining R126mil equity is

understated and that the actual cash finally realized could be well above the GBP357mil calculated

above.

Balance Sheet

As this is an NAV play I intend to focus only on the balance sheet. The Sep2015 balance sheet is shown

below.

(Please see appendix for a list of properties)

Important observations include

 Completed properties make up GBP53mil of the GBP208mil property portfolio. The cap rate

used to value the completed properties is 5.6%. I think this could be on the light side considering

that LXB sold the Brocklebank Retail Park for a 4.25% yield in May2016. LXB have focused on

long leases with blue chip tenants so I think a cap rate below 5% is easily attainable. However, I

going to be conservative and ignore this potential uplift in valuation as I do not want to second

guess the external valuations of these properties.

 Developments make up GBP153mil of the property portfolio. As discussed in more detail below,

IFRS requires development properties to be valued using the “Residual Method of Valuation.”

The Residual Method tends to understate the fair value of the property especially when the

developments are near completion.

The following is an extract from the 2014 AFS highlighting the weakness of the residual valuation

method.

Residual Method of Valuation.

Under this approach, total costs including construction costs, professional fees, contingency and

finance costs together with an allowance for developer's profit are deducted from the valuer’s

estimate of the investment’s value at completion to arrive at a surplus which is called the

Residual Land Value, i.e. the amount that a purchaser would be willing to pay for the

development in that state and at that time. This approach works well in the early stages of a

development however matters can become more complicated as the development progresses

towards the date when rents start to accrue. It is important that Shareholders understand that

these valuations which are properly recognised for accounting purposes are different to (and in

general lower than) the values which the Board would place on those assets when considering

offers for investments. In some cases, there is a significant difference between the carrying

value and the price we would be prepared to accept. This is most notable in the case of Rushden

Lakes because, when calculating the Residual Land Value, notwithstanding the planning success

and the investment’s very significant long term potential, the independent valuer is required to

reflect, amongst other things, that only 9% of the space is pre-let.

Valuation

The current share price is GBP1.00 and the NAV/share as at Jan 1, 2016 is GBP1.01. (per AGM

documentation.)

The key point here is that the GBP1.01 value is an IFRS NAV which undervalues development properties.

Below is an extract from the March2015 interim report.

“Shareholders may find it helpful to understand that the Group’s current internal appraisals are

suggesting that over time there is a further £75.8m of potential unrealised NAV in the

investment portfolio, including the further phases at Rushden Lakes. “

Adding the GBP75mil to the GBP189mil IFRS equity (see balance sheet above) implies an adjusted equity

value of GBP264mil or GBP1.44 per share. This represents a 43% premium to GBP1.01 IFRS NAV.

The reason that development assets are understated is that IFRS requires development property to be

valued using the residual method. The formula used by the residual method is

Value of Property in its Present Condition = Value of Completed contract – Costs to Complete - RiskAdjust

The “costs to complete” includes building costs and a development profit which is typically 20% of the

construction costs. The inclusion of the development profit in the calculation reduces the Residual

Values, but, remember this profit does accrue to LXB.

The calculation of Residual Values also includes a risk adjustment factor. Developments which are 100%

pre-let will have a lower risk adjustment compared to developments which are only 50% let.

Since making the GBP75mil disclosure in the March2015 report management have been curiously silent

on the understatement of the NAV. I have had to make two reasonable guesses at the latest fair value.

Guess 1

LXB is run by an external investment team. They have been incentivized to maximize the cash returns to

shareholders. The incentive is based on the Dec 31, 2015 NAV of GBP1.01 per share. The investment

team will get 20% of any amount above 12% per annum. March 2017 is 15 months from Jan 2016 which

implies an NAV of GBP1.16 (GBP1.01*1.12*15/12) before the investment team begin sharing in the

profit.

The investment team have been working with these assets since 2009. Given their expert knowledge, it is

interesting that they were prepared to accept the GBP1.16 threshold before sharing in the profit. To me

this signals that the ultimate value could exceed GBP1.16, but, until I know more I am going to settle on

GBP1.16 as my base case valuation.

Guess 2

My second guess is much more optimistic. Assuming the GBP75mil management guidance still holds,

then, the NAV jumps from GBP189mil to GBP264mil or GBP1.44 (183.6mil shares in issue). But,

remember the investment manager will take 5.6p leaving GBP1.384 for shareholders.

This implies a 38.4p profit on a 62p investment.

This sounds too good to be true, and, anyway, how can you believe management? Actually, if one reads through

the annual reports it is difficult not to be impressed by management’s achievements. Getting planning permission in the UK is an impossible task.

LXB management got permission, completed developments and let the properties despite a very tough

trading environment.

However, I am reluctant to pin my hopes on this valuation because there will be a rush to sell and some of the

developments will have to be sold even though they are not incomplete.

Risk

LXB plan to sell the Greenwhich and Sheppery properties in the summer 2015. The Stafford and Sutton

properties should be sold by the end of the year as these developments only complete later in 2016

Obviously, a downturn in UK retail properties is a risk end then there is Brexit .

These risks are easy to hedge with a basket of listed UK retail focused REITS (eg INTU, HMSO)

Conclusion

In general management have generally been successful at acquiring, gaining planning permission,

constructing, letting and then selling property developments. The tail end of the development pipeline is

completing and there is an opportunity to exploit the weaknesses in the IFRS valuations without risking much downside.

There is also the option to lock in the potential upside by shorting UK REITS to protect against any macro

weakness in the retail property sector.

Appendix

I have listed the properties in the Appendix as there is not much detail on the individual valuations.

Management want to keep the details private in order not to compromise the immanent disposals.

Properties	SQF	Homes	Completion	Notes
Rushden	494,325		oct16	sold for GBP65mil, May16
Greenwhich Brocklebank	160,356		autumn-16	sold for GBP22.8mil, Dec2015
Greenwhich B&Q	93,500		complete	expect to sell summer2016
Sheppy Phase2	89,276		complete	expect to sell summer2016
Sutton	27,000		sep16	expect to sell eoy
Stafford-Kingsmead	88,343		summer16	expect to sell eoy
Stafford-Retail+Leisure	269,529		summer16	expect to sell eoy
Ayr	151,686	750	2018	???
Truro, Higher Newham		155		???
Truro,Threemilestone	78,000	435		???

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

 The main catalyst is the publication of the March 2016 financials (early august). I expect LXB to show growth in nav.

 Further asset sales and cash distributions.

show sort by

			2016	2017
Price:	1.00	EPS	na	na
Shares Out. (in M):	168	P/E	na	na
Market Cap (in $M):	168	P/FCF	na	na
Net Debt (in $M):	48	EBIT	0	0
TEV (in $M):	216	TEV/EBIT	na	na