LXB Retail Properties LXB LN
May 17, 2016 - 1:53pm EST by
bafana901
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 $M): 48 EBIT 0 0
TEV ($): 216 TEV/EBIT na na

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  • Liquidation
  • Discount to Liquidation Value
  • Residential Real Estate
  • IFRS
  • Illiquid
  • Discount to NAV

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 managements 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

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.
 
 
    sort by    

    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 managements 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

    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.
     
     
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