|Shares Out. (in M):||522||P/E||18.9||7.3|
|Market Cap (in $M):||149||P/FCF||-||-|
|Net Debt (in $M):||302||EBIT||17||29|
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INVESTMENT IDEA: Atlantic 1
Summary quantitative information
The fund: historic background and assets’ perimeter
Atlantic 1 (“QFATL” or “Atlantic 1” or the “Fund”) is a closed-end real estate investment fund originally managed by First Atlantic Real Estate Sgr (“FARE”) and then, following the acquisition of FARE by Fimit Sgr, managed by Idea Fimit Sgr (the “Manager” or the “SGR”). The shares are negotiated in the Telematic Funds Market (MTF) of the Italian Stock Exchange.
Alicentro 2 Srl (“Alicentro”), Asio Srl (“Asio”) and Telemaco Immobiliare Srl (“Telemaco”) established the fund in 2006 through contribution in kind of real estate assets. Alicentro, Asio and Telemaco were real estate investment companies controlled by investment vehicles established by some real estate funds managed by Goldman Sachs. In particular:
Alicentro owned the real estate assets rented to GS SpA (Carrefour Group),
Asio owned the real estate assets rented to companies belonging to ENI group, while
Telemaco owned the real estate assets rented to companies belonging to Telecom group.
Original maturity of the Fund was set at 31 December 2016 and then extended to 31 December 2019 in order to have the appropriate timeframe to maximize the value of the Fund, following the general downturn of real estate investment volumes. According to Fund regulations, the Fund may benefit of a “grace period” of three years to dispose the real estate assets, following the maturity date.
During 2014, Oceano Immobiliare Sarl (“Oceano Immobiliare”), an investment vehicle controlled by some real estate investment funds managed by The Blackstone Group LP (“Blackstone”) launched an offer (the “Tender Offer” or “OPA”) in relation to all the shares of the Fund; price offered was €303, lately raised to €320. The OPA closed with Blackstone retaining nearly 39.5% of the outstanding shares paying €335 per share because of some purchases carried out in the market ahead of the completion of the Tender Offer.
Considerations on the governance of the Fund
Below are reported the most important rules regarding the Fund:
Financial Debt cannot exceed 60% of real estate assets and 20% of investments in real estate companies. In the event that these limits are exceeded because of change in the NAV of the Fund, the SGR will restore the limits, but taking into considerations the best interest of the shareholders (best effort obligation).
Transactions with related parties are subject to (i) the approval from auditors and (ii) the fairness opinion provided by an independent real estate specialist or appraiser.
Profits of the Fund, net of unrealized gains (gains coming from valuation), are distributed semiannually for a minimum amount equal to 90% of the profits.
Fees to SGR (calculated on a semiannual basis and at the beginning of the period) are 0.35% of the value of the assets until the maturity date; subsequently, they will diminish to 0.225% (i.e. during the “grace period”).
The Advisory Committee of the Fund is made up of five experts appointed by the shareholders’ meeting; it issues non-binding opinions, when requested by the board of SGR. List of candidates for the Advisory Committee is prepared by the SGR taking into considerations experts proposed by shareholders having (also jointly) at least 10% of the shares.
Shareholders’ meeting resolutions require (i) the approval of the majority of participants and (ii) the approval of 30% of the outstanding shares. That means that Blackstone retains the full control of the Fund following the OPA.
Quality of assets
Existing assets’ base is made up of 23 properties (46 originally contributed). 87% of assets are offices while remaining 13% of assets have commercial/residential use. 77% of properties are located in Lombardy (mostly Milan and greater Milan area).
Occupancy rate is nearly 84% and drop in 2016 because of termination of the lease agreement in relation to a building in Rome previously rented to Telecom Italia group.
Key assets are shortly described below:
an entire building in Milan downtown (Piazza Cavour) with mixed use residential/office valued €109m; this represents the trophy asset of the Fund;
a number of properties in San Donato Milanese rented to companies of the ENI group for a cumulative book value of some €275m; lease agreements were renewed by the end of 2016 on a 9+9 years basis;
an entire building in Rome previously rented to Telecom Italia valued €54m;
some portion of properties in Lombardy, Piedmont and Lazio, for an overall value of some €53m, rented to GS (Carrefour group); according with the recent master agreement, leases are 9+9 or 6+6, without early withdrawal option; in 2016, the SGR set a competitive process to sell the portfolio but it received just 1 offer based on an unsatisfying price; SGR decided to abandon the disposal process and focused on the renewal of the lease master agreement in order to maximize the value of the portfolio, in the framework of the overall extension of the Fund until the end of 2019.
Summarizing, assets’ base is made up of (i) a large trophy asset and (ii) some good properties rented to highly reliable tenants with recently renewed agreements. Properties are mainly located in the most developed Italian region. The large property in Rome may be now considered a pure surplus asset: for the asset, SGR’s strategy is to seek a good tenant in order to expedite the disposal but that will entail Capex for some renovation of the premises.
The assets of the Fund are mostly real estate properties while cash and other assets are residual and related to operating activities. The invested capital is funded with financial debt for €254m (as of June FY17). Banks are Intesa, Unicredit, Credit Suisse and BPM. Following the recent agreements with the banks, the repayment occurs according with a “cash sweep” based on the periodic cash flow of the Fund. There is a covenant which requires the lower than €180m by end of FY18 (entailing a repayment of nearly €80 by the date) with ordinary cash flows and disposals.
Quality of earnings
In FY16, the Fund recorded more than €40m from rentals. Due to the fact that in the last year occurred (i) the termination of the contract with Telecom Italia group for the building in Rome, (ii) the renewal of lease agreements with ENI group and GS, latest reported profitability did not represent a fair and complete picture of the normalized long-term profitability of Atlantic 1. The following table illustrates the likely projected profitability of the Fund according with the provision of the renewed contracts.
For the current year, forecasted rentals are slightly less than €25m but projected to exceed €34m on a pro-forma basis according with the (already) agreed step-ups in the leases with ENI. Assuming a new lease for the property in Rome with an annual rental of some €5.5m (20% less respect to the previous lease with Telecom Italia), revenue could exceed €40m. Costs projected according to the most recent available information on the cost structure of the Fund.
Normalized profitability (“BASE Case”) expected to be in excess of €17m with the existing perimeter of contracts and estimating interest expense on the basis of the renewed loan’ commercial terms (2.75% spread). Should the property in Rome be rented (“BEST Case”), the income might be in excess of €22m.
The Fund trades at nearly 27.9% discount on GAV. With a 20% haircut to the appraisal/book value of real estate assets, there is still a 10% discount on GAV. Discount on NAV is wider (53%) thanks to financial leverage. Assuming the 20% haircut on the appraisal/book value of properties, discount on NAV reduces to 24%, but still largely positive. Assets’ yield from rentals (calculated on appraisal/book value) in the BASE Case stands at 6.8% but adjusting the calculation for the book value of the vacant property in Rome, the yield jumps to 7.6%. For the equity investor, in the BASE Case yield is 13.6% while in the BEST Case may reach 18.0%.
With an EPS in the BASE Case at €32.7, adopting a 10% capitalization rate for equity, and summing up the potential value of the surplus asset (vacant property in Rome), the intrinsic value may be estimated at €410 per share. The disposal of the surplus asset will certainly make possible an instantaneous significant decline of outstanding debt with benefits in terms of interest expense (nearly €1.2m). Considering the uncertainties surrounding the disposal of the asset in terms of time frame, I have not prudentially factored any benefit in the normalized profitability estimate.
Reasons for mispricing
Market prices of Italian listed closed-end real estate investment funds have been strongly impacted by the prolonged recession and investors’ dissatisfaction. Since 2008, prices have been in a declining path and generally, it is possible to find investment opportunities characterized by wide discounts to book value (NAV). In the last 8-10 years, there was a general downward revision of real estate values in the books of the funds (appraisals) because of the real estate market decline in Italy. Shares of the funds were mostly sold to retail investors at the peak of the latest cycle (2006-2007 period). Following a number of years of depressed market prices, declining NAVs and unsatisfying market performance, real estate investment funds share an overall bad reputation among (retail) investors. Moreover, some perceived “soft” mis-selling practices to retail investors contributed to the bad reputation of the asset class in Italy. OPAs occurred in 2014 and 2016 by international real estate fund managers (Blackstone, Elliott) brought back some interest on these assets. Completed the OPAs, interest of market participants faded again and prices fall down. This continues to be an illiquid out-of-favor segment of Borsa Italiana.
Following OPA by Blackstone, the Fund entered an “interim phase” where SGR has to (i) extend the maturity of the Fund (ii) negotiate with the banks the new terms of the loan. Uncertainty may have created further dissatisfaction among retail investors entered the Fund at the inception.
Motives to invest
Estimated intrinsic value highlights a 70% upside. Current market prices entail a yield for the equity investor in excess of 13%.
A robust assets’ base made up of a trophy asset in Milan (high liquidity) and good properties (office use) with prime tenants. Properties mostly in greater Milan area. Lease agreements recently renewed (long-term perspective for rentals). Limited vacancy rate (mostly due to a large property left by Telecom Italia). Extended maturity date of the Fund (2019) combined with the described asset base should permit an ordinary liquidation of assets by SGR.
Discount on GAV (27.9%) and on NAV (53.1%) highlights some degree of protection on the downside.
Current and pro-forma yield on assets (rentals on book value) corroborates book value as a fair picture of actual portfolio’s market value.
Predictable operating cash flows assure wide coverage of annual interest expense.
Projected increase of rentals (and therefore net income) may not be (entirely) factored by the market because expected from steps-up provision in the recently renewed lease agreements.
Following a recovery in 2015, 2016 was a very positive period for the Italian real estate segment represented by offices thanks to the macroeconomic stabilization in Europe/Italy and the prolonged expansionary policy of ECB. Assets for retail/commercial use posted a positive performance in 2016 in particular thanks to the higher interest for shopping malls. Overall, the consolidation of economic growth is bringing its benefits to the real estate sector. Growth in volumes should be followed by rising prices with positive end effect in terms of shorter required period for the disposal of assets.
Opportunity to enter next to the recessionary stage of the (economic and real estate market) cycle with the ensued advantages in terms of overall mood around the asset class and entry prices.
Full alignment of interest with the key institutional investor (Blackstone) who took 39.5% of the shares in 2014 following the OPA. Blackstone retains control over the shareholders’ meeting, with the power to change the Manager. Blackstone purchased the shares paying €335.
Financial leverage is nearly 2x (in terms of Assets/Debt). The loan has been recently extended in accordance with the maturity date of the Fund (end of FY19). A potential slowdown of the expected time frame for the disposals may impair the ability of the Fund to repay the debt within the maturity date and the actual possibility to match the provision of the covenant (maximum €180m outstanding amount by the end of FY18). The option to dispose in a very short time the trophy asset of the Fund with a projected net cash in exceeding €100m represents a guarantee that SGR is able to appropriately manage (reduce) financial debt. Furthermore, operating pro-forma cash flow stably exceeds interest expense leaving room for annual repayment based on the cash sweep mechanism.
An instantaneous 30% decline in the value of the portfolio would take away the discount on GAV leaving the equity investor without margin of safety while NAV would be entirely impaired with a portfolio decline in excess of 50%. I assign a residual probability to this scenarios for the following reasons: i) the ongoing trend in the European and Italian real estate market indicates a positive development for volumes and prices in the coming months thanks to a stronger macroeconomic recovery and overall higher confidence, ii) current book value of the assets is not expected to be inflated (they represent the outcome of the progressive downward revision of the appraisals occurred in the last 7-8 years, a period of prolonged recessionary phase), iii) assets’ yield resulting from the recent renewals of lease agreements support the thesis that appraised values represents a fair picture of market values.
The wide margin of safety strongly supports the investment case. In particular, downside risk seems to be very limited thanks to the consolidation of the economic recovery in Italy and the high quality of the portfolio. A context of depressed prices allow a particularly favorable entry price.
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