Description

Overview

Etalon Group (“ETLN”) is one of the biggest and oldest residential real estate developers in Russia. It builds apartment buildings primarily in two core markets: Moscow and St. Petersburg. It is the #2 developer in Moscow with 7% market share and a leading developer in St. Petersburg with 13% market share. Over the last decade, the Russian economy has stagnated. There was a recession in 2008-2009 and then another from 2014 to 2017. During this time, ETLN grew topline 21% a year (2010-2019). ROE averaged 14% and was 15-18% pre-recession. Net margins are typically 10-12% and are largely backed by cash ex growth in working capital. 

Etalon trades at .6x book value, 5x consensus 2020 earnings and 3.5x our estimate of 2022 earnings. It’s a good business that’s priced to return 20% a year after inflation, even assuming no one ever comes in to “save” us at a higher valuation. We believe ETLN is fundamentally misvalued and is worth at least $4.70, 124% more than its current price.

The Opportunity

ETLN went public in 2011 with the shares trading consistently over $6. Those shares now trade at $2.21 after reaching a low $1.6 during the depths of Russia’s 2014-2017 recession. All the initial excitement is gone, both for Etalon and for Russia generally. What’s interesting, however, is that none of the factors underpinning that excitement have changed. Even as Etalon lost two-thirds of its market cap, its book value doubled, and it now pays a 9% dividend yield which is backed by operating cash flow.  

On top of this, there are several forces moving at the same time, in the same direction, which are increasing both the value and the "necessariness" of Etalon and other residential developers: 

1. Russia is one of the most underleveraged and undermortgaged economies in the world. While the rest of the world potentially faces vicious deleveraging, Russia does not.
2. As mortgages gain acceptance in Russia, Etalon benefits due to there being more qualified customers.
3. Housing stock is low in both of Etalon’s markets (Moscow and St. Pete’s).
4. The Russian government has made it a high priority to make housing more affordable in hopes that couples will have more children, reversing Russia’s demographic decline.
5. Housing is actually becoming more affordable to the average Russian, not less. Since 2000, average income per square foot of housing has doubled, putting home ownership in reach of more and more Russians.

As mentioned, Russia’s debt levels are among the lowest in the world. Conversely its savings rate is one of the highest. Credit cards and mortgages are only a recent phenomenon. Household debt/GDP is only 18%. Government debt/GDP is only 15%. By comparison, household debt in the US is 76% of GDP, and government debt is 107% of GDP. China, meanwhile, has total debt levels exceeding 266% of GDP. The runway for additional mortgage debt in Russia is huge. And in terms of risk, whereas the rest of the world has introduced fragility into its financial system in the form of towering debt, Russia’s finances are relatively robust, which means there’s genuine diversification value here. 

Etalon benefits not just from Russia’s growing middle class but also from Russians’ increasing willingness to take out a mortgage. Only 40% of sales currently comes from customers using a mortgage, and that figure is up sharply from 24% in 2014. Twenty years ago, only 7% of the Russian population could even define what a mortgage was. But as comfort with the concept increases, more and more Russians will be able to afford Etalon’s apartments. 

Mortgage terms in Russia are also very different from those in the US. When Russian customers use a mortgage, they don’t put down 20% or so as is customary here. The average down payment there is 80%, indicating that customers aren’t overextending themselves and have a bias toward thrift.

A further benefit to Etalon is the fact that potential homeowners in Moscow and St. Petersburg often can’t find a home because the housing stock is low in both areas.

Enter the Russian government. Low housing stock is a problem in its own right, but the Russian government has taken a growing interest in increasing housing affordability (which is only possible by encouraging what companies like Etalon are doing and expanding supply). Russia faces a grave demographic threat. The fertility rate is well below the replacement rate, which means the Russian population is shrinking. Recognizing this as the serious issue that it is, Vladimir Putin has instituted initiatives to subsidize family formation in the form of mortgage and tax relief for families.

As a side note, one aspect of Leon Levy’s career which is relevant here was his success in picking investments that aligned with government priorities. Understanding the power of government, he’d figure out what new goals the US government had adopted and then buy businesses that were involved with the administration achieving its goal. 

In Etalon’s case, 70% of its customers are families. Because affordable housing is a must-have in terms of getting families to have more children, Russian's policy goals run right through Etalon Group and other residential developers. (This is also why so many of the subisidies are housing-related.) To give you an idea how serious the Russian government is about family formation, just look at the size of the subsidies it’s giving. Russian families get 200 basis points off their mortgage rate. Upon the birth of a second child, the mortgage rate is lowered even more—down to 6%. The prevailing rate, for reference, is 10%. Families also receive a payment to be used to purchase a home equal to 435,000 rubles (40% of annual income to average Moscow resident, 90% for average Russian generally). They also receive a tax deduction on mortgage interest and the purchase price up to 650,000 rubles (60% of annual income to average Moscow resident, over 130% for average Russian generally).

The government has also announced that its goal over the coming years is to reduce mortgage rates across the board from 10% to 8%. LSR, Etalon’s competitor, projects that if mortgage rates went to 8%, the number of people who could afford a home would double. Etalon also has a similar projection—60% potential growth—which speaks to how close many Russians are to affording an updated apartment. Ultimately Etalon is in the business of providing affordable housing to middle-class Russians. As such, it is on the right side of power and the right side of badly needed public policy. No small thing in any country.

Last but not least, Etalon benefits from the fact that it sells a product which is increasingly affordable to the average Russian. 

Russia certainly has many issues, but it’s interesting how the operating environment there is almost the exact inverse of our own. Here, there’s lots of debt. There, there’s significantly less. Here, housing is becoming less and less affordable. There, it’s becoming more and more.

The Business

Etalon attempts to find projects where it can achieve a 15%+ IRR. Its returns on equity reflect that. ROE has averaged 14% since 2010. Before the latest recession, the business was putting up ROEs north of that, in the range of 15-18%. 

Net margins have averaged 10-12% from 2011 to today. Pre-recession, they were roughly 18%. Etalon continued to be profitable in the face of a recession and while growing topline 21% a year. Inflation has averaged 7% a year over this period, so these are still substantial figures in real terms. 

Etalon has stated that it will be in growth mode through the end of 2021, after which its growth trajectory will flatten. At that point, Etalon will likely begin paying dividends at the top of its current range of 40-70% of net income. This is in line with one of its main competitors, LSR Group, which has an 80% payout ratio on net margins of 11%+. So by 2022, if Etalon’s share price stays the same, we are likely to have a business with a 21% dividend yield. This will be hard for international investors to ignore and cuts to the core of what's appealing about the idea. Etalon's dividends are real FCF. They're not some theoretical figure that exists only on a spreadsheet. Perceptions about Russia or Etalon never need to change in order for us to make real money here.

Competitive Advantage

From 2014 to 2017, ETLN grew its combined market share in Moscow and St. Petersburg from 4.5% to 10%. The developer market is highly fragmented in both places, but an interesting trend has emerged recently. The top 20 residential developers have seen their market share increase 50% in five years—from 41% in 2014 to 57% in 2017. The top 20 firms, in other words, have been enjoying not just strong overall growth in the total market but rapid growth at the expense of their smaller competitors.  

We’ve mentioned this before in a previous writeup on TCS Group, and it’s worth mentioning again. As some industries in Russia modernize, huge amounts of market share are up for grabs. As a result, motivated companies are able to secure market positions—and the advantages that come with them—which could last for a long, long time. 

New regulations will only turn turn the crank on the already-existing trend favoring the big against the small. The Russian government has tightened the rules on pre-sales. Most developers pre-sell apartments as soon as they break ground, offering huge discounts the earlier in construction the customer puts down his money (sometimes even up to 40% off). But this practice has been abused by developers who subsequently became insolvent. There were protests, and as a result new regs require prepayments to go into an escrow account until construction has been completed. This means the developers can no longer finance construction with the prepayments and will have to rely on bank loans. This in turn will raise financing costs and is widely viewed as pushing smaller players out of the market, thus benefiting larger incumbents like Etalon.

Imbedded upside

The investment has imbedded within it two sources of upside that are independent of the business itself. The first stems from the fact that Russia is a resource-dominated economy whose fortunes rise and fall with the price of oil and gas. Oil, we have no particular insights into. But natural gas is selling at prices that are far below the marginal cost of production. Henry Hub trades at $2.21 at the strip. Meanwhile US LNG breakeven prices are around $5/ MMBtu, and even short-run margin costs are roughly $4/MMBtu. Structural imbalances can exist for a long time, but nonetheless there’s a strong possibility that at some point the price of natural gas goes up in order for there to be sufficient supply. Investing in Etalon is an indirect way to benefit from rising oil and gas prices without paying a carry and without buying an upstream oil and gas company whose value can be decimated at the drop of a hat. 

The second source of upside stems from the fact that Russia, at this moment in time, is about as unfashionable as it could possibly be. It has perhaps the cheapest stock market in the world. Randomly name any other country, and it’s Shiller P/E is probably at least 50% higher. Russia’s attractiveness to foreign investors is currently at rock-bottom. Investors don’t need to love Russia for sentiment to improve. They just need to hate it less.

Leverage

Etalon currently has 20 billion RR in net debt on its balance sheet, stemming mostly from its recent acquisition of Leader-Invest. This debt level is unusual for the company, as it typically carries a net cash balance. Our expectation is that this will be paid down sooner rather than later. 

Valuation

The effect of Russia’s new regulations will have a temporary impact on Etalon’s margins over the next year or so. Afterward margins are likely to go back to where they were before—11% or more. This gets us to 64 cents in EPS, to which we apply an 8x multiple to leave room for the “Russia discount.” The result is a $5.15 stock in two years, which we discount to $4.70 in present value, including dividends, for 124% upside.

Catalyst

• Inflation stays under control.
• Oil and gas prices increase.
• Mortgage rates in Russia decrease.
• No recession in Russia.
• New regulations are less punitive to margins than believed or are offset by housing price increases.
• Etalon is authorized to buy back 10% of its outstanding shares. A large buyback is a strong signal and helps the per-share economics.