|Shares Out. (in M):||105||P/E||5.7x||0.0x|
|Market Cap (in $M):||20||P/FCF||5.7x||0.0x|
|Net Debt (in $M):||26||EBIT||6||0|
Investment Thesis – Public Service Investment Properties’ common stock is a long because:
¦ PSPI is an orphaned micro cap that recently completed a complex restructuring. This dynamic creates a dislocation that allows investors to buy long-term net leased real estate assets at less than 6x earnings and less than 50% of NAV assuming no improvement in operating performance.
¦ This value will likely be realized in the near term via a sale or dividend reinstatement.
¦ It’s hard to see more than 25% downside in even an absolute worst case scenario.
After a recent extensive restructuring, PSPI’s remaining assets consist of eight senior living facilities (referred to in the UK as “care homes”) in Germany and nine facilities plus a special-needs school and office building in the UK. All assets are fully net leased (i.e., tenants are responsible for all costs) for 20+ year terms with periodic rent escalators. Six of the eight German assets are leased to the publicly traded Marseille-Kliniken Group with the remaining two leased to independent operators. The German assets generate an annual rent of £3.0mm that is increased every three or four years based on the German CPI and are encumbered by £15.6mm of debt. This debt carries annual interest of 4.1% with £0.3mm in annual amortization and minimal maturities before 2020.
The UK assets are located in Merseyside County near the city of Liverpool and are all leased to European Care Group (ECG), one of the larger care home operators in England. Annual rent for these properties is currently £3.9mm with yearly escalators equal to the British CPI. There is £17.6mm of debt secured by the UK assets, of which £10.6mm is guaranteed by the company. PSPI pays 5.7% on these mortgages, and this debt comes due within twelve months. Approximately 70% of the care costs are paid by local governments. My research indicates that the supply of available beds is not expected to increase in the Liverpool market, and government pay rates are viewed as stable (although low in absolute terms) in this region.
Pro Forma Earnings and Valuation
Like most non-US real estate companies, PSPI’s assets are independently appraised annually. Based on the year-end 2012 Colliers valuation, PSPI has an equity value of £0.56/ share, or nearly 3x current levels. My research suggests that the cap rate used for the UK assets is somewhat aggressive, but even if you assume a much higher cap rate there is still significant upside. Furthermore, as shown below it appears PSPI trades at <6x pro forma earnings (there is minimal capex or working cap in this business so net income ≈ FCF), which is clearly much too cheap for fully leased real estate assets with escalating rent.
To think about this another way, property values would have to fall > 45% from the appraisal value to impair an investment at this price. A decline of that magnitude was only seen in a few of the absolute worst markets in the recent housing bubble.
Figure 1: Pro Forma Earnings and NAV
|UK rent||4.0||Dec 2012 appraisal value of assets||84.0|
|Germany rent||3.0||- Debt||33.5|
|Finance lease||0.9||+ Pro forma cash||7.0|
|Proforma revenue||7.9||+ Note receivable||1.0|
|- Admin costs||2.4||= Equity value||58.5|
|EBIT||5.5||Per share value||£0.56|
|-Interest||1.6||Upside from current price||192%|
|-taxes||0.4||Market cap at 0.19/share||20.0|
Risk to UK Assets
While the German assets are leased to high-quality tenants, unfortunately the same cannot be said for the UK assets. ECG is quite frankly a struggling credit. While we do not have a full picture of ECG’s financial health because the company is private, it appears to be undertaking fairly aggressive restructuring measures under the leadership of a new CEO. However, we have to accept the possibility that ECG’s restructuring will be unsuccessful and it will be forced to default.
The UK assets have rental coverage of 1.77x and are 88% occupied. The properties are a mix of larger purpose-built facilities that are more desirable and smaller, older properties. As such, after speaking with several UK-based contacts, in the event ECG defaults I believe it’s highly likely that PSPI would be able to lease the UK homes to another operator on comparable terms – similar to what happened to assets of comparable quality in the recent Southern Cross bankruptcy. At the very least they would be able to lease the more desirable assets. However, even if PSPI needed to offer significant rent concessions to a new operator, there is still meaningful upside to this stock.
For a stress test, let’s say that ECG defaults tomorrow and PSPI is unable to find a new operator. Let’s also assume that the German assets are sold at an 8.5% cap rate (vs. the 7.9% cap rate used in the most recent appraisals, which my research suggests is the current market rate), and there is no salvage value for the UK properties or any assets other than cash. Even in this unrealistically harsh scenario, I am calculating a share price only 25% below current levels.
Figure 2: Downside in a worst case scenario
|Germany cap rate (7.9% used in recent appraisals)||8.5%||Salvage value of UK assets||0.0|
|Value of German assets||35.3||Salvage value of receivables / other assets||0.0|
|Equity value of German assets (A)||19.7|
|Equity value (A+B)||25.7|
|Cash||6.0||- Company guaranteed UK debt||10.6|
|-1yr expenses and interest||4.0||Remaining equity value||15.1|
|+ 1yr German rent||3.0||Implied value per share||£ 0.14|
|+ cash generated in last 8 mos||1.0||Downside from current||-24.6%|
|Remaining cash (B)||6.0|
In my mind, a more realistic downside case would be PSPI only being able to find a new operator for the high-quality assets at roughly 50% of the total rent they are currently receiving. Even in this case, NAV is 60% - 90% above current levels.
Sale of Company – PSPI’s recent restructuring was part of a banker-assisted “strategic review” that began in September 2011. I highly doubt that the conclusion of this review is that the company should continue to exist as an irrelevant micro cap – the company itself has stated there is “no reason” to be public. Furthermore, Elliott owns 46% of the company and controls the board; I assume they simply want to exit rather than hold this tiny stock indefinitely.
Dividend Reinstatement – Going forward, PSPI would be able to support a rather large dividend, and management has stated several times its intention to “reexamine the dividend policy” post restructuring.
Government Payments – England’s fiscal problems are well known, and several of PSPI/ECG’s competitors have been hurt by government funding cuts. My research indicates that funding in the Merseyside area where PSPI’s assets are is fairly stable (although still lower than in much of the country). The UK has a long history of government-provided care homes, and this policy has broad political support. As such, the government is highly unlikely to jeopardize this service.
Debt Maturities – PSPI’s UK mortgages are coming due in short order, with £10.6mm due in December 2013 and £7.0mm in February 2014. The December maturity is guaranteed by the company. Given the current funding market and the significant equity in these assets, this is not likely to be an issue. Furthermore, the company will likely be able to pay off the December maturities from available cash if needed.