Disclaimer

The articles in the blog are intended for informational purposes only, with the aim of encouraging thoughtful discussions. The articles should not be relied upon as financial advice. Please read the important disclaimer at the bottom of the page before proceeding.

Impact of P/NAV ratios on acquisitions and rights issues

 

Earlier this week, I was having a conversation where I was trying to explain how some REITs are able to consistently make acquisitions and grow their AUM, while other REITs are not. My view is that the difference is mainly down to their price to net asset value (P/NAV) ratio which the market assigns to the REITs. REITs with P/NAV greater than 1 are able to take advantage of this cheaper cost of equity to make yield and NAV accretive acquisitions, whereas REITs with P/NAV at or below 1 are unable to do the same – acquisitions would often not be feasible as this would result in NAV and yield being dilutive.

I illustrate this with the examples below.



Let’s say we have two REITs, Reit A and Reit B. Both have similar properties valued at 1 mil, and generate a gross yield of 4%. Interest costs are 2.5%, and the gearing ratio of both Reits are 40% - meaning that the capital structure of the reit comprises of 40% debt and 60% equity. Both Reits have 600,000 shares issued, which gives the Reits a net asset value of $1 per share each. Up till now, both Reits have exactly the same metrics.

Now, let’s assume that as the units of both Reits are traded on the market, somehow, Reit A’s units are trading at a P/NAV ratio of 0.9x, with a dividend yield of 5.56% (assuming 100% payout). Reit B’s units are trading at a P/NAV of 1.5x, with a dividend yield of 3.33%.

What would then happen if both Reits were to look at making an acquisition?



If both Reits were to look at acquiring a property at “market value”, in this case, meaning a property that gives the same gross yield as their existing properties (4%). The target property is valued at $100,000, and the acquisition would be financed by the same debt to equity structure (40% debt and 60% equity), in order to maintain the same gearing ratio for the Reits. This is where the difference in share prices would matter to the Reits. If the discount on new shares is 10%, Reit A, has to issue 74,074 new shares to raise $60,000 of equity, whereas Reit B only needs to issue 44,444 shares to raise the same amount of equity. This means that Reit B’s cost of equity is “cheaper”, because it needs to issue fewer shares to finance the acquisition, hence resulting in lesser dilution of its outstanding shares.



When evaluating the proposed acquisition, both Reits would publish the “pro forma” financial impact of the acquisitions. Here, the capital structure of both reits remain the same (40% debt 60% equity). The gross property yield remains the same, because we are purchasing a property which gives the same yield as the existing property portfolio, and the interest cost remains at 2.5%. The pro forma impact on both Reits would be that the acquisition would be dilutive Reit A’s NAV and yield. NAV will drop to $0.98, while dividend yield, based on the theoretical ex-rights price (TERP) would be 5.50%, down from 5.56%.

On the other hand, Reit B would see its NAV rise from $1 to $1.02, and its dividend yield would increase from 3.33% to 3.44% - both NAV and yield accretive.

What would be the impact of the proposed rights issue for both Reits?

It is likely that Reit A’s shareholders would not approve the deal – nobody likes coughing up more cash, only to see their NAV and dividends get diluted. In fact, the Reit manager for Reit A might not even propose the deal to shareholders, given that it is likely to fail. On the other hand Reit B’s shareholders would likely be glad to throw extra cash at the Reit – given that the deal is NAV and yield accretive.

What can we understand from these two examples?

Fundamentally speaking, there is no difference between the two Reits, as well as the property that is to be acquired. The only difference here is that Reit B is trading at a much higher P/NAV ratio, which allows it to issue fewer shares to make the same acquisition, hence resulting in it being NAV and yield accretive. The longer term impact would be more crucial. Reit B can continue to grow its AUM with more yield accretive acquisitions, and reap benefits such as lower interest costs on its larger asset base, as well as perceived “stability” from it being a much larger Reit. The market would also view Reit B as consistently “growing”, thus may be willing to pay a premium for Reit B. This results in a positive cycle for Reit B, all of which started from the mere fact that its P/NAV was higher than Reit A.

What can Reit A do to grow?

This is not the end of the road for Reit A. It can still grow, but it would require different approaches to grow its AUM. Firstly, Reit A would probably be more selective in its acquisition targets, looking for properties that yield above market gross yields (in this case, >4%). Reit A can also consider other financing options, such as issuing perpetual securities, which count as equity instead of debt. Lastly, Reit A can also consider taking on a more aggressive financing structure for the acquisition, for example, using a 60% debt/40% equity mix, and play around with the numbers until the acquisition can be yield and NAV accretive. However, this would increase the Reit’s overall gearing ratio.

Conclusion

The conclusion here is that simply having a higher P/NAV ratio can result in tangible long term benefits for a Reit, if the Reit is able to take advantage of their “cheap” cost of equity to make acquisitions. In fact, raising equity when share prices are high is what many companies are doing, for example, fast growing companies such as Tesla or Sea Ltd have taken advantage of their high share prices to raise equity. Even meme stocks such as AMC have done the same.

Of course, there are other factors that influence a Reit’s ability to grow, such as the sponsor strength, pipeline of properties from the sponsor, capital recycling etc, but this article mainly serves to explain the impact of having a high P/NAV on acquisitions and rights issues.

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Summary of SATS Q1 FY22 Business Updates

 


SATS reported its Q1 FY22 Business Updates on Thursday, 22 July. SATS is a company that I’ve been following closely, and this article summarises my takeaways from the business updates provided.

Key Operating Statistics

SATS shared a number of key operating statistics, including number of flights handled, meals served, passengers handled, cargo tonnage and total number of employees. These operating statistics include SATS and its subsidiaries, but exclude JVs and associates. In their business updates, SATS had only provided figures for 5 quarters from Q1 FY21 (Apr to June 2020) to the latest quarter Q1 FY22 (Apr to June 2021). Given that Covid-19 had already resulted in a decline in air travel from early 2020, I have added in two more prior quarter’s of SATS’ operating metrics for a more meaningful comparison. Q1 FY21 coincided with the peak of the lockdown in Singapore, while Q4 FY20 was already impacted by a slowdown in aviation volumes. Q3 FY20 would represent pre-Covid operating statistics.



Number of Flights handled is still way below pre-covid levels, even though air travel in other parts of the world have largely recovered. For instance, airlines in the US are actually unable to keep up with demand due to the shortage of workers, leading them to cut flights. SATS’ disadvantage here is that Singapore does not have a domestic air travel market, unlike larger countries. On the positive side, SIA, which is SATS’ largest customer, recorded a 13.7% passenger load factor for April 2021, up from 4.6% in April 2020. SIA aims for 32% of pre pandemic capacity by July 2021.

The cargo segment continues its recovery, and SATS noted that global air cargo volumes has risen beyond pre pandemic levels.

SATS has also drastically reduced their workforce, from around 17,000 employees pre pandemic to around 11,000 employees in the latest quarter. Staff costs remains SATS’ largest operating expense, accounting for around 42% of group expenditure.   

Q1 FY22 Revenue Mix

One of the positives is that SATS has continued to diversify their revenue base beyond the travel sector, with 46% of Q1 FY22 revenue coming from its non travel related businesses. SATS’ non travel businesses include commercial catering, with SATS being one of the caterers for individuals under quarantine in Singapore.

Q1 FY22 Financial Performance





SATS reported Q1 PATMI of $6.4m, profitable for the second consecutive quarter. Govt reliefs continue to provide support to SATS’ financials, as SATS received total govt reliefs of $45.5m for the quarter. Without this, SATS would have reported a PATMI loss.

On an EBITDA basis, SATS has reported four quarters of positive EBITDA since Q2 FY21, recording negative EBITDA of 33.9m only in Q1 FY21, when travel restrictions were the strictest.

Free cash flow, defined as net cash from operating activities less cash capital expenditure, was a positive 7.9m for the quarter.

As of 30 June 2021, SATS had total debts of 726m, a reduction of 147m from the previous quarter as a 150m term loan had been repaid. If rights of use liabilities were excluded, total debt would be 531m instead. Compared to a cash position of 753m, SATS is in a net cash position of 222m. Debt to equity ratio stood at a manageable 34%.

Conclusion

SATS remains my preferred pick for betting on the recovery of the aviation sector, due to its cost structure being more variable as compared to airlines. Airlines face high capex requirements as contracts with manufacturers require them to continue taking delivery of aircraft even when business has slowed. Ongoing maintenance costs and fuel costs are also significant. Whereas SATS has proved to be extremely nimble in cost reductions to minimise losses. Tellingly, despite the huge drop in passenger numbers due to Covid-19, SATS remains in a net cash position with a reasonable gearing ratio of 34%, and has not required any rights issues to raise funding.

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