Investment Matters

History repeating…

This week’s Investment Matters considers the retirement operator and developer, Aveo.

This week your Investment Team was recalling the takeover of Aevum in 2010, by Stockland.  It is interesting to consider Aveo in this light.

But first, what is the discount rate

The discount rate is a driver of property valuations (using the NPV method).  It is a factor that allows the time value of money to be accounted for – putting future cash flows generated by an asset into today’s terms for net present value calculations.  Risk is also considered in the discount rate – lower volatility and risk in regard to receiving future cash flows means a lower discount rate.

A lower discount rate, all else equal, means a higher valuation. 

The discount rate is an important consideration, both in relation to Aevum’s takeover, and in the context of Aveo today.

Overview of Aevum takeover

Aevum was a retirement operator and developer, which was owned by First Samuel clients from Dec-07.  During the GFC (@ 30-Jun-09) its share price traded as low as 43.4% of net tangible asset (NTA) value – a very large discount!

Aevum received a takeover proposal from listed property group Stockland in Aug-10.  The offer was increased, and Stockland was ultimately successful in taking over Aevum in Dec-10.

The offer for Aevum was not excessive or above-the-odds, in fact:

  1. your Investment team assessed that the Stockland offer should have been meaningfully higher,
  2. the Independent Valuer stated the offer was low: the Independent Expert concluded the Revised Offer [increased offer] was not fair as it is less than the Independent Expert’s valuation range for Aevum of $1.91 - $2.22 per share (mid-point valuation of $2.07 per share). (Source: Aevum Target Statement, 6-Sep-10); and,
  3. the average institutional broker valuation was $2.05 per share (source: para 1.3 of Aevum Target Statement, 6-Sep-10).

The final takeover price was $1.77.  Aevum’s net tangible assets per share was $2.02.  Thus Stockland was able to acquire the Aevum’s assets at a meaningful (13.7%) discount to the net asset value.

Furthermore, Aevum used a conservative discount rate at an average of 13.88% (source: Aevum Annual Report FY-10).  This was the highest of any of their peer retirement operators.  If Aevum had used discount rates that comparable entities used, between 12.5% and 13.5%, Aevum’s NTA would have been between $2.29 and $2.09 per share (respectively). 

First Samuel ultimately (and with some disappointment) accepted the Stockland offer after it was increased to $1.77 plus the outstanding dividend, and after the takeover acceptances reached the level that Stockland would have control; we didn’t consider it to be in the interest of clients to be minority shareholders in that situation. 

The Aevum investment did generate a 18.3%p.a. return (average IRR) for clients over the ~3 year period of ownership.

Aveo today

Aveo has a NTA of $3.92 per security (as at 30-Jun-18, source: Aveo FY-18 Annual Report).  The security price as a COB yesterday was $1.60.  That is, the security price is trading 40.8% of NTA.  This is even lower than Aveum during the GFC!  Which isn’t to say we don’t find this perplexing – we certainly do.

This NTA is based on an average discount rate of 13.1%.  This is higher than Stockland’s retirement assets (13.0%, source: Stockland FY18 Financial Report, note (C1c)), and meaningfully higher than LendLease’s retirement assets (12.3%, source: page 60 LendLease FY-18 Financial Results (22-Aug-18)).  In other words, the NTA figure for Aveo is real.

Additionally, for Aveo (and other retirement entities) the distinction to other property classes is notable.  Over recent years there has been significant compression (decrease) in capitalisation rates, across industrial, office, retail and other specialised sectors (note: cap rates are inversely proportional to property valuations). 

Source: Property Industry Funds, Property Investment Factsheet Jun-18

Discount rates for retirement assets have not moved downwards in the same way, i.e. retirement-related properties have not benefited from the significant upswing in the property cycle over recent years.

Aveo is currently undertaking a strategic review, with a stated aim of closing the gap between the security price and the NTA.

Parallels

We are conscious of Aveo being a somewhat similar situation has Aevum.  We don’t believe it is in the interest of security holders – certainly those with a medium to long-term investment horizon – for the strategic review to culminate in a transaction or other outcome that represents a significant discount to the NTA.

Short-term risks

Five factors that we should address specifically in regard to Aveo:  1/ the government's aged care review, 2/ regulatory risk for retirement living, 3/ the residential property downturn, 4/ growth rate assumptions, and 5/ balance sheet strength.  These might be cited - by some - as a rationale for the discount being applied to Aveo’s NTA.  Let’s consider each one …

  1. Aveo actually has a low exposure to aged care.  The vast majority of its business is the operation and development of retirement units (not aged care beds).  Furthermore, our assessment of Aveo’s aged care operations is that they are high quality and issues are not likely to arise for Aveo from any review or anticipated regulatory changes (it may actually be a beneficiary).
  2. In regard to regulatory risk associated with the retirement living sector – we assess the actions taken by Aveo over the last three to four years (especially the rollout of revised contracts for residents, which we assess to be at the forefront of providing a fair outcome with certainty for residents) as greatly reducing the regulatory risk for Aveo.  We assess Aveo as actually leading the new generation and more customer orientated approach to retirement living.
  3. In regard to residential property impact, sales of new and refurbished units are likely to slow in the short term, and potentially even in the medium term, as residential sales' volumes slow (associated with the lending credit squeeze).  In fact, this week Aveo indicated FY-19 sales are expected to be circa 1150 units, based on current sales run rate.  This is lower than the number expected earlier this year (circa 1500), but it is still a strong number; FY-18 was 974 units, and inspection bookings are at record highs (source: Aveo AGM presentation, 14-Nov-18).  We view it as quite likely that the sales rate will slow further in the short term.  However, with Australia’s population aging, the need for retirement living remains, and it is growing i.e. the need will be mostly delayed rather than negated.
  4. Projected price growth rates are an input into the NPV calculation for property valuations (which flows through to NTA). Whilst growth rates may need to be moderated in the short term, this is not expected to have a meaningful impact overall.  If we consider Aevum during the GFC period, its NTA went from $2.22 at the end of FY-07 to $2.08 at the end of FY-09 (and back up to $2.23 at the end of FY-11).
  5. Balance sheet strength – Aveo is very well managed.  If debt is higher than management desires, they have assets that could be quite readily sold.  It is usual to see companies trade down when concern creeps in about balance sheet strength – as investors fear a dilutionary capital raising is coming.  But we don’t assess that a capital raising is on the cards for Aveo.

Certainly the five factors above, individually and collectively, do not warrant Aveo to be trading at anywhere near the discount to NTA that it currently is.

Some other thoughts

A final point in regard to NTA – the NTA of $3.92 does not recognise the value that will be created for security holders in the future, through the development opportunity and optionality that exists in Aveo.  Aveo is a great exposure to a medium and long-term growth dynamic (an aging population), which is hard to find in many other sectors.

In the end, we accepted Stockland’s offer for Aevum at a discount of 13.7% to NTA – reluctantly and with disappointment.  If Aveo’s strategic review was to result in a similar outcome for security holders, it would equate to a security price of $3.38.  And similarly to Aevum, we would view such a result with disappointment.

Conclusion

Aveo’s security price ($1.60) is currently trading at a very substantial discount to the NTA.  It is undertaking a strategic review, with the aim of closing the discount between the security price and the NTA.

First Samuel has lived through a somewhat similar situation with Aevum.  We believe that the outcome for Aveo, whatever that may be, should result in current security holders being able to realise the value of their assets.

- Fleur Graves