Vonovia Stock: Not A Fire Sale, I Remain Very Bullish

vonovia ruhrstadion stadium in bochum germany

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Background

Vonovia (OTCPK:VONOY) (OTCPK:VNNVF) is Germany’s leading residential real estate company. Vonovia currently owns and manages ~550k of residential units mostly in Germany but with some apartments also in Austria and Sweden.

Whilst rental income from holding residential apartments is its main business, it also has additional segments that include:

1) Property development segment

2) Recurring sales (disposal of non-core apartments)

3) Value-add services (e.g., craftsmen, media, etc.).

Vonovia is currently trading at less than ~0.5x of net asset value whereas historically it traded around its book value. Also, note the forward dividend yield is expected at ~6%.

Vonovia’s primary listing is on the German XETRA. I recommend buying in the German market as opposed to the much less liquid ADRs.

In my previous article, on Vonovia, I highlighted the clear opportunity of owning a defensive residential property asset at less than 50% net assets value and a forward dividend of 6%.

I also explained, in great detail, the reasons for the current massive discount to book. To recap, Vonovia is facing an increased cost of capital due to rising interest rates which renders its previous business model of debt-funded inorganic M&A not tenable any longer.

Vonovia management was caught flat-footed and ill-prepared for the impact of inflation across its business. The firm had to clearly repivot its strategy and adjust its investment framework and portfolio to incorporate the materially higher cost of capital. In the Q1 earnings call, the management team was clearly not ready with a plan and Mr. Market punished the shares.

By the time the Q2 earnings came about, management has evolved its strategy to incorporate the impact of inflation and higher cost of capital.

In a nutshell, Vonovia is not engaging in a fire sale of apartments to raise capital and deleverage as some have expected. There was no announcement of a sale of a large portfolio either as others were speculating.

The message was that they are in no rush whatsoever and will only do a deal that is accretive to shareholders. This was somewhat disappointing to the market. The concerns were further exacerbated by apparent rapid cooling off in the German property market due to higher mortgage rates and lower real income for Germans, even though Vonovia reported a like-for-like valuation growth of 5.2% in the first half.

In my view, Vonovia has articulated a well-considered plan to address its higher cost of capital and has done so in a way to preserve flexibility (should conditions change), maximize returns, and in the best interest of long-term shareholders.

In other words, this is not a fire sale but more on that later.

The shares, however, haven’t budged and remained in the neighborhood of their 52-week lows whilst disappointedly not participating in the recent share market rally.

The strategy

As discussed in my prior article, the higher cost of debt capital has forced Vonovia to adjust its capital allocation strategy. This includes the followings:

  1. No new debt or equity capital will be raised. This includes no script dividends going forward at the current valuation.
  2. Majority of development-to-hold projects to be sold and realizing cash gains
  3. Apartments marked for sale increased to ~$13 billion which are expected to be sold over time
  4. The investment program (energy efficiency/modernization) will be fully funded from recurring sales
  5. Reduce maintenance CAPEX as previously this was more than generously spent
  6. It will not acquire any more portfolios
  7. It will target a leverage target in the low 40s and use proceeds from sales for debt reduction and share buybacks.
  8. It is progressing on developing tax-efficient JV structures with institutional investors to synthetically dispose of large portfolio clusters and generate substantial capital that can be deployed to reduce debt and buy back shares.

The aim of the strategy is clear. Vonovia should not be dependent on funding from the capital markets. The funding requirements for 2022 have already been fully secured. And for 2023 and 2024 there are approximately EUR7.8 billion of debt maturities that can either be funded through asset disposals (including the planned disposal of the nursing portfolio), debt (current cost of funds is ~2.5% to 3.5%), or a combination of both. The decision will be taken closer to the time and depending on market conditions.

Clearly though, at a valuation of less than 50% of the book, the most accretive capital allocation option is share buybacks. Note, however, that share buybacks are limited to 10% of outstanding shares per annum under German law.

So what are the likely scenarios going forward?

Whilst the market has been disappointed by the lack of specific timelines on disposals, the CEO has explained their perspective in the Q2 earnings call:

Rolf Buch

So to be very clear, in the past, in the old world, we never had an acquisition target. And that’s why we are not putting — we are not doing the same mistake now by putting a sales target. These €13 billion plus healthcare plus joint ventures will happen. So it’s not opportunistic. They will — we will be sold. The question on how fast we are selling it will be very much dependent on market environment. So we are not doing some fire sales here. And then, of course, the consequence of how fast we will reallocate the capital. But we are not doing the mistake to give you via call now a selling target like we never had an acquisition target. And to be very in your interest because a company with a target is coming under pressure to deliver, and this is not good for the price in both directions.

In other words, the CEO is communicating not just to shareholders but also to potential institutional counterparties. Clearly, the optimal path forward for asset disposal is via a JV structure. The benefits include large-size portfolio sales, tax advantages, and importantly Vonovia retains an ongoing income stream for property management.

Importantly, Vonovia is not in a rush to conclude any deals (no refinancing risks). However, I suspect that a transaction is likely to be done at a price around book value in the next few months and this will be a strong catalyst for the share price to rerate higher.

Final thoughts

In my view, Vonovia is a strong position to close the discount to its net asset value. I believe this is a generational opportunity to purchase a quality asset at more than a 50% discount to a conservative book value and at a forward dividend yield of ~6%.

I suspect the next catalyst will be an announcement of a JV structure and a significant sale of a portfolio cluster within the next few quarters.

Even if this is not announced, the continuous sale of non-core assets should achieve similar economics but over a longer time frame.

I remain very bullish and adding more to my position.

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