Interactive Investor

Stockwatch: two income stocks to keep your eye on

Analyst Edmond Jackson asks whether a mooted merger will benefit both companies as he calibrates macro gloom.

13th February 2024 11:08

by Edmond Jackson from interactive investor

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Investor watching two stocks 600

You would think the initiator of a merger or takeover is the party likely to benefit most. Yet at least in terms of market reaction so far, in the current example of Tritax Big Box Ord (LSE:BBOX) proposing an all-share offer for UK Commercial Property REIT Ord (LSE:UKCM), Tritax shares are down 4% to 154p, while UKCM is up 4% to 67p. Analyst views published so far are sceptical. So, is there logic?

Tritax appears the suitor as the larger partner: a circa £3 billion company owning large warehouses typically near motorways, with tenants such as Ocado, Amazon and B&Q. A substantial exposure to the digital economy future-proofs it relative to £830 million UKCM, which is spread more generally across shopping centres and offices besides distribution centres.

Scepticism exists because Tritax would appear to be diluting its higher-quality asset base given that around 40% of UKCM’s portfolio is non-logistical and Tritax has, in the decade that I have followed it, been in a strong enough position to exact upwards-only rent reviews.

Tritax’s declared rationale is “bringing together assets worth around £6.3 billion, focused on logistics”, which implies rationalising UKCM’s portfolio to retain what complements.

The possible offer announcement entertains “a high-quality logistics portfolio across a broader range of property sizes and tenant users, from mega-boxes to smaller strategically located logistics assets within key urban locations”. It sounds as if Tritax sees scope to add “last-mile” possibly urban-type situations to complement its motorway-side assets; also retail space that could be adapted for warehousing. But there looks to be quite some rationalisation required of UKCM, and is now – with the UK teetering on recession – the right time to be a vendor of commercial property?

Modest boardroom rift at UKCM over the proposed deal

One report has cited the chair of UKCM not being in favour of the possible all-share offer, by way of 0.444 new Tritax shares for each UKCM share. But he has been outvoted four-to-one.

My view is that traditional commercial property – offices and shops – is a difficult area now, given that working from home has altered the demand curve for a lot of offices; and the digital economy has decimated many high streets, even retail outlets. There just isn't demand enough for the extent of commercial property supplied.

It may explain UKCM’s struggling to establish capital growth since the 2008 crisis; its stock chart has been profoundly sideways-volatile. And while offering a 3%-5% yield over this time, Tritax has delivered nearer 5% with better-established earnings cover. Comparative tables also show relatively weaker return on total capital percentages although both companies’ figures suffer occasionally from property write-downs going through the income statement.  

Tritax Big Box REIT - financial summary 
Year ended 31 Dec

Net rental income (£million)18.643.874.6108133144162185206
Operating profit (£m)46.71431102652771814921,013-580
Net profit (£m)41.813491.9248253141449973-599
EPS reported (p)14.721.010.419.417.48.426.355.0-32.1
EPS normalised (p)14.721.010.419.717.58.226.355.1-32.0
Operating cashflow/share (p)
Capital expenditure/share (p)
Free cash flow/share (p)
Dividends/share (p)
Covered by earnings (x)
Return on total capital (%)5.710.09.04.911.518.5-11.6
Return on equity (%)14.812.15.916.427.8-16.1
Cash (£m)98.659.2165.071.947.421.257.670.947.4
Net debt (£m)1023183686377731,1271,2861,2741,567
Net asset value/share (p)104121126140151150170218179
EPRA net asset value/share (p)108125129142153152176223180

Source: historic company REFS & company accounts

UK Commercial Property REIT - financial summary
Year ended 31 Dec

Net rental income (£million)16691.335.125.9266-189
Operating profit (£m)14366.810.8-2.1244-213
Net profit (£m)13253.01.6-10.3236-222
EPS reported (p)
EPS normalised (p)
Operating cashflow/share (p)
Capital expenditure/share (p)
Free cash flow/share (p)
Dividends/share (p)
Covered by earnings (x)
Return on total capital (%)
Cash (£m)72.443.549.012342.130.9
Net debt (£m)17720619875.1206261
Net asset value/share (p)92.893.389.886.7102.079.7

Source: company accounts.

Some relative dissimilarity appears to explain the implied 71p a share, valuation for UKCM in this possible offer, being at a 12% discount to UKCM 81p last declared, according to European Real Estate Association (EPRA) methodology. Although my experience of watching property stocks since the 1980s has been that you see a premium to estimated/accounted values only at exceptional times, such as when a specialist property concept is in high demand. Most of the time – and like the way residential property sales are struck – a discount is the norm.

At 154p, even Tritax trades at a 16% discount to last June’s 183p a share, tangible net asset value as defined by EPRA; although the stock has dropped from over 160p since the merger has been mooted. All mergers and acquisitions add risk, and a debate is already under way between the two company’s shareholders as to who could benefit most.

It is not the first overture towards UKCM. Last November, a similar “possible” all-share merger was declared with Picton Property Income Ltd (LSE:PCTN), a £340 million small-cap REIT owning diversified commercial property. It was scuppered later that month when Phoenix Life (owning 43% of UKCM) said it did not support the proposed terms.

Tritax does rather need a financial step change

As a long-term follower of Tritax, I find its story does need refreshing.

When I drew attention to it as a “buy” from 100p soon after flotation in late 2013, big box logistical assets were a new and timely concept for the stock market. Not only was there demand for such space – enabling upwards-only rent reviews – but institutions prized equity in a specialist manager, rather than them owning warehouses directly.

There followed a strong run to 250p by spring 2022, helped by Covid lockdowns spurring the digital economy. But as expectations shifted towards higher interest rates to contain inflation, Tritax plunged near 130p that October. Subsequent 2022 accounts showed a £760 million fair-value drop in group investment property values; otherwise operating profit had edged up 3% to £183 million. An additional £40 million interest charge on debt meant a net loss of around £600 million given valuation changes affect income statements.

While the stock joined the “everything rally” from last November and ended 2023 around 170p, it has looked as if it needs a bold initiative. I am no expert on what big box logistics’ space is precisely left in the UK, but with Tritax having gone for it aggressively over a decade, attracting a few imitators, additional space could be getting in short supply.

Management has otherwise recently just been tidying its portfolio: selling six assets for £327 million – “being recycled into higher-returning opportunities, primarily within the development pipeline delivering a 6-8% yield, or investment acquisitions”.

The Tritax balance sheet shows why debt is not being added

End of last June, £3.4 billion net assets supported £1.5 billion net debt, all longer term, hence net gearing around 44%. UKCM, meanwhile, had just £196 million net debt relative to £1.1 billion net assets, hence gearing below 19%.

If interest rates stay higher for longer, a merged group would not want the higher costs implied. At least with these levels of debt, it would not be high risk financially and Tritax has the option to trim debt with UKCM disposals.

UKCM shareholders are at least promised to receive at least a 2.8p a share dividend as before, equivalent to a 4.2% yield at the current market price. But the real question is what kind of medium to longer-term outcome there is here for total shareholder return. Does the mooted merger benefit both sides?

A mildly net positive development for both companies

I think circumstances do favour this combination. Tritax’s big box warehousing concept is mature as a UK growth play; it needs a new angle. UKCM ought to benefit from divesting offices and shops.

My concern is this leads to a split in reported and normalised earnings as the merged group tries to take investors’ eyes off integration and disposal costs; although surely disposals are part of normal operations for such property groups?   

Let us also see how UK economic data shapes up this week. I am not comfortable rating commercial property a “buy” if the UK is entering recession. But the merger looks a net positive development for both companies, hence a “hold” stance being appropriate for now and watching what evolves. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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