Heimstaden - Changing Tact - Positioning
All,
Please find our updated analysis here.
Our previous emails have highlighted the age-old problem of mismatch of assets and liabilities and the dire consequences for equity holders. An old story, but one been repeated at many European REIT companies. And it is this mismatch and the fact that Hybrids are equity-like instruments, that the outlook for Heimstaden Bostad’s Hybrids has deteriorated despite the improvement in the underlying operations. The driving force behind the fortunes of Heimstaden Bostad’s hybrids is underlying rates, and as mentioned in emails earlier this year, Hybrid holders had benefited from underlying tightening in rates. Now the situation has changed.
Investment Rationale:
- We initiated with a 1% long position in the 2026 Hybrids at 48% in late September 2023. Subsequently, following the announcement of a corruption investigation by the Swedish FSA at its shareholders, the bonds fell to the high 30s. They subsequently recovered into year-end as more details emerged, but mainly on underlying rate movement. We increased the position to a 4% long position in the same Hybrids at 61.5% in early March.
- However, following further analysis, we are exiting the total position at the current price, of 63%. At current prices there is still an expectation that a deal is forthcoming on the Hybrids. Our analysis shows that dealing with the hybrids does not have sufficient impact on the ICR and therefore not top priority for Heimstaden management. Therefore we believe management will focus on either an equity raise or more likely asset sale. Both of these theoretically are positive for the Hybrids but any deal is likely to be subject to negotiations capturing some discount on the hybrids.
- The main reason for selling is we feel the hybrids are likely to drift over the coming months as no deal is in the offering. The hybrid bonds trade rich to their theoretical spread under the scenario where they are not exchanged. Therefore we are going to continue to monitor the situation, but exit the name at this time.
- There are no operational reasons for the exit - in fact, the first slide of Heimstaden Bostad's presentation leads with the phrase - Q1 2024: A Turning Point? But the reality is, with base rates starting to increase, and no concrete evidence that Heimstaden Bostad's management is focused on dealing with the Hybrids, we feel the expectation of a deal has got ahead of reality. Our further analysis highlights that even when dealing with the Hybrids similar to AroundTown or Unibail, Heimstaden Bostad will still fail the ICR coverage ratio >1.6x during FY25.
- Heimstaden Bostad needs to either raise fresh equity and/or do a medium to large asset sale (either 50% or in full) to maintain its Investment Grade rating.
The positives: Underlying Results:
- Operationally, Heimstaden Bostad continues to show resilient numbers, with like-for-like rental growth of 5%, leading to a Net Operating Income growth. This growth has offset the underlying expanding yields, leading to a 0.8% increase in property values.
- European Housing Prices are starting to rebound, with 8 out of the 9 markets Heimstaden involved in rebounding from cyclical lows and four even exceeding their previous highs. This renewed confidence in housing prices has allowed Heimstaden to achieve a 30% gross premium on their privatisation program, which will accelerate in the coming months. This enables Heimstaden Bostad to forecast a stable ICR at c.1.6x, partially due to using the proceeds from the privatisation program for liability management and Heimstaden Bostad’s hedging profile.
But But But…
- The longevity of Heimstaden Bostad centres on its maintaining its Investment Grade rating which is ultimately driven by maintaining an ICR >1.6x. We have revised our model, adjusting proceeds from the Company’s privatisation program producing a forecast of ICR ratios for the next 11 quarters.
- Under the most advantageous scenario of extending the hybrids (re-issuing at 7.5% coupons complying with S&P’s methodology of 50% equity), the ICR falls below 1.6x in Q2 2025. Note this is also using the other most bullish scenario that all upcoming unsecured debt in FY24 and FY25 is replaced with cheaper secured debt financing at 5%.
- Therefore even when dealing with the Hybrids via an extension (tender and exchange technically), the Company will still fail its ICR and lose its Investment Grade ratings.
So, what are the options:
- Option 1 - equity injection: A SEK10bn equity injection in H2 2024 would ensure compliance with ICR ratio out to mid FY26. Under this scenario refinancing rates would reduce and therefore ICR ratio would be >1.6x out to the end of FY26.
- This option may be the easiest to model but the probability of such an injection appears to have diminished. In our note, in early March we had seen a “self-help" path for Heimstaden Bostad and therefore reduced our expectation of an equity cheque. We maintain our view that there is equity value in Bostad, but only if Heimstaden Bostad maintains its IG rating. So therefore we would expect an equity raising would be successful if it was the last resort. However, while other options remain, we assign a low probability to an equity raise.
- Option 2 - asset sale: Hypothetically, a portfolio sale of SEK20bn at c.10% discount to NAV would allow Heimstaden Bostad to meet its ICR ratio out to mid FY26. We have modelled the asset sale not to be completed until H1 2025.
- This has become our base case scenario given the outlook for rates and the evolution of interest costs for Heimstaden Bostad and this scenario ensures that Heimstaden Bostad maintains its IG rating. Our example (asset sale in H1 FY25) demonstrates there is no immediate urgency to consummate a deal in FY24.
Impact on Hybrids:
- Initially, an equity raise and/or asset sale would be positive for all credit instruments, including the hybrids. However, under an equity raise, any new equity providers would likely link any new cash to capturing some of the discount on the Hybrids and not pass all the benefits of the equity raise to the Hybrid holders.
- The same is true of an asset sale, albeit more difficult to link any asset sale to a sub-par tender for Hybrid holders. But our base case of an asset sale is unlikely to materialise in the short-term, and therefore the hybrids should trade off to low 60’s/high 50’s in line with a running yield of c. 11%.
Heimstaden AB:
- Heimstaden AB has sufficient liquidity to meet the maturities of its two SEK 2025 bonds. However, recovery for the Euro bonds and hybrids is reliant on dividends and asset coverage from Heimstaden Bostad. Without a transaction (asset sale or otherwise) at Heimstaden Bostad, there is no possibility of debt repayment at AB. Therefore the March 2026 Euro bond maturity creates a deadline for Bostad to do a deal.
- It is difficult to imagine a recovery at AB without the hybrids also benefiting, and therefore we would reiterate our view it is better to be closer to the asset at Bostad level, even in Hybrid form. We don’t however see any event of default in the next two years at AB, and would view the coupon on the Euro bonds to be relatively safe. The coupon is low though and only provides c. 6-7% running yield.
Other Issues:
- Fredensborg, the parent entity of Heimstaden AB, has established a residential specialist manager called Heim Global Investor. The firm is expected to raise institutional capital for investment funds with residential strategies and is currently marketing its first vehicles. We are a little sceptical of the motivations of this new entity and are contemplating this new entity buying some assets from Heimstaden Bostad as part of any asset sales.
- The investigation into Alecta’s investment in Heimstaden Bostad continues with no end in sight. The Swedish financial regulator launched an investigation amid allegations of a lack of vigilance and governance in their investment.
Happy to discuss.
Tomás