CLS Holdings: A 23% Discount To NAV And A Boss With A £294m Shareholding

15 July 2016
By Maynard Paton

Today I’m continuing my hunt for Watch List shares with a look at CLS Holdings (CLI).

Here are the initial attractions that prompted this research:

* Illustrious financial progress: The accounts exhibit a 20-year history of rising net asset value alongside a remarkable record of substantial share buybacks.

* Owner-orientated boardroom: The company’s founder retains a £294m/51% stake and continues to serve as an executive director.

* Interesting valuation: The shares have fallen 30% from their high and currently trade at a 23% discount to the group’s 2015 net asset value.

As usual, I’m applying a question-and-answer template to help me pinpoint companies that match the criteria set out in How I Invest. I’m looking for as many Yes answers as possible.

Activity: Commercial property landlord
Website: www.clsholdings.com
Share price: £14
Shares in issue: 41,151,086
Market capitalisation: £576m

Does the business boast a respectable track record?

Yes.

CLI was established as Central London Securities in 1987 by Swedish entrepreneur Sten Mortstedt. The group has since acquired London properties that now boast an £800m market value, and during 2013 spent an initial £100m on buildings elsewhere in the UK.

Sizeable European expansion started with Sweden in 1998, then France in 2000 and then Germany in 2006. At the end of 2015, overseas assets totalled £525m to represent 37% of the group’s estate.

The vast majority of CLI’s portfolio consists of freehold offices, with the group claiming to target “modern, high-quality well-let properties in good non-prime locations in key European cities”.

CLI also states it is “an active manager” that “repositions properties through lease restructuring, refurbishments and developments” and operates with “an opportunistic approach to acquisition, development and disposal”.

Some 41% of the group’s rent comes from various UK and European government departments, with a further 29% from large corporations such as Cap Gemini, BAE Systems and Honda.

CLI floated in 1994 and Companies House has annual reports going back to 1992. The archives show that revenue was £25m, net asset value (NAV) was £131m and the dividend was a pro-rata 4.9p per share during the group’s first year on the stock market.

Jump forward to 2015, and revenue had swollen to £119m to help bolster NAV to £763m. Meanwhile, regular share buybacks replaced dividends from 1998, and the equivalent ‘payment’ to shareholders since the float has subsequently multiplied nine-fold to 45.3p per share.

While CLI’s revenue advances and profit growth have been quite acceptable in absolute terms, progress has been far more impressive on a per-share basis:

	2010 to 2015	2005 to 2015	2000 to 2015	1995 to 2015
Revenue CAGR	8.5%	3.4%	6.3%	7.1%
Operating profit CAGR	6.1%	1.9%	4.3%	5.2%
Net asset value CAGR	16.3%	8.0%	5.3%	8.9%
Net asset value per share CAGR	18.7%	15.1%	12.1%	14.1%
Dividend/buyback per share CAGR	13.9%	7.1%	10.9%	11.4%

Some very smart property sales and shrewd share buybacks, particularly during the 2008 banking crash, have done wonders for CLI’s NAV per share figures.

In fact, assets worth about £200m were sold during the early part of 2008, which reduced debts by £100m that year and allowed £70m or so to be spent on buybacks at less than £4 a share. NAV per share dropped 16% during 2008 — CLI’s only setback of note during its quoted history.

The last five years have shown CLI enjoying growing rents and rebounding property values:

Year to 31 December	2011	2012	2013	2014	2015
Net asset value (£m)	367.5	417.1	480.9	652.9	762.8
Net asset value per share (p)	818	963	1,094	1,521	1,810
Revenue (£m)	80.1	80.2	91.2	99.6	118.9
Operating profit (£m)	49.5	49.5	57.2	63.7	65.7
Profit on property disposal (£m)	-	-	4.5	8.7	4.3
Net valuation gain (£m)	18.0	16.2	(0.2)	186.0	98.0
Net finance expense (£m)	(32.5)	(9.2)	(20.9)	(23.0)	(17.5)
Other items (£m)	2.7	(0.4)	30.8	1.4	0.7
Pre-tax profit (£m)	37.7	56.1	71.4	236.8	151.2
Earnings per share (p)	82	106	147	449	306
Buyback per share (p)	27.2	30.2	34.7	37.0	45.3

I’m pleased the accounts have not been full of adverse exceptional items, with the only one-off of any size involving a £22m goodwill write-down during 2008.

Has the business grown mostly without acquisition?

Yes.

CLI’s expansion has been almost entirely dependent on direct property investment alongside purchasing various minority stakes in other property ventures.

As far as I can tell, the group’s sole non-property acquisition involved a Swedish youth community website, the goodwill for which (£22m) was written off entirely during 2008. The latest balance sheet showed goodwill of just £1m.

Has the business mostly self-funded its growth?

Yes.

The 2015 balance sheet displays share capital of £94m versus earnings retained by the business of £584m. The last issue of shares relating to a property investment occurred 20 years ago and cost £2m.

Does the business possess an asset-strong balance sheet? 

Sort of.

CLI’s 2015 balance sheet carried investment property of £1,367m, other property worth £138m, cash of £101m, various corporate bonds worth £73m and a Swedish equity investment valued at £43m

Those assets of £1,722m twice cover total debt of £796m, which does not look too onerous to me — although there are other quoted commercial landlords with much greater asset-to-debt ratios.

Nonetheless, CLI’s total debt for 2015 is at the same level as it was in 2007, while between 2005 and 2013 the asset base often covered total debt by a much tighter 1.7x. Yet the relatively greater amount of debt back then did not harm the firm’s progress.

What’s more, the current 3.4% blended rate of interest on CLI’s debt does seem rather attractive, with interest on loans taken out last year payable at just 2.5%.

The 3.4% overall debt cost compares to the 6% current rental yield on CLI’s estate — the 260 basis-point difference comfortably exceeding the group’s 200 basis-point minimum benchmark.

At present, about 60% of CLI’s borrowings are on a floating rate.

It is also worth bearing in mind that 85 of CLI’s 115 properties are operated via single purpose vehicles, so debt problems generally can’t escalate beyond the associated property and impact the rest of the group.

I should add that CLI does not have any legacy pension issues.

Does the business convert profits into free cash?

Yes.

Year to 31 December	2011	2012	2013	2014	2015
Operating profit (£m)	49.5	49.5	57.2	63.7	65.7
Depreciation and amortisation (£m)	0.2	0.2	0.3	0.3	1.3
Non-property capital expenditure (£m)	(0.2)	(0.2)	(0.3)	(0.4)	(0.2)
Working-capital movement (£m)	4.3	4.4	6.4	(10.2)	9.1
Net debt (£m)	(477.9)	(457.5)	(560.7)	(542.2)	(573.8)

Cash expenditure on non-property tangible assets is negligible, while working-capital movements are generally quite favourable.

Does the business enjoy a competitive advantage?

Possibly.

Similar to most property companies, CLI manages to convert a high proportion of revenue into profit. The operating margin was 55% during 2015 and in previous years has topped 60%.

Any long-lasting competitive advantage, however, will surely revolve around the boardroom.

Anyone can buy London office blocks if they have deep enough pockets, but making an acceptable return through subsequent management initiatives is the hard part.

I can only surmise that the aforementioned financial history of CLI signals the executives having the knack for successful property ownership and management.

In fact, I’d say management’s decision to dispose of various buildings for £200m in early 2008 — and then buy back £70m of shares during that year’s market lows — probably overshadows every property ‘bargain’ the group has ever bought.

Does the business produce a respectable return on equity?

Maybe.

Return on average equity for 2015 was £130m/£708m = 18%. An attractive figure, especially in the property sector where assets tend to produce relatively low yields at present. That said, last year’s bumper return was supported by large valuation gains, which won’t be repeated every year.

During the last ten years, the return on average equity figure has fluctuated between -22% and 34%, and has averaged 12%.

My own calculations indicate that, between 2005 and 2015, CLI’s NAV improved by £408m while a further £214m was spent on share buybacks. The resulting £622m return on the original 2005 NAV of £355m indicates a 10-11% compound average return.

Does the business employ capable executives?

Yes.

The aforementioned Sten Mortstedt served as CLI’s executive chairman between the flotation and March 2016, and can therefore take a lot of credit for the group’s illustrious track record.

Although Mr Mortstedt has now relinquished his chairmanship duties, he remains an executive and I would like to think he still has a very active role in the business. The replacement executive chairman has worked for CLI since 1999 and has served as a board executive since 2008.

Something to bear in mind with Mr Mortstedt is his age — he turned 76 earlier this year.

So perhaps him stepping down as chairman was the first phase towards his eventual retirement from the board. On that note, I see two younger Mortstedt family members serve as non-execs.

Does the business employ good value-for-money executives?

Probably.

Mr Mortstedt received a £359k basic salary and other fees (for “consultancy services which related to specific advice”) of £425k during 2015.

I guess the £784k total is not completely outrageous when CLI’s operating profit that year was £66m.

Mr Mortstedt’s salary and other fees have compounded at a robust 10% during the last five years and 11% since the flotation.

But I doubt there will be many complaints from long-time shareholders about his rising remuneration, given the group’s dividend/buyback ‘payment’ and NAV per share have compounded at similar rates (or more) during the same time.

I like the fact that Mr Mortstedt does not collect a bonus or receive any pension contributions. I also like how all the directors have made do without an option scheme since 2007.

Does the business employ owner-orientated executives?

Yes.

It is probably no coincidence that Mr Mortstedt’s accomplishments at CLI have been achieved with him owning a substantial portion of the business.

His ownership has bobbed between 44% and 54% since the flotation, and at the last count he enjoyed a 51% shareholding with a £294m market value. A family relation controls a further 6% of the group.

Mr Mortstedt’s percentage shareholding has varied due to CLI’s regular buybacks and how many shares he is willing to tender each year.

It is notable that Mr Mortstedt was happy to own 44% of the group during the credit boom of 2005-2006, only then to increase his holding to 54% during the banking crash by not tendering as many shares for buybacks.

Since the buybacks commenced in 1998, CLI’s share count has reduced by an impressive 60% at a cost of £366m. My sums suggest the average price paid has been less than £6 a share.

Does the business enjoy reasonable growth prospects?

Maybe.

Annual results in March provided a relatively optimistic outlook:

“The forthcoming “Brexit” referendum may cause some temporary political and economic uncertainty in the UK, but beyond this we expect the UK economy to continue to grow. In addition, the commercial property market, particularly outside of the West End and City of London, should perform well in 2016, reflecting an excess of tenant demand over commercial office supply.

The economy in the Eurozone continues gradually to recover and we believe our overseas assets will continue to benefit from record low interest rates and a pick-up in occupier demand.

With our proven and successful business model, a strong balance sheet, ample liquid resources and our highly skilled and committed staff, the Group is well positioned to continue to deliver value to our shareholders and to benefit from the challenges and opportunities which lie ahead.”

The purchase of two German properties earlier this month for a combined €50m suggests the group hasn’t been too fazed by Brexit just yet.

Mind you, just how London property valuations will move during the next year or two remains to be seen.

I mean, CLI has close to 60% of its investment properties (by market value) located In London, while 2015 valuations in the UK capital were based on 5% rental yields versus 7% just two years ago.

I also reckon the market value of CLI’s London portfolio on a per square metre basis has advanced by an incredible 50% during the last three years.

All told, I feel CLI’s London properties may struggle to sustain their latest valuations should the economy wobble, buyers disappear and rental yields increase.

Does the share price stand a good chance of becoming a bargain?

I think so.

The £14 shares already trade at a 23% discount to the £18.10 per share NAV of 2015.

Coincidentally, that 23% discount is just about halfway between the 30% premium peak seen last year and the brief 80% discount witnessed right at the bottom of the banking crash.

Another way of looking at CLI’s value is from a return on equity standpoint.

Assuming CLI can earn an average of 10% a year from its £763m net asset base, typical annual earnings would be £1.81 per share — represented by a mix of rental profit and valuation gains.

In theory at least, enjoying £1.81 per share a year from a £14 purchase is equivalent to a worthwhile 13% annual return.

Meanwhile, the trailing 45.3p per share spent on buybacks last year supports an annual 3.2% ‘return’ to shareholders.

Is it worth watching CLS Holdings?

Yes.

There’s a lot to like about CLS. It seems to be a simple, dependable and inexpensive business — three traits that often combine to make a good share investment.

Of particular note is the distinguished track record — including the fact this property business managed to sidestep the banking crash entirely. That in itself tells you all you need to know about the skill and talent of founder Sten Mortstedt.

Indeed, I trust that Mr Mortstedt, at 76, remains motivated to at least sustain the value of his £294m shareholding.

I guess the main downside here is that a material part of CLI’s recent progress has been supported by rising London property valuations. Extending those gains, at least in the near term, may be hard to achieve.

Furthermore, while CLI’s progress on a per share basis has also been extremely impressive, it remains to be seen whether the group can repeat further bargain buybacks on a sizeable scale.

All told, though, CLI appears more than good enough for my watch list… and maybe one day for my portfolio.

Maynard Paton

Disclosure: Maynard does not own shares in CLS Holdings.