VNNVF - Vonovia: Updating My Short Thesis Following Q2 Results

2023-08-08 11:27:25 ET

Summary

• Q2, 2023 results confirm that the debt overhang issues are real and that it is extremely hard to stop the deteriorating performance when the interest rate environment is harsh.
• Despite major efforts on the balance sheet optimization front and relatively solid rental growth, the quarterly rate of change in the underlying performance is still negative.
• The worst thing is that Vonovia has not yet felt the real consequences of materially higher interest rates compared to what they are currently carrying on their books.
• This quarter we saw an uptick of 1 bp in the cost of financing, while there are still some solid ~300 basis points to go.
• My short thesis remains intact as I strongly believe that the interest rates will remain elevated for a longer period of time, which will, in turn, sooner or later percolate through Vonovia's books.

I'm reiterating my Strong Sell rating on Vonovia SE after reviewing the 2nd quarter results.

On March 28th, 2023, I issued a contrarian thesis against Vonovia SE (VONOY) (VNNVF) arguing that the Company has assumed just too much of a leverage to survive without making value-destructive share issuances.

After the Q1 report, I published an additional article in which I elaborated on several aspects that clearly send a signal of further pain to come.

Let me know quickly recap the main drivers of my bear thesis:

1. Portfolio yield significantly below the prevailing cost of financing rate. Before entering the 'higher-for-longer' scenario, Vonovia's ERPA net initial yield was 2.7%, while the average cost of debt was 1.5% (in 2022). This spread allowed to capture value for shareholders, but in the context of current interest rate levels at which Vonovia can secure its financing (ca. 5.5%), the spread is set to gradually become negative. Granted, there are some doable improvements to be made on the yield front, but the pace and the magnitude of rate of change in the financing costs are too aggressive relative to Vonovia's ability to enhance the top line. If the rates do not drop over the foreseeable future, which is highly unlikely at this point, Vonovia is set to enter a structural period of value destruction.
2. Too optimistic approach on fair value adjustments. Some of Vonovia's covenants are based on the asset values, which against the backdrop of considerable debt burden puts Vonovia in a position in which the incentives are biased towards maintaining the status quo on the fair value side. Since the ECB started increasing the interest rates from 0% to ~5% the FV adjustments have been extremely immaterial - just a couple of percentage points. Even if the top-line is still growing, such a movement in the underlying discount rate should per definition render a notable effect on the FV side. Plus, while it is clear that the public market can at times be irrational and overreact, the fact that since early 2022 the Stock is down ~55%, while FV adjustments have revolved just around several percentage points seems suspicious.
3. Painful refinancing process down the road. There is a huge gap between the current weighted average cost of financing rate recorded at Vonovia's books and the level the Company can obtain in the financing markets. Once the debt rollovers kick in, the interest cost component should render adverse effects on the underlying FFO. Here the difference between Vonovia and other REITs is the net debt to EBITDA factor, which in this case (for Vonovia) is too astronomical - i.e., ~16x. If we couple surging interest rate cost component with a huge base of debt and a tiny spread between net yield and cost of financing, it quickly becomes a nightmare scenario.
4. Deteriorating Q1, 2023. Other aspects, which enhanced my thesis after the publication of the initial article stemmed from Q1, 2023 performance. I strongly encourage you to take a glimpse into my recent article . So, here I will not go into details, but the key elements, which should be taken into account were: (1) ~ 20% decline in the FFO even though the weighted average cost of financing had not started to percolate through the system; (2) uptick in net debt to EBITDA despite management's efforts to bring down the leverage; (3) ambiguous disposal of €1.0 billion minority common equity participation in Südewo Portfolio, which if adjusted for pro-rata participation imply a significant discount relative to the book value.

Now, I have to admit that my "sell thesis" has been a complete disaster because of the strong total return performance by Vonovia - ~40% since the date of my first article (shares of VNNVF bottomed out at $17 when I published near the end of March 2023). However, looking at the Q2 figures, I have to also admit that my conviction about Vonovia's permanent value impairment has strengthened.

Essentially, it is the usual problem with shorting companies that whenever the valuations are depressed pricing in a justified decline in value, each positive announcement no matter how impactful it is can send the stock price materially higher.

For example, during Q2 Vonovia announced a buyback of its outstanding bonds at a 11% discount to the nominal value. Vonovia bought back ~ €1.0 billion. While this sounds good, if we contextualize this with the total debt burden, it explains just over 2% of the total debt. And the fact that Vonovia was able to buy back bonds at 11% discount was not a surprise at all since we could see how the public market were discounting the outstanding bonds before Q2. We could also interpret this as a confirmation that the cost of financing for Vonovia has gone up and is materially above the currently carried weighted average cost of financing.

So, let me now turn to the Q2, 2023 data and walk you through my thinking on why the bear case has just become more straightforward.

Synthesis of Q2

Given that my thesis is structural without any catalysts besides the "ECB factor", which could either destroy the Company completely or make it one of the best investments in the German market, for me it is critical to assess data in the rate of change terms. In other words, I predict a "gradual bleed" process, where quarter by quarter Vonovia marches closer to a massive equity dilution event (i.e., cost of financing over dwarfing the yield component and inflicting knock-on effects on the covenant side).

This is why I will focus on the quarter-to-quarter data comparing Q1, 2023 to Q2, 2023, which is the opposite approach to how Vonovia reflects its rate of change in the Q2 financial statements (they compare H1, 2023 to H2, 2022). If I was to look at the Q2, 2022 data and contrast it with Q2, 2023, the conclusions would be rather boring - negative performance across the board.

1. Group FFO per share increased by 2.8%, which was mostly driven by a solid performance in the rental segment.
2. Net cash interest expense increased by 3.1% despite bond buybacks.
3. LTV and net debt to EBITDA remained flat at very high levels - 46.6% and 16x, respectively.
4. Interest coverage decreased by 0.2x to 4.6x.
5. The number of shares went up by 2.2% due to scrip dividends.
6. Additional EUR 3 billion were recorded as a negative fair value adjustment.

As a result of all of this, the EPRA NTA declined from EUR 53.7 per share in Q1, 2023 to EUR 49.7 per share in Q2, 2023 (or 8% of a decline).

Vonovia's share price reaction upon the issuance of Q2 figures was negative 2%.

The key message that I would like to extract from the Q2 figures is the structural difficulty of Vonovia to ride out of the overleveraged situation when interest rates are so high. The technical term that we can see happening now is the "debt overhang situation" when the leverage has become so high that sooner or later there will be a default due to insufficient cash generation in the context of the embedded covenants (unless there is an equity dilution event).

As of YTD, Vonovia has made three sizeable divestitures (i.e., Sudewo portfolio, five notable properties in Berlin with a total of 1350 apartments, and exit from French JV) monetizing their assets and / or participation in JVs, it has introduced scrip dividends, which relaxes the pressure from dividend distributions and replaces that with share issuances, and it has used most of the received proceeds to retire some part of the outstanding bonds at a discount to the nominal. Plus, performance-wise Vonovia has done a solid job by capitalizing on the favourable supply and demand dynamics in the German residential space.

With all of this in mind, we can still see deteriorating performance on the underlying cash flow level and the corresponding coverage front.

And dear readers, the worst thing is that Vonovia has not yet felt tangible pressure from the higher interest rates. As of H1, 2023, the weighted average cost of debt stood at 1.6%, which is just 0.1% higher than in Q1, 2023.

Looking at Vonovia's publicly traded bonds, we can see YTM levels of around 5 - 5.5%. Loan (or bank) financing terms are a bit more favourable hovering around 4 - 4.5%.

If we tripled or aligned Vonovia's cost of financing level to what the Company can actually get in the market, there would be a direct breach of ICR covenant (i.e., ICR falling below 1.8x).

To breach the LTV covenant it would take a 25% downward correction in asset fair values. In my opinion, this is unlikely (although the market is pricing in a more aggressive drop) due to the lack of supply of residential units in Germany.

Final thoughts

Q2, 2023 results reveal in how difficult situation Vonovia is, where aggressive deleveraging efforts in conjunction with strong like-for-like performance is not sufficient to offset the consequences from astronomical leverage.

Even after bond repurchases, monetization of JVs and / or several residential unit blocks, and improved rents, the results have worsened.

The most shocking thing is that this has taken place despite the average cost of financing level of Vonovia going up by only 1 basis point. In reality, considering the prevailing market terms, there are some ~ 300 basis points to go.

Granted, this will not happen overnight as Vonovia has already paid off notable portion of 2023 maturities and will likely make huge efforts to do the same thing for 2024 maturities. The current debt maturity profile is rather well-staggered. Plus, Vonovia has entered several swap agreements fixing rates on favourable terms for the next two years on some portion of the outstanding debt that was still variable before Q2, 2023.

However, if the 'higher for longer' scenario really takes place, Vonovia will sooner or later face significant consequences via the breach of covenants or just considerably squeezed margins. And here the key area of concern is the ICR coverage ratio. If we assume that Vonovia will eventually land its cost of financing rate close to the current market level, the ICR would clearly fall under the stipulated (minimal) level of 1.8x.

In my humble opinion, the short thesis boils down to the path that ECB will be taking over the next couple of years. If we have status quo or higher rates, it will eventually erode the current headroom in the ICR coverage or significantly squeeze the free cash flows. If rates go down, Vonovia should survive without major share issuances, and bulls would enjoy decent gains from recovery in the multiple.

The other key risk, which has to be considered for bears is that this will be a slow process as the current debt maturity profile of Vonovia protects the cash flows from rapid convergence to the market level cost of financing. This coupled with relatively depressed multiple can cause serious damage for the short sellers whenever there is something positive announced (no matter how material).

Finally, it is great to see that some external analysts have started to believe in the short thesis as well. A month ago analysts at Stifel downgraded Vonovia to "sell" from "hold", arguing that the Company is subject to "a protracted hangover" after "a seemingly endless party of growth fuelled by ever cheaper finance". Almost the exact wording that I used in my very first short article on Vonovia four months ago.

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