Vonovia: Slowly But Surely Closer To Fallen Angel Status (VNNVF)

On March 28^th, 2023, I went against the crowd and assigned a clear sell rating for Vonovia SE (OTCPK:VONOY) (OTCPK:VNNVF), while all Seeking Alpha analysts, who reported on VONOY had a unanimous consensus for going long on the Company. Since the issuance of my article, the stock price has gone up by ~20% and there have been two additional analysts labeling the stock as a buy.

There has not been any major announcement or change in the macro circumstances that could justify the uptick in stock price. Besides VONOY announcing €1.0 billion of asset disposal (which actually reveals a ton of red flags – see below in the article), the headwinds for VONOY have actually become more pronounced – e.g., a formation of strong consensus towards 7th interest rate hike by ECB putting an extra strain on VONOY’s cash flows and significantly depressed German real estate M&A market.

In my opinion, the market has overreacted on the news about VONOY’s recent asset disposals and that whenever share price is drastically depressed, there tends to be a significant share price volatility until a point when massive equity dilution takes place.

Now, before going into the details of Q1 figures, let me recap the key thesis of my previous article in which it was indicated that VONOY is on the brink on a permanent value impairment.

1. Extremely tiny ERPA net yield of 2.7% (net annualized yield against the gross fair value of portfolio), which is significantly below VONOY’s cost of financing leading to situation in which the cash flow generation is not sufficient to service lenders and cover maintenance CapEx.
2. Against the backdrop of VONOY’s on the run bond YTM level of ~6% and the prevailing weighted average cost of debt recorded in the books at 1.5% it is only a matter of time until debt overhang issue materializes, which will force Vonovia to either carry out massive divestitures or source in expensive equity.
3. The net debt to EBITDA metric of ~16x in conjunction with VONOY’s aggressive fair value methodology should eventually render the fulfillment of the existing debt covenants impossible unless, again, a sizeable equity infusion exercise is conducted.

I encourage you to take a look at previous article for more details as it will provide a better context for the following argumentation and help connect the dots how the underlying bear thesis is gradually playing out.

Q1 results confirm that the market is rational

In finance a term “fallen angel” is associated with bond issuers and / or specific bond issuances that have been downgraded from investment grade to junk territory. In my opinion, this is inevitable in VONOY’s case unless the ECB suddenly embarks on a totally different policy stance and start to cut rates in an accelerated fashion. This is, however, highly unlikely and completely opposite to what the prevailing consensus indicates.

Below I will highlight the key financial items that reflect where VONOY currently stands and at what direction it is heading.

1. The FFO per share has declined by ~20% relative to the Q1, 2022. The most shocking thing is that this decline is not explained by the recent asset disposals since the finalization of transactions are expected to occur in the subsequent months. The key drivers behind the negative result were significantly higher operating costs associated with general cost inflation factors, an uptick in interest expense and slightly lower occupancy rate.
2. An additional fact, which make the whole performance more worrisome is that the Company has not yet incurred materially higher cost of financing terms given currently distant maturity profiles. As of Q1, 2023, the weighted average cost of debt still stood at ~1.5%, which is far below the market level rates, which VONOY can access. So, on top of the current challenges in the FFO front, there are notable hardships waiting around the corner that will inevitably put an additional strain on the underlying cash flow generation.
3. Despite VONOY’s promise and dedicated efforts to reduce the leverage, the Company’s capital structure just become a bit more indebted. Net debt to EBITDA rose from already astronomical level of 15.8x to 16.1x. To put this in the context of U.S. equity residential REITs, VONOY’s leverage profile is more than twice as indebted as for the comparable U.S. peers that on average carry a net debt to EBITDA of 7.5x. Similarly, the LTV metric also increased from 45.1% to 46.1% (all this on a quarter on quarter basis). Please, notice a very interest relationship here. The LTV of 46.1% in theory and looking at common benchmark levels is deemed a healthy level, while the net debt to EBITDA of ~16x is commonly considered totally out whack. Typically, when you have a healthy LTV you tend to have a healthy net debt to EBITDA as well. Well, in VONOY’s case the relationship does not hold because the underlying profitability (cash generation) of the assets is insignificant and way too low to justify the financing costs even at the 1.5% level. Again, this confirms my thesis of imminent debt overhang issue.
4. Finally, it is great to see that also my thesis on imminent FV corrections starts to slowly materialize. In Q1, 2023, VONOY recorded a negative FV adjustment of ~3.5% on its total portfolio holdings. My expectation is the Management will continue the process of slowly making FV corrections against the backdrop of surging interest costs and an additional ECB rate hike around the corner.

In essence, the Q1 was a complete disaster for the Company, and the outlook looks even more pessimistic given that VONOY has not even started to absorb the effects from considerably higher cost of financing levels. Yet, we have to also remember that this year VONOY will likely avoid a significant increase in its weighted average cost of debt level since 2023 maturities will most likely be covered by the recent asset disposals (and not refinanced). Nevertheless, sooner or later the Company will have to face the challenge with higher interest costs and while additional asset disposals can defer the refinancing moments, they also inflict (and inherently) damage on the FFO due reduced assets base from which to generate cash.

Now when we have a clear understanding of Q1 financials, let me pinpoint to two important highlights and help you explain what risks they imply.

Disposal of €1.0 billion Minority Common Equity Participation in Südewo Portfolio sends major warning signals

While the sale of minority stake to Apollo might optically seem like a very favourable deal, if we peel back the onion a bit, there are many red-flags associated with this transaction.

According to the Management, the sale was conducted at 5% below the NAV based on Q4, 2022 values. In the context of current VONOY’s Price-to-Book multiple of 0.49x, a 5% discount might seem as a clear indicative that there is a huge disconnect between what the market thinks and what actually is happening on the ground.

Unfortunately, in my opinion, this is just a pure marketing, which creates false optimism among financial market participants, who are not willing to dig a bit deeper.

First, as a part of this deal it was negotiated that Apollo receives rights to dividends from the Südewo Portfolio that correspond to a higher pro-rata share than what is warranted by the level of equity ownership. There is a lot of details disclosed about the transaction when it comes to clauses, which put VONOY in a good light, but, unfortunately, there is no information given about the level of Apollo’s rights to future dividends. Theoretically, Apollo could carry from 31% to 100% of ownership rights towards future cash flow streams from Südewo. This is pure speculation, but it would not make sense to negotiate such clause and waste resources on expensive advisers to achieve only a slightly higher share than what could be warranted under conventional terms.

Now, if we take a step back and return to the fact that the part of portfolio was sold at 5% discount to NAV. This percentage correctly reflects the “form” but completely misses and does not capture the “substance”. The real valuation of portfolio from the VONOY’s is much worse. If you factor into a DCF model an assumption that the free cash flows (or in this case dividends) can be accessed at a lower extent that what is justified by the equity ownership level, the valuation will get drastically reduced (depending on the magnitude in the difference between equity ownership and rights to dividends). Again, unfortunately, VONOY has not disclosed the portion of dividends that goes to Apollo, so we can only speculate, but the key takeaway is clear – the real valuation that VONOY got is at a notably steeper discount to NAV than 5%.

Second, VONOY will continue incur all of the costs associated with the partially sold portfolio. In other words, we should expect lower revenue from these buildings, but the exact same level of operating expense (if not higher given the presence of significant cost inflation factors as also indicated in Q1 figures).

Third, the partially sold portfolio is located in the southwestern state of Baden-Württemberg, which has above average rents and a very strong demand for residential units. This might indicate that VONOY can only sell its prime assets that embody very solid prospects on future cash flow generation. If VONOY follows its aggressive disposal strategy as it is currently outlined in the management report, we could arrive at point, where VONOY has no attractive asset to sell and where its portfolio is comprised on structurally less attractive (lower yielding) properties.

Finally, VONOY has in many instances articulated that it holds a call option to repurchase the Apollo’s stake at an IRR of 6.95%-8.30% (including dividends received). Theoretically, holding such optionality is deemed positive. However, in my opinion, the value of this call option is zero as in the context of VONOY leverage profile and struggles on the cash flow side, the chances of the Company finding extra ~ €1 billion to buy out the minority, while it also actively tries to find buyers for the existing properties is very small.

Disposal to CBRE Investment Management is not better either

At the exact same day when the Q1 earnings were announced, VONOY revealed another major transaction of asset disposal to CBRE Investment Management for a total of ~ EUR 560m.

Again, on the surface it seems like a positive sign, bet when zooming into the details, a couple of warnings signs pop up.

The yield at which the assets were sold stood at 4%, which is 1.3% higher than the average level of VONOY’s total portfolio yield. This implies that the Company sold the properties at a ~32% discount to its average portfolio value.

Furthermore, three of the sold assets were class A building located at prime locations, while two were still under construction and have to be completed by the VONOY. This, in turn, strengthens the third point under previous chapter.

When CFO is asked to leave, you know that something is not acceptable with financials

With Q1 figures, the Company also announced that Helene von Roeder (chief financial officer) will resign from the position by the end of June, this year.

Helene took the CFO position since 2018 over which period VONOY has more than doubled its net debt position and significantly damaged its financial coverage profile.

For example, the ERPA net yield has decreased from 3.5% in 2018 to 2.7% in 2023 (Q1), LTV has gone up from 40% to 46% and net debt to EBITDA has deteriorated from 12.1x to 16.1x (on 2023 Q1 vs 2018 year-end basis).

It is highly unlikely that Helene decided to leave the Company by herself. In my humble opinion, the supervisory council of VONOY is finally realizing at what disastrous situation the Company is currently at and is now actively taking all measures to shield the shareholders’ value.

The bottom line

The Q1 results confirm all of my thesis points outlined back in March, 2023. The Company is structurally positioned towards facing either a massive equity dilution or an inevitable rating downgrade to junk category if expensive equity injections are not found.

There is simply no shareholder-friendly way out to increase the portfolio’s yield to a level, which is above the prevailing cost of financing rate. Currently, VONOY faces significant headwinds on the FFO generation that stem from cost inflation factors (i.e., higher operating expenses), reduced portfolio size that will decrease cash generation and slightly reduced occupancy rate. These factors have led to a 20% drop in FFO even though the Company is yet to recognize negative effects from surging financing costs.

Against the backdrop of imminent rate hikes by the ECB, higher financing costs at a Company level, frozen M&A markets and a heavily debt-saturated balance sheet, the Company is set for a disaster.

In my humble opinion, Vonovia SE just got from sell to a strong sell.

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