| Stock: | Rural Funds Group | ||
| Exchange: | ASX | Symbol: | RFF |
| Date: | March 6, 2019 | Latest price: | $2.27 |
| Market Cap: | $757.4 m | Fair Value Estimate: | $1.49 (Gordon’s Growth model) |
| Forward P/E: | 15.4 | Net (adjusted) Asset Value: | $1.75 |
| Financial Y/E: | June 30 | Rating: | Underperform (LT) |
| Sector: | Real Estate |
Industry: | REIT – Agriculture |
| Investment Theme: | Dividends & Growth | Structural Trends: | Global population growth and rising middle class in Asia. |
Company Profile
Rural Funds Group is a real estate investment trust (REIT) that specialises in agricultural properties which it leases to tenants on long leases.
Farming sectors include:
- cattle
- poultry
- cotton
- tree nuts (almonds and macadamias)
- vineyards.
RFF also invests in water rights.
Strengths & Weaknesses
Long-term global population growth is expected to increase pressure on food and water shortages, driving up agricultural prices. Rising living standards in Asia have also led to increased animal protein consumption:
We are likely to face increasing scarcity of food and water. Advances in technology have improved crop yields, but increased meat consumption in China and other Asian economies will reduce overall output. The area of land required to produce an equivalent amount of edible protein from livestock is 4 to 5 times higher compared to traditional grains and legumes, and up to 10 times higher for beef. Diversion of land use for ethanol production may also restrict food output. (The Patient Investor: Structural Trends)
There is a common misconception that “Farms don’t really deteriorate or need updating in the same way that shopping centres, warehouses or office buildings do (Motley Fool).” There is a symbiotic relationship between the farmer and the land. Only by investing time, effort and capital is the land likely to yield the best return. A tenant is likely to have a shorter-term outlook, without the same sense of stewardship towards the land.
It is also a misconception that triple-net leases mean that the tenant bears all the risk, while the landlord collects a steady return. Agricultural prices are notoriously volatile and the value of the land is determined by the return that can be achieved by the farmer. If prices fall for example, tenants may be unable to meet their rental payments and may seek rental relief until the market recovers. Weather events (drought, floods, hail, etc.), pests and disease can also impact on crops and livestock, affecting the financial viability of tenants.
Large scale tenants may be able to diversify risk but are still vulnerable to pricing and other widespread events.
RFF has some strong tenants, although it appears that the fund is carrying operational risk through its lease to Cattle JV, a wholly-owned subsidiary. We also note that recent cattle properties acquired, totaling $58.5m, are leased to Stone Axe Pastoral Company whose board is dominated by private equity firm Roc Partners (also likely to have a shorter-term outlook).
Another misconception is that rural funds only hold investments in agricultural land that is at low risk of impairment. Here is a breakdown of RFF assets at fair value:
Almost 20% of assets are trees and vines (bearer plants), while investment property includes “buildings and integral infrastructure including shedding, irrigation and trellising”. Intangible assets (12.7% plus 6.1%) consist of water rights, while finance leases (7.7%) include loans to tenants to fund establishment of feedlots and breeding herds.
Financial performance
Distributions
Distributions per unit have grown at a healthy 5% p.a. from FY15 to FY19 (forecast), with management targeting 4% future growth.
Forward dividend yield, based on consensus estimates, is 4.66%.
Capital structure
The fund has $301.9 million of debt at 1H19 (pro forma), with a gearing level of 32.7% (based on adjusted asset prices). I consider this high for an agricultural fund, considering the variability of operating cash flows in underlying farming enterprises, and would prefer to see a lower limit of no more than 25%.
Valuation
Stated net asset value at 1H19 is $1.75 per unit, based on most recent valuations of underlying assets.
Using Gordon’s Growth Model and a required return of 11% p.a., with 4% growth, we arrive at a fair value of $1.49 per unit.
Technical Analysis
Long-term Momentum declined in 2018, after a strong up-trend, as RFF consolidated above support at $2.00. But yields on quality REITs have recently been falling as the prospect of interest rate rises (in Australia) fades.
Support at $2.00 has held firm and rising Trend Index troughs indicate buying pressure. Breakout above $2.30 would signal a fresh advance, with an immediate target of $2.60.
Conclusion
While RFF may present a short-term trading opportunity if it breaks above $2.30, we consider it too highly-priced for a long-term investment.
Disclosure
Staff of The Patient Investor may directly or indirectly own shares in the above company.