#1 K2A a company trading at 0.19x P/B with a clear catalyst

Interest rates and debt maturity, the nightmare of real estate companies

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Overview:

K2A Knaust & Andersson Fastigheter AB is a leading real estate company in Sweden, specializing in the development and management of environmentally certified residential and community properties. While the real estate sector has faced volatility, K2A's unique focus on sustainability and high-quality assets positions it to benefit from long-term market trends.

Investment Highlights

Undervalued stock: K2A has experienced a dramatic share price decline of 96% and is currently trading at an all-time low. In this article, I will explore the reasons behind this decline and explain why it might present an opportunity for value investors. The company's market capitalization stands at approximately 352 MSEK, and you can currently buy the company at 0.19x P/B value.

Clear Catalyst: The game-changing catalyst for K2A is on the horizon: the anticipated reduction in interest rates and strategic refinancing of its debt. These developments could dramatically reshape the company's financial landscape, setting the stage for a significant boost in earnings per share (EPS) and unlocking substantial value for investors.

Great Margin of Safety: Trading at just 0.19x Price to Book value, K2A offers a compelling margin of safety for investors. This significant undervaluation provides a cushion against potential downside, making it an attractive proposition for value investors looking for a secure investment with substantial upside potential.

Management Alignement: The company's management, led by CEO Johan Knaust, has significant insider ownership. Johan Knaust alone holds 25,194,100 shares, representing 28.7% of total shares. This substantial insider ownership ensures alignment of interests with shareholders and a focus on long-term value creation.

Operational overview

First, I would like to focus on the company revenues. K2A primarily generates revenue from rental income derived from residential buildings and student housing. Remarkably, as illustrated in the accompanying image, the company has managed to consistently increase its revenues year-over-year since its founding in 2014. This achievement is particularly noteworthy given that, in 2023, K2A sold over 800 million SEK worth of properties yet still managed to increase rental income for the year. The company has already posted its revenues for Q1 2024, and the positive trend continues unabated.

This fact highlights the strong demand for K2A's properties, underscoring the attractiveness and resilience of their portfolio.

Next, I would like to focus on their operational evolution:

The operating margins of K2A have shown exceptional improvement, particularly in recent years. This positive evolution is largely due to the company's strategic shift in focus from new projects to enhancing operational efficiency. By optimising their existing processes and maximising the value extracted from their current portfolio, K2A has managed to significantly boost their operating margins from 40% to 55%, demonstrating the effectiveness of their efficiency-driven approach.

This achievement is even more impressive considering the challenging years the real estate sector has recently faced. Despite market volatility and economic headwinds, K2A's commitment to operational excellence has enabled them to navigate these difficulties successfully and emerge stronger.

However, it is important to note that K2A's EBT has declined over the last two years, entering negative territory. This decline is primarily due to a dramatic increase in interest expenses. The rising cost of borrowing has impacted the company's profitability, overshadowing the gains achieved through operational efficiency. This increase in interest expenses is one of the key factors that has led to the sharp decline in K2A's stock price.

It is also important to note that in FY23, the company recorded an impairment on their property values amounting to 471 MSEK, which represents approximately 5% of their portfolio value. This impairment has further exacerbated the situation for investors who bought into the company two years ago at much higher valuations. The combination of increased interest expenses and significant property impairments has made the investment outlook more challenging, contributing to the sharp decline in the stock price and underscoring the importance of K2A's strategic initiatives to turn around its financial performance.

Interest rates Catalyst

The first catalyst for a rise in K2A's stock price is the anticipated reduction in interest rates. Currently, inflation in Sweden stands at 3.74%, having declined from its peak. This, combined with a slowing economy, is likely to prompt central banks to start reducing interest rates soon. As borrowing costs decrease, K2A’s financial performance is expected to improve significantly. Given the company's enhanced operating margins, this improvement will likely surpass its pre-inflation levels, thereby boosting the stock price.

The elephant in the room

The looming expiration of substantial debt has become a pressing issue for the company. With the maturity dates for two bonds issued in 2021 and significant debt owed to financial institutions fast approaching this year, investor anxiety has reached a fever pitch. This has led to a sharp sell-off, causing the stock price to plummet to its lowest levels in recent history.

Key Points of Concern:

1. Bond Maturing in June 2024:

- Amount: 400 million SEK

- Interest Rate: Stibor 3M + 3.25% (current rate: 7.32%)

2. Bond Maturing in December 2024:

- Amount: 300 million SEK

- Interest Rate: Stibor 3M + 4.40% (current rate: 8.41%)

3. Debt to Financial Institutions:

- Amount: 1,274 million SEK

The convergence of these debt maturities has intensified fears among investors about the company's ability to manage its obligations without severely impacting its financial health. The resulting sell-off has driven the stock price to unprecedented lows, reflecting the heightened risk perceived by the market.

Strategic Plan to Address Imminent Debt Maturities

The company has outlined a decisive strategy to bolster its balance sheet and enhance liquidity. Key measures include:

1. Property Sales: The company plans to sell select properties from its portfolio. The proceeds from these sales will be used to repay the outstanding debt that is set to mature soon.

2. Debt Refinancing: With an improved balance sheet from the asset sales, the company aims to refinance a portion of its debt. This will help manage financial obligations more effectively and maintain operational stability.

This dual approach is designed to address the immediate debt maturities while positioning the company for sustained financial health and growth.

During 2023, the company made several asset sales, detailed below along with the amounts and book values:

1. Sale of the property Umeå Äppellunden 1:

   • Sale price: 135.7 million Swedish kronor (Mkr).

   • Discount to Book Value: 0.2%

   • Details: This property, with a rentable area of 3,852 square meters distributed across 83 units, was sold on December 19, 2023.

2. Sale of six properties in Gävle, Västerås, and Uppsala:

   • Sale price: 1,095 million Swedish kronor (Mkr).

   • Discount to Book Value: 3.9%

   • Details: Four properties were sold on May 31, 2023, and two properties on December 1, 2023. This transaction increased the company’s liquidity by 400 Mkr and included a total of 575 units with a rentable area of 25,750 square meters and a rental value of 57.4 Mkr.

3. Sale of four properties in Växjö:

   • Sale price: 650 million Swedish kronor (Mkr).

   • Discount to Book Value: 0%

   • Details: The properties were sold on June 30, 2023, increasing the company’s liquidity by 235 Mkr. In total, 261 units were sold with a rentable area of 17,960 square meters and a rental value of 32.8 Mkr.

These sales represent significant strategic moves for the company in terms of liquidity and overall balance sheet health. The company has continuated the sales during first half of 2024.

1. Sale a property in Lund (30th of May 2024)

   • Sale price: 160 million Swedish kronor (Mkr).

   • Discount to Book Value: 0%

2. Sale a property in Lulea (17th of June 2024)

• Sale price: 330 million Swedish kronor (Mkr).

Bondholders Approve Extension of Bond Maturities by 1.25 Years

On May 28, the bondholders accepted a 1.25-year extension for the payment of the bonds. The new expiration dates are as follows:

• MTN 101:

  • Original Expiration Date: June 1, 2024

  • New Expiration Date: September 1, 2025

• MTN 102:

  • Original Expiration Date: April 1, 2025

  • New Expiration Date: July 1, 2026

• MTN 103:

  • Original Expiration Date: December 18, 2024

  • New Expiration Date: March 18, 2026

This extension ensures that the company has more time to manage its financial obligations effectively. A significant portion of the reason for the recent share price decline have been mitigated, as 700 million SEK in bond payments have been deferred. However, the company still faces the upcoming expiration of its credit facilities with financial institutions.

In fact, in the 2023 annual report, the company identified the maturities of these bonds as the debt expirations with the highest risk. Bank loans are generally easier to refinance or extend, as financial institutions specialise in managing such transactions. This should alleviate investors' anxiety for a while.

Valuation

As a value investor, I always seek a good margin of safety in my investments, especially in those with risks associated with debt expiring soon. This is also the case here.

The company’s asset balance sheet is primarily composed of properties. At the end of 2023, the property value was 9,100 MSEK.

To achieve the margin of safety I desire, I will apply a 20% discount to the value of the properties to get an adjusted book value.

Here are the calculations:

As shown in the image, if you subtract the total liabilities from the adjusted asset value, you get an adjusted book value of 536.3 MSEK. With a current market capitalisation of 352 MSEK, the company is trading at a 34.37% discount to its adjusted book value.

By making this adjustment, you can achieve the desired margin of safety. It is also notable that the property values used in the calculations already account for an impairment of about 5% from last year. Furthermore, since the company began selling properties last year, most have been sold at nearly 100% of book value. This demonstrates that the values on the balance sheet are accurate, providing us with the opportunity to enjoy a great margin of safety by applying a 20% discount to the properties.

DEBT Expiration and dilution

Usually, an easy way to repay expiring debt maturities is by diluting shareholders through the creation of new shares. However, in my opinion, this will not be the case in this situation.

Why?

Management alignment.

Management Insider Ownership

1. Johan Knaust

   • Role: Board Member and CEO

   • Ownership:

     • 2,841,840 A-shares (2.95% of total shares)

     • 15,453,015 B-shares (16.05% of total shares)

     • 6,806,160 D-shares (7.07% of total shares)

     • 93,085 Preference shares (0.10% of total shares)

2. Johan Ljungberg

   • Role: Board Member

   • Ownership:

     • 2,412,000 A-shares (2.51% of total shares)

     • 9,289,661 B-shares (9.65% of total shares)

     • 13,864 Preference shares (0.01% of total shares)

3. Johan Thorell

   • Role: Board Member

   • Ownership:

     • 2,412,000 A-shares (2.51% of total shares)

     • 6,666,496 B-shares (6.99% of total shares)

     • 19,499 Preference shares (0.02% of total shares)

4. Claes-Henrik Julander

   • Role: Board Member

   • Ownership:

     • 2,176,800 A-shares (2.51% of total shares)

     • 5,194,622 B-shares (5.93% of total shares)

     • 17,659 Preference shares (0.02% of total shares)

Concretely, insider ownership stands at 54.3%, leaving a float of 45.7%. With this alignment, it is certain that the management will act in a way that benefits shareholders.

Conclusion

Currently trading at 0.19x price-to-book value and offering a significant margin of safety with a 20% discount applied to its properties, this company presents an exceptional investment opportunity.

You are acquiring a real estate company at a time when the sector is at its lowest, yet the company's operational performance is at its peak. They have consistently improved their operating margins, and once interest rates begin to decline, the company will benefit significantly from its strong operating leverage.

Additionally, the primary concern for investors regarding the two bond maturities expiring in 2024 has been temporarily resolved, with an extension of 1.25 years. This extension provides both management and investors with breathing room. During this period, management will continue to unlock value by selling high-quality properties and increasing the company's liquidity.

Given these factors, the likelihood of achieving substantial returns at the current price, with low risk, is high, especially considering the extended bond maturities.

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