Office Vacancy, Disposals And Leverage Risks May Ease As Index-Linked Leases Support Stability

Catalysts

About CLS Holdings

CLS Holdings is a pan European office property investor and manager focused on multi let, income producing assets.

What are the underlying business or industry changes driving this perspective?

• Although leasing momentum is improving with rent on marketed space and refurbishments potentially lifting contracted rent toward GBP 131.5 million, the pace of backfilling the current 15 percent vacancy and over rented space at Spring Gardens may prove slower than expected. This could delay a recovery in net rental income and earnings.
• While index linked leases now cover over 60 percent of rent and support gradual income growth, inflation driven uplifts in Germany and France could be offset by weaker occupier demand in Paris and slower take up in secondary German cities. This may limit sustained improvement in net margins.
• Although the GBP 400 million disposal program is over halfway complete and should reduce loan to value into the 35 to 45 percent range, selling additional assets in still cautious investment markets may require pricing concessions that depress EPRA NTA and constrain future revenue growth.
• While large development and refurbishment projects such as Citadel Place, the Brix, the Yellow and Debussy aim to reposition the portfolio toward higher quality, faster growing assets, construction risk, permitting delays and cost inflation could defer the expected uplift in rental income and compress earnings in the medium term.
• Although improving office utilization, limited new supply in key U.K. and German locations and long duration leases to public sector tenants point to more resilient long term cash flows, any reversal in employer office space requirements or regulatory shifts in U.K. lease structures could cap future rental growth and pressure long run profitability.

Assumptions

This narrative explores a more pessimistic perspective on CLS Holdings compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming CLS Holdings's revenue will decrease by 16.4% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from -39.0% today to 62.4% in 3 years time.
• The bearish analysts expect earnings to reach £53.3 million (and earnings per share of £0.13) by about December 2028, up from £-56.9 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as £81.6 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 7.5x on those 2028 earnings, up from -4.2x today. This future PE is lower than the current PE for the GB Office REITs industry at 8.8x.
• The bearish analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 12.82%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Persistently elevated vacancy, currently at 15 percent with a concentration in a few large U.K. and French assets, could take longer than expected to backfill despite improving leasing momentum. This could delay the uplift in contracted rent and put sustained pressure on revenue and earnings growth.
• The strategic disposal program of GBP 400 million, which has already reduced net rental income and EPS by 16.7 percent to 4p per share in the latest period, may continue to be executed at discounts in a cautious investment market. This could structurally lower the rental base and constrain future earnings and EPRA NTA.
• Development and refurbishment projects such as Spring Gardens, the Brix, the Yellow and Debussy expose CLS to execution, planning and cost risks at a time when the office cycle is only tentatively bottoming. Any delays, cost overruns or weaker than expected tenant demand would weigh on net margins and earnings recovery.
• High leverage, with loan to value still at 49.2 percent and only forecast to move into the 35 to 45 percent range as disposals complete, leaves the company sensitive to further valuation declines, refinancing costs and covenant driven constraints. These factors could restrict reinvestment capacity and dampen long term earnings potential.
• Structural shifts in European office demand, including evolving work from home patterns and localized oversupply in parts of Paris and some German cities, may mean that even index linked leases and diversified tenants are insufficient to fully offset weaker occupier demand. This could limit like for like rental growth and compress net rental income over the long run.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for CLS Holdings is £0.7, which represents up to two standard deviations below the consensus price target of £0.8. This valuation is based on what can be assumed as the expectations of CLS Holdings's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of £1.0, and the most bearish reporting a price target of just £0.7.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be £85.3 million, earnings will come to £53.3 million, and it would be trading on a PE ratio of 7.5x, assuming you use a discount rate of 12.8%.
  
• Given the current share price of £0.59, the analyst price target of £0.7 is 15.1% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.