By July 22, 2013 Read More →
Value Investing: Taking the Long View on Egyptian Real Estate with TMG

Value Investing: Taking the Long View on Egyptian Real Estate with TMG

That the Egyptian economy is in dire straits is no secret. As we noted in a recent paper on the subject (link), despite the momentous changes in the political arena, prospects for the Egyptian political economy remain relatively bleak. Although markets have responded well to the unseating of the Brotherhood from Egypt’s political hot-seat, the concurrent return of the military to power is hardly a cause worth celebrating – especially when one considers Egypt’s growth prospects.

NABATAEANS have found a real-estate play in Egypt which – although not for the faint-hearted – is arguably worth a closer look.

In these times of acute economic upheaval in Egypt, we are seeing real estate being used as a currency hedge by well-off Egyptians. Thus on the demand side, the picture is anything but bleak, driven by population growth and over 600,000 weddings a year.  Meanwhile, a superficial glance at the figures suggests that valuations of property developers in Egypt are in uber-bear mode – and understandably so given ongoing events in the political sphere. The discrepancy between perception and reality is interesting, as the situation, we feel, yields an investment case that builds off classic human cognitive biases (overreaction in an opaque, complex system).

I: The Business and History

Talaat Moustafa Group (TMG) is the largest real estate developer in Egypt, with further operations in Saudi Arabia. However, the company mainly focuses on the development of large integrated housing communities for the Egyptian upper middle class.

TMG is listed in Egypt, (current market cap of 9.5bn EGP @ 7 EGP per USD) and makes up 5% of the Egyptian stock market. In 2012, the firm reported net income of 545.7m EGP on revenues of 4,636m EGP.

Source: Market Watch

Source: Market Watch

TMG has been in business for over 30 years and has sold nearly 9.6 million sqm of developed residential and commercial real estate. TMG’s current land ‘bank’ comprises of 49m sqm of land. This land is partially under construction and partially in the early stages of development. Just over one third of the land bank – 34m sqm – is allocated for the development of city (“Medinaty”) which will eventually house over half a million people.

The company caters primarily to the middle and upper income bracket of the housing market, and has begun to diversify into tourism (investing in “Four Seasons” hotels across Egypt, for instance) in order to stabilise its income streams, which are otherwise dependent on overall local economic confidence levels. Interestingly, the high-end premium hotel sector (which Four Seasons occupies), has proven surprisingly resilient in the face of an overall drop in tourism.

TMG’s main project “Medinaty” – to the east of Cairo – was started in 2006 on an area of 34m sqm and will comprise up to 120,000 homes upon completion – with a total value of over US$3bn. The first families took up residency in 2010, but the project is designed to span over 25 years and will eventually house around 600,000 people.

It is critical to note that the “Medinaty” deal has been a source of controversy for several years. TMG stands accused of obtaining the land from the Egyptian state in 2005 without proper tender. Effectively this means that the bidding process was closed, with no auction to set a “fair” price. The land was for the most part sold to TMG for US$1 per square meter – most likely as a result of the owner’s family being on “favourable terms” with the Mubarak regime’s then housing minister, Ahmed el-Maghrabi. (TMG allegedly bribed the former housing minister to obtain the land.) The company may be forced to revalue the Madinaty  land, which would lead it to pay the government a higher tax.

As things stand, tax on the project is equivalent to 7% of the developed residential units (which are to be handed over government as in-kind payment).

This tax may increase to 30% in a worst-case scenario. This appears to be unlikely however, with most analysts estimating the final tax to fall in the 10-20% range. Either way, higher taxes could eat into future margins – with net margins currently at around 11% in crisis times and in the far higher teens pre revolution.

Importantly, considering the current drive to bring back investors to Egypt, it seems even less likely that the government is going to levy a punitive tax on the country’s largest property developer. Previous courts have dismissed the case, but a judge has permitted an appeal against TMG in January with a decision probably to be reached in September of this year. By now, 31% of the real estate has been sold and the infrastructure for the first phases of the project is complete.

TMG has several more projects across Egypt developed and under construction. The main ones are el Rehab (half developed) to the east of Cairo, San Stefano in Alexandria, and resorts in Luxor and Marsa Alam on the Red Sea.

Source: TMG Annual Letter

Source: TMG Annual Letter

Demand has been strong for housing in all of these projects – even in the years since the 2011 revolution. To a large extent, this can be attributed to TMG’s preferred integrated communities (these are large, gated, ‘self-sustaining’ compounds with amenities equivalent to those of a small town) outside of Cairo.

Of particular interest is that TMG’s assets are worth a multiple of the current market capitalization of EGP 9.5bn.

II: The Egyptian Housing Market

Property prices have been resilient in light of political developments in Egypt since the 2011 uprising and the fall of the Mubarak regime. TMG owns some high quality real estate and is profiting greatly from demand driven by 600,000 annual marriages, the unbearable overcrowding of Cairo, and inflation with currency devaluation that fuel a flight into hard assets.

Real estate prices have historically been very stable in Egypt in times of economic crisis, as capital tends to find its way into “safe” assets.

Furthermore, TMG – unlike most of its competition (Palm Hills and SODIC) – is in a unique position to supply to the middle-income market segment through these large-scale integrated projects like el-Rehab and Medinaty. Essentially the competition is focused more on smaller scale compounds which do not offer similar “city features”.

III: Balance Sheet and Financials

As we are looking at a real estate firm, scrutinizing balance sheet is a good place to start.

Assets are currently around 54bn EGP. TMG’s book value is around 12.75 EGP per share. When Goodwill is accounted for, the residual is around 40bn in assets in the form of land, receivables, cash, investments etc. This is on a market cap of 9.5bn. The majority of that makes up its semi-developed land in Medinaty and El-Rehab.

TMG’s overall debt stands at 3.3bn, of which most (2.7bn) is long term. It earned 545m last year and its interest expense was 185m, a ratio of 3 – but these are the most economically depressed times possible in Egypt.

Overall financial leverage of the business is very low with a debt to equity ratio of 1:7 and it pays its taxes in kind, which gives TMG significant cash flow flexibility.

The company currently has a sales backlog of 18.8bn EGP to be delivered over the next four years. This works as a guaranteed income stream for the future as customers pay down their purchases.

TMG’s revenues have fallen since the pre-revolution days by around 13%. Net income is however a third of what it used to be, as fixed costs in the construction sector are high. A greater decline in profitability would have been expected, but net income proved to be somewhat resilient.

TMG Financial Indicators 2007 - 2012

of which Revenues from Hotel:232.9584540608348421
Gross Profit850.21,9271,4861,5221,1851,228
Interest Expensex-181.0-207.0-175.0-158.0-185.0
Net Income1,3251,4421,106940577.5545.7
Earnings per share0.640.700.540.450.290.26
Total Assets41,40353,67053,90654,87353,88954,946
Current Assets10,92634,31934,05333,98832,94733,854
of which Cash/liquid assets / marketable securities3,4051,4242,1711,7092,1712,014
Total Liabilities18,77029,85129,05929,18927,58728,617
of which net debt:x1,9131,8922,2273,0013,303
(All figures in million EGP)

IV: Operations and Competitive Advantage

In our opinion, TMG is a (cheaply priced) bet on Egyptian real estate demand resulting from inflation fears, and offers the possibility to buy into the Egyptian economy at a time of great fear. The notion of being greedy when others are fearful resonates with us.

Overall, TMG has a construction track record unmatched by its Egyptian peers SODIC and Palm Hills. This reputation helps buyers decide where to buy houses as growing numbers of Egyptians seek to escape from the smog and mayhem of Cairo.

Importantly, TMG has excellent relationships with several local banks that allow it to sell its own mortgages – something that gives it unique appeal to middle income families and a real advantage over many of its competitors.

The communities that TMG is building are proving popular among Egypt’s new urban middle classes, who often favour life outside city-centres of Cairo and Alexandria. Teaming up with many Western architects and designers to build quiet yet urban fully integrated satellite cities has been a key part of TMG projects’ appeal.

It’s worth emphasising the value placed by Cairo’s urban middle and upper class Egyptians on  leaving the mayhem of Cairo. The city has between 20 to 25 million inhabitants – who navigate a road network that was built to sustain no more than 3 million. Levels of congestion, as well as air quality, are notoriously bad. Poverty is rampant and since the fall of Mubarak, crime rates have risen dramatically, leading many Egyptians to place a premium on moving into gated communities on the outskirts of the city.

A rising number of Businesses are relocating to Cairo’s “satellite” cities (a process the Mubarak government had actively encouraged), where the air is better, the housing stock is modern and communities are gated and protected.

V: Management

TMG is majority family owned and is run by Tarek Talaat Moustafa, the son of Talaat Moustafa Talaat, the group’s founder.

On a slightly disconcerting note, TMG’s founder is currently in jail for having ordered the murder of his Lebanese girlfriend in Dubai… While it adds a somewhat sinister dimension to TMG’s story, this unsavoury reality does come with a silver lining. With the founder in prison, the company currently has few feuds outstanding with any current political players.

Moustafa Talaat Moustafa was already jailed under Mubarak and hence the company has been slightly out of the limelight in the hunt for ‘crony’ businesses.

Land is currently being withdrawn from most of TMGs competition, but TMG has been to some degree spared as a result of its swift business execution. It has an excellent track record of pre-selling its housing units and executes infrastructure development quickly, often ahead of schedule. This gives it a powerful shield against government legal claims.

To briefly explain: Considering TMG pays its taxes in the form of developed property for lower income families, once a house is built and sold as a villa or larger apartment, the government will have a hard time to claim it as tax in the form of social housing. This is of course only in case the government decides to increase TMG’s tax rate.

TMG’s current main Medinaty case has been in and out of court, but management has been very diligent in the development of its land bank. This will make a large revaluation nearly impossible.

VI: Risks

Investing in Egyptian Equities is risky. Price can serve to mitigate this reality. We consider the following to be among key risks:

1) Macroeconomic, as Egypt probably will get worse before it gets better.

2) Company specific, as we will always remain somewhat skeptical of accounting in developing countries such as Egypt

3) Political and legal: the judiciary is heavily politicised, so there is no guarantee against arbitrary, politically motivated fines or levies against the company as a result of its past land deals with the state

In a worst-case scenario, TMG will have to pay the Egyptian government 30% of the Medinaty built-up-area (BUA) in kind as part of a revaluation settlement. The current agreement is 7% to be given to the government upon completion.

The government has a strong interest in not punishing this company too hard, in light of already very wary investor confidence. However, we don’t like counting on the kindness of others – especially not the Egyptian government.

VII: Why is TMG so Cheap?

The reasons for TMG’s cheap valuation are of course manifold. The primary reason is most likely the question mark over the Medinaty land court case. Depending on how this issue is resolved, the market will most likely begin to reflect the true value of TMG’s real estate portfolio and resilient earnings power.

With the brotherhood kicked out of government, the remnants of the old regime are attempting a return to “stability”. It is difficult to assess the implications of the recent military coup, but chances are that it bodes ill for prospects of a democratic transition in Egypt – in the short-term at least.

Secondly, the company is lumped up with all other real estate development companies and the sector is not well understood by the market as defensive in times of currency devaluation.

TMG’s valuation has also been dragged down by  general market gloom and difficult economic circumstances in Egypt. Housing is ultimately a confidence business and confidence has never been this low.

Nevertheless, considering TMG’s profitability even in these times of great turmoil is impressive and a good indication of what’s to come if things stabilize.

VIII: Price and Valuation

The shares currently trade at a 0.4P/B ratio. Naturally we don’t want to take book value at face value. But, the land bank is the key to analysing a real estate developer. As we researched this company, we noticed that not a single US real estate firm – be it a developer or REIT – trades at a low P/B multiple. The largest firms averaged between P/B ratios of 2 -3.

Considering the non-existence of a mortgage market in Egypt and non-speculative demand for housing, we contend that property prices are probably quite stable – especially in light of currency devaluation. This indicates the steep discount at which TMG trades.

Book value per share is 12.75 EGP. Even if one takes a good chunk out of goodwill and we factor in a “worst-case” scenario of a 30% in kind payment (instead of the 7%) to the government, you get a book value of about 7.9 EGP. Still twice what Mr Market gives TMG.

Hence, we have a real estate firm that trades at a steep discount to book value. This basically implies you can buy its entire land portfolio at a third of its real price and get the business and reputation for free. Even in this time of crisis the company generated a net margin of 12% and in 2008 (not the best of all years in macro terms), the net margin was 26%. We consider this proof of earnings resilience.

So if in 2012 it earned 0.26 EGP per share and in 2008 it earned 0.70 per share, how much could TMG earn in a normal economic environment? At current earnings – in really the worst possible economic times – it has a PE of 15, but with 0.70 per share earnings on current prices, you get a PE of 5.

IX: Conclusion

Overall, we think this company is likely unlikely to suffer drastically this time of crisis, while there is a strong likelihood that TMG will do well when the situation eventually stabilises. The population of Cairo will have to continue to buy housing – for cultural and practical reasons and TMG is uniquely positioned to provide supply for this growing demand.

We take a longer and more specific view. If there was a time to start scooping up Egyptian assets and make use of the gloom it is now. TMG offers strong downside protection and a very high payoff when things stabilize.

On a final note: There are certain economic truths regarding the Egyptian real estate sector that should put a settlement of the Medinaty dispute on top of the courts current priority list. Currently 14% of Egypt’s workforce is employed in the construction sector. 90% of construction work is in the private sector and it used to attract nearly 20% of FDI before the fall of Mubarak.

If TMG gets disproportionately and unfairly penalized, real estate construction and investment are likely to suffer, however.

Source: Medinaty Website

Source: Medinaty Website

Source: Google Earth

Source: Google Earth

(Flickr image courtesy of peifferc)

About the Author:

Carl Livie is Nabataeans’ editor for financial markets and value investing. He studied Arabic and Islamic Studies with a focus on the economic development of the Middle East at the School of Oriental and African Studies in London. Carl has been active in the Egyptian start-up scene, where he co-founded the online services provider, but also spent time at UBS’ derivatives sales and structuring desk in London. Carl’s long-standing interest however has been identifying contrarian-minded and value-oriented investment ideas around the globe with a particular focus on the Middle East.

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