SEGRO Plc: Why This UK Logistics Leader Is A Must-Watch (OTCPK:SEGXF)

We believe SEGRO Plc (OTCPK:SEGXF) deserves more attention than it is getting from investors. This company is in several ways the British version of Prologis (PLD), a very well managed industrial and logistics REIT with strong competitive advantages.

Similar to Prologis, it has significant embedded growth that should propel earnings higher in the coming years. First, market rents are significantly higher than its current in-place average rents, which should push operating income higher as these contracts expire and get renegotiated. Second, the company develops properties itself and has an attractive land bank that should allow it to keep creating new assets at great locations and with good rates of return. Third, industry dynamics and e-commerce growth continue creating significant demand for good logistics locations, further increasing average market rents and occupancy. Finally, similar to Prologis, the company has a very strong balance sheet too.

Putting everything together, the company believes it can deliver roughly 53% rental growth over the coming three years. In 2023, despite facing higher financing costs, the company was able to deliver a 5.5% adjusted earnings growth, and decided to increase its dividend by 5.7%. Similar to what is happening in North American real estate, the industrial asset class continues to be driven by attractive fundamentals and it is outperforming most of the other real estate classes. Despite this, higher interest rates have also affected its share price, but if rates start coming down soon, sentiment towards the company could see a quick improvement.

Company Overview

While the company is very focused on the UK, it does have a significant presence in several other European countries, as illustrated in the slide below. E-commerce penetration in Europe has so far been lower, but it has been increasing, which should provide a significant tailwind for the company for the next few years.

In addition to e-commerce players like Amazon (AMZN), the company also serves customers in the logistics industry like FedEx (FDX), DHL (OTCPK:DHLGY) and Maersk (OTCPK:AMKBY), grocery chains like Sainsbury’s (OTCQX:JSNSF), data center operators like Equinix (EQIX) and Netflix (NFLX), and auto makers like Tesla (TSLA) and Porsche (OTCPK:DRPRY). In other words, important corporations, many of which are growing very quickly. At the same time, the company has good diversification, which reduces risk and puts the company in a good negotiating position.

FY23 Results

Despite a +12.1% increase in net rental income, higher financing costs reduced adjusted profit growth to +6%. A slightly higher share count reduced adjusted EPS to +5.5%. Still, given the interest cost headwinds we view the result as satisfactory. Book value was reduced despite rent increases, mostly as a result of adjusting valuations to the higher interest rate environment. The company retains a reasonable loan-to-value of 34%.

Occupancy

While vacancy ticked-up in 2023, occupancy remains very high for the company, and construction starts have been falling due to increased costs and normalizing demand. SEGRO shared that vacancy remains particularly low in its chosen sub-markets, and that it has seen positive releasing in early 2024.

These dynamics are providing significant potential for higher rents to be captured in coming years. The company currently estimates embedded growth potential of roughly £137 million, and this is reflected in high elevated rent changes on review and renewals.

Developments

Besides rent increases, the company has an additional growth vector with new developments. Below are some examples of 2023 development completions which were done with a yield on cost of roughly 7%.

The company has a significant development pipeline of £575m net investments, which includes some selective disposals and additional prime land acquisition. The company is prioritizing pre-let developments, and developments on land the company already owns could deliver yield on new investment money of close to 10%.

Perhaps one of the most promising expansion areas is new data centers, where yield on cost averages between 8% and 12%. The company has identified 24 potential sites across Europe and the UK, for roughly 1.2 GW of new capacity.

Growth

Considering that the company normally pays out around 85% to 95% of its full year adjusted earnings as dividends, leaving relatively little for reinvestment, it is impressive that it still has managed to grow adjusted earnings per share at a rate significantly above inflation. This has been in part thanks to rents renewing at significantly higher rates, new developments with high yields on cost, and solid cost controls and operational efficiency. Assuming valuation multiples remain unchanged, this level of growth can potentially offer investors double digit returns when combined with the 3%+ dividend yield.

Dividends have been increasing at a similar rate to adjusted earnings, roughly 8% CAGR the last few years. This has resulted in the dividend almost doubling when compared to 2016. Given the significant structural tailwinds we see for industrial and logistics real estate, and the company’s land bank advantage, we see a path for future growth for at least a few more years.

Balance Sheet

While not as high as Prologis’ ‘A’ rating from S&P Global (SPGI) and ‘A3’ from Moody’s (MCO), SEGRO has an investment grade credit rating of ‘BBB+’ from Fitch, with a negative outlook. This is still a solid investment grade credit rating, and similar to Rexford Industrial Realty’s ‘BBB+’ with outlook stable from Fitch too. For its part, STAG Industrial (STAG) has a lower credit rating of ‘BBB’, but with a stable outlook. In any case, Prologis does have a slightly stronger credit profile, but SEGRO is very close to the rest of its U.S. peers.

Its balance sheet is quite strong, with an average debt maturity of 6.9 years, but down year-over-year from 8.6 years previously. Its cost of debt at an average of 3.1% remains quite reasonable, although it too has somewhat deteriorated compared to the previous year’s 2.5% average interest cost. Its loan-to-value (LTV) ratio is a still healthy 34%, but it too saw a small deterioration compared to the 32% from the previous year. Around 95% of its debt is either fixed, or has a capped interest rate exposure. Overall we are not too worried about the financial strength of the company, but do believe in the short to medium term higher interest rates will continue to prove a headwind.

Valuation

Unlike its U.S. peers, SEGRO follows IFRS accounting, which means it has to adjust the value of its assets depending on market values. This means that its Price/Book Value is usually a better proxy for fair value, even if it can still underestimate or overestimate it. Its current IFRS net asset value (NAV) per share is 886 pence, while the native shares are trading at 853 pence, for a roughly 3% discount to net asset value.

We see shares as very close to fair value, even if the current dividend yield is slightly higher compared to the average of the last five years. Compared to its U.S. peers, only STAG Industrial is showing a higher dividend yield, but its dividend growth has been lower. Conversely, Prologis and Rexford Industrial have lower dividend yields, but have been growing their dividends at a faster rate. We are therefore rating SEGRO as a “Hold”, but believe it is a quality company worth being followed.

Risks

In addition to some of the same risks its U.S. peers have, such as a potential recession affecting demand for industrial and logistics space, SEGRO has an added risk with foreign exchange fluctuations. Being UK-based means dividends will fluctuate with the value of the British Pound. This can move in either direction, but the past decade it has lost ground to the dollar, especially after their decision to exit the European Union. There is also some refinancing risk, although this is mitigated by a balance sheet that remains in good shape, and backed by what is still considered a very attractive real estate asset class.

Conclusion

We believe real estate investors should put SEGRO on their watch lists, as this is an interesting company operating in one of the healthiest real estate sectors, but with a UK and Europe focus. This can add diversification for investors, and we believe the company will benefit from increasing e-commerce penetration in Europe.

Based on the company’s significant development pipeline, including attractive data center opportunities, we believe it can continue delivering solid earnings growth for the foreseeable future. It has been growing adjusted earnings at a roughly 8% CAGR, which means the company could deliver returns of around 11% if it continues growth at the same rate and the valuation remains stable. At close to their net asset value per share, we rate the company a “Hold”, and will continue to follow it in case a market dislocation creates an attractive investing opportunity.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.