gremlin
The following segment was excerpted from this fund letter.
Calgro is a residential property developer focusing on affordable housing for South Africa’s lower- and middle-income market segments. The firm delivers about 2,000 to 3,000 units (free standing homes or apartments) per year, with developments mostly concentrated around the economic hubs of Cape Town and Johannesburg. It also has a growing memorial parks (cemeteries) business with much future potential.
With a population of almost 60 million people and only 6.7 million formal housing units, South Africa’s housing shortage is indisputable. While developers are delivering an estimated total of 75,000 new affordable housing units per year, this is not really making a dent in the estimated backlog of about 5.5 million houses. The opportunity is huge. Even in the face of a challenging economic environment and high interest rates, demand remains robust. Banks and financial institutions recognize the value-for-money offering of Calgro homes and continue to grant creditworthy buyers 100% home loans.
Calgro currently has nine active developments all contributing to revenue and profitability. At fiscal year-end they had a secured pipeline of about 23,000 units, which is massive in the context of their current volumes. After the reporting period, Calgro acquired their new Bankenveld project, which dramatically expanded the firm’s pipeline by a further 20,000 to 30,000 units. At a reasonable run rate of around 3,000 units per year, this equates to pipeline of approximately 15 years.
In my dealings with them over the years and more broadly, management has established a reputation of competence, integrity, and excellent work ethic. They have also demonstrated very good capital allocation skills. As an example, over the past year, Calgro repurchased 21% of their shares at an average price of R2.92, which came in at a sub-3 PE and deep discount to book. Such repurchases are massively value-enhancing to shareholders. Currently, the share price is around R5.60.
Calgro recently released results for the fiscal year ended February 2024. They were excellent.
Although the number of units sold and revenue were down slightly (due to strategic reasons), they drove efficiencies and margins, which led to improved profits.
Gross margin of 27% was above their internal target range of 20% to 25%.
Cash flow was strong. Even after the cash spent on share buybacks, the net debt to equity ratio of 63% remains well below their internal target of 75%. Debt covenants prescribe a ceiling of 150% net debt to equity. The balance sheet is healthy.
Return on ending equity was 15% and return on average equity 16%. We expect this number to stabilize in the 15% to 20% range.
Book value per share was up a solid 41%, aided by buybacks at deep discounts.
And earnings per share increased by 32% thanks to a combination of profit growth and reduced share count.
At the current stock price, Calgro is trading on a PE multiple of less than 3 and a -58% discount to book value. We think it is fair to assume a return on average equity of about 16%. If we invert those numbers and look at it from a different perspective, it means that we currently own a business with a 33% earnings yield that is growing those earnings by about 16% per year. Even if there is zero multiple expansion, we should make a more than decent return. We do believe, however, that at some stage the market will recognize the value in this overlooked gem, and that multiples will expand to more reasonable levels. In the past, there was a time when Calgro was trading at about 4 times book value and a PE ratio of 20. History instructs that these things move in cycles.
We are not necessarily suggesting that multiples go back the highs of the past, but in an environment of slightly easing interest rates, we believe that the performance of the business justifies valuation multiples of at least half of the previous highs, which would imply a share price of 3x to 4x higher than today’s. Time will tell. In the meantime, we are willing to be patient with a 33% earnings yield generated by a trustworthy management team aboard a robust balance sheet.
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