Gremlins
The following is an excerpt from This fund letter.
Calgro is a residential property developer focused on affordable housing for the low and middle income market segments in South Africa. The company delivers approximately 2,000-3,000 detached homes. The company builds more than 1000 houses and apartments per year, with developments concentrated primarily in the economic centres of Cape Town and Johannesburg, and also has a growing and promising memorial parks (cemeteries) business.
With a population of almost 60 million and only 6.7 million formal homes, South Africa’s housing shortage is glaring. Developers are delivering 75,000 new affordable homes per year, but this makes little difference to the estimated backlog of 5.5 million homes. The opportunity is huge. Demand remains strong despite a tough economic environment and high interest rates. Banks Financial institutions recognise the value for money that Calgro homes offer and continue to offer 100% mortgage financing to creditworthy buyers.
Calgro currently has nine ongoing development projects that contribute to revenues and profits. At the end of the financial year, it had a pipeline of approximately 23,000 units, a huge number given current volumes. After the reporting period, Calgro acquired a new project in Bankenveld, which significantly expanded the company’s pipeline by another 20,000-30,000 units. At a reasonable run rate of approximately 3,000 units per year, this equates to a pipeline of approximately 15 years.
In my dealings with them over the years, and more broadly, the management team has a reputation for competence, integrity and a good work ethic. They have also demonstrated very good capital allocation skills. For example, over the past year, Calgro has bought back 21% of its shares at an average price of R2.92 each, a PE of less than 3 and well below book value. Such buybacks create significant value enhancement for shareholders. The share price is currently around R5.60.
Calgro recently announced its financial results for the fiscal year ending February 2024. The results were impressive.
Although sales volumes and revenues declined slightly (for strategic reasons), efficiency and profitability improvements led to higher profit margins.
Gross margin of 27% was above the internal target range of 20% to 25%.
Cash flow was strong. Even after spending cash on share repurchases, net debt-to-equity was 63%, well below our internal target of 75%. Our debt agreements cap our net debt-to-equity ratio at 150%. Our balance sheet is strong.
Ending return on equity was 15% and average return on equity was 16%. We expect these figures to stabilize in the 15% to 20% range.
Book value per share increased a solid 41%, helped by share buybacks at steep discounts.
Additionally, higher profits and a lower share count led to a 32% increase in earnings per share.
At the current share price, Calgro is trading at a PE multiple of less than 3x and a 58% discount to book value. I think it is reasonable to assume an average return on equity of around 16%. If you invert these numbers and look at it from another perspective, we currently own a business that is growing earnings at around 16% per annum with an earnings yield of 33%. We should be able to make more than enough even if the multiple never expands. However, I believe that at some stage the market will recognize the value of this overlooked gem and the multiple will expand to more reasonable levels. There was a time in the past when Calgro was trading at around 4x book value and a PE multiple of 20x. History shows that these things move in cycles.
We’re not necessarily suggesting the stock price multiple will return to its historic highs, but in a slightly easing interest rate environment, the company’s performance justifies a valuation multiple of at least half of its historic highs, which would mean the stock is 3-4x higher than it is today. Time will tell. For now, I’m willing to settle for a 33% earnings yield generated by a reliable management team backed by a solid balance sheet.
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