Will this serial acquirer swallow its latest target at a 33% premium?
Ilija Batljan is the brightest shining star of the Swedish real estate sector in recent years. From a standing start in 2016, he has built one of the largest real estate companies in Sweden, SBB. This was achieved primarily through furious deal-making with the view that yields should be falling. Smart use of bond markets and rating criteria also helped. Additionally, strained public finances at the municipal level in Sweden has made elected officials prone to sell off public real estate infrastructure in spite of record-low borrowing costs. Batljan spotted that opportunity early, likely wise from his political experience as chairman of the city council in Nynäshamn.
The focus areas of SBB are social infrastructure and residential, but Batljan is not above venturing outside of that if there is a deal to be had. In late 2020 he started off the hunt for Norwegian office giant Entra, which also had Balder and Castellum taking an interest. Batljan ultimately chose to bow out when it was made clear that there was no way for him to grab the whole thing at a cheap enough price.
A year earlier, in late 2019, SBB’s takeover of Hemfosa was the largest real estate merger in Sweden up to that point. The launch of the bid took the market by great surprise. Hemfosa did prove to give SBB some indigestion as it contained a lot of non-core assets which had to be disposed promptly. After a hiccup with covid-related financing woes and a temporarily frozen property transaction market shortly after the finalization of the merger, this deal has gone on to become a major success.
Surging stock price notwithstanding, SBB as of now is financially stronger than ever, with some of the lowest borrowing costs in the Nordics. In actuality, it is higher geared than its large peers (especially if you account for the D-shares) but the bond market doesn’t seem to mind much. To some extent, perception becomes reality. If you can borrow as much as you like at 1%, and invest at 4%, is there an upper limit on your stock worth? Of course, this logic unravels the instant in which the bond market freezes, like it did in the spring of 2020. But as long as it holds, it is effectively a cornucopia. SBB is currently looking to get their rating from BBB- to BBB+, effectively sealing their status as a blue chip company and further lowering financing costs. The company has claimed to fulfil all the criteria for a while, but the rating agencies are yet to agree.
On the deal side, SBB has taken part in a flurry of smaller deals after they were snubbed by Entra. Most prominently, they bought 20.08% of housing developer JM on June 7, paying 326.30 SEK per share or about 4.6 billion SEK in total. The deal was brought to Ilija’s attention by large shareholder, confidante and fellow mogul Sven-Olof Johansson, who thought it was a better fit for SBB than his own vehicle Fastpartner, which is more focused on the commercial side. They both called JM a perfect match for SBB.
This was probably also a bit surprising for the market at the time since property management focused companies for so long have traded at large premiums to developers. On the other hand, the develop-to-own business model has become extremely popular and appreciated by the stock market with K-Fast as the outstanding example. As developing rental units has once again started to become more attractive, SBB could just opt to keep whatever rental units an integrated JM produced for them, and create a K-Fast-inspired solution within SBB.
Before 2017, there were a lot of smaller developers around. “Selling on blueprint”, i.e. before start of production was all the rage, making a slim balance sheet possible. Customers had begun to expect an automatic profit from buying condos unseen. Queues formed outside the developers’ office whenever new objects were to be released. In the crash of 2017, most of the minor developers went bust or was bought out on the cheap. In the end, it was impossible to even raise equity capital when the market swooned. JM acted counter-cyclically and kept down project starts at that time, protecting their profits from slumping all that much in the hangover that followed. They also diversified geographically away from their traditional Stockholm focus.
Now once again, developing is a game of balance sheet management - perhaps more than ever. JM is extremely well positioned with a solid cash position. But even JM, as one of the largest players, still pays about 50 bps more in interest than SBB, with significantly lower overall gearing. In some sense, you can make the argument that even the largest standalone developers in the Nordics have to an extent become subscale due to the current bond market dynamics.
The 20% Game
Now let me tell you about an important number: 20%. This is the amount of shares you need to classify an investment in another entity as an associated company under IFRS rules. What it means in practice is that you can consolidate earnings from it, but are allowed to keep the balance sheets separate. This provides you the opportunity to, theoretically, stack leverage on leverage to achieve growth in the relevant earnings metrics - at least if no lender or rating agency object.
In an example of this, SBB bought 20% of Heba, a publicly-traded Stockholm-focused residential player, in March. So SBB borrows at 1% to buy Heba which in its turn borrows at 1% (in Batljan’s personal case it’s leverage on leverage on leverage, as he has debt issued in his holding company too). If it works - as it has done - it goes exceedingly well. If something else… well, let’s not talk about that.
The situation with JM is a bit peculiar. SBB is allowed to consolidate it’s pro rata share of JM’s earnings as profit from property management (JM’s profits are 100% from development - it doesn’t hold on to any of its projects). The market multiple for developers is half that of management companies, so Batljan could perform a great multiple arbitrage should the market approve. The proof is in the pudding: since the purchase, JM’s share price is stagnant , while SBB is up 33%. Granted, obviously not all of the price movement can or should be attributed to that deal specifically. Property managers have been on fire - developers not so much.
Past the 20
So why would SBB have any further intentions other than keeping JM as an associated company? The market doesn’t really like the developers, and it loves SBB. Why risk it? Well, I’m going to split the reasons in the Hints and the Logic. Let’s start out with the Logic.
The Logic
JM has higher borrowing costs than SBB in spite of a very conservative balance sheet. They have excess capital of 5-6 billion SEK on a market cap of 22. As a developer you obviously need some liquidity, but that’s also why large size and a source of funds from property management makes sense from an efficiency standpoint. Additionally, JM owns a giant portfolio of building rights, with almost half as much off-balance sheet. In the current climate, this could likely be monetized quicker via selling some off or starting a bunch of JVs.
With increased competition from highly leveraged institutional players and lower ROIC mandates, Batljan has increasingly shifted his emphasis towards the value of building rights and development profits in his company presentations. In a recent Twitter discussion about his peer Erik Selin’s company Balder, Batljan mentioned project developments as a potentially important source of future profits.
Ilija Batljan on Twitter: "@RationalityWins @HerschelRothman @staffanpventure @WiseacreCap En enkel och vacker kalkyl som gör ytterligare förklaringar onödiga. 👍 Om man ska lägga till nåt det är att projektutveckling kan vara en joker💪." / Twitter
This may provide a window into what is on Batljan’s mind in terms of strategic priorities.
As a minor last note, the long-serving CFO just left JM due to retirement and the similarly long-time CEO is no spring-chicken either. This pair together had been part of top management of JM for 20+ years, steering it successfully through several crashes. What would be better a more fitting end than capping it off with a nice gift to shareholders?
The Hints
The first and most obvious clue here is that SBB bought more shares in JM over the market through July 31. As of that date they own 21.84% of the shares, up from the earlier 20.08%. I would expect an increase in that number come end of August. The multiple arbitrage and the 20% game works exactly the same all the way up to 29.99%. If SBB steps above 30%, they have to make a mandatory bid for the entire company at the highest price point that they have bought shares.
Looking at a potential deal structure, it would probably have to contain a significant share component in order not to jeopardize SBB’s investment grade rating. Since the stock has popped in the last three months, there’s ample opportunity to use the share if the seller is willing to take it.
When SBB bought its Heba stake, Batljan called it “cash management” and “a purely financial investment”. In contrast, he described the investment in JM as a “long-term investment in a fantastic company”. Interviewed on the morning of the deal announcement, he carefully avoided answering the question of whether he wanted to own the entire company.
Sven-Olof Johansson and Batljan both talk in terms of how JM fits with and complements SBB. Does this really matter that much for a passive holding? Additionally, Batljan has declined board representation in spite of being the by far largest owner. This could of course be an interim decision - if the idea is to go up to 30% and not beyond, it’s good to have complete flexibility while the position is built and not be bogged down by insider trading rules. But I think the most parsimonious explanation is that SBB has intentions beyond that.
Batljan could have pushed off the decision towards the AGM in the spring, still giving him plenty of time to reach 30%, but hinted that they were not really interested in being on the board at all. This would make eminent sense if it was just an opportunistic financial investment, like the case with Heba, but the incongruency is that Batljan has argued the complete opposite; JM is long-term and strategic.
What about JM itself?
JM earned 25 SEK per share rolling 12 months, meaning the p/e is about 13. Obviously these earnings are not comparable to a property manager, but if you peruse the history of the company, it’s certainly comparable to any number of qualitative but cyclical companies. The earnings may seem a bit stagnant but they are still actually working off a lower base of housing starts since after 2017. Expectations are for increases in starts and the inventory is currently flying off the shelves. Barring any market upsets, earnings should be increasing in the coming few years, taking the multiple down towards 10 on current market prices.
Meanwhile the annual builds in Sweden are way too low for the number of household formations and has been for quite some time. What’s really striking is the relative stability over the years of JM compared to other developers. Granted, the environment in Sweden since the financial crisis of 2008 has been extremely benign overall. Still, JM performed better than most peers.
In the last 20 years, JM has halved the shares outstanding. As opposed to most cannibals it is however not a regular repurchaser of shares but an opportunistic one. The buyback program was only restarted this spring after being on hold since 2017. This speaks to both the company’s resilient financial situation and the market outlook of management. Dividends have also been steadily increasing over the years with 12.75 SEK per share as the latest number. Another minor increase can probably be expected in the spring, taking the yield to about 4%.
Tying it all together
Does SBB want to acquire all of JM? I think so. Will it happen soon? I’m not completely positive. SBB has an eye towards that rating upgrade, but nobody knows when it will occur. I don’t know how the management of JM and other significant shareholders would be disposed towards an offer by SBB. Obviously it would in part depend on the premium and the cash vs share component in a bid.
Luckily, SBB’s share price has been heavily cooperative lately. If we pretend for a moment that Batljan was indifferent between using shares and cash to buy JM shares on 7 June, then he could pay 433 SEK per share today in SBB shares without even giving a premium against the price at that time. Would a mixed offer at a 33% premium get the company? Certainly possible - but it might be on the low side given management’s inclination towards buybacks here. In effect, SBB would be able to take a couple of turns off the multiple with a streamlining of the balance sheet and more aggressive use of the building rights.
Might Batljan instead take it slow and steady, quietly moving up towards 30% only if the price is right? And then, when he tips over the limit, put in a minimum mandatory bid, with no hopes of reaching 90%, but paying as little as possible for each individual share? Sure, he might and it could conceivably be the optimal strategy in this case. But that would be completely opposite to his usual modus operandi and it would risk ultimately paying way more for the entire company. Every move Batljan has done since coming public has been heavily dependent on swiftness and decisive execution. I don’t expect that to have changed recently. This might have been a deliberately constructed strategy for just a certain time period, but it seems also plainly a facet of Ilija Batljan’s personality. Sometimes on the brash side and stubborn to a fault but more importantly extremely numerate, competent and uncompromisingly ambitious.
JM management may not be keen on a merger and SBB could be unwilling to launch a hostile bid. Should SBB consolidate JM fully, they obviously can’t claim the earnings from development as property management profits anymore. But it would give them access to lots of building rights and an enormously strong development side, from which they can pick and choose what to keep on their books.
A lot of factors is on your side as an owner of JM even if the merger is a ways off. The market is good, demand is great, the finances are in super-solid shape. There are ongoing buybacks at the pace of 0.2%-0.4% of the shares per month, and by the looks of it the new major shareholder will be buying over the market at a clip of 1-2% of the shares outstanding a month. At least for another 8%. Subject to price changes, obviously. Even if no merger is imminent, those dynamics look pretty good to me. You pay about the same as Batljan paid for the great majority of his stake and get to go along for the ride.
And the stock is certainly not expensive compared to the broader market.