CI Banco SA Institucion de Banca Multiple FF/00939

BMV:TERRA13

Earnings Call Transcript 2019-Q3

[Operator]

Good morning. My name is Darrel, and I will be your conference operator today. At this time, I would like to welcome everyone to the Terrafina earnings conference call. [Operator Instructions] Thank you for your attention.

I will now turn the call over to Francisco Martinez, Terrafina's Investor Relations Officer. Please go ahead.

[Francisco Martinez, executive]

Thank you, Darrel. Welcome to Terrafina's Third Quarter 2019 Conference Call. We are pleased to have with us today from Terrafina, Mr. Alberto Chretin, Chief Executive Officer; and Mr. Carlos Gomez, Chief Financial Officer. Mr. Chretin will be taking us through the company's overview and operating review, and Mr. Gomez will review the financials.

Before we begin, we would like to refer you to the forward-looking statements as per the note in the quarterly report. Any information expressed or implied during the call may include forward-looking statements, which could involve certain risks or uncertainties. Terms such as estimate, project, plan, believe, expect, anticipate, intend and similar expressions may identify such statements.

Listeners are cautioned that forward-looking statements made during this call or by the company's management may change based on various important factors not under the control of the company. These comments represent the company's judgment at this time of the call. The company disclaims, however, any intent or obligation to update these forward-looking statements.

Thank you for your attention. And at this point, I will turn the call over to Mr. Alberto Chretin for his remarks.

[Alberto Castillo, executive]

Thank you, Paco. Good day, everyone, and thank you for joining us as we review Terrafina's third quarter earnings result.

Once again, Terrafina posted positive operational and financial results, driven by healthy leasing activity. Our occupancy rate reached a solid 96%, and our annualized rental rate stood at $5.18 per square foot per year. As we reached 9 months of the year with the strong results, we are confident 2019 will finish on a positive note. For the past 3 months, recent macro activity, such as lower interest rates, had benefited industrial real estate, and in turn, produced higher levels of engagement with the sector. In addition, trade tensions have eased somewhat, and the market is more confident that a USMCA agreement may be ratified soon.

Earlier this quarter, we had the opportunity to attend the Mexico aerospace summit, an industry that has grown over the past 15 years from 100 American and European manufacturers to more than 300. The most important aerospace OEMs had established operations in Mexico, and one of the biggest challenges they face is how to strengthen their supply chains with the development of local suppliers through strategic supply chain programs. Since local manufacturing for this sector is quite limited, we expect additional multinational Tier 1 and Tier 2 players to establish operations close to the OEMs, which will generate more opportunities for us.

I also had the opportunity to meet with our top aviation tenants and was able to confirm the success of the operations in Mexico. They continue to grow at a steady pace, reaching all of their productivity goals. In fact, they show considerable interest in continuing to expand their operations in Mexico. So we could see more news on expansions and build-to-suits with the aviation sector, and we are very well prepared to capture these opportunities.

Moving on to our highlights for the quarter. Terrafina's leasing activity reached 1.5 million square feet, with a 95% renewal rate, which results in a 96.3% occupancy rate. The Northern region, where most of the GLA is based, was the most active with 1 million square feet of leasing activity, followed by Bajio region with 370,000 square feet and the Central region with 130,000 square feet. The average length of these leasing contracts is 5.4 years.

We are maintaining our focus on the manufacturing for export segment due to its longer leasing contract terms and higher switching costs, leading to greater loyalty and stickiness. From the 17 contracts that expired in the quarter, only 2 of them were not renewed due -- and that was due to consolidation in the Mexican facilities. Nevertheless, we closed new contracts for more than 500,000 square feet. The main characteristic of these contracts are the long-term maturities, on average 6 years, and a higher exposure to the manufacturing sector focused on multinational tenants and U.S. denominated leases.

Looking at the financial metrics. From top to bottom, we had a very strong quarter. The highlights were our rental revenues reaching $48.7 million and our AFFO that came to $28.3 million, which equates to a distribution of USD 0.0359 per certificate. In summary, we're confident that we will meet our 2019 goals and reaffirm our guidance on distribution for the year of USD 0.30 to USD 0.40.

With respect to 2020, we're cautiously optimistic that as economic and trade uncertainty eases, we will see a pick-up in industrial activity and investment, especially in the leasing segment, benefiting our business. As previously highlighted, next year, we expect market opportunities to add value to our shareholders by means of generating attractive returns of 10% to 12% on investment in our new projects. This will help us to continue to grow steadily as we have done before. We're always prioritizing our tenant needs.

And that's all for me. Thank you. Carlos, please go ahead with the main financial highlights for the quarter.

[Carlos Espinosa, executive]

Thank you very much, Alberto, and to all of the participants on the call for joining us today. I will begin with a brief review of our financials for the third quarter of 2019. Please note that all figures discussed are in U.S. dollars. However, Mexican peso figures can also be found in the report for your convenience. Additionally, NOI, EBITDA and FFO figures exclude noncash items as well as nonrecurring and transaction-related expenses, the latter of which are only included in the AFFO.

On our financial highlights for the third quarter, Terrafina's rental revenue was USD 48.7 million, a 1.3% increase compared to the same quarter last year. The NOI level for the third quarter of 2019 reached USD 49.2 million, with a 94.3% NOI margin, showing an improvement compared to last quarter. The EBITDA was USD 44.2 million, with an EBITDA margin of 84.8%, also an increase from last quarter. FFO levels ended at USD 31.6 million, with an FFO margin of 60.7%. Our AFFO reached USD 28.3 million, and our distribution per certificate reached USD 0.0359.

Looking at the balance sheet. As of September 30, 2019, Terrafina had a cash position of USD 64.9 million, a 10.4% growth compared to last quarter, which is explained by tax reimbursements during the quarter. The total debt increased 2.6% from the third quarter of 2018 to USD 1.042 billion as a result of borrowing expenses related to the tender offer and the new bond issuance in July.

On our credit metrics, our LTV was 40.8%, a 30 basis point decrease quarter-on-quarter, and the debt service coverage ratio reached 3.3x, fully complying with our bond agreements.

Thank you for your time and attention. I will now ask the operator to open the line for questions.

[Operator]

[Operator Instructions] Our first question comes from the line of Francisco Chávez from BBVA.

[Francisco Chávez Martínez, analyst]

I have 2 questions. The first one is, have you decided which will be the payout ratio for the next year?

And the second question is, can you remind us the necessary conditions to trigger an equity follow-on under your sales program? And as of today, which is your NAV calculation?

[Alberto Castillo, executive]

Certainly. Thank you, Paco. Well, first of all, yes, we are going to reduce the payout ratio during -- in 2020, and the payout ratio reduction will not be below 85%.

[Francisco Martinez, executive]

And in regards to your share buyback, what would trigger, what we have followed is that the actual price should be something adequate and below our IPO follow-on offerings that we have done. So it is going to be interesting for us to see below the MXN 28. But I'd say the most important thing is that we need to balance how we are going to allocate our liquidity sources, which right now, as we mentioned during the call, what we are going to favor is the development, and we're going to be doing more expansions and build-to-suits. In this way, we'll be getting the 10% to 12% yield rather than -- for example, today, we're trading at an implied cap rate of a 9%. So we'll be higher, the benefit of doing the development rather than using the share buyback. And for the discount under NAV, Paco, we have right now around a 12% discount to our implied cap rate.

[Operator]

Our next question comes from the line of Eduardo Altamirano of HSBC.

[Eduardo Altamirano, analyst]

I was just curious, you alluded trade tensions easing and helping out in some of your clients on portfolio, at least within the U.S. However, wanted to get an understanding what trade tensions, at least, with China or Asia at this point are working -- they are in your favor.

[Alberto Castillo, executive]

Yes, thank you. Yes, indeed, the trade tension between the U.S. and China means an opportunity also for the manufacturing for export sector in Mexico as it makes more accessible to the Chinese or Asian companies the North American market through manufacturing operations in Mexico. We do have some Asian companies already on our portfolio, and we do see some interest of some Asian companies to develop manufacturing operation in Mexico to access North American market.

Although I have to say that we do have some site selection teams from Asia kicking the tires in different markets, those -- some of those projects have not materialized yet. But to answer your question, we do see that in the next couple of years, we'll see more participation from Asian companies benefiting from these tensions from the -- between the U.S. and China. But even -- if I may add, that even if these tensions are eased somehow, the Asian companies still see an opportunity to establish operations in Mexico for the North American market.

[Operator]

Our next question comes from the line of Jorel Guilloty of Morgan Stanley.

[Wilfredo Guilloty, analyst]

So I have 2 questions. The first one is, so we have seen that supply has been pretty much under control for the industrial real estate sector, and this has led to a favorable demand/supply balance for landlords as yourself. That said, how do you think that -- how long do you think this healthy supply/demand balance is going to last, particularly now that rates are coming down and industrial yields are attractive, which can drive development pickup?

And then my second question is specifically focused on the logistics part of your portfolio. I was wondering if you can comment on how performance is shaping up for the e-commerce-focused part versus the more traditional logistics part.

[Alberto Castillo, executive]

Thank you. Yes. Well, yes, I think that you made a very good statement about the balance between supply and demand. And I think that we see also that industrial real estate developers in markets where the occupancy continues to be very high, and they see some surge in request for proposal or more demand for some space, and they are beginning to deploy capital on the spec buildings in markets, as I mentioned, that are with very high occupancy. And we see that as positive as the absorption continues to be healthy. And to answer your question, how long do we see that this balance is going to stay, I think it's going to be for quite some time. Because I think that we are fortunate to have industrial real estate developers that have learned the lessons of the past, and they are monitoring, they're gauging very carefully the demand in order to not to overbuild and come up with higher vacancies, especially now that the industrial real estate developers are doing a lot of their development with the access to capital that demands also that those capital are deployed as quickly as possible into stabilized levels of income. So that's on the first question.

On the second question, indeed, the e-commerce represents and is going to continue to represent an opportunity to industrial real estate. And we see the 3PL suppliers as well as some of the companies that are logistic -- basically logistics-based companies continue to benefit from this. But also, there is a niche of 3PL suppliers that are doing business with the manufacturing tenants that continue to look in areas that perhaps are not that typical for e-commerce, like in the Bajio. On the other hand, also, we see all industrial real estate developers that are looking at the last mile, the facilities, which are going to be somewhat different, or some people think they are going to be substantially different from the normal e-commerce facilities. So we see that opportunity. We do have, as you know, a very important over 6 million square feet in our industrial park in Cuautitlan Izcalli. And a lot of our tenants there are participating on e-commerce or specialized e-commerce like medical and automotive, but we see also that some of our property managers are looking at opportunities also for last-mile investment in the Bajio and around Mexico City.

[Wilfredo Guilloty, analyst]

One more question, if I may. As you said, you're looking for investment opportunities for last-mile distribution in the Bajio, Mexico City. Have you seen more competition, though, from other players looking to engage in the same subsector?

[Alberto Castillo, executive]

Yes. I see -- remember that we do not make those investments directly. The ones that are looking for those opportunities are our property managers and some of our joint venture partners. And to answer your question, yes, I think that other industrial real estate developers are looking at that opportunity. I think that e-commerce is a theme that people are looking very closely in that -- in how that e-commerce business is evolving and coming up with new type of requirements.

[Operator]

Our next question comes from the line of Eduardo Alvizouri of GBM.

[Eduardo Alvizouri Alvarez, analyst]

My question is regarding the refinancing. Could you give us more color on the MXN 415 million in the nonrecurring financial expenses? I mean can we find out where is it coming from or why is it generated? And is it cash or noncash?

[Carlos Espinosa, executive]

Yes. The amount that you mentioned is composed of 2 parts, which is part of the liability management that we conducted last July. Part of this amount, which is $17 million, is the premium that we have to pay for the tender offer that we did for the 2022 bond that we had. The remaining of those expenses are the expenses that we had to do to complete the liability management transaction, which is the new bond, the 2029 bond that we did. So mainly those nonrecurring financial expenses are mainly these 2 components.

[Eduardo Alvizouri Alvarez, analyst]

And is it cash or noncash?

[Carlos Espinosa, executive]

No. We used our revolving credit facility to get those resources. We didn't use our bank account.

[Operator]

Our next question comes from the line of Froylan Mendez of JPMorgan.

[Fernando Froylan Mendez Solther, analyst]

I have 2 questions. The first one, can you give us a sense of the size of the GLA that will be funded with the retained earnings on the cut of the payout? And in which markets should we see these expansions happening? That's the first question.

And the second one, given the proportion of dividends per share paid as return on capital has been declining rapidly since the fourth quarter of last year, can you give us a sense on what conditions could trigger a scenario where the fiscal income that you generate could actually be higher than the AFFO generated?

[Alberto Castillo, executive]

Sure. Well, first of all, the size of the GLA that -- of the new GLA that we're going to generate in, let's say, in 2020 because of the payout reduction is going to be around 1 million square feet. And I have to remind you that perhaps we're going to use, obviously, the payout reduction funds as well as a portion of our line of credit.

[Francisco Martinez, executive]

And in regards to your second question, Froylan, what we have been analyzing with our fiscal advisers, basically the most important variable that could impact that, the company would have to pay something above the AFFO generation is related to FX movement. So as of today, what we have seen is there is a peso depreciation over the last month. So it had to be the opposite. We'll have to see a peso appreciation that could trigger the company of not having the full reserve to pay for its AFFO and we'll have to use own resources. But right now, our expectation is that we are going to maintain on the similar stage on using -- or with our own AFFO generation can comply with this request from the authorities.

[Fernando Froylan Mendez Solther, analyst]

And you know if some of the levels of FX that would trigger this situation, Paco? And do you know if this is something that could change from a regulatory standpoint, it is something that your guys is speaking with regulators to avoid happening?

[Carlos Espinosa, executive]

Yes. On regards of the FX that would trigger an additional payment that we would have to do, should be below MXN 19.11 per U.S. dollar. So we think it's not going to happen. But still, we need to be very cautious since the relevant exchange rate is the only one that happens on December 31. So that's the definite one.

And on regards of the conversations with the regulators, we have been talking about many, many things. But as of today, we don't have anything definitive that we can share with you. So right now, we are focused on complying with our regulation, the way it is today. And we are confident that with the payment that we have been doing, we are going to be fine on this year.

[Alberto Castillo, executive]

But in addition, if I may, at the AMEFIBRA level, we do hear several items that we are discussing with the regulators. And indeed, this is one of them.

[Fernando Froylan Mendez Solther, analyst]

Congrats on the strong results.

[Alberto Castillo, executive]

Thank you.

[Operator]

Our next question comes from the line of Vanessa Quiroga of Crédit Suisse.

[Vanessa Quiroga, analyst]

My question is regarding your thoughts on follow-on potential -- on a potential follow-on. Because we are already at the price where Terrafina issue shares the last time, and obviously, as interest rates are coming down, NAV goes up. And in this quarter, you had a good appreciation in the investment properties line, and so the gap between share price and NAV is still there. But what are your thoughts on where to balance both of those prices?

[Alberto Castillo, executive]

Well, thank you, Vanessa. Well, first of all, we do not have any follow-on in the horizon. As I mentioned before, our plan for 2020 is exclusively on development. And indeed, there is -- the gap between the NAV and the implied coverage in ways is also reducing. But again, we do not have any plans or any thoughts on follow-ons even in that situation until this is truly accretive to our shareholders. So that's our answer on the possibility of a follow-on.

[Vanessa Quiroga, analyst]

Okay. Okay, great. Then the other question I would have is on CapEx on properties, just tenant improvements and maintenance. What level do you expect for next year compared to 2019?

[Alberto Castillo, executive]

I think that the level of CapEx and leasing commissions for 2020 is going to be higher than 2019. And that is due to the fact that, as you know, about 22% of our GLA rolls over into 2020. And so we have very good expectations of the renewals of all these expirations. But as a consequence of that, the TIs and the leasing commissions for 2020 are going to be somewhat higher than 2019.

[Operator]

Our next question comes from the line of André Mazini of Citigroup.

[André Mazini, analyst]

My question is on the grace period. I remember a while back, you mentioned the average grace period for the tenants will be 3 months. And I want to understand if the market is a little bit harder, you guys have been increasing occupancy, also passing on price increases, if this grace period has decreased, and if there's any valuation between the various regions.

[Alberto Castillo, executive]

Yes. Thank you, André. Well, unfortunately, the grace period is something that is going to stay there because of the industry standards, especially with the contribution of the brokers. We don't think that it's going to be higher, but it's going to be there, even when you have a renewal of a great contract. In many times, the tenants, because of corporate policies, they do engage a broker firm, and they produce a tenant rep letter. And therefore, we have to be dealing with the broker and these -- as I mentioned, these practices of the grace periods is going to stay there. Of course, we try to negotiate the best we can.

I don't think it's going to be above the 3 months that I mentioned before, and sometimes it's even lower. But the good news about this is that, in many times, these grace periods or the amount of the grace periods, we negotiate with a tenant that is going to be invested in the facility. So even with these high occupancies and low vacancies and the fact that we may expect some increases in rent, that it will be very limited to inflation and perhaps to the investment in some TIs. The grace periods are going to stay there.

[Operator]

Our final question comes from the line of Francisco Suarez of Scotiabank.

[Francisco Suarez, analyst]

Congrats on the results and your updated views on distribution policy. That clearly does make sense on capital allocation. On that regard, shall we expect on property development a bias towards spec buildings or towards expansions? Or is this going to be on a case-by-case? Any significant to tell us on your views on what makes more sense, considering the market conditions that you see on the ground?

[Alberto Castillo, executive]

Yes. Thank you for your question, Paco. Yes, we do expect 2020 to be more active on development, but it's going to be exclusively on build-to-suits and expansions. We do not -- although we do have good tracks of land and we have some recommendations from some of the market officers or some of our property managers that perhaps it will be a good idea to do a spec building, we're reluctant to do that because we're going to deploy our capital exclusively on expansions and build-to-suits.

[Francisco Suarez, analyst]

Got you. In other words, you leverage your own knowledge on the ground and the relations that you have with the -- with your existing tenants and the land that is adjacent to your parks, isn't it? Is this the way to see it? I mean any some sort of a bias towards a low-risk kind of development?

[Alberto Castillo, executive]

Exactly. Exactly. Because remember that we do have land -- we do have good tracks of land, but in addition to that, we have land that is adjacent to our current facilities, and that's where most of the expansions come. So yes, we will focus exclusively on expansions and build-to-suits.

[Operator]

We have reached the end of our question-and-answer session. I will now turn the call over to Mr. Alberto Chretin for any closing remarks.

[Alberto Castillo, executive]

Well, thank you all for attending today. We look forward to speaking with all of you again and keeping you updated on the latest developments at Terrafina. Have a great day.

[Operator]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.