CI Banco SA Institucion de Banca Multiple FF/00939

BMV:TERRA13

Earnings Call Transcript 2019-Q4

[Operator]

Good morning. My name is Doug, and I will be your conference operator today. At this time, I would like to welcome everyone to Terrafina's Fourth Quarter Earnings Conference Call. [Operator Instructions] I will now turn the call over to Francisco Martinez, Terrafina's Investor Relations Officer. Please go ahead.

[Francisco Martinez, executive]

Thank you, and good morning, everyone. Welcome to our fourth 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 take us through the company overview and operations, and Mr. Gomez will discuss 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 and 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 out of the company's control. These comments represent the company's judgment at the time of this call. Also, the company has no 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]

Good morning, everyone. The fourth quarter of 2019, in line with the rest of the year, brought positive results for Terrafina. Demand conditions across all regions remained strong, particularly in the north, with very solid dynamics in the manufacturing for export industry. These, as in previous quarters, translated into solid operational and financial metrics.

Our tenant-focused strategy continues to pay off. Throughout 2019, we were able to sign 10.9 million square feet of leases. In the fourth quarter alone, we signed 3.9 million square feet of leases. Early renewals was the biggest component of our leasing activity this past quarter, which reinforces the argument that our tenants have more commitment than ever to their Mexican operations. Furthermore, we added over 1 million square feet of gross leasable area to our portfolio throughout the year at an estimated yield on cost above 10%. This has allowed us to provide additional space to our current tenants when they need it. We strengthened our relationship with them as when they need to grow, we can grow together with them. It also builds our track record for future expansions in built-to-suit projects, which we believe position us to deliver more on this front in 2020.

If I can sum it up in one sentence, I want to reiterate that we're very happy with the results we delivered this year. Despite the lack of visibility we went through with the USMCA, our operating trends are stronger than ever in many ways.

I want to now take a step back and briefly discuss the macro outlook we are seeing. In particular, I would like to dig deeper into the trends we have noted in the manufacturing sector, where we continue to enjoy positive dynamics. Since our exposure to this industry is very high at 73% of our GLA, we are excited to see how it's evolving. A good example that can illustrate the strength we are seeing in this sector is that the electronic component manufacturers are operating at full capacity and increasing their participation in new product lines. We saw this in one of our top tenants in that industry, which require incremental space. Furthermore, as trade tensions between the U.S. and China remain, now exacerbated by the coronavirus, multinational manufacturers are looking to diversify their operations and continue to see Mexico as the ideal place to tap into the U.S. market. This is evident also in the aerospace industry, where there is a clear interest in improving the supply chain with best-in-class Tier 2 and Tier 3 suppliers.

Also relevant, as the automotive sector is increasing hybrid and electrical car production, most of our tenants are adapting to meet these demands as many OEMs have an ambitious production goal for the transition. Terrafina will continue to serve these sectors, maintaining our position as the market leaders, while providing the best service to our clients.

The majority of last year's construction requests came from tenants in growing sectors, including aviation, electronics and automotive. Their high level of employment, steady income and commitment to grow production facility reaffirms our belief in continued stability and strength into our strategy to increase exposure to the manufacturing industry.

Now I would like to provide more color on our operations. As I mentioned before, we strongly believe that the main success in our strategy is being able to keep up with our tenant needs, and by finding innovative solutions and investing wisely, we are able to increase value to our shareholders on a long-term basis.

As mentioned, during 2019, we had almost 11 million square feet of leasing activity which brought our occupancy rate to 96.5%. This is a historic high for our portfolio. 53% of our leasing activity was in the north, 29% in the Bajio region and 18% in the Central region. This is aligned with our goal to retain our leadership position in the manufacturing for export sector.

For the first time, we had 100% renewal rate in the fourth quarter. Renewals represented 36% of our total leasing activity, which means it was a very active quarter with our existing tenants. The weighted annual renewal rate reached 91%. This, I believe, is one of the highest, if not the highest in the Mexican industrial real estate space. Naturally, due to the high amount of early renewals, some capital expenses and broker fees, which were originally projected for 2020, were realized in the last quarter of 2019. This, however, should normalize over the coming quarters as a result of lease expirations for 2020 closed at 8.3 million square feet compared to 9.6 million square feet in the third quarter of 2019. Rental rates maintained a stable growth trend with our U.S. CPI installations, reaching a level of $5.19 per square foot per year, and our weighted net effective rent for the year reached $4.76 per square foot per year.

Looking at the different regions. The Bajio had the lowest occupancy rate, particularly in San Luis Potosi, Queretaro and Jalisco, which posted 84%, 86% and 89% occupancy rates, respectively. We expect to see similar demand trends in this region for 2020 and will therefore be very active with our partners promoting our properties to capture as much demand for new space as we can and improve our occupancy rates. Actually, we have already planned to increase efforts in attracting tenants through our strategic investment already considered in our 2020 CapEx guidance.

Moving on to lease expirations. Through our early renewals, we decreased our 2020 maturities from 22.7% of our total GLA to 19.7%. This also portrays our tenants' need of securing their space to match their clients' contract expiration dates as well as reinforcing their commitment to Mexico. As we move forward, we believe this figure should continue to improve.

As mentioned in previous calls, we are engaged in an asset-recycling network of up to $150 million. We believe with this we can allocate resources into better assets through our expansions and built-to-suit development activity, which yield higher returns and secure long-term relationships with our tenants. This bucket of assets is located mainly in submarkets where we want to reduce our exposure, our older buildings will present some challenges at renewal time. And as we are successful in this strategy, the proceeds of the sale will be used to initially pay down debt, effectively reducing our loan-to-value to the mid- to high 30s. And additionally, some of these resources will fund our current development activity.

Terrafina will continue to execute dollar-denominated lease contracts with best-in-class multinational manufacturing companies, whose underlying business is also in dollars, which eliminates the disruption to our cash flow due to FX movements.

For 2020, we have a robust new development pipeline that could add another 1 million square feet of expansions in build-to-suits. These projects have similar characteristics to the ones we've been working on, with yields on cost above the 10% range in long-term dollar-denominated contracts with multinational tenants. As the lease are known, we will not build the facility of inventory buildings and will maintain our focus on pre-lease developments, which will generate rental revenue immediately after the construction is finished.

Before I pass the call to Carlos, I have one final comment regarding our CapEx figures for the quarter and our 2020 guidance. In the fourth quarter of 2019, we invested $6.2 million in tenant improvements and broker fees. This was much more than what we invested in the other 3 quarters of the year. However, this amount was due to the accelerated renewal activity, which I described before. Also, worth saying, our maintenance cap for 2019 was $0.23 per square foot for the entire portfolio, and our CapEx guidance of 20% to 25% of square feet -- per square foot for the year.

Lastly, on our 2020 guidance, there are 4 key things we are expecting for the year: an occupancy rate between 95% and 96%; an annual net operating income in the $194 million to $196 million range; an annual maintenance CapEx of USD 0.26 to USD 0.29 per square foot for our total GLA; and an annual distribution per share between USD 0.115 and USD 0.117, which is already factoring the new distribution policy of an 85% AFFO payout ratio. If we had kept the 100% AFFO payout ratio policy, our DPS guidance will imply a same-store growth of 3% to 4%. As a reminder, the 15% AFFO reserve will be used for contractual development processes.

Thank you for your time. Now I will pass the call to Carlos. Please go ahead with the financial highlights, Carlos.

[Carlos Espinosa, executive]

Thank you, Alberto. And thanks to all the participants joining us on today's conference call. Please note that all figures discussed in this call are in U.S. dollars, but Mexican peso figures can be found in the earnings report. 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.

As Alberto mentioned, 2019 was another good year for Terrafina. Our above-average leasing activity was the main driver for our positive results due to our record-high occupancy rate and positive trends in the rental rates. Rental revenues of USD 48 million in the quarter were up 1% year-on-year and almost flat quarter-on-quarter.

For the full year, rental revenues of USD 191 million, almost unchanged year-on-year. NOI for the year was USD 190.2 million, flat year-on-year. In the fourth quarter, NOI was USD 48 million, also unchanged compared to the same quarter last year. AFFO reached a total of USD 103.6 million in the year, a 7% year-on-year decrease as a result of increased leasing activity. In the quarter, AFFO was USD 26 million, a 2% decrease compared to the fourth quarter of 2018.

The company distributed 100% of its AFFO throughout the year. DPS, therefore, totaled USD 0.1310 per certificate. It is relevant to mention that as Terrafina is fully covered during the first 9 months of 2019 in the tax income result, fourth quarter distribution will be treated as a capital deployment, which will be tax-exempt.

Moving on to our balance sheet. We closed the year with USD 67 million in cash and USD 237 million in an authorized unused revolver credit facility. Our loan-to-value slightly increased this quarter to 41.5%.

Finally, our average cost of debt went down from just over 5% to 4.83%. We also significantly improved our average weighted maturity from 4 to 7 years. We therefore believe we have a sound capital structure that brings stability to our operations.

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 Jorel Guilloty with Morgan Stanley.

[Wilfredo Guilloty, analyst]

I have 2 questions. On the guidance, I was wondering if you could explain a bit more the mechanics of the lower AFFO payout. So how do these, the dividend that you're going to pay, compare to the potential taxable income that is supposed to be paid out as a distribution? And so how are you getting to this lower payout? Are you using debt losses? Are you using deferred taxes? So I just wanted to better understand the tax mechanics behind it.

And then I wanted to pick up on some comments made about the supply chain earlier. So I was wondering if you can provide a bit more color as to how your tenants are thinking about potential disruption to their own supply chain due to coronavirus. I mean some of them, I assume, are more connected to Asian countries or some of them might have seen some disruptions at some point. So I was just wondering how have those conversations gone and what can you tell us about this.

[Carlos Espinosa, executive]

Hello, Jorel. In regards with the tax results, I confirm it that the payout ratio will be enough to cover at least 95% of the tax result, which is what we are required by law. But if the 85% of our AFFO is above this 95% of the tax result, we will do as we are doing now. Perhaps, we're giving a portion of the dividend of the fourth quarter as a capital refund. But still, this should not affect the operations of the company. It's transparent. Until we have a positive tax result, we will continue to do the dividend as we are doing right now.

[Alberto Castillo, executive]

In -- yes, in reference to your second question, indeed, the coronavirus crisis is eventually going to affect especially the automotive sector. So far, what the feedback that we get from our tenants is that so far it has not affected the operations because they do still have enough raw material in their plants. The ones that are supplied -- the ones that are being supplied from the China suppliers, in that there's still some material in transit. At this time, we don't know the effect that is going to have on some of them. We do know that they're taking already some measures about the importing, about providing information to different companies that are their clients.

So to summarize the question, I think that everybody is concerned about what is going to happen. Everybody is taking some measures also, not only in terms of the supply but also in terms of how to protect the companies from an outbreak of coronavirus in Mexico. So I think it's serious. So far, it has not affected the operations. And I think that everybody is waiting to see what the impact is going to be. It's -- I know it's not a very clear, to you, answer, Jorel, but we, at this point, even today, we're still talking to our tenants to see what the effect it's going to have.

Let me say, however, that as far as the operation of Terrafina, these events, unless it becomes a very catastrophic situation, is not affecting Terrafina as the companies continue to operate. And if there is a slowdown of supply for some reason, there will be a time for when they had to pick up. So it's very uncertain at this time.

[Operator]

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

[Vanessa Quiroga, analyst]

My question is regarding your CapEx guidance. It implies a 15% to 29% growth per square feet compared to last year. And in 2019, we've had already seen a similar increase in CapEx per square foot compared to 2018. So I'm wondering if you think you will continue to require increases in CapEx, do you think, over the medium term. And what is creating the need for this CapEx growth?

[Alberto Castillo, executive]

Thank you, Vanessa. And I think that's a very good question. And first of all, we -- as I mentioned before, the CapEx increase that we had in the fourth quarter was due to the early renewals. We anticipate also that we're going to have some early renewals also during the -- during 2020. And that's why we are assuming -- we are giving the guidance that we have more expenses on the CapEx.

But let me give you some color on that. We -- as you all know, our lease contracts are triple net and the tenants must provide maintenance to the buildings. We are very demanding on the tenants to make sure that they comply with their commitment in terms of maintenance, but also really to lead with an example. We know that sometimes, in our renewal time, we'll also make an assessment of the facility and we deploy some of this CapEx at renewal time as we usually do because we want to make sure that we maintain these properties for the long term. I think that we are being very proactive in making sure that we maintain or upgrade the facilities for the long run. And going back to your number question, we think that that's why we gave you the guidance on 2020. And we feel that this is going to provide a plateau on how these -- our CapEx expenses are going to be in the following years.

[Vanessa Quiroga, analyst]

Okay. So if I understand correctly, you think that going forward, over the longer -- medium to longer term, you can maintain a CapEx per square foot between $0.26 and $0.29?

[Alberto Castillo, executive]

That is correct.

[Operator]

Our next question comes from the line of Francisco Suarez with Scotiabank.

[Francisco Suarez, analyst]

Thank you so much for the color at the beginning of your initial remarks. That was remarkable. The question I have is that it is wonderful to see this level of leasing activity. Congrats on that. Do you think that tenants are also willing to increase the overall tenor of their leases? What can you share about the gap happening in the ground because it seems that appetite is strong, but I don't know if that is so strong that it could lead you to a higher tenor in average and without a negative effect on overall leases?

And the second question that I have is a follow-up on taxes. Do you expect that your asset-recycling program might trigger some taxes as well?

[Carlos Espinosa, executive]

I'm sorry, Francisco. The communication is not very good. Can you please repeat the question?

[Francisco Suarez, analyst]

Yes, please. Let me see if this actually was perhaps my handset. Sorry for that. The questions that I have is that is the lease -- the strong leasing activity that you are seeing on the ground, which is remarkable, do you think that the overall tenor of your leases can actually increase as well without penalizing the overall lease spreads? That's my first question. And the second question relates with taxes. Will the potential taxes related with your asset recycling, if you see any risk of higher taxes with your asset-recycling program?

[Alberto Castillo, executive]

Yes. So thank you, Francisco, thank you. Sorry for the misunderstanding there. Well, first of all, the lease spread, I think that is, yes, we do have very robust lease activity, in that the lease spreads on our portfolio will be mostly on the U.S. inflation. We don't see a substantial growth in rent. Only -- and the rent growth, this will be exclusively on the U.S. inflation. As you know, so most of the rents from our portfolio are slightly above the market rent. So we don't anticipate that this will be a substantial rent growth.

In terms of the tax, we -- the recycling of capital initiatives that we have in motion in the bucket of properties that we have, we're going to have a, perhaps, a very small profit. As you know, that a lot of these properties we have had for over 4 years, in that so there's no need to pay any taxes. And that -- so we don't think that there's going to be a tax issue on the sale of these properties.

[Operator]

Our next question comes from the line of Gordon Lee with BTG.

[Gordon Lee, analyst]

Two quick questions. The first on the asset sales. Should we expect this to be sort of one transaction sold as a portfolio? Or do you expect the recycling to take place through various different deals? And I guess related to that is how advanced are you in some of these discussions? When do you think the timing might be?

And then the second question is just with regards to leasing activity. I was wondering whether you had been -- you had seen any impact on the speed with which potential tenants were making decisions following the approval of USMCA. Has that triggered a little bit more speed in the market? Or do you think it's really not had an impact?

[Alberto Castillo, executive]

Surely. Well, first of all, in terms of the transaction, it's going to be one transaction. It's going to be -- we put together a batch where probably it's going to be a portfolio and it's going to be sold to one buyer. And we expect to close this before the first half of the year.

In terms of the leasing activity in the USMCA, actually, the level of negotiations with the USMCA did not affect the leasing activity. Our tenants that are operating in Mexico, in general, they have had a little certainty about the -- their operations. And for them, it was going to be how they were going to continue with their import and export protocols, but it didn't affect that. We expect that with the ratification of the USMCA by the 3 countries, and the absolute current effect of the USMCA is going to trigger new demand. But in terms of affecting our tenants, it really didn't have an impact on our tenants.

[Operator]

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

[Fernando Froylan Mendez Solther, analyst]

I have 3 questions. The first one, would you say that the renewal negotiation with tenants are requiring larger investments from the landlord than in previous years? That's the first one. And secondly, regarding with the leasing activity in this quarter, was there any specific contract that explains most of these renewal efforts and this increase in tenant improvements? And thirdly, the payout cut implies around $17 million of retained AFFO, and you are -- have already disclosed an expansion for about $6 million. Do you expect the rest of the retained AFFO to go to incremental GLA? Or should we see something from these going to tenant improvements implied in the higher CapEx guidance?

[Alberto Castillo, executive]

Okay. Well, in terms of the -- what was it in terms of...

[Carlos Espinosa, executive]

The renewal, if the renewal is requiring more CapEx.

[Alberto Castillo, executive]

Well, the renewals, I think I mentioned before that we do see an opportunity to be more demanding on the maintenance that is being provided by the tenants. And also -- and by doing that also, we're also doing some more maintenance on the buildings and more investment in the buildings of the tenant, we do that. And that's why we see that as an increase in that. In terms of the second question...

[Francisco Martinez, executive]

Well, yes, there was a specific tenant, which represents close to 700,000 square feet, Froylan, that it was going to take place in the first quarter of 2020. And the negotiations with this specific client went to that moment and in which we were able to close it. So yes, it was a large tenant, specifically in the northern region. And at the end, it will allow us to reduce the amount of renewals for 2020. So that's -- I think that's one of the most important highlights. We're going to have something close to 9.6 million square feet, and it went down to 8.3 million square feet for 2020. And could you, Froy, repeat the last question?

[Fernando Froylan Mendez Solther, analyst]

Sure. So the payout cut implies around $17 million of retaining AFFO. And you already have disclosed the expansion in Coahuila that will require around $6 million for -- from those $17 million. So do you expect the rest of that retained AFFO to go to incremental GLA? Or should some part of these go to these tenant improvements that you're guiding for in the CapEx guidance?

[Francisco Martinez, executive]

Sure. So these CapEx reserves will be specifically used for development activities, will have no correlation with maintenance. And as we mentioned, one of the announcements made recently, a week ago on this tenant in the north region, and also the other announcement made at the end of January related to an aviation tenant. It almost takes 85% of that CapEx reserve from that $17 million. So the idea is that this money will be specifically used for contractual development activity.

[Operator]

There are no further questions in the queue. I would like to hand the call back to management for closing remarks.

[Alberto Castillo, executive]

Well, thank you all for attending today. As we leave behind a record year, we are excited to see what 2020 will bring for us and for the industry. We remain committed to delivering the best-in-class results and create value to our shareholders over time. We look forward to speaking with all of you again soon. Have a great day.

[Operator]

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.