Next Thursday (22 October), almost 4,500 farmer shareholders in Farmer Business Developments (the original FBD co-op) will be asked to vote on the proposal to buy out its joint venture partner (FBD Holdings) in the hotels business (FBD Property and Leisure).

Farmer Business Developments will invest €48.5m and take on new borrowings of €25m to fund the deal and secure its largest investment, FBD Holdings, after the insurer reported a €96m loss in July.

This could have long-term implications for farmers’ original investment in FBD co-op but it may be left with no choice.

The hotels business was formed in 2011 as a 50:50 joint venture between FBD Holdings and Farmer Business Developments. It owns a diverse group of five hotels, including La Cala and Sunset Beach in Spain, Castleknock Hotel in Dublin and Faithlegg House Hotel and the Tower Hotel in Waterford.

Last year, the hotels generated an operating profit of €4.8m on sales of €52m. Profit before tax was €2.2m. However, €1.4m of this related to land sales in Spain. Last year, earnings (EBITDA excluding land sales) was €4.5m. For the first half of 2015, EBITDA was up €1.2m to €2m on the same period last year.

As the hotels business is seasonal and the impact of land sales is included, it is difficult to get a clear picture of the actual profitability so far in 2015. But occupancy and room rates continue to improve.

Based on the last few years’ performance, the return on investment is approximately 1%.

What is Farmer Business Developments?

Over the years, Developments (the original co-op) became an investment holding company, with the majority of its portfolio in one core asset – FBD Holdings. Almost €60m has been wiped off the value of this investment in the past year due to insurers poor performance.

This is currently worth about €60m at today’s share price of €7. It’s second most important investment is in hotels. It also has a €19m investment in a land bank in Berlin. It currently has no debt and has liquid reserves of approximately €22m, which it plans to use to fund this purchase.

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Implications of this deal

  • To fund this deal, Developments will take on a total debt of €45m on an investment that has cost them close to €110m. After write downs and the sale of the Temple Bar Hotel, the property and leisure business has a net asset value at €95m and debt of €21m.
  • There will be a significant cost to servicing the debt. Last year, the loan note payment to both JV partners amounted to €2.3m. This will now be replaced with an interest service cost of €1.5-€2m on the total €45m debt, assuming a rate of at least 3.5%. The facility has yet to be agreed by the financial institution.
  • In the short term, Developments’ only income will now be from the hotels investment. Last year, Developments received a €4.5m dividend from FBD Holdings. It also received interest income from the loan notes of €1.7m. Holdings has said it will not pay a dividend until at least 2017 and it may be 2018 before any cash is received.

    • Under the new finance structure, the loan note income will also end.

  • These hotels are not coming cheap. In 2014, almost 60 hotels changed ownership in deals worth €440m. Last year, Mount Juliet in Kilkenny was snapped up for €15m, while the Heritage in Killenard was bought for €10m. The jewel in FBD’s crown, the Temple Bar Hotel, was sold for €27m this year.
  • Hotels by their very nature make low returns. This is a low-margin business and significant continuous investment is needed. For example, the annual depreciation charge for FBDPLL last year was €1.2m.
  • The Taylor Wimpey JV agreement in Spain is progressing well. Thirty-seven of 60 units in the first development were sold for €11.8m. A second deal has been signed to develop a further 102 units, the proceeds of which could aid cashflow to service the debt.
  • Both the sale of the Temple Bar Hotel and the Taylor Wimpey deal in Spain are in keeping with the core strategic objective of realising value as market conditions improve.

    • Based on earnings (EBITDA) of around €5m and a valuation of approximately €100m, Developments is paying a high 20 times earnings for the hotels business.

    However, as Developments aims to protect its largest investment (FBD Holdings), it may be left with no choice but to play this last card. The question for shareholders is how this bet will come off.

    As with any investment, the rate of return should reflect the risk. For example, to achieve a return greater than 3.5% (the borrowing rate) would mean the hotels would need to return a net profit after tax of €4m. While it could also achieve this return if the assets increase, this may be unlikely in the short term based on current book values.

    Developments needs to service the high debt and cash income will be key, something that won’t be helped as the only source of income will now come from hotel profits in the short term. It needs the insurer’s fortunes to turn around, so the insurer can offer a dividend in the future, and this income can be used to fund the high debt, while the hotels business needs to offer greater profitability.

    To put this in context, it helps to step back and look at what another investment might return. Fairfax, who recently invested €70m in a convertible bond in FBD Holdings, will receive an annual return of 7%. It is likely they will, at some time in the future, end up with a 19% stake in FBD. Meanwhile, Developments will see its ownership decline from 24.6% to 20% in what was once their most important investment.

    Ultimately, it needs to find buyers who will pay a premium over the book value for the hotel assets. Because of the diverse range of hotels, it is unlikely that one buyer will be interested in them as a package. Hotel valuations vary widely and depend on profitability and realistic future value. Location and how much investment is needed to upgrade the hotel must also be taken into account.

    Strategically, this may be the best outcome for the FBD group of companies, but time will tell, and is very dependent on the performance of Holdings in the coming years.