Investing in Aldi, Lidl & Co.

Reading time: approx. 15 min

1) INTRODUCTION

In almost all countries of the western world it is common practice that the largest corporations are also tradable on the stock exchange. Unfortunately, this practice is historically not as deeply rooted in Germany as it is, for example, in the USA. As a result, corporations such as Robert Bosch GmbH, the Schwarz Group (including Lidl & Kaufland), the Aldi Groupthe EDEKA Groupthe REWE Group or the Adolf Würth GmbH generate billions in sales and profits, but there is no opportunity to participate in these profits in the form of shares.

What is immediately noticeable is in particular that very many "supermarket giants" are represented in the above list. In fact, in Germany it is not possible to invest in supermarkets like Aldi, Lidl, Rewe and Co. Since the title of this article is contrary to this statement, I would now like to explain how you can indirectly invest in the German supermarket landscape and thus indirectly also in the local consumer giants.

Instead of directly in the business of the supermarket chains, it is possible to profit indirectly from the fact that all supermarket chains need at least sales space. This article is therefore about a listed company that invests in supermarket real estate: the DEFAMA AG $DEF (+0%) .

In the style of my contribution "How do I choose my dividend shares?" I will now present the company, the business model, relevant key figures and my investment thesis step by step. Disclaimer: I have taken a first position of DEFAMA AG into my portfolio a few days ago.

2) UNDERSTAND BUSINESS MODEL & RECOGNIZE COMPETITION

DEFAMA AG is the abbreviation for Deutsche Fachmarkt AG. The name pretty much describes the company's business model: it sells real estate from "retail parks"and leased out. The company uses the term "retail parks" to refer primarily to grocery stores, home improvement centers, drugstores and specialty stores.

The company itself does not build any real estate but only buys existing real estate at an attractive price. In some cases, this is accompanied by conversion work to improve the usability of the property. This may not sound so sensational and seems rather boring at first glance. However, the more you look into the exact business model, the more interesting it becomes. In the following 5 points I summarize the details of the business model:

1.) Consumption needs space! The ten top-selling food retailers in Germany have a combined sales area of just under 26.5 million square meters [1]. An interesting fact that can be calculated on the basis of the figures from [1]: the highest turnover per square meter of sales area is achieved by Aldi Süd with just under 9650€ per square meter of sales area, followed by Lidl with 7450€ per square meter. The worst performers are Real and Norma, both of which only turn over about 4000€ per square meter. But not every area is suitable as retail space: usually supermarkets should be first floor, offer good parking facilities and be located where many people live in the immediate vicinity. This makes properties suitable for supermarkets relatively rare. DEFAMA specifically owns and buys properties that are either already rented or can be brought into this condition with modest effort. These are usually not large shopping centers but in many cases free-standing individual stores.

2) Small but mighty! DEFAMA's focus is mainly on retail parks in small to medium sized cities as the properties can be acquired there at comparatively low prices. Concentrating on small to medium-sized towns is definitely an advantage: often there are not many options for local residents to buy groceries. This makes it less likely that such "basic suppliers" will close and that a vacancy of the property is imminent. In addition, DEFAMA has a good network with the regional operator and can thus better respond to the specific needs on site.

3) Clear strategy! Only established retail parks with tenants with strong credit ratings are purchased. The guideline issued by the company is that on average about 9 times the annual net cold rent is spent on the acquisition of such a property. The typical purchase price of a DEFAMA property is around 1 to 5 million euros [2]. You are therefore operating in a market that is too small for large real estate investors, but lucrative for DEFAMA precisely because of this. In addition, the company follows a clear buy and hold strategy: the properties are bought to keep them. The company does not speculate on rising real estate prices or sell properties at a profit after a few years. The aim is rather to maintain the value of the property and to collect rents.

4) Diversification on all levels! DEFAMA's top tenants are according to the annual report from 2022: Kaufland/Lidl (Schwarz Group), Toom, EDEKA, Netto, Rewe/Penny, JSYK (formerly Dänisches Bettenlager), Woolworth/KiK (H.H. Holding) and Aldi North. The top 10 leases account for 22% of total revenues [2]. 40% of the tenants are food retailers, all other sectors are represented with less than 15% each. Real estate purchases are financed through loans. Here, DEFAMA works primarily with local regional banks and relies on sometimes creative options such as building society loans. Bonds or promissory bills are not issued. Usually, the loans are structured in such a way that a large part of the repayment is made after 10 years. So here, too, DEFAMA networks regionally and uses this as an advantage.

5) Expertise! The CEO of DEFAMA is Matthias Schrade. He founded the company in 2014 and has a wealth of expertise and network in the retail and real estate sectors. He is the head of the company and owns about 26% of the company's shares. I feel this is a positive thing, as it means that he himself is skin in the game has. The Management Board and Supervisory Board are complemented by other experts in retail and real estate valuation.

It is also worth mentioning that approx. 90% of all rents are so-called index rents are. These are rents that increase annually in line with inflation. This ensures higher rental income even in times of rising costs. Another plus point is the clear focus on value enhancement for shareholders, for example, it is mentioned in almost every Annual General Meeting and also in [2] that the growth of the company is "not an end in itself", but is always linked to the clear objective of value enhancement for shareholders.

The major competitor in the German retail market is the Deutsche Konsum REIT $DKG (-0.14%) . The business model is similar, differing mainly in the way the properties are financed. A good benchmark for a company that leases retail properties is of course Realty Income $O (-0.16%) . Even though it is not currently active on the German market, we would not want to leave out the dividend darling here.

3) SELECT & CHECK KEY FIGURES

We now review specific key figures against which we can assess DEFAMA's profitability and position against the competition. Since DEFAMA is a real estate group, we need to select suitable key figures that are specifically tailored to the business model of a real estate group.

One of these special key figures is the so-called funds from operations or in short FFO. In simplified terms, this is the better key figure to quantify the profit of a real estate group. The classic EBITDA is not not meaningful here, as (theoretical) depreciation and amortization on the value of the real estate portfolio are always taken into account.

We focus on the following key figures:

• Revenue and FFO growth
• Dividend growth and dividend history
• Total debt and leverage ratio
• Payout ratio dividend to FFO

We then compare these ratios with those of our peers. The relevant data for this was taken from [2], [3], [4] and [5]:

Sales growth

The sales growth of the last 5 years amounts to a total of

DEFAMA 124% | Deutsche Konsum REIT 160% | Realty Income 159%

This corresponds to annual growth of 17.5% for DEFAMA, 21.1% for Deutsche Konsum REIT and 21% for Realty Income. Thus, DEFAMA's sales grow slightly slower than its competitors on an annual basis.

FFO/Share growth

The FFO/share growth over the last 5 years amounts to a total of

DEFAMA 81.2% | Deutsche Konsum REIT 88.7% | Realty Income 43.3%

This corresponds to annual growth of 12.6% for DEFAMA, 13.5% for Deutsche Konsum REIT and 7.5% for Realty Income. Deutsche Konsum REIT still has the lead. However, we observe that DEFAMA has moved much closer in terms of FFO/share growth.

Realty Income stands out negatively here: the discrepancy between revenue growth and FFO/share growth is enormous. In the case of real estate groups, this can be explained above all by the fact that property acquisitions are often made through capital increases - i.e. the issue of new shares. This results in a dilution of existing shareholders. Realty Income appears to be making excessive use of this vehicle. The figures show that this is not always to the benefit of shareholders.

Divide growth & history

The DEFAMA has been paying out an annually increasing dividend since its foundation in 2014. This corresponds to a dividend history of 8 years of increasing dividends. Currently the dividend yield is 2,56%. The dividend growth of the last 5 years is on average 6,2%. The dividend is paid annually distributed.

The German Consumer REIT has been paying dividends since 2019. The dividend has only been increased once since then. Currently it is unclear whether and in what amount a dividend will be paid, as the AGM has been postponed from March 2023 to the end of May 2023 due to "strategic discussions" [6]. This for me is a clear warning signal. However, theoretically, a higher dividend can also be decided at the postponed AGM. We calculate with the currently available data: if the dividend remains at the previous year's level, the dividend yield is 5,8%.

Realty Income has been paying an annually increasing dividend since 1994. According to the company, they have been paying dividend annually for the past 26 years. dividend. Currently, the dividend yield is 4,81%. The dividend growth over the past 5 years averages 3,8%. The dividend is paid monthly.

Here I personally like DEFAMA the best. A dividend has been paid out since the company was founded and it is growing almost twice as fast as Realty Income. Deutsche Konsum REIT has completely disqualified itself here.

Total debt & debt ratio

The total debt of DEFAMA amounts to approximately 153 million euros. This compares with a portfolio value (=net asset value) of 257 million euros. The debt ratio (=loan-to-value) is therefore 59,5% of the net asset value. As mentioned above, financing does not involve the issue of bonds.

The total debt (as of 2022) of the Deutsche Konsum REIT amounts to approximately 636 million euros. This compares with a portfolio value of 514 million euros. The debt ratio is therefore 123,7% of the net asset value. Bonds and convertible bonds are also issued.

The total debt of Realty Income is approximately 19.3 billion US dollars. This compares with a portfolio value of $40.1 billion. The debt ratio is therefore 48,1% of the net asset value. Bonds are also issued for financing purposes.

DEFAMA and Realty Income have a solid debt ratio for real estate groups. In the event of insolvency, the liabilities at both would be covered by the value of the properties. Deutsche Konsum REIT has a significantly higher debt ratio - here, liabilities are not covered by the value of the real estate. Another warning signal for Deutsche Konsum REIT.

Payout ratio dividend/FFO

Currently distributing DEFAMA approximately 29,5% of FFO as a dividend. At Realty Income this figure is 75,7%. Again, we do not know how high this value is for German Consumer REIT as it is not certain in which amount a dividend will be distributed. In 2022, the payout ratio dividend/FFO was 34,2%.

Realty Income, as a US REIT, is required to pay out a high percentage of earnings. The 75.7% are therefore no surprise. In combination with the low dividend growth, however, we also see the problem here: there is not much room for improvement. Dividend increases of more than 10% are not to be expected in the future. In contrast, DEFAMA has a comparatively low payout ratio. Here, the profits generated can also be used to buy new properties. In good financial years and in the absence of suitable purchase opportunities, larger dividend increases could be forthcoming in the future.

Overall, it can be seen that Deutsche Konsum REIT is the much riskier investment. It is invested with several financial instruments and a large leverage in the financing. The postponed AGM, the unclear dividend situation and the lack of dividend continuity does not inspire much confidence among shareholders. DEFAMA and Realty Income are similarly solidly financed. Nevertheless, I like DEFAMA better here, as Realty works extensively with capital increases and thus accepts a high dilution of existing shareholders to finance new projects. The difference in FFO/share growth is particularly decisive here.

4) RISKS OF THE BUSINESS MODEL

In times of rising interest rates, the business model of a real estate group has become significantly riskier. Examples such as Vonovia $VNA (+0.02%) and TAG $TEG (-0.13%) also show here in Germany that companies sitting on a high mountain of debt are currently experiencing problems. Dividend cuts or -cancellations are a first warning signal. The problem is mainly that the financing costs for loans will rise. Instead of making million-dollar purchases at an interest rate of 1%, companies now expect a refinancing rate of 5% and more.

I do not see DEFAMA in a similar situation here as Vonovia, for example. The reasons are:

• 90% of all leases are linked to inflation, which means that rental income will increase at the same rate as inflation when inflation is high [2]
• the level of debt is comparatively low
• due to the special type of financing, a large part of the repayment will already be completed after 10 years; thus, there will be smaller residual amounts that may have to be refinanced at higher interest rates
• the average fixed interest rate is still 5.8 years; the current average interest rate is 2.32% [2].

Another somewhat technical point is that, unlike many European real estate groups, DEFAMA has chosen a different method of accounting. At DEFAMA, the properties are posted to the balance sheet at purchase value and then depreciated successively over the years until they are posted to the balance sheet at a value of zero. As a result, the value of the existing real estate is constantly declining.

At most other European real estate groups - such as Vonovia, for example - the value of the portfolio properties is reassessed every year. each year and posted to the balance sheet.

A simple example: DEFAMA and Vonovia buy a property for 1 million euros in 2018. How does the property appear on the balance sheet today?

DEFAMA: depreciates 3% of the property value every year, for example. The property then stands in 2022 with a value of 885 thousand euros in the balance sheet.

Vonovia: reassesses the value of the property every year. Due to general increases in real estate prices up to the year 2021, the property could be valued in 2022 at a value of 1.3 million euros in the balance sheet.

This makes a difference of over 45 from the previous year. As is well known, rising interest rates are currently causing the selling prices of properties to fall, which means that Vonovia's property is unlikely to fetch € 1.3 million on sale. The net asset value therefore tends to be too high.

In the case of DEFAMA, the value of the property is significantly lower and may even be too low. too low in the balance sheet. The true value of the property is probably somewhere between the two figures. However, there is no tendency for DEFAMA no There is, however, no greater risk at DEFAMA that the value of the real estate portfolio (=net asset value) is too optimistic.

5) INVESTMENT THESIS

After my analysis I decided to add DEFAMA to my portfolio. I have already bought a first tranche. My investment theses are:

1.) Focusing on retail properties in small and medium sized cities is a lucrative niche. Attractive purchase prices can be achieved and high returns on equity. There is little competition in these cities and it is unlikely that tenants such as Lidl, Aldi and Netto will withdraw from such markets, as they always want to be widely available in the area.

2) I like the clear strategy of "buy and hold" at attractive purchase prices of around 9 times annual cold rent. The speculation is not on value increases but on earning an increasing rent secured by index rents.

3) The debt remains at the current level and the current financing practice is maintained. Growth will not be achieved at any price.

4) The dividend can be continuously increased and FFO growth remains stable.

I will review these 4 points at regular intervals. The motto is: Buy, Hold and Check. The important thing is always the overall picture over a longer period of time. If, over time, the trend points in the wrong direction, my investment thesis would no longer be intact and the business model assumed at the time of purchase would no longer work. This would then affect my Exit Case correspond.

6) CLOSING WORD

What started as a small contribution of the kind "I have a new position in the depot", is of course again completely escalated in terms of scope escalated. I hope I was able to present my investment case in detail and encourage some to take a closer look at the company.

The current price of about 21€ per share seems attractive to me. This corresponds to a price-to-FFO ratio (comparable to P/E) of about 11,5. The forecast for fiscal 2023 assumes FFO of €2.04 per share. This would correspond to a price/FFO of just over 10. The price of the share has increased by approx. 20% and can of course fall even further. However, I personally see the downside as limited. In my opinion, the main reason for the drop in the price is that currently all real estate concentrates are devalued by the market. In my opinion, this is happening wrongly with DEFAMA for the above reasons.

If you have any questions, suggestions or criticism, you are of course free to express your opinion in the comments.

SOURCES:

[1] Business Insider: https://www.businessinsider.de/wirtschaft/handel/edeka-lidl-aldi-oder-rewe-welcher-discounter-und-supermarkt-in-deutschland-wirklich-vorne-liegt-b/

[2] DEFAMA Investor Relations: https://defama.de/wp-content/uploads/2023/03/DEFAMA-Praesentation-2023-02-23.pdf

[3] Deutsche Konsum REIT Investor Relations: https://www.deutsche-konsum.de/investor-relations/finanzberichte

[4] Seeking Alpha: https://seekingalpha.com/symbol/O/income-statement

[5] Realty Income Investor Relations: https://www.realtyincome.com/investors/quarterly-and-annual-results?tab=annual-reports-proxies

[6] Deutsche Konsum REIT Investor Relations: https://www.deutsche-konsum.de/investor-relations/hauptversammlung/2023