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Date : 15/09/2022

Why we gave Rural Funds Group a long-term BUY rating

Rural Funds Group (ASX: RFF) has remained an excellent dividend stock that offers consistent net profit growth. Join us as our international award-winning team of Research Analysts discuss in detail why you should include this in your portfolio. 

At Shares in Value, we conduct research-backed findings to help retirees, self-directed investors, and self-managed super funds plant their investments in rock solid, stable, and low-risk dividend stocks. Our goal is to help our clients cultivate a portfolio where they can harvest maximum yields. 

Read our exclusive Full Report on Rural Funds Group below.

rural funds group

Company Analysis

Rural Funds Group (ASX: RFF) is Australia’s first ASX-listed diversified agricultural Real Estate Investment Trust.

RFF owns a diversified portfolio of Australian agricultural assets in five core sectors, predominantly leased to corporate agricultural operators. The Company seeks to generate earnings and income growth via productivity improvements and conversion of assets to higher and better use. Rural Funds Group has a clear objective to distribute its growth with a lucrative target of 4% per annum.

Over the last two years, we have recommended Rural Funds Group ASX shares many times, first while it was trading for $2.28 per ASX RFF share. As of the time of writing (16/08/2022), the RFF share price is changing hands for $2.66, up 16.75% since our first recommendation last 11th September 2020.

rural funds group asx trend on trading view
Source: Tradingview

Since the onset of the global pandemic, RFF dividend shares bounced back from their low at $1.62 to $2.66, gaining more than 63%. However, this year we have seen Rural Funds Group ASX shares following the same path as the broad market, with the RFF share price down by about 16%. We think this year’s market correction could be an opportunity to buy or increase your exposure to this quality agriculture real estate investment trust.

We like the stock. RFF ASX dividend shares, over the past five years, has not failed to deliver its commitment to distribute its target annual dividend yield of 4%. Furthermore, Rural Funds Group has consistently delivered net profit growth over the last four years. We are confident that the performance of Rural Funds Group ASX shares will remain on track for FY23 and onward.

reliable income stock
RFF: a reliable income stock with serious long-term income growth potential

 

RFF has a healthy approach to its commitment to dividend distribution growth. The Company is achieving its Income growth through its lease indexation, productivity improvements and conversion of assets to higher and optimised use.

 

Rural Funds owns a diversified portfolio of agricultural assets mainly leased to corporate operators. Overall, RFF has acquired assets in sectors where Australia has a comparative advantage. The Company has a well-defined three approaches to its strategy, including:

  1. lessee selection,
  2. diversification, and 
  3. acquisitions and developments.

Lessee selection

RFF lessees primarily comprise corporate entities, representing 78% of FY22 forecast income. Many of these corporate entities are directly listed on domestic or international securities exchanges or via their parent entity. Rural Funds’ Private farming operations of varying sizes correspond to 11% of the Company’s lease income. Additionally, The RFM entity, the manager and responsible entity of RFF, lease about 10% of the properties from Rural Funds, and 1% relates to investment funds. Both arrangements provide RFM operational experience, which can benefit RFF’s assets and sector due diligence. This allows the Company to identify and efficiently execute development opportunities and lessee selection and management.

Diversification

Over time, RFF’s RFM entity has successfully accomplished multiple layers of diversification within Rural Funds’ portfolio, including by:

  • Asset type: This incorporates diversification across the Company’s infrastructure and natural resource assets.
  • Climatic zone: RFF emphasises implementing climatic diversification in its portfolio of assets. Hence, this limits the risk and the likelihood of multiple lessees being exposed to adverse weather events at any time.
  • Lessees: RFF also focused on mitigating the counterpart risk by diversification.

Acquisition and developments

Rural Funds Group is continuously looking for the next acquisition and additions to its portfolio of assets that grow the diversity of the Company’s earnings. Rural Funds’ investment strategy is to invest across its full asset continuum range, including infrastructure-type assets, high-potential assets for development, and high-value productive assets, to ensure its asset mix can continue to fund its distributions target of 4% annually.

What gives us confidence in the Company’s ability to consistently maintain its dividend yield year-over-year is its ability to invest in opportunities across various agricultural sectors. So far, RFF has reliably pursued investment opportunities that allow the Company to gain productivity and superior asset conversion to higher and better use. RFF’s strategy has effectively lifted assets’ value and income earnings potential.

On top of that, Rural Funds aims to enhance its property’s ability to produce a given commodity. Moreover, what we like about RFF is its flexibility. Thus, the Company is also looking at possibilities for higher and better use of any given property and transforming it into a different, more profitable commodity-producing asset.

In short, what RFF strives to do is to increase productivity or produce a more valuable commodity. This enables the Company to enhance the ability of the operator to generate higher profits, leading to a higher valuation and enabling the landlord to charge more rent, thus supporting RFF’s distribution growth target of 4% per year.

industry analysis
Source: RFF

Industry Analysis

Inflation remains a central and continuing preoccupation of macroeconomic policy

The Australian Bureau of Statistics recently announced that Australia’s inflation rate for the 12 months to the end of March 2022 was 5.1%, the highest rate since the introduction of the Goods and Services Tax in 2000.

In the US, inflation for the same period rose by 8.5%. Consequently, it is now widely accepted that inflationary forces are not transitory, and the global economy has entered a period of rising prices.

Central banks will likely keep rising interest rates in response to these very high price increases until inflation is brought down. The market is now observing and attempting to understand how these two economic forces, rising prices and increasing interest rates, will impact Commodity prices, Australian inflation, and US Inflation.

Over the last decade, governments and their central banks intervened to support economic activity in response to the global financial crisis, which began in 2007. Accommodative monetary policy continued for many years following the crisis. This continued with the response to COVID-19. Consequently, most economies now face an increased money supply by trillions of dollars. With these actions supporting demand, interruptions in supply chains have caused shortages across many sectors. This has resulted in soared commodity prices.

Rural Funds is benefiting from rising land values

RFF proceed to farm acquisitions generally through the use of bank debt. The Company’s debt financing is typically 35% of the farm’s value. According to RFF, the Group favours debt financing as it is often cheaper than equity. In fact, debt has been very affordable recently, with variable interest for farm loans costing around 1.56%. However, it now appears that interest rates are rising, which will impact the RFF fund’s net profits. The Company has taken measures to cover this risk by hedging or using effectively fixed 42% of its term debt, which means that a 1% increase in interest rates based on its current debt would increase interest expenses by just $2.53 million annually.

However, this increased cost can be offset by increased rental income from the Company’s leased assets. RFF, as an investor in agricultural land and water entitlements, has benefited from the recent favourable price movements. Over the past five years, RFF’s vineyard values have increased by 47%, although this sector is currently challenged by very high tariffs now imposed in the once fast-growing Chinese market. Almond prices have declined in the last seven years due to large crops produced by the dominant US industry. Despite this, RFF’s almond orchards fund values have increased by 22% since last year. The value of RFF’s cropping assets has increased by 15% and cattle assets by 98%. Water licence values have also increased during the period by 91%.

Increased assets values are handy for RFF since they increase the fund’s net assets and, therefore, the amount of equity the Company holds to finance its investment activities. Over time increasing asset values and inflation also transfer to the amount of cash income generated by the fund from rents because of the rental indexation mechanisms contained in the agreements RFF has with its lessees. Of the leases, 44% are indexed to Consumer Price Index, and 34% have fixed annual increases, but with a review of the farm’s market value every five years. 

82% of RFF’s leases provide rental indexation due to land value changes or inflation. Importantly, a period of rising commodity prices greatly benefits RFF’s lessees as they generate higher profits from the commodities they produce.

Investment Thesis

Highlights of Rural Funds’ first half of FY22 ASX:RFF financials included:

  • Total net profit after tax (NPAT) of $38.2 million
  • Property revenue up 12%, or $3.8 million, to $34.8 million
  • Balance sheet capacity “within target range”, with gearing at 33%
  • Distributions “in line” with forecast at 5.87 cents

During the first half of FY22, Rural Funds Group made significant additions to its property portfolio. The Group’s total assets were $1.25 billion, up from $1.04 billion in June 2021 by the end of CY21.

Among these acquisitions was a $100 million entitlement offer achieved in August last year, which was used to fund:

  • the developments of 1,000 hectares of macadamia orchards,
  • the purchase of an 8.3 GL water entitlement, and
  • additional asset acquisitions.

During the year’s first half, RFF also made the acquisition of:

  • three cattle and cropping properties that totalled 33,926 hectares, and
  • three mature macadamia orchards.

Moreover, RFF also confirmed a forecasted adjusted fund from operations (AFFO) of 11.9 cents per unit and distributions of 11.73 cents per unit for the second half of FY22. This increase is expected with funds from the J&F Guarantee and acquisitions.

Looking forward to its FY23 distributions, we are projecting RFF’s distribution to be a 4% increase on FY22 at 12.20 cents per share, including franking credits.

Onward FY23, Rural Funds continues to focus on two main strategies that have worked so far to increase investor’s earnings:

  1. Firstly, the conversion of assets to higher and better use, specifically within the macadamia sector.
  2. The second strategy is to improve the productivity of natural resource assets and deploy existing cattle and cropping assets within the portfolio.

RFF exhibits solid financial positions

With a few acquisitions and reviewing the fund’s valuation, RFF’s net assets of the consolidated Group have increased to $764.68 million at the end of CY21 from $648.54 million at the end of FY21. This represents a fund’s appreciation of 17.9%. The Group has also reported total assets of $1.25 billion compared to $1.04 billion at the end of FY21. RFF’s assets have increased by about 20.19%.

The Company has obtained independent valuations on its properties and ensures that each property is independently valued every two years or more often where appropriate. RFF has released the most recent valuations on each property and considers that they remain at an estimated fair value.

company's growth

According to the Company’s growth trajectory over the last five years, we expect RFF’s assets to expand at a CAGR of 25.28%. We believe RFF revenue will be capped at $70.54 million from FY22 to FY24. Accordingly, we expect RFF to maintain a steady cash flow stream over the next three years, and we project the Company’s working capital to grow from $7.39 million to $42 million as the business is highly capable of improving its productivity, bringing its EBITDA margin from 77.86% to 136.56%.

Property leasing valuation increased

What we like about Rural Funds is its diversified exposure to climatic zones and specific asset types. This mitigates the risk of adverse weather events, especially drought, that typically impacts agricultural-related product prices. However, most of RFF’s properties are on the east coast. They are nonetheless evenly spread, which limits the risk. That is one of the Company’s strengths compared with many of its competitors, which have been quite impacted by the recent weather conditions.

Rural Funds has a diverse portfolio of a few different farming sectors such as almonds, macadamias, cattle, vineyards and cropping (cotton and sugar). The Company has a total of 68 properties in its portfolio. It has a long weighted average lease expiry (WALE) of 11.1 years, which is one of the longest in the REIT space.

As of the first half of FY22, RFF held 68 diversified properties:

  • 3 almond orchards (4,139 planted hectares);
  • 7 vineyards (666 planted hectares);
  • 7 macadamia orchards (814 planted hectares);
  • 8 properties with potential for areas to be developed into macadamia orchards with development underway (5,103 hectares)
  • 20 cattle properties made up of 15 breeding, backgrounding and finishing properties (674,983 hectares) and 5 cattle feedlots with a combined capacity of 150,000 head;
  • 23 cropping properties (15,780 hectares).

During the period, the assets held by Rural Funds recorded an increment in the fair value of investment properties of $17,96 million, which is way superior to the first half of FY21, $5,83 million.

RFF is able to limit its exposure to elevated commodity prices risk

Agricultural commodity prices typically soared during inflation periods and then declined during cycles of rising interest rates. Simultaneously, farm values have increased during periods of inflation and experienced generally brief periods of price declines as interest rates have risen. Consequently, as we enter the end of the inflationary cycle, farms will not likely see their valuations continue to increase.

However, in our opinion, we believe Rural Funds’ will not be much affected by a decline in valuation as the Company has been doing very well to enhance its ongoing productivity gains. Thus, over the next few years, we think that RFF will likely experience higher interest rates on its debt while accruing increased rents from higher inflation and recently increased land values. And in the long run, we think that the Company is highly capable of identifying and developing productivity gains across its portfolio of assets and increasing its long-term profitability.

RFF is trading at high multiples, although not that excessively given its robust growth potential

For us, RFF does not just offer a diverse portfolio but also provides long-term growth potential.

Hence, the Company has expressed its intention of growing the distribution by 4% each year. This is comfortably more than long-term inflation. It is worth noting that RFF has been successful with this objective since the Company started paying a distribution several years ago.

RFF’s distribution growth is primarily funded by its annual rental increases at the farms. Those increases are funded by a fixed 2.5% rental indexation at some farms, whilst others are linked to Consumer Price Index in addition to market reviews.

We are confident that Rural Funds can grow its distribution thanks to its farm investments. This allows the Company to retain some of its rental profit each year to re-invest into those farms to make them more productive and efficient for the benefit of tenants and therefore sustain increases in rental fees. 

Rural Funds gave FY22 distribution guidance of 11.73 cents per unit, which translates to an increased forward distribution yield of 4.4%. Furthermore, RFF also distributes its dividends 4 times a year which is not negligible.

RFF's price action

Over the past five years, Rural Funds Group ASX price action has remained relatively stable compared to its peers. This somehow reflects the stability of the Company’s fundamentals. Rural Funds might be trading at a high multiple with its EV/EBITDA at 25X, compared to SHV, GNC, ATM or CGC EV/EBITDA of 17.7x, 7.1x, 16.3x, and 8.4x, respectively. However, its Price-to-Book value remains reasonable at 1.4x. Despite trading at high multiples, we think RFF has a solid margin for growth given its unique approach to acquisitions and divestments.

Recommendation

Are Rural Funds Group ASX shares a buy?

We gave Rural Funds Group a long-term BUY rating previously, and here’s why.

We have recommended Rural Funds several times in the past two years as we saw RFF as a stable business with consistent cash flows and potential growing dividends. We also like that RFF distributes its dividends 4 times a year. We have identified three drivers that will continue to support our thesis. The first one is the business diversification across various types of farming sectors. The second one is RFF’s long weighted average lease expiry (WALE) of 11+ years, which is one of the longest in the REIT industry, and finally, the third driver is a consistent and improved portfolio through diligent acquisitions and divestments. RFF is expected to report its FY22 results on August 23. Therefore, for more cautious investors, we advise staying aside until it is released. However, given the quality of this property stock, a resilient business, with one of the longest WALE in the industry, we recommend a long-term “Buy”.

Disclaimer: Prices on the graphs are approximate and for a 5-year period from 2017.

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