Arco Vara AS unaudited consolidated interim report

GENERAL INFORMATION

Arco Vara AS and other entities of Arco Vara group (hereafter together ‘the group’) are engaged in real estate development and services related to real estate. The group considers Estonia, Latvia and Bulgaria as its home markets . T he group has two business lines: Service division and Development division.

The Service division is engaged in real estate brokerage, valuation, management and consulting as well as in short-term investment in residential real estate . The Service division offers to the group additional value by generating analytical data on market demand and supply, and behaviour of potential clients. Analytical data allows to make better decisions on real estate development: purchase of land plots, planning and designing, pricing end products, and timing the start of construction.

The Development division develops complete living environments and commercial real estate. Fully developed housing solutions are sold to the end-consumer. In some cases the group also develops c ommercial properties until they start to generate cash flow for two possible purposes: for the support of the group’s cash flows or for resale. The group is currently holding completed commercial properties that generate rental income.

As of 31 December 2016, the group consisted of 22 companies, which is three less than at the end of 2015. On 19 February 2016, the group’s subsidiary Fineprojekti OÜ was erased from Estonian Commercial Register, the liquidation process was started in 2014. The liquidation also resulted in derecognition of Romanian subsidiary Arco Capital Real Estate SRL from the group’s structure. In Q1 2016, the group’s interest in Bulgarian real estate fund Arco Real Estate Fund REIT was increased from 70% to 100% and the share capital of the fund was additionally increased by 77 thousand euros. In April 2016, the group sold its 100% subsidiary Arco BB EOOD in Bulgaria and in May 2016, the group acquired a 100% subsidiary Iztok Parkside EOOD in Bulgaria. On 31 October 2016, the group sold its 70.6% ownership in Arco Real Estate SIA (including its subsidiary Adepto SIA). On 22 December 2016, the group established a new subsidiary Kodulahe II OÜ. None of these transactions had significant impact on the group’s net assets.

Significant subsidiaries

KEY PERFORMANCE INDICATORS

·                     In Q4 2016, the group’s revenue was 1.3 million euros, which is 37.6% less compared to the revenue of 2.1 million euros in Q4 2015. Revenue of the Development division amounted to 0.6 million euros in Q4, decreasing by 54% compared to Q4 2015. Revenue of the Service division amounted to 0.8 million euros in Q4 2016, increasing by 1.6% compared to Q4 2015. The group’s revenue of 9.7 million euros for the 12 months of 2016 decreased by 8.5% compared to the 12 months of year 2015. Revenue of the Development division decreased by 11.3% to 7.0 million euros for 12 months 2016. Revenue of the Service division amounted to 3.2 million euros in 12 months 2016, decreasing by 0.7% compared to 12 months 2015.

·                     In Q4 2016, the group’s operating loss (=EBIT) was 1.1 million euros (In Q4 2015: 0.2 million euros) and net loss 1.3 million euros (In Q4 2015: 0.4 million euros). In 12 months 2016, the group’s operating loss (=EBIT) was 0.1 million euros and net loss was 0.8 million euros. In 12 months 2015, the group earned operating profit of 1.3 million euros and net profit of 0.5 million euros. The group’s financial performance for 2016 was affected by the loss from devaluation of assets in amount of 0.6 million euros. The development division earned operating profit of 0.6 million euros in 12 months 2016 and 1.8 million euros in 12 months 2015. Operating loss of the Service division was 0.2 million euros in 12 months 2016 and 0.1 million euros in 12 months 2015.

·                     As of 31 December 2016, the group’s debt burden had increased by 1.5 million euros compared to the year-end of 2015. Net loans had increased by 1.4 million euros over 2016 up to the level of 13.4 million euros as of 31 December 2016. As of 31 December 2016, the weighted average annual interest rate of interest bearing liabilities was 5.3%. This is an increase of 0.3 percentage points compared to 31 December 2015.

·                     In Q4 2016, 2 apartments, 4 commercial spaces and 2 land plots were sold in projects developed in the group (in Q4 2015, 17 apartments and 3 land plots were sold). In 12 months 2016, 77 apartments, 9 commercial spaces and 8 land plots were sold (in 12 months 2015: 90 apartments, 6 commercial spaces and 4 land plots).

Cash flows

FORMULAS USED:

Earnings per share (EPS) = net profit attributable to owners of the parent / weighted average number of ordinary shares outstanding during the period

Diluted earnings per share (Diluted EPS) = net profit attributable to owners of the parent / (weighted average number of ordinary shares outstanding during the period + number of all potentially issued shares)

Invested capital = current interest-bearing liabilities + non-current liabilities + equity (at the end of period)

Net loans = current interest-bearing liabilities + non-current liabilities – cash and cash equivalents – short-term investments in securities (at the end of period)

Return on invested capital (ROIC) = past four quarters’ net profit / average invested capital

Return on equity (ROE) = past four quarters’ net profit / average equity

Return on assets (ROA) = past four quarters’ net profit / average total assets

Current ratio = current assets / current liabilities

Quick ratio = (current assets - inventory) / current liabilities

Financial leverage = total assets / equity

Number of staff at period-end = number of people working for the group under employment or authorization (service) contracts

GROUP CEO’S REVIEW

From the targets set for 2016, we achieved necessary internal growth, but did not achieve profit.  It is hard to reach profit without selling anything and without revaluating your assets. There are no reasons to revaluate our assets upwards, and in order to sell anything, we must first complete the ongoing development projects while launching new developments like a cascade. As a general philosophical remark, I think that earning real money must be preferred anytime to simple rewriting the asset valuations. In real estate you earn real money when you sell something against payment.

Arco Vara will celebrate its 25th birthday very shortly. A few years ago, we went through reanimation from a situation which we had put ourselves into by growing our assets and liabilities much faster that our capacity to sell to our customers completed real estate products. Today, we are gathering speed again, which is a painfully slow process. I am not proud of the results of Q4 and the full year, but I also do not think they are bad results. I see how the results of 2016 will lead us to sales in 2017 and the years thereafter. Presales of development products have been good and this will be recorded as revenue in 2017.  

At the moment, let’s concentrate on 2016 figures. I start with the worse, with the net loss. The full year’s results were damaged by Q4 when we did not sell anything out of our almost empty stock. We did not achieve our annual target to sell our services and products for 10.3 million euros and earn a net profit of at least 0.8 million euros. The actual 2016 results (unaudited) are a revenue of 9.7 million euros and net loss of 0.8 million euros, where Q4 was the biggest contributor to annual loss. 

There are five reasons for the annual loss. First, we were not successful in letting out the offices of Madrid Blvd building, Sofia. Although one additional tenant was signed in Q4, the vacant premises at the end of the year amounted to 3,500 square meters. The lost rental income for 2016 was at least 0.4 million euros, in cash.

Second, since we were not successful in letting out the offices of Madrid Blvd and the effective rents of signed agreements have been lower than expected, the management had to write down the value of the building as of the end of the year. We decreased the valuation by 0.4 million euros. That part of net loss is accounted on paper, not in cash.

Third, around year- end we sold as one-off deal “Baltezers-3” - the block of undeveloped residential land plots in Latvia, at an accounting loss of 0.2 million euros. With this transaction we chose guaranteed cash over possible revenue in the future. We calculated that at times when the Group issues debt to finance its developments at a cost of over 10% per annum, it would not be right to sit for years on undeveloped land that offers zero current yield and negative cash flow after land taxes and other expenses. The management devaluated the whole Baltezers project (both completed unsold individual residential plots and the value of undeveloped chunk of land) as of the end of 2012. Apparently, the devaluation at that time was not sufficient. Since then, we have sold the finished products with a small profit, but very slowly, 4-8 units per year. 

Fourth, we lost 0.2 million euros by rendering evaluation and brokerage services. Looking into the mirror provides an answer for this loss. As of today, we have sold out of the Group the Latvian service unit. It is possible that we will license the trademark and software in Latvia. In Bulgarian and especially in Estonian units, we have undertaken thorough changes in personnel, marketing, service standards, processing of data and sharing the revenues. I expect these changes to deliver current operational profit both in Bulgaria and in Estonia in 2017.

Fifth, the loss was increased by marketing and other preparatory expenses of Iztok Parkside that were borne but not capitalized during Q4. Those costs were foreseen in the business plan and we expect the net profit to be respectively larger, when we will sell out the Iztok products. 

If one wants to sum up the reasons of loss in 2016 and be smart retrospectively, then we made substantial mistakes with the offices in Madrid Blvd. The effect of those mistakes on the P/L statement amounts to more than 0.8 million euros. The only good news here is that the occupancy of the building has improved over the year and the net result of Madrid Blvd building should be significantly better in 2017. 

Next I will describe the internal growth factors of Arco Vara during the past year, which should become visible in numbers by end of 2017 and in 2018.

Kodulahe construction progress and presale met its targets. The first building with 130 units will be sold out by the beginning of 2018, if we continue with average sales pace of 6 apartments per month. The first and the largest building will be completed in Q3 2017. Expected sale revenue exceeds 16 million euros. In addition, we have commenced the design of the second phase – altogether there are five phases on Paldiski road 70c (former name) land plot – and we have concluded a pre-agreement to acquire additional land plot in 2018 in the neighbourhood of Kodulahe project with a view to make a detail plan and continue development of Kodulahe project after Paldiski road 70c plot (2.7 hectars, 330 units) will become exhausted. We will be Kodulahe district developers and sellers at least until 2022. 

Iztok Parkside presale has exceeded expectations. We launched a marketing campaign in December and have sold „on paper“ more than 26% of the total project volume by today.  Expected sales revenue exceeds 8 million euros. The offers presented in construction tender also met our expectations. The sole problem we face today is the delay caused by the bureaucracy of Sofia municipality in obtaining the construction permit. Delay with construction permit causes in turn the delay with concluding and performing the construction contract. As of the date of this report, we have lost at least 45 days against our initial schedule. Completion of the construction works will therefore be postponed into Q1 2018. Although this is a small condolence, we have learned from our competitors that many developers get stuck into municipal bureaucracy in Sofia. 

In Madrid Blvd building we signed in one new tenant and reduced the vacancy. There are ongoing negotiations with several interested parties. The shortest way to eliminate Group’s loss and start making profit is to resolve the problems of Madrid Blvd vacancy.

In Tartu, Estonia, we succeeded in bringing to an end the land exchange with Tartu municipality. We waived our co-ownership in Turu 34a commercial purpose land plot, made a compensation payment to the municipality and acquired from the municipality the sole ownership of Oa Str 37, 39 and 41 land plots that have detail plan allowing construction of 2300 square meters (ca 40 apartments). We have commenced the design works with a view to complete the project by the end of 2018. Considering that the plots are located at the bank of Emajõgi river in a good neighbourhood, and that we shifted ourselves from commercial segment into residential segment, the progress so far could be called a success.

Last but not least the revenues of Estonian and Bulgarian service companies grew. The younger team of professional appraisers and brokers has started to show first results, although there are still big differences between the regions. The biggest challenge of 2017 lies ahead in Tallinn.

We sold Latvian subsidiary in Q4 to Latvian management, preferring one-off money from selling the shares to unclear prospect of earning dividends in the future.

Targets for 2017 and 2018

Arco Vara’s objective of year 2017 is to earn revenue of at least 18 million euros and net profit of at least 1.8 million euros. For this, we need to sell at least 120 apartments and serve at least 6,000 appraisal and brokerage customers. By the end of 2018, we wish to earn at least 20 million euros and make a net profit of at least 2 million euros, which is a new level in the Group’s history and a new threshold for the Group’s future years. Our objective is to be the most people-oriented real estate company. In Estonian and Bulgarian real estate sectors, there remains a lot to be done to achieve this mission. If we succeed, the future Arco Vara will be several times larger than today’s.

In short term, we need to:

1)     Sell out Kodulahe phase I in Tallinn and commence construction and presale of phase II in 2017;

2)     Commence the construction of Iztok Parkside in Q1 and sell it out by the end of Q1 2018;

3)     Let out all Madrid Blvd vacancies by the end of Q2 2017 and refinance the existing loan contract with outstanding balance of less than 9 million euros by the end of 2017;

4)     Commence the construction and presale of Oa project in Tartu in Q4 2017 and sell it out by the end of 2018;

5)     Acquire in Sofia at least one development plot with GBA/GSA exceeding 10,000 sqm in 2017;

6)     Acquire in Tallinn at least one development plot with GSA/GBA exceeding 10,000 sqm in 2018;

7)     Serve in Bulgaria and in Estonia combined at least 7,500 customers per year and earn at least 3 million euros of annual revenue by end of 2018, at which level we will start to make satisfactory profits. 

In order to deliver the above, we need to resolve a bunch of tactical issues related to financing, design, marketing, sales and IT, as well as in our relations with municipal and state bureaucracy. This is what the management and the team are paid for and eagerly working on.

Service division

The most significant event of the group’s services division in Q4 2016 was the sale of the Latvian brokerage agency on 31 October 2016. In 10 months 2016, revenue of Latvian agency was 771 thousand euros (including 7 thousand euros of intra-group revenue) and net loss amounted to 11 thousand euros. With the sale of Latvian agency, the number of employees working for the group decreased by 70 people.

Revenue of the service division amounted to 3,231 thousand euros in 12 months 2016 (2015: 3,254 thousand euros), which included intra-group revenue of 418 thousand euros (2015: 467 thousand euros). In Q4 2016, revenue of the group’s service division was 827 thousand euros (Q4 2015: 814 thousand euros), which included intra-group revenue of 136 thousand euros (Q4 2015: 100 thousand euros). In 12 months 2016, revenue of the Service division from main services (real estate brokerage and valuation services) decreased by 3% compared to 12 months 2015. The main reason is the fact that the revenue from Latvian agency was included in the group revenue only for the first 10 months of 2017. The revenue from main services increased in Estonian and decreased in Bulgarian agency. The drop in the revenue of Bulgarian agency can be attributed to the decreased income from mediating the sales of the group’s own properties - 97 thousand euros less in year 2016 compared to year 2015.

In 2016, all 3 brokerage agencies operated at a loss: Estonian agency had net loss of 188 thousand euros, Bulgarian agency 19 thousand euros and Latvian agency 11 thousand euros (Latvian agency in 10 months). In 2015, Estonian and Latvian agencies had net loss of 209 thousand euros and 73 thousand euros, respectively. Bulgarian agency had net profit of 109 thousand euros in 2015.

In addition to brokerage and valuation services, the service division also provides real estate management services and accommodation service in Bulgaria. The revenue from real estate management was 118 thousand euros in 12 months 2016, 100 thousand euros of which was intra-group revenue (2015: 141 thousand and 105 thousand euros, respectively). Revenue from accommodation services amounted to 144 thousand euros in 12 months 2016 (2015: 132 thousand euros).

At of 31 December 2016, the number of staff in service division was 97 (at 31.12.2015: 165). The number decreased in 2016 due to the sale of the Latvian agency in October.

Development division

In Q4 2016, revenue of development division totalled 647 thousand euros (in Q4 2015: 1,403 thousand euros) including revenue of 519 thousand euros (Q4 2015: 1,306 thousand euros) from the sale of properties in the group’s own development projects. In 12 months of 2016, revenue of the Development division amounted to 7,048 thousand euros, which is 899 thousand euros or 11.3% less compared to 12 months 2015. In 12 months 2016, the revenue from the sale of properties in the group’s own development projects reached 6,562 thousand euros (2015: 7,019 thousand euros).

Most of the other revenue of the Development division consists of rental income from commercial and office premises in Madrid Blvd building in Sofia, amounting to 98 thousand euros in Q4 2016 and 369 thousand euros in 12 months 2016 (77 thousand euros in Q4 2015 and 838 thousand euros in 12 months 2015). Rental income has decreased compared to the previous year due to ending the rental agreement with anchor tenant in Q3 2015 and the renovation works of rental area in Q4 2015. The rental area that was previously rented out to one anchor tenant is now divided into 7 smaller areas. Finding new tenants at the same level of rental fee has proved to be difficult. At the end of Q3 2016, a decision was taken to decrease rental income expectations with the aim of renting out all rental areas by no later than in Q2 2017. In Q4 2016, one new rental agreement was concluded.

In 12 months 2016, operating profit of the Development division was 611 thousand euros. In Q4 2016, an operating loss in the amount of 912 thousand euros was suffered in the Development division. This included a loss in the amount of 708 thousand euros from the decrease in value of inventories and investment property. In 12 months 2015, development division had an operating profit of 1,790 thousand euros, out of which 192 thousand euros in Q4.  

During Q4 2016, the construction and presale of apartments of the first stage apartment building (with 125 apartments and 5 commercial spaces) in the group’s biggest development project Kodulahe continued in Tallinn. By the publishing date of the interim report, presale agreements for 75 apartments and one commercial space have been concluded. The construction of the apartment building should be finished by summer 2017.

In Q4 2016, the group completed a land exchange agreement in Tartu, where a joint ownership in a commercial property at Turu street 34a was exchanged for land plots on Oa street 37, 39, 41 with building right for smaller apartment buildings with GSA above grade of up to 2,300 m2 (ca 40 apartments). Design works have started and the project is scheduled for completion by the end of 2018.

As of 31 December 2016, 5 apartments remained unsold in Madrid Blvd complex in Sofia, one of which was presold. In Q4 2016, 2 apartments were sold. 15 apartments are furnished and are being rented out as accommodation service. Unsold 103 parking places are also rented out.

The last four commercial spaces in Manastirski Livadi project were sold in Q4 2016 and thus the whole residential project (developed in 3 stages with 300 apartments and commercial spaces in total) is sold out by now.   

In May 2016, the group finalized the purchase of a company Iztok Parkside EOOD. As a result, the group’s development portfolio has gained a new development project in Iztok district in Sofia. In September 2016, a bank loan agreement was concluded to fully finance further development costs of the project in the maximum amount of 4.9 million euros. In Q4 2016, detail plan for the project’s property was established and construction tender was carried out, but obtaining the construction permit has been somewhat delayed. By the publishing date of this report, presale agreements for 18 apartments have been concluded already. Three apartment buildings with 68 apartments (7,070 square meters of apartments’ sellable area) will be built by Q1 2018.

By the end of 2016, an agreement for sale of the whole Baltezers-3 project in Latvia (68 plots) was reached. The transaction was completed in January 2017. Accounting loss from the transaction in amount of 200 thousand euros was recognized already in 2016.

At 31 December 2016, 10 Marsili residential plots remained unsold. In Q4 2016, one presale agreement was concluded for one of those plots.

As of 31 December 2016, 5 people were employed in the Development division, the same number as of the end of  2015.

Summary table of Arco Vara’s active projects as of 31 December 2016

Note: Value presented between < > means future target value as the project is in early (S1, S2) development stage and the building rights or the design have not been finished yet. The table does not reflect sellable or lettable volumes below grade including parking spaces and storages. The table does not provide complete overview of the group’s land bank.   

Description of stages S1: Land plot acquired S2: Building Rights Procedure S3: Design and Preparation Works S4: Construction S5: Marketing and Sale S6: Facility Management and/or Lease

People

As of 31 December 2016, 110 people worked for the group (178 as of 31 December 2015). The number of employees has decreased significantly due to the sale of the Latvian brokerage agency Arco Real Estate SIA in October 2016. Employee remuneration expenses in the 12 months of 2016 amounted to 2.8 million euros (in 12 months 2015: 2.7 million euros), out of which 0.7 million euros in Q4 (0.8 million euros in Q4 2015).

The remuneration of the member of the management board / CEO, and the members of the supervisory board of the group’s parent company including social security charges amounted to 111 thousand euros in 12 months 2016 (108 thousand euros in 12 months 2015), out of which 28 thousand euros in Q4 (26 thousand euros in Q4 2015).

Management board and supervisory board

The management board of Arco Vara AS has one member. Since 22 October 2012, the member of the management board and chief executive officer of Arco Vara AS has been Tarmo Sild. The mandate of the CEO was extended by 3 years (until October 2018) by the supervisory board in September 2015.

The supervisory board of Arco Vara AS has 5 members. Since 10 February 2015, the supervisory board consists of Hillar-Peeter Luitsalu (the Chairman), Allar Niinepuu, Rain Lõhmus, Steven Yaroslav Gorelik and Kert Keskpaik.

Additional information on key persons of Arco Vara is presented on company’s corporate web page www.arcorealestate.com .

Description of main risks  

Strategic risk

Most of the group’s equity is invested into real estate development. The group is focused mainly on residential real estate development where development cycle lasts for years, starting from the acquisition of a land plot, moving on to detail planning, design and construction, and ending with the sale of end products to customers. The equity is invested mainly in the early phase of the cycle (purchase of land) on the assumption that there will be a demand for certain products in the future. Considering that the demand for development product is largely based on forecasts, the main risk for the group is investing equity into a development product for which there is no or too little demand in the future.

For mitigating the risk, the group: (i) invests equity into different development projects in different markets (in 2016, in Sofia and Tallinn), (ii) monitors current demand and supply in its home markets and (iii) makes efforts to narrow the time between making initial investment and selling the final product – by signing pre-agreements with clients, acquiring land without no or little upfront equity investment etc. 

Credit risk

The group considers credit risks to be substantially mitigated. The final sales of real estate development products takes place simultaneously with customer payment, therefore customer debts do not arise. Also, cash and cash equivalents are not held in the same banking group.  

Liquidity and interest rate risks

The base currency of all of the group’s loan agreements is euro and the base interest rate is 3 or 6 months EURIBOR. As a result, the group is exposed to developments on international capital markets. The group does not use hedging instruments to mitigate its long-term interest rate risk. On 31 December 2016, the group’s interest-bearing liabilities amounted to 15.5 million euros (increased by 2.7 million euros during 12 months 2016), out of which 9.4 million euros is due within next 12 months, including bank loan in the amount of 9 million euros in Madrid project in Bulgaria. At the same time, the group’s cash and cash equivalents totalled 0.8 million euros as of 31 December 2016 (on 31 December 2015: 0.7 million euros). In 12 months 2016, interest payments on interest-bearing liabilities totalled 0.8 million euros (in 12 months 2015: 0.8 million euros). The group’s weighted average loan interest rate was 5.3% as of 31 December 2016. This is an increase by 0.3 percentage points compared to the end of year 2015. The reason for the increase is new borrowings raised in 2016, which bear an above-average interest rate.

Currency risk

Purchase and sales contracts of provided services are mostly signed in local currencies: euros (EUR) or Bulgarian lev (BGN). Real estate sales are mostly nominated in euros, as a result of which the group’s assets and liabilities structure does not denote a significant currency risk. The group is not protected against currency devaluations. Liquid assets are mostly held on demand or short-term deposits denominated in euros.

SHARES AND SHAREHOLDERS

Share price

Arco Vara AS has issued a total of 6,507,012 ordinary shares with nominal value of 0.7 euros per share. In November 2016, the share capital increased by 390 thousand shares, when a convertible bond issued to CEO was executed. The shares are freely traded on NASDAQ Tallinn stock exchange. The share price closed at 1.24 euros on 31 December 2016. The price has increased by 7.8% within 12 months 2016 (closing price at the end of 2015 was 1.15 euros). During the period, the highest traded price per share was 1.35 euros and lowest price 1.01 euros. As of 31 December 2016, market capitalization of shares amounted to 8,049 thousand euros, P/E ratio of the share was negative (-9.2) and P/B ratio was 0.90 (at 31 December 2015: 7,035 thousand euros, 15.8 and 0.73, respectively).

Structure of shareholders

As of 31 December 2016, Arco Vara had 1,502 shareholders (on 31 December 2015: 1,600) including 1,297 individuals as shareholders (on 31 December 2015: 1,381 individuals) who jointly owned 12.5% (on 31 December 2015: 12.7%) out of all Arco Vara shares.

¹ - Steven Yaroslav Gorelik is active as fund manager in three investment funds holding interest in Arco Vara (Firebird Republics Fund Ltd, Firebird Avrora Fund Ltd and Firebird Fund L.P) of 692,750 shares (total of 11.3% interest).

CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME  

CONSOLIDATED STATEMENT OF FINANCIAL POSITION

CONSOLIDATED STATEMENT OF CASH FLOWS

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY

         Kristel Tumm          CFO          Arco Vara AS          Tel: +372 614 4662          kristel.tumm@arcovara.ee          www.arcorealestate.com