Continuing on the theme of value in construction and building related equities in Europe, I have been taking a look at the UK listed homebuilding sector. The sector trades below book value as well as showing up favourably on the deep value Price/Net Working Capital screen the net nets screen. Finally, nearly all of the homebuilding stocks that I looked at, had a Graham & Dodd PE of less then 10 (this should not be surprising however). It fits my basic criteria of trading on distressed multiples. My key questions then will focus on (i) where are we in terms of long term margin history? (ii) what are the balance sheets like? (iii) what is being implied by present valuations?
I will examine Persimmon, Barratt Development, Taylor Wimpey and Abbey plc. In addition I will take a peak at the construction company, Morgan Sindall plc.
My interest was initially piqued in the UK exposed housbuilding sector when the nearly all appeared in a deep value screen that I use, the Benjamin Graham Net Net screen. This is a screen that it is pretty difficult for companies to meet the criteria but the criteria are relatively simple. The stock to be interesting must trade at a significant discount to the Net Working Capital less total long term liabillities. In essesnce it is the liquidation value of the company. Now I have seen that some market commentators explicitly exclude homebuilders from the screen. I cant really figure out why however. Despite the fact that the principal asset on a homebuilders balance sheet is its inventory of land and work in progress, homebuilders have not in the past decade or so always trade at discounts to working capital less other liabillities. To exclude them from the screen, seems to me to penalise a business for the way it makes money, and I find nothing illegitimate about how a homebuilder makes money (or loses it for that manner). There are legitimate concerns about what is the marketable value of the inventory – that is a margin of safety question I guess.
So at the very least, on an asset value, the stocks appear to offer varying shades of attractiveness. To be honest, I am surprised to see that only one of the homebuilders that I have looked at ahas an ungeared balance sheet, given the trauma that the sector has endured in the past 5 years. In saying that, the levels of gearing appear modest at many of the firms analysed – but that would quickly reverse if we enetered a period of inventory writedowns once again.
In simply looking at the valuation, I would be biased against both Taylor Wimpey & Barratt Development. In one year alone, Taylor Wimpey made losses that erased a decades performance, hence the negative Graham & Dood PE. Furthermore, with a choice of four companies that have low or no gearing, I would need a very compelling reason as to why either Taylor Wimpey or Barratt would be interesting at this point in the cycle.
Sales, Margins & Asset Turnover
I am a believer in a weak form of mean reversion. So the opportunity that I tend to be attracted to not only must have the ability to grow their valuation, but I am also looking for an ability for sales, margins and asset turnover to expand in order to grow returns. In an ideal world if this takes place with a balance sheet that does not have to shrink (delever) returns can really expand throughout a cycle. So in essence I am looking not at the growth the company has had, but asking the following question:
Given where we are in terms of margins, sales and asset turnover, is there potential for improvement back to historical norms, or are the new levels a permanently lower level?
While I am resorting to ten years of annual data and much of the earlier part of that data series was during a property boom, margins are well below historic norms. I have been endevouring to seek out company data that covers the 1990’s without much success.
Margins have improved recently, after sustaining heavy losses from 2007-2009 as large swathes of inventory were written down by the industy. The key for margins is the price paid for land. Thus any factor that results in land prices falling (or rising less)more than house prices is on the face of it good for margins. I think an important point here will be that those companies that have cash on the balance sheet should be able to deploy that to take advantage of land bargains if and when bargains should preseent themselves. Such companies will be seeking to spend cash in order to purchase higher future margins, in theory.
Asset Turnover has fallen consitently for the past decade. During the boom years this was influenced by inventory growth far exceeding sales growth as companies bid up land acquisition costs. More recently the trend has been reversed, sales have not recovered meaningfully while inventory has been broadly static post writedowns. Interestingly, inventory has risen in the past year at Abbey, Bovis and Persimmon – three of the builders with strong balance sheets.
The ideal scenario for the cash rich companies would be a ‘if you build it they will come’ strategy. That is buying land over the next few years in advance of an eventual upturn in housing activity, whenever that occurs.
A worry for an investor would be a double dip in the UK or global economy. To be honest, I am not even sure that the term double dip is appropriate – having spent many years looking at the UK banking and retail sectors, it appears to an outside like me, that the UK is one terrible malaise for the past number of years. If anything results from retailers are getting worse. I am not looking to bet on a recovery or the timing of a recovery – but the UK housing market will surely recover at some stage in the future. Despite share price strength, dilutive capital raisings, several years of losses, the stocks remain good value on book value and thru the cycle earnings methodologies.
The sector has in the past been capable of returns in the mid to high teens. To my mind, any unlevered company that can achieve this should not trade at a discount to book value. It is clear that while Bellway has the lowest returns volatility, Taylor Wimpey has the least attractive returns profile, despite being levered all throughout the last decade.
The stocks that are most interesting to me are Abbey, who despite running net cash and a lower asset turnover than most other companies still managed to have the third highest ROE of the stocks that I have looked at. The company has the secondhighest profitability profile after Bellway. Now given that Abbey has Irish exposure, it is questionable as to how impaired future margins are?
I think that Bellway looks to be a class operator in terms of the builders I am analysing. The company exhibits the least volatility in margins and returns while having consistently strong asset turnover. In all metrics they look to be the mirror image of Taylor Wimpey. It should be said that I did not look at Berkeley Homes, who while very high quality seem to be priced to reflect that. I am seeking to buy attractive stocks not good companies per se.
Recent Results Trends
I have taken a peak at the most recent results statements from the builders to guage their present mood:
Persimmon PLC – Half Year report 2011
Weekly sales are running 4% ahead of prior year and the order book is 10% ahead of the prior year.
“We have supported our customers through further investment in
shared equity incentives and by offering part exchange facilities.
In the first half of the year we retained a shared equity interest in 24%
of our sales. ”
It would seem to be the case that the sales process has become more complex than in the past. Personally I dont like the idea of part-exchange. To my mind it is simply replacing ones own inventory with someone elses. Not so sure where the value added is here. But I guess that this is what builders must resort to in order to facilitate sales and liquidity.
Completions were down 2% during H1, while management expect a flat performance in terms of volume and pricing over the next 18 months. It is the affordable housing segmet that is the key performance driver, as completions of private dwellings fell by 6.4%. The company make mention of the fact that credit conditions for would be house purchasers remain tight.
Like many in UK housing they reiterate the point that supply is constrained.
Completions during H1 2011 have fallen 2% as average price increased by almost 5%. Social housing is the key performance driver and has moved to 24% of completions from 19%. Shared equity is an important driver of sales.
Abbey notes in its annual report (dated late August) that the UK market is “dull over the period with volumes in particular continuing to
run at depressed levels. . . Market conditions continue to soften and there is no indication of any early improvement.
The fall in disposable incomes being widely experienced together with the highly restrictive mortgage market is a significant constraint on
house sales.” That statement stands in contrast to the views of the much larger players in the UK market. Why is that?
Like many of its peers, Bovis Homes had flat completions yoy. But the completions of private homes was down 11% yoy. Meanwhile social hosuing completeions grew from 41 to 120. It seems as if you are not present in social housing in the UK then the market maybe pretty uninteresting.
House Prices & Affordability
The Nationwide publishes monthly and annual data relating to the UK Housing market. The latest report is here.
House prices in the UK have begun to decline once more having staged a strong recovery in 2009 (+5.9% on average) and a relatively flat 2010 (+0.1%). The annualised data for this eyar up to August reveals a 0.4% decline in prices on average. More worryingly, house price affordability, while improving is far from the long terms average. The most recent data sugggest that the average home price too income ratio is just be;ow 5.5x versus a long term average (back to 1981) of 4.2x. Given the backdrop affodability and lack of credit, it is difficult to make a case that volume growth will pick up significantly for the UK housebuilders anytime soon.
It seems to me that if a homebuilder is not in the social housing segment that the market would be pretty dull. I woould worry that an increasing dependence on social housing would be at risk under an austerity typpe fiscal regieme. The optimist in me believes that credit will eventually flow in the mortgage market, and that will underpin future sales growth. However housing affordability indicators are not benign presently. I would be unsurprised if house prices were to begin to fall again. Would homebuilders have to write down inventory once more?
All in all, despite the attractions of valuation I cannot bring myself to invest at present. The share price strength over the past 15 months allied to recent relative strength in the face of a collapsing market should bode well in terms of momentum. Yet reading recent results presentations from the various companies does not fill me with the type of optimism that believes in a follow through in the price momentum. Bovis, Abbey and Barratt Development have potentially the most to gain by a normalisation of asset turnover and margins.
Abbey plc has most of what I am seeking. A strong balance sheet with potential to retire almost half of its equity/or aquire land banks. Either is appealing at a certain point. The company also has a strong operational leverage (however so does the industry). I like the fact that the managment (the key shareholders) are cautious about market developments. They went intol the last downturn with cash, and if there is another downturn they have plenty of cash to weather the storms.
I would like to buy the share, but for the moment I will sit on the sidelines and watch. I cant help feeling that the recent trends in its main markets are unsupportive of the share price strength that has occured in the past 12 months. Granted that share price strength was driven by a combination of deeply depressed valuation and a catalyst in the form of a share buyback. Given that the company could well commence another buyback shortly, then sitting on the sidelines may appear foolish – but its what I will do for the moment. Against this backdrop, there is a valuation level that I do have in mind. If the share price would only co-operate and move to ther, then in all likelihood I would pull the trigger and add Abbey to my portfolio.
I have also had a look at Morgan Sindall plc. More on this later. Appears to be exceedingly well run with a prident balance sheet, superior dividend and strong cashflow.