An update on the house builders.

Friday, 13th October 2017 10:46 - by David Harbage

Last month’s article, “If the boss is selling, should you?” prompted a lot of comment from readers, especially those interested in the domestic residential market and the stocks of UK stock exchange listed house builders in particular. In response to requests, such as where does best value reside amongst these companies’ shares, we produce an industry-specific update of this blog’s ‘Looking out to the horizon – a focus on future profits and dividends’:

Essentially it shows share price information, together with brokers’ views on the leading home builders based on that community’s forecasts (as far out as possible) of future earnings and dividend pay-outs. Beyond that, the author has applied a subjective judgement on the price tag for each stock – based on an appropriate multiple of those consensual profit forecasts. Applying that target price-to earnings rating (PE ratio or multiple) or opinion, which may turn out to be erroneous, to those forecast earnings per share (EPS) produces a forecast of Fair Value for the share price. Comparing that projected valuation to the current share price will suggest upside potential or downside risk.

Clearly, placing a different view on the worth of any company’s earnings – as well as the EPS itself – has a dramatic effect on the ascribed fair value. Let’s see what happens, for example if, instead of the 64.4p consensus EPS forecasts (of 15 research houses) on Barratt Developments’ for the current year’s trading (to 30 June 2018), the earnings turned out to be 60p or 70p and Target PE ratios of 9 or 12 were applied:

Barratt Developments – placing a lower EPS forecast of 60p on a PE of just 9 times equates to a Fair Value of 540p – indicating 19% downside in the current share price.

Barratt Developments – placing the same EPS forecast of 60p onto a higher PE multiple, of 12 times, leads to a Fair Value of 720p – indicating 8% upside in the share price.

Barratt Developments – placing a higher EPS forecast of 70p onto a lower PE of 9 times equates to a Fair Value of 630p – suggesting 5.5% downside in the share price.

Barratt Developments – placing the same higher EPS forecast of 70p onto a higher PE rating, of 12 times, equates to a Fair Value of 840p – indicating 26% upside in the share price.

Barratt Developments – placing the current consensus EPS forecast of 64.4p on a lower PE of 9 times equates to a Fair Value of 580p – indicating 13% downside from the current share price.

Barratt Developments – placing the current consensus EPS forecast of 64.4p on a higher PE of 12 times equates to a Fair Value of 773p – indicating 16% upside in the share price.

It is pleasing to note (by reference to the guidance provided in the 18 September blog) that – with the exception of upmarket London-based Berkeley Group and retirement home builder McCarthy & Stone – earnings forecasts have continued to rise over the past month. Aided by the announcement of higher central government spend on housing (Help to Buy extended, social housing boost), favourable news of builders’ trading, the level of mortgage applications and even helpful weather. 

However, what should the (right) earnings multiple be for each individual company stock? A discount to the wider UK stock market is appropriate, given the historic cyclicality of the industry but, relative to the FTSE All Share index’s forward looking 14 times, how big should it be? The most expensive house builder (Persimmon, deservedly highly rated) is on a 30% discount, the cheapest FTSE250 constituent builder (Crest Nicholson) does not merit an almost 50% discount to the wider market. A higher multiple should be applied to the larger market capitalised companies – to reflect the relative ease of dealing – and a lower one to the (less regulated, less disclosure and less well- researched) Alternative Investment Market (AIM) listed companies. 

In a homogeneous sector, companies with particular geography or proposition should be valued according to the perceived rewards or risks of each business. For example, London-based builders Berkeley Group and Telford Homes are likely to face greater labour cost pressures and enjoy less of any beneficial house price inflation tailwind in the short term. Certain firms offer greater nationwide exposure (typically evident in average selling prices) and more traditional houses (as compared to apartments) – such as Persimmon – while others have particularly exposure to the rental sector (be it in social, affordable housing or the institutional investor ‘build to rent’ sector), such as Countryside Properties.  

As frequently mentioned in this blog, the direction of future profits is a prime driver of equity valuation – and, of course, when trading updates or actual results are announced they will provide a major steer for analysts endeavouring to calculate earnings for the following year. Accordingly, trading updates yesterday from Countryside Properties and Aim listed Telford Homes were eagerly scrutinised by investors. There was little new ‘news’ to impact analysts’ numbers or investors’ opinions and both of these companies’ share prices – which have been strong in 2017 to date – ended little changed on the day.  

Countryside Properties stock has advanced strongly, from a low spot of 224p in February, reflecting a number of positive surprises in its trading – notably in its Partnership division where it specialises in urban regeneration of public sector land, delivering private and affordable housing by partnering with local authorities and housing associations. Yesterday the company announced a 28% increase in completions for the year to 30 September 2017 (to 3,389 homes), albeit with an 8% reduction in average selling price (to £430,000). The latter resulted from a well-flagged move away from the higher value end of its private housing (ASP reduced by 23% to £515,000, but completions rose 53% to 1,197 homes) and ongoing strength in its Partnerships division (ASP +12% to £343,000, completions up 17% to 2,192 homes).

Further progress in its long land bank was achieved last year as Partnership grew from 14,504 to 18,985 plots, while Housebuilding land accounts for 19,826 plots after acquiring another 2,896 units last year. Incidentally, strategically developed land – that progressed from no permission option value through to planning consent – accounts for 83% of the Housebuilding, non-Partnership division’s land bank. Essex-based Countryside’s chief executive Ian Sutcliffe expressed confidence on the outlook, both for domestic housing and in meeting his company’s ambitious medium term growth projections.

The shares of Telford Homes have also outpaced the wider UK stock market - rising from £3 to 425p - over the past year, before settling around the £4 mark. The company can be characterised as building in London’s less expensive parts (affordability is relative, given the average expected £530,000 price of its 4,000 home pipeline), but more recently as a partner for institutional build to rent investors. Yesterday’s statement may appear a little opaque and short of detail to new investors – as the company works on 500 build-to-rent homes, rather than books immediate profits on open market private sales. However the company’s well-regarded management reminded investors that, although earnings would be lower in the half year to 30 September, the group is on track to achieve £40m of profit in the year to 31 March 2018. 

The nature of bigger developments (featuring multi-year projects) is that the revenue emanating from those sites will inevitably be much lumpier. The financial impact of such stage payments is countered by the prospect of a less capital intensive business (initially by reference to site purchase) and a more reliable source of customer demand. (Something which can also be seen via Countryside Properties’ efforts to cultivate the rental sector). Telford Homes’ £580m forward sales are impressive and a further 900 homes in the build-to-rent space are expected to be added to the pipeline of work early next year when detailed planning consent is granted on the Greystar project. Meantime CE0 Jon Di-Stefano (who recently joined the board of land developer Urban & Civic) indicated that the company have been considering ‘numerous opportunities to add to its substantial development pipeline both for build to rent and open market sale’.

So, which of the above mentioned home builders would this writer favour? After making the usual caveat about not making recommendations and highlighting that some valuations are becoming stretched short term, the following appear the most attractive to this observer: Bellway, Crest Nicholson and Redrow – based on a combination of fundamental attractions (product location & offering, balance sheet) and share price valuation. While Barratt Developments, Persimmon and Taylor Wimpey offer a similar national footprint and good fundamentals, their respective equity valuation is less appealing. Beyond those, Berkeley Group’s upmarket, cum London, bias and McCarthy & Stone’s dependence on downsizers provides short term company-specific headwinds. The shares of Bovis and TJ Gleeson appear overvalued compared to their peers – notwithstanding respective recovery (new management after Q4 ‘2016 operational issues) and interesting business model (sale of land in southern England, build in the north). Each of the remainder has an interesting profile: Inland Homes’ asset base would have attractions to a predator in a different macro industry environment (if land were not so easily available), while Countryside Properties (strong growth via rental profile) and Telford Homes (valuation appeal) have clear longer term attractions.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.