Housebuilders

Friday, 6th July 2012 13:04 - by David Harbage

An easing in tension surrounding problems within the Euro zone, allied to mixed economic reports in China, has resulted in a pick-up in appetite for risk assets over the past ten days.

This has been evident in a hike in the world’s equity indices, including the FTSE100 which has risen by 250 points to challenge the 5,700 mark. Markets have been cheered by the prospect of further measures to address flat economic activity; delivered via a 25 basis point cut in the European Central Bank’s prime interest rate (to a record low of 0.75%) and a £50 billion increase in the Bank of England’s bond purchasing (taking the current version of Quantitative Easing up to £375 billion) programme, yesterday. And the new French administration is unlikely to turn their back on austerity measures, if Wednesday’s revision to their 2012/13 fiscal budget (which is set to increase taxes by circa Euro 13.3 billion over the next two years) is any guide.

However, bears will point to the deterioration in the global economic outlook - suggested by June’s Markit survey data – as being a key indicator of underlying activity. Essentially an assessment of the service (which, in most developed economies, tends to dominate the manufacturing) sector, by reference to purchasing managers’ intentions, the data showed a declining trend in China, France, Germany, Italy, Spain and the United Kingdom. Such forward-looking data, typically expressed by reference to 50 being a neutral (no directional change) expectation, featured Germany falling from 51.8 (net expansion) in May to 49.9 (slight contraction) in June. Closer to home, while the equivalent assessment of the immediate outlook showed a fall from 53.3 to 51.3 in June, a survey of the outlook to June 2013 indicated a much weaker reading of 45.5. Hence: the heightened talk of the financial authorities, encouraged by politicians, taking pre-emptive action to address such a slowdown.

In this regard, yesterday’s reduction - of just a quarter of one per cent - in the ECB’s policy rate will be viewed by many as “too little, too late”. By contrast, the Chinese authorities’ decision to slice 31 basis points off its key lending rate (to 6%), its second cut within a month, was not widely expected. This move suggests that the world’s second largest economy – which has recently seen a collapse in property values and a slump in manufacturing - is in need of more substantial stimulation. The writer is not alone in believing that, unlike the European Central Bank (which appears to have consistently erred on the side of caution or inactivity), the decision makers in Beijing have proven themselves to be proactive and nimble in setting appropriate timely monetary policy.       

As previously suggested, it depends on whether an investor or observer takes the ‘half full’ or ‘half empty’ approach. Particularly in the absence of significant corporate trading news, which could change expectations for profits, potential investors in equity are likely to focus on either the valuation argument (which is broadly positive, subject to earnings remaining stable and cash rates low) or the immediate fundamental outlook for business (which is, clearly, less encouraging). Clearly, in the past few trading sessions, markets have focused on the valuation appeal – which probably represents the long call or view – of stocks, and dwelt rather less on the short term view. The reporting season, with US companies normally being ‘quickest out of the blocks’, begins in earnest over the next week or so and these updates – accompanied by management guidance for the immediate outlook – could change perspective. Bulls will argue that a significant margin for earnings disappointment (some would say 30% plus, from current levels), over the current business cycle, is already implied in stock prices.

In our last business sector assessment, published on the 22 June, we took a look at banks and retailers – in particular acknowledging their inherent high exposure to economic activity. The banking industry, and Barclays in particular (by reference to boardroom departures, which followed the announcement of payment of £290m in penalties to the UK & US financial authorities in regard to misdemeanours surrounding the company’s actions in setting interbank interest rates), have dominated corporate news over the past week. Both politicians and professional investors – to say nothing of the general public - continue to be adversely surprised by the lack of transparency in these cornerstone financial institutions which have been global leaders. Unless one can have a reasonable understanding of how a business model operates (its strengths, weaknesses, opportunities and threats), and how it makes money on a sustainable basis – in whatever industry – a ‘caveat emptor’ (buyer beware) tag should apply.

Simplistically, the core savings-lending function within clearing banks is to make profits from the interest they charge borrowers, less interest paid to depositors, after taking provisions for debts which are not repaid. Clearly, in carrying out this role a number of banks, including Barclays, did not maintain the essential high level of integrity one would expect. Investment subsidiaries often house the clearing banks’ traditional treasury functions and merchant banking, as well as offering a more sophisticated menu of financial services, primarily to corporate customers. The failings (setting LIBOR in particular) that came to light date back to the credit crisis, and it is to be hoped that the series of crises which have afflicted the banking industry (PPI compensation) since 2008 will culminate in radical change  – instigated by regulators and the banks themselves - to improve processes, culture and visibility. Restoring confidence in a firm, rather like improving clients’ and investors’ comprehension of a business, is an intangible - which is necessarily difficult to measure, but offers significant opportunity to the owners of both debt and equity. While the five constituent banks within the FTSE100 are very far from being homogeneous, the valuation of their equity appears to carry a significant discount – by reference to a historic assessment of share price to book value, in particular - to reflect the industry’s lack of clarity, and its higher than normal (industry or wider market average) capacity to adversely surprise.

We now turn our attention to an entirely different business sector, which has captured more positive headlines in the financial media in the past week: house building via Persimmon and Taylor Wimpey who provided the market with trading updates covering the first half of 2012. Within our overcrowded island (albeit more in some places than others), owning land and property has obvious scarcity value. The builders of new homes represent a call on the consumer segment of the economy, although outwardly they may be viewed as manufacturers. History shows that this portion of the UK construction industry has a particular cycle, which may not necessarily comply with the wider domestic economic picture.

In practice, the prime variable factors which tend to have the greatest impact on the mainstream (not niche product) stock exchange listed house builders include: the cost of land (with or without planning permission), difficulty in securing planning permission and the cost of building (materials and labour). Also pertinent, of course, is product affordability (mortgage rates and availability, especially to the first time buyer, as well as stamp duty), relative to renting. As such an obvious ‘high ticket’ purchase, prospective buyers require confidence in their ability to be able to service the mortgage debt (job security) and in the prognosis for house price progression (buy versus rent?).

House builders have often failed to anticipate property prices, general interest rates or consumer confidence over a business cycle and, as a consequence, their record of ‘constructing’ value for equity investors has been mixed. When costs of land and building are stable (as they are, currently), and the cost to the purchaser is attractive or steady (house price, but also by reference to interest rates), new home building has been a high margin profitable business – with land acquisition and build cost typically equating to circa 25% & 55% respectively of eventual sale price. (By contrast, commercial, non-residential building contractors operate on wafer thin margins of 5% or less.) However, after almost twenty years of unbroken growth in the UK economy, the financial crisis (described by some as a credit crunch) disrupted the virtuous circle, of house builders growing profits by reinvesting strong cash flows, as the overall domestic economic landscape took ‘a turn for the worse’.

The brightest listed house builders were those who quickly anticipated that land prices had overheated and restrained their purchasing appetite. The likes of upmarket, London biased, brown-field site developer Berkeley Group, chaired by industry legend Mr Tony Pidgley, proved themselves to be especially adept in this regard and astutely managed their land bank to maximise returns to shareholders. A strong balance sheet facilitates sales on terms conducive to the builder, rather than diluting returns on equity by being forced to build (to generate cash) and price more aggressively (at lower levels of profitability).

Persimmon is another builder, of similar market size (capitalisation £1.9 billion), but featuring a nationwide mainstream value (plus upper market Charles Church) offering, which has managed to perform well in the difficult domestic backdrop. Without the aid of overseas investment interest, evident in Berkeley’s revenue, Persimmon has focused on paying down debt rather than ‘empire building’ (maintaining or increasing completions) for its own sake. As a consequence, the company now has c.£135m in cash (£15m debt at the same time last year) and plans to follow Berkeley Group’s lead in instigating a strategy to return excess capital to shareholders over the next nine years (estimated to be £1.9 billion, beginning with £227 million in June 2013).

By contrast with the above mentioned firms, Taylor Wimpey has experienced a much rougher ride over the past five years with its equity owners coming close to losing all value in late 2008. New management took radical action to address the overstretched balance sheet (net debt is now below £150 million, a tenth of the group’s equity worth), scaled back its Spanish operation (a £20m order book equates to less than 100 units), sold its bigger US business and has initiated dividend payments again. Taylor Wimpey achieved 5,083 UK completions in the first half of 2012 (compared to 4,707 in H1 of 2011) at an average selling price of c.£175,000 (c.£168,000 in 2011), and the order book has increased to 5,720 homes worth £960m (5989 units at £932m). The latter demonstrates a commendable prioritisation of profit margin over volume growth, and management expect 2012 to be a year of steady progress in what they expect to be a stable housing market. For the record, Persimmon boasted similar levels of progress - via completions (+6% to 4,712), average selling prices (+7% at £171,400) and a forward order book (+7% at £774m) - in the same six month period.

Based on 12 analysts’ forecasts, the equity stock of both companies appear fairly valued on a price/earnings multiple of 14.2 times likely 2012 profits, with Taylor Wimpey stock set to fall to 11x and Persimmon to 12x earnings anticipated in 2013. The latter’s superior track record meriting, in the writer’s view, the higher rating. For your interest, the same group of analysts value Berkeley Group, whose financial year is to 30 April, on price earnings multiples of 11.8x and 9x forecast earnings in the current year and to April 2014.  

House builders are typically highly geared businesses, by reference to the operational factors of costs & selling prices - but also financially where balance sheets have taken the strain (as in Taylor Wimpey’s case) of aggressive expansion (by merger, acquisition or too enthusiastic historic land purchases). Shorter term concerns surround the inability of first time buyers to access the market (despite the government-backed FirstBuy and NewBuy schemes), and an absence of progress in UK houses prices (supply in the form of repossessions, currently artificially constrained, is set to rise) in what appears to be an increasingly protracted flat domestic economy. As such, a better opportunity may yet present itself to the interested equity purchaser but the longer term merits of buying – into a consistently undersupplied housing market which, upon any semblance of domestic economic normality, should see a burst of pent-up demand - a prudently managed house builder are compelling.