Not all builders are the same.

Thursday, 15th February 2018 07:33 - by David Harbage

As consumers we tend to be careful in selecting tradespeople or builders to carry out work on our homes. Similarly, as investors, we should be circumspect in our selection of individual listed company stocks – even in an industry erroneously perceived to be as homogeneous as construction. After reading Redrow and Bellway’s encouraging trading updates last week, today’s two announcements from Galliford Try proves the above point.

For the record, last Wednesday Redrow reported a 14% increase in home completions in the second half of 2017 – leading to a 20% rise in revenue (boosted by higher selling prices), a 26% increase in profits, a 27% jump in earnings per share (EPS), a 50% hike in the interim dividend and a £1bn order book. Despite increasing its forward land bank by 20% to 31,800 units, net debt halved to £35m which equates to gearing (comparing the level of debt to the overall worth of its capital, with equity representing the other source) of just 3%. Steve Morgan, chairman and 22% stakeholder suggested that 2018 would be another year of significant progress for the company. A view shared by research houses Canaccord Genuity and Liberium Capital who reiterated their respective price targets of 750p and 730p on the 7 February. Of 12 brokers issuing a view on Redrow, the mean forecast for the year to 30 June 2019 is that EPS progresses by 9% (equating to an undemanding earnings multiple of 6.9x) and the dividend pay-out rises by 17%. Incidentally, of those analysts, 7 suggest Buy, 4 say Hold and 1 publishes a contrarian Sell opinion.

On the following day another national house builder, Bellway, provided the market with a trading update covering the six months to 31 January 2018, featuring a 6.3% increase in housing completions. The company advise that this is set to result in a 14% rise in revenue (aided by a 7.7% hike in its average selling price), and, with operating margins set to widen slightly (above 22%), profits for the full accounting year to 31 July 2018 are set to increase by at least 12% (to £507.5m). A 15.7% jump in the order book, north of £1.3bn, also promises further progress looking out to 2019. The balance sheet remains strong, notwithstanding further significant investment in land (acquired in anticipation of a 24% operating margin ‘hurdle’ rate) and net debt reduced by a quarter to £131m, which equates to financial gearing of less than 6%.

Bellway’s chairman John Watson specifically also countered the Chancellor’s perception of slow development by saying that “all sites are actively progressed through the planning system in order that construction can commence as quickly as possible”. He also reiterated the uncontested fundamental shortage of new homes relative to demand and advised that the firm’s plans to open a new twentieth regional division in Scotland were progressing well. For the record, 14 broking houses proffer a recommendation (11 Buys, 2 Holds and 1 Sell) on the stock, with a consensus forecast for the year to 31 July 2019 that EPS and the dividend progress by 7% from the current trading year’s double-digit level. These forecasts would put the shares on a PE ratio (price to earnings multiple) of 7.1 times, which is as low as they have been over the past decade. 

Turning now to today’s announcements from Galliford Try – perhaps best known for its Linden Homes division - a reasonably good trading report on the second half of 2017 was spoilt by its contracting business, which adversely featur joint ventures with Carillion. Completions, revenue and profits in Linden Homes rose by 6%, 7% and 9% respectively in the six month period; while its Partnerships & Regeneration – focused on affordable housing – division doubled profits, albeit on margins of just 4.8% versus private housing’s 18.5%. However, the Construction division – which features public building and infrastructure contracts – saw a meagre £2.7m profit in the comparable previous period become a £17.8m loss, as an exceptional £25m loss was taken in respect of its joint ventures with the failed Carillion business. Much of this relates to a major contract on the Aberdeen Western Peripheral Route (AWPR), a road build partnership with Balfour Beatty and Carillion, which is due to be completed in June 2018.

This blog has previously flagged contracting as an area of investor unease as, despite apparently huge order books (£3.5bn in Galliford Try’s case – more than 5 times greater than the worth of the company’s equity), operating margins remain wafer thin (improving but still currently less than 1% for this firm) as bidding seems to lack prudent financial rigour. Although the company is not carrying huge levels of debt (borrowings net of cash is £85m, and had been falling), compared to its enterprise value (the total value of its equity worth, or market capitalisation, plus its net debt), it has had to ask shareholders for a further £150m today. Management argue that the need to maximise the attractive prospects for its home building division means that it needs further funding to provide headroom for its contracting operations. Financial engineers might have reservations about this – by reference to considering the cost of capital for new equity, relative to its existing ample borrowing facilities – and the share price’s 17% fall today seems to reflect this view.

The AWPR contract is a classic example of the potential downside on major fixed price contracts, with an additional £150+m of cash commitment required to see this particular piece of work through to completion. Management at Galliford Try have reassured institutional investors that it will no longer undertake such fixed price contract work and have sought to improve its internal processes for project selection and tendering. In terms of its balance sheet and dividend distribution policy, the board has stated that it views 30% gearing as a ceiling and will also increase dividend cover to 2.0 times – the latter resulting in a reduction from 32p to 28p in the imminent interim pay-out.

Do the shares of this housebuilder-contractor appeal following today’s revision to its balance sheet and the equity base in particular? Tonight sell-side brokers will savagely mark down profit expectations for the full accounting year to 30 June 2018; (16% EPS growth had been anticipated in the current year, and 11% in the next, ironically via a recovery in its non-housing construction activities). Traders may be tempted to capture a possible bounce-back, as the initial fall to 775p appears overdone, but investors seeking higher quality – by which we mean a more transparent business model & earnings, to say nothing of the balance sheet – should look elsewhere in the building sector.         

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.