Shares digital

by Carlo Svaluto Moreolo

Housing market worries appear to be escalating, judging by recent house price falls reported by the Nationwide Building Society, leaving a growing number of home owners in a potentially sticky situation. There is little doubt that this poses a danger to UK house builders, and share price falls across this sub-sector have been swift and deep. Had you bought 1,000 shares in Bellway this time last year – worth £16,710 at the time – you would today have barely £8,000 to show for it.

Not so long ago the sector was among Britain’s hottest, with investors willing to pile into house building stocks seemingly willy nilly. House prices in the UK had been rising steadily and fast for more than ten years, and a year or so back many economists refused to buy the line that house prices would suddenly start falling simply because they hadn’t risen for such an extended period, although many did predict slowing growth rates. After all, before the credit crunch the UK was enjoying pretty good economic growth, with low unemployment and relatively low interest rates. The fundamental driver of house price growth was, and still is, a desperate need for housing in this country. The population is rising slightly (average growth per year since mid-2001 has been 0.5%, according to the Office of National Statistics) as foreigners keep wanting to settle in the UK.

A slow, excruciating planning system didn’t quite manage to beat managers of house builders, as in fact it resulted in a bottleneck at the supply level that helped keep prices high, with home buyers unhappy but unable to influence the situation in their favour. Over-enthusiastic bankers were happy to lend them huge sums of money, which, in most cases they were able to pay back, although the number of sub-prime borrowers has soared in recent years.

These factors were reflected in UK house builders’ share prices, which only a year ago were fat and bound to grow fatter, according to analysts. But nobody was expecting a financial crisis that would undermine the reputation of the world’s financial system and reach right out to UK consumers. Nine months after the first American banks started admitting their balance sheets were on the verge of collapse, fear still dominates the markets, with institutions too scared to lend to each other, or even to private borrowers. These in turn are facing enormous difficulties in financing the purchase of properties.

Now, however high the demand for housing, if the borrowing to fund purchases isn’t there, clearly prices will drop. In mid-April, the Royal Institute of Chartered Surveyors (RICS) grimly announced that confidence in the UK housing market had fallen to its lowest level in the 30 years that the institute had monitored it.

Grim statistics

The institute’s house price balance dropped for the eighth consecutive month, as 78.5% more of its members reported a fall than a rise in house prices. This compares with 65.7% in February. This figure exceeds the historical low of June 1990, when in the midst of a housing crash, 64.5% more chartered surveyors reported a fall in house prices, and is the lowest figure since the survey began.

The RICS survey also blamed the freeze on the financial markets. It said: ‘Many would-be buyers are either struggling to raise the necessary finance for a move or are exercising caution in the light of current economic uncertainty.’ The survey also added that: ‘With the official interest rate cuts not being passed on to the high street there is little expectation that demand will improve in the near term.’

So it’s hardly surprising that so many sector investors have headed for the hills. That the number isn’t greater still is largely down to potentially attractive dividend yields. Some companies promise double-digit forward yields, compared with a 4.2% FTSE All Share average. However, the full impact of frozen lending and falling house prices has hardly been seen yet – the last full-year and interim results only reflected the second half of 2007, before the full effect of falling mortgage approvals.

Still, the prospect of home owners rushing to sell their houses fearing that suddenly they will lose thousands in value is seen as a very unlikely scenario.

The institute’s survey admits that: ‘price falls are being driven by the inability of many to secure finance rather than an influx of supply into the market.’ More importantly, the balance of surveyors reporting new instructions to sell property is into negative territory, as the pressure to sell continues to be light given the still-strong employment picture.

A question of confidence

We can speculate on how the Bank of England should react, how much money it should pour in the markets and by how much it should cut base rates. But the most relevant question is: how quickly will confidence among financial institutions be re-established? Confidence is still low, despite intervention by policymakers, and the hefty write-downs of assets that are, perhaps wrongly, thought to be over now.

This is the message prime minister Gordon Brown was trying to convey to US banks in his US visit a few weeks ago: that they have to come clean about their balance sheets and say how much money they have lost or are going to lose. If financial institutions continue to demand action without actually taking any apart from tightening lending, many more painful months lie ahead before they start lending each other funds and boost private lending again.

In the meantime, UK house builders can only try and withstand the situation, with fewer completions and lower margins. High raw material costs are not helping. High cost of finance won’t either. Analysts emphasise that high levels of gearing are a disadvantage and possibly dangerous. Refinancing assets such as land and housing stock, for which the pricing outlook is not clear, may be difficult and costly.

Dealing with hungry investors, or hedge funds looking for quick profits may not be easy either. High dividend yields have attracted interest recently but are the dividends actually that safe? House builders haven’t done it so far, but were they to start slashing payouts, their share prices would take another battering. Write-downs of assets are a more remote possibility. It would take even sharper falls in house prices before companies have to start discounting the value of their housing stocks or land banks. In some areas the falls are still very slow. In some places such as Scotland, prices are even rising.

However, average selling prices are bound to fall, along with volumes and margins. Some companies tried to reassure the markets, saying their visitor levels were growing, but many flagged up falling order books. Also we have learned that housing transactions are failing at the last moment: the purchase doesn’t eventually go through because the mortgage money isn’t being released.

In principle, companies with strong land banks will not suffer as much. If they can be selective about which plots they can develop, having got permission to do so, they should be able to control margin pressure. Keeping a constant flow of land with planning permission is key. Having a healthy pipeline of affordable housing work is also a plus: local authorities and housing associations cannot dodge the need for housing and simply stop building, and profiles of cashflow and financing are different with social and affordable housing.

Investors will simply have to be far more selective than in the past about which house builder they choose. A high dividend payout and a low PE will not be the answer. It’s not about making a quick profit any longer, but rather putting faith in companies capable of creating long-term value.

Sector facts and figures

Number of companies: 9

(Main market: 7)

(Aim: 2)

Sector PE: 6.8

EPS growth: 10.3%

Prospective yield: 4.1%

Key indicators

The economics:

• House prices

• Interest rates

• Interbank lending rates

• Mortgage availability

• Demand for rental properties

• Land prices

• Government spending on affordable housing

TOP ANALYSTS

Chris Millington – Numis Securities

Eye on the ball

A bottom-up approach to earnings forecasts is best when analysing house builders, says Chris Millington of Numis.

The Starmine five-star rated analyst, with a background in economics, recently moved to the UK-focused mid-cap stockbroker from Bridgewell, which was swallowed by Icelandic firm Landsbanki.

Millington praises the advantages of processing large amounts of data coming from different sources: not only companies, but also industry sources such as estate agents. This approach has made it possible for him to get his forecasts right so frequently. He tries to be ‘pretty up to the minute’ with the vast collection of data his team gathers to substantiate the assumptions and formulate judgements on the roughly 15 stocks his team follows. ‘We know a little bit more than the buy-side community and can provide timely, correct information.’

Numis forecasts margins for the industry to fall by 140 basis points this year, however Millington says the house building sector has been oversold a lot, and by focusing on quality, investors can certainly be rewarded. Share prices have fallen as much as they did in the early 1990s, in the midst of a housing crash, but the picture is different today. Millington thinks house prices would have to fall a long way before many companies become loss-making.

Clearly, one of the most important things to monitor at the moment is the companies’ land banks. Whether the land was bought at the right price and in the right place will make an enormous difference. It can dictate whether land becomes a liability on the balance sheet rather than an asset: ‘You can’t have the land sitting there doing nothing’, he concludes.

Kevin Cammack – Kaupthing Singer & Friedlander

Experience counts

The City’s fast pace means many equity analysts are young, but currently experience of a few housing cycles is a plus for a house building analyst. In a recently established specialist banking group, Kevin Cammack can boast his long experience: ‘I’ve been doing research in the sector for 20 years, and obviously I’ve seen a few housing cycles and changes in the industry.’

Cammack, whom many will remember for his long career at Merrill Lynch, believes forming a solid macro-economic perspective is the first step towards accurate forecasts: ‘It does tend to be a fairly homogeneous sector, but obviously it is essential to understand the differences between the companies.’

The geographic spread, and in which product areas each company is strong, are important, but their land banks are obviously crucial. ‘It’s impossible to take a view over every piece of land a company buys, but it is important to try and understand how well the land was bought’, Cammack says. A glance would lead analysts to think that, with land prices dropping at the moment, companies that have a shorter land bank are better off. ‘But in reality’, adds Cammack, ‘whichever company bought most of its land in the past 12 to 24 months will be crucified. Does this mean we will start seeing house builders writing down assets? ‘If land prices drop by 10%, most would, if they drop 5%-6% some would and some wouldn’t, otherwise they will be fine.’

Rachael Waring – Panmure Gordon

Retail therapy

Having joined Numis in 2000 as a retail analyst, Rachael Waring moved to house builders, before joining Panmure Gordon just over a year ago, where she is now associate director of building & property research. How did her retail experience help with house building? ‘I guess some of the macro drivers are similar. But it meant obviously going back to basics and learning about a new sector,’ she says:

Building a macro picture, analysing transaction levels and house prices, is her first step, then she looks at individual businesses, especially in terms of products and the markets. What about Persimmon’s profit warning two weeks ago, which seemed surprising, given the faith the City put in the company? Waring suggests investors shouldn’t be too worried about Persimmon as the company has ‘probably the best management team in the sector,’ one that has experienced the downturn of the early 1990s. Persimmon’s warning shouldn’t have come as a surprise, she believes, and investors should be confident that company managers are not failing to acknowledge the potential crisis. ‘All the management teams are being completely honest. There’s no real reason for them not to tell the truth, as it’s going to come out in the numbers. People know how difficult the market is,’ she says. As for write-downs, she concedes that riskier land assets acquired very recently could be a problem for some companies, but at the current level of house price deflation, they should not be a pressing danger.

BEST BUYS

Bellway - Braving the storm

Analysts are bullish on Bellway, and the interims at the end of March demonstrated the company was performing well even in extremely difficult trading conditions.

In the six months to the end of January, as the credit crunch kicked in and consumer confidence slumped, the company sold more homes than in the same period of the previous year, and at a higher average price. The operating margin did fall, and things have deteriorated since then, but broad geographic spread, strong cashflows and exposure to affordable housing will help going forward.

Management appears experienced and capable of leading the company through a slowdown, says analyst Chris Millington at Numis. Thanks to its forward selling strategy, Bellway secured 88% of the full year’s projected turnover, and visitor rates were strong as the year started.

The company is more than likely to see margins shrink in 2008 as more incentives for home buyers are needed and house prices may fall much further in certain areas of the country. However, Bellway’s land holdings are strong, as they were acquired over a long period, which should mean they were bought at attractive prices. The company’s gearing level is low and this is a plus in the current environment, as is the increase in the net asset value per share, at 934p in late March, registered at the interims. The company’s equal split between low-rise apartments and more traditional housing stock means it can access broader markets, says Simon Brown at Landsbanki, and the cheap cost of land provides opportunities for Bellway.

Berkeley Group - Lit up by London

Questions were raised about the value-added residential property developer due to its London focus, as financial turmoil means falling bonuses and possibly fewer buyers for Berkeley’s plush houses. The last trading update in mid-March confirmed a 20% decline in reservations in the previous four months. However, prices in London are holding up fairly well and Landsbanki said following the update that ‘the company’s forward sales position means that all this financial year’s completions are in hand and most of next year’s are secured as well.’

Pre-tax profits should come in at the upper end of expectations. Berkeley says it has a conservative balance sheet, with £3 a share to return to shareholders by mid-2009 according to Landsbanki. It should then pay an 83p-a-share dividend for each of the six years following the current capital-return programme, implying an 11.8% yield.

Landsbanki also points out the quality of its land bank. The forward order book, as of the last update, stood at £1.45 billion, against forecast annual turnover of £922 million for the year to April. The order book included the sale of three blocks of 355 flats, at Grosvenor Waterside, north of Chelsea Bridge, to the Qatari Investment Authority, which shows Berkeley doesn’t just depend on the private residential market.

Landsbanki has a £18.50 target price, which compared with the current 990p seems a long way off, but the stockbroker implies that the current dividend attraction is not recognised, considering that the company is confident it can generate enough cash to sustain the payout.

Persimmon - Solid in a crunch

In a distressed mortgage market, FTSE 100 Persimmon, the UK’s largest house builder by market value, said on 24 April that: ‘the unprecedented tightening in the mortgage’ had caused ‘a further deterioration of the housing market leading to lower sales volumes and increased cancellation rates’, and that the level of reduced demand was having ‘a negative impact on margins’.

But Persimmon’s intrinsic strength has not changed. The experience of its management provides plenty of safety, and its large land bank, a lot of which was acquired nearer the bottom of the cycle, is another plus. The cost of maintaining its huge portfolio, more than 78,800 at the end of last year, was 21.3% of turnover in 2007, flat from the previous year.

Also, the company’s debt position is more favourable than others in the sector. Persimmon is also trying to bring down the level of gearing from the current 30% to 25%, which would highlight the strength of the cashflow profile. At the full-year results at the end of February, the company reported a 21.8% operating margin, at the high end of industry average. Net asset value at the end of 2007 was 781p, well below the current share price, and this discount should support a share price recovery when housing demand picks up a bit. The company’s assets are safe, unless interest rates rocket and house prices stage a disastrous crash.

STEER CLEAR

Taylor Wimpey - The rot sets in

Through a £5.5 billion merger Taylor Woodrow and George Wimpey snuggled up a year ago, staging the last act of a consolidation wave in the sector for some time. The reasons for the Taylor Wimpey deal were clear enough back then: salvaging falling margins in UK house building for both companies, achieving much-needed cost savings, and joining forces to manage tricky regional operations in the US and Spain. The result, sadly, is a company that is not too well placed to withstand the current crisis.

The US and Spanish businesses both have to deal with a huge oversupply of houses, and the debt problems of American citizens worsened the outlook further. Taylor Wimpey did some hefty land write-downs a year ago but, in an interim management statement two weeks ago (17 April), it said that there are more on the cards in 2008. The update came not long after the departure of Ian Sutcliffe, main board member and CEO of the UK housing business, which could be seen as a set back as he helped achieve higher operating margins last year.

In Spain conditions are also poor and in the UK costs savings will give some relief but they haven’t stopped margins from falling. Analysts believe that write-downs of land from house builders in the UK are less likely, however, the company recognised the impact of lower confidence and the lack of finance, saying that it is seeing pressure on prices. The order book was 26% down from a year ago and the company added profits will be at the lower end of expectations. Net debt at £1.9 billion doesn’t help. and the high dividend yield now is not strong enough an attraction to the shares.

Redrow - The wait to be saved

A 35% drop in interim profits was not a great start of the year, regardless of a 19% interim dividend increase. Simon Brown, analyst at Landsbanki, said at the time of the results in late February that the company needed to address key strategic issues of land structure and product positioning, and that its attempts to do so far had been unsuccessful. Brown also added that ‘Any further loss of market share will lead to a severe weakening of the group’s financial capacity to fight back into the market.’

Landsbanki expects full year profits to fall to £75 million from £120.5 million in 2007, a 38% dive, while before the interims it was anticipating £90 million in line with consensus. In early March Numis also downgraded its forecasts, predicting that the 2008 operating margin would fall from 14.5% to 12.5%, which it noted was the lowest in the sector.

Numis argues that the low operating margin reflects both tough trading but also higher land and build costs. The company’s gearing level at 40% is high. Focus on companies whose land bank position is much more secure and flexible.

Barratt Developments - Strength to bounce back?

Analysts have had to upgrade their recommendations for Barratt recently, as its shares simply became too cheap. This is merely a relative measure and Barratt is not the favoured sector play by analysts because of its high level of gearing following its acquisition of rival Wilson Bowden in 2006. Rachael Waring at Panmure is among the analysts who upgraded the stock from ‘sell’ to ‘hold’ but says that, partly due to the Wilson Bowden deal, ‘continued house price deflation could lead to asset write downs later in 2008 or early 2009.’ Were this to happen, the shares would take another hit after the spectacular fall they staged last year, losing around 70% of their value.

The headline interim numbers for the second half of 2007, released at the end of February, were compared to the group’s performance in the previous year. The comparison shows Wilson Bowden is providing a positive contribution to Barratt’s business, but strip out its impact and the results paint a much bleaker picture than last year. On a like-for-like basis, the group registered fewer completions, a small decline in the average selling price and a 18% dip in operating profits. The shares may not recover fully until the cycle makes a clear turn around.

RISING STARS

Di-Stefano’s east end fairytale

Telford on fire thanks to the Olympic flame

The mortgage selling spree is over and house builders simply can’t rely on banks funding their potential customers willy-nilly. But it depends what your customer base is like, objects Jon Di-Stefano, finance director of east London-focused home builder Telford Homes. ‘We have a different profile of buyers. They are professional investors that typically take 75% mortgages, rather than 100% to 90% ones.’

Aim-listed, Telford Homes is deeply involved in the ongoing effort to turn the once beleaguered neighbourhoods of the East End into an area of plush, modern homes. This strategy has paid off handsomely as the company taps into the wealth generated by the London Olympics.

Telford Homes has secured and built quality projects such as Icona, a high-rise development that towers right over the Olympic park. From Romford in Essex to inner-London suburbs like Islington, the company delivers mixed-use and mixed-tenure developments popular with both home buyers and buy-to-let investors.

The company, led by chief executive Andrew Wiseman and finance director Jon Di-Stefano, enjoyed strong top-line and profit growth over the last five years, without a blip so far. Turnover and profits rose steadily from £25.3 million and £4.26 million respectively in 2003 to last year’s £104 million and £13.5 million.

Pre-selling to buy-to-let investors has been the main management’s strategy, and it has proved lucrative. As to the current trading conditions, Telford is pretty confident, saying that final results for this year are thought to be in line with expectations.

The update gave reassuring signs that even after the start of the year people are buying property in East London. The recent launch at the end of January of 66 open market apartments at the Vellum development in Walthamstow went well, with contracts exchanged on 23 of those properties by the beginning of April. More than half of the 41 open market apartments at the Kinetica development in Dalston, launched at the end of February, were exchanged. Both these developments are scheduled for completion in 2010. However, there are obvious challenges ahead. Di-Stefano says that one of them is how to time the launch of Telford Homes’ developments.

The time is right

Carefully timing the launches of the developments has been one of the company’s winning tactics in the past. As a project is launched, it is key to secure enough interest from the the investment market. Given the more cautious approach to investment in properties, in the next months the company may have to delay the launch of some developments. In some cases it may be more convenient to go on with construction rather than launch a development that isn’t successful with buy-to-let investors.

Despite the jitters in the lending markets, the need of housing in the country and in London is evident, and lack of mortgage finance simply holds up demand for housing, rather than wiping it away. This ‘pent-up demand’ is a good thing for Telford Homes, argues the board, as it can boost the demand for rental properties.

A successful partnership

The company’s partnership with housing associations is also providing strong support. Developing affordable housing for them means that Telford Homes can count on £180 million of cash to come into the business over the next three years, with a monthly contractual profile.

Gearing is obviously a key issue for any company today and especially house builders, and Telford at 135% gross gearing may seem a bit more heavily geared than many other companies. Yet, Di-Stefano says he is happy with the level of gearing as around 50% of debt is secured by the value of the company’s land holdings. He adds: ‘Our borrowing rates are still good. We have strong support by our existing lenders and even new banks keen to do business with us.’

The company’s share price performance sadly resembles those of its larger rivals on the main market. The shares fell at steady pace in the last 12 months, from 420p to the current 170p, a 59% fall. However, the risk premium attached to them is obviously higher, being of an Aim-listed company. They still trade at a 13% discount at the 2007 net asset value per share of 148p. Unlike many shares traded on the junior market Telford also pays a dividend. Yielding a prospective 5.8% for 2008 and covered 1.8-times by earnings, if EPS forecasts are to be believed, this is the sort of rating that suggests that investors are confident of getting its pay out this year.

The 2012 Olympics has the potential to do great things for east London, bringing wealthier households to the up-and-coming area. Di-Stefano’s impressive performance to date suggests that he can help guide Telford to housebuilding gold.

CHARTING THE SECTOR

Housing bears rule the roost

Is there hope for the sector after an unrelenting and dramatic sell off? by Simon Griffin

It is difficult to get enthusiastic about the chart of the stocks that make up the house builders on the UK stock market. After an amazing run up from its low in early 2000, the index firstly bucked the trend of the wider market, then when the FTSE 100 bottomed in 2003 it continued to rise, achieving a five- and-half fold hike during summer last year.

The subsequent sell-off has been equally unrelenting and dramatic, with the fall wiping a staggering 65% off the value of the sector. Though the chart shows the index tried to base in the early weeks of the new year, recent further weakness has seen new lows and the worry is that what appeared to be a potential bottom will prove to be a bear flag foretelling of further significant losses and risking a return to levels not seen for eight years.

The only positive note is that momentum has been rising and could yet generate positive divergence which might give an early indication of a recovery, though it is too early to count on this happening. For the bulls, there seems to be evidence of congestive support only 6.5% below current levels and this too might arrest the decline.

Realistically, the 50-day average has provided strong and conclusive resistance to any upside moves during the decline and currently it would need the index to increase by 22% to achieve a break and for the bulls to feel comfortable once more.

STOCK CLOSE UP

Redrow (RDW)

Though, in general, house builders as a sector might look weak, not all the charts are without some hope. Redrow saw its shares climb over seven fold since they started. They shrugged off the wider market gyrations during the dot com bubble and the subsequent bear market and finally topped out at the start of last year at 726p.

I am sure that this long run up must have lulled many holders into a state of semi-conscious complacency. So much so that they may well have missed the break of the uptrend and the bearish moving average crossover, both of which should have closed holders out close to 510p.

The decline has seen the shares lose 65% of their value and come to rest for now on support from congestion close to 246p, a level which can clearly be seen to have capped gains throughout 2001 when it acted as resistance. To the upside another level of congestion at 328p, which supported the market in 2004, failed to do so this time around and would now be expected to offer resistance on bounces as happened in early April.

Nevertheless, we have a positive picture in respect of momentum and provided 246p holds up then a base could be forming, though any break would see further selling. For the optimists a move above 328p in due course would likely also break the 200-day average and build a new uptrend.

Oakdene Homes (OKD:AIM)

If you think the house building sector as a whole has been a blood bath then you need only look at the chart of Oakdene. This time last year it was capitalised at £90 million and in the last 12 months it has seen its value decline by 80%.

For those who like to pan back and see if the chart gave any warning of this drop, the most obvious signal was the ‘dead’ cross made by the 50 and 200-day averages at the start of July. Since then the 50-day average has shadowed the decline and a break above this important measure would be needed to encourage the thought that the decline has ended.

However, we might just be seeing some signs of a base forming. The first is that momentum is rising from heavily oversold territory and producing positive divergence. Also we have seen a recent sharp jump in volume, something that has not resulted in further weakness so the inference is that it must be buying.

This share could reward the brave prepared to take a punt at these levels, however it also offers the opportunity of close protective stops just below 47p and the upside could be significant in the medium to longer term.

The first upside technical target would be a retest of the November 2005 low at 71.5p.