Argonautica

Professional investors can review published thought leadership and market updates from the Argonaut Investment Team.

‘UK Housebuilders’

The positive impacts of government incentive schemes, an underlying structural mismatch in housing demand and supply, together with a recent rise in consumer confidence and mortgage availability have all led to the UK housebuilders* reporting strong results. Notwithstanding all this good news, their share price outperformance has stalled. Investors may now be asking themselves if this is as good as it gets - can earnings expectations rise further from here? We think they can and the key to understanding this is by looking at the most important ingredient to any housebuilder – land.

Since falling 40% from the peak in 2007, residential building land prices in England and Wales (excluding London) have scarcely budged. Indeed since September 2011 to June this year they have risen just 1.6%, while at the same time the prices of newbuild homes in England & Wales (including London) have risen 13%1. Unfortunately statistics for newbuild prices excluding London are not currently available, but as a “sense check” prices for all houses across the UK excluding London have risen 8% over the same period. This has created a massive opportunity for the UK’s well-capitalised major housebuilders. Their strong balance sheets, access to funding and a more benign competitive environment (less competition from smaller, privately-owned builders) have seen them significantly increase their land buying, creating the foundations for future profits. The chart below illustrates the extent of current land buying as well as expected future purchases, compared to the last available residential building land prices.

Chart 1: Most recent residential building land prices (excl. London) and housebuilder land buying activity

1 Source: Argonaut, VOA, UBS, Knight Frank, 25th September 2013

Generally it takes four to five years for land to work its way through a builder’s books. Thus the longer they can purchase land at current price levels, the longer they can sustain profits (all else being equal). In the chart below we have shown the mix-adjusted newbuild prices (incl. London) against the same residential development land prices as shown in Chart 1. However we have brought forward the land prices by four years in order to try and match them to the prevailing newbuild prices.

Chart 2: Mix-adjusted newbuild prices (England & Wales) against residential land development prices (England & Wales ex London)

2Source: Argonaut, Office of National Statistics (ONS), VOA, Knight Frank

From the chart, it is no coincidence that housebuilder operating margins peaked in 2004/05 as they reaped the benefits of accelerating house prices on land bought four to five years previously. Similarly, the land bought following these years at much higher prices, destroyed their margins during the downfall and had to be written down.

While they may be buying an increasing amount of land, housebuilder management teams are keen to stress a disciplined approach, generally targeting a minimum 20% gross margin3. As a reminder, the price paid for land by a housebuilder is largely determined by a residual calculation. In essence the builder first calculates the potential revenue for the site (number of plots/houses x selling price), deducts build costs (labour and materials) and then solves for what he can pay for the land in order to achieve the targeted minimum gross margin.

Crucially, management teams emphasise that they currently assume little to no house price inflation in their business models. This is interesting as from 2009 (when housebuilders began actively re-entering the land buying market again); newbuild house prices have risen significantly as is highlighted in the table below.

Table 1: Median house prices and residential building land prices for England & Wales

2Source: Argonaut, Office of National Statistics (ONS), VOA, Knight Frank
N.b. The VOA stopped publishing data in July 2010. We have used Knight Frank data to extrapolate.

Of course all these data points serve as useful proxies only, as clearly each builder can source land from an array of different options as well as build and sell a variety of housing types. Nonetheless, the trend is important and the current advantageous land buying environment together with rising newbuild prices is almost a perfect storm for the housebuilders, which could see them both achieve and exceed their previous peak operating margins. This is currently not in consensus numbers. Indeed if we apply median peak margins to current consensus sales forecasts for the builders for 2015 (keeping expectations for financing and tax expenses the same), median earnings would be 23% higher4.

Buying land at attractive levels is all very well, but can the builders convert this into housing stock and thus profits? We think so, as boosting the country’s stock of affordable houses is perfectly aligned with the government’s strategy to broaden economic prosperity to all corners of the country5. This is because housebuilding, with its almost wholly domestic supply chain and effect on job creation, makes an immediate and direct impact on GDP. To date government schemes have focused on stimulating demand through greater mortgage availability (Do You Have Enough Equity in UK Property?). Yet to be resolved though is the dearth in supply, with current building levels amongst the lowest since 19245. Indeed, only 20% of England’s housing stock has been built post 19806. This year about 120k new dwellings are expected to be built, against an estimated annual new household formation of 221k7. To help stimulate supply the government is trying to streamline the planning process as well as encourage councils to release undeveloped land. These measures may now be starting to work. Planning approvals in the second quarter of this year compared with the same period last year are up 49%, and permissions in the first six months of this year are up 26% year-on-year8.

Overall, in our view there are a number of powerful tailwinds behind the fundamentals for the housebuilders. Although their positive earnings over the near term will not be surprising to most in the market, what will surprise is both the extent and the duration, of these earnings. In an industry priced on cyclicality, any extension in its profit cycle can be a powerful share price driver.

Greg Bennett
Fund Manager
1st October 2013

Sources

1 Source: Argonaut, VOA, UBS, Knight Frank, 25th September 2013
2Source: Argonaut, Office of National Statistics (ONS), VOA, Knight Frank
3 Credit Suisse, 7th August 2013
4 Bloomberg, 30th September 2013
5 HM Treasury “The Plan for Growth”, March 2011
6 Department of Communities and Local Government, 10th July 2013
7 Department of Communities and Local Government, 9th April 2013
8 Financial Times, 23rd September 2013
* Our housebuilder universe includes Persimmon, Barratt Developments, Taylor Wimpey, Bellway, Redrow, Bovis. Berkley Group was excluded due to its unique business model, focusing on the higher-end London market.

This document has been provided for informational purposes only solely for Professional Clients as defined by the FCA and does not constitute investment advice. Information and opinions expressed in this material are subject to change without notice and are accurate at the date of producing the document. They have been obtained or derived from sources believed by Argonaut Capital Partners LLP to be reliable but Argonaut Capital Partners LLP make no representation as to their accuracy or completeness. The writer of this piece may have conflicts of interest as may have personal holdings in the companies mentioned.