Valuhunteruk

In my previous post on the housebuilders, I looked at the largest companies in the sector and concluded that Bellway probably offered the best risk/reward opportunity with Persimmon being the only other possible candidate. Today, I am going to look at Bellway.

In valuing housebuilders I think the easiest way to understand the business is to value the inventory and the rest of the business separately. Inventory often makes up well over 90% of total assets for housebuilders so we can use the value of the rest of the business as a way to determine the minimum value of equity.

In the case of Bellway, this task is fairly simple as the company does not have a large amount of debt but, unfortunately, as with other housebuilders, Bellway has ventured in the slightly more adventurous waters of second-lein mortgages. These loans amount to a hugely leveraged bet on the future value of a house with very limited upside. As a result, I have marked them down to 75% of carrying value. The only other notable point is that, as with other housebuilders, Bellway is using land payables to finance itself.

Taking all this together the value of the business sans inventories is around £-210m. In other words, for the equity to be worth something the value of inventories have to be at least £210m.

The carrying value of inventory on the Bellway balance sheet is £1.270bn. We can use the current market price and the value we have for the rest of the business to work out what the current market price implies. The equity is currently trading at 781p which is 12% below the book value of 889p. If we subtract the value of the rest of the business (£-210m) from the current share price we should get an implied value of inventory. There are around 120.705m shares outstanding so the implied value of the inventory is 995p (the value of the rest of the business was negative).  The carrying value of inventory is 1052p so the discount is about 5%.

From this we can break it down to one simple question: if you were offered the opportunity to buy Bellway’s inventory at £1.2bn (the implied inventory value of 995p) tomorrow, would you? My default position with these kind of questions is to work out what is implied in a price of £1.2bn and work out whether it is likely or not. One way to do this is to break out the inventory liquidation model I used to value BDEV (here). I still am not really too sure how this model relates to the value of the business as a whole as it doesn’t try to forecast income from company’s financial position, admin expenses, or tax expenses (in other words, it doesn’t forecast net profit). However, what it is useful for is trying to work out the value of a housebuilder’s inventory based on assumptions about future sales, average selling price, and average cost price.

Above, is a slightly modified version of the old model. To make it simple, the only three things forecasted are units sold per year, average selling price, and average cost price (the last two imply your gross margin). On the right, are the stats for the previous full year. I am not sure how realistic the assumptions of 6% volume growth, 2.1% ASP growth, and 1% ACP growth are but these are significantly more modest than the assumptions that go into the inventory liquidation models for other housebuilders. There are some problems as the sum of all units sold is larger than the current plots held (I couldn’t think of any easy way to make it fit together) but the point here is that the book valuation for the inventory is quite easy to explain and the implied value of the inventory in the market doesn’t seem totally inexplicable either.

The question then is: what kind of assumptions can we make about volume and price growth? What are the key factors behind these assumptions? I don’t really know if the future is going to look anything like the assumptions in the model but there is a lot of interesting stuff going on.

My fundamental view is that there is clearly a significant housing shortage emerging in some parts of the UK. Volume growth will outpace growth in ASP as the marginal demand is for lower priced housing. A key part of this will be the indemnity scheme. I am not sure if it will be the game changer that the industry needs but it is focused on the right problems (getting finance) and in Bellway you are getting company that actually has the financial position to take on the credit risk involved in the scheme. If the indemnity scheme works then I think it will increase demand particularly amongst lower priced houses which will limit increases in the ASP but lead to huge volume growth (if it goes well, it could, potentially, double sales). However, even if the indemnity scheme doesn’t work out, the housing shortage is still there so the fundamental case is still strong.

A factor that complicates this view of the housing market are the significant regional disparities. The housing shortage is most severe in the south-east where ASPs are significantly higher. Bellway, for example, sells roughly half and half to north and south in volume terms but the average ASP in the north is some £60k lower, at £144k, than in the south. House prices are already high in the South and it could mean the assumption about faster volume growth and slower ASP is totally wrong. The indemnity scheme  may sell a lot more high-priced houses. As the schemes target is set in volume terms, as opposed to money, this would be an even bigger boost to the industry.

A contrary point is that the government’s welfare policies, particularly the benefit cap, may have a significant effect in forcing people to move out of the south. It could be that the government’s projections for housing demand, that motivated the view of shortage in the south-east, relied on a projection of trends that are completely unsustainable. While there clearly should be a premium for housing in the south are we about to witness a massive exodus to the north, where living costs are significantly cheaper, which will close the ASP premium in the south? Is the current south “premium” totally unsustainable? If so, this will mean rapid volume growth but low ASP growth.

Interestingly, Bellway’s LFY results split by region demonstrate the total contrast between north and south in exactly the terms of this discussion. In the north, fast volume growth and slow ASP growth whilst in the south volume growth was actually negative by ASP growth was rapid. The net effect was 50bps faster ASP growth than volume growth but both were pretty rapid at around 7%.

Perhaps this means that the effect of regional disparity will cancel out for a company with a slight concentration in the South. Certainly, the fact remains that whether people live in the south or north, given no dramatic change in migration, demand is going to turn up somewhere. On this basis, it perhaps seems evident that the economy is naturally going to move away from the concentration in the south as living costs there are just too high to support the current concentration (esp. with changes in welfare policy). Whatever happens I think that this will be a significant factor in determining the outcomes for housebuilders.

Another fundamental factor that appears to be having a significantly positive effect is improvement in gross margins. Most housebuilders that I have looked at have reported that gross margins on new property are above 20%. Apart from improvements in ASP, one reason for the improvement in gross margins is that housebuilders are driving landowners pretty hard. The increasing use of land payables for finance suggests a change in competitive position and for companies that report it, it seems that average land purchase costs have gone down. An important factor also seems to be planning permission however, I haven’t been able to work out how this has played a role. The other reason for improvement in margins is the decreasing cost of construction. BWY has reported costs are down 8% from three years ago and notes that builders are also fixing prices of materials for 12 months or more (i.e they are competing on non-price factors such as assuming the risk of price changes). It is less clear how persistent these factors are but Bellway is investing heavily in new properties (40% of properties with planning permission bought after autumn ’08 and it added about 5,400 to the land bank in the LFY) and has the financial position to continue doing so. If any company is going to take advantage of these moves in gross margins then Bellway will.

Summary:

The core of the case for Bellway is that it is the right company in the right place at the right time. The most important factor is the company’s financial strength. It can make big investment in housing with great gross margins and it can take advantage of the indemnity scheme. Other companies that were more reckless in the boom do not have room to do this and they will be left behind. What is more, despite the significant complications of the UK housing market, the fact remains that demand is going to be strong. It may be the case that this demand is concentrated amongst cheaper properties, as I think will be the case and contrary to what the general consensus appears to be at the moment, but volume growth will still be strong enough for Bellway to make out well. At the current price, Bellway is towards the top end of what I would think reasonable as some of the upside is priced in which is understandable given the company’s financial strength. However, I think the fundamentals of the housing industry are fairly strong over the long-term and there is still some upside at the current price.