Value Investors Club / Barratt Developments plc (bdev)

Description

Summary

I’m recommending long Barratt Developments plc, the U.K.'s largest home builder; LDMR has provided some good background on the industry in his two Bellway write-ups. I believe the market is pricing in macro and industry headwinds but is underestimating the strength of long-term tailwinds. This dynamic allows for an attractive long-term investment opportunity with solid downside protection.

Barratt has a market cap of ~£4.4bln and an EV of ~£4bln (incl. land creditors as debt). They trade for ~5.3x NTM EV/Ebitda, with Ebitda expected to decline ~30% YoY to ~£750mm (down from ~£1.1bln LTM). They operate across the U.K. and delivered ~18k homes in their fisical year ended June 30, 2022 (incl. 750 JV homes). They sell homes under multiple brands and across a variety of price points (Barratt Homes, Barratt London, and David Wilson). Historical financial data below:

Macro headwinds

Inflation & interest rates

Mortgage rates have increased from ~2% in 2021 to ~5% (5-year fixed mortgage) as the Bank of England raised rates from 0 to 4%; this is in response to rising inflation (running ~10%). This will impact U.K. households within a few years as the 30-year fixed rate mortgage isn’t standard (2, 5, or 10 years fixed before they become variable).

Higher taxes and spending cuts

Jeremey Hunt, Finance Minister, in an attempt to restore credibility to U.K. finances (post Liz Truss mini-budget disaster), proposed ~£55bln of tax increases and spending cuts in late 2022 (~2% of GDP). One of the proposed taxes will increase the corporate tax rate from 19% to 25% (effective from April 1, 2023).

This leaves U.K. consumers with significantly higher mortgage payments when they refinance (likely in the next few years), as well as tighter fiscal policy.

Industry headwinds

Regulation

Increased regulation is expected to add complexity and costs to building homes, with some estimates as high as £4.5bln in additional annual costs. Some key regulations:

Future Home Standard ~£2bln cost est. – Comes into effect in 2025 and requires new homes to produce 75-80% less carbon emissions. This will be achieved through requirements like more efficient insulation and a ban on gas boilers (replaced with air source heat pumps).
Energy Conservation: Part L ~£750mm cost est. – Interim step on the way to the 2025 Future Home Standard and requires new build homes to produce 30% less carbon emissions (came into effect in 2022).
Building Safety Levy & Residential Property Developer Tax ~£550mm cost est. – BSL & RPDT are expected to raise ~£5.5bln over 10 years (supposedly temporary) and will be used in the replacement/remediation of cladding issues identified from the 2017 Grenfell tower tragedy.
Other ~£1.2bln cost est. – includes other regulations such as nutrient neutrality, electric vehicle charging (Part S), and Accessibility (Part M).

These cost estimates are from The Home Builders Federation (HBF), who admittedly represent home builders (likely some exaggeration in the costs), but taken at face value these regulations could increase the cost of construction by up to £20k per home.

£20k per home is a significant headwind for home builders (Barratt's gross profit per home is ~£70k), but most of these regulations have been known for years, so the majority of these costs are already baked into home builders' cost assumptions.

Removal of housing targets and Local Planning Authority (LPA) requirements

Planning permission is often cited as the biggest hurdles for home builders. Local Planning Authorities (LPAs) have struggled to catch up on pandemic backlogs and approvals are not being granted at the required rate. The government had tried to push LPAs to speed up approvals by requiring proof of a 5-year land supply, with an overall goal of 300k new homes a year. At the end of 2022, Michael Gove, U.K. Housing Secretary, backed off these requirements after a tory rebellion led Theresa Villiers. The changes mean the 300k housing target is now a “starting point”, and LPAs are allowed to propose fewer homes if they face “genuine constraints”.

The concern for home builders is the land supply will shrink further as LPAs find reasons to not make land available (“not in my back yard”). Local councils assume home building is unpopular, but a polling data shows ~1/2 of voters want more homes in their local area. There's demand for homes to be built, and the aversion to homebuilding will continue to diminish as younger millennials reach their home buying prime.

End of the Help to Buy government scheme

Help to Buy was introduced in 2013 to assist buyers of new build homes (only first-time buyers were eligible from 2021). The government would provide an interest free loan for up to 20% of the purchase price of a new home, only requiring the buyer to put down 5% (the rest would come from a classic mortgage). The scheme has effectively ended with homes needing to be built by the end of March to be eligible (applications had to be submitted by Oct. 2022). Home builders have tried to replace HtB with privately funded schemes but there's been limited interest from banks (Deposit Unlock).

Given the current economic situation and the rise in home prices, there's concern the removal of HtB will significantly reduce first time buyer demand for new homes. Home builders have pointed to a couple of offsetting factors that they believe could help smooth the transition away from HtB. First, HtB is still accessible in Wales (for another year) and it was never rolled out in Scotland (Wales and Scotland make up ~15-20% of volumes). Next, ~25% of buyers get help from friends or family. And finally, for non-first-time buyers, part exchange is an option (has been less prominant over the last few years given how easy it was to sell a home and part exchange couldn't be used with HtB).

Impact

These headwinds have impacted home builders, with Barratt’s forward order book down ~30% at ~10.9k homes (~15.7k Jan 2022). Their H1 23 reservation rate was 0.44, down 44% from H1 22 (0.79 H1 22).

While the headwinds above are very real, there are some strong long-term tailwinds that mean home builders should be able to work through the current headwinds, maintain solid finances, and come out the other end with reduced competition.

Tailwinds

Supply/demand imbalance

The U.K.’s home building crisis is no secret and is easy to identify. Over the past 2 decades housing supply has barely kept pace with the increase in the population, let alone a reasonable replacement rate assumption. There's been an avg. of ~175k homes built a year over the past 2 decades (government target is ~300k).

This has made housing significantly less affordable for potential U.K. homeowners; Since 1970, home prices increased from ~£4.7k to ~£265k, a 207% increase in real terms. Only 28% of 25-34 year-olds own their own home (down from 51% in 1990), and there's been a 50% rise in the number of young people living at home (2.4mm in 2000 - 3.6mm in 2019).

While other factors have had some impact on the cost of housing over the last 40-50 years (declining interest rates, rise of buy-to-let etc.), limited supply has been the biggest driver. The chart below compares U.K. housing supply to France and Netherlands (who have dealt with similar macro factors):

Will the undersupply issue resolve itself? Government intervention is needed to force LPAs to supply more land (they're doing the opposite), but I think home builders can make money either way; if more homes are built and prices start to come down, home builders will have more volume to spread their costs across and the land market will readjust to new price levels. If the supply stays constricted (more likely), house prices probably stay elevated as millennials battle it out for a limited supply of homes; the second option has negative social implications, but decades of under supply puts home builders in a good position (we're a long way from an inventory glut and it can only get fixed by building homes).

Scale advantages

As LDMR pointed out in his 2020 Bellway article, the industry continues to consolidate with the top 10 U.K. home builders accounting for >60% of home completions. The government continues to make noise about helping small home builders but, the reality is, increasingly complex regulations and a competitive land market for small sites make it incredibly difficult for them to profit.

There are two main reasons why small land sites have more competition:

Sellers of land are usually looking to sell in large plot sizes where possible as it’s the more efficient.
Small builders are then forced to compete for small land sites as they do not have the capabilities to build out larger sites. This means there is less competition for larger sites, benefiting those with scale.

Quote from Colin Cole, CEO of Lioncourt Homes highlights the uphill battle small builders face:

“The added bureaucracy of new regulations, nutrient neutrality, the building safety agenda, the building levy and many more issues are strangling the housebuilding industry. It amazes me how some businesses… are able to absorb all these challenges and keep going. It does explain why the number of SMEs in the industry has fallen dramatically over the past ten years.”

With more regulation coming, it’s difficult to see how small home builder can reverse this trend.

Rational land market

Home builders are price takers for pretty much all the inputs in their business (labor, material, home prices etc.), but long-term they have some control over the price they pay for land. Since 2004, Barratt’s cost per plot has increased ~20%, whereas the average selling price (ASP) has nearly doubled.

It’s true not much of this has fallen to the bottom line, gross margins are roughly flat over the period and the average size of a home in the U.K. has shrunk slightly; but it does show that home builders, as an industry, have managed to keep land costs at a level where they can make a profit (outside of GFC). This is currently on display as home builders have pulled back from the land market in response to changes in the economic outlook. Some quotes from recent trading updates:

Barratt:

“We have been increasingly selective in the land opportunities on which we have been prepared to bid, and we continue to apply our minimum 23% gross margin hurdle and 25% return on capital employed. Reflecting the changed market backdrop, we've actually seen negative land approvals in the half year. On a gross basis, we approved 16 sites for just over 3,000 plots, but we saw 22 sites for nearly 3,300 plots were moved as they were no longer proceeded.”

Taylor Wimpey:

“As you know, by the second half, we were very cautious on the land market, both reflecting the strength of our land positions and what we saw as unattractive pricing given market conditions. This has resulted in significantly reduced land commitments in recent months, and we ended the year with a similar number of land approvals to the half year and a landbank that has reduced slightly to 83,000. This is clearly a choice which we made but one we think is right given the market conditions.”

Persimmon:

“We're taking a highly selective approach to any new land investment and are carefully managing our outlet and work in progress position to meet current market demand… When we saw this downturn coming, we took immediate action to cancel uncommitted land deals and as a result of the actions we've taken, we now plan to open 33 fewer outlets in '23 than was previously the case.”

I believe home builders will continue to act rationally and less intense competition, for larger sites (150 plots+), will help builders like Barratt manage to their target metrics long-term.

Conservative leverage

Home builders haven’t forgotten the lessons from the GFC, choosing to operate with conservative gearing. In 2008 Barratt’s net debt (incl. land creditors) was ~£1.5bln, compared to a net cash position of ~£300mm today.

A housing crisis won't pressure home builder finances; they will be able to work through any required land impairments without much difficulty.

Why Barratt?

I prefer Barratt vs the other home builders for a couple of reasons (although I think most large home builders do well from here):

They are the largest U.K. home builder and focus on large sites. They can do this as they have multiple brands they can use, adding flexibility for site planning (Barratt Homes, Barratt London and their more premium brand David Wilson).
They have recently instituted a buyback of ~£200mm (£100mm remaining). While admittedly small, only ~5% of their market cap, they plan to continue repurchasing shares despite the industry slowdown.
They are geographically diversified and sell across a range of price points. This helps reduce risk as the increase in home prices has been localized to areas like London and the South East.
They opeate with a shorter land bank that the rest of the market. Given the current slowdown in activity, this should allow them to work through any overpriced land faster and potentially get back in the market earlier than peers.

Risks

The biggest risk is a change in the land market where home builders don't stay rational. Home building is a cyclical business but there are two reasons to believe the cyclicality can be reduced. The first is there’s a shortage of homes. The second is home builders stay rational and, long-term, the land market will be priced to allow for a reasonable return (for large home builders at least).
Housing bust. A housing crisis is an obvious risk, but home builders are in a very different place than 2008. They are all significantly less levered, there is less competition due to consolidation, and we’ve had another decade of not building enough homes.
Barratt has ~£600mm of provisions related to legacy build quality issues, mainly stemming from cladding issues identified after the Grenfell tower tragedy. Management believes they’ve identified the buildings that are impacted (over 11m) and have estimated ~£21k cost per plot for remediation work. Management expects most of the costs to be incurred over the next 5 years, with the majority being recognized in years 3-5. Barratt has indicated they will try recover funds where possible (from contractors etc.), but this appears a long shot. It's hard to assess how accurate their estimate is but they've identified ~225 building and ~75 developments for review/remediation (~40 buildings and ~10 developments have been remediated).

Valuation

I believe this investment offers solid downside protection based on the factors described above (mainly under supply of homes and rational land market). The business currently trades ~5.3x EV/Ebitda (NTM), on ~$£750mm of Ebitda. Barratt operates the business aiming for ~23% gross margin, ~19% operating margin and ~25% ROCE.

Assumptions 2027 fiscal year:

~17k completions, including JVs, for fiscal year 2027 (down from ~18k in 2022),
ASP of ~£310k (up from ~£300k in FY 22 but down from ~£330k at H1 23)
Ebitda margin of ~17% (Ebitda margin is ~2% higher than operating margin due to D&A)
~925mm shares outstanding (~£350mm in buybacks, incl. £100mm in H2)
~£1.2bln in dividends (avg. 2x cover)

This means ~£5.25bln revenue and ~£900mm Ebitda in FY27. Over the past 10 years the avg. EV/Ebitda multiple has been ~8x with avg. Ebitda of ~£750mm. Using 7x we get a ~£6.3bln EV and market cap (assuming £0 net debt incl. land creditors), for ~£6.8 a share. Including dividends this is an IRR of ~12%.

I believe this is a conservative scenario because it assumes Barratt will operate significantly below their target metrics, house prices stagnate through 2027, and the country continues underbuilding. There's potential for ~20%+ IRR if any of these factors surprise to the upside (i believe this is likely). On the asset side the business currently trades ~1x tangible book; some of the recently purchased land could be subject to impairment in a situation where home prices drop, but ~50% of the land bank was purchased before June 30 2021, when the ASP was ~£290k (>10% lower than current ASP).

The economic outlook in the U.K. is uncertain, but what we do know is there is a shortage of homes, a rational land market, and conservatively leveraged home builders.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

no short-term catalyst - cheap, structural undersupply of homes, rational industry players that have consolidated

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			2023	2024
Price:	4.50	EPS	0	0
Shares Out. (in M):	100	P/E	0	0
Market Cap (in $M):	4,500	P/FCF	0	0
Net Debt (in $M):	-500	EBIT	0	0
TEV (in $M):	4,000	TEV/EBIT	5.5	0