Description

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Two years ago, I wrote a thesis about Bellway, when its stock was at £25.  The business did well since then.  However, after an initial 50% climb in the stock price in the 6 months following the writeup, the stock dropped over 50%. and is now trading at an 8-year low price of £17.   Since the original writeup, the business itself went one way and the stock price to another, which pushed the stock valuation to the lowest since 2008-2009 (actually, through most of 2008-2009 the stock was more expensive than it is now).

I think it is time for a revisit.

I strongly recommend to anyone who’s interested in the name to read the original writeup, which provides detailed information of this UK homebuilder as well as its industry.

What worked

Let’s start with what was actually consistent with the original writeup:

1.       There was indeed no dilution following COVID.  Bellway’s strong balance sheet and earnings did not necessitate issuing equity.

2.       Bellway did not lose money in any of the COVID years.

3.       Unit growth was stronger than I forecasted, growing 10% annually and is projected to again grow 10% this year.

4.       Margins normalized to historical averages.  As expected, the good times of the 2015-2019 period ended (a lot more details on that in the original writeup, but just as a quick recap, the company was overearning as a result of the tailwind from that period’s fast house price inflation). 

EBIT margins are expected to remain in their historical averages of 18-19%.

5.       The ROE returned to over 15%.  This is mostly attributed to:

a.       More cash on the balance sheet (the E is diluting the R in ROE).

b.       Earnings’ getting normalized as discussed above.

What did not work as planned:

1.       Fire regulation.  I did not mention this in the original writeup because I believed that it was behind Bellway at that point, but apparently it wasn’t.  Let me expand now.

In 2017, London experienced the terrible Grenfell Tower fire, which cost the lives of 72 people.  The fire was determined to be a result of the cladding, which turned out to be spreading the fire instead of insulating from it.  Following these findings, the government decided (in several steps) that:

a.       There will be a remediation to all buildings over 11 meters tall that were built in the past 30 years.

b.       The original homebuilders who built the homes are responsible for the remediation (even though all these buildings have obviously been built up to the code at the time).

c.       UK homebuilders will pay a surcharge of 4% on their corporate tax rate to cover the costs of fixing buildings built by offshore homebuilders and homebuilders which no longer exist (i.e., bankrupt).

At the time of my original writeup, it was well known that Bellway was expected to pay for the fire safety improvements of the over 18 meters tall buildings it built that were still under warranty (10-12 years).  After the writeup, the obligation was extended to the 11-18 meters buildings as well as for buildings built in the last 30 years (that is, 18-20 years after the warranty expired).

Bellway set aside a provision of £300M to include the additional buildings covered by the new regulation.  The £300M was calculated based on Bellway’s experience with providing the remedies in the past few years to the buildings covered under the previous regulation.

This addition will bring the total provision to a total of £487M.  This is a large number, but I believe some context might be helpful here: 

a.       This figure is roughly 9 months’ worth of pretax profit.

b.       The company just reported that it has a net cash position of £245M in addition to £500M of debt facilities.

c.       The actual cash outlay for the remediation work will be spread over a 5-10 year period, thus, comfortably spreading out the expenditure.

I was surprised that the British government decided to punish the domestic homebuilders even though they built up to code (at the time).  I believe that this was the reason behind the stock’s drop before the recent jump in interest rates rattled the market.  The recent fire safety issues are obviously not good news for the company, but I believe that it is manageable and is far from an existential risk.

2.       Interest Rates.  In recent months, the stock price took a big drop, likely because of the market’s concern of housing affordability.  This is, of course, a legitimate concern that will undoubtedly impact UK (and global) housing, but there are some points we need to consider:

a.       There is a real shortage of housing in the UK (I don’t want to repeat / copy paste the previous writeup, but there’s a lot of details on it).

b.       People have to live somewhere.  Either they will buy the house, or someone else will buy it and then rent it to them.

c.       With an average ASP of £300K Bellway is the low-cost homebuilder.  People might need to trade down to smaller homes or move a little farther from downtown than they hoped.  That is exactly the inventory that Bellway carries.

d.       I estimate that 60% of the land was purchased before 2020 (75% of the land if including the “strategic land”).  This provides a margin of safety so that even if housing prices decline, there should not be material inventory write-downs.

e.       In the 2008-2009 period, the company had to write down its inventory by 15%.   For the reasons above, I doubt that any impairment will be needed, but even if we apply the 15% haircut from the GFC to the inventory, and we include the full provision of the fire safety, the company is still trading under 0.8x BV.

3.       Valuation.  Two years ago, I expected a reversion to the mean and normalized valuation.  However, since my writeup the company did not trade at a valuation even close to historical averages.  On a P/B ratio, the maximum since the last write up was 1.4x, which is below the 1.5x mean ratio for the last decade and well below the maximum range of 2-2.4x.

Where do we stand today?

The company has earned £4.1 PS in the fiscal year that ended in July 2022.  It has an adjusted BVPS of £27 (adjusted, because I’m already charging the £300M fire safety provision to book value).  Off the bat, we start with a PE of x4 and a PB of x0.6.  This is way too low for a company that has no debt, very little leverage, high teens ROE and 10% annual growth in volume (more in revenue because of cost inflation and even more in EBIT because of the benefits of scale).

For reference, in 2008-2009, Bellway bottomed at x0.4 BV.  At the current stock price, the company will end Fiscal 2023 (9 months from now) at x0.5.

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Catalyst

Nothing imminent, just the cheapest valuation in 14 years for a fine business.  Also, the 7-8% dividend yield (which I expect will continually increase) may ease our patience as we wait for a re-rating.

Frankly, I’m amazed that PE firms don’t snap up UK homebuilders like Bellway.  4x earnings, net cash and far better flexibility with the fire regulations outside of the public eye.  Would not take much for a PE firm to make a killing buying these at a 50-100% premium.