Description
They are a homebuilder based in the UK, with a particular regional focus on London and the South East of the country. They control a land bank of about 46,000 plots across about 90 different sites. They sell about 4,000 homes in a productive year, so there is visibility in terms of volumes for many years. They have particular expertise in large projects which require an extensive amount of pre-planning, communication with government bodies and so on, so the projects are often on the riskier end of the spectrum and would not be something that smaller or less able contractors would be able to take on. Of the 90 or so projects that they are currently working on, only 60 have full planning permission, with about 20 having conditional contracts and about 3 designated as high risk projects. The overall operating backdrop is quite mixed. On the demand side, London requires about 60,000 new homes per year, but trailng 12m starts have never gotten above 30,000, so there is clearly a structural undersupply working in their favour, which they often point out in their presentations. The average selling price they assume in their land bank, however, is £520k, and it is clear that half million pound homes is not where the undersupply is in London - what is needed is more affordable housing, which is not an area of specialisation for the company. About half of the demand in any one year comes from overseas buyers who are making an investment rather than buying a home. The first time buyer P/E in London is also now around 10, several standard deviations above the long-term average (the number is about 6x in the South East). Affordability in terms of mortgage payments as a percentage of take home income is, however, well below the highs and is only a little over the long-term average. The reason for the discrepancy between the two measures is that rates are currently very low in the UK - were the BOE to start hiking, homeowners would be in a spot of bother and the company would be too.
The shares were weak over Brexit but quickly recovered as buyers came back to the market (obviously the currency weakness made investments more attractive for overseas investors). The company had a record year in 2017 as the had volumes at the high end of the historical range and enjoyed ASPs of £680k, up 30% YoY driven by a favourable mix. That drove a very strong 80% growth in EPS to 450p, together with strong cash flow, and the Brexit woes were well and truly in the rear view mirror. The company's volumes have also benefitted from a shrewd management team basically calling the bottom of the market in the credit crunch, and adding to the land bank aggressively quite near the bottom. As these projects have been completed and released to the market, the very strong working capital outflows they saw as the projects were built out has reversed and the company has enjoyed strong FCF and supernormal profits. The chairman owns 3% of the company, worth about £170m at current prices, so not only are the management team astute, but they have a significant amount of skin in the game. They also speak quite intelligently about the business - they are aware of how cyclical the property and construction markets are, and keep the balance sheet ungeared to try to ensure that they are able to be nimble when they need to be. At current prices, the investment in the land bank will probably not be so aggressive, and they have committed to returning 700p/share to investors over the next 3.5 years via a combination of dividends and share buybacks
The company has averaged a ROIC of about 15% over the cycle (from 2005-2017) and ROE of 18% over the same period of time. Both of those measures are currently elevated due to the factors mentioned above (22% and 29%, respectively), but the company guide that they will revert back to the long-term averages as the mix effects reverse in the coming years. A number of hedge funds are currently short the stock, I believe on the rationale that earnings have peaked (not really in question) and that the company has re-rated from 6x to 10.5x (about the mid-cycle multiple) on what will be peak earnings. On top of this, the London property market is seen as quite expensive at the moment on price to take home earnings, so Berkeley is a way to play that, especially with GBP rallying now, which will of course reduce the attractiveness of UK property to foreign investors, who are half of Berkeley's demand. Finally, due to a skills shortage in the construction industry, the company are seeing their construction costs rise at an annualised rate of about 5%, which will put pressure on their margins.
My view on it is that the earnings declines from the peak might end up being less pronounced than people fear. The company have a history of realising prices above the quite conservative ASP assumed in their valuation of their land bank. The value they assume is currently £520k, so I believe that will most likely act as a floor and we could see realisations above that level. I believe that earnings are quite likely to bottom at around 350p in 2020 before recovering from there. Applying a mid-cycle multiple of 10x (and these would be trough earnings) would get you to 3500p of fair value, and on top of this you would have about 500p of dividends to come, getting you to about 4000p of fair value, so not much downside. On a target FCF yield of 7.5%, I think that the shares are worth 5000p, while DCF gets me to 5100p and target EV/IC, so valuing the EVA, gets me to 5350p. Overall I see FV at 5000p, 30% upside.
Investment Positives
*Long history of value creation with high and relatively stable ROIC well in excess of WACC
*Best management team in the sector who called the last cycle well and have a large amount of skin in the game
*Should enjoy £400m+ of equity FCF per annum in the coming years as their portfolio starts to yield cash. Looks attractive on a market cap of £5.2bn
*Strong balance sheet with very modest debt levels and the capacity to reward shareholders
*Fundamental upside of ~30%
*Bear case well understood - hedge funds short of the stock. Only 4 Buy recommendations from 18 analysts covering it
Investment Negatives
*Very geared to London property, which looks incredibly expensive by historical P/E measures
*London market is heavily reliant on foreign buyers, who may be put off by recent GBP strength
*Earnings now going past a cyclical peak and the stock is arguably trading on a mid-cycle multiple of peak earnings
*Some execution risk in some of the projects that they undertake
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 particular catalyst