Description

Cairn homes: price target of €2.00 / 67% total return

Cairn Homes is Ireland’s largest homebuilder. The bull case is very straightforward: the market cap of the company is €900mm, the company has guided to €500mm in operating cash generation cumulatively from 2022 through the end of 2024, and the company should earn at least €100mm in net income per year in 2024.

We argue that the company should re-rate to 10.5x 2024 EPS over the next 18 months (€2.00 per share) – giving a 67% total return from €1.25 per share, inclusive of 8.3c in total dividends received. The company has guided that the use of cash flow will be overwhelmingly tilted to shareholder returns, primarily share repurchases. We assume that the company will repurchase shares at prices up to 2.00 in this analysis as 2024 EPS would be greater than €0.19 otherwise. To answer the most obvious question up front, the company only has €100mm in net debt, so the low earnings multiple is not due to leverage. Given the simplicity of the bull case, we will spend the majority of this note discussing the industry bear case and specifically why housing and homebuilding in Ireland is unique in a global context.

Homebuilders in the UK and the US trade at low earnings multiples because the market implicitly believes that their earnings will decline going forward. The fundamental argument is that earnings will fall because consumers will be unable to afford home purchases at current pricing due to higher mortgage rates and an expected decline in disposable income as a result of inflation in food and energy costs. The logic follows that the decline in affordability will cause builders to sell homes at lower prices or lower volumes or both. Lower home prices should generate significant negative operating leverage since inputs costs will likely be unchanged at best or higher with inflation. There is also a lurking suspicion among investors that homebuilding tends to fare very poorly in recessions, primarily due to the experience of the 2008-2009 global financial crisis which emanated from housing.  Thus, the bear case for homebuilding centers on industry-wide concerns focused on declining consumer affordability. For Irish homebuilders, the default comparison for most investors is the UK market given similarities in mortgage structure and planning regimes as compared to the US. UK housebuilders as a sector trade at ~9x current earnings versus our target price of CRN at 10.5x, although UK builders have significantly greater sensitivity to rising rates (affordability) as well as idiosyncratic exposure to sector-specific levies designed remedy deficient building construction (https://www.bloomberg.com/news/articles/2022-01-10/u-k-tells-developers-to-replace-dangerous-apartment-cladding?sref=6okYcPM8).

We argue that the Irish homebuilding market is unique in a global context given its history in the 2008-2009 crisis, as the shock in Ireland was an order of magnitude larger than that experienced in the US or the UK. During the prior peak in 2007 the local industry was composed of family owned and operated builders who had limited equity capital bases and whose financing relied entirely on the Irish banking sector. The Irish banks themselves also possessed limited equity capital and heavily relied on international wholesale markets for their funding. During the GFC, the entire Irish financial system seized up, triggering a liquidity event for the banks (who ultimately had to be nationalized by the sovereign) and a liquidity event for everyone who relied on the banks for funding, most notably the homebuilding sector. As a result, almost the entire building sector went into insolvency, although the workout processes were handled as liquidations rather than as reorganizations for going concerns. This industry-wide liquidation was a seminal event that generated ramifications which persist to this day. Firstly, the homebuilding sector was rendered overnight into a blank slate, as the incumbent firms all ceased operating. Secondly, the lack of homebuilders meant that close to zero new housing was produced for years, leading eventually to an unprecedented shortage of accommodation in Ireland as population growth and household formation continued unabated over the same time. Thirdly, the local central bank (focused solely on fighting the last war, as ever) implemented strict regulation on mortgage lending criteria that capped loan sizes at 3.5x principal to income. This LTI (loan-to-income) cap had the effect of completely divorcing the housing market from interest rates, as affordability has traditionally been measured in terms of monthly payments (debt service) rather than in terms of the gross loan size. Hence, as rates fell and global quantitative easing spurred a leveraged boom in housing in all other developed markets during the last 7 years, the LTI cap suppressed home prices in Ireland to levels well below what borrowers could have otherwise afforded.

Lack of supply: the following charts attempt to illustrate how large the collapse in housing supply has been since 2007. The industry delivered ~20,400 units in the last twelve months compared to the estimated 35,000 units required per year on current demographics. Going further and taking into account the cumulative undersupply over the last 10 years, annual demand could be up to 45,000 units for the next decade. Both mortgage origination and new housing completion as a % of existing stock are still at levels last seen decades ago, well below natural obsolescence rates and while population has continued to grow. From a pure volume perspective, the entire industry including Cairn is facing the prospect of many years of growth in way that is not present in either the UK or the US.

Source: CRN presentation, CSO, Irish Department of Housing, Central Bank of Ireland

Source: Davy

Source: CRN company presentation

Home prices / affordability: Ireland is the only developed country in the world where housing has the same rough affordability as it did in the early 1970s, due almost entirely to the presence of the LTI cap preventing the transmission of negative real interest rates in Europe into the local housing sector. The real cost of the supply shortage in housing is currently borne by the rental sector, as there is no similar cap on rental payments to income. This regulatory intervention has created a situation where it is approximately 80% more expensive to rent than to own a starter home; Irish mortgage interest rates could increase by an order of magnitude and housing would still be affordable relative to renting on a monthly payment basis.

It is hard to emphasize enough how unusual this situation is. In the US, the market efficiently prices housing to the limits of the marginal consumer’s ability to afford the payment on the mortgage needed to purchase it. The desire (willingness) of a household to own one’s home does not tend to change much cyclically, but what changes is the household’s ability to do so at a given price. As a result, home prices tend to be sensitive to small changes in affordability metrics – both via mortgage rates and via the borrower’s monthly income. The LTI cap has broken that linkage in Ireland, such that borrower affordability is not the main constraint on home purchasing – the availability of new housing supply is, which is a function of the time it has taken for the building industry to ramp up production. Given this dynamic, any supply of new entry level homes has been absorbed immediately upon hitting the market, as evidenced by the exceptionally strong orders books for both public builders. Oddly, in a world where consumer disposable income is under pressure due to inflation, one could argue that homebuilding demand in Ireland should be in even greater given the €1000/month average lower cost for owning versus renting. Furthermore, new homes in Ireland have significantly better building standards (insulation) compared to existing homes, and as a result new homes are cheaper to occupy than existing homes on the basis of monthly utility costs.

Source: CRN company presentation, daft.ie, guardian.ie/mortgagecalculator

Who will supply the needed housing? There are only a few developers in Ireland with the infrastructure to deliver housing at large scale. Both CRN and GLV have estimated that their economies of scale at 1000+ units per year allow them to deliver units at a 500bps+ margin advantage compared to smaller mom-and-pop operators completing 50 units per year. The economies of scale should further expand as both builders reach 2000 units of delivery in the next two years. The advantages take the form of term contracting in the labor market (e.g. subcontractors are booked for several years at a time at lower rates versus the spot market as the subs trade rate for certainty of revenue), bulk purchasing of building materials, scale on central architectural and planning teams, and lower cost of finance. In particular, the larger builders have the flexibility to push multiple projects through the Irish planning system simultaneously given their dedicated resources, a process that can take multiple years to complete. Higher density from planning gains allows for structurally higher margins compared to smaller builders who can only purchase shovel-ready sites given their lack of resources.

While we believe that both CRN and GLV will ultimately deliver significantly more homes than indicated by their near-term guidance, state-sponsored/funded construction will ultimately be required to narrow the gap for the country as a whole. The policy focus of the current and any likely future government is to deliver more social and affordable housing to ease the accommodation shortage in the lower end of the rental market specifically. While the production of low-income housing projects will likely increase, this policy effort will not impact Cairn’s economics or role as a leading developer in the private market for first time buyers (e.g. CRN’s buyer base would not particularly want to live in a government housing project). Even the more populist policy proposals bandied about in Parliament do not impinge on (constitutionally protected) property rights for developers or the concept of  private market transactions in housing; their primary focus is using government-owned land to provide housing for the low end of the market at subsidized prices. As there is no Irish state homebuilder or construction firm of any kind, any government will have to partner with the private sector for the actual construction of this housing, although this activity does not form part of our forecast for CRN.

What about margin compression due to building material inflation? One of the most common objections is that Irish builders will not be able to pass on inflation in building materials cost given the LTI cap constraining home price growth. The narrative tends to originate from the cement and plastics industries, whose inputs are primarily electricity and petroleum, and consequently where output pricing has increased by 20-30% cumulatively in recent years. However, the reality is that while smaller builders are seeing build cost inflation of ~9-10% per year, the larger builders are seeing rates of 4-6% due to their practice of bulk purchasing on behalf of their subcontractors and term labor agreements. Meanwhile, home prices are rising at 5-6% due to Irish wage growth at the same levels; revenue and hard build costs are increasing at the same pace for CRN. Meanwhile soft build costs like land, local authority development levies, and utility connections are not increasing in price and allow overall margins to increase. The struggles of the smaller builders have kept a lid on land pricing despite the market realizing higher home prices, allowing scale builders like CRN to purchase land at attractive levels. Finally, consumers are absorbing the build cost inflation by simply getting less house for the same price:  builders like CRN are increasing housing density in their developments (smaller sizes) which increases the selling price per square foot for new units while lowering the total amount of building material required at the same headline price per unit.

Summary: CRN is a very cheap stock with a long-tailed growth runway. The 19c EPS estimate assumes the current capital return profile and ~2000 units per year of delivery but the reality is that CRN will likely deliver volumes well in excess of 2000 units in the medium term given the acute undersupply of housing. Current guidance is for CRN to deliver 1500 units in 2022, although projects under construction including apartments are already at a 2000 unit annual pace. While no formal guidance exists for the pace of delivery in 2023 or 2024 specifically, we believe the company could approach 2000 units in 2023, or a year earlier than our base case. The catalyst for the stock is simply the company delivering on its plan combined with a relentless open market share repurchase program.

Catalyst

Earnings and share repurchases