Description

Summary

I am recommending a long position in Persimmon PLC (PSN LN), the UK’s second largest homebuilder. Persimmon operates in a profitable, albeit cyclical industry. It is well managed, well capitalized and has historically been a highly profitable and cash generative company.  At 1208p/share, Persimmon is trading at 1.1x tangible net asset value, the low end of its historical range.  It has a market capitalization of GBP 3.8 billion, GBP 11 million of debt and GBP862 million in cash.   Since going public in 1991, the Company’s stock  has traded at an average price to TNAV of 1.6x. It has traded as  high as 2.9x TNAV during industry upcycles and as low as 0.5x NAV for a brief period during the GFC. 

The UK housing industry is entering a downcycle due to a weak economy, inflation, and a spike in mortgage rates. Persimmon stock has declined 64% from its all time high (July 2021), in line with the 68% decline in consensus EPS estimates for 2024. Similar to prior cycles, I believe the stock will discount the bottom in  the UK homebuilding sector sometime in the next 12 months and then gradually re-rate closer to its historical average of 1.6x P/TNAV and overshoot to the upside once historical levels of profitability are discounted.  This will result in a 50-100% total return including dividends within the next two years. 

Even if the cycle turns out to be deeper than expected and the stock overshoots to the downside, there is no risk of a permanent loss of capital. Unlike 2007, when the Company entered the downturn with net debt of GBP 656 million, Persimmon is entering the current downturn with GBP 11 million of debt and GBP 862 million in cash. Management will take advantage of the opportunity to rebuild its land bank for the next upturrn and will buy back shares accretively if it trades below TNAV.  

Industry Background 

Two other UK homebuilders have been written up in VIC in the past three years. “LDMR”  Bellway PLC (October 7, 2020 and October 9, 2022) and “thecoyelf” recommended Barratt Developments PLC ( March 7, 2023). Those write ups and the accompanying Q&A discussions provide a thorough and balanced perspective of the UK homebuilding industry. 

Below I highlight some important points: 

• The UK homebuilding industry is cyclical but very profitable due to the industry structure and the chronic shortage of houses. The largest 10 builders account for 60% of all homes built, and the trend towards consolidation continues. 

• The lengthy land permitting process in the UK creates a chronic undersupply of homes. Homebuilders spend up to five years and 10% of the overall cost of a project up front on zoning and permitting without a guaranteed outcome. This feature favors the large established players with strong balance sheets and diversified portfolios of projects.   Smaller builders lack the capital to adequately diversify across various projects. The owners of land, whether public or private, prefer to work with large established players  given the greater certainty of success in the permitting process.  

• There is a shortage of housing in the UK as a result of NIMBYsm and the difficult permitting process. The current downturn is the result of high mortgage rates and a weak economy,  not excess supply and a broken mortgage market as ocurred in the US during the GFC. The chart below  of net additional dwellings by the UK Office of National Statistics provides some historical context on net new additional dwellings. the UK has 28 million households, or 23% the number of US households. 

• 
  The chart below provides a longer term historical perspective on net new dwellings:  

• The UK Government has introduced various schemes over the years to increase the construction of new homes, targeting a supply of  300,000 net new homes per year. Due to difficulties with permitting combined with affordability issues, these measures have not been enough to incentivize an increase in supply.  Eighty four percent of new homes in the UK are built by the private sector.

•  The recent spike in construction inflation and mortgage rates have exacerbated housing affordability. Below is a chart of the yield on the 2yr fixed mortgage:  

• The tightening cycle and accompanying increase in mortgage rates have led to an increase in delinquencies. However, the UK mortgage market remains healthy and UK banks are well capitalized. The housing stock in the UK is estimated to be worth GBP 8.7 trillion. There are 11 million mortgages outstanidng with a total value of GBP 1.6 trillion. Thirty percent of households have a mortgage of which 59% are 5 year fixed rate. Thirty five percent of households own their property debt free. The balance is made up of renters. It does not appear like we are heading into a default crisis. 

• Affordability has been affected by the combination of cost inflation, stagnant wages, and higher mortgage rates. Nationwide, a mutual building society, calculates a national affordabilty index for first time buyers factoring in an 80% LTV. Even with the recent spike, owning continues to be cheaper than renting in the UK.

• The chart below provides a longer term perspecitve on affordability. Interestingly, the affordability issue in the second half of the 19th century was partially resolved by a reduction in the size of dwellings. Before 1850, the average house had a 913m2 plot size. Fifty years later the average plot size had shrunk to 268m2. 

• Industry revenues peaked in 2021 and were flat to down in 2022. The industry data on new home reservations and mortgage issuance began pointing to a sharp downturn at the end of 2022.

• Consensus revenue estimates for the industry peaked in 2021 and the rate of downgrades accelerated in 2022 and 2023. Currenlty, consensus estimates a 22% peak to trough decline in revenues for for the publicly traded companies. Given Persimmon’s greater exposure to first time homebuyers (FTB), consensus estimates a decline of 33% in revenues. The expiration of the “Help to Buy” program in March of 2023 is expected to exacerbate the situation.

Company Background 

Persimmon PLC, founded in York in 1972,  is the second largest homebuilder in the UK. Its niche is affordable homes for first time buyers. In 2022 it sold 14,868 homes at an average price of GBP 248,618. At year end its land bank consisted of 70,768 plots. 

The Company has a market capitalization of  GBP 3,858 milllion, GBP13 million of debt and GBP861 million of cash. Since 1990, the UK home builders have  experienced three down cycles (early 90’s, GFC, today). Over that period,  Persimmon has  generated a 16% average ROE, a 15% average ROIC, and has paid GBP 5.3 billion in dividends. Even during the GFC and ensuing downturn, the company generated positive free cash flow every year. 

Over the past 15 years Persimmon traded at a premium to peers in terms of PE and P/TNAV because of its industry leading land bank, higher level of profitability (avg 600bps higher margins) and solid balance sheet. In  2020 the stock began to lag its peers, and it has significanlty underperformed peers in 2022 and 2023. The derating has been driven by the view that Persimmon is more exposed to first time home buyers than its peers and and that it will suffer a greater decline in revenues and profitabilty as a result. The de-rating was partially self inflicted, since Persimmon management was the first management to proactively guide down margins. When it reported 2022 results, it stated that it expected a 1,2000 bps contraction in margins in 2023 due to an industry downturn. 

The chart below shows the performance of PSN LN relative to the UK homebuilders index: 

Why Persimmon vs its peers? 

As illustrated in the chart below from JP Morgan research, all UK homebuilders trade up and down relative to TNAV depending on where we are in the cycle. If this thesis is right and we are close to discounting the downturn, the whole group will probably be a good investment over the next couple of years. 

I prefer Persimmon PLC to to owning the UK Homebuilders Index for the following reasons: 

• It is a well managed company as illustrated by its industry leading margins and return on invested capital. Over time the higher profitability compounds value. 

• Given the quality of the company and the degree of derating that the stock has suffered, I believe that Persimmon has greater room to re-rate to historical levels in the next upturn. 

• In the past 10 years the company has been very adept at developing an attractive land bank as evidenced by the company’s elevated gross margins versus peers. Unlike 2007, when the Company entered the downturn with very little cash and GBP of debt, Persimmon is entering the current downturn with GPB 11 million of debt and GBP 862 million of cash. It will be able to take advantage of the downturn to replenish its land bank and buy back shares. 

• The Company provides a quality product that customers like. Persimmon has a 5 Star Rating from the House Builders Federation and a 86.6% build quality score from the NHBC, the UK’s leading provider of warranties and insurance for new homes. 

• I believe the next Government, whether Labor or Tory, will reinstate incentives for first time buyers once inflation begins to come down. Just like the lapsing of incentives in March 2023 hurt sentiment towards Persimmon negatively, the reinstating of incentives for first time home buyers will impact Persimmon’s rerating disproportionately.
  

Risks

The biggest risk is from a short term, mark to market perspective. If results are weaker than anticipated in 2H23 and guidance is brought down further, the stock  will likely suffer another leg down and trade at a discount to TNAV like it did during the GFC. This risk is somewhat mitigated by the fact that Persimmon is entering this downturn with a strong balance sheet and plans to buy back shares and continue paying its dividend.

We have a protracted downturn. UK inflation and mortgage rates remain elevated while wages remain stagnant. The industrys profitbality is reset lower. I doubt this because I think the industry would adjust by building less expensive homes. 

Catalyst

• 2H23 sees a stabilization in volumes and margins. 
• The UK Government reinstates measures to reintroduce the first time buyer incentives that lapsed in March 2023.