Edmond Jackson's Stockwatch: Barratt built to last

Do housebuilding shares currently offer value? Market prices have eased with an interest rate rise appearing on the horizon, although the Bank of England governor supports the "new normal" theory that any rises will be minor.

Companies have restructured since the 2008 crisis to become more efficient and have satisfactory land banks. There is a growing consensus, the only way the UK can check house price rises is to increase supply. Savills have predicted a 55% rise in housebuilding by 2018 and despite mixed figures for construction recently, June has seen a sharp rise in housebuilding with one index surging to 66.6 from 62.7 in May and builders hiring workers at the fastest-ever rate. So might the next three to five years offer overall returns for housebuilders?

The stockmarket is taking a cautious view as if wary of awarding growth ratings to long-term cyclical shares. Yet Company REFS' financial summary for FTSE 100-listed Barratt Developments ascribes price/earnings (P/E) to growth ratios (the classic measure of a growth share) falling from 0.54 for the year to end-June 2013, as low as 0.1 for the latest financial year and 0.25 for 2014/15. It looks odd when any ratio below 1.0 implies value and the best you can typically expect with growth shares is between 0.5 and 1.0.

I think it reflects the rebound in the UK housing market impacting profits while the market is unwilling to ascribe a double-digit forward P/E. Barratt is emerging from a cyclical trough and although it is technically fair to ascribe the PEG ratio after three years of earnings growth, it's been a profits roller coaster.

The government's Help to Buy scheme may be a transient factor ahead of the general election yet it's possible this upturn runs longer than most cycles helped by a significant shift in planning priorities - for example councils relaxing constraints on protected rural land. It would probably need a housing market crash to halt momentum although the Bank of England has already moved to cap aggressive mortgage lending.

Political uncertainty

Mortgage stimulus and check has proven effective; indeed I drew attention to Barratt as a Mid-250 stock at 92p in November 2011 also Persimmon and Taylor Wimpey along a rationale that the new Mortgage Indemnity Scheme would boost the housing market - with Barratt particularly attractive because its shares traded under 0.5 times estimated net tangible asset value compared with about 0.8 times for the sector. In February 2012 I noted how underlying momentum was picking up and emphasised Barratt as a stalwart share for 2013 with the price around 200p that January. It climbed to 355p, then 452p earlier this year, slipping recently to 366p as the market considers what effect rising interest rates may have.

A latest trading statement for the year to end-June signals pre-tax profit of about £390 million, ahead of the top end of analysts' estimates, with the group achieving its 18% return on capital employed target (up from 11.5% achieved in 2012/13) two years ahead of schedule. Management ascribes its revenue momentum mainly to pent-up demand for housing after people sat on their hands, post the financial crisis, with Help to Buy enhancing this. Total forward sales are up by 44.7% to £1.2 billion with average selling price growth of 13% to £220,000.

Profits are also benefiting from utilising recently acquired, high-margin land: Barratt's approach ensures supply for about four and a half years and the update reassures: "We continue to secure excellent land opportunities across all regions that meet or exceed our minimum hurdle rates of 20% gross margin and 25% return on capital employed." This is a bit curious considering land for development is still quite restricted and agricultural land prices have soared as loose monetary policy boosts asset prices globally - so it needs watching for any adverse change, especially if combined with higher interest rates and less keen consumer confidence.

My chief concern is political uncertainty creeping into UK shares then consumer confidence going off the boil after the general election. Ed Milliband may not impress the electorate but many of his policy commitments are genuinely popular and the modern political landscape makes it hard for the Conservatives to achieve a majority government. The UK recovery still substantially rests on consumers having run down savings and retained high debts; so it is possible to envisage the current rush of house-buying, easing.

"Stalwart"

The stockmarket is therefore justified in its caution towards housebuilders although this helps the likes of Barratt retain its "stalwart" appeal - as the shares remain quite modestly rated assuming the UK is now intent on improving the supply of new homes (i.e. free up land for development) and mortgage policies aid buyers while also checking excess.

I also have some concern about Barratt's exposure to London, it is not possible to quantify; a market which currently looks overheated, so mind this downside risk.

"Stalwart" is still implied by the balance sheet transformation from £1.7 billion debt and a market capitalisation of £140 million amid the last downturn, to end-June net cash of £70 million and a market cap of £3.6 billion. This helps put Barratt in a firm position to grow dividends from a restoration with a 3.2p a share, interim payout.

The table shows a 10p total dividend expected for the latest year and 13.6p for the year to June 2015, with good cover of three times assuming earnings per share soars from 14.8p possibly over 41p in two years. High expectations maybe, yet Barratt beat them just recently and the implied near 4% yield lends support at the current market price of 366p. That's a radical change to 1.6 times net tangible asset value albeit justified by the earnings transformation. Mind the pace of earnings rebound means the stockmarket will want to see solid evidence being reported.

I would therefore retain Barratt shares while recognising there is bound to be some volatility ahead for housebuilders, with chances to buy into others as prices dictate.

For more information see barrattdevelopments.co.uk