This small-cap company pays a respectable dividend and the shares are currently too cheap, believes analyst Edmond Jackson. Here’s why.
Despite higher interest rates changing the context for housebuilding and construction stocks, it is intriguing how this one – trading near an all-time share price low - has fallen close to asset value and its chair recently bought nearly £40,000 of stock.
Watkin Jones (LSE:WJG) is a leading developer and third-party manager of student accommodation, build-to-rent and affordable homes. Currently valued around £178 million with its stock at 70p, it listed at 100p in March 2016 and rose to 235p by autumn 2017. It then traded a 280p to 135p range, with Covid dealing a sharp blow. Yet it had recovered to 270p by early 2022 before plunging again last autumn.
Recent delays have pushed revenues forward, but I am attracted by scope here for an extent of mean-reversion upwards. This company’s revenue model is forward-selling developments to institutions even before they are built; hence, there is no need for a land bank like many builders. This, together with a net-cash balance sheet, means Watkin Jones could withstand a possible recession relatively well, and the stock’s risk/reward profile starts to look attractive.
How defensive is the revenue split?
Interim results to 31 March show “build to rent” dominating with £93 million revenue, flat on last year. But gross profit fell 31% to £8.3 million reflecting lower margins. Revenue for student accommodation was down 38% to £48 million and gross profit by 63% at £4.8 million reflecting additional build costs. Accommodation management enjoyed a 15% revenue rise albeit to just £4.7 million, with gross profit up 19% to £3.2 million.
While no forward sales were made during the period, management says prospects are recovering “with both strong tenant demand and rental growth in our core sectors”.
The outlook statement read: “We are encouraged by continued recovery in the forward fund market...starting to see attractive new land acquisition opportunities which support our long-run target margins and are currently under offer or in negotiation for around £500 million projected revenue of new developments...”
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You probably know I am rather cautious, and I do wonder if there has been a low-interest-rate driven speculative bubble in student accommodation building. Has the soaring cost of higher education thus created an inflection point and necessary adjustment back in demand for halls of residence?
Yet supply may be tempered by the general retreat in buy-to-let landlords due to taxation changes, and a new UK-India relationship struck by the prime minister last autumn is meant to improve access for Indian students. It’s unclear whether such elements are drivers rather than merely mitigating factors for demand.
Another aspect is cost of remedying buildings amid stricter rules post-Grenfell. Interim results to 31 March 2022 were hit by a £28 million exceptional charge for the potential cost of remedial work under the new Building Safety Act. Yet the bulk of this may now be accounted for and already weighed on the stock.
Mind, the projects here tend to be lumpy, meaning any delay shifts revenue forwards making forecasting potentially tricky.
Yet the table shows strong if varied returns on equity and capital employed, and free cash flow benefiting from zilch capital expenditure which supports a circa 7p dividend.
Watkin Jones - financial summary
Year end 30 Sep
|Turnover (£ million)||244||267||302||363||375||354||430||407|
|Operating margin (%)||13.3||4.2||14.4||14.9||14.1||8.8||13.3||6.0|
|Operating profit (£m)||32.5||11.3||43.6||54.0||53.0||31.2||57.3||24.3|
|Net profit (£m)||22.2||4.2||35.8||44.2||38.8||21.1||41.9||13.4|
|EPS - reported (p)||10.4||2.0||14.0||17.3||15.2||8.2||16.3||5.2|
|EPS - normalised (p)||11.4||8.8||13.7||15.9||16.0||14.9||16.4||7.9|
|Return on equity (%)||19.6||4.7||31.3||33.2||25.8||12.8||23.8||7.4|
|Return on total capital (%)||25.5||10.7||28.6||17.8||16.0||9.2||17.8||8.9|
|Operating cashflow/share (p)||11.1||5.9||7.5||21.3||9.4||14.9||24.0||-10.4|
|Capital expenditure/share (p)||0.02||0.06||0.1||0.1||0.1||0.1||0.3||0.1|
|Free cashflow/share (p)||11.1||5.9||7.4||21.2||9.3||14.8||23.9||-10.7|
|Net debt (£m)||-40.0||-33.2||-41.9||63.1||60.2||39.2||4.8||-33.6|
|Net assets (£m)||113||103||126||140||161||168||185||177|
|Net assets per share (p)||44.3||40.2||49.5||54.9||63.0||65.5||72.1||69.0|
Source: historic company REFS and company accounts
The interim pay-out was cut 52%, but if medium-term performance does mean-revert positively, there could now be potential to lock in a circa 10% yield. Some may say you cannot look back to a golden era that was built on unsustainably low interest rates. Others argue that the UK still has a chronic housing shortage.
Net tangible assets of £153 million equate to near 60p a share, which is very good backing against 70p to buy shares in the market.
The 31 March balance sheet had £45 million net cash if you disregard £47.5 million lease liabilities; there being £38 million debt financial and £83 million cash. Since operating profit was hit down to just £716k, the £1.5 million interim net interest charge meant a £766k operating loss.
Forecasts for March 2024 year have roughly halved
A forward price/earnings (PE) of five and prospective 10% yield is more likely a value trap, at least in the short term.
Prior to the late May interim results, consensus had been £32 million net profit in the end-September 2023 year, rising to £37 million in 2024 – although admittedly the company is yet to achieve 2018 earning power.
I would, however, broadly go along with another analyst who has slashed the near-term earnings per share (EPS) prospect to about 6.5p, implying a PE near 11 times. If cover of two times is maintained for the dividend, it implies a 4.3% yield.
Such parameters are fair if the UK faces a difficult year or more ahead. Greater falls in profit than revenue, the interims show, may reflect an aspect of operational gearing besides cost increases.
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The worst-case UK scenario would be getting trapped in stagflation, where interest rates continue edging up and stay there. Yet US inflation data appears encouraging, explaining why US equities are rising in the hope the Federal Reserve’s latest board meeting will conclude it best to leave rates where they are.
If the economy muddles through and a fundamental shortage of UK housing reasserts itself, Watkin Jones more likely offers value, say on a two year-plus investment horizon, which is prudent anyway.
Such a probability is underlined by the chair buying nearly £40,000 worth of shares at 78p the day after interims, even if the market price has drifted since. He now owns 184,000 shares overall.
Mind my mixed record calling this stock
In August 2019, I made a “buy” case at 210p after a price drop – along a rationale that despite Brexit, this developer’s strategy was astute in terms of specialist property, institutions would want to own.
It rose by a third to 279p by mid-February 2020, but then slumped in the wider Covid sell-off, with lows around 130p that March and November.
In September 2021, I re-iterated “buy” at 249p, arguing that the stock was only half-way recovered and a trading update asserted “institutional demand is driving forward sales”. It appeared the pipeline offered medium-term growth if tricky to value.
Consensus, however, looked for £44 million net profit in September 2023 and the current (new) chair had bought £148k worth of shares at 231p. The existing chair, stepping down, had added £200k at 230p to own 427,900 shares overall.
I targeted 300p on a one-to-two-year view, but you can buy the shares currently for 70p.
Among the setbacks has been (and there is plenty to read online about) a controversial five-storey housing block at Exeter, although end-2023 remains targeted for completion.
That five deals need closing by 30 September, in a context of delays happening, implies the risk of another profit warning. Otherwise, some £15 million potential profit rolls forward to 2024. But this is why the stock trades near tangible asset value. It may only need “no further major disappointments” in months ahead to rise.
Management talks of “exciting” land purchase opportunities in context of a pipeline reduced from £2.0 billion to £1.7 billion. Perhaps 2021 shows they have form offering jam tomorrow; yet I would also beware cynicism at the current all-time stock low.
I therefore conclude: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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