Interactive Investor

Stockwatch: is this property developer set for lift-off?

7th September 2021 10:58

Edmond Jackson from interactive investor

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Our equities columnist considers the case of a £600 million firm where he believes risk is low but potential for big rewards is rising.

How much notice to take of share price performance over time, as reflecting the quality of an investment made? That would appear the touchstone fund managers live by, but it can muddy interpretation. 

Two years ago, I drew attention to Watkin Jones (LSE:WJG), a circa £540 million developer of student and rental accommodation at 210p – down 16% from a November 2017 high of 249p.

Despite Brexit risks, such areas of the property market appeared well supported by people’s needs also institutional investors – a developer could sell on to. 

Earnings growth had stalled, hence a forward price earnings (PE) around 12x meant a less than ideal price earnings to growth ratio of around 1.2 times. Yet the cash flow profile was strong and low capital spending needs meant high free cash flow, helped by a respectable operating margin in the mid-teens.

This meant a useful 4% yield that looked pretty reliable given strong demand for student and build-to-rent accommodation. 81% of gross profit was derived from student accommodation, which looked supported by foreign students’ demand for UK higher education. 

A forward sales business model added further security, hence a 4% yield potentially more attractive to some investors than a riskier 8% elsewhere.

Return on equity and capital employed in a mid-to-high 20% range. In terms of a fundamentals mix, it appeared a stock to quite comfortably tuck away. 

Covid dealt a blow from which the stock is still recovering 

Its price rose 33% to 279p by mid-February 2020 then slumped with the wider Covid sell-off – hitting lows in a 130p range that March and November. The vaccines rally then triggered an uptrend, but at 249p the stock is only halfway recovered. Is that fair pricing? 

There appear two chief Covid factors, over-hanging: 

First, risk of disruption. After the virus broke, Watkin closed most of its development sites temporarily and a subsequent 1 April 2020 update said it was difficult to predict the scale of impacts caused by any ongoing disruption.

I suspect such a backdrop – which continues to some degree with the return of children to schools – is why the board nowadays seems reticent to give firm guidance as to whether the business is in line with meeting financial expectations.  

Yet compared with a year ago, the overwhelming impression is people now being substantially vaccinated and determined to get on with their lives, businesses too. The outside risk would be fresh government constraints, if the NHS cannot cope over winter.   

Second, foreign students’ demand for UK university places. They are able to return to the UK to resume studies but the key question is what extent the Covid era tempers demand for studying abroad. Might the pre-Covid era represent a peak? 

£12-15 million exceptional cost for remedial work on cladding  

The Grenfell Tower disaster has cast a shadow – in Watkin’s case, revealing in early 2020 how this extent of cost will need spreading over two to three years, messing reported versus normalised profits.  

While there is a possibility of recovering some of this from sub-contractors and consultants who implemented it, “this is likely to take an extended period of time to achieve” and sounds as if further expense would be needed on litigation. The kind of liability some might say a listed plc is better off swallowing than protracting.  

However, this cost ends up being classed, it weighs on shareholder value and has together with Covid disrupted a growth narrative. 

So, in terms both of fundamentals and sentiment, there have been twin aspects of force majeure since August 2019, tempering the investment case I made back then.   

Trading update cites good progress across the business  

This latest update offers significant detail on projects although does not conclude by altering or affirming forecasts for the current financial year soon to close on 30 September.  

There has been completion and handover of four buy-to-rent schemes and five student accommodation developments – with all remaining developments in the current financial year on track for completion in September.  

“Institutional demand across asset classes (is) driving forward sales.” Four planning consents have been achieved and three sites added to the development pipeline, which is said now to have a total estimated development value around £1.7 billion.  

This being the chief reason I draw Watkin Jones again to your attention, and which looks to more than offset concern about Covid disruption or what foreign students might do, in the medium term. It also represents growth in the pipeline although is tricky to value. Management has only now started to quantify development value. 

Consensus expects net profit of £40 million rising to £44 million in 2023, which essentially recovers pre-pandemic earning power (see table) and represents a forward PE of 15.4 times easing to 14x. 

After a 12% dividend reduction in respect of the September 2020 year, consensus anticipates a recovery to pre-pandemic levels after 2.6p a share was paid in respect of the first-half-year – for a prospective yield of 3.3% rising to 3.6% in 2022. 

The stock also trades on 3.6x underlying net asset value (NAV) but is more a construction-oriented developer than an investor-developer, hence NAV being less relevant as a benchmark.   

Watkin Jones - financial summary
Year end 30 Sep

  2015 2016 2017 2018 2019 2020
Turnover (£ million) 244 267 302 363 375 354
Operating margin (%) 13.3 4.2 14.4 14.9 14.1 8.8
Operating profit (£m) 32.5 11.3 43.6 54.0 53.0 31.2
Net profit (£m) 22.2 4.2 35.8 44.2 38.8 21.1
EPS - reported (p) 10.4 2.0 14.0 17.3 15.2 8.2
EPS - normalised (p) 11.4 8.8 13.7 15.9 16.0 14.9
Price/earnings ratio (x)           16.7
Return on equity (%)   4.7 31.3 33.2 25.8 12.8
Return on total capital (%) 25.5 10.7 28.6 17.8 16.0 9.2
Operating cashflow/share (p) 11.1 5.9 7.5 21.3 9.4 14.9
Capital expenditure/share (p) 0.02 0.06 0.1 0.1 0.1 0.1
Free cashflow/share (p) 11.1 5.9 7.4 21.2 9.3 14.8
Dividend/share (p) 0.0 4.0 6.6 7.6 8.4 7.4
Cash (£m) 60.1 48.2 66.2 107 116 135
Net debt (£m) -40.0 -33.2 -41.9 63.1 60.2 39.2
Net assets (£m) 113 103 126 140 161 168
Net assets per share (p) 44.3 40.2 49.5 54.9 63.0 65.5

Source: historic company REFS and company accounts

Non-executive directors and an institution add to their stakes 

Last May, the Watkin Jones family legacy fund sold 25 million shares at 210p, retaining 20.6 million or 8% of the company.  

Then, in July, a new non-executive who is chairman designate for a handover this October, bought a maiden stake of 64,000 shares at 230.5p.  

More interestingly for someone stepping down, the existing chairman added 87,000 shares at 229.5p to own a total 427,900. That is notable given he has a long-term perspective of the business and no need to tick a box for equity ownership like his successor. 

On 2 September, Octopus Investments raised its stake from 10.1% to 11.0%. Obviously, there are two sides to every trade but any material seller is yet to be clarified. 

These more recent trades appear to conflate with Watkin’s growing development pipeline, to suggest there is indeed a fair chance of a steady assault on fresh highs for the stock. I target 300p on a one to two-year view given normalised earnings per share (EPS) at least, of 20p should be achievable – and maintaining the PE at 15x. 

November trading update and capital markets day 

This being an annual event, I would not read any significance into management’s willingness to showcase the business; but at least it signals when more financial detail will be given, after the financial year-end. 

Interim results had shown operating profit easing 2% to £29.1 million although was not much guide to prospects; the comparator period to March 2020 being before Covid essentially struck.

Balance sheet cash rose 23% to £88.7 million despite a £40.1 million net cash outflow from operations, helped by a £19.8 million drawdown of a revolving credit facility. Long-term debt therefore rose 66% to £56.1 million, with total debt 32% lower than the cash position. 

I therefore judge Watkin’s risks as pretty low unless some element of lockdown returns, meanwhile its potential rewards are rising – hence I retain my stance of two years ago. Buy.   

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

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