Stockwatch: This share offers defensive upside

by Edmond Jackson from interactive investor |

Our companies analyst likes strong cash generation here and a special dividend is certainly affordable.

On the face of it, a potentially tricky call: student accommodation is well-established as a property theme such that the stock market offers two listed companies – one principally a builder, another more investor.

Promotional leaflets exist from shadier operators perhaps, about "safe and attractive" returns from this sector, as if a bandwagon. The demographics of youth don't imply growth, but there are plenty of foreign students waiting to step into any shortfall among their British peers, these tending to be wealthy and discriminating about accommodation quality. So, while the story might not be so fresh, and has mixed elements, it could still remain attractive.

Pre-close update re-affirms current expectations

Watkin Jones (LSE:WJG), a This £570 million AIM-listed developer and constructor, has issued a pre-close update for its half-year to end-March, saying its forward-sold pipeline of developments reflects "continued strong demand among institutional investors", particularly a 599-bed scheme in Wembley for delivery ahead of the 2021/22 academic year – with a total pipeline over 7,500 beds across 17 sites for its 2018 to 2021 financial years.

It would appear that institutions see this sector both as more defensive and promising than offices or (heaven help) shops. And, as yet, the situation is not showing signs of over-supply. I should say in relation to "current expectations" in the table, these forecasts appear modest and may be out-dated, the key issue is underlying momentum being intact.

Mid-250 boss moves to this smaller construction specialist

After 13 years as property development director of FTSE 250-listed, £2.2 billion Unite Group (LSE:UTG) – a Real Estate Investment Trust – Richard Simpson took Watkin's reins early this year. Probably it involved a pay rise, although job security would have been a factor too - whether to jump to a potentially more cyclical builder? Implicitly, he believes in scope to extend Watkin's track record of trebling profits in recent years (see table).

Unite's track record has been strong: in the last two years or so its stock has steadily appreciated over 50% to about 920p, and annual results to 30 September 2018 showed pre-tax profit up 25.6% to £54.3 million on revenue up 20.3% to £363.1 million, with an operating margin of 14.8%.

Unite's dividend rose 15.2% to 7.6p, covered just over twice by earnings. There was also a 162% jump in cash from operations to £66.6 million. A confident outlook statement as of 27 February cited "further progress in build-to-rent, which has the potential to become a second important income stream over the next few years."

After flotation at 100p in March 2016, Watkin rose sharply, attracting momentum buyers such that its price/earnings (PE) multiple more than doubled over 18 months to an average 20.5 times for 2017.

This probably helps explain its consolidation over the last 18 months in a circa 180p to 230p range. Currently at about 220p, it trades on a forward PE in the low/mid-teens and a prospective yield close to 4%.

Net tangible asset value is barely 25% of market value however, versus 95% at Unite whose stock is on a PE of 23 times, and yields 3.6%. As we've seen with pubs group Young & Co (LSE:YNGA), a stock with quality asset backing tends to offer relatively stable growth - albeit potentially slower with size – despite a high PE.

From a macro perspective, Watkin's flotation-and-rally could be seen as classic small-cap froth in the late stage of a bull market, lately giving way to soul-searching. Yet the crux question is stock-specific: does Watkin's underlying performance mean the stock can convincingly grow into its valuation?

Student accommodation remains a growth market

The demand/supply balance appears supportive. Despite a decline in the number of 18-year-olds, Watkin has cited 695,565 applications to UK universities in 2017/18 of which 533,360 were accepted. Some 22.5% of the total student population come from outside the UK and with non-EU international students rising by 20% over eight years to 2016/17 to comprise 15.8% of the population. Thus, Brexit is not expected to have a significant effect on accommodation demand.

An independent property consultancy has estimated 627,000 bed spaces which, therefore, covers at least students' first year overall, a situation that doesn't seem radically different to my experience over 30 years ago – when students were guaranteed a first year in a hall residence but could need to start looking thereafter.

"Significant scope remains for increased penetration by private developers as universities turn to the private sector and more students are studying away from home."

Key data like this implies further mileage for developers, despite the sector's undoubted popularity for landlords and investors. Projects need to ensure the high qualities students now demand, location also being vital, where facilities close to campus can drive values higher, albeit at the risk of ending up with saturation.

A UK recession could have mixed effects, perhaps deterring some young people from assuming student debt, but, if the school-leaver jobs market was to contract, then others might opt for higher education.

Watkin Jones - financial summary           Consensus estimates
Year ended 30 Sep 2014 2015 2016 2017 2018 2019 2020
Turnover (£ million) 227 244 267 327 363    
IFRS3 pre-tax profit (£m) 14.1 32.9 13.3 45.8 54.3    
Normalised pre-tax profit (£m) 14.2 36.1 19.8 52.4 60.9 43.3 47.0
Operating margin (%) 6.7 14.3 6.3 16.3 16.5    
IFRS3 earnings/share (p) 4.4 10.4 3.8 14.0 17.3    
Normalised earnings/share (p) 4.4 11.7 8.6 14.9 15.9 16.4 17.8
Earnings per share growth (%) 123 164 -26.3 72.4 7.1 2.9 8.4
Price/earnings multiple (x)         13.8 13.4 12.4
Annual average historic P/E (x)     10.7 20.5 16.0 13.6  
Cash flow/share (p) 18.6 11.1 11.2 18.1 21.3    
Capex/share (p)     1.9 1.9 1.8    
Dividend per share (p)     4.0 6.6 6.9 8.1 8.9
Yield (%)         3.1 2.9 3.2
Covered by earnings (x)     2.2 2.8 3.0 2.0 2.0
Net tangible assets per share (p)     34.2 43.6 54.3    

Source: Company REFS   Past performance is not a guide to future performance

Strong cash performance: potential for a special payout

Watkin's year to 30 September 2018 showed strong double-digit growth all-round: pre-tax profit rose 15.7% to £50.1 million (disregarding a £4.3 million exceptional gain for early termination of management contracts) on revenue up 20.3% with a 13.7% operating margin - said helped by the high quality of Watkin's developments.

Adjusted earnings per share (EPS) rose 13.8% to 16p and the dividend by 15.2% to 7.6p. Net cash inflow from operations soared 183% to £54.4 million, note 9 of the accounts elucidates chiefly due to changes in the working capital balance, primarily the proceeds from a property sale. It means net cash inflow per share of 21.3p, for a cash flow multiple of 10 times, which could potentially interest a trade buyer.

The balance sheet, therefore, has a very strong cash-to-debt profile: £106.6 million cash versus £24.9 million long-term debt and only £1.6 million short-term. With the annual dividend costing £19.4 million, a special dividend certainly looks possible, although it's unclear whether an incoming CEO would want to go down that path than organic expansion or acquisitions. If the board truly seeks to demonstrate shareholder returns it could compromise say with a 10p special payout.

Intangible assets constitute just 9.4% of net assets, hence decent net tangible asset value (NTAV) per share of 54.3p despite this not offering the extent of support like at Unite.

Opportunities to 2021 look well supported

The update essentially repeats the story at January's prelims, about how "Locations and forward sale values for our schemes underpin our earnings expectations over the next 12 months and beyond....for the 2019 year, five of six schemes have been sold and the remaining one secured; in 2020 we expect to deliver seven schemes with four forward sold and three secured; and four development sites have been secured for 2021; a development pipeline of 17 sites with approximate development value of £650 million."

A hard Brexit could undermine property values, but student accommodation should remain an attractive niche, this developer being strongly cash-generative which augurs well for shareholder returns. Buy.

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

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