Stockwatch: Is this share a pre-Brexit buy?

by Edmond Jackson from interactive investor |

There's lots to like about industry fundamentals and a recent price drop has piqued interest.

I'm intrigued to re-examine the situation at small cap housebuilder MJ Gleeson (LSE:GLE) after its stock plunged from 900p to 700p following a 10 June announcement. 

The CEO had left following disagreements with the board "regarding his remuneration and succession planning."  Not for company-specific issues then, and he hasn't left a hole: an interim CEO has been appointed who is non-executive director of a private equity-owned housebuilder selling over 4,000 homes a year, previously its CEO.

Gleeson also looks to have a strong team, and qualities in its business model are shown by a 4 July trading update citing a record 25% increase in home sales to 1,529 during the financial year to 30 June 2019.  The group's "strategic land" trading side sold nine interests in the financial year with another nine scheduled for the current year onwards – three in a sales' process and planning decisions due on a further six.

The latest financial year will therefore be "comfortably in line with expectations."  

Valuation judgments have got more challenging

This has brought the stock up to 800p where, if forecasts are realistic, it trades on a prospective price/earnings (PE) ratio of around 12 times yielding 4.5% and 2.4 times its last reported tangible net asset value (no goodwill or intangibles).

Not surprisingly, what looks a sharp irrational drop on the chart is being bought, although valuation metrics are rather wild in housebuilders currently after the long-term effects of QE, very low mortgage rates and Help to Buy, have boosted asset prices, affordability and hence housebuilder profits.

Persimmon (LSE:PSN), which has quite scandalously benefited the most from Help to Buy (its bosses enjoying bumper remuneration), trades on twice net asset value versus a 1.5x sector average, yielding a remarkable 12% - reflecting both high profits and cautious market pricing, if we are late-cycle.

I'd sit back from specific annual forecasts/ratings to bear in mind, if the best years for builders are passing and a hard Brexit finally deals the blow to confidence and asset values, predicted by "project fear" since the 2016 referendum, a cyclically adjusted view of PE's is vital.

Gleeson's land trading side has been able to add value successfully in recent years, obtaining building consents, helped partly by ongoing asset inflation.  Housebuilding and property shares fell sharply in initial response to the referendum, and while overdone at the time, a degree of risk to asset values hasn't gone away – indeed may be approaching. 

More positively, all the political parties are competing to favour homes' provision and, although Labour has declared its approach to be government-led, practically it's not going to thwart projects already underway or in the pipeline – to deliver more affordable housing.  Help to Buy continues until March 2023.

Brexit is certainly a risk, the real effects we are yet to see if there's no deal. However, the Bank of England is already talking of resuming monetary stimulus – potentially supportive once more for asset values, and with interest rate cuts likely to affect mortgages too. Governor Carney has made plain, though it isn't guaranteed, that if sterling was to plunge thereby push up inflation by way of higher import costs, the Bank could have to raise rates.  As Brexit comes to a head, the prospect for fundamentals has got hairier.

MJ Gleeson - financial summary           Estimates
year ended 30 Jun 2014 2015 2016 2017 2018 2019
             
Turnover (£ million) 81.4 118 142 160 197  
IFRS3 pre-tax profit (£m) 12.2 17.3 28.2 33.0 37.0  
Normalised pre-tax profit (£m) 12.2 18.6 28.3 32.9 40.5 46.0
Operating margin (%) 15.1 16.1 20.2 20.6 18.7  
Return on capital employed (%) 9.5 13.9 18.8 25.4 26.6  
IFRS3 earnings/share (p) 32.8 23.0 43.2 47.8 54.7  
Normalised earnings/share (p) 33.5 25.4 43.8 48.3 55.2 67.0
Earnings per share growth (%) 76.2 -24.3 73.0 10.3 14.3 21.4
Price/earnings multiple (x)         14.5 11.9
Historic annual average P/E (x) 15.5 15.5 17.3 13.7 14.3 13.3
Cash flow/share (p) 10.3 14.9 25.7 36.2    
Capex/share (p) 1.2 1.6 1.7 2.2    
Dividend per share (p) 3.1 7.6 11.8 24.0 32.0 35.9
Dividend yield (%)         4 4.5
Covered by earnings (x) 11.0 3.4 3.7 3.0 1.7 1.9
Net tangible assets per share (p) 241 254 283 317 340  
             
Source: Company REFS            

Yet still a relatively attractive risk/reward profile

It's possible to argue that with affordable housing in the North and Midlands representing over two-thirds of operating profit, versus a risk land trading in the South might slow if the housing market gets a jolt, Gleeson remains well-positioned to trade through.

Lack of affordable homes combined with Southern England's relative dynamism and population supporting asset values, justifies "growth at fair price", which is what I believe Gleeson shares represent today.  Indeed when I've drawn attention to Gleeson in the past – from 408p in May 2015 – it's been on such a basis, its valuation yardsticks have never screamed "value!"

You could also say, addressing the need for affordable housing is a key national priority that will endure beyond any disruption from Brexit; thus, a builder such as Gleeson offers relatively good risk/reward versus other shares.  Since we don't know the extent Brexit may affect the North, it makes strategic sense also for the company to maintain exposure to the South.

In terms of fundamentals' risk, therefore, I believe Gleeson justifies at least a 'long-term hold'.

Mind this is still a small cap stock, the 20%-plus drop in its stock following the CEO's departure (for no adverse reasons) shows it can be volatile in a relatively tight market. So, if the housebuilding sector sold off, then Gleeson would fall too. Likewise, if a recession prompts a liquidity preference averse to small caps generally.  Market risk in a stock like this is always likely to be high.

Working prospects underwritten on a 3-year view

On the homes side, plots have risen by 5.6% to 13,575 with 7,050 subject to planning permission and a further 473 are in prospect to be acquired.  The number of active sites is expected to rise from 69 to 80 or more, this financial year, hence "the division is comfortably on track towards achieving its stated target of doubling volumes to 2,000 new homes per year by 2022" versus 1,529 recently.

Having sold nine interests with potential for 1,755 plots, Gleeson's land side has another nine sites with planning permission or resolution to grant, with potential for 2,929 plots.  Its overall portfolio has 60 sites able to deliver 21,730 plots and 44 acres of commercial land.

So, both divisions offer mileage for a good few years according to how supportive the UK macro context proves.  Though wary as to the Brexit effect in the next two years, I doubt the political context of pressure on local councils to approve housing developments will significantly change, which augurs well.

Forecasts remain somewhat elusive

The table shows £46.0 million pre-tax profit targeted for the latest financial year – results due 16 September – and earnings per share, (EPS) of 67p, apparently based on two consolidated forecasts as of last 13 April. Like so many company updates, Gleeson's latest conveniently cites profits in line with expectations – indeed "comfortably" so – without affirming what they are.

Anyway, I wouldn't fret over specifics for 2019 forecasts and what 2020 may hold: the crux for valuation is how the UK economic context pans out, versus Gleeson's being well-positioned in terms of land/plots, to exploit it.  There's inherent uncertainty.

Operating margins in the high teens to low twenties, percentages imply Gleeson's capability to cope in a more challenging environment, and the table also shows a strong cash flow profile versus undemanding capital expenditure.  Thus together with the 4 July update, reasons to continue holding despite a pretty rich multiple of underlying asset value.

So, it may be that the rebound from 700p to 800p continues to re-establish fresh highs, with Brexit fears misplaced.  An agreed takeover for Telford Homes (LSE:TEF) further shows that, if market values turn jaundiced, buyers may lurk in the wings.

I may be trying to get clever here, but from a fresh 'buy' perspective would prefer to see how Brexit realities are met, given the risk of another price drop.  For the time being: Hold.

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

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