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This ole house

Created:
29 April 2008
Written by:
Mr Bearbull

We've all heard of the house of the rising sun, but what about the houses of the setting sun? Judging from share-price movements, those would be the little boxes in which the UK's housebuilders live. Housebuilders' share prices are telling us, to adapt the words of Stuart Hamblen's country standard, "this ole house is getting’ shaky, this ole house is getting old", balance sheets look flakey with earnings turning cold.

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Just four weeks ago (4 April 2008), I wondered whether shares in housebuilders offered good value, then dismissed the notion. Since then, however, the dogged optimism of company bosses in the sector has made way for realism and share prices have tanked. In that short period, shares in Barratt Developments have dropped a further 33 per cent and those in Persimmon are off 20 per cent.

We all know that the market - manic depressive that it is - overreacts. Perhaps that's what's happening here. After all, no one is suggesting that housebuilding in the UK is going the way of making televisions or washing machines. And some of the dividend yields - especially in Barratt and Taylor Wimpey shares - look really tempting.

Trouble is, they look too good. The market - smart cookie, as well as manic depressive, that it is - had sussed a while ago that the short-term shock to housebuilders' profits may be too juddering to avoid dividend cuts. Now some City analysts are getting round to that notion, too. For example, Jon Bell, at broker Shore Capital, thinks that Barratt will cut this year's payout from his previously-estimated 38.5p to 35p, and at Taylor Wimpey it will be slashed from 16.5p to 9.5p. In which case, the prospective yield on these stocks is 12.6 per cent for Barratt and 7.3 per cent for Taylor Wimpey.

These are still fancy numbers but even they may come under threat because housebuilders have a high proportion of fixed costs in their operations, so any drop in sales volumes will have an exaggerated effect on profits. A fall in volumes could push 2009 into losses, even if enough homes have been sold or reserved to keep 2008 in the black. That said, the 2008 numbers will face another threat - the need for housebuilders to trim the book value of their land banks to take account of fading demand. Because the costs of materials and labour in housebuilding are pretty well fixed, the major variable cost becomes land. In the good times, this works hugely to housebuilders’ advantage - old land bought cheaply contributes to fat profit margins. But those fat margins encourage them to bid up the price of land. That's no problem while demand is strong, but it is when demand falls, ratcheting land values downwards.

Barratt may be most exposed to this effect with, on average, plot costs 26.5 per cent of selling prices (see table). Barratt also has the weakest balance sheet of the major housebuilders as it carries the debt that helped to fund the £2bn acquisition of Wilson Bowden last year. These points may explain why Barratt's shares have been hit the hardest. Even so, they are the ones I am inclined to favour. That's partly because the market seems to have been unnecessarily spooked by Barratt's debt, especially its need to refinance an £800m facility that can't be extended beyond next April.

Besides, it may be better to focus on each group's 'development value' and its stock-market value in relation to development value. Development value is a stab at quantifying the net profits that could be derived from each group's land bank. It takes the number of plots in a land bank, multiplies that by average selling price to find a gross revenue figure. Then it capitalises that at the rate of average profit margins in the past five years and deducts the standard rate of tax. In other words, it is very much a guesstimate and makes no attempt to adjust future profits to present value.

Even so, it may be a better proxy for underlying value than book value. And it's noticeable how the ratio of Barratt's market value to development value is far and away the lowest of the five in the table, implying that all the bad news is well discounted in its share price. Yet the same can't be said for the price of the others. Their ratios suggest they may still be vulnerable to whatever bad news is to come as "this ole house just groans and trembles".

Groanin' and tremblin'
Operational data
Land bank (yrs) Plot cost/selling price (%) Development value (£m) Mkt Value/Dev't value Debt/equity (%)
Barratt Dev'ment 5.3 26.5 2,269 0.4 60
Bellway 5.1 22.2 918 0.9 21
Persimmon 5.0 22.6 2,352 0.8 31
Redrow 4.3 22.3 449 0.9 40
Taylor Wimpey 5.8 na 1,457 0.9 38
Share-price data
Share price (p) Percentage of high Price/book Div yield (%) Dividend cover
Barratt Dev'ment 277 21 0.5 13.9 2.3
Bellway 714 42 0.8 6.7 2.3
Persimmon 598 39 0.8 8.6 2.0
Redrow 264 36 0.7 7.0 1.9
Taylor Wimpey 130 25 0.4 12.2 1.5
Operational data for Taylor Wimpey - UK operation only

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