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A profitable education

It's an area that is now attracting increasing attention from fund managers looking to diversify their portfolios. In fact, a record £5bn was invested in the sector last year, representing a hefty 67 per cent increase in only three years. It's not difficult to understand why given that UK PBSA offers an above-average yield profile compared with other mainstream property asset classes; strong and stable performance both in terms of investment yield and occupancy levels; and a relatively low-risk income stream with the ability to capture annual rental growth.

It also helps that the UK higher education sector is held in high regard overseas, being a top three destination for overseas students. This 'pull factor' is supportive of the attractive supply and demand dynamics of a growing student population as is the fact that English is the dominant international business language, an important consideration for emerging middle classes in countries such as India and China. The figures back this up as overseas student numbers rose from 15.4 per cent of the total UK university intake in the 2008-09 academic year to 18.9 per cent in 2013-14.

Bearing this in mind, overseas students are far more likely to seek accommodation in private PBSA due to the convenience, quality and security offered. For example, around 11 per cent of all international students in the UK resided in private PBSA in the 2013-14 academic year, or more than double the percentage of UK students. Both segments are growing strongly, too: student numbers residing in private PBSA over the past five years have grown in double digits annually over the past five years. Moreover, these trends are only likely to continue given growth in full-time student numbers. The segment now accounts for 1.7m students at UK universities, or 75 per cent of the total, up from only 65 per cent in 2010. There is also latent demand for university places as less than three-quarters of the 718,000 applications for places were accepted in the 2015-16 academic year.

I would also point out that the majority of university-owned PBSA is halls of residence, which are generally reserved for first-year students. It's aging housing stock, as over a fifth, or 65,000 rooms, were constructed between 1960 and 1979, and a further 40 per cent between 1980 and 1999. As a result, this stock lacks the attractions of private sector PBSA. It also needs to be refurbished or replaced, which offers potential for private sector contractors like Watkin Jones to step in.

 

Profiting from a growing student population

The company was established in 1791 and is now run by the ninth generation of the family, led by 47-year old chief executive Mark Watkin Jones who joined the business in 1990. In recent years, it has been growing strongly by targeting PBSA and has delivered over 28,000 student beds across 88 sites since 1999, making it a leading player in this niche market. It's also a residential developer and has completed more than 50 projects, ranging from starter homes to executive housing.

The key for me is that Watkin Jones takes a very low-risk approach to projects by controlling the entire development lifecycle, including site procurement, planning application, transaction funding, construction and delivery, and asset management. Its competitive advantage lies in a business model which enables the company to offer an end-to-end solution for investors, managed entirely in-house with minimal reliance on third parties, across the entire life cycle of an asset. The business has an attractive funding structure, too - its forward sales model reduces risk to shareholders and provides security and visibility of the asset pipeline for investors.

I would also point out that the company has strong relationships with blue-chip investors, and future contracted revenue is contractually guaranteed before construction begins. As a result the forward sale structure creates a more regular and consistent cash flow for Watkin Jones, as the end purchaser is billed on a monthly basis, as opposed to a non-forward sold development where revenue is only received on sale of the asset post completion. In aggregate the company has 17 development projects with over 3,000 beds that are due for completion by August 2017 and have been either forward sold or are in negotiation to forward sell. Completions for the following year are slightly higher, offering strong visibility for revenues and profits. Indeed, the 31 projects in the pipeline should deliver a total of 11,300 beds. The timeframe is generally a two-year construction delivery period, meaning that the company has capacity to work on 20 sites at any one time.

Furthermore, Watkin Jones enters into asset management contracts, usually for a seven-year term, with these blue-chip investors when the properties complete. Its dedicated property management team currently manages over 8,300 beds across 32 PBSAs and has contracts in place to increase that number to 12,500 across 45 developments by September, of which 13 will be schemes developed by third parties. Although only a small part of the business right now, the company should be able to more than double the £2.6m of asset management revenue earned last year to £6m in the 2018 financial year and generate a £1.5m operating profit on a margin of 25 per cent. The aim is to increase the asset management side of the business to 30,000 beds by 2020.

 

Tapping into the private rented sector

The company has also started targeting the growing institutional demand for UK private rented sector (PRS) accommodation, a segment of the property market that is gaining significant momentum, driven by a shortage of new-build housing, a lack of affordability and mortgage availability for owner occupiers.

In fact, the PRS market has more than doubled in size in the UK from 2.4m households in 2000 to 5.2m by 2013. To put this growth into perspective, the total number of dwellings in the UK only increased by 10 per cent in this period, and owner occupied dwellings by only 1.6 per cent. Industry experts see potential for 1.1m more PRS households by 2021, forecasts that have substance given the pressures being put on 'generation rent'. The average age of first-time buyers is now 30, compared with 28 a decade ago, and rising. While incomes are also rising the rent commanded by landlords is expected by property agent Knight Frank to grow by an average of 11.9 per cent a year until 2020, which in turn should support institutional investment into the PRS and demand for Watkin Jones' projects.

Research from property consultancy Jones Lang LaSalle indicates that almost four-fifths of institutional investors surveyed plan to increase their investment in alternative asset classes with the top allocation targeting PRS. Investors are attracted to the sector for similar reasons to the PBSA market: strong supply-demand dynamics; stable cash flows and yields; and the ability to capture annual rental growth. Industry experts suggest that there could be up to £30bn available to invest in the PRS markets over the next five years.

In this context, the board of Watkin Jones believes that there is a strong market for purpose 'build to rent' developments, which could be designed, constructed and forward funded in a similar manner to its PBSA developments, and would offer similar investment characteristics.

 

Profitable growth

It's hardly surprising given these positive dynamics that Watkin Jones has been raking it in, generating operating profit of £33.6m on revenues of £244m in the financial year to the end of September 2015 when it completed 25 PBSA schemes and delivered 7,250 beds. Revenues from student accommodation accounted for 90 per cent of the total and generated an operating profit margin of 18.7 per cent, so it is highly profitable.

So, after factoring in the current development pipeline, Watkin Jones should be able to increase operating profit by a fifth to £40m in the 12 months to the end of September 2016, and by a further 10 per cent to £44m in the following financial year. A first-half pre-close trading update on Thursday 7 April should make for a good read. So, after factoring in a normalised tax charge, and based on 255m shares in issue, this implies EPS of 12.4p in 2016, rising to 13.7p. On this basis, the shares are rated on a very modest eight times forward net earnings.

There is a also decent dividend as the board has stated its intention to pay a 6 per cent dividend yield based on the 100p placing price and declare a final payout of 4p a share for the current financial year even though the company floated at the end of its first half. Moreover, with profits on an upwards trajectory, there should be scope for the payout to rise with earnings.

And it's not as if the balance sheet is stretched to warrant such a modest rating. Net borrowings of £13.1m on listing last week represents less than 18 per cent of pro-forma net asset value of £74m. Guidance points to free cash flow of around £55m in the current financial year, which suggests net funds of around £36m by the end of September and net assets rising to £100m. As projects complete and profit is booked, price-to-book value should drop to about two times by September 2017, hardly an exacting valuation. Or, to put it another way, Watkin Jones offers the potential to deliver a solid annual dividend covered more than twice over by net earnings and enhance shareholder value by growing net assets. That's appealing.

 

Balancing risks with rewards

Of course, there are risks with any investment and the impending Brexit vote is one as there are 125,300 EU students in the UK, or 5.4 per cent of the student population, some of whom will be reliant on tuition fee loans as they are entitled to the same subsidised support as UK students. A vote for the UK to leave the EU could lead to a drain of some of these students from our universities. The flip side is that UK universities would then be able to charge EU students the same rates as non-EU students, making them a more profitable demographic to actively market to. My own view is that the fundamental dynamics for higher education are strong enough to survive a Brexit especially as sterling would undoubtedly fall sharply on a leave vote, thus making UK universities even more financially appealing for overseas students.

Investment demand for PBSA is also being driven by the search for yield in a low interest rate environment, making a rise in UK base rates a threat to demand for alternative asset classes. That said, with inflation on the floor, and the start date for the first rate rise being kicked back, then the benign investment climate is unlikely to change anytime soon.

There are several business specific risks to consider, too. These include execution risks on construction contracts, potential delays in gaining planning permission on new sites, and financing risk if conditions in the credit markets that are providing capital for forward funding arrangements tighten. There is also the risk that other construction companies will be attracted by the high returns Watkin Jones is making, so bidding up the cost of sites and undermining its margins. However, I feel that none of these are significant at this point.

So, having considered the risks and rewards, I am initiating coverage with a strong buy recommendation and a target price of 140p, equivalent to a forward PE ratio of 10 for the 2017 financial year and implying a prospective dividend yield well north of 4 per cent. Please note that I have factored in the 48.5 per cent family shareholding (subject to a 12-month lock-in) of the Watkin Jones family when making this recommendation. Buy.

I have published 31 columns in the past three weeks, all of which are listed below.