A key take for me is the increasing visibility of forward revenues and profits and not just for the full-year to end September 2016. That’s because since last autumn the company has forward sold a further six student accommodation developments (1,660 beds) which have a combined development value of £114m; has three other developments worth £90m (1,234 beds) in legal negotiations for forward sale; and has received planning permission for nine student developments (3,500 beds) of which five have been granted planning consent since the shares listed on the Alternative Investment Market at the end of March.
As a result, all bar one of the 17 sites in the development pipeline (over 3,000 beds) for delivery by the end of the 2017 financial year (September year-end) have now been forward sold, and that one remaining site is in legal negotiations. This means that two thirds of the total development pipeline across 31 sites, and encompassing 11,300 beds, have already been forward sold or are under offer. All 10 of the sites for the 2018 financial year have been secured too.
The benefit of forward selling sites is to reduce the working capital needs of the company materially as in effect the end purchaser, usually a blue-chip institution, funds the development and 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. Furthermore, Watkin Jones enters into asset management contracts, usually for a seven-year term, with these investors when the properties complete. Its dedicated property management team currently manages 8,310 beds across 32 PBSA schemes 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, analysts believe the company could 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 based on an operating margin of 25 per cent. The aim is to increase the asset management side of the business to 30,000 beds by 2020.
Margin expansion and cash generation
Another key take for me was the rapid margin expansion. Gross margins rose by 1.4 percentage points to 16.1 per cent, a performance driven by the move away from low margin contracting work to a focus on the asset light, forward sales, development model. So with central overheads costs being held in check the company increased first half pre-tax profit by 85 per cent to £16.7m on revenues up 40 per cent to £146m.
Analyst Andy Hanson at broking house Zeus Capital believes that gross margins should hit 19.5 per cent in the 12 months to end September 2016 based on a near 11 per cent rise in revenues to £270m as developments complete, a performance that should underpin a 20 per cent rise in full-year pre-tax profits to £39.5m and deliver a 22 per cent rise in EPS to 12.4p. Mr Hanson’s financial models suggest that gross margins can expand even further to 22 per cent on similar revenues in the 12 months to end September 2017, a solid prediction in my view given that over half of gross profit for that period is already forward sold. If Watkin Jones hits those 2017 numbers, it will add a further £7m to gross profit and with operating costs only expected to rise by £2.6m, this ongoing margin expansion explains why pre-tax profits are predicted to rise by a further 10 per cent to £43.6m to deliver EPS of 13.7p.
The third key take in last week’s results was Watkin Jones' prodigious cash generation. Net funds ended the period at £15.4m, over 50 per cent ahead of guidance given at the time of the flotation. And because of the negative working capital situation, net cash is expected to more than double to £36.4m, a sum worth 14p a share, by the end of September 2016 as developments complete and cash is released from work in progress and inventories. Robust balance sheet strength, and the availability of £50m of credit lines secured ahead of flotation, means that the company is incredibly well funded.
So having declared a maiden dividend of 1.33p a share, and reiterated guidance for a final of 2.67p to be declared in the full-year results, the company is well on track to increase the dividend to 6p a share in the 2017 financial year in line with the board’s guidance at the time of the listing in March. That predicted payout is covered two times over by forecast earnings and means the shares are not only being rated on a modest 8 times likely EPS of 13.7p for the 2017 financial year, but offer an attractive prospective dividend yield of 5.5 per cent.
Seriously undervalued
To put Watkin Jones’ current valuation into some perspective it represents a 32 per cent discount to peers in the construction services sector based on its forward earnings multiple for the 2017 financial year; is 25 per cent lower than peers on the basis of an enterprise value (market value less net funds) to cash profit multiple; and the prospective dividend yield is around 40 per cent higher than peers for the 2017 financial year too. And if you compare the company’s rating with other student property companies like Unite Group (UTG:640p) and Empiric Student Property (ESP:110p) the valuation anomaly is even more glaring with the shares trading on less than half those peers' forward earnings multiples for the 2017 financial year. I would also flag up that the company also generates a return on capital employed around 20 per cent ahead of its peer group average, and 7 per cent more than its closest rival.
There is undoubtedly value here and as Watkin Jones delivers its development pipeline and profits roll in, I feel that investors are likely to reappraise the investment case and attribute a higher earnings multiple to the shares which will in turn narrow the glaring valuation anomaly with peers. I also believe that investors are likely to warm to the company’s move to target the growing institutional demand for UK private rented sector (PRS) accommodation, a segment of the property market that is gaining momentum, driven by a shortage of new-build housing and a lack of affordability and mortgage availability for owner occupiers.
Risk assessment
Of course there are risks with any investment and the most immediate one for Watkin Jones is a Brexit. That’s because there are 125,300 EU students in the UK, representing 5.4 per cent of the student population, some of whom are 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. That said, the 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. And sterling would undoubtedly fall sharply on a leave vote, thus making UK universities even more financially appealing for overseas students, so potentially offsetting the impact of higher tuition fees.
So, irrespective of the outcome in next week’s EU Referendum, I believe the fundamental dynamics for higher education in the UK are strong enough to survive a Brexit. Also, investment demand for PBSA schemes is being driven by the search for yield in a low interest rate environment, a factor that is unlikely to change anytime soon given record low government bond yields and a weak inflation backdrop.
Target price
Having initiated coverage on the shares at 103p, a few pennies more than the 100p flotation price (‘A profitable education’, 3 April 2016), I feel that my 140p target price is very achievable. In fact, with net funds likely to swell to almost £66m by September 2017 as the 17 schemes in the pipeline are delivered, my 140p target price in effect only equates to a multiple of 8.3 times likely EPS of 13.7p for the 2017 financial year to which I add on closing net funds of 25p a share to arrive at my target. In other words, forecast growth of net funds alone should see my target price hit even without any earnings multiple expansion. However, if other investors warm to the investment case then the 165p target of Andy Hanson at Zeus Capital could come into serious focus. Either way, there should be significant share price upside here.
Needless to say, on a bid-offer spread of 109p to 110p, I rate Watkin Jones shares a buy.
