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OPINION

London property trading play

London property trading play
August 22, 2016
London property trading play

Admittedly, I was premature in doing so as Telford’s shares continued to make hefty gains on the back of the London housing market boom, peaking at a record high of 495p in May last year. In the circumstances, it’s hardly surprising that some investors have taken the opportunity to bank some profits since then. However, having seen Telford’s share price de-rate sharply from those highs, the risk:reward ratio looks very favourable to me both from a technical and fundamental perspective.

Interestingly, the post-EU referendum trough in the share price coincides exactly with the low point two years ago when shares in UK housebuilders were being battered during that summer’s market turmoil. Also, there is positive divergence on the chart with the 14-day relative strength indicator (RSI) failing to confirm the lower price lows hit post the EU Referendum, a good indicator that a bottom could be in place. In addition, Telford's share price seems to be exerting pressure on its summer highs of 300p, creating a sequence of higher lows each time that this price point is being tested. From my lens a least, a break-out above the 300p price level appears a distinct possibility and one that would pave the way for a relatively quick return to the May highs around 370p.

Importantly, the fundamentals are supportive of such a technical break-out. Not only are the shares trading on a modest 7.5 times earnings reported for the 12 months to end-March 2016, but they offer a dividend yield of almost 5 per cent with solid prospects for another double-digit rise in the payout in the current financial year. Also, Telford’s equity is being valued at only £216m, or 1.16 times book value, a valuation that fails to reflect £640m-worth of contracted forward sales, representing well over half of the cumulative revenue of £1.05bn which analyst Gavin Jago at brokerage Peel Hunt predicts the company will generate over the next three years.

Furthermore, the secured revenue gives significant weight to analysts’ expectations that Telford will be able to grow its pre-tax profit from a record £32m in the last financial year to £52m in the 12 months to end March 2019, a performance that would propel EPS up by 43 per cent to 55.8p. I have good reason to think these growth forecasts are achievable too.

Smart deal making

The first point I would make is that Telford took the opportunity last autumn to raise £50m in a placing at 360p a share to exploit a number of opportunities to acquire new developments.

The board led by chief executive Jon Di-Stefano didn’t waste any time deploying the fresh capital either. A month later Telford purchased a site on Carmen Street in Poplar, east London with full detailed planning consent for a 22-storey development, consisting of 206 new homes including 56 affordable homes and a nursery. The development is located close to Langdon Park Station, which is less than ten minutes from Canary Wharf on the Docklands Light Railway (DLR). Crossrail at Canary Wharf will further improve transport connections in Poplar, and as a result the area is expected to see significant development in the coming years.

Telford paid in excess of £20m when it completed the land acquisition in April this year. The following month it sold the freehold interest in the land and the construction of 150 open market homes together with commercial space for net consideration of £63.2m to M&G Real Estate, one of the UK's largest property investors. The sale was made on a forward funded basis and comprised an initial land payment followed by regular payments throughout the construction period, so Telford will not require debt finance and only limited equity. The private rented sector (PRS) development of 150 homes increases M&G’s PRS portfolio to over 1,200 units which it manages on behalf of UK and international institutional investors, including pension funds, insurance companies and local authorities. Completion of the development is expected in 2019. The 56 subsidised affordable homes will be sold by Telford Homes in a separate transaction to a housing association.

That’s not the only PRS deal Telford has completed this year. In February, the company exchanged contracts for the sale of The Pavilions in Islington, North London to a subsidiary of L&Q, one of the UK's leading housing associations and one of London's largest residential developers. The sale consisted of all 156 homes within the development, 96 of which will form part of L&Q's growing PRS portfolio with the remaining 60 homes sold to L&Q for affordable housing.

The contracted price for the development was £66.75m with regular payments to be made by L&Q throughout the construction period. The development will not require any equity or debt to be invested by Telford. Construction is already under way and is expected to be complete by the middle of 2018. It’s only realistic to expect more deals to be done along these lines given that there is increasing institutional demand for high-quality, well-located developments to be 'built for rent'. Indeed, at Telford’s annual meeting last month, Mr Di-Stefano noted that the board “continues to consider opportunities for further PRS sales, both on existing sites and potential land acquisitions.”

They have good reason to, given the financial upside from these PRS sales. That's because assuming Telford achieves close to its target operating margin of 15 per cent, it will earn huge profits on the £130m of revenue generated from the two schemes. Profits will be recognised earlier too because under contract accounting standards it is based on a percentage build basis rather than on legal completion of the schemes. I would also point out that Telford has no debt finance on its PRS developments, has recouped its land costs and is fully carried on funding, so will make a far higher return on capital employed that on a normal housing development. True, some net margin has been sacrificed to secure the sale of a complete development on this basis, but this is smart business as it not only mitigates investment risk, but reduces financial risk too.

Not that the company is financially stretched as gross borrowings of £38.2m at the end of March 2016 were well within Telford’s bank facilities of £180m, which run through to March 2019, and net debt was less than 10 per cent of shareholders funds of £187m after factoring in cash balances of £20.7m on Telford’s balance sheet.

London housing market

Of course, one of the reasons the shares have de-rated is down to concerns over the London housing market which could impact Telford’s future pipeline of developments which is worth £1.5bn. That’s six times last year’s revenues when the company sold 548 homes at an average open market price of £417,000.

Bearing this in mind, the demand that Telford Homes is experiencing for new homes is being created by a chronic shortage of supply of housing in London and reflects a significant gap between the need for homes and the numbers being built each year. This is only likely to widen given predicted population growth in London over the next decade. True, there have been justifiable concerns over prime residential properties in London, but this is a completely different market to that served by Telford, with the drivers outside of prime areas being housing need and affordability as opposed to pure investment from rich overseas buyers targeting super-prime properties in the fashionable districts of the capital. Indeed, the company's future development pipeline has an average sale price of around £513,000, slightly below the Land Registry average for London of £535,000, and Telford’s new homes are focused on non-prime locations in the capital with prices typically between £500 and £900 per sq ft. To put its target market into some perspective, super-prime properties in Knightsbridge and Belgravia can fetch up to £7,000 per sq ft.

Record low borrowing costs on fixed-rate mortgages are supportive of affordability and demand, as are initiatives such as the government’s ‘London help to buy scheme’, with its greater interest-free loan and a higher price ceiling of £600,000. And the returns are attractive for investors who are achieving attractive rental yields of around 4 to 6 per cent on their Telford homes, and, with minimal voids, a reflection of the chronic housing need in London and the upward pressure on rents from a rapidly growing population.

A good example of the ongoing investor demand for this ‘more affordable’ type of housing is the recent sales launch of Telford’s Liberty Building in London’s Docklands. Two-thirds of the 105 private units were sold to investors at launch in the spring, accounting for over £40m of the aforementioned £640m contracted sales. A minimum of 10 per cent of the purchase price is paid by the buyer on exchange of contracts with a further 10 per cent paid 12 months later, all of which is released to Telford to invest in its business. At the end of March, Telford was holding £70m of deposits from buyers ahead of completion, a tidy sum which it has been recycling into its pipeline.

There is no shortage of developments to invest in either. For instance, three weeks ago Telford acquired a 50 per cent interest in a multi-phase development adjacent to Gallions Reach DLR station near Royal Albert Docks in east London. The development is controlled by Notting Hill Housing and Telford is acquiring a 50 per cent interest in two of the phases to be developed in partnership, the first of which has planning consent for 292 new homes for completion in 2020. The second phase, which will commence after phase one has completed, has outline consent for a further 254 new homes. The area around the Royal Docks is experiencing substantial regeneration and commercial investment following the construction of a new Crossrail station at Custom House, which is due to open in 2018.

Valuation

Telford has proved a canny residential developer during the boom times, and has made the smart move of de-risking two large developments by entering into PRS funding arrangements with large institutional investors. Given the demand for PRS housing, I feel further deals are a distinct possibility. Moreover, with analysts forecasting cumulative EPS of 130p over the next three financial years even in a flat London market, of which 50p is earmarked for dividends, this progressive earnings profile is simply not being reflected in the current valuation.

Frankly, with Telford’s shares priced on less than 8 times earnings, rated on a modest premium to book value and offering a historic dividend yield of 5 per cent, investors are in effect pricing in a sharp reversal of house prices at the more affordable end of the London market, something that’s at odds with the supply-demand dynamics of the market segment Telford is targeting. Clearly, land director James Furlong believes that the share price sell-off has gone too far as he has just splashed out almost £150,000 buying shares at 301p each, having previously sold 100,000 shares earlier in the summer at 350p each. His lead is worth following.

So, ahead of a pre-close trading update in mid-October, I rate Telford’s shares a buy on a bid-offer spread of 289p to 289.5p and have a target price of 370p. Buy.