Barratt's recovery potential underestimated

The UK housing market has defied lockdown predictions, thanks mainly to the introduction of the temporary stamp duty break. A surge in sales volumes and prices has ensued since July. September residential transactions were up a fifth on the prior month, according to HMRC, recovering from the spring slump to broadly the same level as the comparative month in 2019. An influx of buyers, which has continued to outstrip those putting homes up for sale, has fed through to rising sales prices. The average sales price was up 5.8 per cent in October, according to the Nationwide House Price Index, the highest rate of growth in more than five years. 

For Barratt Developments (BDEV), that has translated into a rise in the net weekly sales per outlet of more than a fifth between July and 11 October. Homes completed were also up a quarter and the value of the order book was 18 per cent ahead of the same time last year. 

Yet given demand has been fuelled by government stimulus measures, the consensus in the housing industry is that the ferocious rate of transaction growth witnessed in recent months will start to ease next year. The restriction of the help-to-buy scheme to first-time buyers and the introduction of regional price caps could provide another impediment. 

A net balance of 27 per cent of respondents to the Royal Institution of Chartered Surveyors October residential survey anticipated sales would begin to weaken over the longer term. With unemployment rising and the strength of the economic recovery uncertain, there is a high degree of uncertainty about where activity levels will settle. 

Earnings recovery underestimated?

However, better-than-expected sales during the third quarter has resulted in analysts upgrading their earnings forecasts for Barratt’s 2021 financial year. The consensus pre-tax profit and earnings per share (EPS) forecasts for this year have risen by 6 per cent and 5 per cent, respectively, since the end of August. 

A substantial rebound in sales and EPS is anticipated by analysts this year against the 2020 financial year, and is forecast to grow further in 2022. Sales are forecast to grow by 23 per cent this year and 7 per cent in 2022, recovering to a level slightly above the 2019 peak by 2023. Meanwhile, the forecast earnings growth rate is expected to be 34 per cent this year and 11 per cent next. The pace of that potential recovery may not have been accounted for by the market, given the shares price/earnings growth (PEG) ratio stands at a modest 1. 

Admittedly, unlike peers including Persimmon (PSN) and Taylor Wimpey (TW.), Barratt has neither restarted dividend payments nor given a timeline for when shareholders can expect these to recommence. However, management has said it would implement a policy based on earnings covering the dividend by a multiple of 2.5 “when the board believes the time is right”. Analysts are forecasting that the “right” time will be in 2021, with consensus forecasts for a payout just shy of 20pa share, rising to 28.5p in 2022. At the current price, that would leave the shares offering a potential yield of 3.1 per cent and 4.4 per cent, respectively.

Sales prices expected to hold

Some easing in sales prices has already been accounted for in analyst forecasts, with the average sales price expected to decline by 0.9 per cent in 2021, versus the prior year. But the predicted recovery in Barratt’s earnings is dependent on avoiding a more substantial housing market decline. Rising unemployment, particularly after the end of the government’s furlough scheme in March, could result in a rise in forced sellers, which would weigh on sales prices across the market. 

Encouragingly, though, industry forecasts for average sales prices in 2020 have been upgraded following the surge in activity since July. Based on Oxford Economics’ assumptions, including a rise in the unemployment rate to 6.5 per cent and a 9.7 per cent contraction in gross domestic product, Savills (SVS) forecasts average house price growth of 4 per cent this year and flat prices in 2021.

However, that may not equate to a similar reduction in completions after the restrictions are introduced. According to a report released by the NationalAudit Office last year, three-fifths of those using the scheme between 2015 and 2017 would have been able to afford a property without the support of help-to-buy, while 31 per cent could have afforded the home they wanted. 

Barratt has not closed any construction sites following the second lockdown and guidance issued last month for completions, excluding joint ventures, of between 14,500 and 15,000 this year remains intact. If achieved, that would represent growth of up to a quarter on the prior year, although it would still be behind pre-pandemic completions of just under 17,000 in 2019. Management has reinstated a medium-term target of 20,000 annual completions. 

Defences are readied  

In contrast to the last market downturn in 2008, when it had considerable debt on the balance sheet, Barratt is in a net cash position. Despite substantial cash burn during lockdown, net cash stood at £308m at the end of June, down from £766m a year earlier. After including land creditors – payments conditional on purchased land getting to set development stages – that left total gearing at just over 12 per cent. By early October net cash had risen to around £570m – which management expects to stand at around £550m at the end of June – in addition to an undrawn committed debt facility of £700m. 

Ample liquidity has enabled the group to restart land buying, acquiring 4,160 plots across 15 sites since the end of June. However, in order to rebuild returns on capital and bring down gearing, it is taking a selective approach to purchases beyond land creditor settlements this year. 

Barratt’s operating margin has also proved more resilient to declining completion volumes than mid-cap peers Redrow and Bellway (BWY), coming in at 14.4 per cent last year, down from 18.9 per cent. That could offer another line of defence against any potential sales price deflation. 

As well as the high level of uncertainty over potential sales volumes and prices, there is an element of regulatory risk, too. In September, the Competition and Markets Authority escalated an investigation into Barratt, alongside three other major housebuilders, over potential mis-selling of leasehold contracts and unfair terms concerning ground rents. 

But these negatives look priced in. The shares trade at a modest 11 times forecast earnings and the surprises may continue to be positive based on the recent resilience of the group. In a worst-case scenario, Barratt has ample firepower to withstand any further short-term disruption to completion levels. However, if it can meet guidance and industry sales price forecasts prove accurate, there a good chance the shares will re-rate further. 

Last IC View: Buy, 539p, 2 Sep 2020