Are housebuilders on firm foundations?

Jun 25 2008 by Iain Laing, The Journal

It is understood a number of house- builders are already in discussions with creditors

SHARES in UK housebuilders continued to tumble yet further last week, as ongoing negative news flow emerged with respect to the domestic housing market.

Equity valuations in the housebuilding sector are now at distressed levels, with Barratt trading on a historic price-to-earnings ratio of around one, and ostensibly yielding over 50%.

Such distressed valuations may appear extreme, but investors’ concerns could prove to be justified. Some housebuilders – notably Taylor Wimpey and Barratt – have been operating on margins of around 15%. Given that land is a lagged fixed cost, and the existence of significant materials and wage inflation, these margins could be quickly wiped out by falling house prices.

The quality and economic value of land will, of course, vary a great deal from one company to another, but the general problem is that a lot of this land will be good for little else other than building houses.

This aspect of the problem is reflected in the write-down process itself. The mechanism by which house builders write down the value of their land is, in fact, related to house prices and the profit and loss account, not the land market.

The economics are, of course, the same in the medium- to long-term. Those companies with ‘short’ land banks (ie those who have bought a lot of their land recently), or those in geographic areas where prices are falling the most, will be the first to be compelled to make write-downs.

In practice, this probably means the likes of Barratt and Taylor Wimpey are the most vulnerable. Higher-quality players in the sector such as Persimmon – our preferred housebuilder – and others such as Bovis and Bellway should fare somewhat better.

In addition to lower levels of balance sheet gearing, they have longer (older) land banks, and so are less vulnerable to write-downs. The degree of any write-downs, provided no debts covenants are breached, will be reflected in the margins posted at a later date.

In short, house price falls can wipe out house builders’ margins fairly quickly. This, in turn, can trigger write-downs, and enough write-downs can create problems with creditors. It is understood that a number of house builders are already in discussions with their creditors as the possibility of write-downs increases. Those with short land banks, higher debts and lower margins are most at risk. These concerns have been reflected in the poor share price performances of Taylor Wimpey and Barratt in recent weeks. Long-term followers of our research will be aware that we have advocated paying a premium for Persimmon’s strengths within the sector and the company’s resilience is now being demonstrated. However, given our macro-economic view – that house prices should not fall by more than 20% – we believe that housebuilders are now oversold. Consequently, we would therefore recommend retaining any existing positions within the sector.

Andrew Miller is regional office head of Barclays Wealth