Description

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Introduction

The past decade was not a great one for the UK.  It started with the aftermath of the EU meltdown of 2011-2012, followed with Brexit and ended with COVID.  Clearly not a boom time for the UK in general nor for homebuilders specifically.  UK’s GDP is lower today than it was 16 years ago.

In the same decade housing starts lagged their historical levels (a lot more information can be found on the Bellway writeup [1]).

Against this backdrop one might think that Redrow, a UK homebuilder, had a terrible 10-year performance, but this could not be further from the truth.  In the same decade, the company’s BVPS grew 10% / year while paying significant dividends.  Adjusted for dividends, BVPS grew 15% / year.  EPS compounded high teens annually and the ROE averaged over 15% in the same period.

All this was achieved while mostly maintaining a net cash balance sheet and a low leverage ratio compared to pre-2007 days.

Thanks to the increase in mortgage interest rates, the company (and the entire sector) is forecasted to sell fewer homes than it did in recent years.  Consequently, the company is now trading at valuations similar to the 2008-2009 levels, even though it has a significant net cash position and should make money even under harsh assumptions.  While investors wait for a normalized environment, BVPS will likely compound at least HSD.  This rate will dramatically increase as earnings normalize in coming years.

To be clear, there is no doubt (and all homebuilders confirmed this) that housing demand is slowing, mortgage availability remains uncertain, and that the general economy is not doing great.  The point of this write-up is that the stock is too cheap despite this setup and that historically, buying shares at this valuation was extremely profitable if one could have waited a few years for the environment / sentiment to change.

Business Description and History

Redrow is a UK homebuilder that focuses on detached homes / townhouses in commutable suburbs of major cities.  It builds a higher-level product than most other UK builders who cater more to first time buyers (higher ceiling / more character outside / nicer landscaping and so on).  The homes tend to be a more desirable product and they attract a premium in normal times.

The company was founded in 1974 by a 21-year-old Steve Morgan, who still owns 16% of the business.  Steve already sold most of his holdings in the past, only to repurchase / return after the GFC.  He still holds his shares but no longer has a management / board position.

Steve was “lucky” with his timing of sale and then again purchase, but I believe he’s not involved in the day to day operations and is probably just in a monitoring position.

A Bit on Macro; Stealth Housing Recession?

Many investors wait for the anticipated 20-30% decline in UK housing prices, which clearly hasn’t happened so far (housing prices flat year over year and down a few percent off the peak) [2].  I think a point that is often overlooked is that at the same time housing prices flat-lined, inflation has been rampant in recent years and so *real* housing prices, are probably already 15% lower than they were at the peak [3].  Yes, I’ll immediately concede that it is unfair to pick the peak as a starting point because housing prices went up materially before that.  Although one could argue that while it is a fair point, who’s to say that the pre-COVID price is the “right” one?  If we get another year with a 5% nominal house price contraction while at the same time inflation is up another 5% (current rate), wouldn’t this already take us to the widely anticipated 20-30% correction?  This would almost completely rhyme with the early 90s British housing contraction when home prices were flat / down LSD while inflation rose MSD.

Flat / slightly down housing prices coupled with inflation (~=wage growth) can restore housing affordability.  Perhaps not all the way to the period of a couple of years ago, but just close enough to stimulate demand again.

Industry Response to the Environment

With higher rates, shoppers are understandably more cautious.  At the same time, the entire industry is acting rationally by diverting capital from land purchase and into repurchasing shares / paying dividends (in essence, opting to contract capital instead of investing in land deals that no longer reflect desired returns).  In a consolidated industry like the UK homebuilding, this is an important factor.  When the cycle finally turns, the housing shortage will likely be even more pronounced.

Permitting is another gating factor.  It has been taking longer and requires more and more know-how, which puts yet another cap on supply while also giving an advantage to the large builders.

Based on discussions with different companies, I believe that there is a roughly 20% disconnect in the bid / ask of land deals.  Apparently, this is part of the normal cycle and just takes time for land owners to understand the new reality.  Most market participants believe that we are probably 6 months away from land prices coming down to where good deals can be made again (the time-frame estimate is based on the cost of capital burden for land owners and some distress that could hit the land market).

Redrow, with its anticipated £200M cash pile by June 2024 fiscal year end will be ready to pounce if the opportunities will be there.

Valuation

The company reported a 618p BVPS for June end. With the stock at 474, P/B is under 0.8.  The P/B average of the last 15 years was 1.24 and the stock is trading at one of the lowest P/B it got over that period.  In fact, the stock was trading at a higher P/B through most of 2008-2009, a period it had net debt (now net cash), a higher leverage ratio, more land creditors due relative to inventory and it lost money (odds of that happening now are low).

Another way to gauge the margin of safety would be how much does inventory needs to be written down for the company to be trading at 1x BV.  The answer is 15%.  Note that this assumes we write down the entire inventory, even though there are offsetting factors:

1. Part of the inventory is already sold, but revenue / release from inventory will be recognized at the time of exchange.
2. There is a small social housing business in which revenue is recognized in tandem with progress, but inventory is good as sold (with minor operational risks of course).
3. Inventory includes options on land that will be sold at a pre-determined discount to market value at the time, making this part hedged from price decline.

Note that in the next 3-4 years the entire owned land bank that was acquired pre mortgage rate shock will be gone.  Already 25% of the pre-shock land bank is sold and again, with house prices nominally flat, this is a very different environment from the 2008-2009 one.  Another way to look at this point is that land represents 19% of the ASP.  A 15% markdown would imply a close to zero land value.

Yet another way to look at the downside of land repricing, is what if we use the current 20% discount that is expected to hit land deals and apply it to Redrow’s land.  Since land is 19% of ASP, a 20% reprice would mean a hit of 4% to margins, which averaged 16% in the last decade.  Even a 40% haircut isn’t likely to move the company to a loss.

Assuming a 700p BVPS in 3 years (fiscal yearend - June 2026) and a return to a more normal PB of 1.3 would result in a double (including dividends).

On an earnings basis, the company generated an over the cycle 15% ROE.  Applying this to next year’s BVPS would give us a normalized EPS of 100p and a PE of 5x.  Getting to 8-9x earnings (last 12 years mean was over 9x), would again be a double (including dividends).

As a sanity check, last year, before the rates shock, the company guided that it will do over 96p PS in the year ending June 2024.  Obviously, the guidance was withdrawn following the rate shock, but nothing has structurally changed in the industry and no reason why it won’t be surpassed with more communities in the future.

Putting all this together, a double over a couple of years seems likely (but probably a bumpy road is to expect).  At the same time, the cash position, cautious industry and the 20% discount to BV, could provide a downside protection from a permanent loss of capital.

Risks

1. Interest rates
   1. After the 2022 mini-budget rate shock, activity came to a standstill.  Then, people got used to the new rates and activity got back to normal levels.  I suspect that the same will happen with this mini-cycle.  People need homes and the UK still has a growing population (demographics + immigration) paired with a housing shortage.
   2. The company reported that 37% of 2023 private buyers were cash buyers (mostly downsizers).  This is a cohort that is obviously less impacted by rates.
2. Fire Safety.  As a result of the Grenfell Tower Fire a set of regulations was RETROACTIVELY created, forcing homebuilders to fix past projects.  Luckily for Redrow, it did not build more than a few dozen non-low rise apartment buildings and so the exposure is limited and has been trending down (in tandem with spend).  The entire expected expenditure is already provisioned for.
3. This is a homebuilder, so a highly cyclical company with large costs made years before the product sale price is known.
4. Labor gaining control next year and adding regulation / tax and other impediments to growth.

[1] https://www.valueinvestorsclub.com/idea/Bellway_PLC/1176881466

[2] https://landregistry.data.gov.uk/app/ukhpi/browse?from=2018-07-01&location=http%3A%2F%2Flandregistry.data.gov.uk%2Fid%2Fregion%2Funited-kingdom&to=2023-07-01&lang=en

[3] https://www.bloomberg.com/news/newsletters/2023-03-01/uk-house-prices-are-already-down-11-in-real-terms  / https://www.housepricecrash.co.uk/indices-nationwide-national-inflation/  

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Catalyst

Inflation slowing down / mortgage rates stabilizing / order book growing