Berkeley Group Holdings

Berekely Group Holdings (BERK)

Px - £35

Target Price -15x to 19x 2015 NOPAT.

Fundamental drivers of the business

Housebuilding is a capital-intensive business. The more capital you invest, the more profit you can make just as in any commoditized business. The challenges in the business come from the competition you have purchasing the sought after land, and the margins you earn are constrained by the demand and availability of the houses nearby.

It seems logical to value homebuilders on the capital they have on their balance sheet and the ability of this capital to generate cash. Tangible book value is the assets that generate earnings for homebuilders, not intangibles so much as it would for a company such as Microsoft. It seems as if the market understands the cyclical nature of house builders and therefore never gets too excited and bids them to high PE multiples. Forward PE is relatively low and P/TBV is at a significant premium, which actually indicates that the market questions the sustainability of recent earnings.

Company	ROE	Price to Tangible Book	Current ROIC	EV/NOPAT
Barratt Developments	11.45	2.45	20.59	10
Bellway PLC	17.42	2.11	22.03	15.15
Berkeley Group Holdings	27.33	2.87	39.89	9.6
Bovis Homes Group	12.6	1.63	15.34	11.5
Crest Nicholson Holdings PLC	21.78	2.6	25.41	14.4
Persimmon PLC	21.03	3.28	33.54	15.56
Taylor Wimpey	16.81	2.69	20.09	16.45

Therefore, buying homebuilders today expecting a re-rating in market multiples is nonsensical as investors know the cyclicality of the business and therefore even in the boom years the PE ratio is never hugely inflated. Berkeley has a 5-year average PE of 12.8 and PESN of 13.8 BERK current PE is at 12 and therefore I do not expect a large expansion in multiple to driver return.

Sustainable earnings growth

If we cannot expect re-rating in terms of multiple expansion, we need favourable fundamentals to drive earnings. These are mostly driven by mortgage availability, government policy, FDI and overall supply and demand of housing and land. I feel that we have been in a pretty ideal environment for the past couple of years, are we too late to join the party?

One fact remains, there is a shortage of housing in the UK, especially London and South East, and the government are publicly supporting housing formations. The future path of rising rates will probably net off, I hope, increases in real wages and therefore an investment thesis here is based on a continuation of the fundamental factors that drive the business.

Paying over book value for a house builder such as BERK does not worry me as much, due to the geography and type of housing they build. Firstly, London and the South East is an area that is subject to persistent demand due to urbanization and foreign direct investment. The UK government and it’s Help to Buy scheme has also pledged to complete £12bn of guarantees over the life of the scheme and as of June 2015 they have only completed £1bn. Spare capacity for mortgage growth to continue its trend and I am somewhat confident the BoE rate rise will not affect this too much.

The Office for National Statistics report that in London there is an estimated 2800 hectares of land available for housing in London that is not in use or available for redevelopment, and over 6000 hectares in the South East which can provide around 330,000 and 210,000 houses respectively. Seasonally adjusted housing starts are still 32% below the March quarter 2007 peak with completions 26% below the peak, highlighting some spare capacity within the industry. So the supply is limited, although available, albeit at a certain price, and therefore the issue comes with not finding the supply to build, but finding it at favourable prices. This is where the business model of BERK will prosper. By taking on complex plots of brownfield land, they have full support of the government who introduced policies in 2010 and extended in 2014 to target brownfield sites for housing and build around 200,000 houses on brownfield sites by 2020.

Business Strategy

With regards to land cost, BERK need to ensure the spread between housing sales and land purchase is adequate, and their timing of purchases throughout the cycle is not prone to basic behavioral biases, i.e. overconfidence buying at peak of market. This emphasizes the importance of ROIC in this business and the expertise of management in capital allocation being crucial to the success of the firm. BERK emphasise their long-term outlook on their business and claim to understand the cyclical nature of the market, which determines their buying habits.

BERK has consistently increased capital invested and therefore inventories too, as these are the assets that generates return in the business. Capital has increased from around £1bn in 2006 to over £3.5bn today and ROIC has followed from 10% to over 35% in the same period. Having a consistently increasing asset base de risks the business from any huge fluctuations in underlying housing prices. On this capital, the high and increasing levels of ROIC highlight the profitability of the business and the great capital allocation of management.

Understanding the markets in which we operate is central to Berkeley’s strategy and gives us the confidence to buy land without an implementable planning consent where we understand what local stakeholders want. (BERK 2015 10k)

BERK is in the business of placemaking, not just housebuilding. They claim to create value by identifying and purchasing land and to then build and sell. They take on complex sites and ‘brownfield’ land (areas that previously had commercial or industrial use) and then seek to create developments. This is a very different business model than its competitors who seem to buy ‘consented land’ or housing sites.

The firm takes the risk of buying land that has not yet been consented to developments. This is a huge risk, which can weigh on profits and margins if the acquired land has planning permission rejected. BERK is delivering 10% of all new homes in London and has unconditional contracts for sales that deliver £3bn in cash over the next 3 years. The firm currently has 37,473 plots of land plus strategic options on 5,000 plots. At an average selling price of £456,000 this gives gross margin of £5.2bn (c30%) on the balance sheet. Gross margin is driven by house prices and land purchasing strategy. The cheaper you buy the assets, the higher the margin when developed and monetized. Land supply is constrained and in demand, therefore margins will definitely be squeezed going forward due to new entrants and scale. Land plots and inventories have a CAGR of 5% and 13% respectively for the last 6 years and capital employed has increased 2.2x over the 6-year period. Capital is crucial to buy the land that eventually generates the gross margin and flows to earnings.

Valuation

EV/NOPAT – concentrating on the ROIC of Berkeley to value the homebuilder provides some metric of valuation to target. Berkeley has been able to grow rapidly post-crisis due to their successful and shrewd business of buying property at depressed prices during the housing crisis and therefore have been able to greatly expand margins in recent years as they have sold these properties. In the long run these high returns on capital of over 30% are not sustainable and therefore to find a fair value we use the 10-year average ROIC of 19%.

Using a WACC of 10% and long-term growth rate of 3% (inflation + greater asset price growth in London and South East). Using 10-year average range of ROIC 15-19% this gives a fair value range of 11.4-12x 2020E NOPAT.

Current valuation is 9.7x Apr 2015 diluted NOPAT. Now how much do we expect Berkeley to grow? Revenue and EPS has a CAGR of 33% and 44% respectively over the last 5 years. Assuming BERK grow at 10-15% per year for the next 5 years, this implies that BERK’s fair value is 1.6x-2x 2015 NOPAT. Hence the fair value and price target of BERK for the next five years is 15.5x to 19x 2015 NOPAT which gives a price target range of £52-57.5 providing a 46% upside potential over the next 5 years.

BERK also pledged in 2012 to return £13 per share to shareholders by 2021. They will have already committed £4.34 by Sept 2015; therefore £8.33 in dividends from 2016-21 is on average £1.73 a year which yields 5% at current prices and when discounted at 10% this gives a PV of £6.57. This provides 18% of return on top of any potential price appreciation driven by earnings growth.