The Case For – and Against – Persimmon

Posted on 22/03/2011

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One company that has recently showed-up in my quantitative screen is UK house-builder Persimmon and consequently I’ve decided to take a look at the company in a little more detail despite having a few misgivings.  These misgivings are: (1) I still think UK housing is significantly overvalued and therefore could be subject to a further downturn should interest rates rise or the UK enters another recession; (2) house-builders are hugely cyclical businesses and therefore not a sector I’m particularly keen to invest in; and (3) much of the valuation argument revolves around the stated book value of land inventories – something that is difficult to independently verify and also unlikely to fetch the stated values in a forced-sale scenario.

The first reason that I’m willing to consider an investment in Persimmon equity can be seen in the chart below.

It shows that – throughout a major downturn in the UK economy and housing market – the company has consistently generated positive operating cash flow whether it is measured before or after changes in net working capital (for house-builders like Persimmon movements in net working capital relate mainly to increases or decreases in the land bank inventories held in order to build houses upon).  The average pre-NWC cash from operations in the last five years is £248m, while the post-NWC average is £298m.  These numbers are equivalent to 18% and 22% of the current market capitalisation, respectively.  Capex requirements are negligible, so these numbers are equivalent to a free cash flow yield.  This suggests to me that in the event that the UK housing market recovers, the company should generate a very healthy amount of free cash flow for shareholders, while if the housing market continues to struggle, the company should be able to generate cash by running-down its inventories over time.  Persimmon has a land-bank that contains 58,862 plots, equivalent to 6.3 years production, so this could be gradually reduced without damaging the long-term health of the business.  In addition, in the event of a continuing downturn in the housing market, the company may be able to reduce inventory (in value terms) while keeping the numbers of plots constant.  This would happen if land prices fell and the company could replenish inventories at lower prices than originally paid.  Using a revenue growth forecast of 4.5% per annum and assuming operating margins increase from 7.9% in FY10 to 8.8% in FY16E (still some way below the 21.7% recorded in FY07), I make the following forecasts for cash flow.

The chart shows how with a modest level of top-line growth and a small (and gradually fading) boost from net working capital (mainly inventory run-down) should be able to generate cash from operations of £100-150m per annum over the next few years.  This is equivalent to a free cash flow yield of 7.5-11% based on the current share price.  This should provide shareholders with good returns until the UK housing market returns from the doldrums, for there are very good reasons to expect that it will do so, which are discussed below.

The second reason that I’m positive about Persimmon is the supply vs demand picture of the UK housing market.  Unlike other markets where bubbles were experienced, such as the United States, Ireland and Spain, the UK wasn’t subject to overbuilding, so no significant over-hang of housing supply exists today (vacant-property was estimated at 2.84% of total housing stock at the end of 2009 vs 2.82% at the end of 2006 – data from the DCLG here).  In addition, the United Kingdom housing market is subject to demographic pressure from a growing population (both net immigration and natural changes) which is expected to reach 65.6m by 2018, social pressure from declining household sizes due to an increasing proportion of one-person households and legal/regulatory pressure from planning and land use regulations.

This final factor – UK planning law – is in my opinion one of the key positives.  Due to the Town and Country Planning Act 1990, anyone wishing to build a new house or any other development is required to first navigate a Byzantine maze of complex laws and regulations in order to win the necessary planning approvals.  In addition, the act is biased against building new houses.  Originally, when the first version of the act received royal assent in 1947, the idea was to protect green belt land in order to prevent urban sprawl of the type seen in US cities.  However, a side-effect is that residential property in green belt land close to affluent cities has experienced substantial increases in value.  Today, the owners of such properties form a very powerful nucleus of the wider home-owning constituency against the relaxation of UK planning laws.  For Persimmon, this means that regardless of market conditions, there is likely to be a certain level of demand for homes in the United Kingdom.  This factor may partly explain why UK house prices may have held-up higher than expected in the last couple of years.  Even today, the lack of housing transactions in the UK could be explained by the lack of mortgage financing rather than the number of people wishing to make a purchase.  The full Town and Country Planning Act 1990 can be downloaded here in PDF format for those that are seeking a cure for amnesia.

This view on the supply/demand imbalance is set-out within a recent report from the Institute of Public Policy Research, who believe that England faces a structural shortfall of 750,000 homes by 2025.

Further reasons why Persimmon may make a good investment relate to the company’s balance sheet.  Firstly, Persimmon has negligible debt, with net debt of £49m and a pension benefit liability of £98m, both of which are relatively small when compared to the market capitalisation of £1.33bn. Secondly, the company is rich with tangible assets – mainly in the form of land inventories which total £2.1bn.  In a market environment when some investors are worrying about the potentially inflationary effects of the Bank of England’s monetary policies, a company which has £2.1bn arguably represents an excellent hedge against this risk.  After all, the Bank of England can’t print more land.  Finally, the company is trading at a price/book-value ratio of 0.8x, providing a margin of safety against the risk that the land is worth less than stated in the accounts.

Now for the bad points.  While I note that Persimmon has little debt, trades at a discount to book value, has historically generated positive cash flow and should – on relatively conservative assumptions – continue to generate cash flow, I can’t help but think the next couple of years are going to be challenging for the business and the housebuilding industry as a whole.  Increasing taxes, public sector redundancies and declining real incomes due to higher energy and food costs suggest that house prices are likely to remain under pressure.  The chart below shows that prices remain at elevated levels despite the severity of the recession, while after the previous recession prices fell significantly in real terms and took many years to recover.

In addition, other measures of activity suggest that there has so far been only the most negligible recovery in the UK housing market and that it is possible that the market is heading towards another downturn.  Firstly, the chart below – which shows a 3 month moving average of net mortgage lending, a key explanatory variable of future house prices and transaction volumes – suggests the market is likely to weaken further.

This reasoning is borne-out in the chart below, which shows that activity in the market has been trending-down since late 2009.

Such low activity from house buyers is keeping the construction of new homes at a relatively low level:

Given these existing weak trends in the UK housing market, and the fact that the UK consumer is about to face further pressure from tax rises that kick-in on April 5th, combined with the continuation of public sector redundancies and declining real incomes due to price inflation of essential goods and services, I expect that the UK housing market will continue to be weak for at least the rest of the year.  Therefore, in conclusion, I’m going to hold-back from purchasing Persimmon shares at present in the hope of being able to purchase at a more attractive price in the next 18 months.

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Posted in: Investment Ideas