Description

I believe that Bellway is the perfect pitch – an extremely positive long-term macro backdrop, a fantastic industry setup, a high quality company and the situation is underscored by a dirt-cheap valuation.  I see a 2X/3X return in the next couple of years with little downside.

Bellway is a UK homebuilder, earning an ROE of 5% in the bad times and well over 20% in the good times, all with no debt.  While many UK homebuilders earn juicy over-the-cycle returns when compared to their American counterparts (for reasons that will be explained below), Bellway has one of the best returns, with one of the best balance sheets, yet is also dirt cheap on both a relative as well as on an absolute basis.

Before we dive into the industry and the company, I think it will be helpful to understand the UK housing macro environment.

The UK Housing Market

In the late 80s the UK housing prices started declining and hit their bottom in 1992 [1], shedding 25% of their price relative to the peak.  The housing price decline was caused by a decade of overbuilding that created a supply glut.  On the 1979-1988 decade, UK homebuilders built, on average, 175,000 units a year [2].  That was too much for 1980s Britain and prices started dropping.

With lower prices, homebuilders slowed down and only 146,000 homes were built annually on the following decade (1989-1998) [2].  By 1998, home prices surpassed their 1988 record, with the housing market once again reaching equilibrium.

In the decade 1999-2008, only 156,000 units were built [2] and England was one of the only Western markets that did not suffer from a housing glut in the 2008 GFC.  Finally, in the decade 2009-2018, only 131,000 units were built every year [2].  As a reminder, that is less than the housing completions of the 1990s, a pace so slow that it absorbed a housing glut.

How big is the present housing shortage?  Unfortunately, it is not an easy number to calculate.  Lucky for us, we don’t need an exact number to figure out that there is a massive housing shortage:

1)      The last housing glut happened in the 1980s and was fully absorbed in the 1990s.

2)      In the last 20 years fewer housing units were built (143,000) than in the 1990s (146,000) for a 20% larger population base with changing demographics that increases housing need.  In addition, the last 20 years, unlike the 90s, did not follow a housing surplus.

3)      UK household formation is now estimated to be over 200,000 a year and is expected to remain so in the next few decades [3].  England alone is expected to add 160,000 households a year. [3]

4)      Homebuilders were forced to shut down operations for 2 months in 2020, all but guaranteeing yet another year of minimal housing completions. 

5)      Most of the large homebuilders reported that they pause new land purchases until there’s more visibility with respect to the COVID situation. The years’ long planning process means that the pause in land purchases almost guarantees additional future supply constraints.

For those reasons, I believe that there is a massive shortage of homes in the UK, which will take many years to fill up.  The British government understands the crisis and have targeted building 300,000 annual homes per year by the mid-2020s[4].  That is easier said than done, because new housing planning in the UK is on average a four-years ordeal mired with NIMBY-ism and regulation.  The company estimates that over 10% of the cost of a home goes to cover regulation and permitting.

So far the UK is not closer to reaching the government’s 2018’s goal of building 300,000 homes annually than it was when the goal was set.

I hope this demonstrates why the supply is limited and is likely to remain so. 

At the same time, the demand for housing is strong.  Rent inflation [5], historically cheap mortgages [6] and positive demographics are all significant factors.  Recently, COVID has been causing people who spend more time than ever at home to desire better housing.

Now that we covered the favorable macro, let’s move on to the industry.

The UK Homebuilding Industry

As a notoriously low return / capital-intensive industry, a good US homebuilder earns a 10% over-the-cycle ROE, achieved with an ROA of 5% and a leverage ratio (defined as assets / equity) of 2.  The typical UK homebuilder earns a 15% over-the-cycle ROE, achieved with a 10% ROA and a leverage ratio of 1.5.

Why are the UK homebuilders so much more profitable than their US peers?  Industry insiders would tell you the following:

1)      The top 10 builders build 60% of Britain’s new homes.  Those top 10 players are not all building in the same geographic areas and are not selling at the same price points.  As a result, when bidding for land, there is far less competition in the UK than in the US. 

2)      The permitting process requires substantial know-how that smaller players struggle to acquire (requires experience, talent and so on).

3)      Somewhat related to the previous two points, scale allows the de-risking of projects planning in the same way that a prudent insurer would only underwrite a large sample of events.  For the builders, projects permit will drive more success to some projects than others.  It is a risky proposition for a builder to operate 5 projects, but not to operate 100.

4)      Projects often include social housing and community development components.  No one in the municipality will be blamed for a failed project that was done by a large reputable player (“no one got fired for buying IBM”).

5)      Scale also helps with the cost of funding. The cost of debt is low for the big builders, but much higher for the smaller ones.

Those are not just qualitative anecdotes.  Every year the big-10 builders seem to increase their market-share.  In the last decade, the big-10 market share has increased from 45% to 60%.  I do not see anything that could disrupt / displace those companies nor reverse the trend.

Bellway - Intro

The company was founded in 1946 and is the 4th largest UK homebuilder.  Bellway is building ~10,000 affordable homes a year (in the £280,000 range).  The company has been growing units mid-single digits annually in the past 15 years and close to 10% annually in the past 10 years.  I expect the company to grow units at least mid-single digits in the foreseeable future.

Bellway has net cash and in the last 15 years has generated an average ROA of over 10%, an average ROE of 15% and a BVPS annual growth of 14% (adjusted for dividends).

Bellway – Management

The CEO and CFO joined the company in 2005 and 2008 (respectively) and became CEO and CFO in 2018 and 2011.  The company has a long history of creating value – an investor that bought the shares 30 years ago and reinvested dividends got an >15% total annual return.   However, those returns obviously cannot be attributed to the current management team, who joined the company in the past decade.

While I have spoken to management and have a favorable view of them, they do not have enough of a proven track record to show for.  We do know that they like keeping a clean balance sheet, that they refrained from over-expanding when land deals couldn’t have been underwritten at mid-high teens ROIC and that they warned that they were overearning in the 2015-2019 timeframe (more on that later).

In addition, management acknowledged that more cash is being generated than is needed to fund growth and so 1/3 of earnings are returned to shareholders every year. It is a favorable sign that the company prefers to return cash to shareholders rather than expanding to less profitable locations.

In summary, we do not have a proof that the management team is the Berkshire Hathaway of UK homebuilders, but we do know that they are conservative, return excess capital and view deals through return-on-capital lens.  Enough for us to feel comfortable.

Bellway – Balance Sheet

Not only does Bellway have net cash, its leverage ratio, at ~1.2 is one of the lowest in the industry.  Several homebuilders issued capital in 2020 (Taylor Wimpey, Countryside, etc.) and are still at leverage ratios higher than Bellway.  This gives comfort that even with another UK lockdown, Bellway will not need to raise equity (more on that under the Risks/COVID section).

As a side note, UK homebuilders typically have two forms of off balance sheet items:

1)      Joint Ventures (JV) structures for local partnerships.  Those are accounted for under the Equity Method, which hides an element of leverage.  Bellway’s JV operation is negligible at ~2% of the balance sheet, far below the rest of the large builders.

2)      Land Creditors.  This is the amounts contractually owed on land that was signed on but not fully purchased yet.  Bellway’s ratio of Land Creditors / Inventory is 9% and is the lowest among peers (peers’ ratio ranges from low to high teens).

The point here is that Bellway’s balance sheet is truly pristine and that unlike some competitors, nothing is hiding off balance sheet.

Bellway – Valuation

Bellway’s average 5 years EPS was £3.57, the company is trading for ~£25, giving it a P/E of 7 on the preceding 5 years’ earnings.  On average, in the last 15 years, Bellway’s PE ranged from 9 to 14.

One important point to make is that the company was overearning in those 5 years.  Lots were purchased in the 2011-2013 period reflected the home prices of that time and consequently benefited from housing price inflation.  The company underwrites projects for 24% gross margins while the average gross margins for the 2015-2019 period was 25.2%.

An additional factor weighing on earnings is COVID.  The shelter-in-place period increased the demand for housing because people, spending more time at home, were more inclined to invest in improving their shelter.  In addition, travel restrictions meant less spending on trips and more money left in consumer’s wallets [7], which helps funding the down payment (especially now, when the government waves the Stamp Duty).   Unfortunately, offsetting those positive factors are the new social distancing rules.

The company indicated that social distancing regulation makes the construction process less efficient.  On a 8/11/2020 result release, the company estimated that the current “productivity rate” (construction progress) is 80% of its pre-COVID pace.  This means that some ongoing costs are incurred for a longer period (cost of holding the land, paying property taxes, paying onsite personnel, etc.).  Those additional costs weigh on margins.

Assuming no further improvement, management believes that this would mean that the company operates in a 15% operating margin (down from just over 20%).  15% EBIT margins translate to 15% ROE, after applying taxes and balance sheet leverage, which offset each other.

The company indicated that the 80% pace is constantly improving, with new ways of optimizing construction to social distancing being regularly applied.  Also, I do not know that social distancing will be with us forever.  Finally, those new extra costs are factored into new land purchases (but obviously bear no impact on past land purchases).

If we assume that social distancing stays with us forever while at the same time the company finds no new ways to be more efficient within the current framework and yet Bellway still pays the same prices for new land, the company will still generate a 15% ROE.  With a BVPS of (rounding down to) £25, EPS will be £3.75 and the P/E will be 6.5.  In this scenario, and assuming a continued distribution of 1/3 of earnings, the dividend would be £1.25 per share.  With 2/3 of earnings retained, revenues are expected to grow mid-single digit and EPS is expected to grow 10% / year due to operating leverage (Admin costs to revenue has trended down from 5% a decade ago to 3.5% and are expected to continue trending down with more scale).

If we assume a return to a normal environment, with a 20% ROE (1-2 points lower than the last 5 years), then the EPS will be £5 and the P/E drops to 5.

How much is the business worth?  We can take the asset approach or the earnings approach.

Based on book value, Bellway trades at a current fiscal yearend (ends in July) P/B of 0.8, the lowest since 2012.  In addition, in each of the last 15 years, the company traded for more than that at least for a period of time in the year.  Also, in the last 15 years, the average highest P/B for the year was 1.5.  With 1. 5 times book value, the company should trade at over £35, or over 50% premium to current price.  While we wait for the multiple to expand, BVPS should grow at the rate of ROE, 15% / year.  This means that if it takes Bellway 2 years to reach a P/B of 1.5, we’ll more than double our investment. 

An interesting anecdote is that if bought at a P/B of 0.8 in the last time the stock was trading for this multiple (2012), an investor would have realized a 2x, 3x, 4x return in 1 year, 2 years, 3 years respectively.

Let’s move on to earnings-based valuation. 

Based on earnings of £3.75-£5, Bellway trades for a P/E of 5-6.5, the lowest since 2009 with the exception of a short period in 2016, around Brexit.  In the last 15 years, the average year-high P/E was 12.5 times.  Applying this figure on an EPS range of £3.75-£5, yields a price range of £47-£63, or 90%-150% higher than current prices.

The EV/EBITDA metric looks even more favorable because there’s no debt and negligible D&A.  Even at the low-end EPS of £3.75, the EV/EBITDA is less than 5. Assuming no return of capital, the EV/EBITDA drops by more than half a turn every year with earnings accumulating in cash.

It’s quite hard to come by a valuation matric that does not imply >100% return in a couple of years.

Bellway – Downside Protection

In the years 2008-2009 the company wrote down 15% of the value of its inventory.  Applying the same 15% haircut to the current inventory, over a 2 years period and assuming a 5% ROE ex-write downs (comparable to 2008-2009), would yield a BVPS of £28.  The £28 BVPS is higher than the current share price, so an investor pays right now a price that already reflects a 15% haircut. 

In 2008/2009, the company did a 5% share issuance, one of the smallest dilutions among homebuilding peers.  Even if we see a comparable inventory write down, I doubt that a share issuance will be needed, because Bellway entered 2008 with £200M in net debt (about 1-time EBT of the time), while now it has net cash.  Not only is 2020 not a housing- or credit- led recession, but also Bellway is more ready for a recession than it was in 2007. 

Why Bellway and not One of the Other Homebuilders?

I think most of the other UK homebuilders are attractive investments, but what is unique about Bellway is that the company is the cheapest among the safest builders and the safest among the cheap ones.

Bellway has a leverage ratio of 1.2 and an over-the-cycle ROE of 15%, yet trades at a 10% discount to book value.

Persimmon PLC, another high-quality builder, generates 2-3 points higher ROE with the same leverage ratio, but trades at well over 100% premium to book value.

Berkley Group, with a larger net cash pile than Bellway (leverage ratio is somewhat misleading for Berkley so I will not use it here), trades at a 75% premium to book value.  Berkley ROE is 5 points higher than Bellway over-the-cycle.

On the other hand, Redrow PLC, which has a leverage ratio of 1.7 and yet a point lower ROE, trades at a 12% discount to BV.

Barratt Developments PLC generates a 10-12% ROE with slightly higher leverage ratio (1.45), yet still trades at around book value.

Bellway – Why is the opportunity there / Risks

1)      Flight to safety in the aftermath of COVID.   UK companies that are dependent on consumer confidence were impacted more than others.  I view this item more as an opportunity than as a concern or a permanent issue.

2)      COVID.  Unlike the US homebuilders, the UK builders were instructed to curtail operations during the April / May lockdown.  There could be another lockdown which will again prevent them from building.  The last time around homebuilders were among the first to be given a green light to resume operation after concerns of long-term housing shortages.  The company reported that during lockdown it burned £15M / month so even with a second (or third or N) lockdown, I believe the balance sheet will not suffer too much.  Another 6 months of lockdowns would put the company’s leverage ratio below 1.33, the lowest in the industry (possibly second to Berkley Group plc).  The debt, after 6 months of further lockdowns will be under £100M and equals a couple of months of normalized earnings (so absolutely manageable).

3)      Changes in the Help to Buy Scheme.  The UK mortgage banks require homebuilders to put a 30% down payment. Help to Buy is a government program that provides loan guarantees for 25% of the down payment, so that home buyers only need to come up with 5% of the home price.  The program is changing to become more limited in March 2021 and will expire in 2023.  About 1/3 of Bellway buyers purchase homes with this program, so there could be an impact.  I believe that the impact will be limited for the following reasons:

a.       Of the 1/3 of the customers who used the program, 1/3 didn’t need it (used it because it was available), 1/3 used it to buy a larger property which they couldn’t afford without it and 1/3 wouldn’t have been able to buy a home at all.  As a result the real impact would be felt by about 10% of Bellway’s homebuyers, if nothing would be done about it.

Bellway is well aware of those changes and has been purchasing lots while factoring into them the ability of buyers to make mortgage payments without relying on the Help to Buy scheme. 

b.       The program might be renewed (it is highly popular).

c.       People bought homes in England before the program was introduced in 2013 and will be buying them after the scheme sunsets.  The industry is working with insurers on mortgage insurance products that will mimic the product and will not materially add to costs.

My opinion is that the strong supply / demand imbalance is far more important than a government program.

4)      Land lease.  4 of the big-10 homebuilders were accused by the regulator for selling homes with leased lands.  Those leases sometimes require (escalating) annual payments and always require approval for home modifications, which opens the door for extorting homeowners.   While Bellway is not part of the 4 builders that were accused it is unclear at this point whether they have an exposure or not.  I expect the company to provide more information about that in the future.  There are two factors that I’d consider mitigating the issue:

a.       UK needs the homebuilders to build.  Destroying builder’s capital base with fines and restitution will limit the number of houses built in the UK.

b.       Bellway’s balance sheet allows it to absorb huge fines that would bankrupt every other builder (and again, at this point they are not even being accused).

5)      Social distancing impact on margins.  As explained, the trend towards 15% ROE / operating margins likely marks the worst-case scenario and still demonstrates how profitable the business really is.

6)      Brexit . The exit of the UK from the EU could have an enormous impact on the cost of materials / labor, growth prospective, regulation and so on.  I’d be lying if I say that I fully understand the impact, but I do not think that it particularly matters.  I believe that what matters is that there are over 200K households formed every year and a decade-long housing shortage.  I do not see how Brexit would change the fact that people need a roof over their heads.

References:

[1] https://www.gov.uk/government/statistical-data-sets/uk-house-price-index-data-downloads-march-2020 (See Index CVS)

[2] housing start info is taken from this source https://www.gov.uk/government/statistical-data-sets/live-tables-on-house-building

[3] http://www.civitas.org.uk/content/files/housingsupplyandhouseholdgrowth.pdf

https://www.ons.gov.uk/peoplepopulationandcommunity/populationandmigration/populationprojections/bulletins/householdprojectionsforengland/2018based

[4] https://www.gov.uk/government/news/government-announces-new-housing-measures

[5] https://www.ons.gov.uk/economy/inflationandpriceindices/bulletins/indexofprivatehousingrentalprices/may2020

[6] https://www.statista.com/statistics/386301/uk-average-mortgage-interest-rates/

[7] https://www.telegraph.co.uk/business/2020/09/30/britons-save-cash-record-rate-lockdown-curbs-spending/

Catalyst

No catalyst per se, just really cheap, high quality business.