The markets being what they are these days have made the entry point on this investment about 12% worse off than when we started writing (i.e. four days ago!).  Given the volatility I'm sure anyone watching BWY will get another crack at a decent price point.  Having said that, we believe Bellway represents a compelling investment opportunity with a good margin of safety and solid upside. 

Description:

Bellway is the 4^th largest homebuilder in the UK, headquartered in Newcastle Upon Tyne, employing close to 1,400 people, with activities in:  land acquisition, finance, planning, architecture, design, build management, marketing and customer service.  They have been in business for over 50 years and have operations that span across England, Scotland and Wales.  Bellway's operations focus on the mid to lower end of the housing market.  This year Bellway's average selling prices was around £175k versus the national average price of £161k. 

Management:

The main executives are:

John Watson, CEO - joined Bellway in 1978, CEO since 1999 (compensation 2010:  £1,091,148, 2009: £799,646, 228,674 shares owned)

Alistair Leitch, CFO - joined Bellway in 1981, CFO since 2002, due to retire at the end of 2011 (compensation 2010 £717,397, 2009: 527,725, 148,638 shared owned)

Total employee options outstanding:  1,682,152 w/a weighted average strike of £6.81 and 3.5yr duration.

Background:

The UK housing market, outside of London, has suffered similar price and activity declines as other western markets; not from overbuilding (excluding Ireland) but from accessibility to mortgages and interest rates.

Historically the largest impact on housing activity in the UK has come from (in order of importance):

• Interest rates
• Government policy
• Overall debt levels
• Access to funding
• Income growth
• Demographic trends

Currently access to funding is the greatest impediment to housing activity and we would expect this to continue despite government efforts to re-start the mortgage market.

As mentioned, overbuilding outside of Ireland has not been a factor in this housing crisis. In fact there is an on- going debate in the UK about the shortage of housing required to meet the current and forecasted number of households.  The table below shows housing production peaked in 1968 and has been on a steady decline since.  Leaving aside the current shortage of housing stock for a moment, private and public studies indicate that at current trend the UK is expected to create over 6m households in the next 20 years.  Should this number be accurate that translates into a need of approximately 3.6 million dwellings (houses and flats) or a build rate of close to 200,000 new dwellings a year.  Trend projection has never been reliable so we discounted the current studies by 20% for conservatism which puts the need at about 160,000 dwellings a year.   If we use the historical stock numbers, 82% of these dwellings (130,000) should translate into private homes each year going forward.  The current situation exacerbates the supply/demand problem as estimates suggest the UK (mainly England) has been undersupplied by 35,000-85,000 suitable dwellings a year since 1996. 

There is always going to be some debate over forecasts and numbers. What we are trying to illustrate is that the current run rate of around 130,000 dwellings is close to a trough level (and is the lowest level since 1954 for private enterprise) and there is a sustainable model of house building in the UK for the foreseeable future.

Completions per year

One of the main reasons why housing development has slowed, besides mortgage accessibility, is due to the complex planning laws across the UK.  Until about 5 weeks ago it could take up to 4 years (if ever) to get permission for a site; now the new draft national planning policy framework  (published in July) will streamline more than 1,000 pages of policy to just 52.  Among its "core principles" it says that those making decisions about planning applications "should assume that the default answer to development proposals is 'yes' except where this would compromise the key sustainable development principles set out".  This is important legislation as its turns around the guilty until proven innocent bias.

Competition:

There are about 5,500 home builders in the UK; The top 10 national homebuilders account for about 45% of all new dwellings, with the top 25 building 65% of the new dwelling each year.  Bellway is currently ranked the 4^th largest with about 5% market share; this has gradually increased from their first appearance in the top ten back in 1995.  Bellway seems to pick up market share during periods of distress due to their unlevered balance sheet.

Top ten UK homebuilders:

1.       Taylor Wimpey

2.       Persimmon

3.       Barratt

4.       Bellway

5.       Berkeley Group

6.       Redrow

7.       Miller

8.       Crest Nicholson

9.       Gadedale

10.   Bovis

Barriers to entry:

Along with the normal barriers associated with product differentiation, scale and branding the following are the biggest hurdles in the market:

Entry and Expansion - it's relatively easy to enter the homebuilding market but difficult to reach critical mass and stay among the top ten, where scale provides benefits.  Over the past 25 years only two builders have remained in the top ten - excessive leverage has had the greatest effect on the survival rate of homebuilders during booms and busts.

Land - acquisition of land and a quality land bank is crucial in the UK market; both take time and capital. 

Financing - access to capital is a main barrier to a firm's entry and survival.  Many of the UK firms operate on a highly levered basis making them vulnerable in downturns.

Knowledge - local knowledge and relationships take time to establish; even with a large amount of capital this barrier makes it difficult for foreign entry and expansion.

Regulatory - federal and regional regulatory requirements take time and on average add up to about 10% of the development costs.

Business Model:

The standard model for most UK homebuilders, including Bellway, is to start with the required profit margin and reverse out the costs to determine affordability of land and project development.

For example; from the per unit sales price most homebuilders target a profit margin of 20-25%;

Less:  10% cost of regulation

Less:  35% build costs, infrastructure etc (including funding)

Less:  30% land value

Bellway uses a capital allocation model where projects are presented by the various regional directors to head office, with the best prospects for return (after clearing the 20% hurdle) being funded.  Management ability to assure conservative unit pricing and costs is essential in maintaining margins.  Except for '09 and '10, where margins were compressed due to the crisis, we found CEO Watson and CFO Leitch to both be very disciplined operators.

Balance Sheet:

Bellway has a clean balance sheet with minimal use of debt.  Management is generally averse to borrowing but will use it when outstanding opportunities arise.  Under normal conditions they have the ability to replenish the land bank with cash generated.  They did raise equity in '09, when debt wasn't available, to take advantage of cheap land prices.

Inventory (land bank) is the main asset and provides the margin of safety to the investment.  It's made up of five parts:  Land with planning, pending planning, work in progress, show homes and part exchange.  Land with planning and work in progress represent 90% of the inventory value.  In order to establish its credibility we spoke with industry competitors and independent evaluators and from what we have been told it is fairly marked to market.  To be conservative we still apply a 20% discount for liquidity.  In 2008 they wrote down the inventory by £131mm (about 8%) and another £66.3mm in 2009 (approx. 5%).  The other important component is the site mix (age of stock) and this is where BWY has an advantage over competitors.  According to the company most of the '05-'07 lower margin stock will be sold off by 2012-13 and the site mix will have over 50% of plots generating in excess of 20% margins.

Earnings:

Earnings are driven by number of houses sold and average selling price.  The main cost affecting margins is the price of land.  Working off the expensive inventory has put pressure on margins along with a decline in volume.  Construction costs have been steady to down over the past few years and the company does not see labour costs being a factor for the next few years.  Although materials prices have been volatile this is only a small portion of overall costs.

The targeted gross margin is 20-25% and should be achievable by 2012-2013.  Operating margins should also start climbing back to their longer term average of about 15%. 

Important to note in the cost of goods sold is a 20% non-cash charge for land repurchases.  Think of this more as maintenance cap-ex.  According to the company, 20% of the sales number is allocated to keeping the land bank topped up.  Spending/investing anything less than this amount generates after tax cash.

Valuation:

As we mentioned at the start the numbers look better about 12% lower when we starting writing.

Enterprise value:  £832mm

Expected 2011 EBIT:  £74mm

Current Earnings:  suggests an EV/EBIT of about 11.25x

Assuming a modest 3% growth in sales (mortgage market improvements, gain market share) and slow return in margins could see 2011-12 EBIT around £90mm (9.24x) and 2012-13 close to £110mm (7.56x)

Valuing BWY from its balance sheet:

TBV:  £1040mm or about 25% from current market value.

If we discount the inventory 20% for liquidity then TBV= £840mm or at market value.

Looking at the business in run-off:

If we assume things don't get much better for the company and sales and margins stay flat, given their current land bank they would have about 7 years of operations.  Since there is no investment in land, all cash is returned to the owners. 

Using the expected final numbers for this year, after tax profits should be around £50mm; add back the 20% of sales for land purchases, £173mm, and total after tax cash for this year is about £223mm.  Discounting that number for the next seven years (starting with 3% ending with 9%) and the present value of running off the business (and paying down debt) is conservatively about £1.1bln or 32% above current market value.

Conclusion:

Obviously getting Bellway 12% cheaper makes the investment more compelling but even from current levels it's a good story.  There is a strong argument that housing completions are at the low end of the cycle and government assistance and recent changes to the planning are going to improve home builder's circumstances.  Bellway is considered in the better part of the market, building more affordable homes, especially when incomes are stagnant.  Under normal conditions, margins are likely to improve as old stock is sold off and better margined plots are developed.  Bellway has been better than the rest managing their inventory and should see margin improvement ahead of the competition.  Their management has done a good job through the crisis and this has translated into market share.

Outside of the crisis the company has been able to produce a solid ROIC averaging 25% for 10yrs  pre-2008 and 20% for 10yrs including 2008-2010.

The company's balance sheet is clean, with minimal use of debt.  The assets are verifiable but even discounting the current stock by 20% still produces value.  In the extreme scenario where someone buys the company to run it down a 32% after tax return could be achieved.