Small Cap Value Report (12 Jul 2016) - ASC, GFRD, NRR, BEG, SOM, WJG, AVN, ABDP

12th Jul '16 by Paul Scott

53 comments 27977 reads

Good morning!

Yesterday's report didn't really get off the ground I'm afraid, my apologies for that. So I'm building up more thrust as we speak, and looking forward to achieving escape velocity imminently!

The big news of course is the "coronation" of Theresa May as our new PM, with removal men apparently scheduled for Downing Street tomorrow. As usual, I'm not interested in discussing the politics of it here, that's a discussion for elsewhere. All that matters for our purposes here is the impact on markets. Perhaps readers could consider that before posting comments below, as it gets very boring when people start ranting on about politics here.

There was a very strong rally yesterday, with the Mid Caps Index (MCX) up about 3.5%. Amazingly it has now recouped nearly all of the Brexit falls. So those of us who held our nerves through the last few weeks, are not looking quite so daft now.

Note also that sterling has recovered a little from recent lows, currently at $1.315.

Markets hate uncertainty, so I think it's clearly a good thing that we actually have a new PM, rather than a lame duck situation until the autumn (what were they thinking?). Also, there seems a general feeling that the grown ups are back in charge now. May seems professional, calm, and experienced. So hopefully she'll make a success of Brexit negotiations, and bring the country together.

Also, I was delighted to hear May talk yesterday about detailed measures to improve corporate governance, such as making remuneration votes binding, and reining in widespread Director greed, which is proving so corrosive for social cohesion. She also favours adopting something like the German model, of bringing in e.g. an employee representative onto Boards, etc.

The nice thing about small caps, is that there are always laggards when the market generally rallies. So even if you've missed the rally, there are (selectively) still some good buying opportunities out there, in my view.

Mind you, if you're gloomy about the outlook for the economy, and hence earnings, then strong bounces such as we've seen this week are the ideal time to be selling into strength. That approach is much more profitable that panic selling during the big plunges.

As mentioned before, I'm scrutinising the trading updates of larger caps too, at the moment, to get a better sense of what the economy is doing. Obviously Brexit has caused a shock to the system, but…

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gaustin

12th Jul '16

Paul

This is re Vislink (£VLK) so some what off topic from today's reviews but I thought it was the best place to post.

Having seen the value in my VLK shareholding destroyed over the last few years by Hawkins et al I would love to see the board removed but appreciate that as a small PI I have little power to bring this about. I would welcome any thoughts you have as to how to try and make this wish come to fruition.

Graham

biloseli

gaustin,

You could try joining Sharesoc, if you haven't already. If I recall correctly, they are campaigning to resolve issues like that, and I think Vislink was mentioned at one point.

Steves cups

Hi Paul,
I note that Watkin Jones (LON:WJG) are presenting at Mello tomorrow. I am very optimistic about this outfit and topped up recently on the 10% share weakness.
Is there anybody out there who will be attending that can give a report on their presentation.
Thanks in anticipation

Steve

FREng

Aislabie

I trust you have seen this (year old) interview with Falanx (LON:FLX) CEO. https://www.youtube.com/watch?v=-9pddMbxFls

Their strategy seems reasonable, but it's a very competitive marketplace.

grumpy5

"The grown ups back in charge" - I love it! Broadly right, I think.

Binding votes on board remuneration is an excellent (and workable) idea. Corporate UK has only itself to blame for that one coming. But worker representation? Can' t see that working out quite so well. Will no doubt lead to lots of important decisions being made outwith the main board, or whatever board the workers sit on.

Biloseli - thanks for the advice

purpleski

hi herbie47

I think the basis is that the land that they are using to build houses on that are sold in Year 4 was purchased in Year 2 or Year 3 when land (as well as houses) dropped in value. I assume that there is a correlation between house prices and land prices (I should know I suppose as I hold both Barratt Developments (LON:BDEV) and Berkeley Group (LON:BKG) ). The paragraph below Table 1 explains this I think.

Thank you to Francis Dwan for this link which I thought was excellent. It is a real education on the economics of house builders.

tic_tac_toe

Hi

Regarding the comparison of BOO vs ASC, Paul notes above that ASC EBIT margin is about 4%, potentially rising to 6%. I am trying to compare this with BOO's margins, which (if I understand correctly) are nearer 50%

Is anyone who follows either share able to confirm why the substantial difference? is this down the differences in marketing spend, procurement approaches, etc? I am genuinely keen to know.

Additionally, I am thinking I might make the Mello event tomorrow evening, so might meet some of you there.

herbie47

Thanks for explaining, I can see what they are saying but I'm not totally convinced most housebuilders have large land banks, believe Bovis Homes (LON:BVS) has over 8 years supply at current rates, of course, if prices do crash then sales probably will as well that is what happened last recession and is why many builders nearly went bankrupt and share prices fell 90%.

Fegger

The Mello presentations are often videoed and appear here: http://www.piworld.co.uk/

Yes I think that the model Aurora shows must be based on smaller land banks. I suppose it depends on the prices paid. Don't know whether this can be gleaned from the accounts?

iwright7

AB Dynamics

I topped up with Ab Dynamics (LON:ABDP) this morning having previously double bagged and top sliced a couple of month's ago and it is now my biggest single shareholding. Fantastic Quality numbers, excellent visibility and improving brokers forecasts. I suspect this is one of the few companies whose customers "love them" - There are not many of these type of operations.

Not too late to buy I think as recently the price was 500p and I suspect ABDP will become worth a lot more a couple of year's hence. Ian

Thanks fegger
I will look out for it on the website you mention
Regards
Steve

millen

13th Jul '16

Barratt's (£BDEV) 30 June trading update this morning says they target a 3.5 year land bank

"The land market remained attractive throughout FY16 and we have secured excellent development opportunities that meet or exceed our minimum hurdle rates of 20% gross margin and 25% site ROCE(3).

In FY16 we approved £1,095.6m (2015: £957.0m) of operational land for purchase, which we expect to equate to 24,387 plots (2015: 16,956 plots). At 30 June 2016 the Group had a c. 3.4 year owned land bank and c. 1.1 year supply of conditionally contracted land. Going forward under normal market conditions, the Group continues to target a c. 3.5 year supply of owned land and c. 1.0 year supply of conditionally contracted land.

Our strategy is to seek to defer payment for new land where possible to drive a higher ROCE, and land creditors as at 30 June 2016 are expected to be c. 38% of the owned land bank (30 June 2015: 35%)."

I'm not sure that prices of development land are quite as volatile as Aurora's example suggests but this is only for illustration. To my mind, builders aren't conceptually that different from other manufacturers - they buy stuff (land, labour, materials, professional services.....), put it all together, then sell the finished goods - the difference is that lead times are several years and the end market (both demand and price) can decline materially over the long build cycle. I'd think traditional housebuilders operate to shorter timeframes than huge commercial development projects.

VegPatch

Hi millen,
I haven't read the Aurora post as I am on my mobile, but conceptually land prices should be the most volatile for a number of reasons:
1. The price paid for land is the residual in the housebuilding model. The builder knows roughly what they can get for the house and have a good idea of raw materials (bricks) and labour. There is also central overheads to consider and a financing charge. If house prices rise ahead of build cost inflation over the say 3 years it takes to deliver a site and the build costs have been largely fixed then all other things being equal the land is worth more. To deliver a house which sells for £100, gross margins are probably 50%, financing and central costs say 10% and a target EBIT margin is roughly 20%, which leaves 20% or £20 which can be paid for land. In 2 years if house prices have risen 20%, so now the selling price is £120, costs have risen a bit to say £55 per unit and financing and central overheads are now £11, assuming a static 20% EBIT margin, that and labour catch up with house prices over time, but land prices are always the most volatile.
2. Think about the cycle - at the bottom house builders are always in preservation mode, running down land banks to generate cash and ensure survival. As the cycle picks up they tend to run balanced books, only replacing land which is sold. Then as they fall into the "it's different this time" mentality they start to buy 'oven ready ' land (ie land with planning) like it's going out of fashion.

So it's cyclical !

A few other things - Bovis land bank is roughly 4 years plus a couple of years from strategic land.

Barratt - runs a shorter land bank, higher capital turn model, so benefits less from rising house prices

That is interesting thanks but it does not quite tie in with various reports I have read, there was a detailed study of builders land banks last year which I can't find at the moment, sure it said Bovis Homes (LON:BVS) had over 8 years. Anyway I did find this in the Guardian "Despite the fact the nine listed housebuilders hold more than 600,000 housing plots, they sold just 66,881 homes between them in their last financial year." This was 30/12/15. Seems some builders only count land plots when they have planning permission.

janebolacha

Extracts from Crédit Suisse sectorial note on housebuilders referred to in today's FT "Markets Live":

"Housebuilders: upgrade to benchmark
We see five supports for this sector:
1. Elements of valuation
We believe that the appropriate valuation parameter for the homebuilders is book value
(largely because they have a relatively short asset life). The P/B of UK housebuilders
relative to both US homebuilders and the market is now back to neutral levels, and the P/B
once we adjust for understatement of book value (because book value did not rise as
much as the normal relationship with house prices suggested) is close again to average
levels.
The yield relative of the sector has also picked up sharply back to historic average levels.
Looking at the long-run relative performance of the sector, around half of its
outperformance since 2012 has now been given up.
2. The sector seems to be discounting a 5% fall in house prices in the UK and
around 9% in London
If we look at the RICs survey, ex London or mortgage approvals they are both consistent
with a small fall in house prices of around 5% nationally, with Berkeley Group, the Londonfocused
homebuilder, apparently discounting an even greater fall in prices in London
The problem is that when house prices fall in nominal and real terms, they typically fall by
a lot more. Real declines in house prices have tended to last, on average, around 3 years
and in real terms house prices have fallen by around 23%.
We don’t think house prices will fall by as much as they normally do. Historically, to get a
major correction in housing you have needed overvaluation, rising rates and a decline in
employment. Currently, overvaluation is apparent only in London and the South East (as
we discuss below), and the cost of servicing a mortgage continues only to decline. That
said, employment does seem likely to fall.
? Outside London, valuations are not stretched
Data from Halifax suggests that while the house price to earnings ratio in London is now
over 10x (having previously peaked in 2007 at around 6.5x), outside London valuations
are not yet back to previous peaks. In the North of England, the house price earnings/ratio
is at 4.3x, down from a peak in 2007 of around 6x.
According to data from Lendinvest, yields outside London remain attractive when
compared to mortgage rates. Rental yields range from 4.8% in Yorkshire to 5.2% in the
North East and 5.4% in Birmingham, which we would consider attractive against an
average 2 year fixed rate mortgage rate of 1.9%.
On a national basis, the RICS sales to stock ratio (which leads house prices by c.6
months) is consistent with a rise in house prices and the Nationwide RICS survey with
inventory being particularly low.
? Interest payments as a percentage of income continue to fall
To get forced sellers you need employment to decline, rates to go up or banks to call in
defaulted mortgages. We doubt the latter two would be allowed to happen. Interest
payments as a percentage of income continue to fall. Prior to the 20% decline in property
prices in 2007-09, interest payments accounted for c.18% of income. Now, that figure is
below 8%.
? Falling house prices have tended to be associated with falls in employment
Historically, employment has tended to lag the housing cycle. We can see though that
employment would need to contract by c0.5% a year to get a fall in house prices.
3. In the long run, this is an undisrupted sector
Not only are there few alternatives to housing (although homes have been made in China
with 3D printers) but UK housing demand is almost permanently above supply. The UK
needs around 220K homes a year yet this year only around 155K homes will be built.
Indeed, every year since 1974 (outside London), supply has been below the required
demand. Moreover, the quoted players have increased their market share to almost 50%
which means that they are now much more disciplined and as our analysts, Harry Goad
and Samuel Thomas, point out, they are building 21% less homes than they were in 2009.
4. The government will likely try to support housing outside of London
The Help to Buy scheme for new build (which has accounted for c40% of new builds) has
already been extended to 2021 and we think it is quite possible that the funding for lending
scheme could be expanded. We suspect that the Help to Buy Scheme for existing homes
will be extended.
5. Short and long term price momentum
The sector is around 1 standard deviation oversold."

http://ftalphaville.ft.com/marketslive/2016-07-13/

Hi Herbie47, well I was a year out. Having looked at the annual report Bovis Homes (LON:BVS) did 3.9k units in 2015, and had a consented land bank of 19k units, so that gives a land bank of 5 yrs at current rates of production.
A direct quote from the annual report in this is "the group has between 4 and 5 years of owned consented land supply at current rates of production" and goes on to say there is a further 5 years of strategic land.
A strategic land bank is units with either outline planning or say on the edge of town that they hope will get planning one day. It can't be sold as land ready to build on, and some plots may never get planning. So its all ways best in my mind to discount this along the lines of a bird in the hand is worth 2 in the bush. My guess is the Guardian is counting both strategic and consented units in its figures.

Here is the link to the annual report http://www.edocumentview.co.uk/bovishomes2016/2016/131069/04adfb2e26a2496f9cef587b125fe1b0/BovisHomes2015.pdf
Always worth checking these things

Afzal

Hi
First experience well written and researched, I am looking the
Company's mentioned.

Paul Scott

14th Jul '16

Richard,

"Regarding the comparison of BOO vs ASC, Paul notes above that ASC EBIT margin is about 4%, potentially rising to 6%. I am trying to compare this with BOO's margins, which (if I understand correctly) are nearer 50%"

No, that's wildly, off the scale wrong, I'm afraid!

I think you may be mixing up gross and net profit margins possibly?

BOO makes a huge margin, of about 20% of turnover. But it then CHOOSES to spend about 10-12% of that on marketing, to drive growth, giving a net margin of around 9-10%.

There's another complication in that BOO is starting to do wholesaling to, e.g. Next Directory which is lower margin.

Also, BOO is doing international sales, and is gaining nice traction overseas, in some markets. USA is interesting, where they're doing alright, but v early stage.

My old employer opened some stores in Germany & Holland, and it gave me accounting headaches, as I had to set up overseas subsidiaries, bank accounts, payrolls, etc. However, what struck me most (this is about 20 years ago now) was how backward markets in Europe are. They didn't have business rates at all. Rents were cheap. So they operated on much lower gross margins. Bring in the Brits, and we cleaned up there, because we factored in much higher gross margins, so our shops were very profitable there.

I think the same thing is happening with BOO. They make great margins. Asos doesn't. Asos is like a bucket shop for other peoples' branded product - it shifts loads of it, but makes bugger-all profit margin. It's not actually a very good business at all. But the growth transfixes stock market investors - many of whom don't actually understand the rag trade at all.

BOO are brilliant rag traders. I know the people behind it. They're smarter, and sharper, than most other people in the sector. One to stick with, I think.

Regards, Paul.

Small Cap Value Report (12 Jul 2016) - ASC, GFRD, NRR, BEG, SOM, WJG, AVN, ABDP

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Paul Scott

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