Taylor Wimpey - too much too soon?

If you'd asked me to nominate one of the stand-out stocks of 2009, it wouldn't have been a housebuilder. Enterprise Inns, perhaps, or Punch – the bombed-out pubs groups – or commercial property stocks once they'd raised their rescue funds in the first quarter; but a housebuilder? No way!

And I was badly wrong about that, because Taylor Wimpey's share price performance has been nothing short of fantastic. From 4.26p at the bottom, in December 2008, to 54.9p in August this year. It's come off since then, but that's impressive performance even by tech stock standards!

The operating performance, though, still looks dire – as you'd expect in this sector. TW has taken massive writedowns – it made a £1.8bn loss in 2008, £1012.8m of which was represented by a writedown on the value of its assets, and there was a further £527m written off in the first half of 2009. That's in addition to a poor trading performance from its housebuilding activities in the UK, US, and Spain.

TW's creation by the merger of Taylor Woodrow with George Wimpey,  marked pretty much the top of the market, on 3 July 2007. By early 2008 it had become clear that the group needed to refinance – having originally tried to raise fresh capital through a placing,  it couldn't manage to raise the equity, and was forced to renegotiate its debt financing. That involved various one-off arrangement fees as well as increased rates of interest payable on the debt.

It was also probably pressure from lenders that led to TW's exit from the construction business. The sale of UK construction activities to Vinci raised £74m in cash, giving a £56.6m profit on disposal – a pretty small amount in the context of a £1bn writeoff. Construction in Ghana represented another loose end that was tidied up, leaving the business with just housebuilding, admittedly a geographically diverse portfolio.

Subsequently, the group has been able to raise equity funds successfully, with a £500m cash call in May 2009 – the commercial property sector had already proven investors' appetite for risk was reawakening. That helped cut net debt from £1.7bn in mid-2008 to just over £1bn now. But the company still has 73% gearing, which is uncomfortably high – for most of the last six years it's been running with 30% gearing or less. And it's not really producing much cash at the moment, so further reductions in debt don't look achievable unless some of the family silver is sold off.

That may be why the sale of the North American housebuilding business has been mooted, according to a report in the Sunday Times [ref] Sunday Times 4 October 2009: http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article6860323.ece [/ref] . This could raise another £560m, which would halve gearing (in the absence of any changes in asset value, of course). North America – including a substantial Canadian business as well as operations in the US – accounts for about a third of group sales, so this would be a major deal.

And it appears a feasible one, as judging from TW's latest results, the American business is on the turn. Interim results showed selling prices increased by 10.2%, though legal completions continued to fall (a decline of 7.7%) - even better, margins increased from 4.8% to 5.2%, so that EBIT actually increased. TW reckons it is the tenth largest US housebuilder, with 28,815 plots in the land bank [ref] Interim results presentation [/ref] , which should make it an attractive acquisition or merger candidate. (The difficulty for a purchaser, of course, will be getting the funds – though with the Dow back over 10,000, that might be not as difficult as it might have been earlier this year.)

In the UK, too, trading has improved. The order book at the interims was two thirds higher than last year [ref] Investors Chronicle, 5 August 2009: http://www.investorschronicle.co.uk/Companies/ByEvent/Results/Analysis/article/20090805/41a1a046-81a7-11de-9111-0015171400aa/Could-this-be-the-last-Wimpey-writedown.jsp [/ref] , which is a remarkably good bounce, and looks better than the market average. Even so, the order book as a percentage of revenue had fallen from 35% in 2007 to 23.5% in 2008 – despite lower revenues –  so forwards visibility is worse than it had been. [ref] Annual report, p2: http://www.taylorwimpey.com/main/cms/includes/asp/CMFileGetFile.asp?fi=4258 [/ref] However, a £938m order book is still well below the £1.3bn level seen at the end of 2006.

Interim results showed an average selling price of £171,000, with prices down 19.3% in private sales (that is, everything that isn't social housing, where the price actually rose very slightly). Unit completions fell 25.6% - and this is where the real damage was done, with social housing volumes down 45%. [ref] Interim results presentation: http://www.taylorwimpey.com/main/cms/includes/asp/CMFileGetFile.asp?fi=4282 [/ref]

The price for private sales seems to have stagnated rather than continuing to fall – the peak was £203,000 in 2007, so we're 16% below that, but we seem to have been there for the past three half-year periods, pretty roughly.  What intrigues me, though, is not the average price so much as the mix of prices. Only 3% of completions in the first half of 2008 were represented by properties worth less than £100k – by the first half of 2009 this had increased to 17% of the total, while properties over £500,000 in value scored not a single sale, and the price bands between £300k and £500k also look very threadbare. The top end has really shrunk [ref] Interim results presentation [/ref] . That gives TW a massive skew to the bargain end of the market, which could play in its favour if the mortgage market really loosens up.

TW has managed to achieve some substantial cost reductions. It's gained 10-20% cuts in quotes from subcontractors, and a 50% cut in administrative overheads [ref] Interim results presentation [/ref] , though materials costs haven't moved significantly downwards. 13 out of the 39 UK regional offices were closed during 2008, and staffing was cut from an average 9727 to 8069. At the same time the company expects to get significant benefits from product efficiency and redesign, especially on the ex-Taylor Woodrow product, though as far as I can find out management hasn't released any estimates.

Okay then, there's something of a recovery story here. And it's backed up by a large land bank, which after all those writedowns must be fairly conservatively valued. According to management, the company has a short term development land bank of six and a half years at current completion levels [ref] Interim report 2009 [/ref] , against a traditional 4 year holding. Then there's another eight and a half years of strategic land supply.

But are the shares already up with the story? Some analysts think not. Morgan Stanley for instance thinks the shares are worth 64p [ref] The Guardian, 8 October 2009: http://www.guardian.co.uk/business/marketforceslive/2009/oct/08/taylorwimpey-barrattdevelopments [/ref] .

The difficulty lies in working out what the business is worth, given that it's currently loss making and most analysts expect a loss for both this year and 2010. Operating margins are still low, and it has a ferocious interest bill to pay; plus, the business has now lost in two years twice as much as it made in net profit in the previous three. Even if the market continues to improve, it's got a big hole to dig itself out of.

And what really makes me worried is looking at the long term track record, the business doesn't seem to have done all that well out of the property bull market. You'd expect EDBIT to have grown dramatically from 2004 to 2007 as house prices rocketed – in fact,  it declined marginally every year throughout the boom, with operating margins falling from 15% to 10%, then to just 2.5% in 2008.

That leaves us only the asset value to base an investment decision on. According to the interim report, the asset value is 44p a share – just above the current share price. The way I'm looking at it, over the next two years, that 44p will be reduced by trading losses, perhaps to about 38p – so I'd need to see a 10% rise in house prices, and hence asset values, to make up for it. (Yes, I know that's a bit back-of-envelope, but I haven't got time for a 3000-cell spreadsheet.)

And I don't really believe the bull story. Things are getting better – but I don't think they're getting 2006-style better. The issue for me is a simple one. The whole sciencer of economis is about demand and supply. Taylor Wimpey's chief executive Peter Redfern claimed in the last annual report that there was a structural undersupply of new housing in the UK [ref] Annual report, page 11 [/ref] . That's true, if you compare 252,000 household formations against 200,697 new homes built in 2008.  But the problem, as he admits, is one of affordability - 'many of those looking to buy homes remain unable to obtain an appropriate mortgage'. I have a feeling that is not really going to change in the short term – and if unemployment increases further, we could see the current slight uptick in the residential property market fading out again.

So I'm afraid I shan't be investing in TW any time soon – not unless things really do change.