British housebuilder Barratt Developments (OTCPK:BTDPF) remains solidly profitably and has an attractive yield – for now. The question for me is whether things can stay that way in the face of an uncertain outlook for the housing market in Britain.
I last covered Barratt in an October 2020 piece “sell” piece (Barratt: Upbeat Outlook But Mixed Prospects) since when it has fallen 29%.
The Macro Picture for U.K. Housebuilding
The question for Barratt and its peers at the moment is what comes next in the housebuilding market in the U.K.
Investors who were around during the 2007-08 financial crisis may recall that the Barratt share price fell more than 90% in under a year from its February 2007 peak.
For now, things look better than then. The economy is stronger than it was then, there is arguably a bigger gap between demand and supply in the U.K. housing market and there is not yet the nervousness about banks that there was then. Nonetheless, storm clouds have been gathering over the U.K. economy as elsewhere and already this has affected the outlook for the housebuilding sector.
Barratt’s completions last year fell 3.9% and revenue rose only 1%, return on capital employed fell sharply (30.0% to 22.2%), and the total dividend fell.
Looking forward, it noted in its annual results that “short-term demand has been impacted by mortgage affordability challenges” and talked of “an uncertain trading backdrop in FY24”. It is targeting 13,250-14,250 new home completions in the current financial year. That would be a fall of 17-23% on last year which had already seen a 4% fall versus the prior year.
Barratt is not an isolated case and indeed is not even amongst the gloomiest sounding for now, by some distance. Persimmon (OTCPK:PSMMF) saw new home completions fall 36% in the first half, Crest Nicholson issued a profit warning in August and described conditions as “challenging” and noted that “trading conditions for the housing market have worsened during the summer of this year”, while Taylor Wimpey (OTCPK:TWODF) ludicrously headlined its interim results as a “resilient first half performance” despite completions year-on-year falling 26%, revenue 21% and pre-tax profit 29%.
Looking at that overall picture, several things become clear which are pertinent when considering the current investment case for Barratt as well as sectoral rivals. Sales have been falling sharply, due primarily to mortgage availability and the ability and willingness of buyers (especially first time buyers) to raise the necessary funds and put them into a transaction, selling prices have broadly held up alright so far (which does not mean that that will continue to be the case) and the outlook is not promising.
Barratt and the Macro Picture
There are better and worse large operators in the sector when it comes to balance sheet strength and business models. But what is clear, as happened in the financial crisis, is that if there is a prolonged downturn in the U.K. housing market, nobody will escape unscathed, including Barratt.
The full-year figures for last year show that in some ways the company continues to do well.
Barratt remains firmly profitable and indeed increased pre-tax profit to over £700m. It improved its margins slightly and basic earnings per share grew.
On top of that, for now at least the balance sheet is strong. Net cash at year end of over a billion pounds was only 6% lower than the prior year end. That represents over a fifth of the current market cap of £5.2bn.
But the company will need a cost focus, solid balance sheet and its wits to prosper in the current environment. As at 27 August, it was just 49% forward sold with respect to private wholly owned home completions for FY24 compared to 62% at the equivalent stage last year – despite targeting a much reduced level of completions for the year.
The risk here is simple but potentially hugely destructive: a deep crash in the U.K. market for newbuild housing could see profits wiped out across the sector, including at Barratt. History tells us that builders (who do not want to scare off potential buyers thinking that waiting could get them a bargain) maintain an unrealistically cheery prognosis about where the market might go until one day it is obvious to everyone that the bottom has fallen out of it and sectoral profit will be decimated for years. I am still not convinced that that risk will materialise. Although U.K. housebuilding is clearly seeing much lower demand, there are still counterarguments. The economy has been weak for several years already but has avoided a deep recession. The demand and supply mismatch persists (although I think that argument is overstated: there is high demand for everything from Tiffany rings to Learjets but demand without ability to pay doesn’t pay any bills) and although demand is sharply lower it remains sizeable. But things look ominous to me and the nature of housebuilding means that, if builders need to keep things going to cover fixed costs during a downturn (which they do, albeit at a reduced level) we may see increased discounting, reducing profit margins and leading into a vicious circle on pricing.
Clearly some investors like the balance sheet, cost focus and ongoing sales at Barratt, where the shares have moved up 25% in the past year.
Even with that price gain, that means the shares now offer a dividend yield of 7.8%. The company paid out £360m as dividends last year and the net cash outflow for the year was £70m (on top of a net cash outflow of £183m the prior year) so even if market conditions stabilise I have doubts about the sustainability of the dividend. With markedly fewer completions forecast for this year, I expect that cashflows will worsen and see the current dividend as being at risk. If things deteriorate faster than the market currently foresees, I doubt next year’s dividend will match last year. Persimmon already more than halved its (admittedly huge) dividend alongside a profit warning in the Spring and while it had historically targeted a very high payout ratio, I see it as the canary in the coalmine.
The P/E ratio for Barratt stands at 8 but the question is how resilient the earnings are. We simply do not know and history is not encouraging. Last time around in the financial crisis, the firm crashed to a massive loss. It grew steadily from 2014 to 2019 and has been moving, unsteadily, downhill since then. I expect the earnings picture to get worse given the company’s perspective on its current year completions, with the possibility that any pricing downturn would further damage earnings.
Given the weak outlook for completions and the market uncertainty, I think even 8 looks like an unappetising P/E ratio for the builder and retain my “sell” rating.
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