Stockwatch: A share full of upside surprises

Is it time to favour the smaller housebuilders? A Conservative majority government is likely to be seen as favourable for the industry, with smaller firms offering more select exposure and scope to leverage profits than mid to large caps. Mind that small caps can be a bull trap if the housing market does turn down, which is why investors want evidence of a decent probability that the cycle has legs.

Such factors help explain the five-year chart in MJ Gleeson soaring during 2013 especially, when investors saw small caps as a powerful play on George Osborne's Help to Buy initiative transforming the housing market. A sideways-volatile trend followed for over a year as more evidence was awaited. The surprise general election result is a key reason for Gleeson shares currently edging up to 408p from 347p earlier this year.

Similarly, a latest survey shows the asking prices for homes slipped during the election run-up but are likely to rise again.

Northern/Southern England, dual strategy

Gleeson has two divisions: building affordable homes in the North of England which contributed 66% of group profit on 87% of group turnover in the financial year to end-June 2014; and "strategic land" trading of greenfield sites in the South, representing 34% of profit on 13% of turnover.

Management justifies this dual approach by way of exploiting low land prices in the North, to build homes for people on low incomes (circa £125,000 selling price), while "strategic land" exploits the high prices house-builders are willing to pay for quality sites in the South. Arguably both activities have positive long-term economics because Northern jobs/salaries can't pace rising house prices, hence more affordable homes are needed; while such is the supply/demand imbalance for building plots in the South, their market price will keep rising.

Mind there could still be short-term negative cyclical influences: e.g. some 42% of Gleeson's home sales are linked to the Help to Buy scheme which some economists regard as an unsustainable prop, versus house-builders who reckon it has been a necessary catalyst amid recession.

Setting the context, a latest trading update, shows Gleeson Homes with 41 active sites compared with 37 last year, and talks to acquire a further 13 sites adding 1,855 plots to a total 7,750 in the pipeline. The strategic land side, meanwhile, has capability to deliver 20,900 plots. The board is confident of "substantial improvements in the group's trading performance in both the current year and beyond" with underlying profit either meeting or beating expectations according to the timing of land sales.

Financials offer "growth at fair price"

This is no bargain-basement stock, but you won't find any such house-builder now the industry has enjoyed a few years' upturn. The realistic challenge is more determining which companies are able to surprise on the upside. Gleeson's prospective price/earnings (P/E) is in the mid-teens (see table) and the dividend, while growing strongly, implies a yield only just over 2%.

So the hope is mainly towards capital appreciation unless the board moves to distribute a higher element of earnings. The company is actually in a good position to do so, enjoying around 100% conversion of operating profit to cash which exceeds its 80% target over the last five years. (The table shows a volatile trend in net cash flow per share due to land/plant/equipment purchases to enhance earnings.) Gleeson's earnings rating also likely benefits from this strong cash conversion profile.

Results for the six months to end-December 2014 showed £8.4 million cash-at-bank despite a £5.5 million outflow as inventories (new homes) rose by £5.8 million to £106.6 million, in context of £128.9 million net assets. Another benefit of strong cash conversion is the group having negligible debt hence the interim net interest charge was just £68,000.

While interim pre-tax profit of £3.9 million looks scant relative to N+1 Singer (Gleeson's broker) forecasting £17.5 million for the 2014/15 year, there was a strong second-half weighting to the last financial year and the board has just indicated the possibility of beating expectations - so the prospect ought to be sound. While the implied profits uplift is in excess of 40%, housing completions are up 30% and the strategic land side appears to have considerable momentum in both sales and replenishing the portfolio.

Employment and planning consent, seen as key risks

While interest rates and mortgage availability continue to be supportive, Gleeson regards "uncertain employment prospects in some geographic areas" as its principal risk - implying a widening North/South divide in the economy. Indeed, Northern Britain has a higher element of public sector employment, potentially exposed if a Conservative government is serious about cuts to help reduce the public deficit/borrowings. In reality, Osborne started his chancellorship ambitiously to get public finances under control, yet public sector net debt has risen by just over 50% from £960 billion in April 2010 to £1.5 trillion this last April. Whether the Conservatives will genuinely take a knife to the public sector and endure some political flak, remains to be seen.

Variability in dates for planning consent is another risk mentioned, although this appears to relate more to timing of cash flows than any real change in the underlying trend.

Independent broker targets 15% upside

At 408p a share Gleeson trades at a 2015 high, if still down on 455p just over a year ago. That’s quite a premium to the last declared net asset value of 240p a share, but perception is now more about earnings. Independent broker Liberum Capital targets 469p, which appears fair now that a Conservative government should benefit confidence, allowing momentum in Gleeson's markets to continue.

For more information see: mjgleeson.com.