QUALIPORT
Qualiport Avoids Housing Boom

By Maynard Paton (TMFMayn)
February 27, 2003

Do house builders make good long-term investments? That's the question many investors are now asking. The sector is currently characterised by a rare combination: strong, growing profits and single-digit price to earnings (P/E) ratios.

Mainstream

Aided by the buoyant property market, just about every listed builder has churned out good results over the past few years. Barratt Developments (LSE: BDEV) for instance has doubled sales and pre-tax profits in the past four years alone. Yet at 407p per share, Barratt's forward P/E is a little over 5. But for seekers of quality companies, sustainable competitive advantage, not valuation, should be the primary consideration.

Sad to say, but mainstream builders such as Barratt have little in the way of an operational moat. To the ordinary man in the street, there's little product differentiation; one rabbit hutch estate looks very much like another.

While the builders may point to their designs, construction techniques and brand, the number one consideration for the typical 'greenfield' house buyer is location. Land though is unfortunately a finite commodity. The big builders may still be able to get the best sites, but only by outbidding smaller rivals.

Old age

For long-term players, niche builders are the best bet, with McCarthy & Stone (LSE: MCTY) probably the most attractive.

With a 75% estimated market share, McCarthy is the country's leading builder of private retirement housing. The developments are essentially blocks of one- and two-bedroom apartments, designed with the independent pensioner in mind - at least one occupant of each flat must be 60 or over. Underpinned by the cheerful property market, McCarthy has delivered a decent financial performance of late:

Year to August 31st            1998    1999    2000    2001    2002

Turnover (£m)                 107.1   123.4   147.0   167.5   187.8
Operating profit (£m)          29.7    39.6    51.0    60.3    75.9
Pre-tax profit (£m)            28.5    39.1    53.5    60.5    75.4

Earnings per share (p)         17.3    25.3    34.7    39.2    49.2
Dividend per share (p)          4.5     6.3     8.7     9.7    11.4

Operating margins at 40%, an incremental return on equity of 28% and a £38m net cash pile are the financial highlights. Signs, then, of a decent business? Well, they're certainly signs of a decent house builder. In terms of the company moat, these points probably apply:

* Reputation: McCarthy built its first retirement homes in 1978. The company's established name must count for something;

* Management: After a hiccup in the early 1990s, Keith Lovelock became chief executive in 1993 and has since steered the company to recovery/prosperity. He and his team must know all the do's and don'ts of this particular building niche;

* Service: McCarthy developments also come with various residential services, so newcomers will need to brace themselves for a long-term commitment to customer care (not a common feature in the house building industry), and; 

* Diversification: Mainstream builders moving into McCarthy's patch risk the threat of operational distractions through diversification.

Land cost

While any builder's recent accounts may appear great, they can be a little misleading. As reported profits are drawn up on a historical cost basis, long lead times between land purchases and the final property sale can 'inflate' profits.

The next table shows the recent trend of unit sale prices and land costs at McCarthy:

Year to August 31st             1998    1999    2000    2001    2002

Units sold                     1,320   1,470   1,536   1,550   1,671  
Average unit sale price (£k)    77.6    80.2    89.5    99.0   112.0

Land held for development (£m)  28.8    33.1    63.7    96.3   115.9
Land bank (units)              2,745   2,910   3,525   4,734   5,015

Cost per land unit (£k)         10.5    11.4    18.1    20.3    23.1

Hindered by planning red tape, it tends to take three or four years after McCarthy purchases a plot of land before the final resident moves in. (Unlike mainstream builders, McCarthy has to complete every unit on its developments before the first buyer can move in).

While the annual results use that year's sale prices, the associated land cost is based on the original purchase price of a few years back. McCarthy doesn't reveal the exact historical cost figure for 2002, but going on 1998-2000 prices, it could be somewhere around the £15,000 per unit mark. During the twelve months to August 2002, McCarthy admitted the average cost of land purchased that year was £25,100 per unit.

An indication of what could happen to McCarthy's profits if house prices plateaued would be to adjust 2002 profits for the £25,100 figure. Thus: 1,671 units multiplied by £10,100 (the difference between £25,100 and the estimated £15,000) gives £17m. Subtract that from the 2002 operating profit of £76m, and you get a 21% shortfall. Sooner or later, the rising cost of land will catch up with McCarthy. Read more.

Cash

The next table highlights working capital movements at McCarthy:

Year to August 31st            1998    1999    2000    2001    2002

Operating profit (£m)          29.7    39.6    51.0    60.3    75.9

Change in
  working capital (£m)         (2.0)    5.0   (16.0)  (27.5)  (32.4)

After 1999, more and more cash has been used to fund an increasingly large land bank. Not a problem if house prices continue to rise. A big problem though if they fall.

Summary

McCarthy has carved out a good niche in what is generally a ho-hum industry. The firm has a definite edge, although growth in demand for decent retirement housing may attract more rivals down the line.

The main issue surrounds the company's finances. There's the 'historical land cost' affect on profits and as the working capital table shows, the requirement for significant upfront investments in land. This is all part and parcel of the industry, but it all brings extra question marks (and thus extra risks) to the investment decision.

All in all, it's difficult to envisage McCarthy as a 'quasi gilt', a company that could perpetually spit out all of its cash to shareholders. At the moment, McCarthy has enough land for (i.e. can only generate profits for) another five years, so perhaps its forward P/E of 6 (at 322p) is warranted. McCarthy also lags in the Qualiport's repeatedly good investment test, too.

In conclusion, there are plenty of high margin businesses around with obvious competitive advantages, but whose accounts don't suffer similar issues. Is McCarthy a Qualiport contender? No.

More: McCarthy & Stone discussion board