Stockwatch: 20% potential upside and 7% yield

Are shares in housebuilder and construction group Galliford Try (GFRD) now in a recovery trend after a near three-year fall from over 1,800p?

Galliford Try has been afflicted by various exceptional costs from construction projects like cost/time over-runs, sullying a generally resilient performance. There was also equity dilution by way of a 1 for 3 rights issue last February at 568p, raising £150 million to deal with exceptional project costs of the Carillion debacle, also to exploit growth opportunities.

A near-33% discount to market price implied investors needed some incentive though. While cost/timing over-runs are an inherent risk of the construction industry, a latest trading update affirms more settled news in context of a 7% dividend yield covered twice by projected earnings.

There’s also a fair cash flow record and modest capital spending needs, thus the stock is edging up in a sense the bad news-flow is stemmed and a lower yield may be justified for current risk.

Probing for equilibrium between yield and net assets

At 970p, Galliford is rising steadily from February’s 800p low, having spent six weeks to end-March in a volatile-sideways range up to 1,025p.

Since early April there has been a linear recovery trend from 840p, with the 22 May update now citing “strong operational and financial performance…making good progress against growth plans to 2021…the group is well capitalised with a strengthened balance sheet to support our planned growth.”

The operational narrative reads well: Linden Homes’ sales remain “encouraging at 0.71 units per site per week”, also with ongoing margin improvement; Partnerships & Regeneration is benefiting from strong demand; Galliford is also on course to move on this summer from a major road by-pass project at Aberdeen, responsible for more recent exceptional charges and delays – bad weather in February and March causing the latest aspect of cost pressure.

Mind, however, the stock’s 175% premium to tangible net asset value, reflecting a mature house-building cycle sustained to date by mortgage subsidy and low interest rates. Goodwill and other intangibles accounted for 31.3% of net assets as of end-2017.

I’m sceptical of the 478p per share figure in databases (see table) since this would have been derived from the last published figures i.e. interims to end-December 2017, whereas post rights issue the number of shares has increased from 82.5 million to 110.3 million, thus tangible net assets per share of 353p.

So, valuation involves a dichotomy between a 7% yield and a big premium to net assets, some would say is a cautionary factor in terms of the long-run house-building and construction cycle. This aspect isn’t unusual relative to similar stocks, except in its extent, and partly relates to a supportive macro context of Help to Buy and low mortgage rates.

Market equilibrium price is, therefore, a probing between these two key measures, with low interest rates also encouraging investors to respond to the yield.

Galliford Try – financial summary               year ended 30 Jun           Consensus estimates   2013 2014 2015 2016 2017 2018 2019 Turnover (£ million) 1,467 1,768 2,348 2,495 2,662     IFRS3 pre-tax profit (£m) 74.1 95.2 114 135 58.7     Normalised pre-tax profit (£m) 73.8 93.5 118 132 145 173 192 Operating margin (%) 5.1 5.7 5.2 4.9 5.3     IFRS3 earnings/share (p) 69.8 93.0 111 131 58.7     Normalised earnings/share (p) 69.4 91.0 115 127 163 138 136 Earnings per share growth (%) 23.3 31.0 26.8 10.5 27.7 -15.1 -1.3 Price/earnings multiple (x)         6.0 7.0 7.0 Historic annual average P/E (x)   14.2 14.8 10.6 9.4 6.3   Cash flow/share (p) 0.6 68.0 48.9 98.6 138     Capex/share (p) 6.3 8.2 8.1 -3.0 5.3     Dividend per share (p) 33.0 40.0 60.0 72.0 88.0 70.0 68.0 Dividend yield (%)         9.1 7.2 7.0 Covered by earnings (x) 2.2 2.3 2.0 1.8 1.9 2.0 2.0 Net tangible assets per share (p) 456 494 502 540 478    

Source: Company REFS                    Past performance is not a guide to future performance

Closure on Aberdeen bypass may also provide a catalyst

Since total over-run costs on the Aberdeen Western Peripheral Route (AWPR) have absorbed some £150 million of group cash, getting shot of this project will remove a millstone from Galliford’s neck.

The 22 May update mentions “good progress on site, with progressive handover of sections of road underway” albeit “some further cost pressure from weather delays, likely to increase the exceptional charge in the current year.” This should, however, be lower than the £25 million charge taken in the first half year, and the project is expected to complete this summer.

The AWPR drain on resources compares with Galliford’s end-2017 net cash position of £112 million, albeit with a big balance of £1,351 million cash versus £1,238 million bank overdrafts.

The calendar year-end debt profile had been 86% short-term weighted, for net debt of £84.9 million, which generated a net interest charge of £4.4 million covered 19.5 times by first-half year operating profit. The latest update cites “average net debt below the guided figure of £275 million excluding the additional cash raised”.

Thus, Galliford is not currently hampered by finance costs in respect of its debt, although the substantial short-term element is potentially an issue according to the extent UK interest rates rise in due course.

All divisions declared on track for profits growth

Linden Homes is marginally ahead like-for-like in terms of £1,183 million sales reserved, contracted or completed, and its landbank is up by 450 plots to 11,750 plots. All plots are secured for 2019 together with 77% of plots for 2020.

Partnerships & Regeneration, specialising in affordable homes and community-style builds, is ahead more significantly by 42.3% in terms of like-for-like sales reserved, contracted or completed. This may reflect project timing issues, but also general UK demand for more affordable housing, i.e. Galliford being well-positioned. Its landbank is up by 51 plots to 2,918 plots and the contracting order book is up 17.3% to £1.15 billion.

By comparison, the Construction side’s order book is down 5.7% to £3.3 billion, albeit with “encouraging performance on current projects” and a similar 71% of financial year 2019 revenue secured.

20% upside based on a risk de-rating to 6% yield

Galliford’s operations now come across well and full-year profits are in line with the current range of expectations. A case can, therefore, be made for the stock both as a medium-term ‘trading buy’, able to grind higher as the market accustoms to shock-free news, also with scope to lock in the present 7.2% prospective yield.

A 6% yield would for example imply a market price of 1,150p, representing near-20% upside based on a total payout of 70p per share. Moreover, this consensus may be conservative relative both to past years and earnings cover.

The forward price/earnings (PE) ratio is a modest 7 times, but obviously such a blend of low PE and high dividend yield, versus a premium to net asset value, is quite typical among housebuilding and construction stocks.

Conservative income investors may fret, inherent cyclical risks demand a more cautious view; but that’s why such a stock is priced for a relatively more generous yield than most well-established businesses. You have to decide whether the sector is for you if preferring stocks to tuck away.

There’s a modest 3.7% of stock out on loan: of three hedge fund groups involved, two marginally increasing and one reducing its position.

I wouldn’t read much into that beyond one respecting news flow is improving versus a modest (if mixed) valuation, and two possibly taking a bearish view on the sector. Thus, for fairly risk-tolerant investors. Buy.

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