Sunday, 26 March 2017

Why UK Home builders are an amazing cartel!

"Then something awoke me.
The old man laid down his hand to light a cigar. He didn't pick it up at once, but sat back for a moment in his chair, with his fingers tapping on his knees.
It was the movement I remembered when I had stood before him in the moorland farm, with the pistols of his servants behind me.
A little thing, lasting only a second, and the odds were a thousand to one that I might have had my eyes on my cards at the time and missed it. But I didn't, and, in a flash, the air seemed to clear. Some shadow lifted from my brain, and I was looking at the three men with full and absolute recognition.
The clock on the mantelpiece struck ten o'clock.
The three faces seemed to change before my eyes and reveal their secrets. ////
'Whew! Bob! Look at the time,' said the old man. 'You'd better think about catching your train. Bob's got to go to town tonight,' he added, turning to me. The voice rang now as false as hell. I looked at the clock, and it was nearly half-past ten.
'I am afraid he must put off his journey,' I said."
 - 'The 39 steps' by John Buchan

Sometimes you just know something and can't explain it - until it reveals itself and you realise it has been standing there all along and you could not see it. This same thing happened to me today whilst looking at the UK Home builder Persimmon. I realised the UK home building sector is a cartel and it is a very British version of corruption. But it is corruption nonetheless. I don't mean the companies actually collude to restrict supply, they don't have to, the planning system does it for them.

Firstly; Persimmon is a great business! A really great business. The company has had stellar earnings growth and amazing returns on capital since 2012. This company has no debt, a £2.6bn landbank & WIP, a small gross pension liability and really high cash flow. I am questioning my short now (based on macro) and this is because all the other home builders have similarly low leverage, high returns businesses!

Now Persimmon is a home builder. Ordinarily construction is a bad business. Why? Well it is cyclical, capitally intensive, has no pricing power - due to competitive tenders and then the companies tend to carry huge debt loads to finance projects and generate some return on equity. So what gives Persimmon such high returns on capital employed?

Well principally they have pricing power and they also control their own pipeline of construction. This functions so well because of the strict and complex UK planning laws and the very nature of 'land' as an inexhaustible and finite resource. 

But Persimmon and the others are generating the high ROCE pricipally from the planning system; i.e having the clout and expertise to see larger tracts of land turned over from low value agricultural or other uses into high value development land - then you simply pop some homes on it and call yourself a 'home builder.' The returns are I would argue principally generated through land use change not construction.

In any business such high ROCE would be causing a huge influx of competitors and it would be driving down prices as supply floods the market to satisfy high demand. 

Persimmon Annual Report: Look at that ROCE!

But instead we have the big 6 home builders hoovering up profits at the expense of the common British serf. The UK press jabbering on about the big six energy companies are really missing the show here. The big six energy companies might cost a few hundred pounds a year from their activities, the home builders are costing people thousands.

Google Finance

The UK home builders are like the OPEC of house prices. They control the flow and price of new homes coming onto the market and they are aided in doing this by the planning system itself. Acquiring and developing land through the planning system takes years - so as a home builder you steadily control your pipeline of land projects to ensure you can tease out homes at the minimum rate thus commanding the maximum price due to their scarcity. Now throw in some well intentioned stimulus for the sector during the rough post 2008 period and then continue the stimulus for way too long (I wonder what the home builders political donations looked like since 2008) and you have a massive boom.

So why aren't more homes being built? Well small developers can acquire the odd site but most construction companies and builders are tradesman not businessmen and construction doesn't lend itself to scale. Therefore they are unlikely to gather together and lay their hands on enough capital to be able to acquire significant sites to move the home building needle. Even if one did start a new company today it would take years to develop the scale to be profitable waiting for land to gain the necessary permissions to even start the process of building.

Therefore the home builders have a huge barrier to entry.

This means UK home builders can sit on the finite supply of land, tease it out slowly in the form of finished houses and gain maximum price for each unit - much as OPEC tries to do by not pumping too fast - you only get the oil once.

Now of course the home builders do compete with all the existing houses in the UK for a market. Thus the general actions of central bank stimulus on interest rates and the fiscal stimulus to the wider economy and the home lending segment in particular has created a total bonanza of profits for the sector.

So what is the upshot from the OPEC comparison? Now this is my crucial point. Listening to Diego Parilla on the RealVision podcast pointing out how OPEC fails to control prices when oil prices fall is the key warning for the UK home building sector. Let me explain:

When oil prices fall OPEC nations need to sell more volume to make up the lost revenue (for example those generous Saudi social transfers) - they don't care if the price is $50 a barrel they just need to sell 2 barrels to get their $100. So supply increases - thus exacerbating the problem of falling prices. Well what happens when the background house price in the UK drops; these UK home builders then start to produce more homes to keep up earnings and returns, at lower prices, driving up supply when prices are falling. The current market structure is causing supply to be more constrained by high prices. Thus the risk of a housing bust is being exacerbated by the cartel structure of the UK home builders. Therefore a generalised 'healthy correction' fall in the wider UK house price level could kick off a dangerous cycle of oversupply - this is such an amazing paradox as it explains why with record high house prices we have record low house construction!

[Obviously oil supply is more easily increased than housing and the structures of the two markets are different but the oil collapse in 2014 is indicative of the turmoil created in a 'tight' supply controlled scenario. Therefore the sector is at risk of a generalized race to the bottom to sell inventory accompanied by land bank impairments as values fall. At least this time they aren't carrying huge debt loads like 2008.]

Why is it corrupt? Well a better planning system, more pressure on the sector to actually develop sites and increased incentives and competition could all disrupt this cosy arrangement. But to date I just see it being further perpetuated. It is a special sort of corruption we have in the UK. We don't do Latin style 'cash in the briefcase' corruption. Rather we keep it endemic - between the 'have land' and that 'have not land.' Who said the aristocracy are gone?

My previous argument is that put simply these companies are facing a cyclical peak in their earnings due to the likely deterioration of the wider macro from current levels simply because the current rear view mirror economic data has been so good. But structurally this is one amazing business and the person picking up the tab is the common homeowner.

Economics suggests the market should be flooding with new supply but the flawed regulatory and market structure in the UK means it won't be - and outsized profits remain for the home builders. Another risk is such outsize profits tend to attract government hungry for revenues (remember those oil windfall taxes!). 

However I can't see that happening as I fear the press would be too short sighted to perceive the benefit of taxing the sector when the popular narrative is 'we need to build more homes.' Maybe a rolling 'land bank' tax would work well to incentivise maximum development of land and disincentivise the sector from teasing out homes so slowly. Until then, what a stitch up for investors at the expense of the public!

Disclosure: Disclosure: I have a small short position in Persimmon Plc. These are opinions only, not investment advice. If in doubt read my disclaimer.

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