Turkey of the week: debt-laden house-builder

By Paul Hill Sep 11, 2009

Paul Hill

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News from the UK housing market is steadily improving, with selling prices stabilising and mortgage approvals up. So maybe we shouldn't be surprised that Barratt Developments' share price has jumped by more than 500% from its December lows. But this optimism looks misplaced – and here's why.

Firstly, by 2010 the UK will suffer a double-dip recession in which house prices fall further, which will trigger more land impairments for the already debt-laden firm.

Next, the recent 'stability' has been largely caused by lower-than-expected numbers of repossessions as low interest rates have enabled more people to keep hold of their houses.

But joblessness will keep rising, and borrowing costs will at some point return to more normal levels. When this happens, there will be another flood of distressed sellers.

Barratt Developments (LSE: BDEV), rated OUTPERFORM by Credit Suisse

Another problem is the poor availability of mortgage finance. This was reflected in the latest Bank of England figures, which showed that UK personal debt (still a Himalayan £1.45trn) fell in July for the first time since records began in 1993.

Finally, while there's plenty of talk of improved visitor levels and lower cancellations this year, profit margins are still under pressure because of the incentives on offer. Indeed, Barratt has had to resort to vendor financing, in the form of hefty part-exchange deals or ten-year interest-free loans. This would become a major drag if property values were to dive again.

Given Barratt's relatively high (around 50%) weighting towards apartments (the epicentre of the sector's woes), I would rate the group on an eight times through-cycle operating profit (assuming a 10% margin verses 2% currently) on turnover of £2.3bn.

After adjusting for the £1.28bn debt load and the £62m pension deficit, this gives an intrinsic worth of roughly 150p a share – 40% below today's level.

Worse still, it's likely that the firm will be forced into a dilutive rights issue in order to buy land on which to build future homes. With its lenders having the whip hand, the board has little room for manoeuvre. The shares look more bubble than bedrock. Annual results are due out on 29 September. 

Recommendation: SELL at 278p

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Published in Tips & advice | More articles by Paul Hill

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