Persimmon (PSN.L) - A Resilient Business At An Attractive Price But Not A Sleep Well Investment
The UK's largest homebuilder of affordable homes has been time-tested over multiple crises trading cheaply. However, it doesn't look like it can create value over the long-term. Avoid.
Persimmon (PSN.L) is one of the largest homebuilders in the UK. It builds homes under three brands and is known for selling more affordable ones with an average asking price of 20% below peers. What’s unique about Persimmon is that it has the most established off-site manufacturing of timber walls, roof tiles, and bricks, essentially a vertically integrated business.
The business benefits from a structurally undersupplied UK housing market where there has been no real solution for the lack of high-quality housing for over a decade.
The business is also resilient and has improved operationally since the great financial crisis in 2008. It has survived the worst period in the housing industry, and the company and balance sheet have transformed, with margins improved markedly. The latest financial update also shows an excess cash balance sheet of nearly £1B, giving a solid buffer as it prepares for a higher interest rate environment.
I believe the valuation is attractive at the current price (£14/share) and might offer an upside for nimble investors who can time the market (not us).
However, Persimmon is not a sleep-well investment. I don’t think it can compound value creation in the long term. British peers are scaling up their off-site manufacturing capability to close the cost advantage with Persimmon. Additionally, compared to the US leader, NVR Inc (NVR), it shows Persimmon’s improved business is still very inefficient.
Persimmon may appear more profitable and generous with its capital allocation to shareholders. Still, its inability to turn over cash and reinvest at a high rate means there is a limit to how big it can grow and how much value it can return to shareholders.
**This article may not give you an investment idea today, but it may help you avoid a bad one, which is just as important.
My following analysis will feature a business with a score of 16/20, an anti-fragile company with a dominant market share of ~70%, a 25%+ ROIC capital allocation record over 20 years, and, importantly, can be acquired at an attractive price. You can also access my previous analysis, VAT Group, which passed as an investment at publication.
A resilient business
Founded in 1972, Persimmon is one of the largest homebuilders in the UK, among Barratt Development, Berkeley Homes, and Taylor Wimpey. Their operations are more or less the same. They buy land, apply for planning permission and build homes.
Revenue makes up the average selling price and the number of homes sold, and costs are mainly materials and labor. There is very little differentiation between businesses.
Source: gurufocus (FY2021 income statement)
However, Persimmon is a more resilient business than the others. Since the Great Financial Crisis, it has thrived by bringing more construction off-site, resulting in improved margins and a rock-solid balance sheet.
In detail, it was the only business that survived the Great Financial Crisis in 2007/8 without external capital. During this challenging period, housing sales volume and prices declined by 50% and 30%, respectively. All home builders’ revenue fell 50% the following year and was trapped in a highly levered balance sheet. Most took over five years to recover to the pre-crisis level. Despite the harsh climate, Persimmon was the only one that generated positive free cash flow (see table below) and the only one with the excess cash to repay all its debts aggressively. In 2010, three years after the crisis, Persimmon was debt-free and reinstated its generous dividend policy without diluting shareholders (!).
Source: FY 2011 Annual Report
What the company has done well is it has used the experience to transform the business. Between 2010-2015, PSN.L replenished its landbank at reasonable prices and restarted building; it took them seven years to recover to the pre-crisis level. Once the market improved, it used the excess cash to expand off-site manufacturing operations, starting with timber frame walls, roof tiles, and brick factories. In effect, it became a vertically integrated business. The shrewd strategic decision cut building time and cost and improved margins markedly. Gross margin improved to a high 20% level from high teens, and net margin improved to nearly 20% from the single digit level. Return on capital investment has also doubled to over 20%. More importantly, it alleviates the industry-wide problem of shortage of labor and critical materials. The new business model proved its value as Persimmon only had a moderate impact from the supply disruption during Covid time.
The final two factors that make Persimmon a resilient business are the huge excess cash and its product. The balance sheet has over £800M of cash with no debt in the latest financial update. That is an inversion from the situation in 2008 when it had £1M of cash and over £800M of long-term debt. Persimmon is well-position to weather whatever comes in the current housing decline.
Finally, Persimmon’s market position is safe because it builds the most desired homes. Over 50% of Persimmon homes are entry homes for first-time buyers under the Persimmon brand, with prices 20% lower than the UK average. These are more affordable and, unfortunately, are also severely under-supplied. In a downturn, the average sale price would not decline drastically.
Structurally undersupplied market
Since 2010, the UK government has targeted building 300K houses, but only 200K were delivered yearly, creating a shortfall of about 1.2 million homes.
Source: House of Common
Interestingly, housebuilding today is only half of what it was in the 1960s, while the population has increased by 25%.
Source: House of Common
To make matters worse, 54% of UK homes (27M) have poor energy ratings (D or lower EPC ratings), amongst the poorest insulated in Europe. Moreover, it also has the oldest housing stock in Europe, with 38% of houses built pre-1946, compared to 24% in Germany and 11% in Spain.
The situation is a massive opportunity for Persimmon as its homes are the quickest and cheapest to build (which comes with quality issues). The UK government will also want to support the industry to push for the net zero climate change target by 2050.
No sustainable competitive advantage
Persimmon’s transformation to a vertical business since the great financial crisis has helped lower costs and shorten construction time. However, I don’t see Persimmon’s cost advantage in this commoditized market to sustain and create long-term value more than peers. Persimmon’s ROIC is currently superior to peers; see the charts below.
Barratt Developments, Berkeley, and Taylor Wimpey also have off-site manufacturing facilities. Barratt aims to deliver 30% of its homes using this modern method by 2025. Berkeley also produced its first modular homes in 2022. Meanwhile, Taylor Wimpey has over 20% of its timber frame walls built off-site. Persimmon is more established, but once the peers catch up in scale, Persimmon’s advantage will fade away. And perhaps so will the sales volume and margins.
It’s tough to build a sustainable competitive advantage in a commoditized industry. And if there is one closest to achieving that, it would be NVR Inc (NVR), the largest homebuilder in the US. Persimmon could take a leaf from its playbook, but it would require another significant business transformation.
Look at the gap in revenue per share and operating cash flow per share (OCF/share) between these two companies over the last 20 years.
NVR has increased revenue per share and OCF per share by 750% and 1900% compared with 80% and 168%, respectively. While both business processes appear the same - buy land, apply for planning permission, build and sell, their ability to create value is a world apart.
NVR grew its business top line by 8.5x while Persimmon remained pretty much the same over the last 20 years. Persimmon’s building output has never crossed 16 thousand homes per year.
The underlying reason is that NVR has been reinvesting its capital more efficiently. It doesn’t buy land outright like Persimmon, thus, doesn’t have to lock in a huge chunk of capital upfront for years from build to delivery of the completed homes. Additionally, the disparity in efficiency is evident as NVR’s inventory turnover is four times faster than Persimmon (3.70x vs. 0.85x), and the cash conversion from inventory to receipt of cash payment is 322 days shorter, 78 days vs. 398 days (!). NVR enjoys a much higher capital velocity which helps to create more value than the UK leader while requiring minimal idle cash. The effect magnifies when it also reinvests more of its capital to work.
Persimmon may not have a high-quality business model like the US leader, but the investment case is still strong for investors with a shorter holding horizon. I believe the market is overly pessimistic about Persimmon. Even assuming the worst-case scenario like 2007/8, I value Persimmon at £18/share. In a more moderate recession and faster recovery, I value the business at £21/share, providing substantial upside in both cases.
My assumptions for the worst case emulate the 2007/8 crisis numbers. I assume the market crashes in 2023, causing house completion to drop by 50% and real house prices to drop by 20%. I also assume the recovery to take eight years to get back to pre-covid levels. In this case, earnings before interest and tax (EBIT) would drop to 4% and recover to 25% by 2027, with Capex at 1% of Sales, Negative Net change in Working Capital at 4%, WACC at 9%, and Terminal Growth at 2%.
Source: DTF Capital
Persimmon’s P/E multiple averaged 12x in the past decade. So, by 2032, net profit is estimated to be about £630M, implying a £7.6B market cap.
Both valuation methods imply some margin of safety from today’s price (£14).
-Slower recovery: completion volume and house prices collapse even further, and recovery takes longer than eight years.
-Execution risk: inability to acquire high-value land and planning permission (current supply is 4.5 years’ worth) and build good quality homes.
-Macro risk: the industry is highly cyclical - driven by factors outside of the company’s control, such as the level of interest rates, mortgage availability, government support measures, and changing customer preferences (covid brought about flexible working and the ‘search for space’).
-Sustained shortage of critical materials and a shrinking skilled labor force continue to impact the construction industry.
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Sleep Well Investment scorecard
Let’s see how Persimmon fares under my Sleep Well Investment stress test.
This final step aims to filter out only businesses that can perform over multiple economic cycles and keep winning market share. Inspired by Nassim Taleb’s anti-fragile concept and studies from various reputable investors and hedge funds, it divides investment criteria into three groups in order of importance:
Business quality [13 points]
Competitive position and risks [4 points]
Valuation [3 points]
Points are deducted for an unconvincing corporate mission, commoditized products, and intense competition and business risks.
The following table shows how I assess these categories and the corresponding Persimmon score.
No business gets full points, but from 13 points, I rate a business as robust and investable. A score above 15 means the business is anti-fragile, thus, time-tested. A score above 16 points means the business is both anti-fragile and durable, which likely keeps it winning against competition and future external shocks. Below is how much capital I am comfortable allocating to my portfolio accordingly.
13 = robust business - 1% of the portfolio at cost-basis
15 = antifragile business - 3%
16+ = sleep well business - 5%
Additionally, scoring high doesn’t automatically mean an investment. Each stock would need to have a price below the required margin of safety point. A quality asset must be offered at an attractive valuation; otherwise, it would not make a good investment. Each to its own, and all method has trade-offs. No investment or checklist is perfect.
Persimmon scores 10/20. It fails to make the grade in durable moats and capital allocation. It also gets punished by strong competition from Barratt Developments, Berkeley, and Taylor Wimpey. The valuation looks attractive at £14/share and can offer an upside in the short term. However, I prefer to own a business with stronger moats that can compound value creation over time, so Persimmon isn’t my cup of tea.
Persimmon’s investment case is grounded mainly on a low price. I am not convinced (yet) that it can create long-term shareholder value once the asymmetry between the current price and intrinsic value closes.
I also find Persimmon’s cost/scale competitive advantage perishable. Its British peers are catching up as they also open off-site manufacturing facilities. Thus, it needs to look at its US peer for inspiration, which I believe is a much higher quality business and potentially a better investment long-term (currently not at a reasonable price).
Thank you for getting this far. This article may not give you an investment idea today, but it may help you avoid a bad one, which is just as important.
My following analysis will feature a business with a score of 16/20, an anti-fragile company with a dominant market share of ~70%, a 25%+ capital allocation record over 20 years, and, importantly, can be acquired at an attractive price.