Persimmon: Affordable Homes Builder Leveraged To Lower Rates (OTCMKTS:PSMMF)

Alongside the rest of the UK homebuilding sector, Persimmon Plc (OTCPK:PSMMF), a leading builder within the affordable home niche (via its core ‘Persimmon’ brand) and to a lesser extent in upmarket homes (via its ‘Charles Church’ brand), has rallied strongly towards the end of last year. Fundamentally, it’s a timely reminder that the housing sector is ultimately a call on interest rates. So as badly as the stock has been hit by ‘higher for longer’ rates in recent years, the pivot toward rate cuts means a cyclical housing recovery may have only just begun.

In the meantime, Persimmon management has been pulling its weight and then some, as its FY23 trading update showed. Building on a net cash balance sheet and attractive land bank, the company is as well-placed as ever to capitalize on protracted mortgage rate declines going forward. Persimmon is also unique in its leverage to a volume recovery – achieved via its outsized exposure to the hardest-hit lower-income and first-time buyer segment. The upcoming UK election is a key catalyst; the usual supply-side hurdles remain, but housing is increasingly becoming a ‘hot button’ issue and I wouldn’t be surprised to see renewed policy support pre and post-election.

A Solid Finish to FY23; Guidance Bar Moves Higher

Persimmon recently pre-released a strong trading update for 2023 (ahead of full-year results in March). Key highlights included 9.9k home completions, which, despite still being down YoY, came in ahead of prior guidance. Pricing was also solid at GBP255.75k (up ~3% YoY), though the combined impact of lower volumes, input cost inflation, increased incentives, and other one-offs kept a lid on operating margin expansion in the back half of 2023. The group’s cash balance also finished the year strongly at GBP420m; even after accounting for GBP380m of land creditors, there’s plenty of buffer here against the “highly uncertain” market condition caveat.

The more important takeaway, in my view, is that forward-looking numbers are already trending in the right direction. At year-end, private sales in the order book were up ~11% overall and ~4% in value to GBP499m (equivalent to 1,877 units). Management also cited a favorable response to its Boxing Day campaign, which has yet to flow through to the numbers. In any case, a pick-up in demand at the ground level is welcome news, given the current ‘work in progress’ pipeline (~4.1k equivalent units built). Assuming the accompanying guide for lower build costs also holds true, Persimmon looks well-placed for more positive earnings revisions in the coming months.

Monetary Policy – From Headwind to Tailwind

UK house prices have been battered over the last year or two and, in real terms, are well below their peak levels. This shouldn’t be too surprising – housing prices are, after all, a function of rates, and the UK central bank, the Bank of England (‘BoE’), has embarked on its steepest hiking cycle in decades. The heavy lifting is done, though, and with inflation largely back under control, the path is now clear for a policy reversal. In line with the Fed’s dovish U-turn (three cuts this year per the official ‘dot plot’), the BoE now looks set for a similar pace of rate cuts over the coming months.

To be fair, market expectations have also run slightly ahead, and the four/five cuts currently priced into implied overnight rates for 2024 (see chart above) are likely well-understood by the market. What likely isn’t priced in, on the other hand, is the impact of mortgage rates, which, while slightly lower than before, have yet to fully adjust. Neither has the broader UK economy, with real wage growth only just turning positive and GDP largely flat YoY. All things considered, the bar is low and that means betting on a UK housing recovery remains compelling. Having been among the hardest hit (both on earnings and valuation) from the last round of hikes, by virtue of its focus on affordable homes, Persimmon should lead the way higher as rates reverse.

Don’t Count out Optionality from Fiscal Policy

Counterbalancing the lower rates call, at least in the near term, is the prospect of looser fiscal policy – starting from the upcoming Spring budget. Recent news flow, for instance, has pointed to incremental income tax cuts and further stamp duty relief (on top of Chancellor Hunt’s Autumn Statement extension). Yet, the scale of these measures seems too modest to derail a BoE easing cycle. And for all the talk of fiscal space, debt and deficit levels are still quite high (metrics the incumbent government has been very much focused on per PM Sunak’s ‘five pledges’), so I don’t see too many hurdles to rate cuts later this year.

The long-term optionality for housing is even more interesting, in my view. For context, housing affordability is a major issue in the UK, and as a result, ramping up the annual housing supply target appears to be a bipartisan goal. Housing Secretary Michael Gove’s toughened stance on council planning (historically a key hurdle to supply expansion) was a case in point, though he did fall short of committing to the government’s original 300k/year target (vs the current 200-250k/year pace). This issue will only get worse if recent record migration numbers are any indication, and political pressure to ramp up housing will likely only intensify from here.

To be clear, a quick resolution to the planning stalemate is unlikely anytime soon, but the rate of change is clearly skewed in the right direction, and there will be big winners and losers going forward. Persimmon, by virtue of its targeting affordable housing supply, is, in my view, a prime candidate to benefit from favorable policy action – whether it comes pre- or post-election, any signs of progress here will help the stock.

Cyclical Recovery

By all accounts, Persimmon’s trading update capped off a resilient FY23 – outside of a YoY decline in completions (albeit by a lower margin than expected), the P&L and balance sheet (strongly net cash) have held up remarkably well through a challenging backdrop. Now that rates are finally set to decline, though, the same headwinds that weighed on the UK housing sector will reverse, and by virtue of its exposure to affordable housing, Persimmon is a prime candidate to ride a cyclical recovery. The stock may have rallied in recent months but at a historically discounted ~20% premium to tangible book, this is still a name with ample space to re-rate further – particularly heading into election season.

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