Off the hook? McCarthy & Stone received a big boost this week after the government agreed to exempt builders of retirement homes from its proposed ban on ground rents. McCarthy & Stone is Britain’s biggest builder of retirement homes and the prospect of the ban, which had put about a third of its annual profits in jeopardy, had weighed heavily on its shares.
Down by as much as 35 per cent in the months after the government’s February proposal, McCarthy & Stone’s shares have rallied strongly for two days, rising a further 6 per cent or 7½p to 135p yesterday, as analysts, including at Peel Hunt, have begun to increase their profit forecasts.
Tempus recommended selling McCarthy & Stone shares in February, moving to a “hold” last month after it detailed a recovery plan. Is it time to rethink again?
McCarthy & Stone controls about 70 per cent of the market for building new retirement homes, putting up more than 2,000 of them a year, with an average selling price of about £300,000. It built its first homes in 1977, was listed on the stock market in 1982, was taken private in 2006 and relisted in late 2015 at 180p.
The government proposed its ban after it emerged that some landowners were sharply increasing the ground rents that leaseholders on their sites pay each year, a trap that meant homeowners not only faced unaffordable charges but also were unable to sell their properties.
McCarthy & Stone is not guilty of this, locking in its annual ground rent rises at stable rates over 15 years. The vast majority of its properties are leasehold, however, and almost all of them contain communal spaces such as lounges that are obviously appealing to those living in retirement villages. Being able to charge for them has been central to its model.
What it does is sell on the freeholds of its properties to third parties that will benefit from the ground rent income stream, using the money, about £25 million to £30 million a year, to build new homes. Under the process, it receives about £600,000 relating to ground rent per development. The cost of building a communal space on a site runs to between £1 million and £2 million a time, so being able to capitalise the future income means that it can offset one against the other and keep annual charges down.
During the course of this year’s uncertainty, McCarthy & Stone told investors that a ban on ground rents could reduce this year’s annual profits by about £33 million, or a little more than a third based on last year’s pre-tax figure of £92.1 million. Not only would it have been unable to raise development capital in the way it does, but over time it probably would have built fewer homes and pushed up its prices.
The builder had already taken steps to offset about half of the effect of a ban, including by renegotiating sale terms with landowners, but nevertheless this is very good news for McCarthy & Stone as it both validates its business model and removes a large amount of uncertainty from future earnings. Peel Hunt lifted its pre-tax profit forecasts by £15 million for 2010 and £20 million for the following year.
McCarthy & Stone is now the right side of two of its three problems. The ground rents problem has gone and it has, rightly, called a halt to an ambitious growth drive in favour of prioritising higher margins, increased returns on capital and lower costs. However, it has exposure to the second-hand property market (most of its customers have homes to sell) and this remains a worry, albeit less so because of its new option to part-own or rent. That, and the chronic uncertainties of the housing market, mean that it remains one to hold.
ADVICE Hold
WHY Shares are good value, but there are numerous worries in housing, even in the retirement market
Diversified Gas & Oil
The judicious ordering of words in its name means that Diversified Gas & Oil can avoid the rather unfortunate acronym of “Dog”. As an investment proposition, this company is nothing of the sort — and, in fairness, about 95 per cent of its business is in gas rather than the black stuff.
It was created in 2001 as an oil and gas production company in West Virginia and has been a spectacular growth story since it listed on Aim in February 2017 via a 65p-a-share placing that raised $50 million. It set the tone only 21 days after its float with the first of numerous acquisitions.
Diversified Gas & Oil has made no fewer than eight purchases, most notably in June buying assets from EQT Corporation, of the United States, for $575 million, its biggest deal yet.
Its proposition is intriguing. All of its assets are in America’s Appalachian basin, stretching across states including Kentucky, Ohio and Pennsylvania. Rather than exploring, it buys wells that are producing from the big US shale operators that are keen to get out of conventional drilling to concentrate on fracking. It manages the production process, often more cost-effectively than the previous owners, which retain the right to drill on the field more deeply using their preferred technique.
Diversified Gas & Oil has about 50,000 wells, some producing as little as 3,000 to 4,000 barrels of gas a day but with a guaranteed lifetime that can be as long as 50 years. It has been financing its deals through a combination of credit facilities and follow-on share offerings, including for $250 million at 97p a share in June.
The shares have suffered several recent hits amid press reports in Pennsylvania that it was facing closure and clean-up costs on finished wells of $100,000 apiece. The reality is more like $25,000 and the company is close to a firm annual arrangement with the Pennsylvania state department for environmental protection that will provide some certainty.
The shares, up ½p at 106p yesterday, trade at a multiple of 19.7 times earnings but have a forecast yield next year of more than 9 per cent. Compelling.
ADVICE Speculative buy
WHY Well-run, high-growth at low-risk end of the market
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