McCarthy and Stone (LSE:MCS) built its first owner-occupied retirement development in Milton Keynes in 1977. Five years later it joined the Unlisted Securities Market and two years after that obtained a full listing on the LSE. In 1988 it sold 2,596 apartments, more than it did in 2019.
In 2006 it delisted after being taken over by a consortium led by HBOS. Just before the Great Recession it completed 2,327 apartments (FY 2007). Over the next two years UK house prices declined by 20%, with completion volumes down 50%. It was thus difficult to persuade retirees to sell up and by a MCS apartment. And this was at a time when the company carried £900m of debt.
Despite cash saving measures such as reducing land buying, suspending construction, reducing the workforce from 1200 to 500 and renegotiating terms for land to be acquired it was unable to service the debt.
In 2009 the debtholders swapped some of their loans for all the shares in a new corporate entity which took all of MCS’s assets.
In 2015 MCS re-floated on the stock market with a £200m revolving credit facility in place after raising £76m from selling some shares. Market capitalisation was over £1.5bn (compared with £425m today).
Between 2015 and 2017 the chosen strategy was to go for extraordinary growth in the number of units produced and sold. The directors aimed to double to 3,000 apartments per twelve months and to get to a 25% return on capital employed. They never achieved either target. But they did raise costs while trying.
Return on capital employed was a very impressive 20% in 2015. In 2018 it was a less impressive 10%.
At the time of the 2015 flotation and through to 2017 the company concentrated on building for sale. It did not go in for building to rent, nor did it regard the management of the completed development and care services as a profit centre (there was an arrangement with a non-profit organisation for much of the care).
Today the main part of the business is to build and sell. But MCS is growing other sources of income, as the directors set out in the 2018 Report: “we will...aim to leverage our longer term strategic opportunities within our services and product offering. We will aim to create even deeper and longer relationships with customers to increase our customer appeal, diversify our revenue streams and reduce our exposure to market cyclicality. The long-term aim will be to create retirement communities that enrich the quality of life for our customers and their families and to become the UK’s leading developer, manager and owner of retirement communities.”
Management Services look after over 20,000 customers in 434 developments. MCS has a target of generating more than 5% of revenue from Management Services.
Typical service charges:
The rental side of the business was re-emphasised in July by John Tonkiss, CEO, in the 2020 interim report: “we will continue to focus on our long-term strategy to transition to a service-led organisation, offering a choice of tenures and a range of services – a strategy we know is the right one and which has supported our homeowners during this difficult time. We remain particularly excited about our rental offering in terms of its benefits to customers and increased attractiveness to investors.”
There are already over 200 rented apartments valued at £50m or so, generating a 6.5% yield. There are also 25 rent-to-buy and a score of part-rent-part-buy units.
MCS make a lot of money – up to £30m in a year – by selling the future ground rents paid by apartment holders. These are typically £400 - £500 pa per apartment fixed for 15 years. Increases are at 15-year intervals linked to the RPI, or, if greater, 2% pa. Leases are for 999 years.
The excuse that MCS make (and has been accepted by the government) is that the ground rents pay for the construction costs of unsellable communal areas, which usually account for 30% of the development space. Grounds rents are typically sold for £0.6m per development.
MCS remain the “head landlord” and “head leaseholder” even after the freehold is sold. This makes for continuity for homeowners ensuring they don’t have to deal with the third parties (e.g. pension funds) buying the ground rents.
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My last newsletter explained that McCarthy and Stone (LSE:MCS) was valued by Mr Market at less than net current asset value (I bought at 72p last week). The main reason for the plunging share price is fear among investors that MCS will, for months or years, not be able to sell its apartments. At any one time it has finished or currently in construction 1,500 – 2,500 apartments. It relies on retired customers being able to sell their old family homes in an property market. For a while Covid-19 restriction meant people had difficulty selling to finance the purchase of a MCS place. Perhaps the property market will freeze again and MCS will run out of money before recovery comes.
It has to be acknowledged that it won’t be easy to shift apartments over the next year or so, but the question for today is whether that difficulty is likely to be terminal for the business. We can start the analysis by looking at profits and cash flow
Profit and loss, 2016 – 2020
£m 2016 2017 2018 14 months 2019 H1 to end April 2020
Turnover 636 661 672 725 101
Cost of sales -500 -530 -567 -620 -109
Gross profit 136 131 105 105 -8
Other income 9 9 11 21 ?
Administration expenses -45 -39 -44 -64 -85
Other operating expenses -5 -7 -8 -14 ?
Operating profit 95 94 64 48 -89
JVs and interest -2 -2 -5 -5 -2
Profit before tax 93 92 58 43 -91
Tax -19 -18 -12 -9 17
Profit after tax 74 74 47 35 -75
Earnings per share 13.9p 13.8p 8.6p 6.5p -4.1p
Dividends per share 4.5p 5.4p 5.4p 5.4p 0
Apartment average sales price £000s 259 273 300 308 297(rounding to the nearest million causes some inconsistencies in additions. H1 2020 EPS is underlying – ignoring brand write-off)
Turnover is generally around £650m to £700m over 12-month periods, which represents sales of around 2,200 apartments. However, during the six months to 30th April sales more than halved due to lockdown. And the impact of the crisis on the second half is expected to be much greater. But the current mini-boom in the housing market might help with that.
Even before Covid-19, gross profit margin fell from 21% in 2016 to 14% in 2019. This was mainly due to a poor strategy of rapid expansion exacerbated by the economic malaise after the EU referendum. The strategy was changed in 2018 to concentrate on return on capital employed rather than revenue growth.
As well as the “cost of sales” increases the administration expense line shows the penalty paid for trying to greatly raise the rate of apartment construction and sales – admin rose from £45m to £64m. Operating profit margin fell from 20% in 2015 to 7% in 2019.
In the six months to end-April true total administrative expenses amounted to £20.2m which was only slight up on the same period in 2019 (£19.5m). The rest is exceptional items and amortisation of brand. Leaving that aside, because revenue is down so much administration expenses (underlying) as a proportion of revenue grew to 20% compared with 7% in 2019.
Operating profit, prior to Covid-19, declined from over £90m to £48m for full years. The Covid-19 freeze in sales and a large write-off of brand value caused an operating loss in the H1 2020. Ignoring exceptionals the operating loss would be £25m at the interim stage.
Dividends have been stopped as one of managers cash conservation measures – see later for other measures.
Profit after tax and earnings per share halved before Covid-19. But the 2018’s strategic change should address that – see below.
The average sold price for an apartment fell in the six months to the end of April 2020 by about 3%. Most of that period was unaffected by Covid-19, so I deduce that the price falls were pretty large in the spring.
Overall impression: This company had a £387m market capitalisation when I bought in last week. It has demonstrated an ability to produce annual earnings of over £70m after-tax, but profits were headed in the wrong direction even before Covid.
Now that Covid is here managers have rejigged so that cash burn is down to about £7m per month.
When MCS floated on the stock market in 2015 the prospectus stated that managers intended to raise the number of apartments constructed and sold from around 1,500 per year to 3,000 per year. And they were going to do this within a four-year timeframe.
It turned out they were wildly ambitious. They increased costs, strained the organisation and cut corners. And even then, found they could only raise annual sales to 2,302 (the best year was 2017). The chairman and CEO leading that strategy have now gone.
The new team announced in 2018 that their emphasis would be to “shift away from volume towards buying quality land with margin enhancing potential as opposed to being focused on quantity of sites [and] to actively manage our land bank to less than 4 years supply to meet our new steady state volume targets of c.2,100 units per annum…a shift in business mindset … to increasing ROCE and margins…rightsizing the operational cost base…Focus on build cost reduction and developing a more efficient sales and marketing model.” (2018 Report)
The cost reduction and cash saving programme began two years ago has proved helpful in providing some protection in the 2020 downturn.
Cash flow....………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
McCarthy & Stone’s (LSE:MCS) shares have fallen from 290p in 2016 to 72p. The precipitous fall since March has pushed them significantly below net current asset value per share. Furthermore, the main current assets (valued at £709m) are properties held by the company either ready for sale apartments to elderly folk, rentable assets or land with planning. Even if I allow for the possibility of a severe property recession by knocking off one-third of the balance sheet value of that property the market capitalisation of £387m is less than the net current asset value by a comfortable margin of safety.
Because most property companies are reliant on borrowed money the sector has been rejected by Mr Market. But is there really a high risk that MCS will be unable to finance itself in a severe recession?
At first sight borrowing looks high at £198m (a revolving credit facility to March 2023, with interest at Libor + 1.6% or 1.7%). But then you look at the cash balance and see what the managerial team have done. They are prepared for a period of 2.5 years of no sales at all by building cash up to £147m. Net borrowing is only £54m.
Additional preparation comes in the form of arranged access to another £300m under the government/BoE Covid Corporate Financing Facility. MCS can sell commercial paper with a term of 12 months. Drawdown can take place any time until 23 March 2021.
Currently, cash balances are so high that they do not need to draw down the CCFF. In fact, they probably never will because they are still selling property despite the Covid-19 restrictions.
Thus, I’m confident that with a 70% share of the independent retirement living market MCS will survive the recession. Even better, it might find plenty of site acquisition opportunities at low prices over the next two years especially near or in town centre locations, e.g. shops up for sale.
The Business Model
MCS build and sell (with a few rented) retirement properties for communities of retirees. They have experience of constructing over 60,000 since 1977. Annual output is, in non-Covid years, over 2,000 apartments.
After the sale of apartments MCS provide management and care services. The care is not like that in a care home – MCS provide independent living in retirement with a social circle. Care it’s much simpler than in old-people’s homes. It merely consists of things like one hour of cleaning per week, entertainment events, a bit of shopping, helping care for pets, changing bedding, safety cameras, 24-hour emergency cover and on-site restaurant meals.
MCS generally buy brownfield sites near town centres to accommodate around three to four dozen apartments on 0.5 – 3 acres. Average selling price c £300,000.
To help sales along MCS frequently (recently as much as 49% of the time) buy in part-exchange the old family home of the retiree. These are quickly sold on – the time taken………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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