Taylor Wimpey RNS

As per yesterday's post, TW have announced:

• They are raising equity, probably via a placing and open offer. No surprises there.
• They have renegotiated their financial covenants, to remove the EBITDA interest cover requirement, and replace it with one based on operating cashflow. Good - they had essentially no chance of meeting the EBITDA cover.
• They will write-down assets by £660m. Suspect this is just the first of many write-downs.

http://production.investis.com/taywim/regulatory_news/rnsitem?id=1214805927nRnsd8167X&t=popup

So no surprises there. This is a good first step to TW's survival of a UK recession. Now we need to see how much cash they can generate over the next 6 months.

Taylor Wimpey - Open offer

The Telegraph and the Times are reporting that Taylor Wimpey is finalising a £400m - £500m open offer:
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/29/cnwimp129.xml
http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article4232047.ece
(the Times reports bank debt of £1.9bn, but I think they're confused - £800m of that is debentures).

Good news if they can avoid the dragging out of a rights issue - and per my last post I thought this sort of cash injection would be needed as a condition for banks relaxing their financial covenants.

According to Berkeley, land prices are down 25%:
http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article4227871.ece

Accounts
So where will this leave TW's accounts? Taking the numbers from mid-2008 in my last analysis:

Inventory: £5.4bn (this assumes they are depleting their land bank and slowing new builds)
Receivables: £300m
Cash: £200m

Current Payables: £600m
Non-current payables: £300m
Debenture loans: £800m
Bank loans: £1bn
Retirement benefit obligation: £200m

Assets of £5.9bn, liabilities of £2.9bn.

25% land write-downs would suggest about £1bn write-down on inventory. A £500m injection of cash would mostly go to paying down bank loans. So things might look something like this:

Inventory: £4.4bn
Receivables: £300m
Cash: £300m

Current Payables: £600m
Non-current payables: £300m
Debenture loans: £800m
Bank loans: £600m
Retirement benefit obligation: £200m

Assets of £5bn, liabilities of £2.5bn. Net debt is £1.4bn, vs. net assets of £2.5bn - gearing of 56%. The key challenge is then to keep things on an even keel throughout the credit crunch.

Prospects
Let's look at two potential outlooks for the next couple of years.

Positive scenario
A mild recession spreads across much of the world. Falling demand means that oil prices fall back to under $100 a barrel. The pressure on inflation in Britain eases substantially. The Bank of England keeps interest rates at 5% for the remainder of 2008, and then makes some modest cuts in early 2009. Particular sectors in Britain such as construction and retailing lay off workers, but these are not enough to substantially affect the economy at large.

In 2009 the economy begins to pick up in the US. Subprime-related write-offs are reversed at some institutions that have taken the biggest hit, such as RBS. Large, well-capitalised banks begin to compete harder for mortgage business.

House prices undergo a prolonged, slow decline, falling 20% peak to trough. Construction costs fall along similar lines, due to widespread unemployment in the construction sector. Land prices fall by 40% peak to trough. Lower interest rates start to have a galvanising effect towards the later half of 2009.

Taylor Wimpey rides out the slowdown, keeping margins at around 10%. Gradually volume begins to pick-up.

Negative Scenario
Oil prices continue to soar. The inflationary pressures cause the Bank of England to raise interest rates to 7% by the end of 2009. Significantly higher mortage payments lead to widespread economic malaise. Repossessions and bankruptcies spike. For those without at least 30% equity in their homes, mortgage rates are approaching 10%.

House prices fall 50% peak to trough. Barratt and Taylor Wimpey are forced sellers of land, driving prices down 90%, and causing all indebted housebuilders to breach financial covenants. Ruinous debt-for-equity swaps leave existing shareholders holding pennies. Meanwhile, small builders with no debt snap up land on the cheap, and take advantage of plummeting construction costs.

Conclusion
We live in interesting times.

The 4 Cs

What makes a bad company? My answer is the 4 Cs:

Cyclicality
The company sells a product for which demand is strongly cyclical. During a downturn their sales plummet.

The company's margins are wafer-thin, so they have no room for cutting prices to boost demand.

The company has high fixed costs.

The company has a negative tangible book value, and no reserves to help them see out a downturn.

Competition
The company produces a generic product which is easy for others to copy.

The company is not the lowest-cost producer.

The company has many competitors.

The company does not have a strong brand.

Capital
The company requires substantial capital investment in order to expand.

The compant is heavily leveraged and pays a high price for it.

Competence
Management is inexperienced in the sector or over the business cycle.

Management takes credit for successes and blames failure on external forces.

Warren Buffett
This has come across a very Buffet-esque post. WB invests in companies that avoid these pitfalls, like GEICO, Coca-Cola, Gillette, etc..

Me
Most of my purchases have looked at value rather than the real quality of a company. I've been reluctant to pay a high price for a great company. Perhaps that's because prices really are too high, or perhaps I've not paid enough attention to the 4 Cs.

RBS - Has operated with insufficient capital, and that cost me as a result. Management has blamed problems on the "unprecedented" credit crunch, when this seems to be a normal part of the credit cycle.
TW - This does badly on most of the tests.
ZRX - Broadly speaking I think ZRX avoids most/all of these pitfalls.

I'll take another look at some quality companies that are moderately priced, and see if I am interested.

Keeping score

Keeping score
Here's a simple question. How important is the purchase price of my investments?

Here's a simple answer. Not at all.

For a long-term investor (which I am, or would like to be), there can't be any debate about this. Once I have put down my money, the deed is done. If I own 1000 shares in company XYZ, it doesn't matter if I paid 1p or £1 for them. Any decision to sell the shares, or buy more, must be purely rational based on the current share price, and not take any account of my purchase price.

The only reason to keep track of the purchase price (besides tax reasons) is to keep score. Interesting, perhaps. But not relevant to any future decisions.

I need to be on my guard here. My instincts are to place huge weight on purchase price:

• Not wanting to sell at a loss. This would be tantamount to admitting a mistake, which is hard to do.
• An urge to average down when share prices fall. If I'm 50% down I want to double my investment so that I'm only 17% down.
• Not wanting to increase my holding at a higher price than my initial purchase. If I'm 50% up I don't want to double my investment and end up only 25% up.

Now this doesn't mean that it is irrational to buy more shares when the price falls - as long as I'm doing it for the right reasons, i.e. because I have spare cash and want to increase my holding because the share is good value.

Equally if I buy shares at a 50% discount to true value, and they then shoot up 80% without any change to the real value, then there is no point buying at only a 10% discount.

Timing

An attempt to rough out my investment strategy for the next 2 years.

H1 2008

I would like to build a reasonably diversified portfolio. But I want to buy shares cheaply. I think the next few years will give me the opportunity to do this. I need to be on my guard for opportunities as they arise, but I need to be patient as well.

So far I have a large number of bank shares, bought too soon. Patience would have paid off here.

I have a moderate number of building shares, bought too soon. Patience was definitely warranted here.

I have a large number of chemicals shares. No particular timing problems.

I have a large number of diverse IT shares. No particular timing problems.

I have a small number of pub shares. These are hard to call - I think they will probably go lower. I have probably bought too soon, but will be patient before buying more.

I have various ETFs. No particular timing problems.

H2 2008

I have some money left to invest. I will get some more in a month or two. I will get more in November, and a lot more in January.

For the moment I think my focus should be on increasing my ETF investments. I think a 50/50 split between ETFs and my own choice of shares is a reasonable split. I'm currently at 28/72. I will try to focus on that for the rest of the year.

H1 2009

I will look at bank shares again in the light of a full year's results. I believe RBS's earnings will remain robust, and that banking shares may be amongst the first to benefit from a recovery.

If a general bear market has been in force, I will look at defensive shares such as GSK, DGE, in the hope of picking them up on the cheap.

I will look out for any heavily oversold quality shares in sensitive sectors such as housebuilders, big-ticket retailers, etc..

H2 2009

In the hopes of recovery I will look at builders, retailers, office owners and others that have suffered in the downturn, trying to pick up a mix of quality companies well placed for a recovery.

H1 2010

Assuming a recovery is taking hold, I will look at companies that will benefit from expaning corporate investment: software services, building supplies, etc...

Ouch

Not a good day today:
RBS down 9%
ZRX down 8%
TW down 19%
GNK down 4.%
QDG down 5.5%

Overall I'm down 6% on the day, and 20% in total. Not pretty.

It's very depressing to see such a sea of red, and I can't help wishing that the prices would go back up to near where I bought. But that's not rational - I'm going to be a net buyer of shares for the next several years - I want them to be cheap. It's obviously unfortunate that I bought shares a few months ago when I could be buying now and getting (a lot) more for my money, but I don't pretend to be able to time the market.

Are there any genuine reasons to be concerned?

• Does the market know something I don't? I'm pretty sure insider trading does go on, so this could indicate that something is happening that I'm simply unaware of. If I was going to believe this, then I'd have to give up investing altogether, on the basis that I could never beat the market. I'm not ready to do that just yet.
• Have I miscalculated and bought at too high a price? True as this might be (and I'm not convinced it is), waiting for the share price to tank before making such a judgement is clearly the wrong way to approach things.
• Will the share price affect the prospects for the company in question? This is the key question, and for some companies the answer is clearly "yes". Let's examine that in more detail.

How can a depressed share price adversely affect a company's prospects?

To take a far from random example: Taylor Wimpey (Barratt would be an even better choice but I know more about TW). TW's balance sheet is essentially:

£0.82bn intangibles

£6bn inventory

£0.85bn receivables, cash, tax and other assets

Assets = £7.67bn. Net tangible assets = £6.85bn.

£2.08bn payables (inc tax)

£1.55bn loans

£0.33bn retirement obligations and various other miscellaneous liabilities

Liabilities = £3.96bn.

So at the moment TW has net assets of £3.71bn, and net tangible assets of £2.89bn.

TW's inventory is split £3.88bn land and £2.02bn development costs, with the rest fairly miscellaneous stuff that I don't understand.

A typical house's price at the moment is made up:

25% land

15% gross margin

60% construction costs

So that £2bn development costs represents about £3.3bn worth of houses. About £700m of the land will be part of them.

Let's assume house prices fall 20%. What can TW get for its inventory? £2.64bn. Its other land might be worth only £640m (an 80% fall). That would suggest TW's true inventory value might be just £3.28bn, for net tangible assets of £4.13bn. That leaves TW only just solvent, and with gearing close to infinite.

Assuming they successfully reduce both assets and liabilities somewhat, they could end up with tangible assets of £2.5bn and liabilities of £2.25bn. Net debt of £1.2bn, but net assets of only £250m. To get gearing back under 80% they would need a cash injection of about £600m.

TW's market cap at the end of today's trading? £554m. Tricky to raise more capital than the market says you're worth (but not impossible). If TW was valued at £2bn it would be a different story. If TW was valued at £5bn it would be dead easy. A lesson to be learnt there? TW was valued at about £5bn less than a year ago. How quickly things change.

Taylor Wimpey - Conclusions?

Further to yesterday's post on Taylor Wimpey. What banking covenants are they likely to have? I'm expecting:

- Minimum interest cover - EBITDA to interest costs: let's say 3 times. For 2007 this was just over 4. Are they dumb enough to leave themselves this little margin for error? Probably.

- Gearing - net debt to net asset value: assume no more than 50%. At the end of 2007 this was 38%. Again, a fairly small margin, but that wouldn't surprise me.

Expect both to be calculated at year end. Net debt will vary through the year, e.g. at the moment it is up to £1.9bn from 1.4, but I think they're expecting it to fall again.

So what does this mean for this year? My (very pessimistic) guess was something like a 40% reduction in volume and 50% drop in margins. That would mean profits drop to about £120m, combined with interest payments up to £180m. Not good!

At year end my numbers suggested net debt of £1.7bn vs. net assets of about £2.4bn. Again, not great.

So TW have a lot of debt in debentures with a long life. These shouldn't have any covenants associated with them, which is good. My estimate for end-2008 was for bank loans of £1bn. If my 2008 estimate happens I think they could be a bit scuppered there. A significant rights issue would almost certainly be a condition of renegotiating the financing terms. I'd imagine getting gearing back under 50%, i.e. a rights issue of £500m, or about 50p per share, would be required, and TW would pay higher interest costs in the short-term (so wouldn't see much reduction in interest payments in exchange for that capital).

I'm prepared for that rights issue to happen, and I still think the shares would be good value if it happens. However, I'm not going to go crazy and buy more unless I see some indication that things are improving, since I think I hold enough of this share at this point in the cycle. It could go a lot cheaper.