Report on Berkeley Group plc

3rd

February 2014.

Alan Ballantine, Patrick Herbst and Isaac Tabner.

Contents

1 Strategic Capabilities ............................................................................................. 1

1.1 Introduction ...................................................................................................................... 1

1.2 Assessment of Strategic Capability ..................................................................................... 1 1.2.1 General Strategy.................................................................................................................................... 1 1.2.2 Expansion Strategy ................................................................................................................................ 3 1.2.3 Lifecycle ................................................................................................................................................. 3 1.2.4 Key Change Factors (PEST) .................................................................................................................... 4

1.3 Industry Analysis ............................................................................................................... 6

1.4 Company Analysis ............................................................................................................. 6 1.4.1 Board ..................................................................................................................................................... 6 1.4.2 SWOT analysis ....................................................................................................................................... 7

1.5 Overall .............................................................................................................................. 7

2 Capital Structure .................................................................................................... 8

2.1 Debt ................................................................................................................................. 8 2.1.1 Operating Lease Commitments ............................................................................................................. 9

2.2 Equity ............................................................................................................................... 9

2.3 Pension ............................................................................................................................. 9 3 Cash flow Statement Analysis ............................................................................. 10

3.1 Net cash from operating activities £115.1m (2012: -£162.5m) ........................................... 10

3.2 Cash inflows from investing activities (2013: £7.2m, 2012: £63.5m) .................................. 11

3.3 Cash outflow from finance activities (2013: £58.2m, 2012: £164.6m) ................................ 11

3.4 Balance Sheet ................................................................................................................. 11

4 An Analysis of Company Operating Performance .............................................. 12

4.1 Profitability ..................................................................................................................... 12

4.2 Working Capital and Liquidity .......................................................................................... 13

4.3 Stock Market Standing .................................................................................................... 14

5 Prospects in comparison with its peers ................................................................ 15

6 Part B: Analysis of Employee Benefit Obligations ............................................. 16

6.1 Senior executives remuneration ...................................................................................... 16 6.1.1 Summary of directors’ remuneration.................................................................................................. 17

6.2 Post retirement employee benefit obligations (pensions) ................................................. 17

7 Case Study 2 Part C ............................................................................................. 18

7.1 Profit Forecast for the Year Ending 30 April 2014 .............................................................. 18

7.2 Notes to the Forecast ...................................................................................................... 19

7.3 Cost of capital ................................................................................................................. 19

7.4 Competitive assumptions ................................................................................................ 20

7.5 Forecasts of Dividends (and everything else) .................................................................... 20

7.6 C4 to C6: Valuation .......................................................................................................... 25

7.6.1 Base Scenario ...................................................................................................................................... 25 7.6.2 Valuation – Sensitivity Analysis ........................................................................................................... 26

7.7 C7 Relative valuation ....................................................................................................... 27

7.8 Share Price Performance ................................................................................................. 28

8 Overall Conclusion Part Includes part C8 ........................................................... 28

1

Part A: plus part B section 1.

In this report frequent reference is made to the Berkeley Group 2013 Annual Report, hereinafter (BKG

AR 2013) and to the interim results announcement dated 6 December 2013 (BKG IR 2013). Where

appropriate the note and page numbers will be cited for reference purposes. Note some references are

from dates post 3 February 2014 and have been included to provide a more complete and up to date

analysis.

1 Strategic Capabilities

1.1 Introduction

Berkeley Group Holdings plc (“Berkeley”, or “group”, or “company”) is a company operating in the

construction industry specialising in the building of high quality residential homes and other schemes. Its

main market is London and South East England where it has built up an extensive knowledge of the

market over a period of more than thirty years. The narrative suggests the directors have no intention of

expanding outwith this geographical area since it is clearly and area they understand the market very well.

A quote from the accounts state:

“The Berkeley Group Holdings plc (“Berkeley”) is a developer of residential-led

mixed-use schemes, with a history of creating successful, sustainable places.” (BKG

AR 2013, p1).

The majority of its developments are on Brown field sites1 or recycled land and the company is keen to

portray itself as one that adopts good ethical and environmental policies. Without doubt the company has

been successful historically and the latest annual report and interim results show strong figures.

The year-end of Berkeley is 30 April and the results for 2013 show a turnover of £1,373m (2012:

£1,041m) producing an operating profit of £280m (2012: £226m) and profit after tax of £210m (2012:

£158m) (BKG AR 2013, p87). It employs, on average, 1,326 (2012: 1,139) staff (BKG AR 2013, p95)

and the basic EPS is 160p (2012: 121p).

The share price is 2,547p with a PE ratio of 15.9, which compares to the sector and market PE ratios of

20.6 and 14.77 respectively (Case study 2 question, Objectives). With a market capitalization of £3,502bn

it is one of the largest firms in the HOMEUK sector (Datastream ratios, p4).

1.2 Assessment of Strategic Capability

1.2.1 General Strategy

Berkeley’s strategy is essentially to:

“Remain one of the most successful and sustainable businesses in Britain.”(BKG AR

2013, p4).

This is to be achieved through quality land acquisition, investing in work-in-progress and to concentrate

on developments where an appropriate return can be made. Part of its long-term strategy is to return

approximately £1.7bn in cash to existing shareholders in a series of dividends totalling £13 per share over

the next seven/eight years to 2021 (BKG AR 2013, p5). The reason for this objective is so that the

company can focus on projects that deliver value without growing beyond what the directors consider to

be the optimum size for the business.

One of the objectives is to grow both earnings per share and the land bank but at the same time preserving

its financial strength. The initial target was that the land bank should grow to £3bn by 2015 but this target

has already been met, one year ahead of target. Clearly this is a good sign in that the company has found

sufficient high quality sites in which to invest as well as being able to fund the purchase of those sites

from borrowings and cash from trading. During the year:

1 sites that have previously been developed or build upon

2

“..Berkeley has invested a further £315m in new land, acquiring ten sites with some

3,000 plots. Eight of the sites are in London, some 99% of the plots, and two outside

London.” (BKG AR 2013, p42).

At 30 April 2013 the company owned 25,684 plots (October 2013: 25,060 plots) with an estimated future

gross margin of £3,047m (30 April 2012: £2,852m) and an average selling price of £409,000 (2012:

£378,000).

It is good to see a long-term strategy in place especially since it is quite specific in that it clearly states it

will be concentrating on profitable development projects as opposed to chasing growth just for the sake of

it. Indeed, the Chairman is keen to point out that the company will operate at its natural size, which could

explain why such a large amount of cash is being returned to shareholders i.e. the company has reached

its natural size and thus it is more efficient to return funds to shareholders rather than invest in projects

and land that does not fit its investing and operating criteria.

At the heart of the company’s strategy is its Vision for the Future, namely “Vision 2020”. This framework

has been in place for three years and evolves continually. From an investor’s perspective this is healthy

in that the directors are reappraising constantly the structure of the framework. The five areas of focus

are:

“Operations, Homes, Places, Customers and People.”

Each of the above key areas has further commentary as to what each means and the relevance of them to

the overall strategy of the group. This vision seems to be clearly thought out and ‘translated’ into

objectives that can be measured. In 2012 the group made a number of commitments in relation to the

supply chain, community relations and environmental management. Each of these commitments has been

assessed with hindsight and all have been met with the exception of the reduction in average site water

consumption, which has not met the target of 3%. Given the number of targets this is a very creditable

performance.

The group’s revenue arises predominantly from residential sales (97.5%) although it does have some

commercial sales. It also has revenue from selling student accommodation and has an increasing amount

of rental income from investment properties. This move towards rental income will reduce the operating

risk of the company. The building industry is very cyclical and thus when the market it at a low point the

lack of profit generated from construction will be to some extent offset by the steady income generated

from the rental income. However, about 75% of the rental portfolio is to be sold to M&G and thus this

mitigating factor will be substantially reduced in future years.

Throughout the annual and interim statements the group gives the impression it cares for the community

and its customers. It has always adopted a holistic approach in order maintain a sustainable, competitive

and profitable business. A review of some of the recent developments shows that the projects will often

comprise residential units alongside shops, restaurants, gyms and nurseries. This is an attempt to produce

homes where customers want to live, which in turn, enhances their marketability. The impression given is

that the houses and schemes are one of quality, which in turn can command a premium price in addition

to enhancing the marketability of the houses. The group also develops schemes with a lower than average

capital value such as student homes in Clapham and Aldgate, London (BKG AR 2013, p16).

The management team are clearly focused on providing what the customers want and seem to be very

successful. This targeting of a well-defined segment of the market is a good strategy, which distinguishes

Berkeley from its competitors and is a positive point for any potential investor.

The group concentrates on developing brownfield sites, which is good for the environment and seems to

build high quality houses commanding an above average price. The average price of a house sold by

Berkeley during the six months to 31 October 2013 was £350,000 (2012: £335,000) (BKG IR 2013, p4),

which is slightly lower than the figure of £354,000 for the average selling price during the year to 30

April 2013 (BKG AR 2013, p47). The average price is dependent on the sales mix (houses, flats, student

accommodation) and does not necessarily mean a decrease in the selling price of an individual property.

The rhetoric in the accounts does suggest there is a shortage of housing in London and South East

England, which in turn is likely to push up the average price of property, at least in the short-term.

By targeting London and the South-East of England, Berkeley has experienced a strong demand for their

properties in good locations where there is a fundamental under-supply of the type of housing built by the

group.

3

Assuming this trend continues, this should ensure a constant demand for housing, which in turn will

underpin future sales. Seemingly there is a constant demand to acquire properties in London. This is

supported by the increase in the forward sales figures.

The management team have significant experience in the housing market and recognise that the property

market is cyclical in nature (BKG AR 2013, p3). They are using this to their advantage by taking the

opportunity to purchase sites that, in their opinion, represent good development opportunities at the right

point of the cycle (investment phase). In order to mitigate further this cycle, Berkeley forward sells

whenever possible, i.e. sells the property before it is built. This is good for cash flow and eliminates the

speculative risk of building a property in the hope that it then sells. Apparently this is often the case for

properties in London but outside of the City properties are more often acquired after they have been

completed. A glance of the value of completed units at 30 April 2013 shows a decrease from £68.6m to

£45m coupled with a large increase in the Work-in-Progress, both of which support the assertion of

forward selling and keeping only a small number of completed houses ‘in stock’.

1.2.2 Expansion Strategy

Berkeley is not chasing turnover and is sticking to its long-term strategy. In this respect the expansion of

the group will largely be dictated by events outwith their control, such as the economic cycle and the

availability of mortgages. However, the impression given is that a significant proportion of the purchasers

of the property are from overseas who like to invest in London. This mitigates the impact of mortgages

being hard to obtain as it is likely these will be wealthy individuals who will not require finance to

acquire a property. Although this is an advantage it may mean that when mortgage funds do become more

freely available the increase in sales will be less than other house-builders, whose customers may rely

more heavily on mortgage funds to finance the purchase of a property.

Berkeley has an impressive land bank, which has been built up over the years, especially during recent

years where investment opportunities have arisen for buyers with cash, such as Berkeley. The land bank

at 31 October 2013 is that the group controlled 25,060 plots (April 2013: 25,684 plots) with an estimated

gross margin of £3,047m, up 6.8% from April 2013. If this is comparable with the gross profit of £403m

then the group holds sufficient land for approximately the next eight years; clearly a healthy position to be

in should future plots become a scarce resource.

Given the conservative nature of the directors it is unlikely the volume of sales will increase significantly

in the foreseeable future. However, if the average selling price per property increases significantly then

the turnover will also rise in line with the selling price with an even more dramatic effect on pre-tax

profits2. The converse of course could also happen.

1.2.3 Lifecycle

The group is well established in the market place and in terms of market value is of comparable size to

the national groups of Persimmon and Taylor Wimpey. It is also larger than other well-known groups

such as Barratt Developments, Bellway and Bovis, although this is likely to be due to the downturn in the

housing market affecting these companies more so than Berkeley. The industry is also well established.

In terms of a lifecycle model, the industry is probably at the consolidation/mature stage in that

competition is high and the firms that survive are the ones with efficient and flexible operating systems.

The UK residential housing market is cyclical and the management clearly recognise this fact. In terms of

a competitive advantage, it is likely Berkeley is better placed than most to come through the tough

economic conditions that are currently being experienced, notwithstanding the recent improvements as

reported by the media.

2 If the selling price increases then this is likely to flow through into the bottom line to the costs having already been

incurred such as land cost.

4

1.2.4 Key Change Factors (PEST)

Political

Planning permission to develop brownfield sites is vital for the success of the group. It does seem that the

UK government is keen on developing brownfield sites as opposed to giving planning permission for

greenfield sites to be developed. Clearly this is good for the group in that this is the area it is

concentrating on.

Climate change is currently a major topic discussed regularly by numerous countries, including UK.

Seemingly the UK is to reduce its carbon emissions by 80% by 20503. As this issue becomes more

important to the public it is likely the demand for carbon neutral homes will increase over time. One of

the aims of the current government is for all new homes to be Zero Carbon by 20164. The management of

Berkeley do seem to embrace this objective and have taken steps to reduce their operational carbon

emissions in addition to building homes that are more Carbon efficient. In fact this is one of the

underlying themes as discussed in Vision 2020.

Without doubt Berkeley is taking the Zero Carbon target seriously, which may actually increase the

demand for its properties as customers become more environmentally aware. Without a detailed analysis

of the competitors it is difficult to assess whether or not Berkeley will have a competitive advantage with

this issue. However, given the group constructs higher than average priced properties it is likely they will

be able to incorporate more Carbon efficient elements to the properties since it will form a smaller

percentage of the overall cost as compared to other, lower priced properties. It is also likely to appeal to

the more affluent sector of society who can afford to be concerned about such issues.

The cost of landfill taxes has risen steeply in recently years and is likely to increase rather than decrease

in the future. Although this will affect all builders, companies that specialise in regenerating brownfield

sites are likely to incur greater cost increases than those that do not (more rubbish to dispose of).

Obtaining planning consents that enable a commercially viable project to be undertaken is crucial to the

success of a project. With the pressure on housing arising from an increase in the population the

impression given is that the rules have been relaxed. However, this could be in relation to individuals

seeking consent to extend their own property rather than to large scale developments, which would still

require the appropriate approval. Although this is an issue at local level it is likely to impact all building

companies and not be a specific disadvantage to Berkeley.

Following the change in government four years ago, a Comprehensive Spending Review took place that

resulted in less public sector funding being available for the provision of subsidised affordable housing.

This may have a small impact on Berkeley due to the requirements of some authorities whereby they

insist on a proportion of affordable housing being built as part of an overall development project. This

may have an impact on the company but given the average price of the properties it is likely this will be

small.

In order to stimulate the market the government have recently announced a “Help to Buy5” scheme in

addition to the mortgage backed indemnity scheme, NewBuy. This will encourage sales but the number

of Berkeley’s customers that have purchased under this scheme is only around 5%.

The reduction in the corporation tax rate will enable Berkeley to generate more post-tax profits, all things

being equal. In Parliament there seems to be continuous debate about the introduction of a “Manson Tax”

for properties with a value of more than £2m. At present this is not an issue that will impact on Berkeley

but if introduced Governments have a habit of tinkering with limits and the £2m may fall with time.

However, it is not considered to be an issue for Berkeley in the short to medium-term.

Economic

The recent years have been called “the Age of Austerity” by some sections of the media and UK has

experienced a “double-dip” recession although recent economic indicators suggest the country is entering

a period of economic recovery. After the unprecedented global economic turbulence of recent years, the

3 Not in case study material, from knowledge and listening to news on the subject

4 ibid

5 The UK governments lends up to 20% on the cost of a new-build home up to a valuation of £600,000

(www.helptobuy.org.uk/equity-loan/equity-loans accessed on 4 March 2014

5

UK housing market in London and South East seems to improving and the average property price is

increasing. This improvement is clearly a good sign for the industry, which as a whole suffered dreadfully

in the downturn.

The recent GDP figures show a very low rate of growth during the last year or so (increased 0.7% during

last quarter of 20136). This increase is likely to be good news for the house building industry and could be

a significant factor for investors looking for a medium to long-term investment especially if the rate of

growth starts to accelerate.

Interest rates are at an historical low but the direct impact on the profits of the group is minimal due to the

very low borrowings. Although low rates should enable investors to borrow funds for large purchases,

such as a house, this is currently not necessarily the case due to the banks persistent reluctance to lend

money. In instances where the banks are prepared to lend money it is only to those with larger deposits

e.g. 10%, which is very difficult for purchasers of properties with an average purchase price of £354,000

(would need to have a deposit of at least £35,000). Recently, some lenders have reduced this percentage

but it is still nowhere near the 110% mortgages that were sometimes available prior to the Credit Crunch.

The fact that the UK government controls at least two major UK banks does not seem to alleviate this

point.

The relative recent strength of the pound relative to some other currencies has meant properties in the UK

are less attractive to overseas investors than they were, say, a year ago (dollar has weakened against the

pound in the last year or so). However, since Berkeley operates at the higher price/quality end of the price

spectrum their developments are the type of properties sought by overseas investors and it is likely this

will not deter too many from purchasing property in the more popular areas of London.

Social

The trend away from high rise block accommodation has stimulated the demand for housing, which is

good for Berkeley. Arguably the 60’s baby boomers (there was a boom in the number of babies born in

1960s), who are now in their late 40’s/early50’s are now at the stage of their lifecycle where they want to

live in safe, secure, good quality accommodation and are likely to be in a financial position to be able to

afford it. These potential customers are likely to find the houses built by Berkeley to be desirable.

The fact that the housing market has been weak for approximately five years and that obtaining

mortgages has not been easy to come by suggests there is an element of pent up demand for houses within

the UK. As people age their requirements for differing housing changes e.g. increased size of family with

children of differing gender, and thus when conditions improve there could be an upsurge in the demand

for houses, which in turn may be favourable for Berkeley.

Unemployment rates are relatively high (around 2.3 million in UK) and thus the labour rates are likely to

remain stable, if not decrease, as subcontractors compete to obtain work from Berkeley (not sure what

percentage of work is undertaken by subcontractors as opposed to employees, but likely to be high due to

the relative consistency of the profit margins and relatively low amount of employees). Similarly, the

demand for employment is high thus suppressing the labour rates. A high unemployment rate will also

reduce the number of people who can afford to purchase a property.

Eco-friendly housing is seemingly more popular and the low-carbon build policy as pursued by Berkeley

is likely to be an attraction to some potential purchasers.

Technology

The management’s commitment to Carbon neutral homes and to increasing efficiency suggests they are

making good use of advances/improvements in products due to technology. It is unlikely the internet will

give Berkeley an advantage since it is unlikely many houses will be purchased using the internet alone,

although it will make the supply chain easier to manage. The trend towards protecting the environment

has resulted in a greater demand for Carbon Neutral homes, which Berkeley are seeking to deliver.

Overall, the worst of the dire housing market conditions appears to be over and the London housing

market is recovering slowly. Should this continue the short to medium-term future looks much brighter

than compared to a few years ago. This should bode well for Berkeley.

6 http://www.bbc.co.uk/news/business-26351549 accessed 4 March 2014

6

1.3 Industry Analysis

There are a number of major national chains that are volume builders such as Barratt Developments and

Taylor Wimpy. In addition to these there are hundreds of smaller family firms that will concentrate solely

on their local market. Arguably, Berkeley was one of these although their local market of London and

South East England it a very large market and the turnover is now far from small.

The residential housing market has seen the average price of houses decrease significantly (20% - 30%)

during the two years following the bursting of the housing bubble in mid 20077. However, since the low

point prices have risen slowly to such an extent that they are not much lower than at their peak. One of

the features of a fall in the price of houses is that some people will have negative equity8, which makes it

harder for them to sell and raise money for a new property. They may also lack the confidence to

purchase another property having lost money on their previous purchase.

The number of purchasers of ‘buy-to-let’ properties has decreased significantly in recent years due to the

unavailability of funds (no more 100% mortgages). This means there is less fluidity in the market

(number of transaction is less) which in turn will make it harder for others to sell and move up the

housing ladder (one of the problems in England is with a chain – unless there are sellers/buyers lower

down the chain it makes it harder for those further up the chain to do the same).

There are many suppliers to the industry which will mean that the power of suppliers is relatively low.

This is the case for both materials (mainly commodities – brick, glass, cement, wood, plastics etc.) and

labour.

In contrast to the suppliers the power of buyers is collectively high. If the houses are mispriced for the

area then it is likely customers will purchase similar accommodation from other developers. One factor

that does make each builder/developer have an advantage is the uniqueness of the location for each of the

houses. In some cases this may be minimal (many similar houses in a similar area) but with others the

location will give a unique selling point to the developer, which will enable it to make a reasonable profit

on the development. This is almost certainly the case with Berkeley.

One noticeable trend in the house building industry is that if house prices are too high then more people

will rent property. This means that there will be a natural ‘brake’ on the increase in prices as people can

then afford to wait until the prices become more reasonable before they purchase a property. This of

course ignores the emotional9 effect of being a property owner, which in UK is likely to be significant.

Overall, the house building industry is competitive and it is likely that firms which have developed a

niche strategy will be the ones that survive with any reasonable rate of return in the future. Arguably

Berkeley falls within this category.

1.4 Company Analysis

1.4.1 Board

A review of the board shows it has a wealth of experience in both the housing sector and with Berkeley.

Tony Pidgley, the group chairman, co-founded the company in 1976. With the exception of the chairman,

all of the directors have either degrees, professional qualifications, or both. At April 2013, in addition to

the five executive directors, there were six non-executive directors (“NEDs”), one of whom, Veronica

Wadley has been appointed recently (AR 2013, p57). The board is thus evenly balanced and has recourse

to people with a breath of experience across a range of disciplines. One of the NEDs is stepping down

and a replacement has been found; Mr Adrian Li, Deputy Chief Executive of the Bank of East Asia

Limited.

A quick review of the photographs (some of which could be quite old) of the directors shows the ages

range from mid-40’s upwards and thus the age profile is reasonably well balanced between relatively

young directors and the older co-founder, Tony Pidgley.

7 From industry articles on web and in newspapers. Comments such as these are not necessary for the class report,

although they are desirable, but would be expected in a dissertation case study. 8 House worth less than the loan to purchase the property.

9 Being seen to own a property and ‘to be keeping up with the Jones’. Furthermore, owning a property enables the

owner to customise it, which is not necessarily the case with rented property.

7

A review of the summary CV’s of the directors’ show that the board is well balanced with industry

specialists in prominent positions. The only potential weakness of the board is that it is likely to be

influenced heavily by the opinion of Mr Pidgley, which may be an issue when he decides to retire.

However, the younger directors are well placed to bring continuity to the company when this occurs.

1.4.2 SWOT analysis

A summary of some of the strengths and weaknesses of Berkeley are listed below:

Strengths

Experienced management team pursuing a clearly defined strategy

Market leader in their chosen geographical area

Flexible operating strategy

Range of lower and higher priced houses less likely to be affected by “Age of Austerity”

Healthy balance sheet/cash position

Long land bank

Consistent high level of forward sales

Constant demand for properties in London from overseas purchasers

Weaknesses

Challenging trading conditions

Banks are reluctant to lend money

Restricted to one geographical area, although very large

Co-founder may want to retire within a few years

Opportunities

Rapid increase in sales when banks start to lend

Further geographical expansion

Increase in commercial property sales

Threats

Banks continue to withhold mortgage funds

The Olympic factor starts to fade, in the short to medium-term

UK enters another recession

Consumer confidence does not return

Large fall in land prices (land bank will have to be written down)

Probably the greatest strength of the company is the experienced management team coupled with what

seems a flexible operating model (can reduce costs when sales are falling). The biggest weakness is the

banks withholding funds from potential customers.

1.5 Overall

Berkeley seems to be well managed and is following a good, well-focused strategy given the competitive

threats it faces. The results are dependent on external influences, largely outwith the control of the

directors. Its business model e.g. the forward sales, limits the downside risk, which should be of some

comfort to a potential investor. Although at present, there is no overriding factor to suggest Berkeley will

outperform significantly over the next 12 months, it does, nonetheless, appear well positioned to take

advantage of any improvement in market conditions. It is also likely to be well placed to resist any

downturn in the industry should this materialise and thus is a relatively safe investment in a potentially

risky sector.

8

2 Capital Structure

Although there is always the problem of comparing with the sector: in this instance, the sector appears to

consist of other companies similar to Berkeley and thus direct comparison is relevant. With the exception

of Gleeson and Crest, the sector is also made up of companies that are broadly comparable in terms of

market value, so either of the average or median figures can be used as a benchmark.

2.1 Debt

Debt to equity (%) 2009 2010 2011 2012 2013

Berkeley 0.0 3.8 24.1 5.5 1.7

Median UK Homes 24.6 11.7 14.2 7.2 7.7

Average UK Homes 33.6 17.1 12.3 6.7 9.6

Table 1: Debt to equity

With the exception of 2011, the gearing ratio, as defined as total debt as a percentage of common equity

(Datastream), has been very low. In the recent past the group has effectively been debt free although his

changed in 2011 when the ratio rose to 24.1% but then fell back in 2012 and 2013 where the ratio fell to

5.5% and 1.7% respectively, as shown in Table 1. In absolute terms this is very low. It is also low when

compared to both the median and average sector figures of approximately 8-9%. The sector figures have

increased marginally and this too suggests Berkeley is better placed in terms of lower risk than its

competitors. The low figure is consistent with the strategy and unless some very high priced good-value-

for-money land is acquired close to the year end it is likely this situation will continue in the short to

medium term.

A review of the borrowings figure (BKG AR 2013, note 16, p102) shows £22m is due for repayment

within 12 months. However, this is a small amount and is not a cause for concern. Furthermore, the

group has committed borrowing facilities of £525m of which £275m expires in May 2017 with the

balance of £250m expiring in April 2018.

It is clear there is no pressure on the group to repay the borrowings within the next 12 months.

The increase in borrowing facility is likely to be due to the group’s strategy of investing during the

investment phase of the industry lifecycle i.e. increasing the land bank by acquiring good quality sites at

reasonable prices10

. Assuming this is a good strategy, the increase in the borrowing facility is expected

and should not give cause for concern for a potential investor. The other reason for the increase in the

facility is the directors ensuring there is sufficient cash to pay for the committed dividend payment on or

before September 2015.

Had there not been a reasonable facility available then it could be argued the group is not able to acquire

as many good quality sites as it could, which in turn may limit the future profitability of the group. The

low absolute amount borrowed suggests the level of debt is under control and not an issue for the group.

A further advantage of the facility is that it demonstrates to councils and other organisations that the

company has the financial backing to continue its operational existence for the foreseeable future and is

able to fund very large projects. An interesting feature is that one of the targets set to trigger a bonus for

the directors is the percentage increase in the land bank growth (BKG AR 2013, p69). Whilst this may be

an incentive to increase the land bank unnecessarily (there are other measures to restrict purchasing of

poorer quality sites, such as an ROE target) it is not thought this will be a deciding factor in whether or

not to finalise an individual land acquirement deal.

The group has also kept the debt low by not declaring significant dividends in the past, although during

2013 £19.7m was paid. This has the twin advantage of enabling land to be purchased, thus ensuring one

of the bonus targets is easier to meet, and keeping the net asset value per share high. This may change

going forward as they have committed to returning £1.7bn in cash to shareholders by 2021 (BKG AR

2013, p5).

10

Some of the large purchases of land in central London will be in £’100m

9

2.1.1 Operating Lease Commitments

Operating lease commitments at 30 April 2013 are £8m (2012: £10m) (BKG AR 2013, note 25, p105),

which if a capital element of, say, £6m11

is brought onto the balance sheet would increase the debt to

around £26m. This results in a negligible increase in gearing to 1.9%, which is still a very low figure. In

conclusion, the overall debt burden does not give any cause for concern.

2.2 Equity

Six different shareholders own a significant stake (greater than 3%) in the group with First Eagle

Investment Management owning the largest individual stake at 9.97% (BKG AR 2013, p59). Four of

them seem to be large professional investment companies, which between them own approximately 25%

of the company. One of the other two significant shareholders is one of the co-founders, the current

Chairman who owns 4.27%, a sizeable stake for an individual.

Notwithstanding the Chairman, no one investor can thus overly influence the company by threatening the

board that they will vote against them should they disagree with one of the board’s policies. It is likely

these shareholders will be investing for the medium to long-term with no takeover ambitions. If

professional investors think there is value to be had holding a significant stake in Berkeley then the shares

are worthy of further investigation.

The directors have significant shareholdings in the company (BKG AR 2013, p77) and thus their interests

should be aligned with those of other shareholders (if the company performs well then so do they). The

directors also have significant share options suggesting that they may be wealthy individuals (clearly this

is a broad assumption).

Although the directors’ interests are aligned with other shareholders, it is questionable whether or not the

incentive to make a few more million pounds is in reality that great for people who are already very

wealthy, such as the Chairman and Managing Director. There is little doubt they have been well rewarded

for the past success of the group under their stewardship but investors are investing for the future and not

the past. The value of the incentive would have been much greater a few years ago when the directors

were not so wealthy, although this could possibly be the case for the more recent appointments. Whilst

money may no longer be a motivational factor there will be other influences that will encourage the

‘wealthy’ directors to perform well.

2.3 Pension

A brief review of the pension plan (BKG AR 2013, note 5, p97) shows the assets exceed the obligations

and thus this does not give cause for concern to a potential investor, especially since the defined benefit

plan has been closed to further accrual with effect from 1 April 2007 (BKG AR 2013, note 5, p96).

Overall, the capital structure of the group is sound, if not conservative. The directors’ interests are aligned

with those of other shareholders and the company is effectively free of debt.

11

If future payments are £8m a reasonably estimate of the capital element within these payments is £6m. However,

this is only an estimate and the exact figure is not important, only the order of magnitude.

10

3 Cash flow Statement Analysis

A summary of the cash flow statement for the year ended 30 April 2013 (BKG AR 2013, p90) is

shown below:

£m

Profit after tax 209.7

Non cash adjustments -20.7

Cash generated from operations 189.0

Cash flow from operating activities -73.9

Net cash flow from operating activities 115.1

Net cash flow from investing activities 7.2

Net cash flow from financing activities -58.2

Net increase in cash and cash equivalents 64.1

The group increased its cash and cash equivalents by £64.1m (2012: -£263.6m) during the year giving a

total amount held at the year-end of £66.8m (2012: £2.7m). At 31 October 2013 the cash balance had

increased to £78.9m (BKG IR 2013, p1). Given the low debt position the cash flow appears healthy, and

at first glance, the company does not have any cash flow issues. A more detailed analysis is as follows:

3.1 Net cash from operating activities £115.1m (2012: -£162.5m)

Note that the starting point per Berkeley’s accounts is the profit after tax (BKG AR 2013, note 25, p105),

which is different to the starting point of operating profit in the Thornton’s case study. This will mean

there are more adjustments to convert the profit after tax to a cash position so that the ‘standard headings’

used in the cash flow statement can be used.

A review of the movement of net cash from operating activities shows the majority of the change is due to

the decrease in the working capital figures12

. However, during 2012 the group sold a holding in a

subsidiary generating a profit of £30.7m, which is subtracted from the profit after tax13

. Thus a more

accurate ‘starting point’ for comparing the profit after tax for the year would be to compare £209.7m with

£127.4m.

Last year the movement of working capital absorbed £314.3m cash, whereas during 2013 a much lower

amount of £102.2m cash was absorbed. The main reason for the change was due to a smaller increase in

inventories (£244.5m as against £341.2m) and a greater release of cash from an increase in trade and

other payables (£154.5m as against £50.3m).

The increase in inventories14

is in line with the management’s strategy of continually purchasing land as

and when it becomes available. The fact that the rate of growth has decreased is likely to be due to the

increased volume of sales rather than a management decision to cut back on the purchasing of land. A

review of the components of the inventories (BKG 2013, note 12, p101) show that the land has decreased

but the work-in-progress has increased substantially by £289.1m. This reflects the movement from the

investment phase to the development phase and is consistent with the strategy of the company. The

increase in work-in-progress suggests more sites may be completed and sold next year, which is a good

sign for a potential investor.

The increase in the trade payables and other creditors is consistent with an increase in the volume of the

business and is thus to be expected.

12

Inventory, receivables and payables – technically a decrease of cash is an increase in the working capital

requirements of the business. 13

This is a similar but opposite book entry to depreciation in that the profit after tax will have been increased by the

profit on sale of the subsidiary. In order to arrive at the cash position it needs to be deducted – this effectively

cancels out the accounting profit. 14

Inventories include, land, work-in-progress and completed units

11

Interest payable has remained constant at a little over £5m reflecting the low level of debt15

and there is

clearly no concern over the level of interest cover either on a cash or profit basis.

Income tax paid16

was £69.2m as compared to £53.7m last year. The increase is simply a function of

greater profits, which is clearly good news. Perversely, the greater the tax charge, the better! Similar

comments to those of the interest cover apply to the tax charge.

The cash available to management prior to investing and financing activities is £115.1m (2012: negative

£162.5m), which is clearly a significant improvement on last year.

3.2 Cash inflows from investing activities (2013: £7.2m, 2012: £63.5m)

The net cash inflow arose largely from £12.6m proceeds from the sale of investment properties being

offset by £6.6m being spent on property, plant and equipment. This is in contrast to 2012 when the

inflow arose from the disposal of a subsidiary undertaking (£75.7m) being offset by a £10m loan to a joint

venture, both of which are considered one-off items. Capex spend is likely to be the ‘normal’ level of

spend on investing activities, which based on the amount of cash available to management is easily

affordable especially in light of a depreciation charge of less than £2m17

.

3.3 Cash outflow from finance activities (2013: £58.2m, 2012: £164.6m)

The cash available prior to the spend on financing activities is £122.3m, which is clearly healthy. During

the year £38.5m (2012: £163.7m) was incurred repaying borrowings and £19.7m (2012: £nil) was

distributed to shareholders via a payment of a dividend. This dividend was the first instalment of the

directors commitment to repaying £1.7bn to shareholders by 2021 and is thus in line with the strategy.

Overall, the group is very cash generative. There are sufficient funds for the directors to pursue their

strategy of purchasing land and returning cash to shareholders via a programme of future high dividends

(£13 per share to be returned via a dividend in the next eight years) and share repurchases.

3.4 Balance Sheet

A review of the balance sheet (BKG AR 2013, p88) at the year-end shows net assets of £1,322m (2012:

£1,100m) with retained reserves of £2,199m (2012: £1,977m). The total assets of £2,497m comprise

mainly of tangible assets with intangible assets only amounting to £17m. The largest component of the

assets of the group is inventories at £2,067m (2012: £1,852m).

Trade receivables have remained constant at £106m, which given the increased sales is a good

performance. This is reflected in the trade receivable days falling from 35 days to 30 days (datastream).

Trade payables and other creditors have generally increased across the board and is consistent with the

increased business activity. It is comforting to note the small increase in the ‘Deposits and on account

contract receipts’ figure to £426.m, which reflects the buoyancy of the market.

The net asset/share at the year-end was 1,009p (2012: 839p) (BKG AR 2013, p115) and has increased to

1,062p at 31 October 2013 (BKG AR 2013, p1). The current share price is £25.47, which gives a market

to book value of 2.4. With the market price being at quite a premium to the book value this does not

provide the investor with a safety net close to the share price below which it is unlikely to fall. The

difference between the market price and the cost price of the investment properties does not make a

significant difference to the calculation.

Overall, the group has a strong balance sheet and there are no issues that would prevent an investor from

considering a purchase of the shares Berkeley.

15

Interest could still be charged even with no year-end debt since it may have existed during the year and paid

off/substantially reduced before the year end. 16

This is corporation tax 17

The group is spending more in replacing assets than is being charged to depreciation thus suggesting the assets are

being renewed constantly and, which is just as likely, being increased in line with the increased trading activity.

12

4 An Analysis of Company Operating Performance18

4.1 Profitability

Operating profit margin(%) 2009 2010 2011 2012 2013

Berkeley 17.8 17.3 18.3 18.8 20.1

Median UK Homes 3.4 6.9 8.5 11.4 12.9

Average UK Homes 4.2 7.4 9.6 12.2 13.9

Table 2: Operating profit margin

The current operating margin has been improving gradually over the last four years with a notable

improvement during the last 12 months. This suggests Berkeley’s strategy of concentrating on projects

where it can make a good return is working. The fact that this margin remained relatively constant over

the four year period to 2012 when banks were lending very little mortgage funds is testament to the

effectiveness of the operating strategy of the group. One of the advantages of the flexible business model

is that it can be flexed to suit market conditions19

. Although during this period Berkeley’s margin was

constantly higher than the sector it is noticeable that the rate of growth of the margin of the sector is

faster. This may be due to the fixed overheads being absorbed into greater sales thus reducing the cost

per sale and thus increasing the margin. If market conditions relax it may mean that over the next 12

months the sector average will increase once again at a faster rate than Berkeley’s. A review of the

margin in the interim report shows it has fallen back marginally from that of last year suggesting it may

have reached a plateau and is unlikely to increase significantly in the foreseeable future. This is

consistent with the size of the group operating at its natural size.

One interpretation of the margin could be that Berkeley is a good defensive stock in that it will perform

well in most economic conditions with a degree of predictability and stability. In contrast, the industry is

more volatile in that when conditions are bad it performs badly but when conditions are good, it performs

well. A potential investor will need to form a view on the state of the housing market, and their level of

risk, during their anticipated holding period before deciding on which builder, if any, to invest in.

Return on equity (%) 2009 2010 2011 2012 2013

Berkeley 11.7 9.6 10.6 15.6 17.3

Median UK Homes -2.8 3.6 4.8 7.2 9.2

Average UK Homes -10.4 4.8 4.7 8.2 9.5

Table 3: Return on equity

As shown in table 3, the return on equity and capital invested figures20

show a similar trend as the

operating profit margin although Berkeley’s return on equity21

has been higher than the sector for all of

the last five years, suggesting it is perhaps more than just a defensive stock. The rate of change in the

percentage for the sector does indicate the potential for larger future growth should the market conditions

recover to their previous levels. Whether or not this will ever happen is of course highly debateable.

A review of the interim results show the Pre-Tax Return on Equity, as defined by the group, has increased

further from 24.5% to 25%. Whilst this is not a large increase it is nonetheless an improvement and the

absolute level is impressive. This reinforces the view that the group demonstrates stability and a

management team that appears to be very much in control. Based on the trend coupled with positive

comments from the management team it is likely this level will be maintained, if not marginally improved

over the course of the next 12 months.

18

The ratios are taken from Datastream, p4 unless otherwise stated 19

Possibly by the use of subcontractors who can be used, or not, depending on the availability of work 20

The return on equity and return on capital employed figures are expected to be very similar for Berkeley 21

The RoE could be analysed using NI/S x S/A x A/E to see if further information could be ascertained. However,

given the trend in the operating margin coupled with constant low gearing it seems apparent the main factor

influencing the trend is the operating margin.

13

4.2 Working Capital and Liquidity

Current ratio 2009 2010 2011 2012 2013

Berkeley 2.2 2.1 1.8 2.0 2.3

Median UK Homes 3.7 3.8 3.5 3.6 3.1

Average UK Homes 4.4 4.1 3.6 3.6 3.2

Table 4: Working capital and liquidity

As shown in Table 4, the current ratio has remained constant at around 2.1 for the five years to 2013 with

minor variations from year to year although it has increased by 15% from 2012 to 2013. The industry

figures are much higher averaging around 3.5 but showing a marked improvement22

in the last 12 months

from falling from 3.6 to 3.1. The reason for the rise in Berkeley is likely to be due to the increased work-

in-progress component of the inventory (see comments on quick ratio) as the group start to develop more

of the land bank, as cited by the managing director.

“…committed £315m to acquire then new sites and, with 73 out of 87 sites now in

construction, has increased its net investment in work in progress in the year, by some

£289, which underpins the Group’s ability to generate future earnings”.(BKG AR 2013,

p5)

This suggests Berekeley’s working capital is under control and that whilst the industry average is

noticeably higher, it too is falling to a more manageable level.

With the ratio being more than 100%, this suggests it is able to meet its current liabilities as and when

they fall due. As a result of Berkeley being in the construction industry, inventory is a crucial indicator of

the liquidity of the business and thus it is important to analyse the quick ratio. As shown in table 5, the

reason for the high current ratio is due to the high level of inventory which cannot be converted into cash

very quickly. However, it can be used as collateral against future borrowing should the need arise. Given

the low level of debt on the balance sheet and the £525m borrowing facility it is considered highly

unlikely Berkeley cannot pay its debts as they fall due and thus Berkeley does not have any immediate

liquidity problems.

Quick ratio 2009 2010 2011 2012 2013

Berkeley 0.5 0.5 0.3 0.1 0.2

Median UK Homes 0.3 0.5 0.3 0.3 0.2

Average UK Homes 0.5 0.5 0.3 0.3 0.2

Table 5: Quick ratio

The current ratio of Berkeley and the industry are at the same level, which, subject to some small

variations, has been the case for the last five years. During the last three years it has reached a level of

between 0.2 and 0.3, which suggests this is the natural level for this industry, which in turn in comforting

for an investor notwithstanding the figure is significantly lower than 1. There is no reason to suggest this

will ratio change substantially over the foreseeable future.

Inventory days 2009 2010 2011 2012 2013

Berkeley 855 965 982 849 739

Median UK Homes 821 636 671 591 592

Average UK Homes 806 720 716 665 612

22

In this instance an improvement is a reduction, which although is showing less liquidity is a measure of improved

efficiency.

14

Table 6: Inventory days

As shown in table 6, Berkeley has reduced the number of inventory days from 982 in 2011 to 739 in

2013. Although the managing director has stated the group is still spending heavily on land and work-in-

progress the fall will be due to the increased level of activity, which in turn indicates a measure of

improved efficiency i.e. the sites and work in progress is being converted to sales at a faster rate. Given

that land is a scarce resource this is not a major issue but does lower the risk of land write downs should

the housing market take a significant turn for the worst. The trend is not too dissimilar to the sector and

the difference in the magnitude of the figures is likely to be due to the differing type of properties being

sold by the average industry competitor23

. There is nothing to suggest this level of improvement will not

continue in the foreseeable future.

One of the stated aims of Berkeley is to build up its land bank. A fall in the Inventory days may suggest

the increase in the land bank is not keeping up with the increase in sales. Clearly very little information

can be gleamed from a fall over a couple of years although at 31 October 2013 the number of plots had

fallen from 25,684 at April 2013 to 25,060. Without knowing if the plots are comparable little can be

concluded from such a relatively small decrease.

4.3 Stock Market Standing

The share price at 3 February 2014 is 2,547p with a p/e ratio of 15.9. The p/e ratio for the sector and

market is 20.6 and 14.77 (Case Study Question, Objectives) respectively, which suggests the group is

relatively undervalued (the market expects the future profits of other firms in the sector to outperform

Berkeley). The sector figures could be distorted if the reported earnings are small, i.e. other things being

equal a firm moving from, say, a small profit to a more normal profit is going to have very high PE if the

price anticipates even a modest recovery or if the equity figures have been reduced as a result of a number

of years of retained losses.

As a result of the strategy of increasing the land bank no dividends have been declared for many years

although a small distribution of £19.7m was made during 2013. One interpretation is that a few years ago

the management team have faith in their strategy and foresaw greater returns being made for shareholders

by retaining and reinvesting the cash generated from profits rather than return it to the shareholders via a

dividend. However, the directors want to keep the company operating at its natural size and have now

reversed this and intend to return surplus cash amounting to £13 per share to shareholders via declaring

dividends in three tranches no later than 2015, 2018 and 2021. For an investor investing for income this

provides a good level of comfort in that it is effectively a return on investment of over 50% over the next

seven years, ignoring discounting and any change in the share price. The dividends are, of course, not

guaranteed but the degree of conviction of the statement and objective does suggest the directors will

work hard to achieve this goal.

The basic EPS has increased from 121p in 2012 to 160p in 2013 (BKG AR 2013, p87). A review of the

interim results to 31 October 2013 shows a similar increase from 82p at 31 October 2012 to 100p at 31

October 2013. Clearly this increase is welcome and supports the management’s decision to concentrate on

London and South East England where the market seems to be buoyant.

As discussed previously, the net asset value of the group at 31 October 2013 is 1,062p, which compares to

a current share price of £25.47. It could be argued that an investor is effectively paying a premium of

£14.85 to secure the future profit stream of the group. Given the current EPS and potential dividend

stream of nearly £13 over the next seven years, this seems not unattractive.

Overall, most of the main indicators are showing figures that have generally improved over the last 12

months. For a group operating in a competitive market the indicators are encouraging, especially when set

against the competitors. They do suggest an investment in Berkeley would be a relatively safe investment

with steady growth opportunities. However, the upside growth is likely to be steady at best rather than

explosive should the market conditions improve gradually over the next 12 months.

23

E.g. construction of 1000’s of very similar houses by national building firms as compared to bespoke community

schemes for each location.

15

5 Prospects in comparison with its peers

Many comparisons with the industry have already been made in this report. On the face of it Berkeley is

relatively well placed in that it is relatively debt free and is demonstrating a positive trend in profit

margins. It also has a £525m bank facility to take advantage of historically good value for money land

prices and to enable it to develop its land bank should the opportunity arise.

Many of its competitors are national chains catering more for the mass market than Berkeley does.

Berkeley’s intimate knowledge of the market it serves and flexible business model will enable it to

respond more rapidly to a changing market, whether up or down. This reduces the investment risk,

although arguably, limits the upside-gain.

In this context it is useful to compare and contrast the operating performance of Berkeley Group with that

of its peer Taylor Wimpey, also in the house-building sector. Despite sharing the same sector, the

strategies of the two firms are very different. This can be inferred from the data in Figure 2 that presents

historical capital expenditure, depreciation and the key inputs to the Return on Equity (ROE) analysis for

Berkeley and Taylor Wimpey PLC.

Figure 2 – Historical Operating Performance of Berkeley Group and Taylor Wimpey PLC

Note: Capex = Capital Expenditure, Depr = Depreciation, S = sales, NI = Net Income, TA = Total Assets, E =

Equity. Furthermore, the above ROE figures are extracted from the accounts by Thomson Reuters Datastream and

may not always equal sustainable ROE derived from DuPont analysis using the formula ROE = NI/S×S/TA×TA/E.

Although both firms exhibit comparable capital expenditure and depreciation rates, Taylor Wimpey has

until recently exhibited both higher gearing and higher asset turnover reflected in the averages. Normally,

DuPont style ROE analysis would predict that high gearing and asset turnover, would lead to high return

on equity. However, the data in figure 2 show Taylor Wimpey having a much lower average but more

variable ROE than Berkeley. This is explained by the very low average profit margins realised by Taylor

Wimpey compared to Berkeley. High asset turnover and low profit margins are characteristics of the high

volume mass market strategy of Taylor Wimpey. Unfortunately for Taylor Wimpey, this segment of the

housing market has been very competitive. During the collapse of the housing bubble in 2008/9/10 they

had a large stock of unsold inventory in an undifferentiated product that they had to offload at below cost

YearCapex %

Sales

Depreciati

on %

Sales NI/S S/TA TA/E ROE

Capex %

Sales

Depreciati

on %

Sales NI/S S/TA TA/E ROE

1992

1993 3% 1% -5% 104% 254% -12.5% 3% 1% 8% 57% 135% 6.3%

1994 2% 1% 1% 100% 232% 3.2% 2% 1% 8% 51% 137% 5.8%

1995 2% 1% 3% 95% 233% 6.3% 3% 1% 14% 66% 136% 12.7%

1996 3% 1% 3% 89% 249% 5.6% 2% 1% 11% 70% 145% 11.2%

1997 3% 2% 4% 92% 232% 8.7% 1% 1% 10% 61% 145% 9.1%

1998 2% 1% 5% 87% 222% 9.2% 1% 1% 15% 54% 156% 12.6%

1999 2% 1% 5% 90% 211% 10.0% 2% 1% 14% 60% 141% 11.9%

2000 1% 1% 6% 90% 208% 11.3% 1% 1% 13% 67% 137% 11.8%

2001 1% 2% 9% 92% 186% 15.9% 1% 1% 14% 64% 149% 13.4%

2002 1% 1% 9% 63% 175% 10.0% 1% 1% 15% 57% 164% 14.5%

2003 0% 1% 7% 84% 182% 11.1% 0% 0% 15% 59% 159% 14.1%

2004 0% 1% 9% 62% 225% 12.6% 1% 0% 14% 70% 151% 14.7%

2005 0% 0% 10% 79% 206% 16.1% 0% 0% 14% 75% 137% 14.2%

2006 0% 0% 9% 91% 192% 14.8% 0% 0% 12% 74% 251% 22.2%

2007 0% 0% 8% 87% 190% 13.8% 0% 0% 14% 81% 132% 14.8%

2008 0% 0% -6% 47% 204% -5.3% 0% 0% 17% 64% 162% 17.6%

2009 0% 0% -40% 78% 362% -113.6% 0% 0% 14% 77% 189% 20.4%

2010 0% 0% -18% 86% 271% -42.7% 0% 0% 9% 67% 186% 10.7%

2011 0% 0% 10% 66% 217% 14.2% 1% 0% 15% 31% 200% 9.3%

2012 0% 0% 4% 86% 165% 5.4% 0% 0% 14% 32% 223% 10.2%

2013 0% 13% 56% 163% 11.6% 0% 0% 20% 38% 194% 14.4%

Averages 1% 1% 2% 82% 218% 0% 1% 0% 13% 61% 163% 13%

Taylor Wimpey Berkeley

16

in order to realise cash from working capital. Their problems were compounded by high levels of gearing.

In contrast, the low gearing and high margin differentiated product offered by Berkeley allowed the latter

to escape the financial crisis relatively unscathed.

Overall, Berkeley is likely to be one of the safer companies within the sector generating relatively stable

returns. As to whether it will outperform it peers in the next 12 months, who knows? That is likely to

depend on the economic conditions and the availability of mortgage funds for potential purchasers.

However, for investors who want to invest in the house building sector without it being a pure speculative

punt, Berkeley is one of the safer companies to consider.

6 Part B: Analysis of Employee Benefit Obligations

6.1 Senior executives remuneration

The remuneration policy for executive directors is detailed in the remuneration report (BKG AR

2013, pp. 61 - 77). Base salary, annual bonus potential and share incentives are set in the upper

decile (top 10%) of a comparator group of similar sized firms in the building industry. A

building industry analyst should examine the remuneration policy of the comparator group

companies and see whether or not they also consider their executives to be among the best 10%

in the industry. If so, it raises the possibility of the whole sector exhibiting the “rachet, rachet

and bingo” phenomenon that so enrages Warren Buffet. Note that, by definition, only 10% can

be in the top decile. It also raises the question: if Berkeley Group is such a great place to work

and cares so much about its staff, as implied by the management commentary, why do they have

to pay their executives so much in order to stop them from being poached by the competition?

On the other hand, they have outperformed their rivals through challenging economic conditions,

so there is justification for sector beating pay awards.

The remuneration committee is detailed on p. 64. Encouragingly this states “The members of the

committee have no personal financial interests, other than as shareholders, in matters to be

decided by the remuneration committee, no potential conflicts of interest arising from cross

directorships and non day-to-day involvement in running the business”. In other words,

assuming that this is correct, the remuneration committee should have no reason not to be

independent and objective when setting remuneration of the senior executives on behalf of the

shareholders.

The charts (p. 65) indicate that around 80% of the remuneration of each of the top directors is

performance based. In theory this means that they have an incentive to serve shareholders to the

best of their abilities. On page 66 - 72, the key features of the bonus plan and long term

incentive plan (LTIP) for executives is outlined. In addition to the commitment to return £13 per

share in dividends over the period to 30th

Sept. 2021, bonuses are contingent upon executives

being able to simultaneously exceed both an ROE hurdle and increase the land bank margins.

The respective thresholds for 2013 and 2014 are detailed on pp. 67 - 69.

In addition, the plan aims to ensure that part of a given years bonus is deferred so that if a good

year is followed by poor years, it is possible for Berkeley to clawback the bonus. If this works,

will be a good thing because it takes away the incentive for executives to undertake strategies

producing good short term figures that are unsustainable in the long term if they know that

bonuses earned in one period can be clawed back in later periods.

Overall, the award criteria look sufficiently demanding to ensure that bonuses and LTIP plans

will only vest in the event that substantial benefits for shareholders are achieved. There is also a

risk adjustment factor to discourage executives from gambling with shareholders money.

The requirement for senior executives to hold a minimum percentage of their salary in company

shares (BKG, AR, 2013 pp. 71 – 72) should be effective in aligning their interests with those of

the other shareholders. However, many of the directors own substantially more than the

minimum indicating that they have substantial amounts of net worth tied up in their company,

i.e. ‘skin in the game’.

17

Wages and salaries for the year total £97.4m (2012, £88.7m) for an average number of

employees of 1,326 (2012, 1,139). Hence the average employee cost the firm £73,453 for the

year, or 2.2% of Mr Pidgley’s total remuneration of £3.29m (BKG, AR, 2013 p. 74 and p. 95,

note5).

6.1.1 Summary of directors’ remuneration

Overall, the remuneration committee report contains some encouraging points:

1. Long term incentive payments which are based upon demanding performance criteria

2. Long-term claw-back clauses to discourage short termism

3. Delayed vesting period and restricted liquidation to avoid short termism

4. Large ownership stake by senior directors, e.g. Mr Pidgley.

5. Minimum shareholding requirements for senior executives

On the other hand, there are some features that cause concern:

1. Minimum net asset value condition of just £5.94 by April 2015, but after returning £4.34

to shareholders in special dividends

2. Top decile awards within comparator group

3. Chairman paid 45 × more than the average employee. This is not unusual with many

CEOs earning more than 100 × average employee salaries, although some may reflect

upon whether or not it is distasteful. While not disputing that the founding CEO’s human

capital may be worth more to shareholders p.a. than that of the average employee; is it

really worth 45 × as much? Perhaps, perhaps not?

6.2 Post retirement employee benefit obligations (pensions)

The company operates two defined contribution schemes. In addition, it has a legacy defined

benefit scheme referred to as the Berkeley Final Salary Plan which was closed to future accrual

with effect from 1st April 2007. As defined contribution schemes do not really create any issues

regarding the capital structure, this discussion will focus upon the, now closed Berkeley Final

Salary Plan (BKG AR 2013, pp. 96 – 98, note 5).

The scheme assets at 30 April 2013 were £16m, scheme liabilities were £14.6m resulting in a net

surplus of £1.4m. Given the scale of the group’s operations (market cap > £3.4bn 3nd

Feb 2014),

the closed scheme is of a negligible size in relation to the firms other operating assets and

liabilities. This is a very different and altogether much more favourable situation to that of

Thorntons PLC. Nonetheless, reporting of the plan allows the same principles of analysis to be

applied to this scheme as to any other scheme of a much larger relative scale.

For Berkeley, this analysis will be undertaken, primarily for educational purposes rather than

because we think it has a major impact upon the Groups investment potential. With regards to

your coursework companies, you will have to judge for yourselves, whether or not the pension

scheme of your firm is relevant enough to include a detailed analysis in your report.

The expected rate of return on plan assets of 5.7% is reasonable. Likewise, the assumed pension

increase of 3.25% p.a. is reasonable, as is the assumed rate of increase in retirees’ pensions of

3.25%. The discount rate of 4.3% is comparable to high grade corporate bond yields and

follows the IFRS guidelines. However, the Pension Protection Fund and Pensions Regulator

would probably require a lower discount rate of closer to 2% to be used. If this lower rate is

applied, it could potentially increase liabilities by c. 50% based upon a 20 year liability being

discounted at a proportionately lower discount rate. The average life expectancy assumption is

compatible with the previous year.

Plan assets are spread between global equities, corporate bonds, government bonds and cash,

with greater geographical and asset class diversification reported than at 30th

April 2012. Given

18

the recovery in equity markets since then, the overweight position in equities will have benefitted

the group, although obviously, if the firm had been in a more levered position, like Taylor

Wimpey or Thorntons, it would have exposed it to substantially more risk of further equity

falls.24

Fortunately, this is a problem that does not affect Berkeley to a great extent. Return

assumptions on all assets except corporate bonds are broadly compatible with 2012. Other things

being equal, a widening of credit spreads will decrease the value of corporate bonds in the

portfolio. An increase in interest rates across the board will reduce the value of both corporate

and government bonds, although the resulting higher discount rate would produce an offsetting

reduction in scheme liabilities.

Interest cost (reversal of the discounting over one year) increases the liabilities by £600,000. An

actuarial increase in scheme liabilities of £1.1m is reported and is likely to be a reflection of the

modest decline in discount rates. Benefits paid out were £400,000 leaving an end of year present

value of liabilities of £14.6m.

Expected return on plan assets of £0.8m turned out to be £1.8m resulting in an actuarial gain on

assets for the year of £1m. The group made payments of £0.6m and benefits of £0.4m were paid

out resulting in a closing value of scheme assets of £16m.

7 Case Study 2 Part C

7.1 Profit Forecast for the Year Ending 30 April 2014

(see notes and spreadsheet for further details)

(Note: It is the logic and reasoning behind the forecast that is important rather than the actual figures)

Note £m’s

Turnover spreadsheet 1,577

Operating profit spreadsheet 320.7

Exceptional Profit same as interim -

Net finance costs 2 (6.0)

Share of post tax results of joint ventures 3 5.0

Profit before taxation 319.7

Taxation (23%) 4 (73.5)

Profit after taxation 246.2

Assuming a number of shares of 135m (latest figure from Datastream), the forecast EPS is 182p.

The market EPS forecast is 189p (Datastream Summary Report) and thus on the face of it the shares are

fairly valued.

At this stage it is useful to undertake some form of sensitivity analysis to see if the upper and lower range

of the forecast provides any further indicators. If the sales increase is reduced to 8% and the operating

margin falls to 19% the impact on the post-tax profits is £-7.8m or -6p per share. If the sales growth is

increased to 15% and the operating margin rises to 22% the impact on the post-tax profits is £17.5m or

13p per share. Neither extreme produces a significant variation in the EPS and thus the overall

conclusion is that the shares are fairly priced.

24

British Airways BA is almost a pension fund that happens to operate and airline rather than an airline with a

pension fund, due to its large pension fund deficit.

19

7.2 Notes to the Forecast 1. See spreadsheet

2. Net finance costs

During 2012 the full year’s charge was approximately double that of the first six month’s charge,

although this maybe a coincidence given the lumpy nature of the timing of the cash expenditure

on large plots of land. A review of the interim statement (BKG IR 2013, p5) shows the group is

still ungeared with net cash of £78.9m. It is thus likely the net interest charge will be similar, if

not a little lower, than twice the charge in the first six months. Much of the charge will comprise

of ’’ the amortisation of facility fees and other finance income and costs such as imputed interest

on land creditors” and thus even in the absence of interest charges from borrowings there will

still be a cost. The forecast will assume the charges in the second six months are similar to the

first, in the absence of a substantial increase in debt.

3. Share of post tax results of Joint Ventures

The joint venture made a profit of £2.9m during the first six months and this was attributable to

completions at Stanmore Place and the first completions at 375 Kensington High Street. Without

any further detailed analysis it seems to be the case that the profit/loss from the joint ventures is

relatively small. On the basis that the initial sales at 375 Kensington High Street were profitable

it will be assumed that subsequent sales will also be profitable and that the profit for the full year

will increase to £5m.

4. Taxation

The percentage of tax charged to the pre-tax profits was 23% in the interim report and this will be

assumed to be the rate for the full year25

7.3 Cost of capital

For the cost of equity, we use the CAPM and determine the cost of equity via the beta parameter of the

group’s stock with the FTSE All Share Index. Datastream reports the beta of Berkeley at 0.61 (more

recently even at 0.57), and Thomson One reports 0.66. From the Financial Times homepage,

www.ft.com, we get a beta of 0.76. Using monthly return data for the last 10 years, our own estimate of

beta is 0.87. We use an in-between value of 0.75 for the base scenario. We will then evaluate how the cost

of equity is affected by deviations from this value. As the risk-free rate, we use the 10 year yield for UK

gilts, which stands at 2.72%, so we use a rounded figure of 2.70%. As a final ingredient to the cost of

equity formula, we need an estimate of the UK stock market’s risk premium. An authoritative study by

Dimson, Marsh and Staunton (2006) reports the UK risk premium at between 4% and 6%. We select the

upper end of the range, reflecting the high current uncertainty regarding the economic development, both

globally and in the UK. These assumptions yield a cost of equity of 7.20%. Table 1 shows how the cost of

equity varies with alternative beta parameters and equity risk premiums, where the shaded cells represent

our base assumptions.

Equity risk premium 4.00% 5.00% 6.00%

25

The fiscal year for UK tax for companies runs from 1 April to the following 31 March.

20

Risk-free rate 2.70% 2.70% 2.70%

0.60 5.10% 5.70% 6.30%

Beta 0.75 5.70% 6.45% 7.20%

0.85 6.10% 6.95% 7.80%

Table 1: Estimates for the cost of equity (no adjustment for leverage)

Additionally, we are currently in a rather low interest environment, and one might consider increasing the

risk-free rate over the forecast period (e.g. three years ago, the 10 year yield for UK gilts was 3.8%.)

[As a note of caution, remember that these parameters are based on historical observations. However, the

cost of capital parameters are applied in a forward looking valuation. Hence, past parameters might not be

representative for the future and might need adjustments based on own judgement and expectations.]

Finally, as will become clear in the production and discussion of our forecasts, we incorporate an increase

in Berkeley’s leverage over the coming years. As Berkeley has been virtually debt free the past few years

(given its large cash position), we will take the beta parameter as the unlevered beta and use a levered

beta for the cost of equity. This will raise our assumed cost of equity.

7.4 Competitive assumptions

As argued in the earlier forecasting part, this analyst assumes that Berkeley possesses some competitive

advantage based on its history, sound strategy, and management experience (assuming that management

changes will be handled smoothly). Hence, in the base scenario, Berkeley is assumed to generate returns

on equity above its cost of equity even for the long term. Specifically, we assume that the terminal ROE

will be above the (terminal) cost of equity. This assumption might be interpreted as an optimistic forecast,

and more convinced followers of the company could argue that the historical average ROE of 13% might

be a lower bound for the group. We will later contrast our base scenario to alternative scenarios.

7.5 Forecasts of Dividends (and everything else)

In developing the forecasts, we use a consistent forecasting model, i.e. where the income statement,

balance sheet (and hence dividends) are modelled jointly. We will first look at the current financial year

(2014, ending in April) and then extend our forecasts depending on the expectations for the longer-term

future performance of the group.

1. Forecasts for FY2014

Although we can use the sales and earnings estimate of section 6.1, we need to make further assumptions

in order to come up with dividends and free cash flow estimates. Specifically, we need to specify changes

in working capital, non-current assets, and debt; for further forecasting and valuation purposes we need

even more assumptions, such as dividend pay-out ratios, costs of debt and equity, debt ratios, tax rates,

sales growth, depreciation and return measures.

We start by restating income statements and balance sheets from prior years into a format suitable for our

valuation purposes. To do so, we have to make a number of adjustments which rely upon judgement

rather than any hard rules. For example, to come up with the restated financial statements of table 1, the

following adjustments were made:

1. Short term debt and current portion of long term debt are added to debt; current liabilities less

short term debt and current portion of long term are deducted from working capital. Moreover,

debt also includes non-current trade payables (subsumed in the source data under other liabilities)

as well as provisions. To get to net debt, we finally deducted the cash position.

2. Minority interest and equity in earnings were included in the cost figures (for simplicity).

3. On the balance sheet we have substantial intangible assets and investments accounted for using

the equity method. We also have a lot of cash and the non-current liabilities comprising trade

creditors. For our absolute valuation methods, we could strip some, or all of these out and

calculate the present value of forecast free cash flows/profits to the firm’s operating assets, then

add back in the value of non-operating assets and liabilities at the end, effectively applying a

combination of asset based and present value based techniques using a sum of the parts approach

21

to derive the final valuation. There are merits to this approach. However, we will adopt purely

absolute valuation approach here. [Note that in the past, we even chose an approach which

explicitly made assumptions about the development of the (large) cash position. Hence, we

treated the cash position as an investment into future growth (a ‘war chest’ interpretation). This

was an assumption specific to this example firm, owing to past positions. It also eased the

treatment of debt, which would have been negative if it were net of cash. As the firm has reduced

its cash pile, we stopped pursuing this approach.]

4. Interest income and costs as well as other income have been subsumed under a single item. (The

21m other income in 2012 is a one-off item resulting from disposals that year.)

5. For your companies, you may also choose to make similar simplifying assumptions to those

above. If so, you must be prepared to justify and explain them to your clients/examiners. In fact,

for a dissertation, or a real work example, detailed sensitivity analysis might involve re-working

the calculations under an alternative set of assumptions.

Table 1: Restated income statement and balance sheets (raw data: Thomson Financial)

In a next step, we look at some key parameters and ratios over the past years. First, from the above table

1, we can derive the set of parameters presented in table 2.

Year ending 30th April (£,000) Y2013 Y2012 Y2011 Y2010

Income Statement

Sales 1,372,600 1,041,069 742,612 615,303

Costs (excluding depreciation) 1,095,600 846,024 603,442 508,196

Depreciation 1,800 1,127 858 960

Operating profit 275,200 193,918 138,312 106,147

Net Finance/Other income (expense) -4,500 21,269 -1,414 4,343

Profit before tax 270,700 215,187 136,898 110,490

Tax 61,000 56,674 41,789 30,816

Profit after tax 209,700 158,513 95,109 79,674

Balance Sheet (end of FY) Y2013 Y2012 Y2011 Y2010

Net operating working capital 1,330,900 1,134,444 896,178 555,689

Net non-current assets 90,200 53,758 46,660 41,703

Net assets 1,421,100 1,188,202 942,838 597,392

Net debt 98,700 88,368 9,060 -264,924

Shareholders' equity 1,322,400 1,099,834 933,778 862,316

Net capital 1,421,100 1,188,202 942,838 597,392

22

Table 2: Key past parameters and ratios

From this information, we adopt the following assumptions going forward: the tax rate is set at 23%

(slightly lower than most historical rates), operating working capital/sales is expected to decrease to 90%

(and to further decrease in the future), and non-current assets to sales are expected to be 5.5%.

Depreciation is set at 2% of sales (given the higher past figures, despite the lower long-term average), and

net debt/capital is set to 7%. Furthermore, we keep our 14.9% sales growth and 20.3% operating margin

assumption from above.

Assuming a cost of (net) debt of 5.7% and adjusting for other income, we arrive at our net income

forecast.

Notice that the operating working capital is different from the most recent figures, but in-line with earlier

ratios. The key reason for the decrease is that we try to achieve a non-negative dividend (and free cash

flow to equity) figure by adjusting operating working capital and debt (which is also assumed to grow

further in the future). Given our sales growth forecast, this is one way of compensating for the normal

cash needs under growth (from investments into working capital and fixed assets). This will also feature

in our extended forecasts, as we try to (partially) incorporate Berkeley’s announced targets for cash

returned to shareholders (BKG AR, 2013, p. 5).

23

Table 3: Current year and forecasts for 2013

These forecasts then allow us to produce a forecast for free cash flow as shown in table 4.

(£) 2014

Net income 246,164,353

Change in working capital and cash 88,135,058

Change in non-current assets -3,481,191

Change in Debt 6,702,771

Free Cash Flow to Equity 168,213,257

Table 4: Forecast of free cash flow to equity for FY2014

Similarly, we can derive the dividend and abnormal earnings from our forecasts in table 3: By modelling

the income statement and the balance sheet, dividends have to be the difference between a year’s net

income and the increase in shareholder equity. Thus dividends are equal to £246.164m – (£1,400.35m –

1,322.40m) = £168.213m. This corresponds to a payout ratio of 68% and a dividend of £1.24 per share.

This is includes the already decided 69 pence interim dividend decided upon for September 2013, and

thus assumes a further, and slightly lower, final dividend of 55 pence per share. [Notice that by specifying

the asset side (including cash) of the balance sheet relative to sales and thus implicitly also debt and

equity, dividend payout is a residuum which need not be modelled separately. If it were modelled

independently, the assumptions might be conflicting. This might still be an option in order to evaluate

different dividend policy assumptions, as long as the policies do not deviate strongly from the consistent

path. Major deviations and changes to dividends should be consistent with balance sheet changes. Lastly,

by definition cash flows and dividends are equal in our model.]

Finally, abnormal earnings can be derived. For the cost of equity, we calculate the levered beta (given 7%

debt/capital) as 0.79, which yields a 7.46% cost of equity charge on the FY2013 value of shareholder

equity:

24

Abnormal Earnings (£) 2014

Net income 246,164,535

Book value of equity (start of year) 1,322,400,000

Capital charge 98,661,705

Abnormal earnings 147,502,649

Table 5: Forecast of abnormal earnings (to equity) for FY2014

2. Forecasts beyond FY2013

For our forecasts beyond year 2014, we move away from forecasting operating margins, but rather

forecast ROE in combination with sales growth, and then work our way ‘backwards’ up the income

statement. The full set of assumptions which enter the forecasts and subsequent valuation are set out in

table 6.

Valuation input 2014 2015 2016 2017 2018

Sales Growth 14.9% 14.0% 10.0% 7.5% 5.0%

Operating Margin 20.3%

ROE (based on prior year equity) 18.0% 15.0% 15.0% 12.0%

Tax rate 23.0% 23.0% 23.0% 23.0% 23.0%

Operating Working Capital/Sales 90.0% 85.0% 82.0% 82.0% 82.0%

Non-current assets/Sales 5.5% 5.0% 5.0% 5.0% 5.0%

Depreciation/Non-current assets 2.0% 2.0% 2.0% 2.0% 2.0%

Debt/Capital 7.0% 10.0% 13.0% 15.0% 15.0%

Cost of debt 5.7% 5.5% 5.5% 5.5% 5.5%

Risk-free rate 2.7% 3.0% 3.0% 3.0% 3.0%

Table 6: Forecast assumptions

We chose 2018 as the terminal year, and assume that all 2018 assumptions are carried forward (ie the

Beyond input parameters are the same as the 2018 input parameters). Note first that the tax rate and

depreciation are assumed to be constant over time. Non-current assets/sales and cost of debt decrease

again in 2015 and remain constant afterwards. Working capital/sales is assumed to decrease to 82% by

2016 and remain there. Similarly, the debt/capital ratio increases further to 15% by 2017. These two

developments (in combination with the subsequent growth and profitability assumptions) are crucial for

the cash generation ability and thus the payout to investors (here in the form of dividends).

With respect to sales growth and ROE (notice the switch from operating margin to ROE forecasting after

2014), we assume that Berkeley will be able to achieve a return above its cost of equity due to its superior

management and position in its home market. We expect the ROE to come down to 12% in 2018, which

is almost in-line with the longer term average (13%). This compares with a 2018 cost of equity (taking the

leverage into account) of 8.1%. Lastly, for growth we assume that after the rather high growth in 2013,

growth will slow down further and decrease to a perpetual level of 5%.

By specifying sales growth, ROE, debt, and assets as % of sales, we implicitly define the balance sheet

and thus also the dividend payment. Given Berkeley’s plans to return cash to shareholders, we started out

with some initial assumptions, calculate forecast income statement, balance sheet and dividend payments.

We then reviewed and adjusted our assumptions in order to produce a dividend stream which at least

partly matches the company’s aims while still appearing reasonable and justifiable (table 6 basically

reports the results of this iteration.). The final income statement, balance sheet, dividend payouts and

sustainable growth rates are spelled out in table 7.

Consider for example year 2015. We start by specifying sales from our sales growth assumption:

1,576,706*1.14=1,797,444. This fixes assets (working capital: 85% of sales, fixed assets: 5% of sales).

Given the asset side, we can determine net debt (10% of total assets), equity (90% of total assets), thus

completing the balance sheet. We also know net income from an ROE of 18% on prior year end equity

(0.18*1,400,351=252,063). From there, we can calculate profit before tax (net income/(1-tax rate)) and

tax expense (tax rate*profit before tax). Net Finance/Other income is determined by the cost and level of

debt, to yield operating profit. As depreciation is defined relative to non-current assets, the difference

between sales and operating profit plus depreciation are costs. This completes the income statement. We

25

proceed analogously for all years.

[The full Excel spread sheet will be made available after the valuation seminars, and it is recommended

that students review the calculations and modify them themselves to understand the workings of the

forecast and valuation models.]

Table 7: Forecasts until terminal year

7.6 C4 to C6: Valuation

7.6.1 Base Scenario

Table 8 provides all the necessary forecasts and parameters to value the firm’s equity. Yellow entries

denote direct assumptions, whereas white cells denote either actual data or parameters derived from the

assumptions. (As said before, the Beyond 2018 assumptions are identical to the 2018 assumptions.)

Table 8: Valuation Input Parameters for the Base Scenario

The following three tables show the results and components of the three valuation models, dividend

discount model, discounted cash flow (to equity) model and abnormal earnings model.

Year ending 30th April (£,000) 2013 2014 2015 2016 2017 2018

Income Statement

Sales 1,372,600 1,576,706 1,797,444 1,977,189 2,125,478 2,231,752

Costs (excluding depreciation) 1,095,600 1,254,269 1,459,395 1,679,290 1,816,564 1,968,547

Depreciation 1,800 1,734 1,797 1,977 2,125 2,232

Operating profit 275,200 320,702 336,252 295,922 306,788 260,973

Net Finance/Other income (expense) -4,500 -1,008 -8,897 -12,299 -15,256 -16,018

Profit before tax 270,700 319,694 327,355 283,623 291,533 244,954

Tax 61,000 73,530 75,292 65,233 67,053 56,340

Profit after tax 209,700 246,164 252,063 218,389 224,480 188,615

Earnings per share (in pence) 155 182 186 161 166 139

Balance Sheet (end of FY) 2013 2014 2015 2016 2017 2018

Net operating working capital 1,330,900 1,419,035 1,527,828 1,621,295 1,742,892 1,830,037

Net non-current assets 90,200 86,719 89,872 98,859 106,274 111,588

Net assets 1,421,100 1,505,754 1,617,700 1,720,154 1,849,166 1,941,624

Net debt 98,700 105,403 161,770 223,620 277,375 291,244

Shareholders' equity 1,322,400 1,400,351 1,455,930 1,496,534 1,571,791 1,650,381

Net capital 1,421,100 1,505,754 1,617,700 1,720,154 1,849,166 1,941,624

Dividends 19,700 168,213 196,484 177,785 149,223 110,025

Dividend Payout ratio 9.4% 68.3% 78.0% 81.4% 66.5% 58.3%

Dividend per share (in pence) 0.15 1.24 1.45 1.31 1.10 0.81

Valuation input 2013 2014 2015 2016 2017 2018

Sales Growth 31.8% 14.9% 14.0% 10.0% 7.5% 5.0%

Operating Margin 20.0% 20.3% 17.7% 13.7% 13.0% 10.3%

ROE (based on prior year equity) 19.1% 18.6% 18.0% 15.0% 15.0% 12.0%

Sustainable growth rate (b*ROE) 5.9% 4.0% 2.8% 5.0% 5.0%

Tax rate 22.5% 23.0% 23.0% 23.0% 23.0% 23.0%

Operating Working Capital/Sales 97.0% 90.0% 85.0% 82.0% 82.0% 82.0%

Non-current assets/Sales 6.6% 5.5% 5.0% 5.0% 5.0% 5.0%

Depreciation/Non-current assets 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%

Debt/Capital 6.9% 7.0% 10.0% 13.0% 15.0% 15.0%

Cost of debt 5.7% 5.5% 5.5% 5.5% 5.5%

Unlevered (past) beta 0.75 0.75 0.75 0.75 0.75 0.75

Company beta 0.79 0.81 0.84 0.85 0.85

Equity risk premium 6.0% 6.0% 6.0% 6.0% 6.0%

Risk-free rate 2.7% 3.0% 3.0% 3.0% 3.0%

Cost of equity 7.46% 7.89% 8.02% 8.11% 8.11%

WACC (after tax) 7.25% 7.52% 7.53% 7.53% 7.53%

Adjustment to Other income 5000

26

Table 9: Dividend Discount Valuation

Table 10: Discounted Cash Flow Valuation

Table 11: Abnormal Earnings Valuation

The first two models yield a value of a Berkeley share of 2,338 pence, 8% below the share price on

3/2/2014, and the EVA model yields a slightly higher value of 2,346 pence. The difference between the

valuation models results from the change in the capital structure and the corresponding adjustment in the

cost of equity. This affects the EVA model differently than the cash flow/dividends based models. Given

the above forecasts and valuation, the stock appears fairly priced, if not slightly overpriced. However,

before making a final recommendation, it is worth evaluating the effect of alternative assumptions

regarding the model input parameters.

7.6.2 Valuation – Sensitivity Analysis

As discussed above, both the cost of equity used in the valuation as well as the assumptions regarding

Berkeley’s competitive advantage are optimistic. We therefore consider first, how variations in the cost of

equity parameters affect our valuation. Table 12 provides share valuations for alternative assumptions

where we vary the unleveraged beta.

Beta Share value (DCF) Upside/Downside potential (DCF)

0.60 3393 +33%

0.75 2338 -8%

0.85 1949 -23%

Table 12: Sensitivity Analysis Regarding Cost of Equity Parameters

The results clearly show that alternative assumptions in beta affect the valuation result. With a beta as low

as 0.6, a share value up to 33% above the current share price could be justifiable. [Remember that the cost

of equity also varies with debt and that we assumed increasing risk-free rates. The latter also lend

themselves to a similar sensitivity analysis.]

Discounted Cash Flows (£) 2013 2014 2015 2016 2017 2018 Beyond

Net income 246,164,353 252,063,197 218,389,495 224,480,136 188,614,919 198,045,665

Change in working capital 88,135,058 108,792,688 93,467,109 121,597,114 87,144,598 91,501,828

Change in non-current assets -3,481,191 3,153,411 8,987,222 7,414,458 5,313,695 5,579,380

Change in Debt 6,702,771 56,367,226 61,850,062 53,754,822 13,868,744 14,562,181

Free Cash Flow to Equity 168,213,257 196,484,324 177,785,226 149,223,385 110,025,369 115,526,638

Terminal growth rate 5.00%

Terminal value 3,712,927,197

Discount factor 0.9306 0.8592 0.7934 0.7320 0.6771 0.6771

PV 156,534,519 168,812,956 141,062,048 109,231,976 74,496,173 2,513,955,346

Value of equity (DCFE) 3,164,093,018

Value per share (DCFE) in £ 23.38

Abnormal Earnings (£) 2013 2014 2015 2016 2017 2018 Beyond

Net income 246,164,353 252,063,197 218,389,495 224,480,136 188,614,919 198,045,665

Book value of equity (start of year) 1,322,400,000 1,400,351,096 1,455,929,970 1,496,534,239 1,571,790,989 1,650,380,539

Capital charge 98,661,705 110,417,684 116,732,951 121,390,935 127,495,364 133,870,132

Abnormal earnings 147,502,649 141,645,513 101,656,545 103,089,201 61,119,555 64,175,533

Terminal growth rate 5.00%

Terminal value 2,062,546,659

Discount factor 0.9306 0.8592 0.7934 0.7320 0.6771 0.6771

PV 137,261,811 121,697,229 80,658,448 75,461,611 41,382,937 1,396,512,757

Value of abnormal earnings 1,852,974,794

Book value of equity (at valuation date) 1,322,400,000

Value of equity (EVA) 3,175,374,794

Value per share (EVA) in £ 23.46

27

Optimistic analysts might argue that our current forecasts do not forecast dividend payouts in-line with

the company’s planned return of cash to investors (e.g. we forecast a total payout of £1,186m by 2021,

70% of Berkely’s target cash return to shareholders). On the other hand, our terminal value assumes a

rather sizeable dividend in perpetuity (the terminal value in the DDM is almost 80% higher than the target

cash return). To get to dividend payments which are higher in the near future (but possibly lower in

perpetuity) requires either improved profitability assumptions, further decreases in assets/sales, increases

in debt, or any combination of these. Consider for example that Berkeley achieves a ROE of 18% forever:

This would produce dividends until 2021 very close to the cash the company aims to return to

shareholders. Under this assumptions, the valuation would yield a (DCF based) share price of 4027p, an

increase of 58%! If, on the other hand, these payments come from pure increases in debt (assuming 20%

net debt/capital in 2015, increasing by 20 percentage points to 60% in 2017), the valuation yields a share

value of 1108p, 56% less than the reference price. This is entirely due to the higher cost of equity

resulting from a higher leverage. Clearly, just how Berkeley wants to achieve the targeted returns to

shareholders is an important question to ponder (and put to the management).

7.7 C7 Relative valuation

For a relative valuation, we selected some of those companies as comparable firms, which the 2013

annual report used in its comparator group for the remuneration and incentive scheme definition (BKG,

AR 2013, p.64). We then plot trailing 6 months averages of PE and PTB values as reported in

Datastream. Figures 1 and 2 show the results.

Figure 1: 6M moving average PE for Berkeley and comparison firms

28

Figure 1: 6M moving average PBV for Berkeley and comparison firms

The figures already illustrate some of the issues in using relative valuations. First of all, data for all

comparison firms does not always exist over a longer horizon. Second, negative earnings or extreme

changes in book values distort the comparisons among firms. It is therefore not always optimal to use

averages, as distortions are harder to detect. Moreover, the business composition, risk profile and

strategies of the comparison firms also often differ from the target group.

Nevertheless, the figures also give some rough idea about the current valuation of Berkeley. First of all,

Berkeley’s relative valuation until 2007 was roughly in line with the other companies (except for some

spikes in the PE ratio). After 2007, Berkeley seems to have developed a premium over the sector,

possibly because of its higher quality and greater stability in returns (not reported here). Looking at

current and past PBV and PE ratios, Berkeley seems to be at a relatively high valuation. This can be

justified if future profitability remains above-average (also by Berkeley’s historic standards)

7.8 Share Price Performance

Over the last 12 months, three months and one month the shares have risen 37%, 8% and -4%

respectively. Relative to the FTSE ALL SHARE the shares have outperformed the market by 32%, 12%

and 0% for the same periods (Datastream, p3).This is an impressive performance over the last 12 months

and the question is whether or not this outperformance will continue for the next 12 months? Relative to

the house building sector its performance has remained fairly consistent with that of its peers although it

has underperformed during the last 24 months. This relative underperformance is likely to be a reflection

of the competitors recovering well from a period of poor performance in the years after the financial crisis

rather than any inherent problems with the performance of Berkeleys.

An analysis of the share price over the last three years shows a clear upward trend and although there has

been a downturn in the last month there has been insufficient time to establish a pattern. Notwithstanding

the last month, there are no indications to suggest this trend will not continue for the foreseeable future.

As to how long the upward trend will last? Who knows?

8 Overall Conclusion Part Includes part C8

The strategy of the directors is clear and appears to be sustainable in the geographical area they are

operating in. The management team is very experienced and appears to be more than capable of getting

29

the best out of the group’s assets and trading situation. The industry seems to have come out of the

investment cycle and has moved into the development cycle, which is healthy for Berkeley given the

quality and size of its land bank.

It has a good capital structure with little gearing and the profitability and working capital ratios are sound

and consistent with group’s strategy. The net book value per share at October 2013 is 1,062p, which

compares to a current share price of 2,547p, and although is clearly at a premium is arguably not too high

given the quality of the earnings and the management team. The share price trend over the last 12 months

has been constantly upwards. The management also hold significant shares and share options and thus

their own personal interests are aligned with those of the shareholders. The profit forecast for the year to

30 April 2014 shows the profits are likely to be in line with what the market expects.

Berkeley is without doubt well managed by a board of directors who have a lot to gain from a well

performing group. Whilst the housing market has still not completely recovered from the heady recent

years, it has nonetheless stabilised in the regions Berkeley operate. Berkeley’s above-average priced

houses and holistic approach to building is likely to deliver consistently good performance.

However, although the share price trend seems to be upwards, the recent weakness in the price coupled

with the shares being fully valued using the next year’s forecast earnings suggests the shares are a HOLD

for existing investors.

For investors who want to take a gamble on the housing market there are likely to be other companies in

the sector whose shares are likely to outperform those of Berkeley’s. This is based solely on a review of

the profitability margin trends coupled with the conclusion that the housing market is less severe than it

was a few years ago. Furthermore, the banks will be gradually releasing funds for mortgages as the

political pressure mounts. This is likely to impact Berkeley’s competitors to a greater extent due to the

high proportion of overseas investors purchasing the properties built by Berkeley.

30

References Berkeley Group Plc 2012 Annual Report

Berkeley Group Plc 2012 Interim Results Announcement, 7 December 2012

Datastream: Basic information on Berkeley

Datastream: Relative strength and total return index of Berkeley

Datastream: Summary Report on Berkeley

Dimson, Elroy, Paul Marsh, and Mike Staunton: The Worldwide Equity Premium: A Smaller Puzzle,

Working Paper, 2006, available at: http://ssrn.com/abstract=891620