Redrow may have homed in too late: The housebuilder makes its debut as investors pause for breath, says Tom Stevenson

Steve Morgan, chairman, chief executive and virtual outright owner of Redrow, Britain's biggest private housebuilder, has had his eyes glued to the stock market. Redrow is coming to the market and Mr Morgan will sell just under 40 per cent of the company to raise about pounds 62m.

He will become a cash millionaire. But he will not be quite as wealthy as he might have been. Redrow's pricing, fixed yesterday at 135p a share, valuing the company at pounds 298m, is up to pounds 50m less than might have been expected only a few months ago.

The recent failure of the rival builders Beazer and Wainhomes to get away to a decent premium to their flotation prices put pressure on Cazenove and BZW, Redrow's banking and broking advisers, to ensure the float was priced as competitively as possible. As a result, in only a couple of months the valuation the City attaches to Redrow has shrunk by about 15 per cent.

'We've been extremely realistic,' Mr Morgan says. 'We priced against the five or six builders in the sector we felt were our competitors and then decided to do what was necessary to be seen as the successful issue.'

Instead of matching the valuations attaching to an average of five of its rivals - Wilson Connolly, Wilson Bowden, Persimmon, Bryant and Berkeley - which, on average, are trading at share price to earnings ratios of 19.3 for the year to June, Redrow has decided to come to the market at a p/e of 17.1. Even so, it may not be enough. Some analysts were to be glimpsed yesterday turning up their noses at Redrow's pricing, saying it should have been nearer pounds 270m.

Redrow comes to market having possibly missed the best moment. Given the bullish noises made by building societies on the prospects for house prices this year, and resurgent profits in the spring reporting season, this may seem surprising.

But the City started to discount recovery from the worst housing slump since the war about 18 months ago. Now it is fretting about the next down-swing in the exaggerated cycle that characterises Britain's housing market. After tripling between 'White Wednesday' in September 1992 and February this year, the average price of building sector shares has fallen 14 per cent.

Although housebuilding shares still stand at a premium to the market, the gap is narrowing.

This is part of a normal process that sees such shares fall to a discount as their cycles peak, but City concern about builders' profits is re- appearing sooner than many expected.

Housebuilder profits are determined by three factors: the volume of houses a builder can sell, and so the number of units over which overheads can be spread; the price the homes will sell for; and the price of the materials and labour that go into building them. Of these, the most important is the cost of the land.

What distinguishes a good, profitable builder is the ability to judge the trend of house prices and to buy land at an appropriate cost, one that leaves a reasonable margin of profit.

In practice, what tends to happen in this most cyclical of businesses is that housebuilders, good and bad, panic each other into a land-buying stampede when they perceive house prices to be recovering.

That drives up land prices until buyers refuse - or are unable - to pay the resulting higher sale prices and the spiral collapses. Over the past year or so, land prices in some areas, especially in the South-east, have risen as much as 50 per cent. With land representing about a fifth of the sale price, such a sharp rise means house prices must increase by at least 10 per cent to generate the same level of profit.

What bothers the market most is that builders will find it impossible to push selling prices up by these amounts. So the high land prices that wiped out the industry's profitability in 1991 and 1992 will do the same in 1996 and 1997. Tarmac suffered more than most from paying too much for land in the late Eighties on the expectation that house prices would continue to rise, only to then see them fall.

Earlier this week it disclosed that the cost of the land it was using for a typical pounds 80,000 house was about pounds 20,000. That compares with a cost of pounds 16,000 for some of its competitors.

This is partly because Tarmac keeps only a small 'land-bank' - a stock of land used for building houses. The advantage is that it is not tying up a lot of capital.

But, unlike some competitors, it also has no stock of cheap land, bought when the market was depressed, to draw on when times improve. As a result it must pay the going rate for land if it is to keep up with demand in the good times and maintain its leading position. That leaves it vulnerable if house prices do not rise as quickly as expected, or sales are sluggish.

There is room for optimism about sales volumes. NatWest Securities has calculated that, over the past 40 years, an average of 6 per cent of the country's housing stock changes hands each year, implying an average period of 15-17 years of residence in a house.

At the peak of the housing boom in the late Eighties that rose to 9.5 per cent of total stock, implying about 10 years in each house. Turnover is now under 5 per cent, suggesting people are staying in their homes for an implausibly long 20 years.

A return to the long-term trend would increase the number of house transactions from a low of about 1.1 million to 1.5 million a year, which would boost the new house market and allow builders to recover a much greater proportion of their fixed overheads, in turn increasing the profit on each house sold.

Other factors likely to drive the number of housing transactions higher are the high affordability of houses, with mortgages representing the lowest proportion of disposable income for 25 years, thanks to lower house prices, cheaper mortgages and growing earnings.

As for an increase in house prices, the message is less clear-cut. The numbers point in the right direction but confidence, the most important factor of all, is under pressure from tax increases and persistently high unemployment.

In the long run, house prices and average earnings have tended to track each other fairly faithfully. Since 1955, real earnings, after accounting for the effects of inflation, and house prices have risen at 2.7 per cent a year.

At the moment house prices have slipped below the long-run trend line and arguably there should be a period of catch-up.

According to NatWest Securites, for that to happen by 1996 house prices would have to rise 10 per cent this year and next.

That seems unlikely, but the firm still forecasts rises of 4, 7 and 5 per cent for the next three years. It cites several reasons for this optimism. There is not yet a credible alternative to owning your own home in Britain and buyers are acting in the belief that they will have to pay more in a year.

Increasing demand is starting to put a strain on supply in preferred locations and, of course, recovery tends to breed recovery.

How the City views these competing factors will determine the price it will pay for what is undeniably one of the sector's best companies. Redrow, soon to join the top 12 housebuilders, has an impressive profits history, a well-priced long land-bank and a good track record in reading the market.

How much credence is given to that story, and how much money Steven Morgan is allowed to take out of the business is, probably for the first time in his successful career, now out of his hands.

Bottom Line, page 32

(Photograph omitted)

(Graph omitted)