Summary
- Persimmon will stay in the bear market territory until inflation is under control, ignoring the occasional relief rally.
- The dividend payout ratio as a percentage of Persimmon's free cash flow is too high and unsustainable.
- Expect a dividend cut by Persimmon if the UK housing market goes down.
Overview
Persimmon Plc ( PSMMY ) (LSE:PSN) is a British housebuilding company, headquartered in York, England. It is the largest listed housebuilder by market capitalization on the London Stock Exchange and is a constituent of the FTSE 100 index.
Among its housebuilder peers in the FTSE 100 index, Persimmon has the highest dividend yield of 15.66%.
This article will discuss why the dividend is so high and why it seems that no one is buying the stock despite the stock price being nearly 50% down this year.
Why is no one buying housebuilders?
UK inflation is at decades high and the country is suffering from one of the worst cost-of-living crises in modern history. Goldman Sachs has recently forecasted UK inflation to reach 22% next year, which is expected to induce a recession in the UK.
Inflation is picking up pace and there are no positive signs which would suggest that inflation is slowing.
The Bank of England is mandated by the UK government to maintain financial stability, which includes an inflation target of 2% per annum.
Inflation in the UK is currently at 10.1%, five times higher than its target, and is expected to go even higher.
The Bank of England can try to control inflation by regulating the amount of money flowing into the economy. It can do this by increasing the "bank rate" which is the interest rate paid by commercial banks for borrowing money from the central bank or earned by commercial banks when keeping cash with the central bank.
Hence, an increase in the bank rate does two things:
- It encourages commercial banks to lend less if the interest rate is high enough and;
- It increases the borrowing rate for new mortgages and the payments for mortgages on variable rates.
These two things help to reduce the flow of credit and money in the economy, which eventually reduces inflation. The general rule of thumb is that it takes 12 to 18 months for the changes to be felt.
Now, the tricky part is finding the right balance so that increases in the bank rate do not tip the UK economy into a recession. No one really knows how high the bank rate should go up to tame inflation, and that is why there is so much macroeconomic uncertainty.
For instance, in the 1980s Paul Volcker became famous by increasing the U.S. federal funds rate (equivalent to the bank rate in the UK) to a peak of 20% in June 1981 to tame inflation which reached 14.8% in March 1980. This created a recession between 1980 and 1982 in which the national unemployment rate rose to over 10%.
UK inflation is accelerating and is expected to get much worse. If UK inflation does reach 22% what does this mean for the bank rate? Will the bank rate increase to the same level as the U.S. in the 1980s, and what does that mean for mortgage rates and the overall housing market?
These are largely unanswered questions with potentially devastating economic consequences for the UK housing market. As long as these questions remain unanswered, I believe that housebuilders, including Persimmon, will remain in a bear market, ignoring the occasional relief rally.
Why is the dividend so high?
I believe that Persimmon's dividend yield is excessively high because the market does not believe that it is sustainable. If we are to look at Persimmon's 2021 cash flow statement, we can try to calculate the dividend payout ratio as a percentage of free cash flow.
I am using a slightly adjusted formula by swapping earnings for free cash flow. I think it provides a better picture than using earnings as the latter can be more easily manipulated than cash in financial statements.
So, here's the calculation using Persimmons 2021 cash flow statement:
Net cash inflow from operating activities | 784.8 |
Less Purchase of property, plant and equipment | -20.9 |
Free cash flow | 763.9 |
Dividends paid | 749.6 |
Dividend payout ratio (Dividends paid/Free cash flow) | 98.13% |
A 98% dividend payout ratio is clearly not sustainable and gives the wrong signal to the market.
It can be interpreted as saying that paying dividends is the best use of free cash flow for the business as opposed to re-investment in the business to generate future returns.
UK shareholders like dividends, but they also like a growth story which can support future dividends.
Persimmon also does not have a great history of stable and growing dividends. From the chart below, we can see that the dividend was cut several times.
As the dividend payout ratio is so high, I believe that a dividend cut is coming soon, especially if the UK housing market goes down amid the macroeconomic uncertainty.
Conclusion
I would stay clear from Persimmon and housebuilders in the UK because of the current macroeconomic situation. I believe that housebuilders will stay in a bear market until UK inflation is under control again.
Also, the dividend payout is too high, so be prepared for a dividend cut if the UK housing market goes down.
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For further details see:
Persimmon: Inflation, Interest Rates And Dividends