Why I'd avoid McCarthy & Stone plc after 10% drop and buy this stock instead

Shares of retirement home builder McCarthy & Stone (LSE: MCS) fell by up to 15% this morning.

The shares slumped after the developer warned investors that its 2017/18 profits could fall significantly if it fails to win exemption from a government plan to reduce ground rents on new long leases to zero.

A hidden weakness

This summer saw a scandal emerge relating to new-build homes being sold under leasehold agreements. Doing this enabled housebuilders to boost their profits by selling the freehold separately to a third-party investor. In some cases the ground rents charged to homeowners have risen rapidly after an initial period.

Of course, flats are usually sold leasehold, so buyers of McCarthy & Stone properties are unlikely to have questioned this aspect of their purchase. The problem is that the company appears to have become dependent on the profits it makes from selling freehold reversions.

Analysts expect the company to generate a profit of £89m in 2017/18. In this morning's statement, it said that it expected to make a profit of £33m from the sale of freehold reversions. If the ban on ground rents goes ahead, I believe the group's profits could fall sharply.

My view

McCarthy & Stone believes retirement properties should be exempt from the ground rent ban. But in my opinion such developments are no different to regular apartment complexes, which also require centralised maintenance and services.

I'm not convinced that the firm will win its plea for exemption. In my opinion, today's news simply highlights this group's weak underlying profitability.

Today's fall follows the slump seen in September, when management warned that profit margins would be hit this year by higher levels of incentives. These appear to include paying buyers' electricity bills and service charges for several years.

Offers like this have supported higher sale prices. This supports revenue growth, but doesn't disguise the reality that the group's 2016/17 return on capital employed (ROCE) was just 12.5%, well below the housing sector average.

In my view, these shares are best avoided. I believe there are better opportunities elsewhere.

My personal pick

My top choice among housebuilders is FTSE 250 group Redrow (LSE: RDW), a share that I own myself.

Redrow has reportedly already stopped selling leasehold homes. So the firm's future profitability shouldn't be affected by yesterday's ban. There are a number of other things I like about this stock that's led me to favour it over some rivals.

The first is that the firm remains under the chairmanship of founder Steve Morgan, who owns a 25% stake that's worth around £600m at current prices. I believe Mr Morgan's interests should be well aligned with those of shareholders.

Although the group's dividend yield of 3.4% is fairly average, this payout is expected to be covered 3.5 times by earnings this year. This should reduce the risk of a dividend cut if markets stumble.

Redrow's ROCE has increased every year since 2012 and reached 21% last year. That's nearly double McCarthy's figure of 12.5%. Despite this, the firm's shares trade on a forecast P/E of 8.3 and a price/book value of 1.9. That's cheaper than several comparable rivals.

I continue to hold Redrow and believe further gains are possible in 2018.

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Roland Head owns shares of Redrow. The Motley Fool UK has recommended Redrow. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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