Summary:

MHO is a small, regional homebuilder based in Columbus, Ohio. I believe that the current quote is pricing in a material risk of bankruptcy, a scenario I find basically unimaginable.  The stock is trading at 0.68x its current BV of $44.37 / share.  (Tangible BV is nearly identical to stated BV – there is a small amount of intangibles from the small Shamrock acquisition, and no goodwill, to the best of my knowledge).

 

My thesis is incredibly simple.  The current environment for homebuilding is awful.  While I do NOT believe that housing has bottomed, I do think that within 3 years from now, it will have turned.  We are already 1-2 years into the present downturn.  Moreover, the stock price should be forward looking, at least 6 months if not more.  So I am basically underwriting that the housing downturn will not last longer than a total of ~5 years.  I believe this a very conservative assumption. 

 

Once the smoke has cleared, I believe MHO will trade up to a normalized BV multiple of ~1.35x, double where it is today.  Assuming this occurs at the end of 3 years, you would earn a 25% compounded annual return.  To the extent earnings are positive on a cumulative basis in the next 3 years, BV will grow and the stock should more than double.  Moreover, if the stock remains at such a low BV multiple for an extended period of time, then your returns could be enhanced significantly by very accretive share repurchases.  Finally, I think it is entirely possible that sentiment changes sooner than 3 years from now, further enhancing your return.

 

Resource Conversion:

Earnings, ROE, ROIC will all remain under severe pressure for at least the next year or two.  However, this investment is obviously not about near term earnings.  It has a lot more to do with resource conversion.  In short, the current level of inventory investment is massively out of whack with MHO’s business operations.  As MHO chews through that inventory at a faster rate than it replaces it, a massive amount of capital should be released.  The proceeds should then be used to repay debt and invest either in repurchasing stock or in newer, lower priced land.  Alternatively, if there is not a major drop in inventory investment over time, then revenues should grow materially as that investment level gets utilized more efficiently.  Most likely, we will see a combination of both.

 

To illustrate the excess inventory investment, current inventory turns are below 1x.  Over the past 13 years, inventory turns have averaged 1.65x.  Bringing turns back most of the way towards normal, back to say 1.55x, would increase turns by 61%.  So either revenues should increase by 61%, or inventory $ should drop by 38%, or some combination of the two.  Suppose that revenues stay flat and the adjustment comes from lower inventories – that would imply inventory dropping by $429mm.  This is in the context of a $420mm equity market capitalization.

 

Another way to see the excess inventory investment is to look at inventory as a % of LTM revenues, currently 87%.  Over the past 13 years, this has averaged 54%, and just 47% from 1994-2003 (before management decided to dramatically invest in new land, particularly in Florida).  Assuming this ratio gets back to 55% and that revenues stay flat (revenues will fall in 2007, but I am looking beyond 2007), that would imply inventory drops by $437mm.

 

Why I believe inventory levels will fall over time:

While inventory levels will certainly not fall overnight, there are several drivers I envision that should result in lower inventory investment. 

 

First, MHO has slowed new land acquisition almost to a halt.  After averaging $270mm / year of raw land purchases in each of 2003-2005, management anticipates spending just $25mm in 2007.  Moreover, MHO has walked away from nearly all its options (less than $10mm of deposits, LOCs, and pre-acq costs remain), so I anticipate land spend to remain extremely low (there is not a huge amount of land to takedown from existing options).  Nor does MHO engage in landbanking, so unlike many competitors, I do not envision MHO being “forced” to take down land.

 

Second, specs currently total $131mm and completed specs nearly doubled from Q3 to Q4 alone as cancellations spiked.  Moreover, as market demand has fallen more quickly than production has been ratcheted back, the average home under construction today has more $ sunk into it (is further along in the construction process) than usual.  Therefore, homes under construction $ as % of backlog $ is now 65%, double the long term average.  Falling back to the LT average would release $173mm alone.  (Note that because homes under construction is a component of inventory, this $173mm is not in addition to the $429mm and $437mm estimates above – it is a component of the $429mm and $437mm estimates.)

 

Third, I expect that land development $ spending should also fall as we move forward.  This is because MHO has already been moving land through the development pipeline aggressively in the past few years.  To illustrate, at the end of 2004, raw land $ of $268mm represented 53% of the total investment in unsold land of $502mm.  At the end of 2006, raw land $ of $228mm represented just 29% of the total investment in unsold land of $773mm.

 

Fourth, management stated on the last call that 2007 land sale profits should approximate 2006 levels.  If land sale profit margins are flat, this would imply land sale revenues should approximate 2006 levels of $49mm.  And if land sale margins fall, that would imply land sale revenues in excess of $49mm to maintain the same level of land sale profit dollars.

 

Finally, given that net orders have fallen so precipitously and now that the seasonal peak quarter for closings (Q4) has passed, I would expect MHO to “get religion” on price cutting to drive sales.

 

Other positives:

Transparency.  The level of detail that MHO consistently gives on its quarterly calls is better than any other builder I am aware of.

 

Simplicity.  No landbanking.  Minimal JVs.  No highrise.

 

Honesty.  Notwithstanding the fact that MHO did accelerate its land investment late in the cycle, management made it very clear even in 2005 that competitors’ claims of homebuilding no longer being cyclical and“trees grow to the sky”, etc. were utter nonsense.

 

Cheapness.  Even if MHO simply returns to BV, the stock would be up ~50% from the present quote; and that is likely to occur far sooner than in 3 years.

 

Florida Risk:

As MHO realized that the economy in the Midwest was deteriorating significantly, management decided to shift resources out of the Midwest and into Florida.  This happened in a major way beginning in 2003.  Unfortunately, this was not long before Florida peaked.  Florida is now 40-50% of MHO’s business, vs more like 20% historically.

 

To compound the Florida risk, while MHO took a significant impairment in Q4, writing off nearly 7% of after-tax BV, the bulk of those impairments were outside of Florida.  So there may yet be another shoe to drop in the form of Florida impairments.

 

However, I think that when you actually run through the numbers, the risk is more manageable than it sounds.  First, MHO had been making 35-40% gross margins in Florida at the peak.  So there was a lot of cushion to start with.  Second, the current investment in unsold Florida land is $305mm.  Even assuming a draconian 40% writeoff, that would amount to approximately $5 of BV / share after tax.  Note that MHO’s writeoffs to date have been more on the order of 20%.  And it appears that MHO has been quite conservative to date in its impairments, given that it impaired 30% of its communities last quarter, a far higher % than any other builder I know of.

 

Debt risks:

First, MHO’s bank debt has a covenant requiring maintenance of 2x EBITDA / Interest on an LTM basis.  I suspect this covenant will be breached in either Q3 or Q4.  After all, management EPS guidance for 2007 is just $0.50 - $1.00 assuming no further impairments, which I estimate translates into less than $40mm of EBITDA.  (I expect MHO to report an EPS loss for 2007 after impairments, but impairments are added back to EBITDA for purposes of the covenant).  And I don’t see how interest incurred will be less than $20mm to maintain the 2x ratio.

 

However, I expect the banks to waive the covenant breach for several reasons.  First, they will have seen MHO’s significant debt paydown by then.  (Management expects to repay $160mm of the revolver in 2007).  That would imply a revolver balance of just $250mm at the end of 2007 on management’s estimate.  To think that the banks would be uncomfortable with a $250mm revolver balance in the context of a company that will certainly have over $900mm of inventory seems preposterous.  Worst case, I think, the banks grab security for a short time before either relinquishing it shortly thereafter or getting refinanced out.  In any event, I don’t believe that the banks grabbing security triggers anything in the bonds.  Note that MHO was proactive in terming out its bank revolver through October 2010.

 

Also, for context, if MHO repays $160mm of debt in 2007 and BV remains flat ($0 of 2007 EPS), then year-end 2007 net debt to cap would be ~38.5%.  That would be a strong investment grade credit metric, although MHO has no present intention of becoming investment grade.  I find it incredibly hard to imagine that MHO would still be trading at 2/3 of BV with an investment grade net debt to cap metric.

 

Other risks:

I believe that the company’s late founder, Irving Schottenstein, was a phenomenal entrepreneur with excellent instincts.  For instance, MHO was MBO’d at the prior trough in 1990 and also entered the DC market around that time at the bottom.  Irving passed away 3 years ago.  That said, current Chairman/CEO/President Robert Schottenstein, Irving’s son, is no stranger to the business as he has been with MHO since 1990.

 

MHO does not look cheap on EBITDA as MHO’s balance sheet is presently bloated at the same time that margins are falling.  I believe this will change over time as inventory investment declines and debt is repaid as discussed above.

 

As discussed above, MHO is too long land at present.  However, I believe MHO is actively addressing this issue and will be successful in paring it back.

 

Catalysts:

·        Release of excess capital for debt paydown improves credit metrics and BV multiple expands meaningfully as stock price no longer implies severe bankruptcy risk.

 

·        Company gets acquired or taken private if stock price remains at current depressed levels.

 

·        Highly accretive share repurchases in 2008-2009 if stock prime remains depressed.