Description
Technical Olympic USA is the cheapest US homebuilder today worth investing in. At $19.50, the stock is trading at 4.3x management’s 2006 EPS guidance of $4.52 (which was raised on their Nov 9 conference call, at the same time they discussed the current problems in Florida) and 1.3x BV (1.0x 2006 BV based on ’06 EPS), a level that I believe has become extreme. For reference, the comps trade a bit north of 6x ’06 EPS and 2x BV.
While I believe some of the “better mousetrap” story so strenuously put forth by public homebuilder bulls, I do not agree with all of it and will be the first to say that the macro environment really scares me. I think that certain areas in particular are bubbles, and that homebuilders have benefited tremendously from a decline in interest rates, extreme mortgage liquidity and lax underwriting, etc. If I had to guess, the cycle most likely is indeed finally turning after lasting longer than most anyone could have expected. Management said on the Q3 call that across the country, housing demand is slowing (aside from Texas, which is suddenly stronger), and there has been a change in psychology. In general, I have been in the skeptics’ camp in recent months. All that said, I think that valuation on TOA in particular provides tremendous risk mitigation and the potential for large gains if the bears’ case turns out to be overstated or take longer than expected. (At a minimum, I think TOA could be a nice hedge against many short ideas that are positioned for a bursting of the housing bubble; or the long side of a hedged trade in which a basket of other homebuilders could be shorted).
The homebuilders tend to trade within a pretty narrow valuation band. Certain names that become outliers typically revert to the mean (look no further than Toll earlier this year, which had been trading at a very significant premium to earnings, the bulk of which has since vanished). TOA trading up from current levels to the comps at 6x would imply roughly 40% upside.
It seems quite clear that 6x is not the long term normalized multiple for the group. Of course, today’s margins for the group are certainly above normalized levels. At the same time, the public builders will continue to grow as they take market share (how wouldn’t they, given their outsized landbanks relative to their current market shares?). What is tough to discern, is whether the growth occurs fast enough to outweigh the margin erosion (and likely slowing in asset turns). But suffice it to say that the potential upside on TOA is not limited to a reversion to the comps’ trading levels – the group’s multiple may well change too.
TOA is 67% owned by Greek parent Technical Olympic S.A. (“TOSA”). In fact, a secondary offering was attempted in August (4mm secondary shares and 1.5mm primary), only to be pulled and replaced by a downsized offering in September at a similar price but with a more “favorable” split. The September offering was done at $28, with TOA selling 3.4mm shares and raising net proceeds of $89mm and TOSA selling 1.2mm secondary shares. The “overhang” from TOSA’s ownership likely contributes to the present discount, but at the same time contributes to the opportunity here. With a float of less than $400mm, TOA also suffers from an illiquidity discount that should go away over time as TOSA sells down its stake. Management has stately clearly that after a very well timed and opportunistic foray into US homebuilding in the late 1990s, TOSA readily intends to divest the bulk of its stake in TOA over time.
TOA also has relative inexperience with Wall Street and has had some difficulty communicating its message in the past. The most recent example of this has related to lack of clarity with its JVs. As background, the bears would argue that many homebuilders enter into JVs in order to obtain off-balance sheet leverage, provide much less financial transparency to public investors, and manipulate return on capital metrics.
In truth, what would concern me more as a bear on the subject of JVs, are companies with a long history of making extensive use of land JVs such as Standard Pacific (“SPF”). Because of how JV accounting works, when SPF takes down developed lots from its JV, it does so at cost. Instead of the land JV recognizing the gain, recognition of the land gain is deferred until the SPF consolidated homebuilding operations build and sell a home on it, at which time the “land gain” is buried in SPF’s consolidated gross margins. So SPF’s current consolidated margins benefit from extreme off balance sheet leverage to past land gains in one of the nation’s hottest markets that will likely not be recurring. As an example, SPF’s Talega JV bought 3500 acres of land in the late 1990s for $35mm. That JV will end up producing over $500mm of land profits, though the vast majority will not be recognized at the JV level.
In contrast, TOA does not have any longstanding land JVs from which its current level of earnings is deriving large benefit. As recently as 2003, TOA didn’t even have any land JVs. Only recently has TOA grown its use of JVs extensively. Given concerns about affordability today, it strikes me as rational to utilize the JV structure in making future acquisitions of land or smaller homebuilders, what with debt that is non-recourse and less of an equity commitment required.
TOA’s largest JV relates to the August 2005 acquisition of Transeastern Homes. Transeastern was the 37th largest builder in the US, with a focus throughout Florida. I think that investors have been largely “turned off” by the transaction’s “convoluted” structure, but I think that closer examination reveals it to be incredibly smart. TOA created a new JV to acquire Transeastern. 75% of the purchase price was funded with new non-recourse JV debt. The JV is 50/50 owned by TOA and Transeastern’s former owners. TOA invested $90mm cash equity and a $20mm bridge loan, while the former owners rolled $75mm of equity/property and have the potential for a future $75mm earnout. TOA expects it to be accretive to 2006 income by $35mm (a pretty astonishing ROE made possible largely by the new JV debt). So the former owners are presumably happy since they presumably took cash out of the business (largely via the new third party JV debt financing), TOA is happy because it invested minimal capital in a non-recourse basis, TOA has the benefit of the former owners having rolled very significant equity and also being incentivized towards a future earnout. It would seem to me that this should be the new prototype for how a public builder acquires a private.
TOA’s other large JVs are out West. In Q3, for instance, TOA transferred 10 communities from the consolidated West operations into a JV. This was done purely as a financing technique, in which TOA was able to remove $90mm of cash and replace it with non-recourse JV debt.
There has also been concern over Q3’s reduced orders on a consolidated basis for Florida and the West. But excluding the 25 communities acquired in the Transeastern transaction, the number of active communities (including both consolidated and JVs) has actually fallen y-o-y due to delays in new openings and deliberate efforts to shorten time from contract to delivery. (Given the construction delays in Florida and out West that have been mentioned by many management teams, TOA has made a concerted effort to slow down orders to let production catch up. Once a customer’s order has been placed, the final price of the unit has been set, but the costs to produce it are not yet all fixed. In a time of rising costs, it makes sense to shorten the backlog period in order to enhance gross margin).
The drop in consolidated (non-JV) orders has been further accentuated as JVs account for a larger mix of new communities going forward. Moreover, as mentioned above, 10 communities in the West region were transferred in Q3 from consolidated operations to a JV. And this was not the first such transaction. Also, Transeastern has historically run its operations with a longer backlog. As TOA reduces the length of Transeastern’s backlog, there has been and will continue to be for some time, temporary pressure in JV orders related to Transeastern.
I suspect that tax-loss selling could also be partly responsible for TOA’s current valuation, as TOA is trading just above the 52 week low and materially lower than both its highs reached this summer and the September secondary at $28. In that sense, January could provide a small lift as well. TOA is trading where it was in the summer of 2004, while the comps are almost uniformly trading materially higher than they were 1.5 years ago. I recognize that in theory TOA could have been materially overvalued back then. That said, the biggest corporate “events” since then have simply been the Transeastern JV and the “opportunistic” secondary offering in September 2005. It’s hard to imagine how the Transeastern JV destroyed a lot of value given the way it was structured unless the purchase price was massively inflated. And the secondary offering was either savvy, opportunistic, and value adding if the capital was raised at a price you deem as inflated; or else the current share price decline has been excessive. Even the bears will tell you that historically the way to invest in homebuilders has been to buy when they trade at or below BV and to sell when they hit 2x or higher. With TOA at 1.3x current BV and 1.0x 2006 expected BV, it may be early, but then again, today’s valuation may not last.
Perhaps the most valid concern holding back the stock of late is Florida. Florida represented 38% of consolidated home sales in the first 9 months of 2005, 56% of consolidated (non-JV) backlog dollars at 9/30/05, and the percentage of the total business including JVs is now higher post-Transeastern. Materials and labor shortages have surfaced in Florida, exacerbated by the recent spate of hurricanes. Likewise, electrical hookups and regulatory inspections had been largely put on hold as the focus in the aftermath was on existing homes and not new ones. Management admitted on the Q3 call that margins in Florida will suffer, and it is still too early to determine to what extent. At the same time, management actually raised guidance on the call. While management’s guidance may well turn out to be overly optimistic, I do think the 4.3x valuation provides some decent margin for error. I also derive some level of comfort from the fact that guidance was raised not at time when the company was firing on all cylinders and everything was going better than expected, but rather at the same time that management was acknowledging some of the serious headwinds facing the business.
While TOA operates in several decidedly non-hot markets such as Texas, Colorado, and Nashville, the bulk of its markets are indeed ones that I would classify as hot – Florida, Phoenix, and Vegas. That is concerning to me. However, TOA has made a concerted effort to stay out of California for now. While hot markets always concern me, I am less concerned about TOA’s hot markets because they are still materially more affordable than California. While some of it has been reflexive, self-fulfilling, and thus not necessarily sustainable, Vegas, Phoenix, and Florida are the areas with the strongest job and population growth in the country. I don’t doubt that Vegas, Phoenix, and Florida may be cyclically overheated. But the long term demographic trends for housing are indeed in their favor relative to other areas of the country. Moreover, TOA’s decision to increasingly shift their hot market exposure into JVs and increasingly shift their consolidated exposure towards the non-hot markets seems prudent.
I also derive some comfort from the fact that although they have been trending up significantly this year, TOA’s margins remain below the comps. Management has stated that they have now built up the infrastructure such that they could double the size of the operations with minimal incremental investment in infrastructure. In addition, as TOA continues to digest past acquisitions and as the related purchase accounting effects roll off, that should provide added lift over time.
I have stayed out of the more generic homebuilders debate on the site relating to other names in the space. But given TOA’s valuation in both a relative and absolute sense, I felt compelled to bring up this idea. Moreover, if/when the housing bubble bursts, TOA’s valuation disparity only grows – if earnings fall 50% across the board, TOA is till trading for just 8.6x vs 12-13x for the comps.
Share repurchases have been all the rage for homebuilder investors of late. Given TOA’s rapid growth and investment in its business, it has understandably been left out of that conversation. Suffice it to say that given TOA’s relatively long land supply (>7 years), when it throttles back on growing the business / land acquisition / investment in JVs for land acquisition, the cash flow it would produce and could use in share repurchase would be substantially more accretive at 4.3x earnings that at the 6-7x other builders have been doing. And if that disparity is no longer there when the time comes to repurchase shares, then hopefully the reason will be that TOA’s stock has already risen.
Risks
Florida slowdown is longer lasting and deeper than expected.
Presence in many of the hotter markets (excluding California).
Embedded leverage, even if it is non-recourse. In a major slowdown, if unlevered earnings don’t exceed cost of that financing, earnings will fall.
Significant use of landbankers, which is a more costly source of financing.
TOSA majority ownership.
Catalysts
Outlier valuation reverts back towards group mean.
If spring selling season turns out OK, the entire group should ramp.
Stronger orders numbers once deliberate efforts to restrict sales and shorten backlog have been completed.
Share repurchase once investment in the business slows.
Investors get more comfortable with the JV’s.
Increased liquidity and reduced overhang as TOSA sells down.
Potential acquisition of TOA by a larger builder if its multiple disparity persists.
Catalyst
Outlier valuation reverts back towards group mean.
If spring selling season turns out OK, the entire group should ramp.
Stronger orders numbers once deliberate efforts to restrict sales and shorten backlog have been completed.
Share repurchase once investment in the business slows.
Investors get more comfortable with the JV’s.
Increased liquidity and reduced overhang as TOSA sells down.
Potential acquisition of TOA by a larger builder if its multiple disparity persists.