Like most consumer industries, residential housing construction is declining sharply in the wake of the Covid-19 shutdown. The industry’s recovery, which was accelerating at the beginning of the year, is now reversing rapidly.
In this issue, we review five homebuilders whose valuations appear to overly discount the industry’s recovery prospects.
Cabot Turnaround Letter 520
HOMEBUILDERS: KNOCKING ON THE DOOR OF OPPORTUNITY
In this Issue:
Homebuilder Stocks
Insider Buying After the Market’s Lows
Recommendations:
Buy: Lamb Weston (LW)
Price Target Changes and Sells
Performance
Like most consumer industries, residential housing construction is declining sharply in the wake of the Covid-19 shutdown. One indicator: single family housing starts fell 17.5% in March, one of the fastest rates in decades. New demand will continue to drop and contract cancellations will surge in April, particularly with 26 million job losses. The industry’s recovery, which was accelerating at the beginning of the year, is now reversing rapidly.
However, is the recovery derailed, or just delayed? The demographic tailwind from Millennials reaching the traditional home-buying age remains in place. Single family housing starts, at 1.04 million units in February, was only about half the pace of the peak of the last housing bubble and even below levels of the 1980s and 1990s, when the U.S. population was much smaller, leaving plenty of potential for higher volumes. The stay-at-home restrictions may incentivize many to move out of crowded cities into spacious new suburban homes.
Affordability, long a concern for home buyers, is being helped by historically-low interest rates, and could be boosted further if financial market conditions begin to improve. And, if inflation returns, demand for homes would likely rise significantly, especially if interest rates remain low, as consumers rush to buy before the next price increase.
Listed below are five homebuilders whose valuations appear to overly discount the industry’s recovery prospects. Their shares sell close to or below tangible book value, a useful valuation metric as most of a homebuilder’s assets (primarily land and in-process homes) are recorded at approximately market value.
Green Brick Partners (GBRK) – Green Brick has a unique strategy: rather than operating as a single company, its local subsidiaries and affiliates to run their businesses with considerable autonomy, on the logical assumption that they know their markets better than centralized management. Administrative functions, riskmanagement and financing are provided by the main office. Conservatively capitalized Green Brick builds suburban townhomes, first-time and second-time moveups, age-targeted and urban housing in Texas (its home state), Georgia, Florida and Colorado. Another unusual twist is that Greenlight Capital has long-held nearly 50% of the company’s shares, as the hedge fund’s manager David Einhorn co-founded the company in 1986.
M/I Homes (MHO) – Twice-Turnaround Letter recommended M/I Homes (gains of 75% and 92%) is a Columbus Ohio-based builder founded in 1976 by the locally-renowned Schottenstein family. The company focuses on affordable, empty-nester and luxury homes to buyers in the upper Midwest, Texas and southeast regions of the United States. M/I Homes is conservatively run, reflected in its low-risk balance sheet and land acquisition strategy that emphasizes controlling lots with options rather than outright ownership.
MDC Holdings (MDC) – MDC builds homes for first-time and move-up homebuyers in the western United States with a smaller presence on the east coast. Chairman and CEO Larry Mizel, who founded the company in 1972, still controls 15.8% of the company’s shares. MDC’s balance sheet is conservative, with $450 million in cash, plenty of untapped credit line capacity, and no senior note maturities until 2024. MDC raised its generous dividend by 10% in January, although this was before the downturn started.
Meritage Homes (MTH) – Meritage concentrates on entry-level and first-time move-up homes primarily in the southwest, west and southeast United States. The company is simplifying its roster of home plans and customizations with a strategy first deployed by car makers. This has helped Meritage expand its margins while making it easier on customers who don’t want to be overwhelmed by hundreds of choices. Complementing this strategy, Meritage is emphasizing speculative home-building (without a buyer in advance), which has now reached over 60% of closings. This may lead to higher near-term unsold inventory as buyers wait-out the virus, but over time may help Meritage meet a demand recovery and boost its margins further. The company has plenty of liquidity and a reasonable amount of debt.
Toll Brothers (TOL) – Toll Brothers is the country’s largest luxury homebuilder, even as it is expanding upon its wide range of price points in more affordable categories. The company operates across 24 states. In addition to the downturn, Toll has struggled with cost over-runs at its Metro Crossing project, but we expect this issue to fade over time. Overall, the company has a quality reputation, reflected in its ranking as the #1 Most Admired Homebuilder by Fortune magazine for six consecutive years. Its balance sheet and financial flexibility remain capable of carrying them through the current downturn.
STOCKS WITH HEAVY INSIDER BUYING AFTER THE MARCH 23RD MARKET LOW
A year ago, in our May 2019 edition, we wrote about the how heavy insider buying may indicate that an undervalued stock is ready to take off. The stock market (and economy) have of course changed immensely since then, so we are taking a fresh look at stocks with sizeable post-market-low insider buying in the open market. Open market buying (as opposed to the conversion of options) by executives, directors and major shareholders, who know more about their company than anyone else, suggests that the future for these businesses is brighter than their weak share prices imply.
These insiders are required to report their stock purchases and sales to the Securities and Exchange Commission (SEC) every month. These publicly-reported insider purchases are different from “insider trading”, which are illegal practices where individuals trade stocks on material, non-public information beyond the boundaries set by the law.
Listed below are seven companies with heavy recent insider buying, but whose shares remain well below their levels earlier in the year. For valuation, we generally use estimated Enterprise Value/EBITDA, or (earnings before interest, taxes depreciation and amortization, a measure of operating cash flow) for 2021, which may be a reasonable post-recovery year.
Darden Restaurants (DRI) – Insiders have recently purchased nearly $4.6 million in shares since the March 23rd market low. The largest purchase was for $1.5 million by the CEO, and nearly all of the directors have been notable buyers. As one of the nation’s largest restaurant chains (owning the Olive Garden and other brands), Darden has relatively modest debt, considerable cash and a solid group of franchises that will likely be popular again when its 1,800 restaurants across the country, in Latin America and the Middle East eventually re-open. Its operations are well-run, with a strong management team and board following the aggressive leadership replacement initiated by an activist investor in 2014.
Halliburton (HAL) – As one of the largest providers of drilling services to oil and gas exploration companies, Halliburton is struggling with the industry’s deepest crisis in generations. Its shares remain 60% below their 2020 highs and are down 84% from only two years ago. However, the company is well-managed, is aggressively slashing its cash outflows and will likely be in a stronger competitive position as weaker service providers disappear. We expect the dividend will be cut or suspended. In an encouraging vote of confidence, director Murry Gerber acquired $4.1 million in shares just prior to and shortly following the March 23rd lows.
Howard Hughes Corporation (HHC) – This unique company owns and develops land, with an emphasis on high-end properties where it can build entire towns. Its core developments are near Houston, Las Vegas, Washington, D.C., Honolulu and New York City. While the economic downturn may weaken its near-term prospects, particularly in energy-driven Houston, it is well-positioned to prosper in a recovery. The company generally self-funds its growth through non-core asset sales. To adjust to tightening capital market conditions, Howard Hughes recently raised equity capital by selling 12 million shares, of which 10 million were purchased by hedge fund activist and long-time board chair Bill Ackman for $500 million. Other board members also purchased sizeable amounts of shares.
JPMorgan (JPM) – If any bank will survive and prosper after the pandemic, it will be JP Morgan. Exceptionally well-managed with a sturdy capital base and industry-leading risk controls, the bank recently posted a reasonable first quarter profit despite adding $6.8 billion to its loan loss reserves. Board member Stephen Burke recently bought $6.6 million in stock at just under $88/share. JP Morgan shares aren’t particularly cheap, as its valuation assumes that the bank will recover much of its earnings power by 2022, but for investors looking for a high-yielding and high-quality bank stock, this fits the bill.
MGM Resorts International (MGM) – Global gaming company MGM owns the iconic Bellagio and MGM Grand casinos in Las Vegas as well as resort properties in China and Japan. Investors worry that customers, who often need to board an airplane prior to visiting MGM properties, will only slowly return. Some investors are also concerned about the recent departure of the long-time CEO and MGM’s move toward an asset-light approach that entails selling the land under its Las Vegas casinos. Yet, insiders recently purchased over $9 million in shares, led by CEO Paul Salem who acquired $7.9 million in MGM stock. An additional $18.7 million in shares was purchased by board member and activist investor Keith Meister. While the company’s leverage is elevated, the capital markets welcomed its offering of $750 million in 6.75% senior notes (upsized from $500 million), and so it now has nearly $3 billion in cash on hand.
Westlake Chemical Corp (WLK) – Westlake is a major producer of niche specialty chemicals, a strategy that allows it to generate above-average profit margins. Its products are found in a wide range of everyday products across the consumer, construction, food packaging and automobile industries, providing diversification that should help to stabilize its cash flow during the current downturn. Its balance sheet remains reasonably sturdy and management is considered to be strong. The founding Chao family, who controls about 73% of the company, added $22 million in shares to their holdings immediately after the market lows.
RECOMMENDATIONS
Purchase Recommendation Lamb Weston (LW)
Background:
Lamb Weston is the largest producer of frozen potato products in North America and the second largest in the world. Selling french fries to fast-food restaurants (McDonald’s is a 10% customer) is a major part of its business. While the United States produces 80% of its revenues, it has 27 processing facilities around the world that serve fast-food and full-service restaurants and other customers in 100 countries.
Based in Eagle, Idaho, Lamb Weston was founded in 1950 by F. Gilbert Lamb in Weston, Oregon. The company gained a reputation for valuable innovations, including inventing the Water Knife Gun in the early 1960s that became the industry standard for slicing potatoes. Lamb Weston expanded through organic growth and acquisitions in Asia and Europe. In late 2016, the company regained its independence with its spin-off from Conagra Brands.
Lamb Weston shares remain 32% below their highs on concerns over how deeply its profits will decline due to widespread Covid-19-related restaurant closures. Investors also worry about a slow re-opening pace and whether uneasy consumers and capacity-reducing social distancing protocols will initially and possibly permanently impair the return of normal restaurant traffic unless a vaccine or effective treatment for Covid-19 is found. Concerns also include recent in-creases in input and fixed costs, virus-related supply chain issues and general agricultural risks associated with sourcing potatoes.
Analysis:
Lamb Weston shares offer investors an opportunity to invest at an attractive price in one of the largest companies in a stable, high-margin secular-growth industry.
French fries remain a dining-out staple – there is hardly a menu item that is more universally popular. While near-term demand will clearly be weak, long-term global demand will likely rebound and resume its steady 3% growth rate.
Near-term demand won’t completely collapse, either. About 65% of all fries are purchased at fast-food restaurants, and about two-thirds of those are bought via drive-through windows, carry-out or delivery which continue to remain open for business. States (and countries) are beginning to re-open their economies, providing some clarity to what we see as a normalizing of restaurant traffic by the end of 2020. Recent results from China, where sales quickly rebounded to 70% of normal, provide some encouragement. Also, Lamb Weston will capture some of the (temporary) surge in retail french fry demand.
Lamb Weston has a cost-advantaged position (given its high-quality potato sourcing and large-scale and efficient production facilities) and a high 42% market share in a concentrated industry. The North American potato industry is dominated by Lamb Weston and three other large, family-owned companies, somewhat limiting the risk of aggressive competition.
Last year, the company produced healthy profits (22.0% EBITDA margin) and surplus free cash flow (nearly $200 million) even after funding an elevated capital spending program and its dividend. In a prolonged recession, we estimate that the company would still have break-even or positive surplus free cash flow.
Lamb Weston’s balance sheet is sturdy and its liquidity is plentiful. Quarter-end debt of $2.3 billion was only 2.6x last year’s $853 million in EBITDA. The company raised cash by drawing $495 million draw from its credit lines after quarter-end, and even in the unlikely event that it goes through all that cash, its leverage would still be manageable. And, the nearest maturity other than the line of credit is a modest $280 million due in November 2021, providing time for an eventual recovery.
With Lamb Weston’s overall business and financial strength, its shares look quite appetizing for long-term investors.
We recommend the PURCHASE of shares of Lamb Weston Holdings (LW) shares with an $85 price target.
PRICE TARGET CHANGES AND SELLS
Gold mining company Barrick Gold has exceeded our $20 price target (now trading around $27), as the new CEO has executed on his turnaround. Steadily rising gold prices, now around $1,727/ounce, up 32% since our February 2019 recommendation. We think the company continues to have a bright future ahead and we are raising our price target to $30.
The Covid-19 virus is bringing health and financial hardships to Brookdale Senior Living. We believe there is a considerable risk that occupancy will decline as the elderly and their families find alternatives to its senior housing facilities. Also, higher staffing and supplies expenses will likely add further profit pressures onto Brookdale. These newer problems, when combined with its already- difficult financial picture and reluctance to sell additional properties, leave the company with limited prospects for recovery, so we are moving the shares to a Sell.
Washington Prime Group had a reasonable chance to succeed with its turnaround plan, which required relatively stable rent revenues to help fund the redevelopment of its in-transition malls. However, with its malls now closed, more stores in or approaching bankruptcy, and its access to additional capital likely limited, combined with the pressure of loan covenants, we believe the company’s future is irretrievably lost and are moving WPG shares to a Sell. We note that its 5.95% bonds due in 2024 are trading at 54 cents on the dollar.
PERFORMANCE
The following tables show the performance of all our currently active recommendations, plus recently closed out recommendations.
