Description

Beazer Homes USA, Inc. (BZH)

Recommendation

Buy BZH equity.  BZH is a levered homebuilder that has managed to completely miss participating in the bull market of the last ten-plus years.  Unlike most of its large competitors, BZH has created zero shareholder value since the end of the housing/financial crisis with its stock currently trading around the same price as it did in 2008.  In its defense, BZH came out of the crisis with so much debt that it was always going to be impossible to aggressively compete with other builders with healthy balance sheets.

For the past several years, I’ve been content owning the bonds, which I believe have above average asset coverage, but the recent post earnings stock collapse has also created an opportunity in the equity.  The Q2 numbers were weak with orders and backlog down 4.8% and 11.5% Y/Y, respectively, but what really spooked investors was the very large impairment taken on land in Southern California. But if you’ve followed this Company for a while, you probably weren’t surprised given that the land was acquired prior to 2007 in a very frothy environment and the recent pricing pressures in the SoCal markets makes this land less valuable.  I believe the impairments remove an overhang and position BZH to monetize challenging assets and redeploy capital into more attractive markets away from California. This should improve margins and ROA over time, which may help BZH achieving trading multiples closer to those of its peers.

Stock performance aside, BZH’s operations have actually been surprisingly decent with consistent revenue and EBITDA growth and stable margins.   The Company generates a healthy amount of FCF ($90 – 95mm per annum) and has been able to slowly delever over the years and has even been repurchasing both its bonds and stock in the open market – on May 30th, the Company accelerated the remaining portion of its $50mm buyback plan to repurchase $10mm of its stock in the open market.  The current valuation is undemanding – at $9.99/sh, it trades at ~1.2x TBV and ~5.0x FY20 (September end) EPS. The Company has considerable tax assets and will not be a taxpayer for the foreseeable future – if you include the DTA, BV would increase to ~$16.50/sh.  The tax assets clearly have value but how much is up for debate. At 5.6x EBITDA, the debt load is considerable but also manageable given the staggered maturity wall and the significant FCF that the business generates. The most near-term bond issue that matures in 2022 trades above par suggesting that the market is not concerned about the solvency of BZH.  

While this is clearly not a buy and hold name, even if you happen to be a housing bull, I think it can easily trade back to $14.00/sh (was there only a few weeks ago) or even $20.00/sh (was there early last year) if the housing market continues to slowly grind higher, as I expect it to, and the Company gets to a run-rate EPS of $2.00 – 2.25/sh, which should be doable.  And who knows, with any luck, an activist will take notice of the chronic undervaluation and push the Company into considering a sale transaction or perhaps even a creative deal that can unlock value of BZH’s substantial tax assets. Given the underperformance in the share price, it’s surprising that someone hasn’t shown up to push for a value creating transaction. Consolidation has picked up in the industry in recent years and somehow Beazer has never become a target even with its vast land holdings.  The top three executives alone take home a total of $10mm a year and eliminating just these expenses would be worth a quarter to third of BZH’s market cap to a potential buyer. Obviously, there would considerable additional synergies should someone decide to make a run at the Company – you just have to take a look at the corporate nut here and the math becomes super compelling.

Company / Business Overview

Founded in 1985 and barely avoiding bankruptcy during the crisis, BZH is a midsized homebuilder operating in 13 states in the U.S.   It is one of the few homebuilders that is not majority owned by a founder or family. The Company’s active operations are in the following states: Arizona, California, Delaware, Florida, Georgia, Indiana, Maryland, Nevada, North Carolina, South Carolina, Tennessee, Texas and Virginia.  

The following chart summarizes the Company’s operating footprint:

The West region accounts for the largest portion of the Company’s operations as shown in the following charts.  Note that the Dallas, Phoenix and Las Vegas regions drove the large increase in the West segment.

If you wanted to get more granular, the chart below provides market exposure for BZH as well as some of its competitors:

BZH’s strategy can be summarized as the following: to deliver extraordinary value at an affordable price primarily to millennials and baby boomers. I believe this positioning is demographically sound and is even more compelling in the current affordability challenged environment.  About 55% of BZH’s sales are to first-time buyers and 25% are to active adults.  Given this focus, it wouldn’t surprise many that BZH has one of the lowest ASPs in the industry. In fact, if you back out California, Maryland and Virginia operations, ASPs are below $330,000 making its homes among the most affordable in the country.

The Company continues to grow its community count, which currently stands at 166 and will increase to above 170 later this year.   Sales velocity at the communities has historically been lumpier than it should be and this causes some volatility in the quarterly revenues, which makes investors nervous.  Approximately 25% of its lots are currently under options versus a target of 30 – 35%. As the land on the balance sheet is sold off or developed, the Company will be forced to make acquisitions and enter into more option transactions in order to keep growing.

BZH has developed a nice little niche in the growing 55-plus segment with its Gatherings by Beazer Homes product.  This age-targeted condominiums product was launched in 2016 to address the growing active adults over the age of 55 segment.  These communities consist of four-story, 27-unit condominiums with four different floor plans. Active adults are one of the fastest growing demographic of buyers and the vast majority of them want to retire in place, not out of state. For these buyers, the convenience, safety, affordability and low-cost maintenance of a Gatherings home represents an exceptional value compared to other alternatives. Currently, Gatherings communities have been built in in Florida, Texas, Georgia, Tennessee, Maryland, Virginia, Nevada, Arizona, California, North Carolina, and South Carolina.  The Company is continuing its rollout of Gatherings to other regions with construction activity now in the Mid-Atlantic, Orlando, Dallas and Nashville with other markets starting communities later this year.

Generally speaking, public builder exposure is less favorable than the national average in terms of affordability.  This chart below suggests that while national affordability is currently in-line with its long-term average, public builders in general are over-indexed to areas of the country that are more stretched relative to long-term averages.  While this is a very high level perspective embedded with lots of assumptions, I believe that BZH is in better shape than many of its competitors when it comes to operating in regions that are less stretched from an affordability standpoint.

Drilling down to the most affordable markets in the country, BZH appears to be even more well positioned:

The Company had been quiet on the M&A front but has made two acquisitions recently.  In December 2017, it paid $29mm for land in the Carolinas and in July 2018, it paid $65mm to acquire Venture Homes, a private builder of single family homes and townhomes in the Atlanta area.  The transactions, which will add 34 existing and future communities, were funded with internal cash. The Venture Homes deal moves BZH from the 25th position in the attractive Atlanta market into the top 10, where local market scale advantages go more and more to those with market share muscle to flex in their business operations and community development. As the Company continues to delever, I expect additional small acquisitions in regions where it wants to grow market share.  

Capitalization

BZH has a market cap of $320mm and an enterprise value of $1.5bn.  Net leverage is 5.6x EBITDA, which is very high but is down considerably from historical levels.  Over the last decade, management has made significant strides in reducing both absolute debt and leverage. Since FY08, debt has been cut by more than $500mm and since FY13, leverage ratio has declined from over 12.0x to now below 6.0x.  Mid to longer-term, the Company has a leverage target of below 5.0x.

The Company has plenty of liquidity with $99mm in cash on the balance sheet and availability under the revolver of $135mm.  There are no significant near-term debt maturities and the 8.75s that mature in 2022 are trading in the 104 context.

Summary Financials

Even with the heavy debt burden, the Company’s operations have been respectable. Over the last five years, revenues have risen from $1.5bn to $2.1bn behind a steady increase in orders/closings and higher ASPs.  Margins have generally also been steady allowing for EBITDA to grow from $127mm to the current run rate of ~$200mm. With lower debt levels from paydowns, the Company has been able to reduce interest expense from above $130mm to $95mm.  As a result, BZH should generate ~$90 – $95mm in FCF per annum which it will likely use to repurchase bonds, repurchase stock, and make additional acquisitions of small regional homebuilders. This fiscal year, the Company is planning on repurchasing $50mm of its bonds and max out on its remaining $26mm under its stock buyback authorization.

Below are a few historical operating metrics for the Company:

Looking ahead, I expect BZH to continue to grind forward at a slow pace focusing on growing its communities in markets where it’s having good success today (Dallas, Houston, Las Vegas, Phoenix, Atlanta, etc.).  The new communities coming online will have ASPs in the low $300ks/high $200ks. ASPs for the Company overall will decline over time but should be relatively steady for the next several quarters. Given the lower ASPs, the rising prices for land in good locations, the shortage of labor, I think that we’re at peak margins today but believe that BZH will generate higher EBITDA and FCF over the next several years.  

For some time, the Company’s mission has been to drive higher ROA by dramatically improving EBITDA without increasing the asset base.  With $180mm of non-earning land assets on the books that will begin to produce revenue over time, the Company is on a path to get to 10% ROA in the coming year, a significant improvement from 6.4% in FY15.  As future profits eat into the DTA, ROA will only increase further.

In the most recent quarter, the Company took a massive $147mm impairment charge on its land holdings.  The impairments related to 15 assets, all of which were currently or previously classified as land held for future development and 14 of these assets were acquired before 2007. The largest impairments totaling $109mm were taken against 9 projects in Southern California that are under development or/are actively selling. Demand for new homes has slowed considerably in SoCal where affordability has become challenging. BZH, along with its competitors, concluded that the only way to move new homes in this region was to lower prices.  As a result, the need for price reductions reduced the NPV of the projects, which led to the large impairments. The balance of the impairments was related to 6 land projects that were held for future development in Northern and Southern California that are now up for sale. After these impairments, BZH has no remaining land held for future development in California. The Company doesn’t believe there will be a need for any further impairments based on current market trends.

Valuation Thoughts

On most metrics, BZH trades at a large discount to its comps.  To an extent, this discount is warranted given the stretched balance sheet and slower top line growth, however, I believe the market is overreacting.  Given that many of its peers trade above 9.0x EBITDA, I’m comfortable using a 7.0 – 8.0x range to value the Company. I’ve assumed that the tax assets are worth $75 – 125mm, a sizeable discount to the $256mm DTA on the balance sheet.  This gets me to a rather wide valuation range of $7.00 – 22.00/sh for the Company. This is a classic levered equity situation and so shouldn’t be surprising to see such a wide valuation range. If investors prefer to use P/E multiples instead, I think you can get to a mid to high teens stock valuation assuming EPS of ~$2.00.  On a TBV basis, one can argue that the Company is fairly valued at 1.2x. However, if you believe that the DTA has value (as I do), then here too BZH is trading at a discount to comps.

Thoughts on Consolidation in the Homebuilding Industry

I won’t waste anyone’s time sharing deep thoughts on the state of the homebuilding industry because unless you’ve been living under a rock, you probably already know what’s been happening.  I will just say that I’m positive on new home sales over the next several years though I certainly don’t expect massive growth.

I did, however, want to briefly touch on the topic of consolidation in the industry.  We’ve seen consolidation pick up steam in the last several years kicked off by Lennar’s large acquisitions of WCI and CalAtlantic.  Since then, there have been a flurry of additional deals, both large and small, as publicly traded homebuilders struggle to grow organically in a challenging environment.  The importance of size and scale in the homebuilding industry cannot be understated, particularly in attracting and retaining labor, navigating the land entitlement and development process and realizing construction efficiencies.  In a slow growth environment, builders are increasingly seeking greater volume and cost controls in order to offset higher land and input costs and drive better profitability and returns. Size helps to better manage land and labor constraints and allows builders to do more with less.  

While size does matter, its also not very likely that builders will participate in risky behavior and go out and spend fortunes on land given the experience of the last cycle.  More likely, they will be looking to merge as we get later in this economic cycle. BZH certainly would fall into this line of thinking. The Company was days away from going bust and ten years later is still burdened with debt so realistically it is in no position to go out and do something stupid, even if management entertained the possibility.  Instead, it is more likely that if the share price continues to lag, the board may finally be pressured into considering a sale. I believe BZH would be an attractive target for a large or mid-sized competitor. It has a large enough business to make a major impact on a buyer where the addition of $2.0bn in revenues would catapult the combined entity much higher in the market share standings.  

This is obviously all hypothetical because without activist involvement, the odds are low that BZH puts itself up for sale given how much compensation they’re taking out of the business.  Let’s take a look at the corporate expense bucket at BZH:

I’m not an expert on merger integrations of homebuilding companies but I suspect most of this corporate expense would be redundant if BZH was combined with a larger, or even an equal sized, competitor.  This would be a near certainty if the buyer’s geographies overlapped nicely with BZH’s.

But I think there would be additional synergies outside of the obvious corporate bucket.  Let’s take a look at Lennar’s acquisition of CalAtlantic. At the time of the acquisition, CalAtlantic was doing $6.6bn in home sales revenue, a little more than 3x BZH’s revenues. Lennar had forecasted annual synergies of $250mm by the end of the second year post closing.  The synergies would come from the usual places such as SG&A and direct cost savings but also from production efficiencies, leveraging a technology platform and financial services. Less than six months later, Lennar had increased the synergies forecast to $365mm, nearly 50% higher than the original estimate.  This works out to 5.5% of total revenues of CalAtlantic.

Applying the same percentage to BZH’s revenue base results in a potential synergies amount of $116mm to a buyer.  As a reminder, BZH’s market cap and enterprise value are $320mm and $1.5bn, respectively. I don’t need a calculator to come to the conclusion that the potential is substantial for both a buyer and BZH shareholders.  

It’s a long shot but a guy is allowed to dream and wonder..……

Catalyst

No major catalysts here other than continuing to chop wood - keep generating cash flow and paying down debt to get leverage down below 5.0x EBITDA and be opportunistic on the acquisition front (without equity dilution) to increase market share in the stronger markets where the Company operates.