Description

Brookfield Homes Corporation (“BHS”), a residential homebuilder, was recently spun-off from Brookfield Properties (“BPO”), a corporation which owns, manages and develops North American commercial properties. No one owned BPO for exposure to BHS, as it was less than 10% of the market cap of BPO at the time of the spin. It has traded briskly since the spin, and did not experience the attendant sell-off characteristic of many spin-offs. However, we believe it is still an attractive investment opportunity.

As public homebuilders go, BHS is on the small side with an equity market cap of approximately $370mm. Furthermore, it has more market concentration, and is somewhat more levered, than its public comps. BHS delivers homes in California and Northern Virginia. More specifically: 53% of lots are San Diego/Riverside, 17% are in the San Francisco Bay area, 6% are in Southland/L.A. and 23% in Northern Virginia. These tend to be higher growth markets than the national averages. San Diego has progressed well despite the telecom/tech bust that hit parts of San Francisco and Northern Virginia. According to management, San Francisco and Northern Virginia have been regaining strength.

I will not bore you with a bunch of other statistics that are readily available in the Form 10/A, such as average sales price, backlog, deliveries, etc.

At $11.50/shr BHS is trading about 1.1x BV and about 7.5x earnings vs. comps that trade at 1.4x BV and 6x earnings. While BHS has more debt than is typical for a homebuilder, BHS is in a position to repay $100mm of 10% debt which it currently has on its books (details of potential source of funds for this payback are included in the next paragraph). This will leave BHS with about $300mm of project debt by the end of 2003. Eliminating the 10% debt will save about $0.19/sh on a base of approximately $1.50/sh, not insubstantial. Furthermore, current cash interest is close to $25mm run rate (including the 10% debt), for EBIT/cash interest coverage of 4.6x, which is very manageable. Pro forma for the aforementioned debt reduction, cash interest coverage goes to nearly 8x, in line with comps.

There are a few aspects of BHS that we find attractive relative to comps. First is its land inventory. While many consider substantial land holdings a risk, we see it as a source of opportunity for BHS. BHS has 22,100 lots available to it against annual production of about 1600 lots, nearly 14 yrs of production, (about 8 yrs of which is owned, the balance is optioned). This compares to about 5 yrs of production (under 3 of which is owned outright) for the public comps. The importance of this is that BHS stands to generate significantly more FCF than its peers as a % of its reported income. BHS can either draw down some of its land inventory or make a bulk sale to pay down the debt, pay a dividend, etc. Management is currently considering such options. Considering that the cost of developed land runs about 30% of revenues for BHS (raw land being about 50% of that cost), you can see how cash generative a year of land run-off would be. That being said, BHS will be putting some capital into lot development in 2003 to increase its lot delivery potential to above 1900 by 2004. Secondly, BHS has approximately $130mm in NOLS which will shelter earnings for the next 1-2 yrs. Lastly, BHS was a taxable distribution to shareholders. As such it is not subject to the usually 2-year waiting period for spin-offs to be acquired. We think that given its size and concentrated land position (in relatively land constrained markets) BHS is an attractive take-out for larger companies such as LEN, which is interested in making further acquisitions. (I would not read too much into it, but last week’s stock dividend announcement by LEN on the B shares can be LEN giving themselves some more room to make stock acquisitions with their A shares. The B shares automatically convert once they fall below 15% of aggregate shares outstanding. The stock dividend gives them a little more room.)

We believe that a DCF, as opposed to a pure earnings multiple, is the most appropriate way to value BHS. Homebuilders typically trade at a low multiple of reported earnings, in large part because the ongoing land purchase requirements depress free cash flow. BHS is non-typical as a result of the substantial land inventory, and associated higher free cash yield. On a DCF basis we get to about $16/sh, including the present value of the NOL, an increase to 1900 lots delivered in 2004, and using a conservative terminal value of 1x book. Given the level that public comps are trading at, we would not expect to see that value unless there is a significant land sale or a take-out, although we believe such an event is likely. That being said, $14/sh would not be unreasonable in the interim.

Management options of about 1mm shares strike at $10/sh.

BHS is 48% owned by Brascan Corporation (NYSE: BNN). They have stated their intention of not selling shares, and increasing their position if share price warrants. Brascan was in the market buying shares shortly after the spin.

The CEO and CFO have also been purchasing stock. Their latest purchases were at $11.61 for aggregate consideration of approx. $1.2mm.

Risks:
1. Major housing correction
2. Market concentration in California and Northern Virginia
3. Brascan ownership. Even though they seem to be better buyers than sellers here – you never know. Furthermore, after accounting for Brascan ownership free float is only $180mm. Liquidity going forward will probably not come close to current volumes.

Catalyst

1. Significant land sales to pay-down debt, pay dividend, etc.
2. Acquisition by larger competitor
3. Typical spin-off dynamics, i.e. BPO selling pressure weighing on stock will dissipate, potential sell-side coverage to be initiated.