Brookfield Homes BHS S W
September 27, 2006 - 6:27pm EST by
2006 2007
Price: 28.64 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 760 P/FCF
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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With an estimated fair value of approximately $20, I believe that Brookfield Homes represents an attractive short opportunity from its current price of $29 both on an absolute and relative basis to its homebuilder peers. Brookfield has significantly benefited over the past several years from a very robust housing environment in Southern California and Washington, D.C. (its primary markets).  With the benefit of industry high leverage, the Company harvested significant land gains to generate extraordinary ROEs over the past 3 years, but I believe that is about to change and returns will soon compress to levels more on par with the industry.  However, the Company trades at a roughly 50% premium to the group despite its high leverage, small size and geographic concentration in rapidly decelerating markets.
Company Description
Brookfield is a homebuilder that focuses on the move-up and upper-end residential home market in its three key geographic regions of Northern California, Southern California and Washington D.C.  The company focuses on master-planned communities and adds value throughout the land development process from raw land to completed home.  Brookfield was spun-off from Brookfield Properties in 2003 and is majority owned by Brookfield Asset Management.
At 6/30/06 Brookfield’s tangible book value per share was $10.96.  The company’s earnings guidance for 2006 is $6.20 to $7.20 per share and implies roughly $4 to $5 of earnings in the second half of the year.  This would put year end book value at $15 to $16 per share, and at the current stock price equals 1.8x to 1.9x book value.  I believe that management’s guidance is aggressive and that second half earnings are likely to be closer to $3 per share given the continued deterioration in their markets, putting year end book value at $14 and the current valuation at greater than 2.0x book value.  As a reference point, the only analyst who covers the stock has earnings of $2 in the back half of this year.
Currently, the homebuilding sector trades at an average multiple of 1.25x year end book value with a low of 0.75x  for WCI Communities and a high of 1.4x for Toll Brothers (I have excluded NVR which employs a different “asset-light” option based model and trades at over 3x book value).  At greater than 2.0x my estimate of year end book value, Brookfield is a clear outlier.  Based on the average comp multiple of 1.25x, Brookfield is worth $17 and even at Toll’s group-high valuation of 1.4x it is only worth $20.
Why does Brookfield trade at a premium and why is the premium undeserved?
I believe that Brookfield trades at a premium valuation for the following two key reasons/misperceptions:
1) Brookfield has a very long land supply and the Company adds value taking land through the entitlement and development process so GAAP book value dramatically understates the fair market value of assets
At 6/30/06, Brookfield owned and controlled over 29,000 lots.  The company expects to close 1,200 to 1,300 homes this year and therefore has an astounding 23 year supply of land at the current closing rate.  In Brookfield’s case however, a 23 year land supply does not translate into land that was taken under control many years ago and therefore has seen years and years of price appreciation that is not reflected in GAAP book value.  In reality it is likely that Brookfield’s land was on average taken under control about three years ago.  Below is a land vintage table for Brookfield that I have estimated on a FIFO basis at 12/31/05:
Vintage                                     Lots                 %                    
2000                                        971                  3%
2001                                        2,648               9%
2002                                        7,019               24%
2003                                        5,946               20%
2004                                        8,558               29%
2005                                        4,370               15%
Total                                        29,512             100%
Average Age                            2.9 years
Estimating a mark-to-market value for land is both theoretical and imprecise, but it is helpful to at least use some back-of-the-envelope math.  If on average Brookfield took control of its land in 2003, it likely enjoyed two strong years of value appreciation (homebuilders generally say that land purchased in 2005 is now underwater in Brookfield’s markets).  Let’s say that the land appreciated somewhere between 10% and 20% per year from 2003-2005 for total appreciation of 20% to 40%.  We’ll conservatively assume that 2006 is flat even though almost every major homebuilder has withdrawn from purchasing land and the likely price to sell a parcel today is well below 2005 levels.  The following table shows the estimated NAV under this range of assumptions. 
                                                                        20%                 30%                 40%
Land on Balance Sheet                                     $416                $416                $416
Land Controlled through Options                      $804                $804                $804
Land Held in JVs                                              $138                $138                $138
Total Land Value at Cost                                  $1,358             $1,358             $1,358
Pretax Mark-Up                                               $272                $407                $543
After-tax Mark-Up @ 38% Rate                      $169                $252                $337
Per Share Mark-Up (26.6mm shares)               $6.35               $9.47               $12.67
6/30/06 GAAP Book Value / Share                  $10.96             $10.96             $10.96
Estimated NAV                                                $17.31             $20.43             $23.63
At a $20 mid-point, Brookfield is currently trading at a 45% premium to NAV.  This is significantly higher than the rest of the group which trades at only a slight premium to NAV (it is generally believed that most homebuilders do still have some embedded gains on land purchased several years ago, so NAV for most homebuilders is likely somewhat higher than GAAP book value).  Using what I believe is the most compelling discrepancy, WCI (a Florida-based builder that we wrote up on VIC on 8/22/06) will have approximately $25 of GAAP book value at year end and roughly $30 of NAV, yet trades at $18 – just 60% of NAV.  As a further point, WCI took control of their land primarily through direct purchase (33% of the lots that WCI owns were acquired between the years of 1995-1998) whereas Brookfield generally takes initial control through options which involve price escalators, etc. that add to the effective purchase price (a negative offset to appreciation which I have ignored above).
2) The company earned an 89% ROE on beginning equity in 2005 and the current guidance is for an ROE of 65-75% in 2006, both significantly better than the group average
While the Company did enjoy a remarkably good year in 2005 and has guided to a solid 2006, I believe that recent ROEs are not indicative of normal returns.  As a guideline, management has a stated long-term target return on equity of 15-20%, well below the returns it is currently enjoying and in line with the expected returns of most other homebuilding companies.  So how did things get so out of whack at Brookfield?  The Company primarily operates in what were some of the hottest housing markets in the country in 2005, as 63% of revenue was generated in Washington D.C. and San Diego.  As a result of the strength in those markets Brookfield saw its overall margins progress as follows:
                                                            2001    2002    2003    2004    2005    Q106   Q206
Gross Margin on Home Sales               N/A     N/A     18%     22%     30%     30%     27%
Gross Margin on Land                          N/A     N/A     36%     45%     58%     67%     54%
EBIT Margin (1)                                   13%     13%     18%     19%     28%     24%     27%
(1) EBIT Margin excludes capitalized interest.  Q2 2006 adjusted for normal SG&A load due to stock comp volatility.
When you pair this rise in margin with the most levered balance sheet in the industry (nearly 70% debt/cap vs. an industry average in the high 40s) the results can be pretty dramatic.  However, current market conditions are obviously quite different than they were 12 months ago.  While nearly every housing market in the country has fallen off significantly since last year, it is worth noting that San Diego is now often quoted anecdotally by homebuilding management teams as one of the weakest markets in the country.  As a result, I believe that Brookfield will experience significant downward pressure on home sale margins for the remainder of 2006 and 2007. 
Additionally, the market for land sales has effectively been shut off.  The national homebuilders are almost universally walking away from their own option deposits on land and are looking to limit incremental outlays on land.  This will make it extremely difficult for Brookfield to support their ROE through the high margin sale of land. 
Other Issues That Support a Short Thesis
-         Speculative building / Incentives
Brookfield builds a fair amount of speculative inventory.  The company had 100 speculative homes in inventory at 6/30 versus a backlog of 483 homes.  However, Brookfield defines a spec home as one where cabinets have been installed and there is no contract to sell the home.  Builders define specs in many different ways, but this strikes me as one of the most aggressive definitions.  This build-up of speculative inventory in oversupplied markets should put additional pressure on margins.  Anecdotally, field checks have indicated that Brookfield has communities where nearly all of the units are being built without contracts and not surprisingly this has resulted in heavy incentives which should translate into significant margin pressure going forward.
-         Geographic Concentration
Brookfield effectively operates in only 3 markets making it one of the most geographically concentrated homebuilders.  Generally geographic diversity for a homebuilder is awarded a premium valuation.  In Brookfield’s case, geographic concentration has worked quite well on the way up, but I believe it will increasingly be viewed as a negative as market weakness continues.
-         Leverage
As I mentioned above, Brookfield is the most levered homebuilder with debt to cap of roughly 70%.  The company has been smart about using project-level financing, so I don’t believe they will find themselves with liquidity/covenant problems, but the leverage will certainly amplify the volatility in ROEs and asset values as markets continue to weaken.
Risks to the Short Thesis
-     Joint Venture Structures
Brookfield controls roughly 4,000 lots through JV structures.  At 6/30/06 Brookfield had $65mm of JV investments on the balance sheet (22% of equity) and $65mm of earnings from JVs in 2005.  The information on the economics of the JVs is limited, yet they have been a significant source of earnings.  As market conditions continue to cool for land purchases I would expect earnings from the development of land in JVs to decrease materially, but it is difficult to assess the economics because of the limited information on the structures.
-     Rebound in Local Markets
If market conditions in the Company’s key geographic areas turned it would obviously negatively impact the short, but it does not appear that a turn is likely at this point and I believe the valuation imbeds a considerable margin for error.
-         2006 earnings guidance is cut/missed
-         Stock is re-rated as margins and ROEs return to normal levels


- 2006 earnings guidance is cut/missed
- Stock is re-rated as margins and ROEs return to normal levels
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