Description

Opportunity

CalAtlantic is an underfollowed and relatively unknown homebuilder trading at a large discount to its peers despite a consistent historical track record of industry leading returns.  This gives investors 40%+ upside opportunity from a re-rating as the market recognizes the mis-pricing.

Background:

CalAtlantic was recently formed by a merger of equals between Standard Pacific  (SPF) and Ryland Group (RYL).  This merger brings together a top-notch land portfolio (SPF) and operational team (RYL) that has and should continue to generate well above industry average returns on equity. 

Standard Pacific

Standard Pacific was a midcap homebuilder based in Irvine, CA.  Their homebuilding operations were geographically focused in California, Texas, and FL with the balance of sales in the Carolinas, Colorado, and Arizona.

Standard Pacific’s high quality land bank and geographic exposure afforded the company with industry leading gross margins that are unmatched by other large cap homebuilders (see below). 

Standard Pacific was unique in that they disclosed backlog gross margin each quarter providing about two quarters of forward margin visibility.  Through the third quarter of 2015, Standard Pacific’s backlog margins have been firm at 25.5 to 26 percent suggesting continued stability.

In summary, SPF is a high quality midcap builder with the good geographic exposure, outsized and predictable margin structure, and a management team that is highly respected by the street.

Ryland

Similar to SPF, Ryland was a mid-cap builder based in Westlake Village, CA.  Ryland had a diverse geographic footprint (see below) with exposure to both entry level and move-up markets – no real differentiation versus the overall market in footprint or product suite.

Ryland was unique in that their return on equity was significantly higher than the average homebuilder driven by higher than average inventory turns and their willingness to use options contract to increase their returns on invested capital. 

CalAtlantic

On June 14, 2015, Standard Pacific and Ryland announced that the companies had agreed to a merger of equals with Standard Pacific as the surviving entity (now named CalAtlantic).  The announced transaction was met with pretty aggressive selling by the market.  CalAtlantic has underperformed the ITB (homebuilder ETF) since the announced transaction by ~1,200 basis points and the combined company has had little support from the sell-side (4 buys and 10 neutrals) with the general pushback being “I want to see what it looks like as one company.”  Pro forma geographic exposure for CalAtlantic is shown below.

Valuation

For those willing to take the time piecing together CAA pro-forma financials, the market is providing an opportunity to buy a best in class homebuilder at an unjustifiably steep discount to its large cap peer group.  This is an asset that has historically had well above average returns on equity, a high quality California land portfolio, and best in class management team.  As can be seen in the table below, SPF and RYL have significantly outperformed industry returns over a long period of time and are expected to continue to do so into 2016.  And despite the superior financial performance, CalAtlantic currently trades at a significant discount to the large cap group on earnings and book value based on consensus estimates. 

CAA should trade at a premium to the group, or at a minimum at the high end of peer multiples.  Simply applying high-end of large cap builder peer multiples to CAA consensus numbers gets $50/share for CAA. 

But CA consensus should be adjusted for run-rate synergies and purchase accounting adjustments.  Currently, 2016 consensus earnings estimates include $75m of purchase accounting adjustments from the merger with RYL, but CAA has actually recently guided this to $10m in 2016 after putting a large amount of the purchase accounting in 2015 instead. This would add $0.32/share of EPS in 2016.  Full run-rate synergies from the transaction provide an additional $0.05/share of eps in 2016.  Combined, these adjustments add $0.37/share to 2016 estimates.  At the high end of peer multiples, this adds $5/share to the $50/share price, or $55/share (40% upside).  At a 1x eps premium to the group (rewarding CAA for consistent return outperformance), the price target goes to ~$60/share (~50% upside).

Risks

CAA has similar macro risks to other homebuilders including interest rate sensitivity, cyclical volume, and pricing risk.  As there are a number of publicly traded homebuilders, this risk can be hedged out with a variety of names.  CAA regional exposure can also be hedged with builders over-exposed to similar regions. 

Catalyst

Continued execution. 

Housing data.

Time.