Description

Capital Pacific Holdings, Inc. (CPH) is a regional homebuilder based in Newport Beach, California and operating in Southern California, Arizona, Colorado, and Texas. The company divested most large development projects a year ago and is now a conventional homebuilder.

CPH just reported fiscal-year earnings of $0.43 per share and therefore has a market-comparable P/E of 10. However, unlike the typical homebuilder that is trading at more than two times book value, CPH is trading at a discount of more than 35% to tangible book value (adjusted). CPH has a particularly strong – and improving – balance sheet that makes the company attractive as a value play, especially since its lower leverage and reduced debt costs should translate into higher earnings down the road.

Earnings are somewhat difficult to forecast because of fluctuations in the number of active projects and variability in home closings. Quarterly results for the fiscal year that started in March 2002 should initially be somewhat soft since CPH entered the year with only 22 active projects and $74 million of backlog. However, the company has reported that it expects the number of active communities to rise to between 33 and 40 in the next year and that backlog has already increased to approximately $100 million.

Given the rise in backlog and the outlook for higher activity later in the year, CPH should be able to at least match its earnings of last year and could ramp up to earnings of $0.55-0.60 per share. Revenues are likely to be lower this year due to the smaller starting backlog, but reduced interest expense should have a significant impact on earnings. CPH should incur only about $6 million of interest expense this year (5.5% on $115 million of debt), down from $14.8 million in the last fiscal year. Reported interest expense may still be approximately $12 million (as previously capitalized interest is run through the income statement) but that would be a dramatic decrease from the $28.9 million of interest expense reported last year. Interest savings may total more than $1.00 per share on a pretax basis this fiscal year.

As noted above, CPH trades at a significant discount to tangible book value. At February 28, the company had $93.1 million of shareholders’ equity plus $8.3 million of deferred gains from its asset divestiture. With 14.9 million shares outstanding, adjusted book value is about $6.80 per share. The $5.4 million of negative goodwill shown on the books at fiscal year-end will be recorded as a one-time gain in the quarter that just ended May 31. At $4.28 per share, CPH’s stock is trading at 63 percent of adjusted book value.

One concern for investors has been CPH’s leverage. As recently as February 2000, the ratio of liabilities to adjusted equity was 2.4:1. That ratio has declined to 1.5:1, however, as the company divested some assets and as a number of the company’s projects entered the final phases in which they generate significant amounts of cash. In the last two fiscal years, operating cash flow was $29.8 million and $51.6 million, respectively.

Leverage is likely to fall further in fiscal 2003, unless the company reinvests in large new projects. In particular, the company holds $38 million of assets (out of $250 million total) at the holding company level that mostly comprise one project – Montecito at Newport Coast in Orange County, California. Most of the homes in this project have been “sold” and the remaining completions and closings should mostly occur during the current fiscal year. The ratio of liabilities to adjusted equity could be as low as 1.2:1 when this project is complete.

Catalyst

Potential catalysts include: 1) Stronger backlog and earnings momentum as the fiscal year unfolds, 2) Increased investor recognition of the balance sheet strength, and 3) A sale of the company.

Regarding the last possibility, three large holders control 85% of the common stock. Of these, Farallon Capital Management (a large hedge fund that owns 27%) has held its stock for more than four years and former President Dale Dowers (with 11%) is no longer affiliated with the company. While CEO Hadi Makarechian (with 47%) could be a longer-term holder, it is possible that the sale of the company’s development assets could be a prelude to a sale of the remaining homebuilding company.