Description

July 16, 2006 – Champion Enterprises (CHB; $8.60)

 

Champion Enterprises (CHB) is one of the top 3 producers of HUD-code manufactured housing in the country.  It is also the largest producer of modular housing.  The stock is down nearly 50% since early May, in excess of its comps.  I believe it has been caught in the downdraft with traditional site-built production homebuilders, probably the most beaten up sector on the Street.  Meanwhile, manufacturing housing industry production remains in the doldrums.  While the timing of the industry recovery remains uncertain, I believe that the risk-reward is compelling at $8.60 / share.

 

Industry Production

Manufactured housing (MH) production levels are down by roughly 2/3 from the recent peak of 373,100 units in 1998.  In the past 3 years, excluding 17,000 FEMA units in 2005, production has seemed to have bottomed out at ~130,000 units.  The reasons are various.  As lenders led by Conseco flooded the industry with excessive and overly aggressive financing in the 1990s, manufacturers expanded capacity and retail outlets to meet the inflated demand.  Predictably, many of the chattel loans that should never have been made went bad, precipitating the Conseco bankruptcy and a mass exodus of lenders from the marketplace.  (I believe that in 1998 there were at least 11 different MH lenders securitizing their contracts via the ABS market while today there are 2-3 at most).  With financing much less accessible, demand plummeted.  In the meantime, repossessions skyrocketed from normalized levels of 25,000 / year to estimates of 90,000 – 105,000 in each of 2002 and 2003.  Competition from repos further depressed production levels.  Moreover, as interest rates fell to generational lows, traditional mortgage underwriting became lax, and subprime mortgage lending exploded, traditional site-built housing became more affordable relative to MH than ever before.

 

While the above chain of events is rather widely known, the depth of the downturn is striking.  You have to go back to 1962 to find a lower # of MH shipments.  But even that doesn’t do it justice, because the number of households was so much lower 44 years ago.  Back in 1962, MH shipments as a % of total HHs was 0.22%.  But today, that ratio has fallen all the way to 0.12% vs a 47-year median of 0.31% and mean of 0.34%.  Likewise,  the # of MH shipments as a % of total housing starts has fallen to less than 7% vs the 47-year median and mean of 17%.  (Please see industry production stats and percentages going back to 1959 at the end of this post).

 

Even in the last trough in 1991, production was 170,900 units, substantially higher than today’s levels and again at a time when there were fewer households (production today would be in excess of 205,000 units adjusting 1991 production levels to today’s # of households).  Median production over the past 47 years has been 241k units, and the mean 260k units.  Again, however, that is misleadingly low since the population has grown so substantially over the past 47 years.  Using the 47-year median of 0.31% MH shipments as a % of total households would imply “normalized” production today of 354k units.  Suffice it to say that normalized production levels appear to be at least 50-100% above present levels.  And this also ignores the fact that MH quality relative to site-built has improved dramatically over the years.

 

In fact, at the latest annual meeting in Omaha, Warren Buffett and Charlie Munger said with characteristic understatement that they expect at some point the industry will be producing over 200,000 units again, though most likely not in the next year or two.  They also remarked that Clayton could become the largest homebuilder in America in future years.  Note that the largest production homebuilders already produce over 50,000 units per year.

 

All in all, though it is hard to envision a ramp in industry volume in the near term, it is bound to happen at some point.  With each passing year at severely depressed levels of production, I believe that that time gets closer.  Moreover, several of the other headwinds for MH have begun to reverse.  While still low, mortgage interest rates have been rising for site-built construction.  And while still lax, mortgage underwriting standards are beginning to get more stringent.  Meanwhile, affordability metrics for traditional housing are now at 14 year lows after a modest increase in interest rates combined with a massive increase in prices across many regions of the country.

 

In addition, down payment assistance programs such as Nehemiah have come under increasing scrutiny.  Such programs are reported to have “helped” 625,000 families buy traditional homes in the last 6 years that otherwise would have been unable to do so (see front page of WSJ from July 5, 2006).  I suspect that this further shifted natural MH buyers away from MH and into site-built.  If we assume that just 50% of these families would have otherwise been MH buyers, which seems conservative, that would imply that MH demand was artificially depressed by about 50,000 units per year on average from 2000-2005 (presumably by less in the earlier years and more in the later years as these programs took off).

 

I believe that Buffett’s purchase of Clayton in 2003 and its subsequent purchase of Oakwood out of bankruptcy (formerly 2 of the top MH producers and today the combined #1 producer) add rationality to the industry.  And the fact that 3 years have now passed since Buffett essentially “called the bottom” by making the Clayton acquisition makes it seem that we are that much closer to the upturn.

 

Significant capacity has also been removed from the industry since it peaked.  Production capacity is estimated to have fallen by 25-40% since 1999.  The # of MH retailers is estimated to have fallen from roughly 9,000 at the peak to roughly 5,000 today.

 

Decreased levels of repos from the peak in 2003 should provide less competition to new production going forward.  They also make 2004-2005 production levels appear much lower than on 2003 on an “apples to apples” basis since they were competing against fewer repos at that time.  Finally, dealer inventories are close to all-time lows.

 

Champion in Particular

Stepping back from the more macro industry backdrop, CHB in particular appears to be well positioned and is the largest and most liquid public pure-play.  CHB has been nursed firmly back to profitability after years of losses, despite the low levels of industry production.  Manufacturing margins are up year-over-year for the past 12 quarters and are at levels last seen in the late 1990s.  Meanwhile, the stock price is not too far above where it settled out in late 2003, after Buffett’s purchase of Clayton, despite the fact that the capital structure has been significantly improved and the company is no longer losing money.

 

CHB has also become the largest producer of modular housing in America.  Modular presently represents ~25% of CHB revenues.  Modular is similar to MH in that it is produced in a factory.  However, it is typically mortgage financed instead of chattel financed and often cannot be distinguished visually from traditional site-built homes (multiple floors/levels are possible, for instance).  This appears to make modular the best of both worlds because of the manufacturing cost advantage of factory production, combined with the financing cost advantage of mortgage financing vs chattel financing.  Furthermore, modular homes tend to appreciate in value because the land is owned, in contrast with traditional chattel-financed MH that tends to depreciate.  The modular market is small, estimated at just 44,000 units last year, but growing.  It is extremely fragmented, historically undermanaged by “moms and pops”.  For instance, modular homes today are often sold out of catalogues instead of from model homes.  In addition, the segment can be grown by enhancing marketing and awareness.  Modular provides CHB with slightly higher margins than traditional HUD-code MH.  In addition, there is less of an issue with the NIMBY zoning that often tries to keep traditional “trailer parks” out.  CHB has made recent modular acquisitions and intends to look for more. 

 

The stock presently trades at 8.3x 2006 and 2007 consensus EPS estimates of $1.03.  (While earnings are expected to be higher in 2007 than 2006, the company at present does not provision for income taxes given its history of losses.  While its present NOL balance has a valuation allowance reserved against it, that is expected to be removed at some point in 2006, at which time the deferred tax asset will come on balance sheet and add around $100mm to book value, and necessitate the ongoing provisioning for income taxes going forward).

 

In short, after this most recent pullback in CHB stock, the present valuation based on present depressed industry conditions seems quite reasonable, if not slightly cheap.  The risk-reward is much more compelling at $8.60 / share today while we wait for the MH industry to turn.

 

 

Catalysts

• Increased chattel lending to the industry as new lenders enter and existing lenders expand.  Admittedly, bulls on the industry have been awaiting this development for years and aside from Buffett’s entry via Clayton and its Vanderbilt financial services subsidiary, it has yet to materialize.

 

• Industry shipments return to normalized levels, at least 50-100% above present levels.

 

• Continued growth into modular.

 

 

Risks

• Value trap.  Industry production has remained in the doldrums for 3 years.  If increased chattel lending continues not to materialize, the downturn could be prolonged.

 

• CHB management has recently made acquisitions in the modular business and intends to continue making further acquisitions.  Overpaying and integration difficulties are standard risks to this strategy.  That said, the most recent acquisitions are expected to be immediately accretive and it is too early for there to have been integration difficulties.

 

• Industry capacity is brought on more quickly than demand returns.

 

• Increased competition from inventory of traditional site-built homes as the real estate bubble deflates.

 

• Management ownership is minimal.

 

• Margins have already improved to near prior peak levels.

 

 

Industry Production Data

 

	MH	MH % of	MH % of	MH % of
	Shipments	SF Starts	Total Starts	Total HHs
1959	120.5	9.8%	7.9%	0.23%
1960	103.7	10.4%	8.3%	0.20%
1961	90.2	9.3%	6.9%	0.17%
1962	118.0	11.9%	8.1%	0.22%
1963	150.8	14.9%	9.4%	0.27%
1964	191.3	19.7%	12.5%	0.34%
1965	216.5	22.5%	14.7%	0.38%
1966	217.3	27.9%	18.7%	0.37%
1967	240.4	28.5%	18.6%	0.41%
1968	318.0	35.4%	21.1%	0.52%
1969	412.7	50.9%	28.1%	0.66%
1970	401.2	49.4%	28.0%	0.63%
1971	491.7	42.7%	24.0%	0.76%
1972	575.9	44.0%	24.4%	0.86%
1973	579.9	51.2%	28.4%	0.85%
1974	338.3	38.1%	25.3%	0.48%
1975	212.7	23.8%	18.3%	0.30%
1976	246.1	21.2%	16.0%	0.34%
1977	265.6	18.3%	13.4%	0.36%
1978	275.7	19.2%	13.6%	0.36%
1979	277.4	23.2%	15.9%	0.36%
1980	221.6	26.0%	17.1%	0.28%
1981	240.9	34.2%	22.2%	0.29%
1982	239.5	36.1%	22.5%	0.29%
1983	295.8	27.7%	17.4%	0.35%
1984	295.4	27.2%	16.9%	0.35%
1985	283.5	26.4%	16.3%	0.33%
1986	244.3	20.7%	13.5%	0.28%
1987	232.8	20.3%	14.4%	0.26%
1988	218.3	20.2%	14.7%	0.24%
1989	198.1	19.7%	14.4%	0.21%
1990	188.3	21.0%	15.8%	0.20%
1991	170.9	20.3%	16.9%	0.18%
1992	210.5	20.4%	17.5%	0.22%
1993	254.3	22.6%	19.7%	0.26%
1994	303.9	25.4%	20.9%	0.31%
1995	339.9	31.6%	25.1%	0.34%
1996	363.3	31.3%	24.6%	0.36%
1997	353.7	31.2%	24.0%	0.35%
1998	373.1	29.3%	23.1%	0.36%
1999	348.1	26.7%	21.2%	0.34%
2000	250.4	20.3%	16.0%	0.24%
2001	193.1	15.2%	12.0%	0.18%
2002	168.5	12.4%	9.9%	0.15%
2003	130.8	8.7%	7.1%	0.12%
2004	130.7	8.1%	6.7%	0.12%
2005	146.8	8.6%	7.1%	0.13%
min	90.2	8.1%	6.7%	0.12%
max	579.9	51.2%	28.4%	0.86%
median	240.9	22.6%	16.9%	0.31%
average	260.4	24.8%	17.0%	0.34%

 

Note: 2005 production was inflated by an estimated 17,000 FEMA units.

Catalyst

Increased chattel lending to the industry as new lenders enter and existing lenders expand. Admittedly, bulls on the industry have been awaiting this development for years and aside from Buffett’s entry via Clayton and its Vanderbilt financial services subsidiary, it has yet to materialize.

Industry shipments return to normalized levels, at least 50-100% above present levels.

Continued growth into modular.