Description

THESIS:
Fleetwood Enterprises is both a company-specific and industry turnaround story that is misunderstood by the market. The combination of new management initiatives and improving industry trends will lead to earnings acceleration that is underappreciated by the Street.

INVESTMENT HIGHLIGHTS: Why is FLE Interesting?
1) “New” management is aligned with shareholders and has been active in executing a turnaround:
• In March 2005, President and CEO Elden Smith came out of retirement to replace Ed Caudill, who stepped down after failing to turn the company around during his 2½-year tenure. Smith had been with Fleetwood from 1968-1997, heading the RV Group from 1973 until his retirement. Under his guidance, the RV Group’s revenues grew from $39m to over $1.3B.
• Smith recently purchased 100,000 shares of stock and his employment contract provides no severance package unless there is a change of control.
• In only 4 months during his second tenure with the company, Smith has:
 Reduced headcount by 1,200 people (9%).
 Reduced 24 corporate officer-level positions from 24 to 11.
 Restructured the bonus system for fiscal 2006 to one that is 90% based on bottom-line profitability and 10% based on evaluations (which was previously split 40%/60%).
 Announced and executed a plan to sell the manufactured housing retail and financing businesses which had represented a significant drag on the company’s operating results.
 Announced a transaction to refinance its convertible securities, eliminating a $49m dividend in arrears that could have been a major potential drain on liquidity.
 Reversed earlier management’s move towards centralization, establishing 3 profit centers in RVs (motor homes, travel trailers, folding trailers) in order to reassert better product focus.
 Subdivided the Housing Group into 3 regions to be more responsive to differing regional markets.

2) Significant potential fundamental business improvement:
• FLE reported an operating loss of ($44)m for fiscal 2005. However, several initiatives have already been implemented which will help the company achieve near-term objectives. Assuming 2006 projected operating income of $52m, the company needs $95.7m of year-over-year operating income improvement. The elimination of the operating losses from the finance and retail business accounts for $22m. A reduction of 1,200 employees at $40,000 per employee accounts for another $48m. Thus current initiatives can already imply 2006 savings of $70m, or 73% of the necessary improvement to achieve near-term projections.
• Management has indicated that it expects 4-5% overall operating margins without industry improvement, implying fully-taxed earnings power of $0.95-$1.25.

3) Convertible refinancing to create buying opportunity:
• FLE recently announced a refinancing of its 6% convertible trust preferred securities due in 2028. The strike price of the existing security was significantly enough out of the money ($48.72) to have little estimated short interest by convertible owners associated with it.
• The refinancing will eliminate a dividend in arrears of $49.6m, which could have presented a significant drain of cash for the company.
• Most importantly for the near-term, because the financing is likely to have a more traditional structure (4% coupon, 20% conversion premium), it is likely to generate significant short-selling in the near-term, a technical overhang that represents an opportunity to build the position.

4) Net operating loss carry-forwards add significant value:
• FLE has the benefit of significant net operating loss carry-forwards of $188m, and the company should not become a taxpayer for several years. Given its projected future earnings, the present value of the realization of this NOL is worth approximately $2 per share.

5) Stock is significantly out of favor:
• 14.8m shares of the estimated 53.2m share float are currently shorted, representing 28% of the outstanding float and 16.3x average daily trading volume. Based on capital markets research, we estimate that only 7-8% of this 29% is attributable to hedging of FLE’s convertible debt instruments.
• Only 6 sell-side research firms currently cover the stock, with 3 “Buy” recommendations and 3 “Sell” recommendations.

6) Potential takeover target:
• Berkshire Hathaway has been extremely active in the sector since 2003.
 Berkshire began its consolidation of the manufactured housing space with its $3.7B acquisition of Clayton Homes in 2003. Berkshire’s strategy has been to borrow money to support profitable, interest-bearing receivables, and according to Warren Buffett’s annual letter to shareholders the company has relended $7.35B to Clayton as of January 2005. With two additional portfolio purchases in the works, Clayton’s total receivables should reach $9B as the industry’s largest manufactured housing lender, but in the same letter Buffett indicates that this is likely the end of this growth.
 In April 2004, Clayton acquired Oakwood Homes, making it the largest producer and retailer of manufactured homes as well.
 On June 27, 2005, Clayton acquired Sacramento-based Karsten Homes, adding 4 manufacturing plants to increase its total to 36. Clayton’s wholesale market share increased to over 20%.
 On July 7, 2005, Berkshire announced that it would acquire the majority of Fleetwood’s manufactured housing retail sales network and retail loan portfolio. The transaction will increase Berkshire’s dealer network by 25%+.
 On July 20, 2005, Berkshire acquired RV maker Forest River, the largest privately held US RV manufacturer. Forest River is the #2 towables company in the US. This was Berkshire’s first purchase in the RV space. In the press release, Forest River owner Peter Liegl commented, “With Berkshire’s strong reputation and financial backing, we now have the firepower to make investments and acquisitions at a rate that otherwise would not have been possible.”
• With operations in all aspects of FLE’s current business, Berkshire is a legitimate potential acquirer of part/all of the pro forma FLE.
• Thor Industries (THO) has also been a significant consolidator in the RV space.
• Consolidation in the industry should have many positive benefits for FLE, including better producer discipline, higher equity valuations and potentially an outright sale of FLE.


COMPANY DESCRIPTION:
Housing Group
• A manufactured home is a building, transportable in one or more sections, that is built on a permanent chassis and is designated for use with or without a permanent foundation when connected to the required utilities.
• 2nd largest producer of manufactured housing in the US with a 17.6% market share in 2004.
• 2004 shipments 67% single-section, 33% multi-section.
• Single-section:
 22.7% market share.
 Single-section homes range in size from 530 square feet to 1,290 square feet.
 Average retail price of $27,700 (excluding land costs).
 Designed for the affordable housing market, which includes first-time, retiree and value-oriented buyers.
 2004 saw a disproportionate increase in single-section sales because of relationships with government agencies on emergency relief projects and manufactured housing community operators.
• Multi-section:
 15.8% market share.
 Multi-section homes range in size from 750 square feet to 3,420 square feet, sold for an average retail price of approximately $52,000 (excluding land costs).
• Market structure:
 66 industry manufacturers in 2004.
 10 largest companies accounting for 80% of retail market.
 Compete with used and repossessed manufactured homes, new and existing site-built homes, apartments, townhouses, condominiums.
• Manufactured housing market is experiencing its most severe trough in 40 years.
 Industry sales of 130,000 units in 2003 and 2004.
 Down from a high of 373,000 units in 1998.
 1991 trough was only 170,900 units.
• 2 factors for manufactured housing decline:
 Financing has become uncompetitive - GreenTree and Chase have exited the market, and rates are now significantly higher than those for traditional site-built homes.
 Number of repossessed homes available for sale has been unusually high due to defaults related to lax lending practices of late-1990’s-early-2000’s. Estimate number of repossessed homes sold was 100,000 units in 2003 and 2004, vs. normalized levels of 25,000.
• Recent positive signs of an industry turnaround:
 Lenders are returning to marketplace, as Berkshire Hathaway has increased its presence. Competition among lenders should lower interest rates to make manufactured housing more competitive with site-built homes.
 Inventory of repossessed homes available for sale appears to be falling as the number of credit defaults slows.
• Restructuring.
 Company had been a vertically integrated producer of manufactured homes.
 This included a retail operation (FRC) with 124 locations in 21 states and HomeOne Credit, the company’s financing arm.
 The retail operation has been the most consistent source of substantial losses in recent years. The company’s vertically integrated strategy hinged on providing lending through a large company-owned network. While the company had been willing to wait for the industry to turn around to provide dealer productivity improvements, the strain on its balance sheet driven by the operating losses as well as the capital requirements of the financing business proved to be too much to bear.
 On 7/8/2005, the company announced a definitive agreement to sell the majority of FRC and HomeOne’s lending portfolio to Berkshire Hathaway’s Clayton Homes.
 The purchase price will be $74m for the retail business and $70m for the finance business. Net of liabilities, total proceeds will be $15m of cash and $20m of new NOLs (created by an approximate $50m loss on the sale).
 The company will continue to hold $35m of discontinued assets and will still serve as a landlord for 22 company-owned retail stores. These assets could eventually be sold for additional proceeds.

RV Group
• Manufactures a full line of recreational vehicles, including Class A and Class C motor homes and several towable trailers.
• 2004 revenues 62% motor homes, 32% travel trailers, 6% folding trailers.
• Restructuring:
 Company and industry plagued by significant overproduction in early fiscal 2005 in the face of weak sales related to calendar 2004 hurricanes.
 Management has cut production to alleviate this pressure, taking company inventory down from 1,000 motor homes and 3,900 towables in January to 600 motor homes and 2,800 towables by June.
 In dollar terms, excess inventory cut from $80m to effectively $0m (had initially targeted a $55m-$60m reduction, but appear to be overshooting this target).
 Inventory correction will be complete by end of current quarter.
 Cutting 9 different product lines over the next several months.
 Phasing out discounting, especially volume discounts at some dealers.
 Headcount reduced by 1,200 employees in the last quarter, mostly in production.
 Will operated motorized and towable divisions more independently to return focus to each unit and improve profitability, targeting 7-8% margins of Thor and Winnebago within 5 years.
 Fleetwood badge will be featured prominently, rather than the individual brand.
• 2nd largest player in overall RVs with 16.8% market share (Thor is #1 with a 23% share).
• 2nd largest player in motor homes with a 17.9% market share (Winnebago is #1 with a 19% share).
• Largest player in several sub-categories, including Class A motor homes (21% share) and folding trailers (38% share).
• 5 largest industry manufacturers represented approximately 70% of retail market.
• Motor homes:
 Class A motor homes range in length from 26-45 feet, with an average retail price of $168,000.
 Class C units range in length from 22-31 feet, with an average retail price of $74,000.
 In 2004, 4 of industry’s top 10 selling Class A and 2 of top 10 Class C motor homes were made by Fleetwood.
 Motor home brands: Jamboree, Tioga, Terra, Fiesta, Flair, Storm, Bounder, Southwind, Pace Arrow, Bounder Diesel, Expedition, Discovery, Providence, Excursion, Revolution, American Tradition, American Eagle, American Heritage.
 Market share has increased over last 3 years, driven mainly by new, innovative Class A diesel products and high-line Class A gas products partially offset by market share erosion in entry and mid-level Class A gas products.
 Class C market share down from 20% in 2001 to 12% in 2004, but the company has a refocused effort to expand Class C distribution through existing dealers and commercial rental customers. In addition, added capacity for East Coast production of Class C products to increase market share in the region.
• Travel trailers:
 Travel trailers range in length from 18-39 feet, have width of 8 feet and an average retail price of $24,000.
 In 2004, 2 of industry’s top 10 selling travel trailers were made by Fleetwood.
 Travel trailer brands: Pioneer, Mallard, Wilderness, Prowler, Terry, Gearbox, Pegasus, Orbit, Pride, Triumph.
 Market share has declined over past 3 years from 13% to 12% due to increased competition in the travel trailer industry, lack of participation in a few growing market segments (luxury and hybrid) and declining volume in core Prowler, Terry and Wilderness products due to lack of acceptance by the customer.
 Recently entered sports utility segment with Gearbox activity support vehicle, and introduced several new floorplans in the hybrid and ultralight product categories. Redesigned core products released this summer with enhanced features and benefits at a more competitive price.
• Folding trailers:
 Folding trailers range in length from 17-27 feet, with an average retail price of $9,140.
 In 2004, 3 of industry’s top 10 selling travel trailers were made by Fleetwood.

Major Shareholders
Current top shareholders (as of 9/30/2005) include:
• First Pacific: 11.8%
• Perry Corporation: 6.3%
• SLS Management: 4.8%
• Gamco Investors: 4.3%

RISKS
• Run-off in sales associated with sale of retail operations.
• Continued aggressive industry competition.

VALUATION:
• FLE currently trades at 13.5x calendar 2006 EPS, vs. a peer group average of 16.5x.
• In addition, FLE has NOL carry-forwards worth approximately $2 per share.
• We believe that FLE will trade towards the high end of its peer group range during 2006, pricing in significant further operating improvement as this will merely mark the beginning of what should prove to be a multi-year up-cycle for the company.
• 17x fiscal 2007 earnings plus $1.95 in value for the NOL implies a valuation of $18.65, or 52% above the current market price.
• 15x fiscal 2008 earnings plus $1.95 in value for the NOL implies a valuation of $21.14, or 72% above the current market price.


RECOMMENDATION:
FLE is one of few stocks in the market that is currently trading at a cyclical bottom. The potential earnings acceleration coming from an improved corporate structure and cyclical industry improvement should lead to significant out-performance in the stock. Importantly, near-term expectations are still very low, which is often a sweet-spot for cyclical companies – the stock can perform as long as the market can visualize better times ahead.

Catalyst

• Monthly sales data.
• Quarterly results.
Note: that it is not likely necessary to see a full year of operating results to drive stock price performance, as the company will achieve quarterly performance implying improved annual run-rate results within the next 2-4 quarters.