Description

Business Description

Skyline Champion (SKY) builds modular and manufactured homes that retail for ~40% of the price of similar quality site-built homes, excluding land costs. SKY owns 49 manufacturing facilities across the US and Canada, 41 of which are currently operating and 8 of which are idle for future growth. It sells to local dealerships, directly to customers online, and owns 18 direct retail locations concentrated in Texas and the Southeast U.S. Core manufactured and modular home customers are retirees looking for a second rural home or to downsize, younger starter home purchasers, and low-income homebuyers.

Manufactured homes are significantly faster and more efficient to build than traditional site-built homes. SKY’s order to delivery time ranged from 90-120 days prior to the pandemic, 3x+ faster than build times for traditional homes. Scrap is reused on the manufactured home production line, but the bulk of savings comes from labor costs, which SKY estimates at up to 25% per home compared to equivalent on-site construction.

SKY trades gross margins (historically ~20% vs ~25% for site built) for better speed, resulting in 2.3x avg asset turnover vs <1x for public site-built homebuilders since 2018, which drives significantly better returns on capital (34% return on tangible capital for SKY vs <20% for site-built players).

Why Does the Opportunity Exist?

-          At $51, shares are down 41% from January 2021 highs on concerns that demand in SKY’s lower end customer demographic will be disproportionately affected by higher interest rates

-          Investors misunderstand that the trade-down dynamic benefits value-priced manufactured

-          As a result, SKY shares have underperformed traditional homebuilders D.R. Horton, Pulte, and Lennar by an average ~8% since the Fed’s first 3/16 rate hike, despite SKY’s recent quarter QoQ unit order volume essentially flat, vs (-18%) for traditional homebuilders

Summary Thesis: BUY at $51 / share

1.       Margin improvements will be stickier than the market expects

-          Large backlog provides long runway for operating leverage based on better capacity utilization, driving stronger gross margins even as pricing normalizes

-          Capacity utilization alone drives 5400 bps of EBITDA margin expansion in FY23 even at 2021 ASPs and raw materials costs

-          Bulk of pricing increases won’t be given back when materials prices normalize as manufactured housing dealers expect that ASP increases will stick if materials prices fall

2.       Demand for manufactured homes is less interest rate reflexive than demand for site-built homes

-          77% of manufactured home purchases as are titled as personal property (rather than real estate) because buyers choose to lease the land rather than purchase, and as a result are originated at high interest rates (8.5%)

-          Management noted at the September 2022 RBC Industrials Conference that manufactured home spreads have tightened to ~100 bps from ~250 bps a few quarters ago and ~500 bps a few years ago

-          As a result, changes in loan affordability for SKY’s products have been small relative to broader housing, and while inflation and recession risks to its consumers’ purchasing power are real, SKY is relatively well positioned to benefit from consumer trade-downs

-          Meanwhile, SKY has expanded its base of business, entering a contract with FEMA to supply $200m in disaster relief units in FY23, and is expanding partnerships to supply modular construction for pieces of

3.       Current valuation pricing in doomsday demand scenario

-          At $51/share, SKY currently trades at 4.8x EV/23E EBITDA (fiscal year ends April 2023) and 7.3x FY23 EPS, less than half of its 5-year averages of 12x fwd EBITDA and 23x fwd EPS.

Manufactured housing industry overview: a friendly oligopoly

The US manufactured housing industry is an oligopoly dominated by Berkshire Hathaway’s Clayton Homes (48%), Skyline Champion (17%) and CAVCO (12%). SKY is the result of a 2018 merger between #2 market share player Champion Homes and #4 Skyline Corporation.

US manufactured homes as a % of all homes built peaked in in the 1970s at 30%, declined to ~20% by 2000 and troughed at ~8% prior to the GFC, and has stayed consistent at about 10% since 2009. The overall decline was due to stricter Housing and Urban Development (HUD) regulations rolled out in 1974 that added additional safety restrictions and costs to homebuilders, along with the fact that financing is limited by financial institutions exiting the market beginning in 2002 after Fannie Mae and Freddie Mac determined that the US government would no longer guarantee manufactured home chattel loans. President Biden’s 2022 Housing Supply Action Plan includes steps to support manufactured housing production and availability, as manufactured homes are the most efficient method of delivering value priced single family homes to low-income demographics.

The industry has consolidated as scaled players have taken share from regional providers. The industry structure has improved according to a manager at a SKY competitor, “Everybody's a friendly competitor – we were just all at conference together. Everybody looks at each other's pricing and keep an idea of each other's backlog. It's a harder business for the dealers these days - buying has shifted online, people want to pick out their floor plan, countertops, appliances, and other things.”

Skyline differentiates on the high-end of manufactured homes, providing greater customization than its competitors. “We retail 7 different manufacturers but sell the most from Champion… The homes show really well and have great curb appeal. They also have the best variety in terms of unit types. They’re pretty customizable.” – Dealer at Texas Built Homes

The quality of manufactured homes is much closer to site-built than during the peak volume of era of the 1970s, and SKY products are increasingly viewed as a budget option for medium-income demographics. "Stigma of a manufactured home is still there - half the conversation is overcoming that bias - but the quality of manufactured homes has really improved. A lot of people that were going to build a house are looking at buying a modular house for pennies on the dollar… I sold a $275k modular home for that would have gone for $1m if it was site-built at the same quality.” – Dealer at TX Built Homes

Thesis 1: Margin improvements will be stickier than the market expects

SKY’s gross margins have steadily improved from 16.6% in FY18 to 20.4% in FY2020 based on operating leverage from better capacity utilization before jumping to 26.7% in FY22 and 31.6% in Q1 FY23. Skyline passes on all raw material price increases between order date and production start to their customers (dealers), who may or may not be able to pass on to customers. The gross margin step function increase in FY22 was driven by average selling price in FY22 ($84k) was up 26% from FY21, ahead of its 16% total input cost increases, as SKY was able to pass on materials increases to its dealers as they took place without giving back pricing when input prices (primarily lumber) normalized.

Dealers think this dynamic is sustainable: “The only call I’ve gotten taking prices down as lumber prices are starting to come back to normal is from Clayton, and they’re the low-cost competitor. I don’t expect them [SKY] to give back the price increases.” – Dealer at Texas Built Homes

“Will it ever be where it was two years ago? No, I don't think so because they never really give it all back. They give you some of it back.” – Interview with CEO of a Skyline Customer

Meanwhile, SKY has room for high return on capital capacity growth as it works through its $1.4b backlog, which would take 8 months to clear even if new order demand was zero. Even if orders fell 30% from FY22 levels, the backlog would last through FY24. FY21 gross margins were 20% at only 68% capacity utilization, and operating leverage from better overhead utilization alone implies a 24% gross margin at constant FY21 pricing.

Management has recently stated that it believes that 26-27% gross margins are sustainable, even in a down cycle. If costs approach normalized levels and SKY can hold onto only half of its 2022 pricing increase, management’s 26% gross margins are likely to be highly conservative.

Thesis 2: Demand for manufactured homes is less interest rate sensitive than demand for site-built homes

77% of manufactured home purchases as are titled as personal property (rather than real estate) because buyers choose to lease the land rather than purchase. Median interest rates for manufactured home chattel loans were 450 basis points over the average prime interest rate (APOR) in 2019.Management noted at the September 2022 RBC Industrials Conference that manufactured home spreads have tightened to ~100 bps from ~250 bps a few quarters ago and ~500 bps a few years ago. As a result, loan affordability for SKY’s customer base remains strong relative to broader housing, and while inflation and recession risks to its consumers’ purchasing power are real, SKY is relatively better positioned vs traditional homebuilders despite its shares faring worse since the Fed’s tightening program began.

SKY has also expanded its base of business, entering a contract with FEMA to supply $200m in disaster relief units in FY23, and recently announced a partnership with a top-100 private builder for SKY to serve as the builder’s single-family subcontractor beginning in early CY23. With traditional home build times and regulation requirements extending significantly, partnerships are a major opportunity for SKY to take share from site-built homebuilders and extend its growth even in a depressed demand environment.

Thesis 3: Current valuation pricing in a doomsday scenario

At $51/share, SKY currently trades at 4.8x EV/23E EBITDA (fiscal year ends April 2023) and 7.3x FY23 EPS, about half of its 5-year averages of 12x fwd EBITDA and 23x fwd EPS.

SKY has $413m of net cash on its balance sheet, and maintenance capex requirements are minimal (capex has averaged 1% of sales since 2016). SKY’s net cash and projected FCF through the next three years are equal to 40% of its current market cap.

The base case shown below uses conservative assumptions: ASPs fall 15% between now and FY24, order demand falls 30% from FY22 highs, repurchases are only 50% of FCF, gross margins at 26% (low end of management’s downturn case) and EBITDA margins normalize at 15-16%, down from 22.4% in the most recent quarter.

Conclusion

Despite the current macrorisk and environment, the company is well-positioned to capitalize on its market position, and should continue to take share, leading to a base case return profile that is quite attractive and downside protection per Thesis 3.  Specifically, modeling ASPs falling 15% between now and FY24, order demand falling 30% from FY22 highs, and EBITDA margins normalizing at 15-16%, (down from 22.4% in the most recent quarter) results in a FY 24 EBITDA of $408m.  Assuming only 8.5x FY25 EBITDA (well below 12x long-term average) results in $81 / share and a 35% IRR through March of 2024.

Catalyst

Additional partnership agreement announcements

Further government support of manufactured housing via Fannie/Freddie and subsidies

Macro stabilization