| 2006 | 2007 | ||||||
| Price: | 14.36 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 600 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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WCI Communities is a luxury Florida homebuilder that offers tremendous upside for the patient investor. At the current price of $14.36 and trading at approximately 60% of trailing tangible book value and less than 50% of my estimate of net asset value, WCI has the potential to at least double over the next couple of years. Hit by the severe downturn in the Florida housing and high-rise market, WCI has traded down to distressed levels that seem to indicate a very high probability that the Company will encounter severe financial difficulty. Despite a terrible operating environment, the Company has significant asset value, ample liquidity and an aggressive cost-cutting plan to allow it to be well-positioned when the market environment improves, even if that is several years away. The float is almost 50% short and as it becomes clear that the business can weather the current downturn, the stock should over time trade at or near levels that more appropriately reflect its asset or take-out value of approximately $30 per share.
WCI operates in two divisions: Traditional Homes and Tower Residences. The Company was founded in 1985 as a developer of leisure-oriented, master-planned communities, and in 1995, the Company made a defining acquisition of Westinghouse Electric’s real estate business, which provided WCI with a significant bank of attractively located land throughout the state of Florida. Currently, approximately 40% of the Company’s land on the balance sheet was purchased pre-2000 and the average age of the land is likely around five years old, offering significant unlocked value given the rapid rate of appreciation in land over the past decade in Florida.
The Company’s Traditional Homes business builds master-planned communities targeting affluent active adults and second -home buyers with homes averaging around $600,000. The communities are highly amenitized, often including golf courses, health clubs and marinas. Approximately 80% of this business is in Florida, with the remaining 20% in the Northeast and Mid-Atlantic regions. The Florida communities are well-located, often within just a few miles of the beach. The Company has a reputation for producing high quality product to an affluent clientele and has historically seen around 50% of its sales to all-cash buyers. Sales in this business have been very strong the past several years given the overall housing boom, but margins have been below acceptable levels given a significant rise in material/labor costs, a lack of centralized purchasing and cost fallout from the hurricanes in 2004/5. The Company has taken significant steps to improve margins and efficiencies to bring the Company more in line with industry averages, but the next year will be very challenging as cost improvements are overwhelmed by a roughly 50% decline in the new order rate as the market has corrected from unsustainable levels and new buyers wait for a stabilization in the overall environment before placing new orders. Long-term, the Company should benefit significantly from the continued in-migration of the baby-boomers to Florida and the general above average growth rate in demand for well-located, high-end amenitized communities.
The Company’s Tower business builds waterfront high rises averaging about 100 units per project with an average sales price of around $1 million per unit. WCI has developed a reputation for making high quality, distinctive product in attractive locations. This business has boomed over the past several years driven by strength in the overall housing market and a significant influx of investors into the Florida condo market. The Company has over 20 projects under construction, but importantly, the Company has sold out over 80% of its inventory and buyers have put down non-refundable deposits of around 20% with prices generally locked in well below the current market. The dramatic overbuilding of the Florida condo market will result in few new towers constructed for the foreseeable future, but I believe the existing projects are healthy and should not pose a significant risk to the Company as I will discuss in more detail below.
WCI currently has $24 of tangible book value per share and net debt / total capital of 62%. The Company’s latest guidance for EPS is for $2.75 to $3.25 on the year, which based on the low end of the guidance, would put year-end book value at around $25 per share. The low end of guidance reflects the current operating environment and is largely a work through of backlog after accounting for the current high level of cancellations. The Company has 2 million shares remaining on its buyback program that management has indicated it is likely to use that would push book value closer to $26 per share. Given the dramatic decline in new orders in both the Traditional and Tower business, it is unlikely the Company will make much of a profit in 2007. The Company has indicated its cost structure is highly variable and it has already significantly reduced its cost base, making it unlikely the Company will report a material loss next year. Additionally, as the Company dramatically curtails its new investment in land and slows the Tower business, WCI should generate significant cash flow that should bring debt / total capital down to around 50% by end of 2007. The cash flow generation and any excess land sales should free up capital for more share buybacks. Assuming an additional 3 million shares repurchased in 2007 and no net income, book value should rise to around $27 per share. I think in a “normal” environment the Company should be able to generate an adequate ROE (based on strong land position, cost controls, more effective capital management, favorable demographics, etc.) to allow the Company to return to its historical price / book value range of around 1.1x to 1.4x (excluding the “peak” valuation period in 2005 that averaged over 1.5x book), implying value within 2 years of at least $30 per share.
WCI is likely trading at such depressed levels due to concerns that the Company’s current backlog of towers will experience significant cancellations resulting in a large write-down to book value. This speculation has been fueled by concerns over high MLS listings in several of WCI’s soon to be completed towers.
It is important to understand how the general tower business works from a risk and accounting standpoint. When WCI decides to build a tower site, it pre-markets the building to ensure it will have sufficient demand to warrant the project. As a result, the Company has historically waited to sell 50% or more units of a building before moving to the construction phase. The past several years, the Company has actually seen this rate go much higher as demand has been very strong at the launch of a project (due to robust market conditions and strong investor interest). In order to get high interest in the project, the units are typically offered at attractive prices (vis-à-vis the market at that time). An order requires an average non-refundable deposit of around 20%. During the next two years, WCI constructs the tower and sells any remaining units. At close, WCI delivers the unit to the buyer and the buyer delivers the remaining 80% of the purchase price. Historically, a combination of high deposits, low initial pricing and a strong market has kept the default rate to 1-2%.
From an accounting perspective, the Company recognizes revenue and costs under the percentage of completion method. To illustrate, imagine a $1 million unit with a $200,000 deposit that costs $700,000 to build and has a construction time of two years. Initially, the Company will book the deposit as a cash asset and an offsetting customer deposit liability. Over the next two years as the tower is built, the Company will recognize revenues and costs ratably based on the progress of the tower as defined by what percent of the total cost has been spent. On the balance sheet, a contract receivable is established and increases with revenue recognized, reflecting the remaining amount owed to WCI from the purchaser of the unit. At close, the Company will have recognized $1 million of revenue, $700,000 of costs and $300,000 of profit on the P&L over the past two years. On the balance sheet, the Company’s cash will go up by $800,000 at close, the contract receivable of $1 million will be eliminated and the customer deposit of $200,000 will be eliminated. If the buyer doesn’t close, WCI keeps the deposit and writes off the receivable and moves the unit to inventory. To the extent the inventory is worth less than 80% of the original purchase price (reflecting the cushion provided by the deposit), WCI would have value impairment. The Company keeps a reserve account of 1-2% of units, so any impairment would be on levels above the reserve.
What I believe is poorly understood is that almost all of WCI’s units sold appear to be well “in-the-money”. Price appreciation has been rapid since construction began on almost all the towers and the original pre-construction sales prices were low even based on market prices at the time. Even if 100% of the buyers were investors (which is not the case at all – it is likely less than 50%) and solely focused on value, there is no rational reason for them not to close. While inevitably a slow market will cause defaults to tick up, these buyers would have to walk away from an average of $200,000 cash down when the unit is worth well more than he or she paid. Some investors/analysts have been focused on MLS listings in particular towers, but they fail to note/recognize that the prices people are asking for are often 50% or higher from their original purchase price and not at all indicative of future cancellation rates.
So, I would surmise that even a draconian scenario would result in no more than 20% defaults, which would be of very limited impact on the Company. Assuming the Company had to resell those units 30% below purchase price (net of commission), the estimated after-tax book impact would be around $24mm ($2bn of cumulative receivables x 20% defaults x 10% price below original sale net of deposit and commission) or only $0.60 per share. Even if defaults were double my estimate (which is extremely unlikely), the impact to asset value on the Company is immaterial.
1) Under-marked asset / book value. The Company should have around $25 of tangible book value per share by the end of 2006. However, the Company’s book value is on a historical cost basis and approximately 40% of the land on the books was purchased prior to 2000 and the average age is likely around 5 years old. Given the rapid appreciation of land values in Florida (particularly in WCI’s locations), the unlocked value of the Company’s land bank far outweighs the potential for value impairment on any land purchased over the past two years (particularly since most of those recent acquisitions were under option – limiting the potential for write-offs). With an average land age of approximately 5 years, a 50% mark-up to the company’s land would seem reasonable based on a conservative estimate of 10% annual land appreciation in Florida for the past several years. With $900 million of land on the balance sheet at 6/30, this would imply an after-tax mark-up of roughly $6 per share, implying net asset value in excess of $30 for WCI. From time to time, WCI does sell land and the historical transactions directionally support this valuation. Last year, the Company sold a plot in Jupiter, Florida to Toll Brothers for $100 million, which was equal to 4x WCI’s cost. The Company has an adjacent lot advertised at $75 million for sale as well as a lot being prepared for sale near Palm Beach potentially worth around $50 million (both plots have a very low basis).
2) Strong cash flow generation to reduce leverage and fund buybacks. In a slowing market environment, WCI’s business model becomes highly cash generative. As discussed in more detail above, when WCI builds a tower project it is fronting all of the capital required other than the 20% customer deposit. Given market conditions, WCI has significantly curtailed new tower projects in 2006 from an original budget of 15-17 towers to the current level of 3-5 towers. As a result, the Company will largely be harvesting existing tower projects over the coming 12-18 months. In addition, the Company has significantly cut back on its new land spending budget from an original target of over $350 million in 2006 to the current level of approximately $75 million. If necessary, the Company can continue to operate for the foreseeable future with minimal land investment given their current owned land inventory of approximately 20,000 lots. The net collection of contracts receivable and reduced land spending should result in significant cash flow generation on the order of $200 million in the second half of 2006 and an additional $300 million during 2007. In addition to operational cash flow, the company is actively pursuing other ways to add to liquidity and de-lever the balance sheet. WCI recently sold a majority stake in its mortgage business and is also exploring the sale of part of its golf course and recreational amenities assets, which management indicated that it should be able to sell for at least book value. Given these cash flows, the Company will be able to reduce leverage and opportunistically buy back stock through the remainder of 2006 and 2007.
3) Attractive long-term demographics support demand. Longer term, WCI’s key Florida market should benefit from significant positive demographic drivers. Florida is one of the fastest growing states in the nation driven largely by domestic in-migration from other states and immigration from Latin American countries. In addition, the Company will continue to benefit as the baby boom generation moves through peak earning years and eventually into retirement years as the company targets an affluent, older customer with a significant proportion of second home and active adult buyers.
4) Potential take-out value. Approximately 20% of WCI is controlled by the founders, both of whom are over 70 years old and may be looking to monetize their investment over the next couple of years. WCI would be a perfect fit for Toll, which has a large Florida presence, competes in the same high-end niche and has a growing tower business. Lennar is also a logical buyer given its Florida and tower presence. Either builder could likely pay up to $30 per share and not incur any goodwill on the books (which homebuilders typically shun).
1) Defaults in the tower business. As discussed earlier, due to the large deposits combined with appreciation in values since the units were sold, I don’t believe this will be a material issue for the Company.
2) Continued tough market conditions. Anecdotally, it is clear that speculative buyers of new homes and condos in Florida (and the nation) have driven the level of new construction significantly above the trend level over the past several years and have precipitated the current level of excess inventory. In WCI’s case, the focus has clearly been on the Company’s tower business. It is impossible to know precisely how long it will take to work off the excess inventory created by speculators, but it is helpful to look back at the Company’s historical order trends to get a general sense. Order activity in the tower division more than doubled from average levels of 450 from 2000-2003 to 1,050 in 2004 and 2005. Given the positive future demographic trends and geographic expansion to markets outside of Florida, it seems reasonable to believe that “normalized” demand level for WCI tower product should be higher than the 2000-2003 period average – say roughly 500 to 600 units per year going forward. This would imply that WCI was building nearly twice as many tower units as necessary in 2004 and 2005 and therefore would need to work through about two years of speculative inventory (roughly 12-18 more months from here) before returning to normalized demand levels.
3) Option / land write-downs. As mentioned above, a significant portion of the land on the Company’s balance sheet was purchased during the 1990s, so on balance I believe that the likelihood of a material impairment to the Company’s land is minimal. However, in the past couple of years, WCI has increasingly taken control of land through option agreements. If current market conditions persist, it may make sense for WCI to walk away from these land options (as many other homebuilders have recently been doing). If WCI were to walk away from all of their land options, the loss is limited to the option deposits (roughly 7% of the transaction value), which totaled $42 million at 6/30 or only $0.60 per share after-tax.
4) Capital management. One key risk facing investors is redeployment of cash flow generated from operations. I think the extent of the current slowdown and the deployment of cash towards buybacks and debt paydown has significantly mitigated this risk. Also, the Company has significantly reduced its land expenditure budget targeting only the highest return projects based on land taken under control several years ago at attractive prices.
5) Leverage. WCI’s debt to capitalization currently stands at approximately 62% compared to the homebuilder average of roughly 50% and the company’s historical average in the low to mid 50s. As discussed above, the company should be able to de-lever over the course of the next 12-18 months and return to a level closer to its historical average.
6) Historical ROE performance. Since going public in 2002, the Company’s ROE has ranged from 15-20%, lower than its homebuilding peers over the same period. The primary drivers for the underperformance were sub-par gross margins (owing to the hurricanes and lack of centralized purchasing and cost control) and slow asset turns. The Company has aggressively targeted improving its gross margins with an increased focused on centralized purchasing, and assets turns should ultimately improve (when demand recovers) as a result of increased use of land optioning. I believe these two factors can drive “normal” ROE to around 15%, justifying a premium to book value.
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