Description

Summary:
WCI Communities, Inc. is a homebuilder specializing in the luxury segment that generates substantially all of its profits in the state of Florida. Half of its profits come from its large (6+ Stories) Tower projects, a little less than half from a Traditional homebuilder division, and the remainder from Land Sales, Real Estate Services and the Amenities division. The company struggled following its IPO in March of 2002 partly due the more discretionary nature of their product as well as some company specific issues that have since been resolved. Based on order and backlog growth, their business really began to break out in Q4 of ’03. Due to a longer construction cycle time, these results didn’t really start to show up in EPS until Q3 ’04 and should produce extremely strong results in ’05 and at least into ’06. They should also produce a much stronger ’05 than the homebuilder group and have decent visibility into ’06 due to their slower backlog conversion unlike the others. WCI also acts as a defensive name since its high end buyers are not interest rate sensitive like the mainstream market (43% pay cash) and the company has tremendous unrealized land value on its balance sheet to provide support if the industry does come under pressure. They are just beginning to deliver the backlog that reflects the late ’03 order recovery and thus earnings should be the likely catalyst for the stock. And finally, Florida is shaping up to be the margin outperforming market in ’04 (like Vegas, CA, and DC the last few) which should produce strong orders and draw attention to the name as a predominantly Florida only builder.

Business:
WCI’s core business is a homebuilder of single and multifamily homes, and luxury tower homes. They also have a real estate service division (title and mortgage), land development division, and an amenities operation (manages marinas and golf courses in their communities for profit). WCI has traditionally just operated in the state of Florida, however as they indicated that would, they expanded into the Northeast in May of this year through their acquisition of Spectrum homes. Due to their product, buyer and state of operations, WCI is unique in the homebuilding group. Their average price home is about $610k vs. $300 for the group and $230 where the majority of builders operate. They also experience cash sales for about 45% of their homes which is a testament to the wealth of their buyers. Based on 2003 results, the Tower business accounted for 47% of their gross profit, the Traditional Homebuilding division 43%, Real Estate Services 5%, Land Sales 3% and Amenities 2%.
The Traditional Homebuilding is still unique in that the communities are more amenitized than others with golf courses and marinas and are developed over a longer period of time. All of their homebuilding operations are divided into three divisions; Retirement, Primary/Move-Up, and Second Home/Luxury. The breakdown is 40%, 27% and 33% by order units and 32%, 12%, and 56% by order dollars YTD. The average order price YTD is $476k, $273k, and $1,042k for the segments. The company has historically experienced gross margins in the low 20’s on the traditional homes and low 30% on the tower residences. The traditional homes gross margins are being held back by purchase accounting adjustments due to Spectrum this year (should end after 1H ’05), but are strengthening along with the market in Florida. The tower gross margins are also having a better year this year as pricing power has been coming back to this luxury segment. The tower business is less competitive than mainstream homebuilding given the capital intensity of it and the expertise needed, but it has its drawbacks as well. The cycle time from planning to title transfer of all the units can take up to 36 months as opposed to 3-6 months for most single family homes. This means that percentage completion accounting must be used and significant capital must be put to risk. WCI mitigates the risk by taking non-refundable deposits of 10-30% of the purchase price (=200k average) and beginning construction of the tower only after about 50% of the units have been pre-sold. Their construction costs are also guaranteed by the subcontractors which prevents a cost overrun that wipes out their expected profits. WCI only has a tower or two in the overly competitive Miami market and their reputation for a very high quality product usually puts them above the riskier lower prices that tend to see more speculative buying.

History:
WCI went public on March 19, 2002 at $19. After reporting a solid Q1, the stock headed past $30 and then their struggles began. Their Q2 showed signs of weakness at their higher price point homes in both the Tower business as well as the Traditional homes. The Tower results were also affected by fewer towers open for sales year over year. Combined with a weak tape for the group, the stock dropped all the way to $14. A preannouncement came on 10/15/02 due to two charges that were being taken. One for $3.8 mil was associated with 5 defaults of homes in backlog from one of their Towers. Given the economic environment, these buyers could not afford anymore payments. WCI was forced to reverse the recorded revenue and profits by taking this charge. The other charge for $8.4 mil was a more complicated situation where an employee had left off an important rescission clause in completed contracts. After the nature a particular tower changed for worse in terms of amenities and the like, buyers were able to back out of their contracts due to the omission in the contract. Lesson learned. All contracts must now be approved by their lawyers at company HQ. The stock was severely punished following these events and justifiably so. Having just recently gone public, management’s credibility was seriously damaged. Investors were already less comfortable with their tower businesses percentage of completion accounting, so actually seeing the charge and reversal of recorded profits simply reaffirmed all of those concerns. And to matters even worse, the fundamentals of the business had been deteriorating with weaker results and orders sending the stock to $9 after disappointing guidance for ’03 was given on 10/25/02.
The stock languished until the end of Q1 ’03 when they reported a weak Q, but affirmed ’04 guidance and provided a slightly more promising outlook lifting the stock to $13. During the summer of ’03, the luxury segment trends were encouraging led by comments from Toll Brothers helping the stock recover even further to $20. The stock remained in a trading range the rest of ’03 as parts of their business appeared to be recovering while others like their luxury segment continued to struggle. Orders in that final Q of ’03 were extremely strong, but it was not reflected in their ’04 guidance due to the conversion cycle and necessity for the backlog to continue to build. Investors began to recognize the building backlog in early Q1 ’04 as the stock rallied along with the industry, but this was short lived as homebuilders came under interest rate driven fears during the summer. WCI raised guidance in Q2 only to have to lower it in Q3 due to the effects of the Florida hurricanes. The lowered guidance was not that negatively received as earnings were simply pushed out of this year and into ’05 since getting homes closed on time would be difficult with the lower availability of inspectors, utility hookups, etc. The current guidance calls for ’05 EPS of 3.10-3.50 or 30-50% growth. The wide range is due to an uncertain sale of a large land parcel on the East coast. However, it is hard to imagine them coming in below the high end of that range considering their backlog growth in excess of 80% for both Tower and Traditional even without the land sale which could be worth 50 cents. This is obviously priced in to some extent after the recent rally in the stock and group leaving WCI at the high end of homebuilder valuations on a P/E basis.

Valuation:
WCI is currently trading at 8.4x ’05 consensus of $3.46. This compares to 8.0x for the homebuilding group and Toll Brothers at 9.0x which is a better comparison due to the high end focus and its higher EPS visibility. At this price, WCI is trading closer to the high end of the 6x-10x P/E range that the group normally trades possibly making the current entry point less attractive. However, WCI deserves to trade at a higher multiple due to the undervalued land on its balance sheet and the stronger momentum in their business which is likely to make the current consensus ’05 EPS look very light and produce first cut ’06 numbers much higher than current market expectations. Using a less conservative, but still realistic ’05 EPS number of $4.00 gives a P/E of 7.3x and initial ’06 EPS of $4.80 representing 20% growth puts the ’06 P/E at 6.0x. Net Debt/Cap is currently at 57% which is higher than the group average of 36%, but the EBIT should still cover interest expense by 6x in ’04.
WCI earnings are also arguably depressed as opposed to other builders that have been the big beneficiaries of the rate environment and are producing earnings, orders, and margins well above anything they have done in the past. Most of this builders are producing earnings 200-400% above 2001 levels while WCI is about 10% above where they were in ’01. Thus the factors that have held WCI back the last several years seem to be turning in their favor and they are less likely to be hurt by a reversal of the factors that helped other builders since they never benefited from them to the same degree in the first place.
WCI’s land value is one of the most intriguing aspects of the company. The company does not provide you with estimates of the market value of the land on their balance sheet, but it is clearly understated. They control about 18,000 acres or a projected 20,000 lots with 77% of those directly owned. This provides a 6-9 supply of land which is much higher than the 3-5 year industry average and in more attractive Florida coastal areas. They have provided the following data on the age of the 18,000 acres that they have under control:

34% 1995 and earlier
13% 1996-1998
17% 1999-2000
16% 2001-2003
20% 2004

Given that home prices in their markets have experienced 15-20% annual appreciation during these years and land values have even surpassed that, the $686.165 mil in Land and Land Improvements on their balance sheet at cost is dramatically undervalued. Assuming realistic assumptions, their Book Value is understated by $350-500 mil or $7-10/share. This would bring their Price/Book Value which is already below industry levels of 1.6x vs. 2.4x (even greater discrepancy using Tangible book value since WCI has less goodwill than the average builder) closer to 1.0x. Land values continue to rise dramatically in Florida and many other builders are targeting the state for greater investment. This not only increases the value of the WCI’s land, but leaves WCI with a competitive advantage as they already have the land necessary to hit their growth targets and at a much lower cost basis than other builders.

Opportunity:
WCI is in the perfect situation to show tremendous growth over the next several years. Thee dollar backlog of homes in the Traditional segment has strengthened the past 6 quarters and is currently up 96% year/year. With the pricing strength in the Florida market, the margins in backlog are very solid ex purchase accounting and continue to strengthen. The tower business recovery began a year ago and those results are just starting to come through in their earnings. The dollar backlog is this division has strengtened the past 4 Q’s and is at record levels up 82% year/year. Their order growth and backlog growth are both the strongest in the industry. The community count for traditional homes is up 43% and 10% for towers providing the necessary inventory to continue showing order and sales growth. Florida is beginning to be recognized as the strongest market for 2004 and investors are looking for ways to play it without taking on the risk of declining markets. The stock has rebounded sharply, but the market still does not appear to be recognizing the growth they are ready to deliver.

Year/year growth

Current Communities Traditional Tower
C4Q 04
C3Q 04 42.9% 10.0%
C2Q 04 61.5% 0.0%
C1Q 04 -13.3% -26.7%
C4Q 03 0.0% -25.0%
C3Q 03 -6.7% -9.1%
C2Q 03 -18.8% 0.0%
C1Q 03 7.1% 7.1%
C4Q 02 0.0% 33.3%
C3Q 02 0.0% 0.0%
C2Q 02 -5.9% 85.7%
C1Q 02 -17.6% 75.0%
Orders
C4Q 04
C3Q 04 58.5% 256.8%
C2Q 04 66.7% 23.1%
C1Q 04 65.9% 186.8%
C4Q 03 71.1% 115.9%
C3Q 03 1.7% -41.0%
C2Q 03 -18.5% 135.3%
C1Q 03 -20.3% -42.4%
C4Q 02 20.1% -28.1%
C3Q 02 0.6% -10.7%
C2Q 02 7.7% -30.6%
C1Q 02 -3.1% 5.7%
Orders/Community
C4Q 04
C3Q 04 11.0% 224.3%
C2Q 04 3.2% 23.1%
C1Q 04 91.4% 291.1%
C4Q 03 71.1% 187.8%
C3Q 03 8.9% -35.1%
C2Q 03 0.3% 135.3%
C1Q 03 -25.6% -46.2%
C4Q 02 20.1% -46.1%
C3Q 02 0.6% -10.7%
C2Q 02 14.4% -62.6%
C1Q 02 17.6% -39.6%
Order $ Value
C4Q 04
C3Q 04 49.1% 230.4%
C2Q 04 72.0% -24.1%
C1Q 04 39.7% 249.6%
C4Q 03 116.2% 185.7%
C3Q 03 48.7% -16.9%
C2Q 03 1.8% 184.0%
C1Q 03 15.0% -36.9%
C4Q 02 7.5% -15.5%
C3Q 02 0.0% -48.7%
C2Q 02 13.6% -14.8%
C1Q 02 -7.8% 37.2%
Backlog
Units
C4Q 04
C3Q 04 98.8%
C2Q 04 70.2%
C1Q 04 25.4%
C4Q 03 1.5%
C3Q 03 -5.7%
C2Q 03 -0.1%
C1Q 03 20.7%
C4Q 02 41.1%
C3Q 02 4.7%
C2Q 02 1.7%
C1Q 02 -13.6%
Dollars
C4Q 04
C3Q 04 95.9% 81.7%
C2Q 04 81.6% 41.5%
C1Q 04 34.9% 83.2%
C4Q 03 28.3% 35.6%
C3Q 03 18.0% -0.8%
C2Q 03 16.3% 20.9%
C1Q 03 29.1% -30.0%
C4Q 02 27.8% -20.1%
C3Q 02 13.5% -4.7%
C2Q 02 13.2% 23.6%
C1Q 02 3.1% 61.1%
Avg. Price in Backlog
C4Q 04
C3Q 04 -1.5%
C2Q 04 6.7%
C1Q 04 7.6%
C4Q 03 26.4%
C3Q 03 25.1%
C2Q 03 16.4%
C1Q 03 6.9%
C4Q 02 -9.4%
C3Q 02 8.5%
C2Q 02 11.4%
C1Q 02 19.3%


Risks:
- Rising Interest Rates; Barring a substantial rise in rates, it is hard to imagine rates having much of an impact on WCI given their customer profile. However, it probably isn’t fair to use historical data to gauge what impact an increase in rates would have on their business since we are coming off of unprecedented levels. The interest rate risk may be more of a perception risk than an actual fundamental one and it is difficult for a homebuilder’s stock to perform well when rates are rising.
- Discretionary nature of their product; While WCI may not be as interest rate sensitive as other builders, they are more at the whim of the higher end buyers confidence level and interest in purchasing their product. Thus WCI underperforms in the ’02 type economic environment that affects the high end, but may be the beneficiary of asset allocation as potential buyers have less attractive alternatives to real estate
- Florida exposure; While Florida trends are some of the strongest in the county, any shift in fundamentals or investor sentiment towards the state will hurt WCI more than others. The higher level of speculators and speculative inventories in FL is also a real risk
- Valuation; Based on current ’05 estimates, WCI is at the high end of the normal valuation range and at risk of underperforming or stagnating from here. A sellside downgrade of the stock is also possible and likely to have a material impact on the stock.

Catalyst

- Order numbers; WCI and Florida have strong momentum right now and this should continue into the New Year. WCI’s strength is likely to draw greater attention and provide even better EPS visibility.
- EPS; WCI’ earnings are likely to beat expectations substantially going forward given conservative guidance and consensus and robust backlog
- Group rally; Homebuilders have historically performed well early in the year and this may occur again particularly if interest rate expectations come down.
- Florida Play; Florida is starting to garner more attention as the market that is likely to outperform the most in ’05 and WCI is almost a pure play on the state.
- Short Interest; Given its past issues, WCI has the highest days to cover short interest in the industry at 8 days and 8% of the float. This is likely to go down if they can produce some consecutive solid quarters.