Tyro Partners - Long Thematic Idea - Cavco Industries CVCO $146.20
Dan McMurtrie and Alex DraimeI are Co-Founders and Portfolio Managers at Tyro Partners LLC, where they manage Tyro Absolute Return Fund, LP. They have been investing together since attending college together at the University of Notre Dame. Tyro is a seed stage Long/Short fund that aims for high absolute returns with low correlation to the broad market. The fund focuses on investments with exposures to major economic themes, favorable valuation characteristics, and data visibility. Please feel free to reach out for more information at firstname.lastname@example.org or @dhsmcmurtrie on Twitter. These guys are quite impressive and I am proud to present their well thought out thematic trade idea. Take it away Dan and Alex...
We would like to talk about one of our favorite themes in the market going forward, and detail one possible way to express it. We are very optimistic about the role of Manufactured Housing Units (MHUs) as shifting U.S. demographics and income distribution over time have made MHUs attractive options for an increasing percentage of Americans. Income distribution, age distribution, and immigrant population growth all contribute to major affordable housing shortages that are approaching crisis levels. In areas with particularly extreme wealth bifurcation, such as the San Francisco Bay Area, this has already become an observable day-to-day reality. One of our favorite companies in this space is Cavco Industries Inc. (NASDAQ: CVCO), the second largest manufacturer after Berkshire Hathaway’s Clayton Homes. We are long CVCO.
Background – In the past few quarters we observed more and more companies we follow commenting on labor shortages. As we dug into the major drivers there it became clear that Affordable Housing was a much bigger issue than many on the Street may think. We think this has to be addressed and MHUs are the answer.
Thesis – Manufactured Housing peaked in 1999 and has been a secular downtrend ever since. We believe this has reversed and the industry will offer many great investment opportunities over the next decade, such as Cavco Industries Inc. (NASDAQ: CVCO).
Time-horizon – 2-3 Years.
- 2017: Recently observed spike in MHU Manufacturer Order Backlogs.
- 2018: Restart of Fannie Mae/Freddie Mac purchases of MHU-linked loans.
- 2018: Legislative reclassification of MHUs by HUD.
- 2018-2019: Cavco ramps up its financing business.
Vehicle or Structure – Cavco Industries Inc. (NASDAQ: CVCO) equity.
Risk-reward – We think CVCO offers more than a 5:1 return to risk profile, largely due to the long-term compounding potential of the position if we are correct. The main risk to CVCO is our top down view being proven wrong. CVCO has a clean balance sheet, reducing the probability of an extreme downside event. Even so, if our view on the space is proven false, we could see both earnings and multiple contraction.
Risk Management – From a technical perspective, CVCO has exhibited trending behavior over time. Keeping it simple, it is likely prudent to use the 100-day or 200-day Simple Moving Averages as areas to add near and sell if the stock breaks below. From a fundamentals perspective, if CVCO’s backlog declines significantly, the Fannie Mae pilot program halts, legislative efforts fail, and industry shipment data reported by the U.S. Census decline, we would exit the position.
CVCO, and the sector more broadly, is a multi-year play. We see at least 75-100% upside over the next ~3 years with additional upside beyond that as the company can meaningfully compound capital over the next decade, though we would not be shocked to see the company acquired at some point. The MHU industry is in a period of consolidation and upside targets on CVCO will be heavily impacted by their reinvestment decisions going forward. If they can continue to acquire existing small producers at low multiples while also moving capital towards its adjacent financing businesses (currently less than 7% of consolidated revenue), our upside target is far too conservative. While this isn’t the type of investment where we intend to try to call each quarter, there is enough industry data to be able to monitor units, pricing, etc. and track the performance of the thesis. The key catalysts for the CVCO are generally the same as for the industry at large: margin expansion, credit supply loosening, deregulation, etc.
The market for MHUs peaked in 1999 and then imploded prior to the financial crisis as defaults on MHU-linked loans led broad mortgage defaults, resulting in credit supply declining and shipments going over a cliff.
Relentless land and home price appreciation have stifled recovery in MHUs. We believe this is largely played out as upticks in interest rates, creeping inflation, tight labor markets, and extreme pent-up demand for affordable housing increasingly place MHUs as an attractive option for more and more Americans. Many of the highest growth areas of the United States face the largest gaps in affordable housing options, now manifesting in rapidly tightening hourly wage worker supply.
Below is a map showing affordable housing supply for every 100 Extremely Low Income (ELI) households. States such as California, Florida, and Texas, which are particularly reliant on labor supply are currently experiencing the most extreme shortages. The additional graphics show the recent impacts of inflation on low-income Americans and the continuing uptrend in home prices.
Key MHU Market Developments
Idiosyncratic Shock (Hurricanes): Strong hurricanes during Q3 2017 destroyed or damaged over 100,000 MHUs - a considerable portion of existing inventory - and emergency orders from FEMA have tightened the supply and demand relationship in the space. Many factories are currently running at max capacity with large order book backlogs.
Automation, Economies of Scale, Fragmentation: Manufacturers are finally starting to utilize automation technologies that are already standard in the EU, driving future margin growth (2018 forward) beyond what most investors expect. Operating leverage as capacity utilization picks up at larger players will benefit from more significant economies of scale resulting from Automation and better planned manufacturing cycles as larger backlogs enable increased visibility versus historical scenarios. Perhaps most importantly, the MHU market is highly fragmented and generally very poorly run, meaning larger players have ample opportunity to drive returns by rolling up existing small players at significant discounts to public market multiples.
Source: September 2017 CVCO Investor Presentation
Land & Housing Price Exposure: While we don’t pretend to have any ability to forecast interest rates (if someone knows how, please let me know), MHU players have significantly positive exposure to orderly increases in interest rates if it moderates land and property value increases. Additionally, large manufacturers will be able to produce material returns from financing businesses so long as they do not over extend themselves. Currently, some participants are still shell-shocked from the financial crisis and almost totally unwilling to take leverage or credit risk both at the company and customer level. It is likely that if our top down view of the sector is validated, some enterprising activist investors or PE buyers will prod companies to change that, as they are almost certainly overly cautious currently. For example, in 2016, PE firm Centerbridge purchased lender Cascade Financial Services to run alongside Champion Home Builders.
Increasing Credit Supply: Beginning in 2018, Fannie/Freddie and related institutions will begin pilot programs to purchase chattel loans and mortgages tied to MHUs, including those not tied to the land beneath them. This was mandated in by the federal government as part of the GSE bailout but initial discussions regarding planning were not even initiated until 2015. Certain states, such as New Hampshire, have already moved to upsize these programs.
Deregulation & MHU Re-Classification: There is a considerable lobbying effort underway in DC to expand the role of MHUs in addressing affordable housing, and to clear some of the red tape with regards to optically “normal” housing being classified as a mobile home simply because all or part of it was constructed in a factory. Depending on the state, regulations here may hinge on the type of foundation the unit is placed on, ownership of the underlying land, or other factors. On September 15, 2017, Rep. Norma Torres from Pomona, California introduced the HUD Manufactured Housing Modernization Act of 2017 (H.R. 3793) “to require the Secretary of Housing and Urban Development to consider the appropriate inclusion of residential manufactured homes in certain programs, and for other purposes.” The stated purposes for the bill almost exactly mirror the issues raised above, and while we wouldn’t gamble on any individual piece of legislation, we do think that something like this will have to happen. Luckily, there is a notable supporter driving this and other similar legislation: Berkshire Hathaway. Warren Buffett owns the largest MHU manufacturer, Clayton Homes, as well as the largest MHU financing companies, 21st Century and Vanderbilt. BRK has been lobbying successfully in favor of financing deregulation, Fannie/Freddie re-entry to the market, and MHU reclassification. For the record, the last time a Buffett-backed MHU-related bill went to the House Financial Services Committee in 2014-2015, it was described as him “manhandling” the committee. Historically, MHU legislation has been able to muster bipartisan support, and we find it interesting that this piece of legislation is being put forward by a Democrat despite the majority of MHU lobbying dollars going to Republicans. Historically the lobbying strategy has been to fund GOP candidates and have Democrats propose legislation to achieve bipartisan support.
Distribution of Household Income, 2015
Data: One of the things we like about this thesis is that there are numerous data sources available to track the MHU market, ranging from Census data to state permit filings, which allow us to track our thesis. We are very open about saying that just because we think this should work, it may not, and should any of the above issues go south we will happily exit our positions.
Trading the Theme - Long Cavco Industries CVCO
In terms of expressing this view, there are several ways to do it. In the private market there are a few PE and Real Estate vehicles. On the public side there are targeted Affordable Housing REITs, Materials Suppliers, and MHU Manufacturers. Keeping it simple, we like the manufacturers, particularly CVCO, as a long term position.
CVCO is the second largest producer of manufactured homes in the United States with ~14% market share, behind Clayton (~49% market share) and ahead of Champion Homebuilders (~11%). The company currently trades at an enterprise value of $1,250mm with net cash of $78mm. It is underfollowed by the sell-side, with only a small handful of brokers providing research coverage. The company does not appear superficially cheap on a multiple basis, trading at ~14.7x consensus FY2019 EBITDA (CVCO’s fiscal 2019 ends March 2019), but we believe that CVCO can materially outperform current estimates to such an extent that the current multiple is not particularly relevant as a means of determining value.
CVCO should be able to drive significant top-line growth and margin expansion in its factory-built housing segment, benefitting from the favorable macro backdrop for the sector. We see a sharp increase in volumes in the next several years, with the company hitting over 22,000 units in annual production by FY2021. Assuming CVCO’s market share remains flat, this implies ~157,000 total shipments for the industry, still well below pre-2003 levels.
At the moment, the company is facing some near-term headwinds from labor availability constraints and some input cost inflation which put some near-term pressure on gross margins, but these will be passed through via pricing over time. As volumes pick up to meet demand, we expect housing EBITDA margins to rise from 6.6% in FY2017 to 12% by FY2021, roughly where they were in the middle of the last cycle as operating leverage kicks in. This would drive segment EBITDA up to somewhere in the $125-150mm range from $50mm in FY2017.
CVCO’s financial services segment consists of CountryPlace, a mortgage business, and Standard Casualty, a property and casualty insurance business. This business is a small part of CVCO’s revenue (6.8% of net sales for FY 2017), but it delivers a higher margin than the manufacturing business, bringing in $12.9mm of EBITDA in FY2017 at a 24.4% margin. We believe that CountryPlace offers a significant opportunity for CVCO in the event that Fannie Mae and Freddie Mac follow through on the pilot program to expand the secondary market for chattel loans. Even in the absence of such a regulatory shift, management has indicated that it is looking to expand its presence in the mortgage financing business and serve as a one-stop solution for its customers. This seems to us like a natural step; an expansion of the mortgage business would represent additional upside to our projections.
The main difference in business model between CVCO and Berkshire Hathaway’s Clayton is the difference in focus on the financing business. Clayton makes a far larger portion of its earnings from financing than it does from manufacturing, a fact Warren Buffet called out in his 2016 annual letter. CVCO management is, in our opinion, overly conservative and could radically improve the economics of its business if it focused more heavily on the financing business. They may need external capital to do this, or they may be better suited under the umbrella of a financial company or conglomerate, but there is significant value