UK Homebuilders - Time to Get Aggressive

It's no big secret that most developed countries were caught up in a housing bubble recently, with U.S. leading the burst, but many others following close by. The UK market is now among those showing signs of strain with housing prices down 2.5% in March and largest homebuilder reporting 24% decline in revenues, blaming the sudden evaporation of mortgages. The homebuilder stocks plunged further on the news, most are now down to multi-year lows. While I'm bearish on the housing prices and macro outlook in general, I believe that stocks in the sector have already priced in all the possible bad news and are trading far below intrinsic value, similar to the bargain levels U.S. homebuilders were trading at 6 month ago before rallying 50%+. There may not be good news to come for a while, and the stocks may come under further pressure, however I don't recommend bottom-fishing: when you see a bargain, seize it.

UK market overview and U.S. perspective
Prices. Similar to the U.S., UK experienced rapid price appreciation recently. According to Hallifax, new home price has increased from 72K pounds in 1990 to 196K in Q1 2008 - almost 3x. This increase is even higher than the one in the U.S., where average price went up from $151K in 1990 to $292K in 2007.
How much is the market overvalued by? One source is July 07 Fitch report which estimates that U.K. housing is overpriced by 20%. Applying a quick back-of-the-enveloped methodology gives a much more drastic potential for the downside: current average house price is~6 times the income of an average household, with historical average being 3-4x, which would imply that the housing prices should go down 50% to get in line with historical averages. Given the current low interest rate environment though I suspect the Fitch figure is closer to real downside, which is approximately what the analysts are now expecting in the U.S. as well.

Volumes. Here U.K. is in much better shape than U.S. The U.K private starts were 139K in 2006, compared to 119K in 2000, 17% increase, but down from 159K in 1989. Each year U.K adds 180K of households, so household formation alone, at ~70% home ownership rate, 70%x180=126K units a year. Add replacement on top, and you see that there was little to no overbuild in the U.K. Volumes are falling down this year, but that is caused by the bank tightening screws on mortgage lending due to their bleeding balance sheets, not because of oversupply of homes. Analyst expect 25% volume decline in 2008, with modest recovery in 2009. I expect that by 2011 overall volumes should get back to 2007 levels.

Barratt Developments - Leveraged Bet on the Sector

While the entire sector is poised to rally, I like Barratt's potential the most. The company is UKs largest homebuilder with 12% share of the market. Stock is down from 12 to 2.85 yesterday, with the company now trading at 0.3X Book. Investors have punished Barratt even more than most other players due to 1.75B debt on company's balance sheet, most of which was accumulated after acquiring Wilson Bowden, another UK developer. However the market seems to forget about 5B of inventory sitting on Barratt's books. Most of that inventory is not in already started projects that Barratt may be forced to dump at firesale prices, but in land acquisitions which are significantly more liquid. Even so, in declining market the inventory warrants a discount: applying a 20% cut to it reduces current 2.9B of shareholder equity to 1.9B. That's vs current market cap of 900M, or more than 100% potential return.

Airlines - Jump in When Outlook Is Bleakest

6 months ago I was going to start purchasing the homebuilder stocks, but was finally swayed by all the "experts" saying how things are only going to get worse from there, with further reductions in inventory revenues and precipitous drops in sales. I factored all those things in and still stocks seemed to very cheap both given their earnings potential and p/book values. Result? Most players since then are up 50%. Should have listened to Warren Buffet: is just next to impossible to time the market, you should just buy the stocks when they are selling far below intrinsic value and eventually they'll get back to it.
I think currently the airlines are selling far below what they're worth intrinsically. The combination of rising oil prices and weakening macro have created a tremendous pressure on profitability, leading to for every airline, and as a result all major U.S. airlines have lost up to 70% of their values. The current valuation levels seem to assume that the airline profitability will never recover to normative levels, with the permanent high oil prices and intense competition eating away all the profits. I meanwhile happen to believe that the industry's management is not masochistic, and likes to earn some acceptable level of return over the long run, even though that return may gyrate wildly year over year. What should this return be? Take Continental. The company has $6B worth of planes. These planes better make 12% a year in EBIT or why the heck do they own them? 12%x6=720M. On revenue of $14B, that's 5% operating margin. Multiply that by 10x, not outrageous multiple, and you get what I think is a fair EV for Continental, compared to the current $4B. Or otherwise, the equity should be worth $3B more than right now, or ~57 a share. While this whopping 235% return will not materialize anytime soon, I think that at least 100% should be attainable within two years. Buckle your seatbelt though.

Men's Warehouse - Are we liking the way they look?

I've decided to throw in some bad puns into the blog. Thankfully no one is paying attention anyway. 800 retail location selling suits + 450 tuxedo rental stores. The tuxedo rental business has been acquired in 2007 from Federated, and the After Hours brand has been repainted to MW Tux. The retail locations are operated under MW name (600 locations) and K&G (100) which caters to lower income consumer. Another 100 locations are in Canada operating under Moores name.

The company prides itself on having prices that are 20-30% below those in department stores. It sources ~40% of its merchandise directly, principally from Asia.

Average store economics. Retail location is 5.7K sq feet on average, MW Tux is much smaller, 1.3K, while K&G is much larger, 23K. Net sales per sq foot are 478 for MW and 220 for K&G. Comps have been tough recently, especially for K&G which declined 10%. Each MW location thus sells 5.7K x 480 = 2.6M., with almost 50% gross margin. SG&A is another 35% of sales. SG&A has grown as % of sales recently due to acquisition of After Hours which brought along 8 additional distribution facilities and also increase in salaries.

Future prospects. Management historically has rolled out stores aggressively, however 600 U.S. locations seems to be the cap. For 2007, company has opened 42 stores, in 2008 plans are to open 20 new MW stores, 22 Tux and 3 K&G. Assuming average store productivity, that's around 3% revenue growth. I expect comps to very tough - just look at the previous downturn and you'll see 10% decline. Making quick back of the envelope, assuming only 50% of SG&A is variable, you get ~20% decline in EPS. Take a more gloomy view, the gross margin will not stay flat as % of sales but will actually decline several percent, while SG&A will stay flat, and then you'll get ~30% decline.

Ok, now having written this I actually checked the most recent press releases, same store sales for Q4 and analyst commentary, and behold, the earnings are actually projected to fall 30%, and the traffic trends are down 7-8% already.

Valuation. Currently trading at 24 a share, or 12X 08 EPS. For a company with 5-6% growth prospects (2-3% sq footage growth, and 2-3% comps), 14X EPS feels like the right number. We can assume the EPS will revert back to 2.5 in 2009-2010, in which case the stock should be worth $35. Right now the risk reward is not overly compelling, but if the price dips below 20 again, I'd be a buyer.

Genesis Lease - Lets repeat Aircastle's story

Genesis Lease was formed in 2006 after acquiring 41 plane from GE affiliate, and has so far expanded its portfolio to 53 planes. Fleet is even newer than Aircastle's (6 years average age), customers are airlines outside NA (which only accounts for 15% of revenues), only 5 leases are coming up for renegotiation in 08-08, and distributable cash flow is $2 per share. Current stock price? $11, implying 20+% yield. Only recently it has been trading in mid 20s. The only culprit here is investor panick, as U.S. recession is inducing fears that global recession is imminent, which will bring about collapse of all airlines and with them - the lessors. This negative outlook brings you an opportunity to buy the stock that I expect to generate 100% return over the next two years. I don't like the taste of my own words so lets hope I don't have to eat them.

And from Silgan we move to another packager, Crown Holdings. Different from Silgan in the fact that it is a) bigger ($8B in sales) b) much more international with the U.S. accounting for only 30% of sales c) operates in . Similar to Silgan, a lot of recent growth has come from acquisitions, as Crown grew from 2B in 89 to 8B in 97. And now we present the business segments:
Beverage Cans and Ends. $3B in revenues, aluminum beverage cans are sold to beverage and beer companies like Coke and Heineken.
Food Cans and Closures. $2.5B in revenues. In North America holds #3 position behind Silgan, but the fundamental business is the same.
Aerosol Cans. 25% share in the U.S. behind Ball's 45% share, produces aerosol cans for Unilever and P&G

Beverage industry. 230B of beverage cans are shipped worldwide, with U.S. accounting for almost 50%. Global growth is 1-2%, as some regions like Asia and South America are growing high-single digits, while U.S. is flat to slightly negative. Crown has 20% share of the U.S. market, behind Ball's 30%. Chinese market, as always, offers pretty good potential, but is currently only 10B cans vs 100B in U.S., Crown holds a 25% share.
Food industry. Crown has 20% in the U.S., where the market has been flat since 1990.
Aerosol market. 4B containers in the U.S. (10 per person a year vs 300 beverage containers. do we really drink a bottle of beer a day??). Crown holds 25% share.

Financials. Historical EBIT margins have been around 8% in the last three years and I don't see it changing much over time. Revenue growth? 4-6%, probably 2-3% in the U.S. and a bit faster in other geographies. I see no fireworks happening for the company, with the stock currently trading at 10x 08 EBIT, it is at exactly the same valuation level as Silgan, and I suspect their price movements will track each other pretty closely. Hm, maybe I'll just stop looking at this packaging sector, way too boring so far.

Silgan Holdings is a packaging company with $3B in sales selling metal containers for pet/homo sapiens food, misc plastic containers and vacuum closures. The company was formed in 1987 through acquiring of Nestle's Segments and continued the acquisition strategy up to this day, which explains the heavy amount of debt on its balance sheet.

Metal food containers. $1.7B sales, $151M operating income. Steel and aluminum containers that are primarily used for soups, vegetables, fruit, meat and pet food. The market for metal containers has been flat historically however Silgan has grown through increasing its share from 10% in 87 to 50% now. 90% of sales are through long-term supply agreements.
Plastic containers. $600M in sales. Custom designed containers for personal and health care, including containers for shampoos, cleaning products and tablets. Market is highly fragmented and company intends to pursue additional acquisitions in the sector.
Closures. Leading global manufacturer of closures with $615M in sales, business formed through acquiring U.S. White Cap operations in 2003 and then international operations in 2007. Products include metal, composite and vacuum closures for food and beverage products like juices, salsa, soups.

Top 3 customers of the company are Campbell, Nestle and Del Monte that account respectively 12%, 11 and 11% of total sales. With Nestle for example, Silgan supplies 100% of total U.S food container requirements under long-term contracts with pricing adjustable based on input costs. Because of high costs of transporting containers, manufacturing is typically located within 300 miles of customer plants. Many customers, localized market leads to a lot of plants => Silgan has 69 manufacturing locations.

Industry. Throughout the last twenty years food manufacturers chose to focus their efforts on core business, divesting packaging arms that have been gobbled up by the likes of Silgan.

Return on capital and growth prospects? You can cans out of metal, which is, lets face it, no rocket science. Hence you expect you returns on capital to be around the cost of equity of ~11-13%. So what are they? Net PP&E is $940M, inventory is $420M, AP is close to AR, capital is ~$1400, while EBIT is $264M x .65% = $171M, which gives us 12%. Bingo. How will this business grow? Probably close to GDP, maybe slightly below. I ran a quick cash flow valuation assuming 12% discount rate and got the equity value of ~$1.4B, that is slightly below the current valuation. Conclusion? No upside, so I'm staying away from the shares that can only get pressured as the economy slows down further.