Beazer Homes Inc. (BZH)

[Wildbilly]

Mea Culpa: BZH May Be Best Speculative Play In Homebuilding

http://seekingalpha.com/article/1622752-mea-culpa-beazer-homes-may-be-best-speculative-play-in-homebuilding?source=email_rt_article_readmore

about: BZH (Beazer Homes USA, Inc.)
Editor's notes: BZH's strong performance, despite a declining community count, and a deferred tax asset that will help with looming profitability make it a high-return way to play housing.
Alpha-Rich ideas are our best money-making long and short investment ideas.
They are released exclusively to Seeking Alpha Pro users 24 hours before publication.
Learn more about Seeking Alpha Pro.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

I previously highlighted Beazer Homes (BZH) as one of the riskier names in the homebuilder group for a number of reasons that can be found in the aforementioned article. I have completely changed my opinion that Beazer should be avoided. It is my belief that Beazer is still a speculative play compared to the other homebuilders but that it now potentially offers the most upside of the legacy homebuilders that survived the housing downturn. Where the story now begins to get interesting for Beazer are the options the company has to potentially de-lever its balance sheet as a standalone company. With a tax asset the company continues to gain more belief in its ability to monetize, Beazer will at some point in time after returning to profitability, trade at a discount to its book value that dwarfs the price to book ratio of any other publicly traded homebuilder. The significant operational improvement seen in the last quarter is almost startling. The land holdings that Beazer has amassed are starting to bear fruit. The company is poised to significantly grow its community count and in turn significantly expand its top line growth and return to profitability. There are still opportunities in the sector that offer a higher margin of error should the housing rally start to fade. However, should the housing market just stay at its current level seen in the recovery, Beazer is probably the one legacy homebuilder that has the potential to see its share price double over the next one to two years based on the brightening outlook for its business.

Why The Thesis Change?

The operational improvement on both a YoY basis and a QoQ basis shown in the Q3 2013 results from Beazer is remarkable. The table below highlights the key operating results figures pertinent to investors from the results of this past quarter:

(click to enlarge)

The bullet points below highlight why the results are so impressive:

The top line growth is notable but should be expected in an improving housing market. What makes this growth impressive for Beazer is that the company accomplished this growth with a material decrease in its community count on both a YoY and QoQ basis.
The single most impressive line item is the expansion in gross margin. On a YoY basis, gross margin % expanded by 890bps to 17.2%. When compared to just the prior quarter, gross margin % expanded by 200bps. This is remarkable and is the best improvement seen in the entire homebuilding sector.
The company has also significantly increased its average sales price "ASP", from $227K one year ago to $254K in Q3 2013. The ASP for homes that have been sold, but not yet closed, was reported at $274K. This is again critical as ever incremental increase in ASP adds additional gross margin $s and operating income for the company.
The item that is not on its face a bullish data point, is the decrease in new home orders. The bearish camp will harp on the fact that Beazer sold fewer homes in Q3 2013 than the company did a year ago, despite a vastly improved housing market. The reason for this is simple and lies in the 20% decrease in active communities on a YoY basis. The company actually sold 1.4 additional homes per active community in Q3 2013 compared to a year ago. The drop in sales per community from Q2 2013 was extremely marginal. This is also a critical factor as the jump in mortgage rates would have fully impacted Q3 2013, and the lack of a significant degradation in sales per community should refute the loudest bearish argument about home sales in general.

What Will Drive Share Price Upside?

Beazer made a strategic decision on how it would approach the housing recovery. Given a heavily indebted balance sheet, combined with cash available for investment below that of some of its larger peers, the company is operating in 2013 on a two pronged approach. First, the company has chosen to forgo volume in order to maximize the profitability on its legacy land assets. Beazer CEO Alan Merrill confirmed this strategy on the Q3 2013 earnings call:

Third, consistent with our decision more than a year ago to forfeit order growth in fiscal 2013 to focus on improving our margins and growing community count in fiscal '14 and beyond, full year fiscal 2013 orders are expected to be essentially flat with last year despite a much lower community count.

This is further evidenced by the guidance provided by the company as to its projected growth in community count over the coming year. Mr. Merrill had the following comments on the latest earnings call about how quickly the company expects to grow its community count:

Moving now to the fourth strategy in our path to profitability plan. With slightly more closeouts than expected, we ended June with 144 active communities. During the quarter, we closed out of 21 communities, but we also successfully opened 17. Our average active community count for the third quarter was also 144, below our longer term target range of 190 to 210.

As I discussed on our last call, we expect to return to profitability well before reaching the low end of our target. And in fact, expect to be profitable for our fiscal fourth quarter with roughly the same number of active communities as we have today. By the end of fiscal 2014, we expect to grow our active community count to approximately 170, give or take a few, as it is difficult to predict the timing of all community openings and closeouts.

Recall that Beazer averaged only 144 communities during the most recent quarter, selling close to 10 homes per community. The company is projecting that it will add ~25 additional communities over the next 5 quarters (by the end of FY 2014). Assuming the company continues to sell ~10 homes per quarter in each community, this will equate to ~1,000 more homes sold on an annual basis (4 quarters x 10 homes per quarter x 25 additional communities). The importance of this growth cannot be understated. These additional homes could add $250M per year in annual revenue, with very minimal additional fixed costs needed to generate this revenue. For perspective, through 9 months in FY 2013, Beazer has generated ~$900M in revenue. Assuming the company generates roughly $1.2B in revenue for the entirety of FY 2013, after a full year of growing its community count in FY 2014, the company should see FY 2015 revenue $250M higher than the level seen in FY 2013 just from growing its community count and without any additional home price gains.

Without the ample cash balance seen by many of its peers, Beazer had to choose whether it would attempt to reduce its punitively high interest rate outstanding debt or aggressively invest its precious capital/cash in opportunistic land deals. The company has chosen to invest in land, and I believe this decision was the right move. The obvious reason is the pending growth in community count that the company will soon see. The less obvious reason is that the company now controls enough land and lots to fund its business for anywhere from 4 to 5 years. Said another way, the company can continue to opportunistically invest in additional land deals in the near term, but it should also begin to generate significant cash flow that can be used to reduce its outstanding borrowings.

The table below from the Q3 2013 10-Q shows the long-term debt position for Beazer:

(click to enlarge)

The company has about $1.5B of outstanding debt, compared to an unrestricted cash balance of ~$300M. About ~$200M of the outstanding debt is entirely offset by restricted cash the company holds on its balance sheet.

Beazer has been creative in its ability to tap the equity markets to raise additional capital as well as having entered into a land banking agreement with a Blackstone affiliated entity that will provide the company with up to $150M in additional firepower to acquire land going forward. The company also has an undrawn $150M line of credit which could also be put to use as needed.

I would expect to see the company get more aggressive now that it has a fully loaded pipeline of land and future communities, in terms of paying down its high interest rate borrowings. In the most recent quarter, Beazer paid ~$29M in interest on its borrowings, of which ~$14M was directly expensed to the income statement. Even with such a significant amount of interest flowing through the income statement, the company was bordering on being profitable from a net income standpoint for Q3 2013. Mr. Merrill provided a projection on the Q3 earnings call that Beazer would be profitable from a net income standpoint during Q4 2013, and on a full year basis in FY 2014. This is where the potential earnings power of the company should begin to be evident. Beazer currently has ~25M shares outstanding which will expand to ~34M most likely during 2014 as convertible equity not currently eligible for conversion is accounted for and increases the total shares outstanding. While dilution is never a positive, in this case, the dilution is being highlighted to show just how immaterial it is in terms of the total earnings power for Beazer. Consider that the company is currently incurring an annual expense run rate of almost $60M from interest expense. This is close to the equivalent of $2 per share. The stock trades at just over $15 per share currently. As Beazer generates cash from its significant land position, and reduces its outstanding borrowings, the company will materially improve its earnings outlook going forward.

Valuation / Earnings Outlook

Beazer currently trades for just under $16 per share. The 52 week trading range is from slightly below $13 to just over $23 per share. The company currently sports a market capitalization of just under $400M. With a book value of ~$230M, Beazer is currently trading at roughly 1.7x book value, which is a favorable valuation compared to most of its homebuilding peers.

Where the price to book valuation goes from appealing to utterly cheap, is when you factor in the deferred tax asset that the company has generated through losses incurred during the housing downturn:

(click to enlarge)

The above slide is from the presentation that accompanied the Q3 2013 earnings report. There are questions as to the overall amount of the deferred tax asset that Beazer will be able to monetize without regard to certain statutory limitations. Even then, if you take the figure shown above of ~$363M that the company shows as the minimum amount of its tax asset not subject to any type of limitation, you begin to see how cheap from a price to book value Beazer will trade in the near future. As the company returns to profitability, it will return this tax asset to the balance sheet which will have the effect of increasing the book value of the company by a corresponding amount. Said another way, the ~$230M reported book value will increase by ~$363M at a minimum when the tax asset is reversed. At that point in time, with a reported book value of ~$593M and a market cap of ~$400M, Beazer would be trading for less than .7x its book value.

Full disclosure, it will take the company years to fully capture the entire value of its tax asset through future profits. At the same time, as the company returns to profitability, it will as well be organically increasing its book value through the earnings it generates. Beazer will at some point in the near future be by far the cheapest homebuilder from a price to book value standpoint.

On the earnings front, the story is just as bright. The company is set to materially grow its community count heading into fiscal year 2014 which will in turn materially drive revenue higher and the first full year of profitability in almost a decade. I noted earlier that I expect Beazer to report over $1.2B in total revenue for FY 2013 and for that to grow materially to over $1.4B in FY 2014. The table below shows the 3 and 9 month results through Q3 2013:

(click to enlarge)

Note the following points:

Gross margin was 17.2% for Q3 2013 which was an expansion of 200bps from the prior quarter. With the higher prices noted previously from homes sold but not yet closed, I predict FY 2014 gross margin will climb to 19% or higher
Commission expenses will directly correlate to revenue and in Q3 2013 were ~4.2% of total revenue.
G&A expense will not correlate with revenue which is a positive. The company will be able to leverage its existing infrastructure to grow its community count with minimal additional G&A expenses. As an example, Q3 2013 revenue was ~25% higher than Q3 2012, however, G&A expenses were only about 7% higher. The company will materially expand its revenue base in FY 2014 without a corresponding significant increase in G&A costs.
The company will incur less in interest expense in FY 2014 as it continues to acquire more land which will allow for more interest to be capitalized into land inventory versus being expensed as incurred. This will materially lower the hit to the income statement from interest expense.
Considering the above factors, my projection for FY 2014 revenue and earnings is shown below:



For what it's worth, the average analyst estimate for FY 2014 is for $1.48B in revenue and EPS of $.40. I think the consensus EPS estimate will be blown out of the water, and if I prove to be conservative with my revenue estimate shown above, all incremental revenue will be complete upside to my projected EPS figures.

I am assuming gross margin continues to expand to 19% in 2014 from the 17.2% level seen in Q3 2013. Commission expense is only marginally more favorable as a % of revenue as the company will be able to offer fewer incentives to sell homes. G&A expense expands to a quarterly run rate of over $32M in 2014 from the $29M seen in Q3 2013. Depreciation expense increased slightly. The item that I do not believe Wall Street appreciates, but will drive significant operating improvement in 2014, is a significantly lower interest expense. Again, as the company increases its eligible asset base for capitalizing interest, more interest will be capitalized to inventory leaving less interest to flow through the income statement. The company has guided for over $170M in additional land investment in just Q4 2013. I have a high degree of confidence that the interest expense number will fall sharply in 2014.

Investment Opportunity

Beazer provides a different opportunity than other homebuilders I have previously profiled that are focused mainly on a specific geographic area such as California. Beazer is one of the largest national builders, with operations in close to 20 states:



The company still struggles with legacy issues, such as its debt burden, more so than other homebuilders. As the image above shows, it is also making marked improvements operationally in a short period of time.

I believe Beazer could earn close to $1 per share in its next fiscal year as shown in the projection previously provided, which would far surpass analyst expectations. That would leave the company trading at just 16x its forward earnings estimate today. Going a step further, by continuing to grow its asset base and retiring debt, Beazer could generate an additional $1 per share in earnings in FY 2015 just by reducing the amount of interest expense flowing through the income statement. In this case, Beazer has the potential to earn ~$2 per share by FY 2015 without even accounting for any additional top line growth or margin expansion.

What are the downside risks? The downside would be that Beazer is more exposed than other builders if the housing recovery were to collapse. Notice that I said collapse, because if the housing recovery were to stall at the current level seen today, I believe Beazer is set up to achieve the projections laid out above without any additional macro gains in the housing market. In a housing market correction or collapse, Beazer would struggle under the weight of its heavy debt burden. The company has no significant debt maturities until 2016 and between the cash on hand and its significant land assets it will monetize, it is highly unlikely that even looking out 36 months in a housing market correction that Beazer would face any type of liquidity crunch. It is important nonetheless to note that the company has less flexibility than some of its peers.

However, at the end of the day, if you are investing in homebuilders, you are investing in a high beta group of stocks regardless of which company you choose to invest in. MDC Holdings (MDC) has a pristine balance sheet and is destroying analyst expectations with each earnings report. Yet the misguided fear of rising interest rates has left this company trading at a dirt cheap price to book value of 1.25x after the stock has sold off almost 25% since mortgage rates began their rise. I say misguided fear, because a recent Fannie Mae study shows that even as the % of home buyers who expect interest rates to rise increases, so too do the % of home buyers who still believe it is a great time to buy a house.

In summary, the market has proven that no homebuilder will be spared if macro news causes the entire sector to no longer be the flavor of the month for the market. With this in mind, if you want exposure to this sector, you will not find a top 10 publicly traded homebuilder that could realistically double outside of Beazer Homes. For that reason, the risk reward is screaming for this company right now and I highly believe the potential reward outweighs the risk.

This is an Alpha-Rich Idea
Alpha-Rich ideas are our best money-making long and short investment ideas.
They are released exclusively to Seeking Alpha Pro users 24 hours before publication.
Learn more about Seeking Alpha Pro.