- Market Capitalization less than $1 billion.
- Net Debt less than 2x EBITDA.
- P/E less than 12x using normalized, mid-cycle earnings.
While markets remain pricey even after the recent decline, there are some pockets of opportunity. Today I will highlight 3 small cap opportunities in the residential real estate sector which have 50+% upside. My criteria are as follows:
- Market Capitalization < $1 billion
- Net Debt < 2x EBITDA
- Trade at less than 12x normalized (mid-cycle earnings)
The first stock I will highlight is a recent IPO - Installed Building Products (NYSE:IBP). While I typically avoid buying (and frequently like to short) recent IPOs, I believe IBP shares could rise 50% or more as the housing market recovers. IBP is the second largest supplier/installer of installation to homebuilders in the US with 15% market share. Unlike other distributors selling to homebuilders, IBP provides installation (in addition to product), allowing it to add greater value (and earn better margins) than companies like Builders FirstSource (NASDAQ:BLDR). Assuming that the market gets back to 1.6 million housing starts (consistent with 30 year average) vs. 900,000 in 2015 and that IBP is able to increase its market share to 18% (has increased share from 5 to 15% since 2005), I expect that IBP will be able to do $900 million in revenue (vs. $432 million in 2013).
Factoring in operating leverage, I expect operating margins to increase from just 4% in 2013 to 8-10% at 1.6 million housing starts. Using the midpoint gets me to $81 million in operating profit. Taxing at 35%, I get net income of $53 million, or $1.76 per share. Putting just a 12x P/E multiple (reflective of strong market position but also cyclicality), gets me to a price target of $21, or 58% above yesterday's close. In addition, there is further upside potential from acquisition opportunities - IBP management has proven to be a skilled acquirer and value accretive acquisitions could enhance per share value.
The UK's LSL Property Services (OTC:LSLPF) is the second largest residential real estate brokerage in the UK behind Countrywide (LSL is the largest provider of appraisal services). Though the UK housing market has seen transaction volume decline as a result of the global financial crisis, LSL has been able to maintain strong earnings by growing market share and expanding into new areas of business (as property management services to landlords and repossession services for lenders). Today LSL trades at 16x trailing earnings per share. However, like the US, the UK residential real estate market is well below trend - with 750,000 transactions, 2013 was 40% below the 30 year average level of transactions. Assuming an eventual reversion to the mean, LSL could see EPS double to 50 pence per share. Applying a 14x P/E multiple, LSL shares would trade at L7.00 (+73% vs. yesterday's closing price on the London Stock Exchange).
Move Inc. (NASDAQ:MOVE) is my final residential real estate pick. Like Trulia (NYSE:TRLA) and Zillow (NASDAQ:Z), MOVE is an advertising tool for realtors. However, MOVE trades at a significant discount to Trulia and Zillow - MOVE sells at just under 1.5x 2014 expected revenue vs. 5x revenue for Trulia and 12.5x revenue for Zillow. While I don't think that MOVE is a great business (and grows more slowly than Z or TRLA), I expect that it will ultimately be purchased by either Zillow or Trulia as (1) significant valuation discount (2) opportunity for large cost savings by combining operations (particularly on the IT development and maintenance side, should also help with pricing) and (3) strategic benefit of bringing MOVE's direct access to MLS listings in-house (MOVE's listings are up to date whereas a significant percentage of Zillow's and Trulia's are stale - i.e. the house has already been sold). Assuming that MOVE is purchased for just 3x revenue (still a big discount to Trulia or Zillow), shares would have 100% upside. It's also worth noting that I've taken a short position in Zillow as I think the business is misunderstood and massively overvalued.
Though the overall stock market looks fairly valued at best, I expect that the 3 stocks mentioned above will perform well on both absolute and relative basis for investors with a 3-5 year time horizon.