I recently wrote that Standard Pacific (NYSE:SPF) looked like a good homebuilder to play the recovery based on its leverage and relative valuation compared with comparable stocks. However, since then the stock has rallied over 20%, and it's time to take a look at where the true valuation will ultimately land.
Homebuilder valuation can fundamentally be disaggregated into volume and price, so we shall deal with those in turn and then adjust for inventory and net debt. In addition, Standard Pacific has significant preferred stock that will likely convert into common so that is extremely dilutive for equity holders, capping the upside.
Volume - strong recovery likely, timing uncertain
First two datasets, one showing the national picture and the other showing SPF's volumes. The 2011 data includes an estimate for Q4 in both cases.
Overall US single family home completions, 000s
source: US Census data
click to enlarge
Standard Pacific Homes - New Homes Delivered 2003-2011e
Looking at the volume data tells us two things, neither massively controversial (1) there was a over-supply in the mid-2000s relative to trend (2) once that over-supply works through the system, volumes will rebound significantly as a normalized level for past decades (not just the bubble peak) is easily 1,000,000 even without population growth and we are currently at 500,000 single family completions at the national level. Of course the currently depressed completion level is for a very good reason - chronic oversupply. Nonetheless, at a national level, volume could ultimately double and for SPF, a tripling of volumes is possible as they have shrunk faster than the national totals. Of course, the timing is uncertain, but consensus for 2012 calls for a 24% increase in completions so we are heading in an upward direction, but will need to see unemployment much a lower level than 8% to 9% to really drive a volume upswing.
SPF is currently achieving an average price of $347,000, this may rise over time due to mix, since SPF's focus state of California achieves 25% higher prices than average. I will also assume the 2010 current gross margin of 22% remains constant and hold prices constant.
If SPF is able to triple volumes at current pricing and margins, that would lead to 7,000 units (back to just under 2003 or 2007 levels) at $347,000 each so $2.4B of revenue and $524M of gross margin. Less $200M of SG&A to get EBIT of $324M or $234M after a 70% tax rate.
Putting that on a 10x multiple gives $2.3B and backing out net debt of $940M and adding land inventory of $1.4B gives an equity valuation of $2.7B.
Dilution - a big negative
Dilution from 147 million preferred shares that will likely convert into common gives a total of 341 million shares. This is of course a major negative for the valuation. I am concerned that when this conversion happens it will be a negative newsflow event for the stock, even if SPF is cheap on a valuation basis.
Resulting Valuation - $5.27 per share for 2012
The resulting valuation is $7.78 per share. However, this is very much a best case for long-term volumes, and the stock won't get there in 2012 as volume recovery will take some time. If we assume 4 years for volumes to recover to c. 2003 levels and apply a 10% discount rate for each year, then the fair price is $5.27. That would be 31% upside from today's price, but does assume strong execution from SPF in maintaining gross margins and keeping SG&A under control.
Standard Pacific remains a good way to play the housing recovery. Volume growth could be substantial, though dilution from preferred presents a risk. Ultimately the stock could get to over $7, but it could take several years to achieve that as volumes will not rise overnight and so $5 is a sensible ceiling for the stock in 2012. For the more risk averse investor, waiting until after the preferred conversion could provide a suitable entry point given the historic volatility in housing.
- Gross margin has been relatively high in recent years, if that is unsustainable, it would lower the valuation.
- Treating inventories as an asset for equity holders is somewhat controversial. On the one hand many of the assets (such as land and land under development) are easily marketable and closer to cash than traditional inventory. On the other hand, for other industries inventories are typically not treated as part of the valuation, but equally not as marketable.
- The timing and ultimate ceiling for the housing recovery is uncertain.
- I'm ignoring their finance business, which could be a source of value, but is relatively small.
- Holding prices constant is perhaps conservative, especially as the focus on California drives pricing through mix.
- Both the ultimate level of SG&A ($200M) and the resulting multiple (10x) are relatively hard to predict and, of course, important to the valuation.
Disclosure: I am long SPF.