- Homebuilder Beazer Homes is trading at 5x EPS and has half its market cap in excess cash on its balance sheet.
- Interest rates are likely to remain low for long, aiding the housing market and preserving the earnings power of the company.
- The stock offers 60% upside if management can immediately take steps to return cash to shareholders.
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As the market continues to rise, and people chase flashy momentum names, there are some stocks being left by the wayside. I'm finding opportunities in the home-building sector, with many of the companies trading at single digit multiples.
A month ago, I recommended investors buy the shares of homebuilder Taylor Morrison (TMHC). The company's recent results were so-so, but the stock still went up, reflecting the large margin of safety at a low valuation. I believe Beazer Homes (NYSE:BZH) has substantial upside with a large cash balance that management should use to highlight the value in its stock.
The company is headquartered in Atlanta and operates in thirteen states. It is one of the smaller public homebuilders, selling about 5,000 homes a year.
Stable macroeconomic backdrop with some puts and takes
There is some anecdotal evidence that the hot housing market is cooling a bit, with higher prices retarding some demand. I would say this is expected, with people getting vaccinated and returning to work. After the housing boom in the 2000s and the subsequent bust, we are back to the level of the 1990s. I believe this pace is sustainable with a larger and growing population. The chart below shows seasonally adjusted annualized new home sales in '000s.
Mortgage rates continue to be low by historical standards. It is still a good deal for people to buy homes they live in for less than a 3% interest rate. There is some concern that higher inflation will cause the Federal Reserve to increase interest rates soon. However, I believe that the Fed is exceedingly dovish (I don't want to use the word "wimpish"). Let's see when they start tapering bond purchases (a few months away at least), and then we can get around to thinking about interest rates going up. Although some people may believe that higher inflation will cause bond investors to demand higher rates, that is not necessarily the case. The same factors that cause inflation (high government spending, income transfers to people, monetization of the deficit) result in too much money chasing assets, including bonds, driving up their price and resulting in lower interest rates. There is simply no political appetite to restrain spending and I see interest rates being low for the duration of the current administration and possibly beyond. I believe rates will go a little higher from where they are now, but not significantly.
Inflation is rampant in the economy, raising costs for anyone who makes things. There is some good news on this front, with lumber prices having retreated from their spike earlier this year. However, the recent wildfires in Western Canada are causing some production to stop and could raise prices going forward.
Financial overview and outlook
In the three months ending June 30, 2021, the company's revenue of $$570 million was up 7% YoY while operating income doubled as expenses held steady. Net income of $37 million resulted in diluted EPS of $1.22 in the quarter, nicely ahead of the $0.90 consensus expectation. The company raised its expectation for fiscal year ending September 2021's EPS to be $3.25.
The consensus estimate is for the company to earn $3 per share this year and $3.38 next year. I believe these estimates are achievable.
The company has $358 million of cash and $1.1 billion of debt. Its market cap is $550 million and Enterprise Value is $1.3 billion. The company has been buying back a modest amount of debt, but is otherwise building up cash and working capital.
Capital allocation opportunity
The company should immediately commence returning half its cash balance to shareholders to whom it rightfully belongs. It should announce a $100 million share repurchase program, which would retire 15% of the share count, assuming the share price increases a bit to the $21 level. Additionally, it should commence a $2 annual dividend, which would represent 60% of net income going forward and represent a best-in-class 10% yield. Together, these actions will use $160 million of the company's $350 million cash balance over the next year. They would signify to the market that management is confident of the company's ability to remain profitable at the current level. Debt repurchases can continue as well, although with interest rates where they are it is debatable whether these represent a good use of capital. The company should be able to generate a reasonable amount of cash going forward as homes in its backlog are delivered and the dollar value of backlog stabilizes.
Valuation: Fair value of $30 for the stock
Buying back stock as I outlined above will increase EPS by 15% to the $3.75 level. I believe fair value for the stock is $30, based on an 8x multiple on this projected earnings power. This is lower than the market multiple and in line with current homebuilder valuations. Thus the stock offers 60% upside from the current $18 price. The other way of looking at it is to assign the multiple on the current earnings projection of $3.25 and add $4 for the excess cash.
In a bull case, earnings will come in at $4 per share and investors will assign a 9x multiple for a $36 target price, offering 100% upside. I do not consider this case to be very likely.
In a bear case, the company's revenue and earnings will miss estimates, with only $3 of EPS after buybacks. Disappointed investors will assign a 5x multiple, resulting in a $15 stock price for 17% downside.
In terms of comparables, D.R. Horton (DHI) trades at 9x EPS, PulteGroup (PHM) at 7x EPS, Meritage Homes (MTH) at 7x EPS, KB Home (KBH) at 7x EPS, LGI Homes (LGIH) at 11x EPS and Toll Brothers at 10x EPS. I believe there is room for consolidation in the sector and Beazer would make an attractive target with its low valuation and small size.
Risks are moderate
The biggest risk here is that the company's earnings will come in lower than expected due to macroeconomic, competitive, or execution factors.
A rapid increase in interest rates could prompt home buyers to pull back and equity investors to pay lower multiples. I believe that interest rates are unlikely to increase a lot with a dovish Federal Reserve and continued monetary expansion.
Shareholders depend on a company's management being good stewards of their capital. There is a risk that the company will make an overpriced acquisition that is material. This risk can be lessened by management returning cash to shareholders rather than hoarding it at the company level.
An investment in BZH offers the opportunity to generate a good return even as the market touches new highs. The company can and should catalyze the return on its stock by distributing the large amount of excess cash it currently holds to shareholders.
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Analyst’s Disclosure: I/we have a beneficial long position in the shares of BZH, TMHC either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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