What a moment! Bulls argue that public home builders' stocks are cheap because of their vast land positions relative to strong long-term fundamental drivers for housing demand. Bears worry that these companies overpaid for dirt at the top of the cycle and that land impairment charges and write-downs are likely. Meanwhile, as management teams continue to fight misperceptions, they grumble about the value of their equity. Some take this grumbling to be the onset of an emerging willingness to go to drastic measures to extract value from their companies.
INTEREST PIQUED We believe that financial sponsors are locked in the same debate. In trying to determine whether or not to make a two-to four-year bet by taking a builder private, with a required return threshold of 20 percent, their first challenge is to model pro forma cash flows as a function of margins that may be achieved on existing land banks. Record land positions, which translate into 6.2 years of supply at current run rates, compare with inventory turns of just 1.2 times. We believe at least half of the land under control on home builder balance sheets has a market value above book value. This would support current margin power unless home prices collapse or other input costs accelerate.
A leveraged buyout (LBO) occurs when a financial sponsor—either a consortium or single buyer, but usually a private equity group—seeks to transition the ownership of a public or private company through an acquisition. The deal is typically financed with a significant portion of debt to replace existing equity with the assets of the acquired company used for collateral. This allows the buyer to complete the transaction without a substantial capital commitment, and some 70 percent of the new enterprise value is financed with debt. With 70 percent leverage, we estimate the average home builders' cost of debt would increase by 200 basis points or to 8.5 percent. Compare this with the average cost of equity at 12 percent.
LIKELY CANDIDATES Financial sponsors troll for companies with reliable cash-flow yields and strong balance sheets to ensure that adequate debt capacity exists and that interest payments can be covered. (See “Pay Out,” left.) In the case of home builders, we believe current cyclically depressed and near-trough valuations make for attractive buyout candidates, especially as accelerating earnings per share will likely lead to multiple expansion once demand improves. Companies that have underperformed in terms of margins and returns despite the record demand and pricing environment, such as Centex Corp. and WCI Communities, are likely candidates for a turnaround.
LEVERAGED RECAPITALIZATION Although we do believe that an LBO is financially feasible, we do not see the long-term benefits to shareholders. In our view, the level of interest among financial sponsors is similar to that in 2000, when the group was out of favor, although no buyouts took place. Strong-willed management teams seem ambivalent to the benefits LBOs, especially as they tend to be independent thinkers, and few companies need the benefit of extreme financial discipline.
Rather, a leveraged recapitalization may be the optimal solution to increase shareholder value. Under this structure, the current management can proceed to grow and manage the business as planned, although less land will be owned with more controlled through options or off-balance sheet structures, such as joint ventures.
Margaret Whelan is an analyst with UBS Investment Bank.
Pay Out To get a glimpse at what the internal rate of return (IRR) would be for a prospective financial player at the end of a hypothetical four-year LBO investment, UBS analysts modeled three exit transaction multiple scenarios—4.5x, 5.0x, and 5.5x—for each home builder. Financial sponsors target a minimum IRR of 20 percent. The model factors in an enterprise value (EV) vs. EBITDA ratio, dated May 25, 2006, and assumes a debt level of 70 percent at the start of the buyout period.