Category: Featured

In-depth analysis or commentary on companies, securities, or the economy

Food for Thought: Amazon Should Acquire Dollar General $AMZN $DG

Reading Time: 7 minutes

Picture this: A long established direct to consumer business has committed to opening a significant amount of brick-and-mortar stores in 2021. Amidst the 2020 online fulfillment craze this company is rapidly expanding its physical footprint.

2020 had us believe “brick-and-mortar retail is a thing of the past.” But we fail to realize is this monumental statement can be true and false at the same time.

What gives? At a certain scale, DTC businesses realized the cost of a retail location is actually a cheap way to acquire incremental customers (especially in high-traffic locations). Here’s a great discussion on Warby Parker doing this, for example .

The same is true for the largest e-tailer, Amazon.

This post will dive into Amazon’s foray into brick-and-mortar and why it’s obvious that it will expand its footprint (hint, it compliments a significant driver of its moat, Prime).

Bear with me on some historical points in this post: It’s important to understand the history. And then we’ll all better understand why Dollar General is an attractive target for Amazon to gain retail footprint AND its logistics expertise.


The Importance of Prime

Doubted at First – Now the Moat

Amazon’s online retail business truly started to gain steam when it launched Prime 2-day free shipping. At the time, people forget many said something like:

“the cost of business just keeps rising, this won’t be that attractive to many customers… will they ever generate profits?”

I took these comments straight from a sell-side report at the time. But Amazon realized this would be attractive.

The annual Prime Membership fee + low prices + free shipping = a very sticky business. Amazon was able to use the membership fee to subsidize the growth and chose to scale much faster than Costco (I’ve discussed their similarities in a prior post).

Last Mile Delivery

Amazon found something consumers want (cheap, near instant gratification with little work) and now has over 200 million paid prime members.

So they’ve decided, “hey, this is driving a moat and causing customers to pick us over others – let’s turn it up a notch.” Now big cities are seeing 1-day delivery or even 2-hour delivery in some cases.

Amazon also has been aggressive investing in a last mile delivery service of their own.

This is from a Fedex deck put out in late 2019

Fedex used this graph to explain why Amazon wasn’t that meaningful to them, and why they are ending a contract with Amazon. All it told me was that Amazon is aggressively investing to control delivery, gain scale, and dominate the customer (as an aside, is this an under discussed AWS-like business for Amazon? I.e. something they first use for their benefit, but then farm out for others in third-party fulfillment. Yes.)


Amazon Embraces B&M: The Whole Foods Acquisition

Turning back to the original point of this post: everyone understands the Whole Foods acquisition expanded Amazon’s brick-and-mortar footprint.

Recall this article titled, “Amazon buying Whole Foods puts it right next to one-third of America’s richest households.” I highly recommend you to read it.

Amazon’s expanded touch points and categories allowed the stores to serve as delivery locations (Prime Fresh) and also are stores where customers can conduct returns.

Similarly, Amazon Go is another retail concept Amazon is experimenting with. Just walk in the store with the app open, grab what you want, and walk out. A true CONVENIENCE store. The goal is no line hassles. In fact, a new article just came out applying this tech to a whole grocery store. Hmm.


So, we’ve established that Amazon:

  • Wants to create as sticky of a customer relationship as possible
  • Wants to get products to customers in a low-cost way
  • Knows supply-chain is key and is investing heavily there
  • Understands retail footprint will be part of the mix

There is still TONS of white space for Amazon

I assume most people reading this post are in a reasonably populated city. Maybe you’ve experienced Amazon’s 1-day delivery, or even 2-hour delivery. Maybe you get Whole Foods delivered.

Congratulations. But you are only part of America. If there’s anything elections have taught us, what you may think is America, ain’t all of America. Okay, I’m slightly kidding there.

If we go back to that Whole Foods analysis that was done that I linked to above – you need to re-read it. The title is misleading. The article actually says, “one-third of Americans with annual incomes over $100,000 live within 3 miles of a Whole Foods.”

What is the median household income in the US again? It’s $68,000. That’s for household. Median individual incomes are about half that.

That means there is actually much more white space for Amazon by going out beyond the Whole Fooders. Clearly, they’ve been focused on high-density population areas with high incomes. But there is a lot of white space out there.

I wish the Census Bureau chart (left) broke down incomes into more brackets, but I compared it with Whole Foods locations from this website (right). Compare dark green spots on chart of the left with dark green dots on chart on the right.

Pretty clear overlap, and it makes strategic sense for Whole Foods (or Whole Paycheck, as some call it). But if you believed in the Whole Foods acquisition thesis and believe B&M footprint can help Amazon reach the customer, that also means there is tremendous white space for Amazon.

Why? Because that last mile delivery is very expensive. Rural locations do not benefit from the same route density and therefore, shipping to them gets incrementally more expensive. Yes, Amazon has been leaning on the USPS for some of this, but if you want to push the envelope ahead of your competitors, you can’t rely on that forever.


Enter Dollar General as M&A Target

  • Who has over 17,000 stores, with ~75% of US population living with 5 miles of a store, and a goal of 25,000 stores?
  • Who has stores specifically where Amazon is underpenetrated?
  • Who has had a relentless focus on logistics, driving a powerhouse?
  • Who already has a private carrier fleet accounting for 20% of their outbound fleet?
  • Who has already figured out produce and fresh food logistics to rural areas?
  • Who provides low cost products to customers, while also earning a high ROIC?

Let me state these points another way: Dollar General provides low cost products to its customers (in some cases very rural areas), yet also carries ~11.5% EBITDA margins (almost 2x Amazon & Wal-Mart’s margins, despite high margin third-party fulfillment revenue for the behemoths), and has a ROIC in the ~50% range?

That must mean Dollar General benefits from some mix of these things:

  1. customer acquisition cost is low (only game in town)
  2. they are getting paid some premium (perhaps for location)
  3. they have very effective logistics (to keep cost low), and
  4. they utilize assets / working capital effectively to drive high ROIC.

Dollar General: A Logistics Powerhouse

If you’ve followed Dollar General for a while or read my prior discussions on them, you probably know that they are a logistics tour de force. We’ve talked about a couple things already, but here are a couple more to consider:

Relentless Focus on Reducing Stem Miles: This is the distance between a distribution center (DC) and a store. Reducing the distance reduces cost. Dollar General has 17 DCs for non-refrigerated products, 9 cold storage DCs, and 1 DC that serves both. Goldman recently conducted some analysis that showed DG had reduced stem miles by ~10% since 2016, despite store count increasing by >20%.

DG Fresh Valuable to the Everything Store: I’m just going to let DG explain this one from when they launched DG fresh in early 2019.

DCs Are Valuable: Amazon details it has ~295 million sq ft of properties across fulfillment centers, data centers, and other in North America. Dollar General only has ~20 million sq ft, but its likely in the areas that Amazon is not.

Amazon has $1.7 trillion market cap. Dollar General is $50 billion. Hm. Could increase your North American sq footage by 7% by acquiring something 3% your size.

The Math: Can Amazon to Acquire Dollar General?

Dollar Generals’ market cap is around $50BN with a $53BN enterprise value, ex-operating leases. In contrast, Amazon spent $58BN in capex during 2020.

Amazon also exited Q1’21 with ~$73BN in cash and can issue debt at super cheap rates. They have equity currency too if they really wanted. But any way you slice it, I think Amazon would have no problem acquiring DG.

The synergies would be dramatic and the shear amount of positive headlines would probably be nauseating – that’s how good of a deal it seems to me. Cross-selling, mini-DCs, adding Dollar General’s logistics in the mix, etc. etc.

Imagine combining these two powerhouses together. Imagine taking the learnings from Amazon Go and applying it to 17,000 stores as fast as possible. Imagine Amazon actually having this kind of access to the whole country.

How would you answer this question? Do you think Amazon will eventually provide 1-day or faster delivery everywhere in the country?

Most know it’s inevitable, but this deal would hasten the inevitable.

LGI is a Buy $LGIH

Reading Time: 6 minutes

I think LGIH stock is potential multi-bagger. Well, it already has been one, but I think it can do it again. When you add in solid growth, good demand fundamentals and a high ROIC business model, it spells opportunity for long-term investors.

Take a look at some of its growth metrics over time. It does around $480MM of EBITDA now, which is about 2.2x from 2 years ago, and 4.0x from 4 years ago. Also… it was the only homebuilder among the 200 largest U.S. homebuilders to report closings & revenue growth from 2006 to 2008 when the housing market experienced a significant decline. So management clearly is focused on growth.

LGIH did $12.8 in EPS for 2020, but I see the path to $23.3 in EPS by the end of 2023 (discussed more below). Therefore, shares are trading at just ~7.25x my 2023 estimates.

LGIH is interesting too because they provide monthly home closing cadence. The May 2021 was up 42% Y/Y and YTD is up 44%. On one hand, easy comps with April/May, but on the other hand, I think they will keep this strong cadence going for a decent period of time.

Let me break it down.


Perhaps by now you know of NVR, a homebuilder with a “unique” business model which I break down here and how the stock has actually outperformed Microsoft (at the time of writing). It is asset light, relying more on options than buying and developing lots, which in turn means less capital tied up, they have high inventory turns, and high ROIC.

LGIH also generates a really strong ROIC, but it doesn’t rely solely on options, as you can see below (controlled = options). It’s split ~55% owned / 45% optioned.

As you can see, LGIH’s ROIC not only is solid for any company, it is improving with scale.

LGIH ROIC

So how has LGIH stock done versus NVR’s? LGIH stock is now officially crushing NVR

LIGH stock vs. NVR stock

However, LGIH still has a unique model. Let’s break it down:

  • Very sales focused:
    • Whereas NVR focuses on the land strategy (a big thing for builders, no doubt), LGIH’s core competency comes from focus on sales and marketing
    • A sales office typically has 2-5 people in it with one loan officer.
    • LGIH trains its sales staff for 100 days
    • The main goal is to convert renters to buyers. They even send direct mailers to apartment complexes pitching renters on buying a home.
    • Now, in talking to some folks about LGIH’s process, it’s clear some people think LGIH is akin to a used-car salesperson (i.e. pushy). However, as we’ll discuss more, the model appears to work really well. Consumer reviews are also pretty solid.
  • Spec homes – big contrast from other builders
    • LGIH is 100% spec homes. Almost the opposite of NVR
      • “Spec” means they build the home without the buyer already secured. NVR only builds on the optioned land once it has the buyer.
      • Everything is typically included, so there are not specific options that each buyer needs to select. They have 4 to 5 home plans in each community that allows LGIH to build and sell faster and drive on.
      • Now, clearly LGIH seems more risky, though in a tight inventory market, the market needs spec homes. Its model is also still low cost.
      • Also, LGIH was the only top 200 builder to grow from 2006-2008
  • Focused on entry-level:
    • Average price point is around $250k, which is square in the entry level price point (meaning first time home buyers).
    • Given lots are expensive these days, LGIH is typically acquiring lots outside of city centers, but also targets areas where there is some retail anchors to attract consumers.
    • This segment of the market should have demand for years to come, given millennials deferred purchasing homes post-GFC and have been renting for longer.
  • Still earns strong returns
    • The average & median builder earns around a 12% EBIT margin, with DR Horton and Lennar near the top given their massive scale (16.1% and 15.5% respectively) and the smaller builders near the bottom, such as Beazer and Taylor Morrison around 10%
    • LGIH earned a 18.3% EBIT margin
    • Another interesting thing to note, going back to strategy, is LGIH’s absorptions blow competitors out of the water. Again, 4 is the average absorption rate per month in 2020. LGIH is around 7. The gap was even wider pre-COVID (i.e. before the buying boom).
    • This means LGIH is selling almost double the amount of homes in a period of time as competitors.

So what drives LGIH’s high returns on capital?

Dupont formula: profit margins (high for LGIH), asset turns (high for LGIH), and leverage (actually low for LGIH).

As LGIH gains size, I think ROIC will continue to grind higher. Now, they’ve gotten pricing, which helps ROIC and margins, but look at ROIC as size has scaled.

LGIH ROIC

As a quick aside, it’s funny to contrast everything we’ve talked about so far with New Home, a luxury builder I wrote about a few months ago that still trades below book value. New Home is small, so its EBIT margins are low. It’s also a luxury builder which just given the nature of the product is slower moving. However, I still think it’s cheap and it’s likely a take-out candidate in a market thirsty for inventory.


Ok – back to LGIH. To my knowledge, only a couple firms cover LGIH. I only could find JP Morgan and BTIG.

Here lies the opportunity. I think LGIH will be a long-term compounder and it’s relatively undercovered. Based on my estimates, I think LGIH will do about $23 in EPS in 3 years (from ~$15 LTM). So with the stock trading at 7.4x that forward EPS today, that seems too cheap to me.

LGIH projections

Sure, I’m looking 3 years out on a cyclical business, but I’d rather have LGIH stock than buy a questionable SAAS name for 20x sales.


The risk to the thesis is, can they keep up the growth? Well, 2020 will definitely be a tough comp. Right now, we are still lapping the easier part of 2020.

However, the risk to LGIH’s growth is not the same as NVR for example.

Recall, NVR uses solely options on lots and those don’t exist in every market. LGIH’s risk is acquiring lots at attractive prices and selling them in high demand areas – lot prices are going up, but so is entry level demand. I think LGIH will just pass that through.

There are other obvious risks to homebuilders. Interest rates, the economy, etc. etc. But I think this cycle is going to last awhile. Sure, we could have a buyers’ strike like the end of 2018 as rates were rising, but I think we actually need several years of housing starts >2MM (vs. new cycle high of 1.5MM right now) to sustain demand.


I watch the builder stocks from time to time. In some ways, they’re HODL’ers. They are so volatile. But a few are worth grabbing on to and just taking along for the ride.

So bottom line: LGIH stock may not be a straight path up, but I think it will compound earnings for a long period of time.

Re-opening Play at a Discounted Price (with Sandbagged Guidance) $ABM

Reading Time: 7 minutes

Looking around, it’s hard to find discounted, pandemic-impacted stocks. The pandemic is approaching its final chapter, so the market is clearly bidding up names that will benefit from a boost in demand following the shocks of 2020 on some businesses (aviation, restaurants, and entertainment). But those sectors look “expensive” now, all things being equal. However, ABM is a stock that is undercovered and pretty interesting.

**This will be a different post than usual: I think the company is sandbagging guidance, so I spend a decent amount of time on that. However, I also like the business. It’s a service business, so there are some puts and takes (particularly operating leverage in the case that I am right), but they generate good FCF either way, have accretively deployed FCF historically, and have a clean balance sheet today. ABM is also a pretty underfollowed stock, which I like and think creates opportunity**

I should lay out my detailed thesis right up top:

  • ABM gained high margin, COVID cleaning work during the pandemic. The guidance basically implies that will fall off immediately post-Q1. But mgmt commentary on re-opening conditions plus contract terms imply this will likely last through the end of the year.
  • Aviation will come back and is still down by roughly half of what it was pre-pandemic.
  • Mgmt has sandbagged guidance; already ~35% of the way there with just Q1.
  • This is a decent business with good FCF that they historically reinvest back into acquisitions.

Quick Background

ABM started in 1909 as a window washing company (then known as American Building Maintenance Industries). Since then, they have grown into a large, diverse services company, mainly in the janitorial market.

Easiest way to think of them now is the service providers that clean commercial buildings, such as those that care for carpets in commercial buildings. They also handle parking management, landscape maintenance, and aviation services (like cleaning the aircraft, or those people you see assisting those in wheelchairs at the airport – that’s likely ABM).

They have 5 segments now, broken up by industries they serve: business & industry (52% of sales), technology & manufacturing (16%), Education (13%), aviation (11%) and Technical Solutions (8%).

So you can see, pretty diverse. But you can also see where I’m going: a decent chunk of the business was impacted by COVID.

As you look at each segment for FY2020, clearly Aviation was the most impacted followed by Technical Solutions (think of a services business to help control energy costs for a building – not really something you’d look to do in a cash preservation scenario).

However, the company also was able to grow EBITDA last year: This is because they pruned some low margin business heading into 2020 (good call) and cost control helped expand margins. Lastly, there were decent amount of COVID-related work that was high margin. More on that later in the post.

So again, here is where we get to the crux of my thesis:

  • The high margin work will continue through CY’21 and likely into CY’22.
  • Aviation will come back
  • Mgmt has sandbagged guidance; already ~35% of the way there with Q1.
  • This is a decent business with good FCF that they historically reinvest back into acquisitions for scale.

High margin work will continue through CY’21 and likely into CY’22.

Yes, we know the constant cleaning of everything for COVID was probably overkill. However, employees are still optically going to want to see heightened cleanliness as we all return to office. Its optics over reality, folks.

According to mgmt,

“average occupancy across the country is approximately 15%. We anticipate this could increase to 25% by Labor Day and grow to 50-plus percent through calendar year-end.”

Mgmt used their janitorial business as an opportunity in COVID. With “EnhancedClean”, they signed customers on to somewhat longer-term, very high margin contracts. Below they say work orders and EnhancedClean are similar margin (high) but they make the specific point that work order is 1x and EnhancedClean can be over the coming months.

The point is, when those employees officially head back post-labor day or by year end, they will want to see the office is a clean place. There will also need to be more cleanings done just as occupancy rises (another area where building owners could have cut costs in 2020).

Plus, with cost controls and pruning of the business, it seems to me like ABM’s margins should be somewhat higher anyway which they’ve talked about on the Q1 call.


Aviation will come back

I think aviation demand will come back, but maybe some business travel is gone forever. Fortunately, when it comes to sanitation, a flight can be 65% booked or 85% booked and the same amount of cleaning needs to be done.

Same for the actual airport. I think this segment comes back, though it is a pretty low margin business.

LTM, Aviation was $585MM in sales, down from $1,017MM in 2019. Seems like there is $400MM of incremental revenue opportunity. Assuming low margins at 3.5%, that’s $15MM of incremental EBITDA. It isn’t huge, but its upside to guide in my view. And I think it will come back quicker than most expect based on recent news.


Management is sandbagging

ABM released its FQ1’21 (ended Jan) on March 9th. Sales were down 7.5%, but EBITDA was +80% Y/Y with 400bps of margin expansion to 8.3%. Adj. EPS was $1.01 compared to $0.39 in the PY (which was pre-COVID).

For guidance, they’re calling for 6.6%-7.0% EBITDA margins and adj. EPS of $3.12 at midpoint.

I went back and looked historically: fiscal Q1 typically is around 25% of sales, but net income tends to be a bit less than a quarter. Q1 adj. EPS was already 32% of their guide ($1.01 of $3.12)

Hmmm…. It seems like management is calling for a strong reversal of current trends. Q1 also had 1 less working day! Aviation was also still very weak during holidays.


Let’s Do The Math

Sure, the high margin work probably will be going away in the long-run, but the rest of the business will be recovering. I think every one of their segments will likely grow sales this year. As stated, I also think the cleaning work will continue at least for this year (more on that below).

Here’s why I think they’ll beat that number:

  • Reasonable to assume sales will be down 5% or less this year
    • Q1’21 sales were down ~7% from Q1’19.
    • For full year sales to be down 5%, it implies the rest of the year will be down ~4%. I think that’s somewhat reasonable, though there’s upside based on Aviation.
  • Mid-point margin guide is 6.8% of sales, which points to $420MM of EBITDA ($6.174BN * 6.8%). HOWEVER, we know Q1 is $124MM of EBITDA at 8.3% margin, so that implies 6.3% margins for the rest of the year
    • This is too conservative – it basically means that high margin cleaning work will be drying up right after Q1!
    • This high margin work should persist because they’ve structured most of it as EnhancedClean under longer contracts

Another way of putting it: fast forward to Q2’21. Do you really think margins will fall by a lot? I don’t. I think Q2’21 will probably look similar to Q1’21. If that’s true, it implies 2H’21 will have super low margins. It doesn’t add up. Shown below, if you think Q2 is 8% margin, 2H will be 5.5% margin. Huh? No.

For the high margin work to evaporate, like their guide suggests, then this slide is false too:

Bottom line: under most scenarios I think the company will beat guide. To put $ amount to it, I think they’ll probably do >$3.45-3.50 in EPS, which is about an 11% beat. I think ABM stock will likely trade up higher than the beat, though. Either way, based on my experience, if ABM beats and raises guidance, the stock should outperform.


Decent Business with Good Reinvestment Potential

Ok I spent way too much time on their EBITDA guide, but I did so just to show confidence.

Let’s first break down FCF expectations. Not too shabby. Around an 8.4% FCF yield.

ABM also has $378MM of cash on hand whereas they typically keep ~$50MM or so. So they have $328MM of excess cash today (10% of market cap).

They’ll likely continue to paydown term loan and their revolver this year, so I think by year end, barring any acquisitions, they’ll have $500MM of excess on hand, or 15% of market cap and will be basically net debt zero.

ABM typically does bolt-on transactions, but the last deal they did was for GCA, a $1.25BN acquisition acquired for 12.5x. Let’s say they do another deal.

With $500MM of excess cash at 12.5x, they could acquire another $40MM of EBITDA (increases PF EBITDA by roughly 10%).

However, they could do another GCA-like deal, but debt-funded, and leverage would only go up to 2.4x. Not bad.

Net / net, I like ABM stock. It has good resiliency. The market is also fragmented, so I expect the acquisitions to continue. Lastly, it looks cheap. Really, the cherry on top is the low guidance which may serve as a catalyst for the stock to pop later this year.

Selling Puts on Intrepid Potash – High Return with Downside Protection $IPI

Reading Time: 3 minutes

Market volatility creates awesome opportunities. Today, I’m going to be talking about a name I’ve followed for some time and actually currently own the stock. But I’m not talking about buying the stock – I think selling cash-secured IPI puts is a solid risk / reward.

Let me break it down. First, IPI is at $28.7 / share at the time of writing. You can sell the Dec 2021 $17 strike put and collect a $1.40. So effectively, you’re buying the stock at $15.60 in a worst case scenario. If nothing happens, you collect 8.2% ($1.4 / $17.0), which is 15.3% annualized – which is above my hurdle rate of return.

Is IPI Cheap?

Currently, estimates for IPI show $50MM of EBITDA for 2021, which I think is too low. Even so, if it is correct, here is the current capitalization. Note, IPI does have a $10MM PPP loan which it expects to be forgiven, so I subtract that out. Trading at 7.7x isn’t bad. Buying at $15.6 with the estimates staying flat equates to 4.3x…

Net / net you can see the balance sheet isn’t overly levered, which is good for a cyclical company (selling mainly potash for agricultural end uses).

Why do I think estimates are too low?

Look at potash prices – they are at levels we haven’t seen since 2014-2015. Yet, consensus is saying IPI is only going to do EBITDA on par with 2018 levels… hm. IPI had to shutter some high cost potash capacity, but back in 2013-2014, the company was doing ~$100MM of EBITDA.

IPI has been announcing price increases too here. Trio is mentioned in this press release, which is a product that has been basically breakeven (or negative) gross margin the past two years. Do you think that will continue in this environment? Probably not. They announced a $100/ton price increase. For context, the average price in Q1’21 was $233/ton. Maybe they don’t get it all, but that price increase should fall straight to the bottom line.

They also have an Oilfield Solutions segment in which they essentially provide water to energy companies that are fracking. It’s historically provided ~$18MM of sales, which is very high margin (54% gross margin in 2019). That should also improve this year as we’ve seen a recovery in rig count.

Bottom Line

For IPI to hit $17 by year end, a lot would have to go wrong from current conditions. Q2 and Q3 would have to be really disappointing, which I just don’t see.

Bottom line: this is a great return for me and I’d be happy to buy IPI at $15.6. I like the stock, but for those who don’t want to own a cyclical and need a place to park cash, this seems like decent risk / reward to me.

Different Way to Play Housing: Manufactured $CVCO $SKY

Reading Time: 7 minutes

I did a recent post on Sun Communities, a manufactured housing and RV park manager. I liked the core business and outlook, but returns on capital seemed too low and the the REIT structure made them over reliant on capital markets for growth. I could be wrong on that name, but I think I found where I’d prefer to play: manufactured housing stocks. And there are two stocks in the space: Cavco (CVCO) and Skyline Champion (SKY). The Oracle of Omaha owns the other, biggest player in the space, Clayton Homes.

Why Manufactured Housing?

Bottom line: Manufactured housing has improved considerably over the past 30 years (both from a product perspective and an industry perspective). With home prices moving higher with tight supply vs. demand, I think we will see considerable demand for something more affordable for years to come. I also think these stocks are “off the radar” for most people. COVID also masked a very large build in backlog.


Why is Housing in a Shortage? Following the last downturn, where we clearly overbuilt housing supply, we went too far in the other direction. We’ve been underbuilding arguably since 2010 when the housing market started to bottom.

If you look at the long-term average of construction starts (pictured below), its around 1.5-1.6MM average starts per year. We just got back to that level 11 years after the bottom. So we just got to long term averages. In 2012-2013, we were still building in line with the lows of 1980’s and 1990’s recessions (I’ll add that the average mortgage rate in the 80s was in the teens percent range… not below 4%).

Another simple way I think about it is, if there are 120MM households in the US and that grows 1% per year, we need at least 1.2MM new housing developments each year, and that is before any teardowns or second homes.

In reality, household formations over the past 10 years have been held back. We all remember the stories of millennials moving back in with mom and dad. Well, that is a deferred housing formation. And that is finally starting to unwind as millennials age, get married, and have higher savings.


Another way to look at it is from “months supply of inventory.” Months supply of single-family homes hit a new all time low recently at 1.9 months. This means at the current sales pace, all of the housing inventory available for sale would be sold in less than 2 months – a new record low.

Tight supply + strong demand = increased prices. Econ 101. And that is bearing out. CoreLogic reported home prices increased 10% Y/Y in January 2021. Low interest rates also haven’t hurt to spur demand…

Could housing cycle down again? Yes. Absolutely. In 2018, when rates were rising, people paused their purchases. You can kind of see the surge in months supply of inventory on that last chart in 2018. However, that just deferred demand.


I encourage you to scan your local market for “entry level” homes. There just aren’t any available. Part of that is also because of investors scooping up rental homes, too. We also now have 3 publicly traded REITs that play in the single-family home market that didn’t exist prior to the financial crisis.

All of this tells me that housing will remain unaffordable to a large swath of the population.

Enter: Manufactured Housing

In areas I look at real estate, the $150k entry-level home doesn’t exist anymore. At least, not within an hour’s drive. Heck, even $250k is becoming more scarce.

SKY had an interesting stat from 2018 that noted, 80% of homes sold below $150k are now manufactured homes. The average price SKY sold homes at was ~$63k, so there is a huge disparity between entry-level single family home and buying manufactured housing.

We also can’t forget that ~37% of American’s earn less than $50k per year. One out of four Americans make less than $35k per year. And that’s the market for manufactured housing.

Statistic: Percentage distribution of household income in the U.S. in 2019 | Statista
Find more statistics at Statista

Some Quick History

This might be a good time to explain some history on manufactured housing. In short, MH saw a mini-preview of the Great Financial Crisis in the 1990s. Both consumers AND retailers were able to get ultra-easy financing. When you think about that in relation to supply / demand, it basically meant demand from consumers was artificially propped up AND retailers were able to stockpile inventory cheaply.  This eventually caused the industry to implode and it still hasn’t recovered from a shipments perspective.

Recovery to these levels isn’t my thesis though. It is pretty hard to argue shipments will go back to bubble levels.

The share of manufactured housing as % of housing starts has been pretty constant though over the past 15 years, which I think could improve some in an affordability crisis. I think it could also exceed recent levels because of this. I also think starts will continue to be above long-term averages.

So we may not get to 222k shipments as highlighted in the chart above, but we could come somewhere in between.


As with any downturn, this led to consolidation. Berkshire is the behemoth, followed by Skyline (which merged with Champion) and Cavco. The latter two still roll up any players that come for sale, but its pretty well consolidated at this point.

As pictured at the beginning of this post, the inventory available has really improved. And they come in all shapes and sizes…..


I Like the Business Model

The business is vertically integrated. A SKY or CAVCO typically manufacture the home, but also operate the retail side as well (though there are individual retailers, too).

Need financing? Cavco and Clayton have retail financing arms, too (and they are GSE approved). Both Fannie and Freddie offer financing support, which is relatively new and I personally view as a game-changer. There was a recent WSJ article on this as well. Now consumers can get access to cheap financing with as little as 3-5% down – very helpful to a consumer who may not have a high degree of net worth. I’ll circle back to the limits of this, though (permitting).

How do they transport the homes? They operate trucking businesses, too.

Anyway, I think the manufacturing side of these homes is interesting. Homebuilding is actually moving more and more to these sorts of “off-site construction” given labor constraints and a desire to speed up build times.


Why Permitting is an Issue

A benefit to Sun Communities is a detriment to Cavco and Skyline. Manufactured housing suffers from “NIMBY” or not in my back yard. So permitting for new communities that allow these types of housing is tough and this has clearly been a governor on growth. That is essentially why Sun has to acquire for growth versus anything organic.

However, with improved aesthetics and a broader realization that housing is unaffordable, we could see some changes here on the margin.


Cavco and Skyline are very similar, so I’ll just show CAVCO highlight below. While EBITDA margins are relatively low, capex is too. So for each dollar of EBITDA earned, they actually convert a decent amount of that into unlevered FCF (excl-taxes, excl-interest). It seems pretty clear to me that the company can scale up earnings without needing to invest too much.

For example, Cavco acquired some commercial real estate in 2020. Otherwise capex would have been $8-$10MM. Said another way, they increased EBITDA from 2016 by $42MM, but recurring capex only went up by $4MM…


Backlogs are Big

In March 2020, Cavco had a backlog of ~$124 million. Today… its $472 million. But if you looked at 2020’s results, it doesn’t look like Cavco really benefitted too much. LTM sales are up 1%. But the reason has been manufacturing disruption. So the results are really more on the come.

Skyline is in a similar place: Their backlog before the pandemic hit was $128MM… now its nearly 4x that. 


Valuation

Admittedly, Cavco and Skyline don’t screen as cheap stocks. Each trade around 15.5x March ’22 EBITDA and 25x FCF based on consensus estimates. Number one, I think the higher multiples are warranted as these businesses can generate good FCF and they also are essentially debt-free (kind of like WD40). I also think growth will be above average for years to come.

I also think consensus is way too low.

Again, these are manufacturing businesses with backlogs that are up 4x from pre-COVID and we really haven’t seen that roll through yet. Therefore, consensus estimating sales up 12-15% for CY2021 seems way too low to me. While labor and raw material increases could squeeze margins, if capacity utilization on the plants are running flat out, that fixed cost leverage will improve EBITDA considerably.

Time will tell. I like both Cavco and Skyline and am just playing it via a basket.