Description

Century Communities (NYSE: “CCS”)

-        Century Communities is one of the fastest growing homebuilders, in the country’s best housing markets, trading cheap on an absolute and relative basis, with the following catalysts:

-        Catalyst 1: Market recognition of the company’s JV, called Wade Jurney Homes (“WJH JV”), one of the best assets in the homebuilding industry, which could be worth more than CCS’ current market cap by 2020

-        Catalyst 2: CCS’ new financial services division, which was a drag in early 2017 as it ramped up, will generate significant incremental revenue and earnings in 2018

-        Catalyst 3: 2018 margins will benefit from lapping initial expenses related to new markets entered in 2017 as well as CCS’ UCP and Sundquist acquisitions

-        The net effect of CCS’ rapid organic growth coupled with the contributions from the WJH JV, the financial services division and new market contributions will expand ROE by ~500bps in 2018 to about 15% which is consistent with the best public homebuilders which trade at much higher P/B multiples

-        We believe that CCS, currently trading at 2018 7.2X P/E and 1.2X P/B with organic growth in excess of 20%, is conservatively worth $55-$60 per share, nearly double the current share price, and is a possible acquisition target given its land ownership in top markets and the WJH JV

Century Communities (CCS) is a $900M small-cap homebuilder located in Denver, Colorado. The company was founded in 2002 by two brothers, Dale and Robert Francescon, who sold their previous company to D.R. Horton in 1996. Dale and Robert are fantastic operators, evidenced by the fact Century has produced a profit every year since inception, including through the financial crisis of 2008. The two brothers still own 18% of the company, aligning their interest with those of outside shareholders. Having started the company from scratch, Dale and Robert have been able to selectively enter the best housing markets in the country, and the company now controls more than 30,000 lots. Century primarily targets the entry-level home buyer, and the company’s largest markets are Atlanta, Denver, and Austin/San Antonio. Existing supply in these markets is very tight, which should yield a strong market for new home construction. Century’s markets are also experiencing population increases, as the company is exposed to eight of the top 13 fastest growing US markets. Century is both relatively and nominally cheap at 7.2X 2018 P/E and 1.2X 2018 P/B with organic growth in excess of 20% and multiple company-level catalysts that should come to pass in 2018. We believe this sets the stock up for appreciation of greater than 70% over the next 12-18 months.

A prerequisite for investing in a homebuilder is having an opinion on the housing cycle. We are bullish on the housing cycle, as supply is very tight while demand should continue to be strong over the next few years. We have provided a detailed top-down analysis of our view on the US housing market as Appendix A at the end of this write-up. The balance of the discussion will focus on CCS.

We were initially attracted to Century Communities due to its exposure to strong housing markets, cheap valuation and excellent management. The two largest markets for CCS are Atlanta and Denver, which each comprising 15%-20% of consolidated closings. Austin/San Antonio, the Central Valley (Fresno) and Las Vegas come next in terms of size, followed by Salt Lake City and San Francisco. Markets that contribute less than 5% of consolidated closing include Houston, Charlotte/Raleigh, Nashville and Los Angeles. The table below lays out the supply/demand dynamic in each of the company’s markets.

The primary takeaways are: 1) Inventories are extremely low in most of CCS’s markets (6 months of inventory is considered a balanced market), 2) sales are up ~5%-7% in most of CCS’s markets despite falling inventories, and 3) even in Texas, where inventories are up year-over-year, sales continue to increase, and supply remains low (outside of Houston, which looks to be balanced).

Rising wages and falling unemployment are obviously two of the biggest factors that have created the current housing supply/demand dynamic. However, CCS also benefits from being in some of the best areas with respect to population growth. In fact, Century has operations in 8 of the top 13 fastest growing states, and all of its markets are ranked in the top 20.

The favorable housing fundamentals in Century’s markets, entering new markets via strategic acquisitions, and excellent execution have resulted in impressive growth metrics. CCS’s most recent quarterly results highlights its strong position with home sales revenue, new contracts and deliveries up 22%, 30% and 31% organically in its legacy regions. On the Q4 conference call, management mentioned that the sales have accelerated and were up 55% in January for CCS’ legacy regions.  

CCS’ strong operating performance has driven book value materially higher over the past 4 years.

While CCS has executed at a high level and the stock has performed well over the past two years, we believe the most exciting times are yet to come for Century. There are three primary catalysts that we believe will cause Century’s stock price to appreciate significantly from today: 1) Century’s JV investment in Wade Jurney Homes, 2) Century’s newly established Financial Services division, and 3) The company will lap expenses incurred in 2017 related to entering new markets and creating the financial services division, which will now yield revenue and profit in 2018.

Catalyst 1: WJH JV

The most exciting part of the Century story is its investment in the Wade Jurney Homes JV. In 4Q16, Century invested a total of $18.3M to acquire a 50% interest in the WJH JV, an entry-level home builder with a unique and innovative model located in the Southeast. Wade Jurney Homes maintains very little land on the balance sheet that doesn’t have a house under construction on it, and the turnover is very high. Wade Jurney buys unsold plots of land in existing developments and therefore has no development costs or risk. The WJH JV employs a low cost distribution and sales model that is a unique for the home building industry.  Instead of selling with a model home, WJH sells its homes over the internet or out of studios located in retail centers alongside anchor tenants like Wal-Mart or Target.  Each of the company’s studios represent about 24 active homes per year.

The WHJ JV also employs an assembly line–style operations model that was born out having no excess lots on the balance sheet. Buyers come to the studios to select the home they want among several different models that fit their desired lot location.

On day one of owning the lot, Wade Jurney starts to build the home. The home is completed and closed 90 to 120 days later. The ASP on a Wade Jurney home is less than $150,000, representing unmatched affordability for the entry-level homebuyer. This is illustrated in the chart below with Atlanta highlighted as an example.  The lowest priced homes offered by each other builder are materially more expensive than Wade Jurney’s. The company does not offer options, and value engineering helps to provide an extremely low price point to first-time buyers to compete with the resale market.

                (numbers above in thousands)

By leveraging its unique model, Wade Jurney grew revenue from $19M in 2013 to $170M in 2016, and was named the country’s fastest growing private homebuilder for both 2015 and 2016 by Builder Magazine. In 2017, the JV sold 2,319 homes, closed 1,742 homes and generated $259M of revenue, representing year-over-year increases of 101%, 54% and 60%, respectively. All of this growth has come from a presence in only four markets: Georgia, Florida, North Carolina and South Carolina.

Even without expanding WJH to new markets, CCS received $12.2M of net income in 2017 from the JV, generating a first-year ROI of ~67%! Put simply, the WJH JV is producing the highest economic returns of any homebuilding operation in the country, including the likes of NVR, LGIH, DHI and PHM.

We believe that the WJH JV is just scratching the surface. The primary logic behind the JV formation was Century would be able to provide Wade with greater access to capital at a much lower cost, in addition to the benefits of scale with respect to growing into new markets and purchasing power. CCS has been relatively quiet on the prospects of entering new markets, likely not wanting to over-play their hand with respect to competition. However, we found an article in the local Greensboro Triad Business Journal that profiled Wade and the JV. Below are a few quotes that indicate the JV is posed for accelerated growth in 2018:

“We want to be everywhere,” said Jurney… “The major (builders) say they target the starter market, but they really don’t. When the market turns, the higher end is first to fall off. I like the safety of our segment.” 1

“Jurney is in the process of entering the Phoenix market with plans to move into the western suburbs of Los Angeles (Inland Empire), Las Vegas and Texas in 2018. Also in the mix is expansion into Savannah and Charleston, as well as Birmingham, Ala.” [1]

As stated before, we believe Century and Wade Jurney are currently just scratching the surface with the WJH JV, as the operation is currently only in four markets. Except for Deutsche Bank, the sell side has taken management’s lack of guidance and assumed muted future contributions from the WJH JV for 2018 and 2019.  We believe that this, along with conservative guidance provided by management with respect to the base business sets CCS up to be a beat and raise story throughout 2018.

There is a desperate need for quality, truly affordable entry-level homes in the US, and we believe that this model can be implemented in many markets across the country to serve that need. Breaking down the economics of WJH and projecting out the next few years, we believe that by 2020E the total value of WJH could end up being equal to or greater than the entire value of the legacy CCS operations.

Catalyst 2: CCS’ Financing Division Inflects from a Drag to Material Contribution

One big advantage that larger home builders have over smaller upstarts is the ability to offer in-house financing to purchasers of their homes, and generate income from selling the loans. These mortgage origination and title business segments are typically very profitable, and help builders increase their returns on equity. Century has been investing in its own de novo financial services division, called Inspire Home Loans and Parkway Title, which will provide mortgage origination and title services to customers. The company has depressed earnings and its ROE by expensing more than $2M over the past twelve months to launch the division. However, beginning in 2018 the financial services division will be up and running in every Century community.

Based on our estimates, we believe this will could add $0.28 to the company’s bottom line and improve ROE by 100bps, which doesn’t take into account the catch-up from lapping the investment period when there was no revenue generation to cover the segment’s startup expenses. Moreover, these estimates do not include any contribution from activity related to the WJH JV. If CCS chooses to utilize its financial services division within the WJH JV’s operations, this could lead to material upside in the financial services division as the WJH JV will be closing 3,000+ homes per year.

Catalyst 3: Annualizing Expenses Incurred for integration of Acquisitions and to Open de novo Markets

Despite home sales rising by 77% in Q4, CCS’ SG&A increased as a percentage of sales to 12.1% compared to 11.9%. The increase was largely attributable to numerous investment initiatives to support growth in 2018.  We mentioned one of those initiatives with the financing above ($2M cost), but other one-time costs include the acquisitions of UCP and Sunquest homes and CCS’s de novo entry into the Charlotte and Salt Lake City markets, which put additional pressure on SG&A in 2017.  For 2017, the one-time transaction related costs of UCP alone were $8 to $10 million. These costs coming off, along with $10 million in expected synergies from the UCP acquisition should add another $0.75 to $0.80 to earnings for 2018.

Conclusion

To determine the current value of CCS, we believe that legacy CCS will add at least $100M of book value in each of the next three years, bringing book value to roughly $1,000M in 2020. At that point Century, with its financial services division, will be delivering a mid-teens ROE, similar to or greater than the largest US homebuilders. We use a prospective 1.5x book value multiple on 2020E book value (a discount to peers who produce similar ROEs), add the estimated value of CCS’s stake in the WJH JV, and discount that per share value back to today using an 11% WACC.

Our base case assumptions for 2018 yield an EPS estimate of $4.25, which compares to current sell-side consensus of $3.69. Our estimates call for closings of 4,900 homes during 2018, which compares to guidance of 4,500-5,000. We would note that Century’s initial 2017 guidance of 3,000-3,300 closings was later revised up to 3,500-3,800, indicating that the initial 2018 could have a level of conservatism built in. We assume the WJH JV will contribute $19M. Our base case assumes a 12.5% SG&A as a percentage of revenue cost estimate, although this could be conservative as the company laps significant one-time expenses as discussed previously. Our bull case calls for a higher number of deliveries, lower SG&A as a percentage of revenue and a higher contribution from the WJH JV. Our bull case assumptions get us to roughly $5.00 in EPS. If Century hits our base case EPS estimate of $4.25 the company would be producing an ROE of ~15%, putting it among the highest in the homebuilding industry.

The net effect of Century’s organic growth (50% organic growth in closings during January 2018 excluding any UCP contribution), the implementation of the financial services division, and WJH JV growth will expand CCS’s ROE by nearly 500bps and drive EPS to $4.00-$5.00 per share, representing growth of 39%-74% over 2017. Our base case assumption of $4.25 in 2018 earnings would translate to an ROE of 15% (assuming an average BV/share of $28 in 2018), better than both DHI and PHM. This implies the stock is currently trading at 7.2x 2018E earnings, a material discount to peers who generate similar ROEs. We believe with best in class growth, markets and returns, investors will place a premium multiple on CCS, similar to other asset-light/high-return homebuilders such as DHI, LGIH and NVR. As 2018 progresses and investors become more aware of the story, we believe the market will place a 2.0x P/BV multiple on the consolidated company, which would imply a stock price of $52-$60 during 2018, representing upside of 63%-88%.

Appendix

The Big Picture: Macro for the Housing Market

No homebuilder pitch would be complete without a discussion of the current macro backdrop as it relates to US housing. We believe there are many reasons to be bullish on US homebuilding. First looking at the supply side of the equation, existing home inventories are at record lows across most markets. The primary reason is the lack of new home construction from 2009-2015.

With the housing market now more than balanced, we’re still under-producing new homes at 800,000-850,000 units per year versus the long-term average of 950,000-1,000,000. Moreover, there has been a significant increase in US population since the 1980’s and 1990’s, which would imply an even more underbuilt market and higher equilibrium target of builds. Underbuilding over the past ten years has created a national shortage of housing inventory, which continues to hit new lows in terms of months-of-supply.

We believe this supply shortage of existing homes will lead to healthy new home demand for at least the next few years. In addition, compared to past cycles when builders would over-heat, the current labor shortage will likely provide a natural governor on homebuilders’ propensity to over-build. This cycle should therefore be extended compared to past cycles.

Turning to the demand-side of the equation, the US consumer is healthy with unemployment at 4.1%. Wages are set to continue rising and consumer confidence is sitting near an all-time high. Mortgage debt service payments as a percent of disposable personal income is also at a 40-year low.

The most important driver of the new home market over the next 4-5 years can be summed up in one word: Millennials. We’ve talked to many independent and public homebuilders, and each one points to the wave of millennials entering prime first-time home buying age as having an outsized impact on the market. This age cohort will primarily benefit the homebuilders who cater to the entry-level buyer, such as CCS.

With a healthy supply and demand backdrop for the homebuilders, the last piece of the puzzle is financing. The Mortgage Credit Availability Index, which tracks the availability of mortgage credit, continues to expand (i.e., loosening credit). And while the index has expanded significantly from the levels of 2009-2010, it is nowhere close to approaching the absurdities seen during the mid-2000s.

The second piece to the financing dynamic is mortgage rates. We’re not going to say that if mortgage rates go to 6%-7% it’s not going to impact the homebuilders. Clearly there’s a point at which rising mortgage rates will affect the affordability level for homebuyers. However, current 30-year mortgage rates (4.5%) continue to hover near all-time lows. Moreover, as we demonstrate below, given US wages are rising at ~4% per year, the effect of a 100bps increase in the 30-year mortgage rate would not outpace the after-tax wage increase of CCS’s average buyer.

Therefore, while we acknowledge the risk of rising interest rates, we do not believe that the current backdrop impairs the ability of the average CCS homebuyer to secure and afford mortgage financing.

Risks/Other Factors

• Homebuilding is cyclical. Factors such as employment, consumer spending, lending practices and housing supply can all greatly influence the health of the housing market. While we currently believe these factors to be tailwinds, there are no assurances they will remain so.

• 3 L’s: Land, Labor & Lumber. While the company has mitigated some of its land risk with the UCP transactions, Labor and Lumber are very much risks to homebuilders’ gross margins. Labor has been tight in most markets, which has pushed up wages. Interestingly, as multi-family housing starts have been trending lower, we foresee a situation when labor shifts from multifamily/commercial construction to single family building. Regardless, labor will likely remain tight. With respect to lumber, the price of lumber has trended up over the past few years, and continues to steadily rise. If CCS is unable to push through price increases to compensate for the rise in input costs, margins could be squeezed.

• Century is concentrated in certain markets. While the UCP goes a long way towards diversifying Century’s portfolio, Century still has a high concentration of sales and lots in Atlanta, Denver, Las Vegas and Austin/San Antonio. Should there be market specific events that impact those local housing market, Century would likely suffer. These events include acts of God such as weather related events.

• Interest Rates. We discussed this risk in our macro backdrop, but interest rates rising at a rapid pace pose a potential risk.

• Affordability. Housing prices have risen over the past four to five years. While rising prices for existing homes should be a positive for new home affordability, new homes sales could suffer if pricing rises faster than wages. While we believe CCS is better positioned than other home-builders, as the company serves the lower end of the market, if housing becomes unaffordable for entry-level buyers it will negatively affect the company.

• Mortgage origination risk. CCS’ new financial service division originates loans for its consumers. The loans are held on the balance sheet before being sold to third parties. There is always a risk related to holding the loans on the company’s balance sheet, and there could be risk down the road if the mortgages go bad and are put back to the company.

• Debt. CCS has increased its leverage with the purchase of UCP. We believe the company will reduce its leverage going forward, but it should be noted that the current debt level is higher than it has been in the past and higher than the average home-builder.

• Valuation. We understand one of the pushbacks will be the valuation we ascribe to the WJH JV. Our valuation method is based on our belief that the market will ascribe a valuation similar to LGIH/NVR based on similar operating metrics. We believe that if CCS is able to execute and deliver a 15% ROE, then it should trade in-line with companies such as DHI, NVR, LGIH and PHM who produce similar operating results, which would imply a consolidated ~2.0x P/B. The market might not agree with this sentiment.

• ATM. CCS has an at-the-money program which it utilizes from time-to-time. The program was utilized more in the 4Q17 as the company wants to lower its debt/cap ratio to at-or-below 50%, it is currently at 52%. This isn’t necessarily a big deal, but we wanted to highlight its existence.

Additional Disclosure: This information is provided for informational purposes only. This information is not complete and is only current as of the date hereof and may be superseded by subsequent market events or for other reasons. This information is not investment advice and is not a recommendation to purchase or sell any specific security. The author does not make any representations or warranties as to the accuracy or completeness of the information. The author has a position in the security presented, which may be increased or decreased at any time with no notice to the recipient of this information.   This presentation contains forward-looking statements that include statements, express or implied, regarding current expectations, estimates, projections, opinions, and beliefs of the author, as well as assumptions on which those statements are based. Words such as “believes,” “expects,” “endeavors,” “anticipates,” “intends,” “plans,” “estimates,” “projects,” “assumes,” “potential,” “should,” and “objective,” and variations of such words and similar words, also identify forward-looking statements. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, including those described in this presentation, and accordingly, actual results may differ materially and no assurance can be given that the security presented will achieve the results discussed herein. Recipients are cautioned not to place undue reliance on any forward-looking statements or examples included in this presentation, and the author assumes no obligation to update any statements as a result of new information, subsequent events or any other circumstances. Such statements speak only as of the date that they were originally made. Please do your own due diligence.     

[1] Brasier, John. “Wade Jurney Homes assesses first year of partnership with Century Communities.” Triad Business Journal. 2017.

Catalyst

-        Catalyst 1: Market recognition of the company’s JV, called Wade Jurney Homes (“WJH JV”), one of the best assets in the homebuilding industry, which could be worth more than CCS’ current market cap by 2020

-        Catalyst 2: CCS’ new financial services division, which was a drag in early 2017 as it ramped up, will generate significant incremental revenue and earnings in 2018

-        Catalyst 3: 2018 margins will benefit from lapping initial expenses related to new markets entered in 2017 as well as CCS’ UCP and Sundquist acquisitions