A Cavalier Investment in Modular Homes
Often times, value investors find low priced common stocks trading at a discount to fair value for legitimate reasons. Cavalier Homes (CAV) is certainly one of the legitimately low priced common stocks on the market. This investment idea came to us from a trusted friend and colleague and it appeared to be undervalued. The hot tip piqued our interest because it was based on a sound thesis: low income people will need to purchase modular homes in many of the gulf coast regions affected by Hurricane Katrina. Unfortunately, in this case there seems to be no legitimate catalyst for price appreciation. Rather, there exists a compelling catalyst for significant price depreciation or worse share price stagnation. The theoretical valuations are not validated by the reality of current business conditions.
The most compelling piece of the CAV story is the negative catalysts facing the company’s business model. First and foremost, no lending industry exists to meet the demands of modular home buyers. The company’s 10k and 10q reiterate this issue numerous times, which leads us to believe that this is a dying industry. In the year 2004, lending institutions left the business of consumer loans for modular housing en masse. The primary reason is that lenders prefer to write loans on land rather than a building, which is perfectly logical. Lenders can more easily recoup their losses on a bad loan for land rather than a tangible asset. What would the bank do with a plethora of modular homes? They might be able to sell them to overcrowded schools or construction companies, but that is too creative a solution.
Secondly, the consumers of CAV’s product, modular housing, are not the most credit worthy customers. For the most part, CAV relies on low income consumers in rural areas with the majority of sales being made in the following states: North Carolina 15.3%, Louisiana 12.6%, Alabama 12.2%, Florida 10.3%, Georgia 10.6%, South Carolina 8.5%, and Mississippi 7.5%. There is certainly a geographically diverse consumer base, but this base will not be mistaken for J.D. Rockefeller anytime soon. Furthermore, the lending rates that CAV charges its own dealers range from 8% to 14%. These rates are a strong indicator of the credit issues that face this industry.
The Katrina thesis is compelling, but coupled with the above issues becomes a moot point. In reality, CAV’s growth has been driven by the contract it signed with HUD homes for 2,638 modular houses for Katrina relief. The problem is that this event is a one time catastrophe; such catalysts do not make for compelling growth or turnaround situations. Furthermore, the company has been hurt by rising material costs. In reality, the Katrina effect is more of a double edged sword. Katrina has generated revenue growth, but at the same time, she has generated increased costs of good sold. This does not bode well for margins in a highly competitive industry.
On a positive note, the company seems undervalued in comparison to the rest of the Manufactured Housing Industry. The problem is that no significant catalyst exists to drive the current share price toward what we believe to be its intrinsic value of $7.30. Please view the following spreadsheet to understand our analysis:
Manufactured Housing
While analyzing the company two interesting solutions which might be able to change CAV’s business fortunes came to mind. First, the company might consider going private or finding a buyer for the firm. The company trades at a 50% discount to the historical two year average from 2004 to present. Furthermore, if our analysis is correct, and the assets of the company are worth close to $7, there should be no reason that someone would not want to buy the firm outright. The problem with this scenario is that it sounds good but does not seem to be based in reality.
The more realistic solution would be to implement an auto dealership business model. Auto dealers both sell cars and provide financing to the customers that purchase the car. Currently, CAV provides financing to its dealers of its products. It seems that a prudent course of action would be to extend this arm to the company to consumer lending. CAV could then create a sort of GMAC type of subsidiary. Doing so could create dramatic results; (1) if successful they would then be able to sell the financing arm of the business to a buyer at a significant and meaningful price; and (2) if the company successfully implemented this solution it would attract lenders into this barren market.
Cavalier Homes seems to be a cavalier investment in our eyes. No compelling positive catalysts can be identified through reading the annual and quarterly reports. While valuation seems to be compelling, it is impossible to validate our calculations based on the reality of the business climate. If anything, it seems that CAV is the equivalent of a football team that needs to throw up a Hail Mary in order to even think about winning. For this reason, we think that this stock should be sold and not considered for purchase.
