CVCO - Staying Bullish On Cavco Industries: A Promising Homebuilding Pick

2024-01-13 02:30:24 ET

Summary

• Most economists were wrong about 2023, and there are now mixed opinions about how 2024 is going to be.
• Cavco Industries, a manufactured home builder, is impacted drastically by this uncertainty but is expected to benefit from strong long-term trends.
• Resilient U.S. market and ongoing trends such as low house affordability make Cavco Industries a promising investment opportunity.

Investment Thesis

Until recently, the market was a lot more pessimistic. While most economists proved to be wrong about the economy and the stock market in 2023, there are a lot of mixed opinions about 2024, especially about where rates are going to be at the end of the year.

This discussion around rates affects the housing market and homebuilders dramatically. One of the homebuilders I have covered with a "Buy" rating, Cavco Industries (CVCO), is definitely impacted by all this uncertainty. While the stock outperformed the market since my initial coverage, I still believe the company will benefit further from trends such as low house affordability and the reluctance of homeowners to sell in the face of high mortgage rates.

That is why I believe Cavco Industries is still a promising investment opportunity. The resiliency of the U.S. market, together with the ongoing trends mentioned, makes me confident to reiterate my "Buy" rating.

Introduction

I have published two "Buy" rated research on homebuilders. The first one was on NVR (NVR), which I published on the 31st of August, 2023. That has been performing strongly since, and I have reiterated my rating with my recent article on the 11th of January.

The second homebuilder I covered was Cavco Industries. It has been a volatile ride since my article back in September and similar to NVR, much has changed since. This article is a follow-up to that initial coverage.

While there are lots of macroeconomic developments at play, I have covered the housing inventory situation and talked about mortgage rates while evaluating NVR. So while I may mention them, I will not get into too much detail. There is another trend that specifically affects Cavco, which I'll talk about later in this article.

Without further ado, let's get into it.

Company Description

Cavco Industries produces manufactured homes in the U.S. It is one of the largest businesses in its niche and has a history of 60 years.

The homes Cavco manufactures are mostly small single-story homes that are customizable. Based on what the customer wants, they can be built to have a specific number of bedrooms and fireplaces, air conditioning, and/or high ceilings. The company also sells park-model RVs, vacation cabins, and factory-built commercial structures.

This is not an easy business to operate, simply due to the fact that the products are manufactured in plants and transported to the customer. Moving manufactured homes is expensive, even if you have the means. That is why you have to optimize your supply chain.

Cavco has access to an extensive network of distributors, community operators, and residential developers. Similarly, it has 29 manufacturing plants throughout the U.S. and two in Mexico. This allows the company to be active locally while being a nationwide player. Each manufacturing plant works with distributors in its proximity. See for yourself below.

Having footprints in so many different regions, the company owns and operates a large number of brands. They include mortgage companies, manufacturers, and local sellers in different regions. The two mortgage companies it has are crucial, as house affordability is a big theme for Cavco, which we'll discuss further.

Performance Since Publication

I published the Cavco article on Sep. 19, 2023. While the stock moved along the market for nearly 3 months, it outperformed in December, before falling in January.

Since the recommendation, Cavco Industries is up 16.3% at the time of this article's writing, while the S&P 500 is up 7.6% respectively.

Cavco stock surged 30%, coming remarkably close to my previous target price of $363. It then fell nearly 11% due to market correction and recessionary concerns.

Have a look at it below.

While this has been a profitable trade so far, let's delve into the reasons and discuss the future.

The Economic Outlook Supports Growth

I have talked about the current state of the economy and two powerful trends driving the homebuilding industry in my follow-up article about NVR .

As I have highlighted, the U.S. economy is still strong with lower-than-expected inflation and higher-than-expected employment. Especially in Q3 2023, GDP grew by an extraordinary 4.9% . In these circumstances, it is not easy to talk about the possibility of a recession.

The housing market continues to be affected by high mortgage rates, but not necessarily negatively. Homebuilders have been supplying all the demand for housing thanks to homeowners not selling their homes as they have locked in below 3.5% mortgage rates in 2020 and 2021. Consequently, existing home sales were down 15% year-over-year in October 2023, while new home sales surged 18% . I believe every drop in mortgage rates would only fire up more demand for new homes until rates fall to around 3.5% again.

Additionally, the trend which was the main focus of my initial coverage continues to be a big driver of business for Cavco. It has become exceedingly difficult to afford a house.

This Bankrate survey explains that although owning a home is seen as a hallmark of the American dream, a significant amount of aspiring homeowners cannot afford it. We can see why with the comparison of the median sales price of houses sold and the median household income . It shows that affordability was at its lowest in 2022 and improved only slightly in 2023.

The same Bankrate survey also found that 64% of Americans are willing to make sacrifices to become homeowners and find more affordable housing. These stats are promising for Cavco Industries, which specializes in affordable homes.

As house affordability remains an issue, Cavco is likely to see demand increase for its products.

The Company Is Set to Supply This Increasing Demand

Cavco slightly missed EPS and revenue consensus in Q2 2024, but management highlighted some positive developments. The management admits that the macroeconomic environment is not easy for potential homebuyers, and this is one of the reasons why the company is operating at a reduced level.

However, management mentions that the homebuyer interest is healthy as indicated by online leads and store traffic, and dealer inventories are now generally under control across company-owned stores and the independent dealer network. In fact, the company has witnessed a trend of improving orders from street dealers.

The company was able to operate at optimal size and pace in this challenging environment. It is because of this that the cash flow from operations decreased only slightly in the last twelve months compared to the fiscal year 2023.

This is just a small slowdown and I expect the aggressive growth trend in the chart above to continue.

Valuation

The DCF analysis below follows the same return on assets assumptions from my initial coverage article. With an updated free cash flow calculation, I find an adjusted free cash flow of $212 million in fiscal year 2024 and $235 million in fiscal year 2028.

I am using a very conservative terminal growth rate of 2%, in line with long-term inflation targets, to calculate the terminal value. The cost of debt is disregarded in the cost of capital calculation as the company's debt-to-value (D/V) ratio is lower than 1%. The cost of equity is calculated using a long-term risk-free rate of 2%, a market risk premium of 5.7%, and the stock's 5-year equity beta.

While other analysts might add all cash to enterprise value to find the equity value, my approach is slightly different. I believe cash has an operating part, which is used for the daily operations of a company for a year. While there are many ways of calculating it, I typically use a number between 5% and 10% of annual revenue. I consider any remaining cash excess, which the shareholders have a claim on. I use this excess cash value in equity value calculations.

Using these calculations, we find an equity value of $3.44 billion for CVCO, which means a target share price of $393.55. This is a 24% upside at the time of this article's writing.

Risks

Risks related to this investment are mostly macroeconomic risks affecting the homebuilders.

First of all, the valuations have recently surged higher with the expectations of several rate cuts in 2024. If there are fewer or no rate cuts, we might see a downturn in valuations.

Additionally, if housing affordability continues to worsen to the extent that Cavco's affordable houses are not considered affordable anymore, this would impact demand dramatically.

Lastly, a recession with a weak labor market has the potential to reduce demand for the company's products significantly, and therefore might cause the stock to fall.

Conclusion

Cavco Industries has been one of my favorite coverages lately. It benefits from strong long-term trends such as homeowners not selling their homes, low house affordability, and a resilient economy. The stock has performed well so far since September 2023, and I think the drivers of the valuation are still valid.

I believe that the fact that young adults are not able to buy homes is going to remain a big discussion, and as surveys show, people are ready to make sacrifices to find affordable homes. Cavco Industries, with its established position in many local markets, is ready to supply.

Investors need to keep watching these trends, and how Cavco benefits in the long run.

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