To Capture the Best Returns from US Homebuilders, Buy Canadian

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Uncited.
Firm: Hedge Fund
Location: Seattle, WA

Recommendation: Long Shares of Brookfield Residential Properties (NYSE: BRP)
Timeframe: 1 to 2 Years
Recent Price: $10.91
Target Price: $20.00

Strategy: Value

Quick Thesis:
Homebuilder stock prices have rallied strongly since last fall driven by upbeat comments from industry insiders. The S&P Homebuilder Index is up 66% since the end of September 2011 outpacing the broader stock market’s gain of 26%. Current valuations have risen to the point that a partial return to normalized earnings is already priced in. Enterprise Values for most homebuilders are roughly equal to 2003 levels . However, current sales are just a fraction of 2003 levels and some homebuilders continue to lose money.

In contrast, Brookfield Properties (BRP) is profitable yet trades at a discounted valuation to current income. In fact, at today’s price you can pay less than fair value for the profitable Canadian operations and retain a free option for the recovery in the depressed US operations. In the event of an actual housing recovery in the US, it is likely that future profitability of BRP will be much greater than current levels. Therefore, BRP is recommended for purchase.

Why is BRP Cheap?
» Complicated – recent spinoff from a cross border transaction, still dual listed
» Obscure – small cap with limited float and no analyst coverage
» No indirect ownership – BRP is not included in any ETF’s
» Leverage – BRP is levered, but the debt is held by a related party (BAM)

Catalysts to unlock value:
» Housing recovery in US
» Coverage by street analysts or inclusion in ETF’s
» Continued stock buybacks or an outright buyout by the parent company, BAM
» A spinoff of the US operations into a separate entity

Background
Housing activity in the US has bottomed and will likely increase in the future. The simple reason is that housing starts have reached a level where the stock of housing is unsustainably low given the current population base, household formation growth, and natural demolition levels of old and unusable housing. However, the exact timing of the recovery is unclear.

Assuming a similar level of housing activity as in 2002, next year’s profits might resemble something like net income in 2002 following a similar level of inventory in 2001. Keep in mind that sales and margins during a fairly benign housing market like 2002 would be a huge recovery from current conditions. Still, we see that some valuations already price in a partial recovery with DHI, TOL, NVR, and MTH all sporting double digit price multiples to 2002 income.

Valuation
BRP trades at roughly 13 times current net income due to the profitability of their Canadian operations. BRP is also cheap on a current EBITDA basis with a single digit EV/EBITDA multiple.

Since earnings are so volatile, homebuilders typically trade on a Price to Book (P/B) basis. Even on this measure BRP trades at a discount to peers. On a per lot basis, BRP trades at a fraction of other homebuilders.

BRP is differentiated from the US based homebuilder peer group in that roughly half of the business is based in the US with the other half based in Canada. The Canadian operations are running smoothly and generating substantial profits. In fact, we would argue that the US operations are obscuring the value of the Canadian business. Note that the entire business (including the loss-making US division) is trading with a market cap ($1,058 million) that is only 8 times pre-tax profits.

Summary
Brookfield Properties (BRP) is profitable and trading at a depressed valuation to current and future profitability. In fact, at today’s price you can pay less than fair value for the profitable Canadian operations and retain a free option for the recovery in the depressed US operations. In the event of a housing recovery in the US, it is likely that profitability and valuation multiples of BRP will be much greater than current levels. Therefore, BRP is recommended for purchase.

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