Trading Down in the Housing Cycle-Nobility Homes

There are several ways to deal with a housing bubble. Take the equity out of your oversized palace by selling it. Trade down to something that is practical rather than palatial. Rent and wait out the turn of the cycle. For most of us, we ride it out and stay with our existing home...hoping that time-tested trends will return us to that level of prosperity that we thought we had had. For some retirees, the lack of savings or pensions and the ongoing pressure of rising property taxes (ugh...especially in NJ) force the sale of the hallowed home estate, the release of the equity, and the southern migration to the sunbelt of Florida. How do we invest in that trend?

Most of us would agree that conventional housing stocks appear cheap relative to what may well be cyclical peak earnings. If not now, most of us would conjecture that the peak is nearby. But like most cyclicals, cheapness on a P/E basis is illusory...the down cycle soon makes that price look rich in retrospect. And so it is with most housing stocks in my opinion...peak profits and low P/E's tend to coincide with peak prices.

What do these trends mean to the investor? One of the beneficiaries of this trend may well be the manufactured housing industry. In a recent interview of Paul Nouri, an analyst at Sidoti and Company, he correctly points out that the manufactured housing industry already went through its own recession, if not depression. The industry was a casualty of all the usual factors of cyclical excess...overbuilding of inventories, loss of control of the retail distribution chain, reckless lending by various participants including Greentree Acceptance and Conseco, etc, etc. Repossessed homes' values were one half to one third of what they were at the time of the original loan, and became inventory that competed for new sales. As my mother would say, it was a mell of a hess.

The turn was precipitated by a flushing through of inventories, a large reduction in manufacturing facilities and manufacturers, a reduction in dealers, and a huge reduction in finance availability. Deals simply became more sensible, more rational. Hurricane Katrina and FEMA also helped manufactured home shipments...in Mr. Nouri's estimation, adding some 15,000 to 17,000 shipments out of a total of some 145,000 homes shipped last year. Annual shipments in the late 90's were around 360,000 homes just to put it into perspective. Because manufactured homes can only be shipped relatively short distances, some plants have been shut because their local market no longer justifies their continued operation. The remaining manufacturers "get it" and appear to have right-sized their operations.

Manufactured housing often gets a bad rap from those of us who are arrogant enough to believe that only a stick built home really "cuts it." Manufactured homes are built to HUD standards which in Florida must withstand 100-140 mph winds. On average, manufactured homes sell at 30 to 35% less than stick-built plus generally are sold at mortgage rates that are typically lower than conventional housing mortgages. JD Power ratings will be coming soon to the manufactured home builders and they seem much more serious about quality.

The purchase of Clayton Homes by Berkshire Hathaway (BRK.B) pretty much defined the bottom in the industry. Clayton with its fully integrated manufacturing, retailing and financing ability as well as its ability to develop sites is the class act in the industry. Close behind, as a pure play integrated manufactured housing company is tiny Nobility Homes (NOBH) which operates only in Florida. NOBH is integrated in that it sells financing through a joint venture and also retails its products through 19 stores. The joint venture provides additional opportunity for profit but also provides the company more input in the design of unique finance programs for prospective homebuyers. In my view, this was and is important to the success of Clayton in the past, and NOBH in the future. In addition, NOBH also has an independent insurance agency which provides property and casualty insurance as well as extended warranty coverage to NOBH customers . Some 93% of Nobility sales were made on a retail basis through its retail sales centers in 2005, up from the prior year;s 72%, again another opportunity for margin.

This is a terribly thin stock since management, and particularly the founder and CEO own about 63% of the stock leaving a modest float of 1.5 million shares. The company has about $12.3 million in cash on the balance sheet, or about $3.07 per share. There is another $11.8 million in long-term investments.

The company trades at 10.9 times EBIT on an EV/EBIT basis. Not much difference between EBIT and EBITDA here...plant and equipment investment is modest, hence, so is depreciation. ROIC was running at 19% in the TTM. No long term debt either.

The company has treated its shareholders as partners. An annual dividend of 30 cents was paid in January, up from the prior 20 cent level. The company has a 100,000 share repurchase authorization of which some 24,000 shares were bought back in 2005. These numbers may seem modest, yet 100,000 shares represents almost 7% of the free float for this company! Executive compensation is modest at only $218,000 for the CEO ...his wealth is obviously tied directly into his equity ownership.

The trends toward higher priced, larger manufactured homes, the trend toward Florida retirement community living, and the turnaround in this depressed sector of housing should bode well for a recovery in the stock.

Given its modest float, and the costs of remaining public, the quality of its balance sheet, and the excellent position in the Florida marketplace, I believe that NOBH is a reasonable candidate for the ongoing consolidation of the industry.

Disclaimer: Neither I, my family, or clients currently have a position in NOBH. I, my family and clients currently own a position in Berkshire Hathaway.