Skyline Champion

Trailer trash? Certainly not shares of Skyline Champion

Trailer trash? Certainly not shares of Skyline Champion. It has gained market share in the factory-built housing market, improved margins, and sits on a big cash pile. Elevated home prices plus ‘higher for longer’ mean housing affordability will continue to be a challenge. Prospective home buyers will have to give serious consideration to factory-built units, which are less expensive than site-built houses. The industry outlook is bright, and Skyline Champion is probably the best way to get exposure to this multi-year theme.          

History

The company’s roots go back to the 1950s. By the mid-1990s, Skyline Corporation was amongst the leading players in the manufactured homes industry with a market share of ~7%. It also manufactured and sold recreational vehicles.

The factory-built housing market reached a cyclical peak in 1998. From that point industry sales declined ~85% until 2009. Restrictive financing conditions, caused by borrower defaults following what Warren Buffett termed ‘atrocious’ marketing practices, contributed to lower sales. In the mid-2000s, with US housing prices racing ahead and ‘liar loans’ easily available, why would anyone have bought a factory-built house? 2009 was the bottom for factory-built housing but the recovery proved tepid for several years.  

Skyline Corporation had a near death experience during this period. It posted net losses for 8 consecutive years (05/2008 to 05/2015). It began the downturn with no debt and $124 m in cash & investments. As of 05/2015 the cash balance was just $5 m. It sold its RV business that year, but the proceeds were immaterial.

In January 2018 Skyline and Champion Enterprises announced a business combination. At the time, Champion was unlisted and owned by private equity, having gone bust several years prior. The new company took the Skyline Champion name and remained public. Champion executives took control of the enlarged company, which was the 2^nd largest in the market. From that point everything changed, and for the better.      

Skyline Champion grew further with the March 2021 acquisition of ScotBilt Homes.

Two significant transactions were announced in mid-2023:

·         19.9% of ECN Capital Corp, a publicly traded Canadian consumer finance firm. Skyline Champion will pay $138 m for the 19.9% stake. In addition, Skyline Champion and Triad Financial (an ECN subsidiary specialized in this business) will establish a JV, of which Skyline Champion will own 51%.

·         The acquisition of Regional Enterprises, the #4 player in factory-built housing, for $328 m.

Operations

The core business is factory-built housing. Most products follow the standards laid down by the US Dept of Housing & Urban Development (HUD). It also produces park model RVs and commercial structures.

It has 43 manufacturing facilities. Sales are mostly via independent, non-exclusive retailers though it also has 31 company-owned stores. For the industry as a whole, ~50% of sales go to retail buyers and ~1/3 are purchased by operators of factory-built housing communities, such as Sun Communities.

The company additionally has a logistics unit, which is a specialist transporter of factory-built homes using 3^rd party truck owners.

The sales mix is 92% US factory-built housing, 6% Canadian factory-built housing, and 2% other (primarily transportation).

The addition of Regional Enterprises adds 3 manufacturing facilities and 43 retail sales centers. It is predominately located in Alabama and Mississippi.

The associate, 19.9%-owned ECN Capital, is predominately involved in providing inventory financing to retailers of manufactured homes and originating loans, with the intention of selling, to retail purchasers of manufactured homes. It also has a small business financing purchases of RVs and boats.

Business quality

Barriers to entry are low in factory-built housing. A new entrant needs an assembly facility, some manufacturing equipment, a labor force, design and floor plans, a supply chain, and distribution network. Due to the difficulty in transporting the finished product, this is a regional business. Manufacturers explain that sales must be made within a 350-500 mile radius of assembly. It may be possible to find some corner of the nation in which a new entrant could carve out a local niche.  

Low barriers to entry suggest operators will struggle to produce economic profits. This has been the historical case for factory-built housing manufacturers:

·         Skyline (prior to the Champion merger) produced an average ROIC of negative 4% over a nearly 20 year period.

·         Cavco Industries, the current #3 player, produced an average ROIC of 6% from 03/2004 to 03/2017.

Granted, the periods noted above capture a horrible period for factory-built housing manufactures, in which demand was under severe pressure. 

Clayton Homes, the industry leader and owned by Berkshire Hathaway since 2003, is probably the exception to the rule. In its last 6 years as a public company (until June 2003) it produced an average ROIC of 11%. It has remained profitable since being acquired. It has scale, vertical integration, and effective management. 

Recent returns have been much better:

·         Skyline Champion has posted an average ROIC of 17% in the past 6 FYs.

·         Cavco Industries generated 16% during this period.

In addition to an improvement in demand, industry consolidation may have boosted return on capital for the market leaders. The top 3 players, which control ~85% of the market following the Skyline Champion acquisition of Regional Enterprises, held ~65% in 2015.

As Skyline Champion’s market share has expanded, it appears to have become a more efficient producer and better able to leverage operating costs. At the same time, the industry has essentially become an oligopoly of 3 players.

Increased bargaining power should enable Skyline Champion to demand discounts for raw materials and machinery and negotiate better terms for transportation and leases. In addition it should be better able to scale corporate expenses and investments in IT and automation. All signs are that this is happening:  

·         Gross margin reached 31% last year compared to just 17% in 03/2018.

·         SG&A costs had declined to 11.5% of revenue compared to 14.1% 3 years ago.

Of course, some of the improvement is due to the strong demand environment and recent quarterly data suggests some pullback in margin. But much of the gains are likely to be maintained.

Cyclical environment

For now the industry is in recession, like the broader housing market. Most recently, industry shipments are lower by ~20% YoY.

Growth potential

Pity the first time home buyer. Median personal income is $40,500 as of 2022. Times two, a married couple may pull in $80,100. After federal and state income tax, call it $62,000. For a site-built home, they may be looking at $400,000. Assume a 20% down payment and 7.8% rate on a 30-year fixed rate mortgages. The result is a $2,632 monthly payment. The mortgage payment is ~50% of take home pay.

A reasonable alternative is a factory-built home, the price of which is closer to $100,000. Splurging on a premium model plus purchasing some land, maybe the price is $150,000.

The factory-built homes being produced by the likes of Skyline Champion are a far cry from the 1970s junky mobile homes parked in flyover states. Have a look on their websites.     

For factory-built home producers, the exciting opportunity is for their products to revert to a much higher % of total single family starts. From 1965-1995, factory-built homes were ~25% of total single family home starts. In 2022 the figure today was closer to 10%.

In addition, there is the matter of under-investment in homes in the US and declining rates of home ownership.

The industry sold 113,000 factory-built homes in 2022. Why can’t this figure trend towards 200,000 in the next 3-5 years?

Such a boom would surely bring in new competition, including tech-based, non-traditional forms (3D-printed homes, robot workers, etc.). But the big 3 players have widened the moats around their businesses and new entrants would have to compete against the oligopoly. There is no reason why incumbents couldn’t take the lead in these new production methods.

There is one important hurdle to capturing this growth – financing. Buyers of factory-built homes typically pay far higher interest rates than buyers of site-built homes. This at least partially offsets the lower house cost. There may be some changes afoot, led by Fannie and Freddie, which would address this. Policymakers supporting affordable housing would seem to be aligned with the effort to reduce financial costs for purchasers of factory-built homes.   

Balance sheet health

Financials as of most recent reporting (July 1, 2023) are robust. The company had gross debt of just $12 m, which is not due until 2029, and cash of $798 m.

The transactions with ECN Capital will lead to more balance sheet risk going further.

The first consideration is the 19.9% ownership of ECN Capital. ECN Capital faces two challenges:

·         It has a weak funding position. The company’s cost of debt for its term debt was 7.2% in 1H 2023. A C$-denominated bond, due in 2025, yields >13%. Its main competitor, the financing arm of Clayton Homes, obtains its funding from Berkshire Hathaway at a 100 bps mark-up. Clayton is probably funding at <6.5% for new money. Money is a lender’s raw material - how can ECN be competitive in this environment?  

·         The business lacks scale. To support the operating segments (Manufactured Housing Finance and RV and Marine Finance) the business requires $35 m of corporate overhead. (As an aside, it appears ECN Capital owns an aircraft – surely executives of a loss-making company should be flying commercial?). The company has recently announced a ‘simplification’ drive and hopes to reduce this corporate overhead. Time will tell.   

In the new reality of ‘higher for longer’ ECN Capital loses money. Net worth declined to $141 m from $194 m in just 6M. For Skyline Champion, it appears this asset comes with an implicit commitment for additional investment. Perhaps it finds this desirable. ECN shares currently trade at C$ 2.10 compared to Skyline Champion’s C$ 3.04 purchase price – it is already deep in the red. The convertible preferred shares will be carried at FV – so it will have to recognize this loss immediately. The common share portion of the investment will be carried as an associate, which will be at risk of impairment.   

The other issue is the 51%-owned JV it has entered into with Triad. Management has stated this will not be consolidated, and that Skyline Champion will not use its own balance sheet to fund the JV. If so, this limits the risk to its balance sheet and may result in a greater turnover figure.

Capital allocation

The company will still have ~$375 m in cash and liquid assets following the two recent transactions (ECN and Regional Enterprises).

Factory-built housing requires limited sustaining investment. The capex-to-sales ratio has been 1% in the past 5 years. Internal investment may focus on production automation and digitization.  

Additional acquisitions are probably on hold as management needs to focus on integrating recent transactions. On a mid-term basis, additional acquisitions of manufacturers are possible though these will likely be small given the existing size of the business. It would seem additional investment in lending is possible. It could even pursue development / operation of factory-built housing communities or purchase site-built home manufacturers – areas in which Clayton is active.  

In the past decade it has not paid a dividend or repurchased any shares. There has been no indication it intends to do so.

Management & corporate governance

The shareholder roster is dominated by institutional investors. Insiders own 2% of outstanding shares.

There are 9 directors, 8 of whom are non-executive. Notably, the CEO and Chairman role are separate.

There have been no major management changes in the past two years.

The CEO earned $8.1 m in the previous FY. He owns stock worth ~$25 m.

Valuation

Taking the consensus estimates, 03/2024 multiples are not low at 10x EV/EBITDA and 17x earnings. Rolling out to 03/2025, presumably with the industry in recovery, the figures are 8x and 14x. Free cash flow yield is 6% this year, 7% next.

These multiples don’t quality the stock as being sharply undervalued, though perhaps near fair value given the growth outlook.

Overall, not a stock one needs to buy aggressively today though one to add to on pullbacks.