Trailer Cash

Heard the one about what a redneck divorce and a tornado hold in common? (One way or another, someone's losing a trailer.)

Or maybe you've run across one of those humorous trailer trash tests featuring questions like, “If your front porch were to collapse, would more than five dogs be injured?” and “Do you have to go outside to get something from the fridge?”

There's no getting around it: Mobile homes and the people who live in them are easy marks for comedians, and the manufactured-housing industry probably suffers a little by association. Still, it'd be a mistake to let the jokes influence your opinion of the industry as an investment opportunity.

For starters, manufactured homes — which range in style from trailerlike structures that most people refer to as mobile homes to prefab affairs that resemble traditional houses — are a serious force in the housing market. According to the Manufactured Housing Institute, they accounted for 13 percent of all housing starts in the United States in 2001. Further, about 8 percent of the U.S. population lives in the nation's more than 10 million manufactured homes.

Better Days

That said, it's true that the manufactured-home industry has fallen on tough times recently. Specifically, sales of the homes have been off for the last four years, but according to housing analyst Barbara Allen of Natexis Bleichroeder, the industry is showing the early signs of a rebound.

Manufactured housing “has stabilized at a low level, and we're seeing flickers of improvement,” says Allen.

For starters, inventories of manufactured homes appear to have bottomed. The Manufactured Housing Institute's graph of shipment changes, measured year over year, have started spiking into positive territory for the first time since 2001.

In addition, U.S. manufacturing employment is improving, after declining every month from August 2000 to January 2004. That helps, because the blue-collar types who are employed in this sector of the economy happen to be the largest consumers of manufactured housing.

Another positive is that interest rates are rising. Ordinarily a bad sign for housing purchases, higher interest rates are actually good for the manufactured-housing business, because as rates rise, the spreads between manufactured-home (factory-builts) loans and those for traditional houses (site-builts) grow narrower, making factory-builts more competitive against site-builts. (The spread currently sits at 450 basis points.)

Allen compares site-built mortgage costs and manufactured-home loans in terms of monthly payments, since this is, after all, the bottom line for homebuyers. During May, rates rose, which made the monthly costs for a manufactured home $88 cheaper than for an equivalent three-bedroom site-built home.

If we assume a 2 percent jump in rates going forward, the advantage remains with factory-builders over site-builders, says Allen, because the rates on loans to manufactured-home customers have been running unusually high compared to the cost of the loan to lenders. “Normally it should be 300 bps above cost, but it's been running 500 to 700 bps above cost, which reflects the fear among lenders out there,” she says. “So even as the cost of funds goes up, we have room to bring spreads back to a more normal range, which means loan rates could even go down.”

In addition, she adds, “Even if both monthly payments move up, manufactured is still cheaper, so you're going to pick off those customers who won't be able to buy site-built.” A strengthening economy with rising rates doesn't say happy things about traditional homebuilders, who have enjoyed four years of investment outperformance while manufactured homes have languished. In part that's because site-builders, but not factory-builders, benefit from loose underwriting standards encouraged by no-down payment mortgages. Also ominous: Some analysts are arguing that site-building is no longer cyclical. Allen remembers hearing the same claim made for factory-builts:

“In 1998 and 1999 my fellow sell-side analysts were saying factory-builts were a growth industry and that things were different this time,” she recalls. “Well, they've all disappeared. Some analysts are now saying that about homebuilders.”

Pricing drives housing. At some point, low prices become compelling — not for everyone, perhaps, but certainly for that chunk of the public with median incomes between $28,000 and $30,000. In 2002, the average factory-built cost $51,000, compared to $173,000 for the average site-built.

Looking Good

Also helping the manufactured-housing market is the fact that the prefab houses have come a long way in the last decade. Modern prefabs, which usually get bolted to a nonremovable steel chassis and meet the federal “HUD code” standards, typically provide enough amenities to have them fit into manicured neighborhoods, including vaulted ceilings, split levels, walk-in closets, fireplaces, Jacuzzis and that most crucial of add-ons, the deck.

Manufactured homes are only now recovering from a near-perfect storm of woe from a few years back, when substandard loans begat high default levels, which begat high levels of foreclosures and repossessions. The repos in turn collapsed prices on new models and ruined the manufacturing business.

Warren Buffett described consumer-financing practices in the manufactured housing industry as “atrocious” and wrote that much of the industry volume “came from buyers who shouldn't have bought, financed by lenders who shouldn't have lent.”

This two-sided imprudence had a cleansing effect on the industry: About half the retailers and half the manufacturers of a few years back are now out of business.

Repos were the main driver, according to Allen. “When a bank owns a physical asset they usually discount it heavily, making it almost impossible for a manufacturer to compete,” she says.

Since lenders' terms have gotten stricter, though, repos are less of an issue for manufacturers.

“It used to be that dealers would call up a manufactured-housing lender to order a home, and they'd sell it for 20 cents on the dollar,” Allen says. “Starting last summer, they'd say, ‘You've got to take two others and the price is 50 cents on the dollar.’”

Getting Into a Trailer

One way to participate in this improving industry would be to buy shares in the highly diversified Buffett vehicle, like Berkshire Hathaway, which became the industry's largest manufacturer, with about a 22 percent share, after buying Clayton Homes in August 2003 and picking up most of the assets of Oakwood in April 2004. Once again, Buffett is investing when things look bad, buying a business not known for technical arcana, deploying Berkshire's balance sheet to rebuild confidence where most lenders fear to tread.

According to Allen, the main beneficiaries of Buffett's acumen will be Berkshire shareholders, to the extent that Clayton, backed by Berkshire, ups its focus on quality lending, “the entire industry is better off.”

Allen likes Cavco, a recent spin-off from site-builder Centex, which is the largest builder of manufactured homes in Arizona and sells nicely in California. The analyst, who owns shares, recently raised her Cavco estimate for fiscal 2005, ending March, to $2.25 from $2, and looks for $3.15 in fiscal 2006. Based on like multiples for high-growth manufactured-home companies, Allen believes Cavco warrants a 20 to 25 times multiple, an assumption that implies a $60-per-share fair value.

Recent results have been impressive. For the period ended June 30, 2004, sales increased 22 percent, to $36 million, while earnings per share rose to 52 cents per share, as compared to a prespinoff 31 cents last year. Management noted that Cavco is benefiting from strong housing demand in California and is experiencing order backlogs higher than last year's.

Champion Enterprises, widely considered the 800-pound gorilla of the industry, even though it ranks second to the Berkshire holdings, is a manufacturer offering dozens of home brands and hundreds of models. For the second quarter, Champion's operating profitability reached the highest level since fourth-quarter 2001, and the company made money in retail for the first time in four years.

Debt at Champion is down 50 percent from year-ago levels and order backlog is up 120 percent to $90 million. Champion also made solid progress in advancing its modular-home initiative, which produces structures that are pricier and appear more like site-builts than the typical factory-built. Modular unit sales rose 32 percent from last year and 21 percent against Champion's first-quarter number.

On the quarter, BB&T Capital Markets reiterated their buy rating, calling Champion Enterprises “the best pure-play way to participate in the turn of the manufactured-housing cycle that we believe is emerging.”

With this and other plays like it, comedians can lob all the trailer jokes they want, and investors will happily laugh — all the way to the bank.

Prefabulous Plays