- I was skeptical of the long thesis on UCP because analysts tout strong inventory valuations but glosses over the fact that it takes time to realize value - i.e. they do not apply a present value.
- It turns out that the approach of valuing lots by ascribing value as % of home prices is flawed but surprisingly robust. This is because the 2 missing factors are offsetting: 1) Applying a discount rate would decrease value, but 2) this method also understates cash flows and correcting for that increases value.
- Valuation is $18/share. UCP trades around $12 per share at the time of writing.
UCP and Its California Inventory
UCP, Inc. (UCP) is a land developer turned home builder that historically focused on California. Its operating subsidiary, UCP, LLC is 57.5% owned by PICO. As of 6/30/2014, UCP owns 4,639 lots and LTM net new order was only ~300 units. UCP has enough inventories to last years, so valuing the company requires valuing the lots.
When people hear that UCP owns lots in California, they think of San Francisco, Silicon Valley economy…etc. and assume high prices. However, UCP mostly operates in inland locations like Fresno and Madera where it could take 3 hours to reach the coast. According to Zillow, median home prices for Fresno and Madera are less than $200k. Other areas where UCP has strong presence are Monterey County in CA (prices in the $400-450k neighborhood) and Thurston County in Washington (low $200k’s range). These are not exactly your premium million dollar homes in San Francisco. UCP acquired Citizens Homes earlier this year, which allows them to expand into the Southeast.
The Long Thesis
This is an asset play. Much of UCP’s land inventories were bought during 2008-2009, when lots are cheap. These are now worth much more than what market value would suggest. With enough inventories to last several years, UCP also has some nice options: a) monetize the lots by building homes themselves, b) sell lots to other builders, or c) sell itself to another company. Being acquired is a possibility due to the small market cap and their local footprints.
The bullish write ups I have seen tend to value the inventory without a discount rate, then net out the liabilities to result in a massive net asset value. There was a PICO article published 9/8/2014 on SA included detailed valuation of lots by locations. The methodology separates inventory into developed and undeveloped lots. For developed lots - assigns a reasonable home price for the area (say $450k for Monterey Bay area), and assume lots are worth certain percentage of home value (50% here). For undeveloped lots, just assign value per lot based on location, using UCP’s historical revenue per lots sold for context.
I duplicated the exercise below and got a very similar ~$350mm of value for the lots (164mm for developed lots and 183mm for undeveloped). Netting out liabilities and minority interest this would value UCP at ~18 per share.
It's tempting to stop here without applying a discount, and point out as upsides the optioned lots (which are not included here) and UCP’s potential as M&A target.
There are 2 things missing here. The first is obvious - it will take years for UCP to monetize this inventory and thus time value discounting is not only necessary but makes a big difference. Clearly, it takes time for local housing demand to emerge, and for UCP to build and sell those houses. The second missing piece is what amounts should we be discounting? Just spreading the $350mm of total value and discount back would be a mistake, because the total cash flows UCP will get is actually more than that.
The second point requires some explanation so bear with me. What exactly do we mean when we say a lot is worth x dollars? An excellent article heremakes it clear that the value of a land lot is what another builder is willing to pay for the lot, and still be able to generate some profit. The profit part is key. For example, if other builders are willing to pay UCP $100k to buy some inventory, incur another $80k of construction cost, and sell the house for $200k, their profit is then $20k. The lot to ASP ratio would be 50%. How much cash flows will UCP get for this lot?
· If UCP sells the lots to another, then you should discount just the $100k proceed from the lot sale.
· UCP however, plans to build the homes itself. In this case UCP gets $120k of incremental cash flows ($200k selling price – $80k construction cost). The other way to think about it is they get $100k of working capital back, plus $20k profit.
This is why the $350mm value above understates cash flows - because it implicitly assumes UCP will sell these lots to another builder, and thus fails to include the profits UCP will get upon a home sale.
I get to roughly $18/share. It turns out that applying a discount rate is offset by this extra cash flow - even with some very conservative assumptions about sales pace.
Value destroying growth is always a risk
Growth ambitions are dangerous in homebuilding. At the peak of cycles, financing becomes widely available so builders gorge themselves with expensive inventories. During a crisis when they should be buying cheap, they can’t because of financing constraints. In short, builders always risk buying at the worst times.
By virtue of having land that can last years, UCP can theoretically avoid this type of behavior. In my opinion, the best case for UCP would be to stop trying to expand, and focus on monetizing its existing lot inventory as quickly as possible. Of course, management teams never want to liquidate themselves and UCP has in fact been acquiring.This makes them more like other builders, but with subpar scale and diversification. Business expansion also makes UCP a less likely M&A target (which I wouldn’t count on as the basis for an investment anyways). These factors perhaps call for a higher discount rate than peers, but still result in a strong valuation.