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Third Avenue Management Comments on Cavco Industries

July 23, 2014 | About:
Vera Yuan

Vera Yuan

81 followers
The Fund's largest position is the common stock of Cavco industries inc. (CVCO), which represented 5.6% of the Fund's net assets as of quarter end. Since Cavco is not a household name, we thought it would be helpful to discuss the history of the investment and why we are so excited about its future. The Cavco investment originated during the 2008 financial crisis. Fleetwood Enterprises, a leading producer of manufactured homes and recreational vehicles ("RVs") had filed for bankruptcy, and its announcement of the sale of its RV business in a bankruptcy auction indicated that the manufactured housing business could be available on similar terms. Fund Management had long followed the manufactured housing industry and knew that Fleetwood had a strong brand name and reputation as a quality manufacturer. Fund Management contacted Joe Stegmayer, the Chairman and CEO of Cavco, to discuss the situation and learned that Cavco was also interested in the Fleetwood manufactured housing business. Fund Management had known Joe Stegmayer for many years, dating back to when he was president of industry leader Clayton Homes, and had tremendous respect for his managerial capabilities. Cavco was a small (three plants) regional manufactured housing producer based Arizona. Under Joe Stegmayer's prudent management, the company had maintained generally profitable operations and a strong, debt free balance sheet during the long industry downturn (See Manufactured Housing Shipments chart that follows on the next page ). Therefore, the company was in position to consider acquisitions. However, given Fleetwood's considerably larger size, Cavco wanted a financial partner for the acquisition, and, hence, we formed a 50-50 joint venture company ("Fleetwood Homes") to purchase the Fleetwood assets. The Fund and Cavco each contributed $35 million to fund the joint venture.

Fleetwood's manufactured housing assets, consisting mostly of seven manufacturing plants, were purchased by our joint venture for $26 million in august 2009 at a bankruptcy auction. The only other bidder for the assets was Clayton Homes, which is now owned by Berkshire Hathaway. Under the terms of our joint venture agreement, Cavco operated the assets. Impressively, despite continued industry weakness, Cavco was able to operate Fleetwood profitably in 2010. Therefore, when a larger, vertically integrated competitor, palm Harbor, experienced financial distress in 2010, Fund Management was willing to make an additional contribution to the joint venture ($36 million) to pursue this attractive expansion opportunity. after much negotiation and diligence on palm Harbor, the Fleetwood Homes joint venture agreed to provide debtor in possession ("Dip") financing for palm Harbor's November 2010 bankruptcy filing. In 2011, Fleetwood Homes rolled this Dip loan into a purchase of substantially all of palm Harbor's assets for $84 million at another bankruptcy auction. These assets consisted mostly of five manufacturing facilities, 49 retail outlets and 100% of the common stock of profitable insurance and finance subsidiaries that had not filed for bankruptcy.

In 2013, the Fund sold its stake in the Fleetwood Homes joint venture to its partner, Cavco, in exchange for approximately 21% of Cavco's common stock. The sale price equated to a 29% premium to our cost, but, more importantly, the Fund received Cavco stock at $49 per share, compared to $78 as of quarter end. Fund Management wanted to take Cavco common stock as opposed to cash because we believe the company's long- term prospects are very attractive.

Despite the strong recent appreciation of Cavco common, we believe that there is still considerable upside as the company benefits from the acquisitions of Fleetwood and palm Harbor and a manufactured housing industry recovery. as the chart below illustrates, the manufactured housing industry remain s extremely depressed. 2013 industry shipments of 60,000 are only slightly above the trough of 50,000 in 2009-2010. The twenty year average shipment level of 183,000 is more than triple the current level. One factor that should drive a more significant industry recovery is improved financing availability. Following the burst of the easy credit driven industry boom in the late 1990s, most manufactured housing lenders exited the industry. However, recent performance of manufactured home mortgages underwritten over the last ten years, including those by the finance subsidiary that Cavco purchased from palm Harbor, has been healthy (much better than sub-prime site built mortgages). Freddie Mac's recent announcement of a program to purchase the debt of manufactured housing community developers is a positive sign, and we expect more financing options to become available for the industry. The paucity of financing in the manufactured housing industry is reflected in its share of the overall housing market. Between 1980 and 2000, manufactured housing accounted for 29% of new home sales. This percentage fell to about 10% from 2004- 2006 during the sub-prime site built boom and has recently increased to only about 12%. With the overall housing market still depressed, we believe the manufactured housing industry will benefit over the next several years from gaining share in an increasing overall market.

Cavco’s recent financial results demonstrate the operating leverage inherent in its business model. Unlike Site built homebuilders, manufactured home producers do not need to invest in land. The production environment is controlled and cost efficient ($42 per square foot, compared to $86 per square foot for the site built industry). Cavco's facilities are currently operating at a capacity utilization of only 43%, indicating that sales could expand significantly without additional capital investment. in fiscal 2014 (March 31st year end), Cavco's revenues, operating income and earnings per share increased 18 %, 30 % and 173 %, respectively, as the company gained market share and benefited from the modest industry recovery. We believe that the Company will continue to generate substantial earnings growth over the next several years, as the industry continues to recover. Finally, Cavco's strong balance sheet with $73 million of cash and no debt (excluding non-recourse finance subsidiary debt) positions the company to make additional acquisitions or investments to drive further growth. Cavco's management team, led by Chairman and CEO, Joe Stegmayer, has proven to be very capable in both making and integrating acquisitions.

From Martin Whitman (Trades, Portfolio)'s 2Q 2014 Shareholder Letters.


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