Monday, July 29, 2013

UCP Inc - Worthwhile on its Own?

This will be the last post on the PICO/UCP story for a while, but I haven't had much time to dig into new situations and there just seem to be fewer interesting investing ideas with the markets drifting higher and remaining relatively calm.  As I've covered recently, UCP is the home builder/land developer unit of PICO Holdings that recently completed its initial public offering.  While I consider the transaction a positive for PICO, given PICO's complexity and management compensation structure, UCP might be the better investment for the near term as its a purer play on the continued housing recovery.

To summarize, UCP Inc (the publicly traded entity) owns 42.3% of the operating company UCP LLC, while PICO owns the other 57.7% and will remain the controlling shareholder.  UCP is primarily a California home builder and land developer with some additional exposure to the Puget Sound Area in Washington state.  Below is a snapshot of the current owned and controlled lots in UCP's inventory:

Since UCP essentially didn't get started until after PICO bought it in 2008, UCP has no legacy or problem assets on its balance sheet, the majority of their lots were purchased opportunistically in the 2008-2011 period and are carried on the balance sheet at historical cost.

What have real estate prices done in the areas where UCP operates?

While Zillow isn't the perfect data source, their estimates all show year over year price increases in UCP's markets of anywhere between 12-22%.  So if anything, the real estate on the balance sheet is likely understated, but for the sake of being conservative I won't make any adjustments.

Below is the pro forma balance sheet after the offering:

Based on the current market price of $14.23, UCP has a market capitalization of $261 million, and a price-to-book ratio of about 1.2x.  Other home builders trade for a multiple of book value, but a good recent comparable seems to be TRI Point Homes (TPH) as its almost exclusively based in California, was formed by a private equity investor during the crisis and as a result of its January IPO, has plenty of cash.   TPH trades for 1.6x book value, a 33% premium to UCP, maybe some of that is justified by more desirable community locations, but given the similarities, I think its a good comparable.  UCP also compares favorably on the home building margins and it has the optionality of being a developer and selling their lots to other builders.

So why is UCP cheap?  Besides its small size and geographic concentration, there was very little hype leading up to the offering, little coverage since,  and it hit the market as home builders have been tumbling with the rise in mortgage interest rates (the home builder index is only up marginally on the year, but was up significantly in 2012).  It just seems to be overlooked here, UCP debuted at $15, the low end of its range, and has traded lower ever since.  Some of that discount is probably a result of the organizational structure, as PICO will continue to hold 57% of the economic interest and control the board, making an acquisition or other transaction unlikely.  Additionally on the negative side management is getting a nice raise, and doesn't own any shares outside of the initial options they were granted in the offering, plus there will be extra expenses UCP will incur as a stand alone public company.  

But I think the positives and the valuation outweigh the negatives.  I'm generally positive on real estate still, there will be pauses as interest rates rise to a more natural level, but with pent up demand from years of low household formation and long term demographic shifts away from the midwest and to places like California, UCP could be a good short-to-medium term investment.

Disclosure: No current position in UCP, I own shares of PICO

Monday, July 8, 2013

PICO's UCP is One Step Closer to IPO

UCP, PICO's homebuilder and developer, took its next step in the IPO process by announcing terms on Monday to sell 7.75 million shares (more if the underwriters exercise their option to purchase additional shares) at a range of $15 to $17 per share.  For those unfamiliar with UCP, it was substantially formed by PICO in 2008 as the real estate crisis was hitting California where UCP is principally based.  PICO, through UCP, took advantage of the crash and picked up an inventory of lots through California and Washington, many of those lots were purchased in 2008 and 2009 at rock bottom prices.

Back in April, I wrote up a quick update after UCP filed an initial filing with little financial details.  I figured PICO was selling out, rather than looking to raise capital for further expansion.  While short-term, the sell out scenario would have resulted in a quicker pop to book value, the capital raise is a smart move long as UCP is going to need more capital in order to battle in the competitive homebuilder industry.  One of PICO three main businesses will now have a quotable market price making PICO a little more transparent and easier to value, and it gives UCP more flexibility to raise more capital on its own.

One additional quirk in the filings is the complicated organization structure.   The new public shareholders are going to have a 42.3% interest in the newly formed UCP, Inc., which primary asset will be a 42.3% stake in UCP, LLC.  PICO is going to maintain 57.7% of the economic interest in UCP through their UCP, LLC Series A Units (which are exchangeable for Class A common stock in UCP, Inc on a one-for-one basis) and also receives UCP, Inc. Class B common stock which have no economic interest, but square up the voting so that PICO has 57.7% of the voting rights.  Got all that?

I'm not a tax accountant (so this could be where those smarter than me comment below), but there appears to be some built in tax advantages to the structure as PICO exchanges UCP, LLC Series A Units for UCP, Inc shares some of the real estate assets in UCP, LLC will receive step up cost basis treatment, and through an agreement with UCP, 85% of this benefit will accrue to PICO.  Possibly also giving PICO incentive to pursue this route and simplify the structure?
Coming down to what all this all means for PICO shareholders.  A $16 share price (the midrange between $15 and $17) equates to a $293 million market capitalization for UCP.  PICO will own 57.7% of UCP for a market value of $169 million, versus $110 million in current book value, is an increase of $59 million book value (13% increase on PICO's $460 million book value).

I still have concerns around PICO management's lack of ownership, but CEO John Hart does have a lot of options expiring in a few years at significantly higher prices ($33.76, expire 12/12/2015), so that should give him motivation to increase the share price, but the incentives are still misaligned by the fact that he doesn't own much stock himself.  He's been at PICO since the mid-90s, makes $2 million a year, and only has ~$700,000 in stock.  But this IPO is a step in the right direction of making PICO simpler to understand which will hopefully unlock value for shareholders.

Disclosure: I own shares of PICO, no plans to buy UCP directly