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Our digital Institutional Small & Mid-Cap Bulletin for professional subscribers offers powerful content featuring a pair of companies not often covered by sell-side analysts. Two stock highlights, one geared toward near-term investors and the other for long-term accounts, offer readers current, unbiased recommendations with in-depth analysis. These monthly featured stocks are among the approximately 1,800 that appear in The Value Line Investment Survey® — Small & Mid-Cap. Tap into Value Line's equity coverage, where you'll have access to complete content, and the ability to create watchlists and alerts based on the featured companies offered in this exclusive bulletin.

 

October 2017

 

 Near-Term Investment

Century Communities, Inc. (CCS)

By Jeremy Butler, Editorial Analyst

Century Communities, Inc. (CCS) develops, designs, constructs, markets, and sells single-family attached and detached homes. It offers a wide range of homes at different price points and operates in metropolitan areas in Colorado (Denver, Colorado Springs, etc.), Texas (Austin, San Antonio, and Houston), Nevada (Las Vegas), and Georgia (Atlanta). In addition, the company buys the land on which it builds its houses. It also offers title and lending services to the buyers of its homes. On August 4th, the company expanded its reach to 10 states (adding exposure to Washington, Utah, North Carolina, South Carolina, California, and Tennessee) by merging with UCP Inc., another homebuilder. Based on homes sold in 2016, Century Communities is the 16th-largest publicly traded domestic homebuilder. It has about 570 employees and is headquartered in Greenwood Village, Colorado.

In May, 2013, Century Communities staged a private placement of 12.1 million common shares at $18.50 a share. In May, 2014, the company commenced an initial public offering (IPO) of eight million shares at $22 a share. Since its IPO, CCS has made six homebuilding acquisitions (including UCP). On September 13th, CCS was named by Fortune Magazine as the 26th fastest-growing company in the United States.

Investment Rationale
From a top-down perspective, the homebuilding industry is very attractive, and a rising tide in this sector of the economy should help to lift all boats, including Century Communities. Mortgage rates are low, and it appears as if they will stay that way for a while, since inflation remains minimal and the Federal Reserve appears to be taking a cautious stance when it comes to raising rates and unwinding its large holdings of Treasury securities. In addition, wages and household incomes are creeping up, which is boosting consumer confidence. Job growth and the low unemployment rate are also helping drive demand for housing, as are favorable trends in household formation. Although recent months have seen sequential declines in housing starts, the numbers have been increasing on a year-over-year basis, and we think the housing market is stronger than the data suggest, given low inventories of homes for sale. Too, the latest (August) figures on building permits, a more forward-looking indicator, were encouraging.

As noted, housing inventory levels in the states Century Communities operates in are low, meaning that demand for new houses has increased. Century Communities has easy access to affordable debt in order to buy the land it builds its homes on. And although the cost of building materials is rising, greater competition in the building supplier market is preventing costs from increasing too much.

Furthermore, larger homebuilding companies, such as Lennar Corp. (LEN) and D.R. Horton (DHI), often find it more cost effective to purchase smaller homebuilding entities like CCS rather than buying new land and building houses on it. Consequently, we think CCS could potentially be a takeover target. Lastly, recent flooding caused by Hurricane Harvey in the Houston market doesn’t appear to have severely hurt demand for the company’s homebuilding services in that area. Indeed, the need for rebuilding is expected to elevate Century’s backlog. At the end of August, trailing 12-month home sales tallied 3,820, up from 3,344 in the previous 12-month period. This increase in demand for Century’s homes should translate into higher sales and earnings, which could lead to a higher stock price.

How Century Operates
CCS acquires land with cash or option contracts. The option contracts are structured such that CCS has the right (but not usually the obligation) to buy the land at predetermined prices within a defined time period. Locating and purchasing land to build homes on is the most difficult part of the process due to the presence of numerous other homebuilding entities looking for land in choice areas. Moreover, an understanding of population growth patterns, zoning restrictions, and infrastructure development are vital to the decision of where to buy land. Desirable homebuilding areas are those with good access to major job centers, schools, shopping, recreation, and transportation facilities. Not being far from a major metropolitan city is another attractive characteristic. If past is prologue, CCS should continue to get its fair share of choice homebuilding locations. Once a client has signed a contract to buy a CCS home, the company helps him/her finance it via its wholly owned subsidiary, Parkway Financial Corp., a mortgage lender.

Finances
Annual sales have grown from $171 million in 2013 to almost $1 billion in 2016 and are on track to reach almost $1.2 billion in 2017. Higher raw material costs and a rise in interest expenses (due to a greater debt load) have shrunk margins. As such, share earnings haven’t been growing at the same pace as revenues. Indeed, although annual share net increased from $1.07 in 2014 to $2.33 in 2016, it is expected to decline to $2.25 this year. Cash on the books has ballooned, however, from $29.5 million at the end of 2016 to almost $350 million at June 30, 2017. This puts the company in a good position to act fast when a good land-buying opportunity appears. The debt load, too, has mushroomed, from $260 million at the end of last year, to $777 million at the end of the second quarter. We think that margin recovery is achievable as the UCP acquisition is integrated and cost synergies emerge.

Conclusion
As stated, finding choice land on which to build houses is a difficult and competitive business. Still, as can be seen from Century’s results, the company has been able to find good plots of land to build its houses on, and we think that this trend will continue.  In addition, new home sales in the United States are climbing, and relatively low mortgage rates should continue to encourage home ownership. Lastly, CCS builds a wide range of homes at different price points to keep its operations diversified. All of these factors should lead to higher sales and earnings, which may well result in an increasing stock price.

 

At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.

 

Long-Term Investment

MaxLinear, Inc. (MXL)

By Kevin Downing, Editorial Analyst

MaxLinear, Inc. (MXL) designs semiconductors used in home broadband (i.e., high-speed Internet) communication devices and telecommunications infrastructure equipment. Specifically, its chips are integrated into cable and satellite television set-top boxes and cable modems; digital televisions; data center interconnects; and 4G/5G cellular base stations (towers). Their primary function is to capture and process large amounts of data quickly and efficiently and make that data usable for watching TV and browsing the Internet. MaxLinear’s manufacturing process results in chips with coveted traits of relatively high performance, low power consumption, and reduced signal interference.

Around 55% of revenue is currently derived from Internet-connected home devices; 25% is generated from infrastructure products; and 20% comes from industrial applications in automobiles and healthcare. Customers include original equipment manufacturers, module makers, and original design manufacturers. The top ten accounted for approximately 74% of revenues in 2016, with the largest, ARRIS Group, making up 27%. Clearly this adds some risk, though management is working to diversify its revenue streams (see below).

The company was able to expand its top line by a 40% compound annual growth rate over the 2011-2016 timeframe. Around two-thirds of that stemmed from internal growth, thanks largely to the fact that 65% of its employees are in research and development. The remaining one-third of the impressive growth figure was gained through acquisitions (the company has executed seven over the last two-and-a-half years). The most significant purchase was industry peer Exar Corporation for $472 million in cash. The deal closed in the second quarter of 2017, and initial revenue from the new business is now contributing to the bottom line. MaxLinear had previously been debt free, but took on a $425 million term loan to pay for the acquisition. The company appears committed to aggressively paying down that debt sooner than it comes due. The combination is expected to result in $15 million worth of cost synergies within a year or so. Exar brings various power management and interface technologies to the product suite, which fits well with the company’s goal of diversifying its revenue streams. The combination should also yield cross-selling opportunities and new distribution channels.

Including Exar’s portfolio effectively doubles the company’s addressable market, which management predicts will be around $10 billion by 2020. This is expected to allow revenue to reach $1 billion by the 2020-2022 timeframe, which compares favorably with Wall Street’s consensus 2017 revenue forecast of $427 million.

The primary growth area for MaxLinear is networking devices (which mediate data on computer networks). Rising demand for these products is being driven by increased data traffic from smartphones and tablets (owing largely to social media video streaming); increased Internet of Things connections; streaming video services like Netflix and Hulu; cloud computing activity; and data analytics in data centers. All this is requiring the need for “fatter and faster” data pipes. In response, the company is looking to repurpose its core consumer-facing broadband technology and apply it to attractive, high-growth data center and wireless infrastructure markets. This, along with recent acquisitions that cater to those industries, is expected to expand infrastructure sales at a 35% clip annually over the next five years.

A big part of that revenue growth will likely be from the increased adoption of faster 5G wireless infrastructure (4G is the current standard). The consensus from participants in that space is that 5G base station buildouts probably won’t rise significantly until 2019, however. Encouragingly, the company still expects to be able to grow wireless infrastructure sales while waiting for the 5G opportunity. Indeed, MXL’s sales of microwave backhaul modem and RF transceiver technologies (infrastructure products that are necessary for wireless communications) are expected to increase from the current $20 million-$30 million per year range to $75 million-$100 million over the next few years, thanks largely to new engagements with major telecom customers. These inroads with top telecom companies should allow MaxLinear to capture a solid share of the 5G opportunity. 

In the connected home space, cable company and Internet service provider Comcast (CMCSA) is in the process of upgrading its cable modem technology. The transition should begin to ramp up in early 2018. The division does face a potential headwind from fewer conventional cable-TV subscribers (i.e. cord-cutters), however, its exposure to Web-based video delivery platforms and Ultra-High Definition set-top boxes should more than offset this.

Although the long-term growth prospects appear sound, the company faces some challenges over the near term. Second-quarter revenue fell short of Wall Street’s consensus expectation by around 3%. Part of the miss can be explained by steeper-than-expected declines in legacy satellite products (such as outdoor dish units). There was a satellite component shortage that also hurt sales of satellite modems. The other negative was less optical equipment (i.e. fiber optic cable) buildout activity in China, a trend that has been felt throughout the telecom equipment industry of late. The $5 million in optical sales made in last year’s second quarter came down to approximately $1 million in the recent June quarter. In response, the $30 million 2017 sales estimate for that business has been pared down to $10 million. We expect optical demand to rebound eventually, and MXL is well positioned to reap the benefits of that potential recovery.

The company is currently guiding for third-quarter revenue to rise 18%-23% year over year. In the connected home segment, seasonal weakness in cable modems and further declines in legacy products should be offset by strength in cable video and 4K (Ultra-High Definition) satellite set-top-boxes. Meanwhile, softness is expected to continue in optical gear, and there should be a modest step back in wireless infrastructure owing to strong growth in the first half of 2017.

MaxLinear has managed to do what many other semiconductor companies can’t, which is to successfully adapt its core technologies to work well in new, high-growth markets. And although its revenue streams and customer base have become slightly more diversified, all its businesses still rely on the trends–which continue to look appealing–of ballooning Internet traffic and enterprise data center buildouts. Momentum investors will likely be dissuaded by near-term headwinds, but those with a more long-term bent ought to give these shares further consideration.

 

At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.

 

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