Rent or Buy?

As my friends and I reach the point where we can afford respectable housing we begin thinking whether it is better to buy or rent your primary residence. In addition to regular tax savings decisions this issue is further clouded by opinion on whether the housing market will continue to go up. Living in New York City, i have seen a tremendous rise in property values over the last few years. My friends who bought their apartments 3 or 4 years ago are now sitting on housing where value has appreciated at least 50%. There are as many opinions on what will happen to the housing prices as there are people. As a renter and a skeptic i am a strong believer that the housing prices will not continue their rapid rise. Over the last few month my opinion has been given support by economic data that suggests a coming weakness in the housing market: increasing spreads between asks and bids, average time property stays on the market, etc. Additionally, last year or two reminded me of 2000 and the .com bubble. Everybody recognized new economy companies were overpriced, however their valuations continued to go up due to speculation lacking any fundamental support. Eventually in March 2001 that rise rapidly halted and many of the industry participants got shaken out over the next two years. While housing is very different from .com companies in principle situation is the same: rapid rise in values and participation from the speculators. Because of hard asset base that housing has it is unlikely that we will see similar destruction of value as we did for .com companies, yet with fair confidence i can say that we will not see continuing 10-15% rise in annual value over the next three years. It is most likely that valuations will either remain flat or turn slightly lower. With that in mind i created a small spreadsheet which helps one calculate whether it is better to buy or rent their next residence. A personal example is located at the top of this article. In buying one has to take into consideration five things: purchase price, interest rate, personal tax rate, annual maintenance fee and annual tax payment related to residence. With those five things you can calculate what your total spending on the residence will be after tax saving. This is a pure calculation that does not include any possible equity creation through pay down of principle. Alternative is rent which is not tax deductible and a simple monthly fee.

The two things are not exactly the same since with purchasing you get all the possible upside or downside of property valuation. If renting or buying will cost you about the same amount of money for the year than your view of whether the property value will go up or down is essential to your purchasing decision.

Like i said earlier there are as many opinions on what will happen to the property values as there are people. I decided to write this post when a friend of mine told me that he is thinking of buying a place right now for tax saving purposes, even though he thinks it is likely that the value of the place that he wants to buy will fall 10 to 20% within next couple of years. We went through a similar calculation as above in order to figure out whether it would make any sense for him. His answer might be different from yours depending on where you live, however basic consideration should stay the same.

Insteel Industries

INSTEEL INDUSTRIES (Nasdaq: IIIN)
Insteel manufacturers and markets steel wire products for various industrial applications. 90% of their products are used in industrial building and road construction. Majority of the remaining sales are made up of wire products used in tire manufacturing. Insteel is considered a market leader in its segment. I believe that this company is worth at least $21.6 which represents 33% upside from current market price of $16.30.

Reasons to Buy:
Since exiting its unprofitable nail business in 2003, company has shown impressive profitability. Attractive valuation at 25% LTM cap rate.
Expected increase in unit shipments due to recovery of commercial real estate market and the passage of highway bill
Company is showing responsible cash management through debt reduction and reinstatement of quarterly dividend
Customers overbought inventory last year which resulted in reduced sales in early quarters. Unit shipments in core business have required in most recently announced results and is expected to continue growing closer to long term average trend (2% annual)
Increase in domestic carbon wire capacity alleviated supply shortages and significantly improved working capital requirements and returns on capital.
22% insider ownership aligns interest of management with shareholders
Expected earnings contribution from Engineered Structural Mesh (ESM) and other upcoming products which so far have only been cost drivers

Risks:
Competitors may chose to compete irrationally reducing gross margins
Engineered Structural Mesh is an unproven product that may end up destroying value for the shareholders

Catalyst:
Valuation gap will start closing as investment community will realize that company’s sustainable earnings power is closer to that of last two years as opposed to earlier figures which included unprofitable businesses.

Insteel Industries was a long time stock market laggard with stock price languishing around at around $1 until early 2004. The company has been able to significantly improve its profitability primarily through divestiture of unprofitable nail business and subsequent recovery of gross margins which resulted in an impressive rise to an all time high of $25 and subsequent pull back to current level of $16 due to temporarily deteriorating business conditions. The fact that Insteel has been able to generate over $4 per share in operating profits in 2005 speaks volumes about its long term profitability potential. FY 2005 represented a period in which its unit sales dropped by 15% yet the company was still able to maintain 17% gross margins and generate a healthy profit as a result of its low cost model.
On normalized basis Insteel’s gross margins should decrease from current levels to a five year average 12%. A portion of an increase in the gross margin is due to higher than normal spread between the price of raw materials and final product. Historically those spreads compressed due to irrational competition within industry. However valuation is supported by upcoming cyclical upswings in commercial and road construction. In order to be conservative, I assumed a 30% reduction in sale over next two years to reflect possible falling steel prices. Even with these conservative assumptions earnings power supports share price up to $21. Despite a significant run up in the last two years, this scenario suggests that the downside for Insteel shares is quiet limited. On the other hand the upside is more than 100% since it is likely that the company would actually be able to keep their EBIT closer to the current level of 40M due to cyclical upswing in demand and earnings contribution from new products.

Perceptron

Perceptron Inc designs and manufactures process control systems for Automotive Industry. Their products are used by almost all major car manufacturers to quickly identify quality issues in final products. 40% of sales come from four biggest customers (GM, Ford, DCX, and VW) with GM accounting for 19% of the total. Company products to date have been sold mostly in US and Europe. I believe that Perceptron is worth at least $10 per share which would represent a 35% upside from a current market price of $7.12.

Reasons to Buy:
Due to diversified customer base Perceptron is able to avoid problems of other auto suppliers that depend on ability of US big 3 to sell cars
Perceptron’s revenues come from new product launches and process reorganizations rather than per car revenue.
Attractive valuation (15% normalized cap rate) for stable business
Free option for growth from Eastern European and Southeast Asian markets
Free option for growth from two new complimentary products
Recently announced share buy back program may increase shareholder value
Credit agreement that does not allow company to pay dividends expires in November 2006. This may result in future dividend payments to equity holders.
13% ownership insiders aligns management’s incentives with those of shareholders
Healthy Balance Sheet

Risks:
Perceptron’s desire to expand into non-adjacent products has potential to destroy value
Company depends on car manufacturer’s ability to develop new models.

Catalyst:
Company’s results in the short term are depressed because of increased spending on new products and development of new markets. Valuation gap will close as company will start seeing increased revenues from new products and markets.

In the mid-90’s when this company came to market it was considered a growth stock with unlimited potential trading as high as $40 per share. Company’s innovative products quickly achieved full market penetration resulting in sale stagnation and eventual fall of a once high flying stock. In 2001 current CEO started to champion a turn around which involved new product development. As a result, Perceptron’s sales reached $54M range and stayed there for the last three years. Top line stability suggests a mature market for Perceptron’s current product suite within company’s geographical footprint (US & Europe). While top line remained stable, company’s EBIT fell from over $8M two years to a FY 2005 level of $4.7M. Operating margin feel partially because of an increase in installation and manufacturing costs and partially due to spending on new product development. Company has spent heavily on development of two new complimentary products (Autofit & Autoscan) without so far seeing much revenue from the additions to their product suite. Similarly, company has been increasing sales force in Eastern Europe and Asia in an attempt to bring their services to developing markets.
Current market price represents a 14% cap rate on the normalized basis (once one time charges related to A/R and inventory write-offs are take out). I believe this is a reasonable price to pay for a stable business with a history cash flow generation. While the case could be made that the company is destroying value through attempt to expand, additions to Perceptron’s product suite and geographic footprint are a natural extension of company’s current business. Improvement in the bottom line that could come from these initiatives is not reflected in today’s valuation and comes as a free option to the holder of the security.

Valuation
In valuing the company I only assumed that the one time charges related to client bankruptcy, inventory write-offs, legal expenses and other should be taken out. The target price of $10 reflects normalized EBIT level and a 10% cap rate in FY 2007. If we take into account value added through the recently announced share repurchase program, remaining shares would be worth over $11 representing an even bigger upside. I decided to exclude this factor from value of the company because they have had a share buy back program in the past which did not result in significant share repurchases. Circumstances suggest that this time company would be more willing to buy its own shares due to the presence of Richard Scott (activist investor) who has been bugging the management to increase shareholder value.