Homebuilders: Why It Should Never Be More Than a Trade

People keep asking me, “When is it going to be time to get back into homebuilders?” And the right answer is anytime you feel like gambling. Buying common shares of a public homebuilder is a lot like lending money to your deadbeat uncle so he can payoff his bar tab. You’re never going to see that money again unless you can convince his drunken buddies to buy his loan from you.

Homebuilders borrow money from you (in the form of common share offerings), to collateralize their debt, to subordinate your shares to future preferred offerings, to buy more property, to build more houses, to borrow more money…to increase SG&A. That’s their purpose. SG&A and stock options for upper management.

The illusion that homebuilders are a good investment is created by thousands of analysts, brokers, mortgage bankers and builders that are reliant on your capitalization for their employment. But the common is so far behind the banks, bond holders, completion LOC holders, preferred shareholders, sub-contractors, suppliers, employees and even home buyers; you’d be way better off investing directly in real estate.

The idea that there’s any barrier to entry in homebuilding is preposterous. It’s a commoditized business that’s been maturing ever since we moved out of caves 5000 years ago. And no specific company brings value-add (the exception, in my opinion, being Pulte’s retirement community specialist Del Webb/Sun City). Margin increases when the dirt appreciates, and margin decreases when the dirt depreciates. It’s not brain surgery or genome mapping, and there’s no recurring income.

Let’s use M/I Homes (MHO) as an example. In 2005 they earned approximately $7 per share. They paid 10 cents per common in dividends (thanks for sharing, guys). The stock traded between $40 and $60 that year. They then used that $7 in earnings to increase SG&A, lever up and expand into Florida (Because, um, I guess Florida didn’t have enough local homebuilders?). Since then, they’ve issued $100 million in preferred, burned through their cash and their backlog, and discontinued a large portion of their Florida operations. The common fluctuates wildly but has been hovering between $9 and $12 per share. While it’s my opinion that there’s no value to the common shares in liquidation (hence their bonds trading at 50 cents on the dollar) – we’ll ignore liquidation for the basis of the trading argument.

Should you buy at $9 and sell at $12? Why not hold out for $15? Should you stop loss at $8? There’s no basis for any of those numbers. It’s nothing more than rolling dice. Like they say on CNBC’s Fast Money, “You can trade anything you want as long as you have an exit plan.” M/I Homes story isn’t unique. Lennar (LEN), DR Horton (DHI), and KB Home (KBH) are all essentially the same with subtle differences in debt levels and land inventories. Trade those too, if you can make money. Just know that there’s no way to value what you’re trading and they have zero intrinsic value.

The argument that their land must be worth something (referred to as “True Book Value” or “Worst Case Book Value” by the analysts) is ridiculous. Their land is encumbered with so many completion LOCs and covenants with municipalities and joint venture partners – that the homebuilders have to build houses at a loss just to get out of the dirt. Ask yourself why there are any building starts out there at all (considering the current inventory overhang), and the answer is the only way out of the vacant lot is to build. Worst Case Book Value is probably overstated tenfold. DR Horton recently sold 2,000 lots in Desert Hot Springs for $7.8 million. They paid $110 million (that doesn’t include grading, sewers, streets, etc.)¹ .

When Carl Icahn offered $22 per share for WCI Communities (WCI) and management turned it down, I knew they were crazy. Here was an insolvent company (which I was short at the time – early and wrong), entering a housing bubble bust and they said no to a 50% premium on their common. Instead Mr. Icahn dumped six million shares in December of ’08 for a grand total of…2 cents. Not per share, 2 cents for all six million shares². And, as the world turns, WCI muddles through bankruptcy.

At least REITs pay a dividend. Toll Brothers (TOL), the Teflon Don of homebuilders, has never paid one. So while you may have been smart enough to pull off that 10 bagger between 1990 and today – the real life Toll brothers have sucked out hundreds of millions in options at your expense. I’d also hazard a guess that if you owned a piece of rental property – you’d also have pulled off a 10 bagger over the past 29 years (not to mention cash flow and depreciation). But let’s say you only invested in Toll three years ago. Your return would be negative 50%. If you invested at the peak, negative 65%. Incidentally, if you were smart enough to buy Toll 29 years ago, you should be smart enough to sell it now. The McMansion era won’t last forever and the aging demographics don’t help your cause.

KBH is back to 1989 prices. HOV, down 65% from their IPO in 1992 – and no dividends. LEN also back to 1992, but credit due, they’ve returned your principal via dividends. DHI back to 1997 with a meager dividend that yielded significantly less than treasuries throughout. CTX back to 1993 with a whopping 16 cent dividend on a $70 stock during the salad years. If you believe in a housing rebound, buy a house. You’ll probably lose less in the next 5 years than you will on the XHB.

Given enough time, all public homebuilders are poor investments for the common shareholder. The builders have to grow in order to justify their P/E. They have to borrow to grow. They’ll never give you back your original investment because their entire house of cards is built on your equity. The only way to profit is to find a greater fool to buy your shares. And if you think there’s always someone to buy your shares, ask yourself why Mr. Hovnanian (‘05 market cap $5.6 billion) hasn’t ponied up $150 million to take his namesake private?

DISCLOSURE: The author is short MHO common stock

Comments

[Guero:]

You have it nailed sir. Large-scale production builders make little to no money selling sticks & bricks. Especially when entire streets have been spec'd out and sold at deep discounts. How good are their financial engineers....tha's what needs to be looked at.

Jan 28 10:58 AM

[PROXIMO:]

My guess is that many other SA readers besides me would like you to post articles more often on SA.

Jan 28 11:58 PM

[Adam Sharp:]

Thanks for your article on MHO last October, good stuff. Made me take another look at HBs as potential shorts. Since then I've had nice profits on MHO TOL and CTX shorts.

The only one I'm still short is CTX. TOL seems to bounce every time it gets around a market cap of $2.7 billion or so. I've heard that debt covenant triggers exist around that level, but never found any evidence other than Yahoo Message Board posts. So don't take stock in it. But it was too resilient, so I covered at $17.

Feb 03 10:44 PM