Public homebuilders, like the majority of public companies, have seen their share prices coming off their lows during the last 12-18 months. But, while many sectors have started to see improvement in business conditions, homebuilders are still limping along with the aid of government programs designed to increase consumer incentive to purchase a home. With housing stocks at levels that we haven't witnessed since the early 2000’s, we set out to analyze whether the move up is too fast, considering the fundamentals and economic factors that existed the last time homebuilders traded at these levels.
From looking at the homebuilders’ ten year stock chart and rolling back from their peak valuations, we noticed that for the majority of the homebuilders the period of early to mid 2003 provided comparable stock price ranges. A handful of builders (Beazer (NYSE:BZH), Hovnanian (NYSE:HOV) and Standard Pacific (NYSE:SPF)) have not traded at these levels and therefore were excluded from the analysis. Toll Brothers (NYSE:TOL) traded at this level in early 2004. As a result, we utilized their financial information from that time period as our goal is to compare certain financial indicators as well as the economic climate that provided the foundation for the stock price valuations.
We are not long-term bears on the sector, however our view is that for the majority of the homebuilders, the current stock price levels are unsupported by either fundamental or an economic landscape that would warrant a bullish perspective on homebuilding. Based on the research, the results are pretty revealing. The economic climate currently provides significant headwinds while they were tailwinds in the 2003 timeframe. Further, as we will illustrate, the quality of the homebuilders balance sheets, including their inventory, is much weaker today as compared to this prior period. The results that we are about to discuss indicate that one of two things have happened with the stock valuations of homebuilders'. Either (1) there is a new normal as to how a homebuilder should be valued. One that bares no resemblance to the way they were priced prior to the housing peak of 2004-2006 or (2) investors have just accepted these price valuations as being sane despite the fundamental and economic indicators screaming that they are not.
During the 2003-2004 time periods, homebuilders generally traded at a price-to-tangible book (P-B) ratio of approximately 1.0 or lower and at earnings multiples of approximately 7-8X. Currently builders are trading at P-B ratios that are significantly higher as you can see from the following table:
DR Horton (NYSE:DHI)
KB Homes (NYSE:KBH)
MDC Holdings (NYSE:MDC)
Toll Brothers (TOL)
We have split the analysis into two parts. Part One will be a discussion comparing the economic factors and Part Two will be a discussion comparing the homebuilders fundamentals.
Part One: The Economic Data
In looking at just the economic and market data, it is quite clear that the conditions that the homebuilders are operating in currently are far worse than what it was in the 2003 time period. To set the tone, we have provided the following table:
Consumer Confidence Index
Single Family Housing Starts
1.5 – 1.6 million
0.6 – 0.7 million
New Single Family Home Sales
1.1 – 1.2 million
0.4 – 0.45 million
HOUSING RELATED INDICATORS:
Homebuilder Sentiment (Overall)
30 Year Conventional Mtg. Rate
Months Supply of New Homes
Months Supply of Existing Homes
Avg. Selling Prices (ASP)-New Homes
Avg. Selling Prices (ASP)-Existing Homes
Single Family Mortgage Delinquency
Foreclosure Started Rate
We hope we are not stating the obvious, but economic and housing related indicators are significantly worse now as compared to 2003. The current economic climate is at historically low levels. Some would say we are seeing improvement, however when you compare where we are to where we were, one can see just far we have to go to get to "normal."
With regards to housing starts and new single family home sales, besides the significant differences between the time periods (roughly 60-70% declines from the 2003 time period), the respective trends are equally as important. Beginning in 2001 through 2004, single family housing starts increased 6.7%, 10.3% and 7.5% and new single family home sales increased during the same period by 6.9%, 11.9% and 10.5%. During the period from 2008 through the current date, we have experienced an unstable set of results, with very little directional confidence.
One of the interesting Housing Related Indicators that caught our eye is the spread between the average selling prices of new homes to existing homes. In 2003, the spread between the average selling price of a new home and an existing home was 11%. Currently, the spread is 30%. We believe this spread is a meaningful indicator.
From our perspective it highlights the issues that homebuilders are faced with. The impact of this higher spread is what many builders have discussed with regards to competition. This wide spread creates a very competitive housing environment for a would-be new home purchaser. An equally important issue raised by these lower priced homes is the impact on appraisals for new home transactions. For new home transactions that involve financing, the lenders will require appraisals. Appraisers utilize resale transactions in developing their appraised value for a new home being sold. What happens in many situations is that the lower appraisal either results in the purchaser/buyer being required to increase the size of their equity, or the homebuilder agreeing to reduce the sales price. Either way, it is a complication impacting the new home sales process. In our view, when you add this wider spread along with the number of homes that are continuing to come into the market, it creates an extremely negative environment for homebuilders to compete. It is difficult to imagine how long it will take for the supply of existing homes to fall back to conditions that provide a favorable environment (such as 2003) for homebuilders. When you combine the much higher month’s supply of existing homes (7.7 vs. 4.7) along with the much higher mortgage delinquency and foreclosure started rates, we believe that this makes for continued difficulty.
Further, with the unemployment rate much higher than what it was in 2003 (63% higher), and the consumer confidence index about 33% lower, it is difficult to understand why investors have embraced the much higher premium over book value as compared to historical levels. It is difficult to find one economic or housing related indicator that indicates that there should be optimism. Even the Homebuilder Sentiment points to the high degree of uncertainty that the homebuilders believe that they are going to face in the future.
Part Two: The Fundamentals
As discussed during Part One, during 2003, builders generally traded at a price-to-tangible book (P-B) ratio of approximately 1.0. Currently builders are trading at P-B ratios that are significantly higher. This seems to be overly optimistic to us for a number of reasons. First, the current economic environment does not seem to provide the tailwinds that would warrant such a premium for an investment in a homebuilder. Additionally, as we will illustrate, the quality of the homebuilders’ balance sheets, is much weaker today as compared to the last time homebuilders were trading at these levels (2003/2004).
During the 2003 period, homebuilders were generating significant income and their gross margins were in the low 20% range. During the peak period from late 2004-much of 2006, homebuilders were generating gross margins that reached the mid to high 20% range. Contrast that with today, when most of the homebuilders are in the low to mid teens. As a result of the much higher gross margins, there was very little question as to whether the land inventory that the builders controlled was viewed to have a fair value in excess of the carrying (book) value. Contrast that to today, where we strongly believe that homebuilders are carrying significant amounts of land inventory that have fair values that are less than their book values. I know that people will point out that the rate of impairments has slowed. However, as most should already know, impairment tests are not a comparison of fair value to book value.
In addition to the far lower gross margins in the current environment, a trend that should not go unnoticed is the significant decline in visibility into future sales. Backlog, which is the near term pipeline of future sales revenues, provides visibility as to the revenue and margin that the builders can expect to realize within the next 12 months. Homebuilders as a group currently have backlogs that are 68% lower than what they were six years ago. Further, the current run rate of home closings is 40% lower today. We view this as critical in the evaluation of the quality of homebuilding assets, as the decline in backlog reduces our confidence in the recoverability of the assets the builders are carrying.
From a credit quality perspective, despite the homebuilders being in a growth mode during the 2003/2004 time period, their debt-to-capital ratios were actually lower than they are today. This ratio has increased for almost every builder since 2003/2004. While almost all of the builders in our group have significantly more cash today (and therefore resulting in a lower net debt to capital ratio) much of this additional cash is as of necessity as builders are generating significant cash because they have been liquidating inventory in the market decline. Further, as we already know, they have stopped buying until only recently and have ceased land development and limited new home construction. We consider these necessary from a survival standpoint, but not very good from an investment standpoint. The premium associated with land is not the actual land itself; it is the value creation that is done, whether it is the entitlements obtained or development and marketing process. Having land projects become mothballed does not seem to us to be a value creating event that warrants a premium over book value. In addition, while we applaud the builders building up cash reserves (for survival), from an investor’s perspective, having too much cash is not necessarily a good thing. Or put another way, why would an investor pay a premium for cash? Given the current P-B ratios, this is exactly what is happening.
Another factor that should be considered which is driving up cash positions is that homebuilders have less sources of financing today. In addition to traditional bank financing that was available on more favorable terms, builders had access to alternative forms of land financing. These included joint venture arrangements and land option financing, commonly referred to in the industry as “landbanking.” Back during the early part of the 2000’s, it was common for a real estate financial company to provide the equivalent of nonrecourse land financing at acceptable rates with as little as 15% equity. These terms do not exist today. This was the type of off balance sheet financing that was widely used by homebuilders as a way of minimizing the amount of land that they had to include in their revolving credit facilities. This allowed builders to generate much higher returns on equity as they were able to tie up many more communities with less capital. As a result of homebuilders defaulting on their option takedown arrangements which were generally associated with these transactions, the financial partners or landbankers became the proud owners of this land which was dropping in value with no market to monetize. The number of financial entities that are still in that business has declined significantly. The ones that have survived are imposing terms that are much more restrictive, thereby making it a much less favorable alternative. This is another reason why builders are being forced to increase liquidity.
The builders’ balance sheets have more overvalued assets and have less financing flexibility than they have historically. Additionally, as real estate financial companies have reduced the builders’ ability to park assets and take them down as needed, as evidenced by the builders’ reversal in the ratio of owned vs. optioned (controlled) lots, this will significantly reduce builders’ ability to generate outsized returns on equity. However, from the current P-B ratios, investors think otherwise.
Disclosure: Short TOL