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Citigroup has taken a very aggressive stance on the U.S. house-builders. Other members of the Humungous Bank & Broker complex thoroughly disagree. Who’s right?

Yesterday I posted some comments from Credit Suisse re the remarks made by Robt. Toll (Toll Brothers NYSE:TOL), taking exception to the ‘rosier than reality’ perspective of Mr. Toll.

Today, I have given some considerable thought to what we can learn from this situation. I hope you read my notes at the end.

This morning one of our community sent the following e-mail:

As you may know, in ironic counterpoint to the Credit Suisse analysis of Toll's earnings, Citigroup's analyst yesterday raised his price targets on a number of home builder stocks. He is not only arguing that there will be a swift and dramatic recovery from the self-proclaimed housing bottom, but that these stocks deserve to trade at much higher multiples. Indeed, he set a price target for many above their all-time highs.

I have read suggestions elsewhere that people suspect Citigroup has selfish motives for pumping up this sector -- either by underwriting new loans for struggling builders, or protecting their exposure to the home loan crisis. I don't know what their rationale truly is, but I am certain that it has nothing to do with providing an honest assessment of the situation. When markets are hyped like this, little guys get crushed.

First, here is the Citigroup research note:

SUMMARY:

* We are raising target prices for the homebuilding stocks across the board, even as we embed more conservative assumptions in our CY07 estimates.

* While many wait for an improvement in fundamental data such as prices or inventory to signal an "entry point" in the stocks, we urge investors to look back to prior cycles, when the group rallied far ahead of fundamentals.

* If (as we expect) order trends turn positive by 1Q07, then even if earnings estimates decline further, the time to buy the stocks is now.

* The rally thus far has already occurred sooner than many expected, and we believe the group is about to accelerate its ascent.

* New Target Prices: BZH $80; CTX $68; DHI $48; HOV $63; KBH $92; LEN $88; MDC $85; MTH $87; PHM $45; RYL $95; SPF $43; TOA $18; TOL $42

* On average, we look for return potentials of roughly 67% over the next 12 months, and retain our Buy ratings on all the builders we cover.

Recently, UBS hosted an annual CEO Investor Conference, with 27 companies participating and 300 investors in attendance. Homebuilder participants included: Beazer, Centex, D.R. Horton, Hovnanian, MDC Holdings, Meritage, Pulte, Ryland, Standard Pacific, Technical Olympic, Toll Brothers, and WCI Communities.

The UBS report is summed up as “Unearthing the Opportunity in a Challenging Environment”. The group trades at an average 15x our 2007 EPS estimates versus its historical average of 8x and a range of 4-15x.

They say key takeaways are:

• management teams are realistic that vacant housing inventory needs to be absorbed before supply can increase, which will take another 12+ months;

• balance sheets are being scrubbed of unprofitable land positions, setting the land cost basis lower and improving financial liquidity;

• opportunities for scale economies and permanent cost-cutting are rife, but execution is key;

• M&A activity is expected, but not until land values stabilize.

.........

UBS Building & Building Products December 6 2006 report

The following is a transcript of the CEO panel at our investor conference held November 8 and 9:

Featured Speakers: Homebuilder CEO Panel

*Ara K. Hovnanian: President & CEO, Hovnanian Enterprises

*Ian McCarthy: President & CEO, Beazer Homes

*Robert I. Toll: Chairman & CEO, Toll Brothers

*Donald J. Tomnitz: President & CEO, D.R. Horton, Inc.

Introduction—Margaret Whelan: This is the fourth year in a row that we’ve hosted our CEO conference... For the first two years, business was very strong; last year we were starting to see cracks; and now we are facing a much tougher environment… The theme for our conference is “Unearthing the Opportunity in a Challenging Environment.”

This correction has unfolded more sharply than most of us expected, and so I’d like to start by having you identify specifically what your company is doing to manage permanent costs out of the business, how your company is mitigating risk and protecting the balance sheet. I find it interesting that as many of the builders have started to report regional profit breakouts for the first time, the Midwest and Central are barely breaking even, with a disproportionate percentage of the profits being generated in the coastal markets.

Question: UBS expects home prices to fall by 10% in 2007. How do you generate an acceptable operating margin and return in markets that do not enjoy pricing power?

Ian McCarthy: We’re looking at a scenario that is quite tough right now, and could become very tough through 2007. I think we all hope, but don’t fully believe, that it will recover by 2008. Certainly, the economists are now saying that by 2008, the uptick will come. We certainly hope that’s the case. But, in the meantime, we have to plan for the worst, and we have to really take action right now to get us through another tough year, and eventually position our company to take advantage of consolidation of the industry during that time.

Our number one goal today is to make sure that we have the strongest balance sheet possible. We started taking action on this about nine months ago, and it was partly in conjunction with our share buybacks. We committed to share buybacks, and pulled back on some land deals; it actually turned out to be a very sensible thing to do at the time. We raised capital in the senior market and the subordinated market, and we renegotiated our bank facilities.

So, we’re sitting on a very strong position today, probably a billion dollars of liquidity, and we really feel that we’re going to be cautious over the next period. We took our headcount down in the last few months by 25%; we took our land bank down in the last quarter by 15%—and we’ll continue to act in that way as we go through 2007 if we don’t see any sign of an uptick.

Obviously, we would like to predict when that uptick is going to happen and take advantage of it, but if we miss the first couple of quarters of an uptick, that’s not the end of the world for me. I’d rather be prudent and cautious over this next—whatever it is—12- to 18-month period that we have to get through. And I really believe when it does come back, when we get rid of the overhang in inventory that we have at this time, this market’s going to rebound very strongly. But, in the meantime, there could be some tough times, and we need to be prepared for that.

Question: Ara, specifically what are you doing to prepare for the tough times?

Ara Hovnanian: Well, it’s a never-ending list of what we’re doing to position. Clearly, one of the things is looking at our assets. We announced two days ago some land charges, about half of which were related to walking away from land options that we reevaluated, and, as I said yesterday in our presentation, at today’s net-net prices, at today’s net-net-net absorptions, we felt that the further investment was not worth it, and we’d rather keep our capital available for the times that will probably be not far away, when new land will be worth it and we can make good returns on our new investments.

We’ve been through these cycles plenty of times before, and I think it’s smarter to preserve the capital. As painful as it is to walk from options, we think it absolutely makes sound financial sense. So, balance sheet management is clearly one of the things we’re looking at.

In ongoing communities, it’s a delicate balance all the time between absorption and margin, and there’s no carte blanche answer. We look at every single community, and even within the same geographical region, the answer is different from community to community. How much inventory do you have? What kind of competition is coming up? Is there a temporary glut on the market? Are you better off sitting back and waiting? What’s your backlog position, because you don’t want to make your backlog nervous. So, that’s something we just take on a case-by-case basis.

Everybody’s talked about trimming headcounts. We’re certainly doing the same. Everybody’s talked about going back to the subcontractors, asking them to reduce their prices. We’re certainly doing that.

One other thing we’re doing in many locations where we own the land, and in some cases even when it’s optioned, is that we are reconsidering the site planning and product in order to enhance profitability. We had one in the D.C. area that was designed as a 12-story mid-rise building. As we re-ran the numbers, we found it economical to lose some density and drop to a seven-story building. That reduced the construction costs, because it went into a different cost categorization. We looked at taking duplexes and separating them, maybe losing density count, but, in this environment, with what was happening in the market in that case, it made sense. So, we’re looking at a variety of our different locations and redesigning the product, either the house types or the site plans. And that takes some time, especially if it involves a site plan, but, in this environment, there is a little bit of time.

Question: Bob, do you want to address that one?

Robert Toll: Is there anything left to say? We’re doing all of the above except not buying a lot of stock back; actually, we’re not buying any back right now. Our balance sheet is in pretty good shape. We’ve got $1.4 million available on the revolver. We’ve got about a half a billion in cash. Naturally, you’re looking at your costs all the time, in good times and in bad times. In slow times, you’re cutting back your overhead, and we’ve done that also.

We’re aware that the cycle is different than it’s ever been before. You’ve got low interest rates. You’ve got low unemployment. You’ve got a stock market setting records. You’ve got a good economy. It’s a strange set of circumstances. It’s been heightened by the fact that the party in power got thrown out during good economic times. That’s unusual. Generally you have drawdown in the party in power in an off-year election, but not to the extent that you see here. People have lacked confidence, rightfully so, because of how we look in the world and how we look at ourselves, and times are changing now.

Because the cycle is different, there’s a possibility that things can come back faster, as well as slower. The accepted intelligence is that ‘07 will suck and ‘08 will do okay, and I don’t see any reason for that being any better than any other prognostication you can invent. So, we’re trying to get ourselves ready for good times as well as for poor times. In the one-on-ones, we were questioned about what will happen if the inventory starts to draw down, finally, the speculative cancellation deals that have come back at us. And the answer is, well, as soon as we see our inventory drawn down, we’ll start to remove the incentives.

Now, there’s a huge market out there that wants to buy. We know it because when we run specials here, there, and yonder, all of a sudden hundreds of people, hundreds and hundreds of people, show up, and they deposit. And then slowly they drift away, and you don’t take that many agreements. But there’s a tremendous number out there that are ready to go into the market. If incentives start to go down—and right now there’s no sign of that, the inventory is still hanging over us, we all have high cancellation rates—but if the inventory starts to go down even a little bit, you’re going to see the incentives go down a little bit, because a majority of the incentives are on the stuff that we’re stuck with, not the stuff to be built. We can sit with the land, but we sure don’t like sitting with the homes.

Question: So, once your inventory starts to go down, you expect your cancellation rate to fall, too?

Robert Toll: Well, once your cancellation rate goes down and your inventory goes down, then your incentives will be drawn in. The minute your incentives are drawn in, people who visited the community and who are in the market— and there’s tons of them who are in the market—start fishing. “All right, Bob and I have made a decision. We’re pretty certain we’d like to go forward. You still have the $50,000 incentive here on the Andover model.” And the salesman says, “Oh, no, that’s $30,000.” “Well, it was $50,000 last week.” “Well, that was last week and this is this week. You see, we sold the end of the inventory on the A model. You’re talking about one to be built. There, the incentives are only $30,000.” The minute that happens, and people go home and tell their friends about it, you may see a fast turn.

So, to get back to the question, I think that you want to be careful that you’re not just getting ready to man the ramparts and guard the fort, but that you’re getting ready for the other side, which could be the good times. So, naturally, we’re watching costs; naturally, we’re watching the balance sheet. We’re not buying back any stock, because I think we’ll make more money with our cash plundering those that have fared less well than us. And we’re getting ready for good as well as bad times.

Don Tomnitz: I’m glad to hear that you’re not buying any stock back. At least there’s one other sorry guy out there!

Question: So, putting the question a little differently for you, Don, because I think Horton has changed its strategy in the last couple of months. How does builder strategy affect buyer sentiment, in that when builders are continuing to discount, continuing to fire-sale the homes, aren’t you really hurting yourselves?

Don Tomnitz: There’s no question. Clearly, we are. We’re shooting ourselves—it’s sort of a death spiral. Because as we continue to increase the incentives and the discounts and so forth that we’re offering, then obviously we create more of a concern on the buyer over here on the side, and that’s why I say as we go through ‘07, we’ve all got to deal with our inventory. Every builder’s got different inventory levels, but the industry in general has too much inventory, and we’re all going to deal with our inventory in a different way. We believe the best way to deal with the inventory is to sell it and get back the cash into the corporate till and redeploy that as we see fit.

But during ‘07, and certainly the first two quarters of ‘07, we’re all going to be dealing with our inventory on a division, subdivision, and market-by-market basis differently based upon our own inventory levels in that particular market. And we’re going to create more doubt in the buyer’s mind during the course of ‘07. And toward the end of ‘07, I think, as the inventory in the industry comes down, then we’ll find ourselves in a position where we are able to achieve some price stabilization, and then I am absolutely convinced that there’s a pool of pent-up demand being created over here, where the buyer is uncertain whether they’re going to buy today, but they’re going to buy.

Question: Do you agree that pent-up demand is building, Ara?

Ara Hovnanian: Yes, I think there is clearly a lot more traffic than buyers in the market. I think there is a bad psychology out in the marketplace today, and what Bob was describing in terms of pent-up demand, which is something we all hope will happen, is reversed today, as we all know. They go to our office and there is $10,000 more in concessions than the prior month. So, they see the trend and they’re saying, “Well, if I wait another month or two, maybe it will get better yet.” And you have people waiting on the sidelines. But I agree, there’s a lot of interest out there, and once that psychology does change—and it will change in the scenario that Bob just described—and the incentives start going the other way, I think the turn may be more rapid than we might expect.

Ian McCarthy: I think the other point that we talked about this morning in our presentation is that, with very few exceptions, most of the public builders are really cutting back on inventory now, managing it very carefully. And we are being prudent, as a group, in terms of how we run the business. But the 75% of the business that’s still in the hands of private builders, it’s in their interest to keep drawing down their bank lines, and to keep doing that, they have to keep building. So, I think that’s causing more of a problem at this time.

How long that runs on for, I’m not sure, because every day those private builders have to put their net worth on the line, and every day those bankers look at the returns they’re getting and the risk profile they have with those private builders. I think we’ll see a lot more consolidation next year. But currently, I think they’re still pushing inventory into the market, because they have to pay their wages, they have to have their draws. So, as someone pointed out to me, they are actually causing an inventory problem. They’re not working it down at this point. But I don’t see it going on for very long.

Ara Hovnanian: Well, Ian, one of the big questions I guess we have is, there are obviously two kinds of inventory. One is a house. And, as we know, we’re all interested in moving that. And those of us that weren’t big spec builders, we’ve inherited accidental specs from a customer that canceled at the last minute, after a house was built. We’re all going to move the standing inventory down rapidly, as much as we can.

The wild card, and the hard question, is, what about the land? And where are public builders, as well, standing with the land? And it’s hard to sell land as just land, developed or undeveloped. So, many are choosing a tactic, private and public, of popping a house on that land, because you can sell it when it has a nice house on it more easily than you can just sell raw land. So, you know, there’s a lot more of that kind of inventory, and it’s not clear how that’s going to play out.

Bob Toll: But are you suggesting that public builders are building specs to move land?

Ara Hovnanian: Not uniformly, but, yeah, absolutely.

Margaret Whelan: Some definitely are.

Ara Hovnanian: I would say that. I don’t think Toll is, but I think some builders are.

Bob Toll: Toll is certainly not.

Margaret Whelan: Bob, is that a surprise to you?

Ian McCarthy: Nor are we. We clearly have said we’re going to mothball communities. We’ll actually close the communities down for sale. If we’ve got an investment in that community that we’re not getting the return on today or in 2007, we’ll keep it.

Bob Toll: Even once he puts a road in?

Ian McCarthy: Yes, we’ll keep it.

Bob Toll: Once you put the improvements in, you’ll still mothball?

Ian McCarthy: To a degree, we will. Yeah.

Question: So, I guess the question is, then, if you really believe that it’s a short-term issue and the inventory is going to be cleared out, and you really believe you’re going to get a better return on capital in the next couple of years from dirt that you’re buying in ‘07 than you will in ROE on your stock today, why aren’t you more engaged in getting involved with these private builders, the land bankers, the joint venture partners, whoever it is who’s controlling the paper?

Don Tomnitz: First of all, we don’t know the value of the paper today. As I’ve mentioned in our presentation, we know what the costs are, relative to our gross margins, but not the value of the dirt.

But as ‘07 continues on, and land sellers begin to lower their prices to us, then I think, if you buy a piece of land today, you’d better have a good, built-in buffer on your gross margin, because there’s a probability over the course of the next six months that you could buy that piece of land for less.

Bob Toll: We are getting involved. I mean, we’ve called all the banks and told them here we are, and we’re available. But it’s too early to expect the builder- developer or loan officer to cut their respective throats because we want to buy that ground at a price that makes sense today. The reason they’re in trouble—the builder-developer and the banker, the bank loan officer, not the credit workout side of the bank—is that they mis-figured, and they paid too much for the land, or they over-improved the land, or they built too expensive a home on the land. But for one reason or another, it doesn’t work. And it doesn’t work even in a breakeven scenario for them. Otherwise, they would be breaking even, and there wouldn’t be a problem.

So, automatically, we know you’ve got to buy it underwater for less than they’ve put into it. And that requires things to shift from the builder-developer to the bankruptcy court, and from the loan officer to the workout department. Those shifts haven’t taken place yet.

Question: As private builders are trying to survive, and improve their liquidity, are they going to build more spec homes that are going to prolong the downturn?

Bob Toll: No. Once it’s moved to the bankruptcy workout department, he’s not making more draws and he’s not building more houses—but they’re not there yet, as it’s still too early.

Don Tomnitz: I do think that many banks across the country are cutting back on the new loans that they’re making to small and medium-size builders, and they’re just dealing with what they already have on the books.

Ara Hovnanian: It’s early because everybody’s not ready to take that pain, the sellers that have the land. And from the buyer’s perspective, you know, I’ve said this many times, we’re anxious for the market to bounce along the bottom. We don’t mind the bottom. What’s difficult is the trip to get there. Because if you go out and make a deal today, the problem is—and you do it based on house price of X and an absorption of Y—the problem is, two months from now the house price might be .9X and the absorption may be .8Y, and all of a sudden that deal didn’t work, because it’s still moving down. I hope we’re getting near the end of that. But certainly that didn’t change from the third quarter to the fourth quarter for us.

Margaret Whelan: We’re not getting near the end of it if the privates are going to go into the spring building more specs. And, you know, the one thing about this conference versus the last five years that’s refreshing for me is that I have not heard one of you, thankfully, complain about your multiple being so low. The only way the group will be revalued to a higher level is you prove to be good stewards of capital at the bottom.

Don Tomnitz: We are unhappy with our multiple.

Ara Hovnanian: Everybody’s PE went up. It’s mostly because the EPS went down.

Margaret Whelan: Exactly. But the way you would get a better multiple through this cycle is by having a better return on capital, and I do not believe you’re going to get the opportunities you saw in the early ‘90s from the RTCs, so maybe now it’s time to start engaging. One of the ways I think about it is that instead of opening new communities and putting supply into the market, you could be taking supply out by buying these companies before they get very distressed next year.

Don Tomnitz: But we are taking inventory out of the market, because I don’t think there’s a public builder in our industry that’s not having a lower number of starts this quarter versus last quarter. So, we are putting less supply and inventory into the market.

Question: But you’re still opening communities?

Bob Toll: We’re still opening new communities.

Don Tomnitz: Well, sure. If we’ve got streets, we’re going to move through the subdivision and build our homes.

Bob Toll: If you haven’t got streets, Margaret’s asking if you’re putting in the streets. If you haven’t got the streets, but you’ve got the land—it’s through the approval process—are you putting in the streets?

Don Tomnitz: Yes and no.

Bob Toll: Yes and no is the right answer.

Don Tomnitz: Because you may have San Diego, where you have a five-year inventory of lots and you don’t need it, or you may have Ventura County, where you only have a one-year supply of lots, and you need to develop those lots. So, yes, we are. The homebuilding business is not the same—I know you may think that—in all 50 states.

Bob Toll: Did you suggest that we altruistically go buy busted builders to stop inventory being built? Did you say that?

Margaret Whelan: Yes, I think if you should stop putting new supply into the market and take their supply out, Bob, it’s a concept, right? You’re going to get the market share. We’ve seen it happen in other cycles. And you’re all saying, “Well, we don’t know the timing of the recovery, so why not take some market share while we’re waiting?”

Bob Toll: I’ll get a share of my shareholders’ boots.

Question: You’re there already, right? And the way to get you out of this is by driving better returns. That’s how I would think about it.

Ara Hovnanian: But I would disagree with you, because we’re not there already. We’re just at 12 months, at the most, into a slowing housing cycle.

Don Tomnitz: Right. That’s correct.

Bob Toll: Watch what you wish for.

Margaret Whelan: Which brings me to the next point. We’re sitting here in front of all your big shareholders, and you’re saying, “Guys, come back in 12 months. Hopefully, we’ll be at a turning point.” The investors are going to sell your stock, so why aren’t you using the capital to buy in the shares here if it’s so depressed? You have more liquidity and dry powder now than ever before.

Bob Toll: Because, as we just stated, when the opportunity presents itself is when it’s moved from loan officer to credit workout officer. And when it’s moved to bankruptcy court, we want to have the powder. That’s all we want to do right now.

Margaret Whelan: You have the dry powder. You have more liquidity now than ever before. The land options are working, as you’re able to renegotiate or walk away.

Don Tomnitz: I will argue with you all day long. You don’t know that you have too much powder, especially when you’re in the forefront of a downturn in the cycle. I’ve seen that too many times. How much is enough powder? We’ve never found enough powder.

Ara Hovnanian: In a consolidating industry, you can choose to use your capital to buy back stock—which, by definition, unless you’re willing to leverage more, is going to cause you to either shrink or certainly grow less rapidly—or you can save your capital, as Bob is suggesting, to take advantage of opportunities and grow more. And, in our case, first of all, my family still owns just under 50%, so I’m not sure that it would make a lot of sense for us to be buying back a lot more shares and concentrate our ownership even more. But we want to save our capital for the opportunities that come every time in these cycles. And the opportunities are not there yet; we have to be patient at this time. But they will be there. We’ve been here time and time again.

Bob Toll: When we went through it the last time, there is not one of us that doesn’t wish that we had bought more dirt. The banks disgorged the properties; none of us wished that we hadn’t bought more.

Don Tomnitz: Absolutely.

Question: We’ve had a couple of people, including some of you on the panel, say in the last two days that land prices are not falling that much. So, if land prices are not falling that much, and we have lots of nontraditional buyers who want to come in and buy land and compete with you, the land prices are not going to go down as much as they did the last time, are they?

Bob Toll: That’s correct, land prices have not fallen much yet. But I’ve yet to see nontraditional buyers trying to buy land. I haven’t run into one, but if you’ll give me his name and number afterwards, instead of taking some markdowns, we have some interesting bargains.

Ara Hovnanian: Margaret, I think land prices are coming down. They’re just a lot stickier than house prices and they lag six months behind. And so housing prices are going down and land prices are adjusting. But not quite fast enough to make economic sense. Once it hits the bottom and rolls along, then land prices will eventually get there and it will make sense. But we’re not quite there.

Question: It seems to me that one of the reasons land prices are sticky is because the private builders often have one- or two-year paper to secure that dirt. So, we’re going to get a flood of land next year. How much do you think land prices will be down by next year, and how will that impact your book value or your balance sheet?

Ian McCarthy: I’d say it’s very hard for us to tell at this time where that is. I think forecasting where there may be impairments is impossible to do. If you think there may be an impairment, you need to take it today. So, I don’t think we are forecasting that there will be considerable reduction in land prices, but there may be. And I think that it comes down to who holds the land. If it’s the farmer who holds the land, does he need to sell today? Does he need to sell next year? Or can he wait for better times?

I think that we need to look at who that seller is. If it’s the workout department of the bank, they will sell it, and I agree with Bob. At some point there is going to be some distressed land there that’s going to be an opportunity for us to buy. Does that then impact other landholders alongside? Potentially, but it’s really hard for us to say at this time, obviously, as it varies by market.

Ara Hovnanian: Land values and land prices are two different things. Land values have come down. That’s unequivocal, I think. The sellers are reluctant to recognize the land value. So, prices are stickier.

Bob Toll: Most cases, they don’t have to recognize the impairment in value. They’re going to be as patient as we are—those who are in shape to be patient.

Question: But your companies are not in shape to be patient. If your net income next year is down 50% from this year, when you start taking big impairments, you’re going to be losing money.

Bob Toll: I don’t see it.

Ara Hovnanian: Neither do I. This year we’ll make some $200 million for the year. The only loss, obviously, is because we took significant impairments in land charges this quarter. From an operating basis, we’re still solidly profitable Question: And you think you’ll be profitable next year, fully loaded for land charges?

Ara Hovnanian: Absolutely, pre any impairments. I think we went through it very carefully, as much as we can in a changing marketplace. We looked at every asset. And we feel pretty comfortable that we’ve walked from the options that deserved to be walked from, and we’ve brought down the land values—by GAAP standards and assumptions we use, which we think are reasonable ones, we think we’ve brought down those values. Now, that’s as of a few weeks ago. If the land market or home market continues to deteriorate, then we’ll have to look at it again.

And, by the way, I heard some scuttlebutt that some were saying we were overly aggressive in our land impairment. And I can only repeat the assumptions we used, because once you set the assumptions, it’s a mathematical calculation. And the assumptions we used in our land impairment, which is about half of our land charges, started with net-net-net prices—after all the incentives, including taking specs that everybody’s trying to move, and accidental specs. If you take that as your pricing and assume that doesn’t change, and also assume that you don’t get further cost reductions, and you take something that’s very close to today’s recent absorption—not 12 months’ absorption for a community, because it was very different in the beginning of ‘06 than it is right now—and you do the calculation, in our case, there was not a choice. We had lands that were impaired. So, people can call that aggressive. I call it realistic.

Now, maybe others have different properties they bought at different times. And, by the way, the majority of it, really, coincides to properties where the contract was signed and/or closed in ‘05. I mean, that was the challenging year in hindsight, and I wish I had gone on a long vacation in ‘05. But we didn’t. We’ve been in the market. And you have to be in the market. But there are times when the market hiccups, and you find yourself with some land at a cost basis that you wish wasn’t there, and we just have to deal with it.

Question: So, you will be profitable next year?

Ara Hovnanian: We certainly plan to be. Absolutely. We haven’t released our projection for ‘07, as some have done. We haven’t released our fourth quarter number. We just gave a preannouncement, as we ended in October. But at this point, I would certainly expect that to be the case.

Question: When you see the changes that have unfolded in the last 12 months relative to the last three or four years that we had this big run-up, it seems that the controls that are in place could’ve been better. Then we wouldn’t have had so many speculators, and so much artificial pricing power. How do you think about the opportunity now to really put the controls into your business?

Ian McCarthy: I don’t think the controls were lacking on our part. I think that there was an overshoot of the market, that people came in as investors. Again, I’ll speak for myself, although I think I speak for most of the other public builders. We put contracts in place to try and weed the investors out. We tried to restrict in every way we could and stop investors coming into our communities, because we felt that if at any point they wanted to turn those over and flip them back out, that was going to be really bad for our communities. So, we tried really hard to stop those, even looking at the type of mortgage they were taking, any kind of mortgages they had outstanding.

So, I don’t think it’s fair to say that we didn’t have controls in place. Those investors did get into our communities. We didn’t keep them all out. But across the whole market, they were just buying because the returns were so strong; the return in the stock market for the equivalent amount of equity outlay, you couldn’t leverage it to the same extent. You couldn’t even get the absolute return in the stock market. So, why wouldn’t investors get in, buy these units, whether they were condos or single-family units, flip them back out again, make a very quick return, almost no equity? And that just pushed the market beyond. But I don’t think it’s fair to say in any way that we didn’t have controls in place. And I think we continue to have the right controls in place.

Bob Toll: Ian, don’t fault yourself. We all went through the exact same scenario. We all had the controls in place. We had people at the end signing four-page documents, “I am not an investor, I am not an investor, I am not an investor,” and initialing it all over the place—and he turned out to be an investor, of course.

But even if we had been 100% successful in Happy Acres 106 and got no investors into that community, they would’ve gone into my dear competitor’s community. Having gone into the competitor’s community, the competitor’s price would have risen in line with the demand that that competitor felt. And there were specific instances we can think of even amongst ourselves as public companies. For instance, one comes to mind in Vegas that happened about two years ago.

What happens is, the price gets driven up for your dear competitor, because he feels a demand from the investor that he’s not screening well so he doesn’t realize the buyer is an investor. And you do a review of your community, and your staff sits around and says, “Why are we selling them for $596,000 when Bobo is selling them for $615,000 and we’ve got a better product? We’re leaving money on the table.” So you raise the price, and then we go out to the market, we’re all still selling. Then one day we wake up and find out that we’re all selling to the same guy, who’s buying a house from each one of us, and that’s what happened in this market.

Ara Hovnanian. And, to make it worse, then we went to buy the next land parcel, because we sold it out, and we now know it’s $615,000, we’re all competing against one another, and we know we can sell it for $615,000.

Bob Toll: Absolutely right. And then we found out, of course, now, in ‘06, well, the investors who would pay $615,000 are gone, and the $615,000 price is now down to $495,000. And it’s created a challenge.

Margaret Whelan: But, see, that’s more what I was thinking about in controls, because everyone’s told me for the last couple of years that it was very limited, and now Don Tomnitz said it’s closer to 20-25% versus the 10% he thought a year ago. Okay, fine.

Bob Toll: Who said that?

Don Tomnitz: I did. I said that.

Margaret Whelan: But my point is more that you are the executives who are signing off the checks to buy dirt at much more elevated pricing, as Ara said, much higher absorption rates than normal. And now you’re having to walk away from that.

Bob Toll: You know, Margaret, if only my darn crystal ball would work better. The darn thing breaks down all the time.

Margaret Whelan: But it’s not a crystal ball. You’ve all been through many cycles and you bought too much land at the top.

Ara Hovnanian: I know, and can I tell you—in fact, in our presentation we put up covers of Fortune, of Barron, and all of them predicted this crash and adjustment and correction, whatever you want to call it, and the years on the covers have been ‘00, ‘99, ‘01. And, you know, if you predict doomsday, one day the market will slow down. And the fact is, had we listened back in ‘00 . . .

Bob Toll: Clock is right twice a day.

Ara Hovnanian: No, we would’ve missed a billion dollars in pretax. So, all you can do is make sure you’re properly capitalized and make sure as you sell inventory you’re replenishing. Monday morning, do I wish we were a lot more conservative in ‘05? Yes. But that’s Monday morning.

Bob Toll: Margaret, when we go out to comp before we buy the ground, we have in our model not only the current price that the developer is selling, but also the price when the bulk of the sales took place, so that we’re not fooling ourselves. I mean, obviously, the developer that we’re comping against, the builder-developer, now has his price. It’s $699,000. And he’s sold five of those. But he sold 15 or 20 of them at a price reduced by, let us suggest, $100,000. Well, we’re using, in our models, that $100,000 reduced price as comp threshold for what we can pay for the land. Still, it happened to be wrong.

But, as Ara said, if we had followed the advice of the media in ‘99 and 2000 and 2001, we would’ve lost the opportunity to gain, which we did, billions of dollars. You look at where these companies were, just the four that are on this panel, 10 years ago. Take a look at how much book there was and what we were worth then. Now, we have accumulated billions of dollars of capital and book, and so we’re very different companies. And I think we can wait through the times that we’re in now, as opposed to ‘87, ’88, and ‘89, when it was perilous for us, and, in fact, some of the majors didn’t make it through. I don’t think anybody thinks that any of the majors are not going to make it through this one.

Ian McCarthy: And a lot of that had to do with the capital structure at the time.

Bob Toll: Right.

Ian McCarthy: With long-term commitments and short-term debt. And, today, every one of us has been prudent in terms of how we structure our balance sheet.

Bob Toll: Well, you can be, because you’ve got the book. You’ve got the capital behind you.

Don Tomnitz: The other thing is, the money that we put to shareholders’ equity over the last three to five years is going to be far above any impairments that anyone is going to take in this industry. So, we’ve got the money, as Bob says. Now, we may have some adjustments to what we’ve already put in the till, but they’re going to be very minute relative to what we’ve put in.

Question: Can you comment on how the incentive structure at the division level or at the community level has changed maybe over the last year or so as things have slowed. Also, how has the compensation structure at the top maybe changed? Obviously, you’ve benefited from the good times. How will it be during slower times?

Don Tomnitz: We change our division presidents’ bonus plan about every two years. We changed it this year, to focus on three primary things: gross margin, SG&A, and ROI. And we deleted some items that we compensated for last year because we wanted the focus of those three items on our business this year.

Bob Toll: We’ve always paid on a discretionary basis. We were in the process of moving to an incentive-based pay program, and as we saw the market go down, we didn’t think that would be fair, and so we pulled it, said we’ll be back when we reach more normalized levels, but they will stay purely discretionary- based. With respect to the CEO pay, I would expect that it will go down. If we’re paid off of what we did in ‘05, currently, it may look outsized compared to what we’re doing now, since 2005 was a banner year. But based on this year’s results, our compensation will be down.

Ara Hovnanian: In our case, we haven’t really changed the structure out in the divisions, so as their profits are dropping, their bonuses are dropping. It’s one of the great automatic overhead adjustments that changes rapidly. Regarding CEO pay, in our case, it’s a percentage of pretax after land charges, so that hits a lot, and that percentage shrinks quite a bit as ROE shrinks. CEO pay goes down more rapidly than pretax profit shrinks. So, there’ll be good adjustments there. Bob gave me a quarter. I’ll save it.

Ian McCarthy: I was going to see if I can earn that quarter now. For us, it’s very much formula-based. We have what we call value-created return on investment, and it’s based on absolute value created for absolute return and incremental improvement. We’ve just closed out September, our fiscal 2006, with record revenues, closings, and EPS, so incentive payments for ‘06 are reasonably strong. The incremental portion wasn’t as high as in ‘05, so CEO pay has gone down for ‘06 to ‘05 even though we hit record results, because we didn’t have the incremental improvement there.

Looking at next year, incremental goes both ways. I made the point this morning that I just announced our 50th quarterly results since we went public in 1994, and it was the first time we’d ever had to forecast down earnings going into the next period. Prior to that, we’ve had 49 quarters of always forecasting up. So, we’ve had a good run there. But we recognize that 2007’s going to be tougher. Incremental compensation is definitely going to go down. Even if we make absolute value created, incremental will go down, and it goes down at a fast rate.

To make sure that we incentivize managers within the company to take actions that we want them to take in this period, we authorized a discretionary plan at the will of the compensation committee but driven by certain factors, which include reducing SG&A. So, we absolutely do not want our managers to think, “this year’s blown, I’m not going to get paid, I know the formula’s not going to work.” We want them focused on revenue levels, EBIT levels, reduction in SG&A, and, if we hit those targets, the compensation committee will look at some discretionary payments.

Question: It seems to me that you’re doing to the land sellers what the customers are doing to you. You’re waiting on the sidelines. You’re waiting for the lower prices. You’re maybe trying to negotiate next year’s prices today, expecting them to be lower, and of course they’re not willing to sell yet at that price. And that’s what your buyers are trying to do to you. Are you a much more sophisticated set of buyers than your customers are—are you guys also building up a pent-up demand for lots? What’s the trigger going to be to get that pent-up demand chasing prices higher again?

Don Tomnitz: It’s going to get back to a market-by-market situation, because we each have different lot inventories and land inventories in each market. So, as a result, in a number of our markets today, we have an adequate supply of land and lots, and we don’t have to be purchasing that land today. As our sales and our closings increase over the course of time, then our year supply of land will go down, so then we’ll be looking at each market and ascertaining whether we need to supplement that particular operation with additional lots.

Bob Toll: Pretty much all of us get sales reports by Monday afternoon, if not by Sunday night, of what’s happening out there. And when we see two or three of those things pop through in a row that shows us on the upswing, we’ll be loosening our threshold, lowering our thresholds, for the land purchase. It’s just a natural reaction.

Question: There’s been a lot of discussion about the possibility of buying smaller private builders as they go into some distress over the next 6 to 18 months. There was also some discussion in the last six months or so about private equity interest in the big builders. Do you think that there will be big, public-to-public mergers, or do you think that some private equity takes out one of the big public builders? Do you think that happens over the next 12 or 18 months?

Bob Toll: The answer is maybe. I don’t think you’re going to see public buying private. We did that when it was the easiest way to get expansion cooking— translation, to get the land. Now, we don’t have to buy the builder to get the land. As a matter of fact, we don’t want to buy the builder to get the land. If we did that, at best—if we give no credit to the builder organization—we get land that was overpriced. We want to get that land at less than the builder’s cost. So, again, we go back to some time ago—we’ll be looking to buy it from the bank, not from the builder.

Ara Hovnanian: My answer would be a little different than Bob’s, but we’ve had a different strategy. We have been acquisitive historically with the private builders. And, in our case, if it’s in a new geography, we would still be interested in buying private builders. For us, and our approach, we’ve found that to be a better way to enter a new marketplace. Having said that, for the same reason we find it difficult right now to make the right evaluations on a piece of land, as prices and absorptions haven’t yet stabilized, we find the same challenge when we evaluate a private homebuilder.

So, we think there will be interesting opportunities, and we think it does play to one of our core strengths. The good news is, there are still many markets for us that we haven’t entered, so we think we can still take advantage of those opportunities, but it’s too early at this moment. Also, we haven’t historically bought fixer-uppers. So, when we talk about distressed homebuilders, there are distressed and then there are distressed—distressed where the wheels start falling off—and that’s less likely, in our case. Again, we’re just not a fixer-upper buyer. We like to buy good, sound companies. In our case, we like land, but we really focus on the management team. And if we’ve got a good solid team there, at the right price, when the market stabilizes, we’re pretty confident we’ll be buyers again.

Ian McCarthy: So, I’ll say that I agree with that, to an extent, and I think that if there’s a new opportunity that we want to get into and there’s a private builder, let’s say, that we can get in there, and it adds value to us, then I think people will still look at those. I think others will, but very prudently. I think more of your question was really about the public-to-public and the private equity.

The private equity guys have been around for a very long time, have really not made much of an entry into the market other than in joint venture, as Ara did with Blackstone. And I actually think that’s quite an interesting prospect. I think that maybe, rather than trying to buy us out at today’s price, which none of us will be happy about, we look at ventures together with them, and that’s possibly an opportunity, maybe a way for them to get in with slightly less risk, and maybe you can comment on it.

Ara Hovnanian: Well, no, I think there’s a lot of interest in that type of transaction, large privates, medium privates, et cetera. As Ian said, I don’t think there is a lot of motivation for the large publics or medium-size publics to sell at today’s prices. It may make economic sense at today’s prices, but I don’t think there’s a lot of interest at today’s prices. Now, if one was willing to make a substantial portion of the purchase stock, so perhaps the shareholders could still share in the upside, perhaps that may have some interest. But at least our company isn’t willing to do that at today’s prices. Now, if there was an extraordinary opportunity, we’d consider that, but it would have to really be an extraordinary opportunity.

Question: A common theme across all the presentations here has been that in the midst of this downturn, the economy’s remained stable, when, in fact, historically that’s never been the case. It seems like the assumption for this ‘08 recovery is that the economy will remain stable. Yet, so much employment is tied to the construction industry. How can you reconcile that, and how can you expect this assumption of a stable economy when it’s never been that way before and there’s so much uncertainty out there as to whether that’s going to be the case or not?

Don Tomnitz: We do not expect the economy in ‘08 to be as good as it is today. I think that would be a false assumption on our part, and I agree with you. Rarely, when you’re in a downturn, do you find that something’s going to help you out of it like a better economy or equally as good economy as today.

So, we’re planning for a worse economy in ‘08, but we’re optimistic relative to what we see in the marketplace, that it won’t be that. Yet, at the same time, as we already identified, we have got the next level of cuts identified based upon whatever the current sales are going to be for about the next four or five months, and we’re going to have to adjust our business based upon what we’re selling. It gets back to “sales solve all problems,” or solves a lot of problems. We’re going to design our business and adjust our business based upon what the sales are, what the current demand is.

Ian McCarthy: I think housing today is down in a fairly strong economy. Housing was up in a very weak economy the last few years and you’ve got to look at that. I think you need to take into account that by ‘08, it’s an election year, and judging by what happened this week, I think that there’ll be money pumped into the economy. There’s going to be a very big drive, and traditionally, there’s money pumped into the economy in election years like ’08.

You know, I think it’s a risk for us. There’s no question it’s a risk as we go through ‘07 and go into ‘08 that if the economy does go down, it will impact us, and it will probably push back the uptick in housing. But I think that’s something that is not fully within our control. Housing’s a big part of the economy, but it’s not the only part of the economy. There are other components of the economy that we’ve got to hope are going to remain drivers while we’re in this somewhat of a downturn.

Ara Hovnanian: I don’t think many of us are trying to make EPS projections for ‘08. As I said earlier, what we are trying to do is make our decisions based on what we’re seeing in the market. And, as I mentioned, at this point, we are still seeing the market continue to correct and adjust, so we’re not being very bullish investors in new properties or companies. It doesn’t have to improve for us to make good decisions, we just would like to see it stabilize, for absorptions to stay steady and pricing to stay steady, and we could do very well in that kind of environment.

Once land comes down—and it lags—but once land comes down, and to make sense at current pricing, then we can do well. And then when you get the uptick, we could do extraordinarily well. The highly regulated markets are where all of the action has been. We build in Texas. We build in North Carolina. Those are wonderful markets. We do very well there. We did well there five years ago. We’re doing well there today. But they’re never the kind of markets that are going to make significant dollars. They make good, steady dollars, good, solid returns. But the locations that really put your equity on the map are the highly regulated markets, because, by definition, they control supply, or supply is controlled, effectively, by the highly regulated market.

As those markets start to improve, and demand increases, and supply is limited, it’s economics 101—its what we’ve seen for the last five years, pricing goes up and margins become phenomenal. You pay the price during these kinds of corrections, but in the long term we still think it’s a great environment to be in. If we buy for pricing that’s stable, we should do well and earn very respectable returns on equity without a lot of leverage. And then if you get improvement in the economy or in homebuilding, particularly in those restrictive markets, then margins go really high.

Question: Ian, you said in your presentation earlier that, being European, you appreciated having the opportunity to run a U.S. housing business, because we really do have fundamental population growth here. Do any of you think about the opportunity to invest cash in other parts of the world, given that the U.S. is depressed now for a couple of years?

Ian McCarthy: What I said this morning was based on the volume here; look at 300 million people here now in October, and look at the next 35, 40 years, we’ll be up to 400 million. That’s what drives our industry. That is absolutely going to be the driver. We’ve got positive birth rate here. We’ve got positive immigration. If you look at Europe, it hasn’t got that. We looked at going back into Europe seven or eight years ago and looked at the opportunities and didn’t feel that they were, at that time, really opportunities that we could match compared to the opportunities we had here.

But I think at some point in the future, if these companies continue to grow as they have done in the last 10 years, when we look at the next decade, and we say what kind of market share do we take in the U.S., should we look to other markets, I think there may be some opportunities. It’s a case, though, of what do you really bring to the table in those other markets? Is it capital? Is there any skill set there? So, I would certainly say today that we don’t have any plans outside the U.S., but in the next five-plus years, there may be some opportunities, and we may want to take advantage of them.

Bob Toll: Yeah, we’re looking now. We were looking before the market turned south here, and now consider that we’re better off saving our powder for here than we are for there. But we are still continuing to investigate there. I haven’t said where “there” is—but specifically Eastern European markets that have relatively recently been let go that have had lousy economies through mismanagement.

Question: Let go into capitalism from the Soviet Union?

Bob Toll: Exactly. And they’ve got tremendous population growth. It’s not going the other way. They’re making people. And they’re making good economies. You look at their housing, it’s off the mark. So, we have skill sets that we can deliver. We have capital we can deliver. Right now, we’re keeping our eye on the ball at home, because these are treacherous times, and we’re keeping powder dry. But, I think there’s good opportunity there.

There’s also opportunity for our brand in very brand-conscious territories or countries. China, remarkably brand conscious. I was just there, took a couple of days with some developers and builders to investigate Shanghai, and there’s opportunity. Now, you have to be very careful, because that’s not like Eastern Europe. It’s capitalism.

Ara Hovnanian: We’re in somewhat the same boat. I mean, we’ve been investigating, not overly anxious to pull the trigger too rapidly. Given the change in domestic circumstances, I think we’re focusing more at home, but still looking at opportunities in a variety of countries, and, at this point, just getting to know them. I mean, there are a couple of reasons why it would make sense, even though, obviously, this country continues to have great population growth.

One is, although Texas and the Carolinas are having a pretty good day, most of the states in the U.S. move in unison, and there are some countries—Shanghai is almost a country, China, India, Russia—that are having pretty solid housing markets right now. So, it would be reasonable diversity in some of those markets. And even England, which was fairly coincident in terms of market cycles with the U.S., I think bottomed a little earlier. It was on the road to recovery earlier. And it creates a little bit of a hedge. So, to some extent, that can provide a nice domestic balance. Number two, as we’re all getting larger, globalization makes sense, as it does with any industry. But we’re all, even the largest, still relatively small or just on the edge in terms of normal globalization standards.

The third reason is really a longer-term one, and that’s that our market is great, but not projected to grow dramatically. Housing starts, 1.8 million to 1.2 million over the next 30 years. And that’s fabulous. That’s a lot of houses. But it’s not

1.8 million for the next five years, 2 million the next five, 2.5 million the next five, 3 million the next five. Meantime, all of us up here are growing. Right now, we’ve got whatever we have, 27% market share as public builders. We’ve been growing market share, trying to double every four, five, six years. Well, you double from 27 once, that gets you around 54. That next doubling is really hard mathematically, so we’re all going to start competing pretty aggressively domestically, and, just like other industries, eventually you have to look, and look at a wider market by definition. We’re all peanuts in the global housing market. So, it will be a natural evolution. But, given what’s happening at home right now, I don’t think anybody’s in a particular rush at this moment. And, unfortunately, some of the markets that are really hot, Shanghai and Moscow, et cetera, probably they’re too hot and may see what’s happening here in a few years.

Don Tomnitz: No!

Margaret Whelan: We’ll wrap it up here. Thank you very much.

Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium).

BZH Rating: Buy 1

Beazer Homes—Balance Sheet Focus and Strategic Growth Management expects a protracted downturn, and has aggressively streamlined overhead to better match the anticipated sales pace. Land positions are also being scrutinized as overvalued assets are abandoned in favor of liquidity, with buybacks a priority use of cash. Once demand reaccelerates, product breadth is to be expanded in existing geographic markets, which provides a low-risk growth opportunity.

Source: Assessing the Homebuilder Stocks