Homebuilding Outlook: Improved Balance Sheets

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Includes: BZH, CAA, DHI, HOV, KBH, LEN, MDC, MTH, NVR, PHM, RYL, TOL, XHB
by: Consumer Contrarian
New home sales across the U.S. are likely to find a bottom over the coming months thanks to past expiration of a national homebuyer tax credit, weak employment figures, higher lending rates and reduced availability of mortgages, and lastly inclement winter weather. Investors willing to look beyond this temporary softness can take some comfort in knowing that the balance sheets of homebuilders are in their best shape in years. As activity begins to improve over the spring, large builders appear poised to take advantage.
I expect the industry to be profitable in 2011. But with only modest visibility on those expected earnings, I consider it more constructive to look at the balance sheets rather than the income statements of the large builders I cover. This way we can better assess their ability to withstand any further downturn or conversely to take advantage of any broad rebound in demand.
Net Debt
The average builder has cut its net debt by roughly $1 billion since 2006 peak levels through a combination of cash flows resulting from reduced inventories and operations, tax refunds and secondary share issuances. Along the way the vast majority of builders have increased their share counts or completed broader restructurings of their balance sheets, despite dilution to existing shareholders.
D.R. Horton (NYSE:DHI) and Standard Pacific (SPF) have most aggressively reduced debt, cutting $3.2 billion and $1.5 billion, respectively, in net borrowings, over this time frame. While DHI, along with KB Home (NYSE:KBH), have paid down debt through operating cash flows (including tax allowances and inventory reduction), Lennar (NYSE:LEN) and MDC have seen little change in homebuilding debt levels. (Please see the table below.)
Net Debt
Stockholder's Equity
Net Debt/Equity
10E
06
10E
06
10E
06
Beazer Homes (NYSE:BZH)
705
1,671
397
1,730
1.8x
1.0x
DR Horton (DHI)
504
3,760
2,613
6,452
0.2x
0.6x
K Hovnanian (NYSE:HOV)
1,689
2,316
(260)
2,075
nmf
1.1x
KB Home (KBN)
871
2,220
632
2,923
1.4x
0.8x
Lennar (LEN)
1,921
1,952
2,609
5,756
0.7x
0.3x
568
406
1,020
2,162
0.6x
0.2x
Meritage (NYSE:MTH)
219
676
496
851
0.4x
0.8x
NVR Inc. (NYSE:NVR)
(1,100)
(199)
1,687
1,152
nmf
nmf
Pulte Homes (NYSE:PHM)
1,636
2,930
2,296
6,577
0.7x
0.4x
Ryland (NYSE:RYL)
107
735
520
1,693
0.2x
0.4x
Standard Pacific (SPF)
671
2,159
641
1,834
1.0x
1.2x
Toll Brothers (NYSE:TOL)
401
1,141
2,556
3,424
0.2x
0.3x
Average
683
1,647
1,267
3,052
0.5x
0.5x
Total
8,191
24,262
15,207
41,629
0.5x
0.6x
Total figures for 2006 include CTX.
Click to enlarge
Stockholder’s Equity
From its 2006 peak of almost $42 billion, public builder stockholders' equity has suffered a drop of 63% (as the table above indicates). Overall, with debt falling as fast as equity, industry-wide net debt as a proportion of equity, at 0.5X, is down moderately from five years ago.
The entire decline in book value decline is accounted for by impairments and other land related charges. These charges, which include option write-offs, add to $28.5 billion since 2006, as the below table indicates. The three largest builders, Pulte, D.R. Horton and Lennar, have each taken land related charges of close to $5 billion, accounting for more than half of the industry total. Meanwhile, NVR has only written down about $600 million of land and options, not surprisingly the least, thanks to its unique land-light business model.
Inventories
Land Charges
Cumulative
10E
06
10E
06
5-yr
Beazer Homes
1,204
3,608
50
44
1,324
DR Horton
3,449
11,343
65
271
4,557
K Hovnanian
1,002
4,071
136
336
2,299
KB Home
1,697
5,752
20
431
2,469
Lennar
4,361
7,831
59
628
4,725
MDC
383
2,753
4
112
1,204
Meritage
715
1,536
2
78
784
NVR Inc.
600
734
(1)
174
594
Pulte Homes
4,969
9,446
90
410
4,974
Ryland
730
2,771
30
63
1,204
Standard Pacific
1,118
3,472
-
309
2,155
Toll Brothers
3,242
6,096
119
152
2,272
Median
1,161
3,840
40
222
2,214
Total
23,469
69,913
573
3,008
28,561
Click to enlarge
Centex included in Pulte’s 2006 inventory level.
The End to Big Impairments
Since 2007-8, when more than $21 billion of these $28.5 billion in charges were taken, write-downs have steadily declined. In the past year (2010), industry-wide adjustments on land values approached pre-bubble levels, and now many builders are operating at or above breakeven – including charges.
Deep ongoing impairments are the greatest risk to stockholder’s equity and thus the valuations of homebuilders. To purchase the builders at the current level, of 1.5-1.6x book value (please see table below), requires confidence that existing inventories are solid - not vulnerable significant downward adjustments – and that profitability is likely in 2011.
Land purchased in the past two years (at relatively reduced or distressed prices) accounts for the majority of existing inventories. In fact, at least three-fourths of recent home sales contract signings at MDC and TOL, to name a couple, are for homes being built on land bought since early 2009. For the most part, these land deals are being underwritten to imply ROI and gross margins of at least 20% based on current sales prices, suggesting a cushion of at least 10% on home prices before further material impairments are triggered. Of course, homes sold on land purchased prior to 2008 is subject to impairments but that land has already suffered one, if not multiple, adjustments to carrying value.
Assuming the three to four percent decline in home prices for 2011 that I forecast last November, the overall group should be profitable this year. Valuations are still cheap enough that if profitability can stabilize around 2010 levels, amid what is broadly expected to be a difficult climate, then investors will be able to look toward the latter part of this year and 2012 with confidence that profitability could grow meaningfully.
Price / Book
11E
10E
09
08
07
06
Beazer Homes
1.1x
1.0x
1.0x
0.2x
0.2x
1.1x
DR Horton
1.5x
1.6x
0.9x
0.5x
0.4x
0.7x
K Hovnanian
nmf
nmf
nmf
0.4x
0.3x
1.0x
KB Home
1.6x
1.8x
1.5x
1.3x
0.9x
1.4x
Lennar
1.4x
1.4x
0.9x
0.5x
0.7x
1.4x
MDC
1.3x
1.4x
1.1x
1.0x
1.2x
1.2x
Meritage
1.5x
1.6x
1.3x
0.7x
0.4x
1.5x
NVR Inc.
2.4x
2.5x
2.4x
1.8x
2.4x
3.1x
Pulte Homes
1.4x
1.4x
1.2x
1.0x
0.6x
1.3x
Ryland
1.5x
1.6x
1.5x
1.0x
1.0x
1.4x
Standard Pacific
1.3x
1.5x
0.9x
0.4x
0.2x
0.9x
Toll Brothers
1.3x
1.3x
1.2x
1.1x
0.9x
1.4x
Average
1.5x
1.6x
1.3x
0.8x
0.8x
1.4x
Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.