I pulled a half-dozen of the larger builders off a list, and went to work assessing where they are in terms of industry positioning, customer base, risk of impairments, etc. Because earnings are going to be so erratic, I used price-to-book for valuations.
The primary companies I focused on are Centex (CTX), D.R. Horton (DHI), KB Home (KBH), NVR (NVR), Ryland (RYL), and Toll Brothers (TOL), although my studying also led to some general observations about the industry as a whole. One primary area of concern has been the increase in land inventory compared to total revenues; this ratio is at a high not seen since 1991 and is accompanied by investors waiting for homebuilders to take losses and write-down the value of their land, a process that is beginning to occur. We note that early 1991 was, perhaps not coincidentally, the bottom for CTX, KBH, and TOL, which were all publicly traded at that time. Because of the time-consuming process of purchasing and developing land, there is often a significant lag between homebuilders’ investments and payoffs. As homebuilders slow (but not stop) investing in new land, it should increase free cash flows, as FCF yield tends to run inversely to fundamentals.
Although investment in land through the 2005-2006 top in housing varied greatly among companies, we feel it is only one facet of a homebuilder to consider. For example, TOL was one of the largest purchasers of expensive land in 2005 and 2006, however, its position as a leader in luxury housing means that it will have more flexibility to pass on costs to their customers. KBH was also a recent large purchaser of land, although not to the same extent as TOL.-With the difficulty of pinning an accurate P/E or EV/FCF on these stocks, Price-to-Book is going to have to be the metric of choice. In 1991, housing stocks bottomed at 0.5x book, and in 1999-2000 they bottomed at 0.75x book. I find it hard to believe that housing stocks will trade at a significant discount to 1x book value on average; the average P/B of the housing stocks here is 1.22.
We believe that the bottom for housing stocks on a P/B basis will be higher than either of the previous scenarios, due to improved capitalization of balance sheets (as seen by generally decreasing leverage) and industry consolidation. Under our reasoning, the sector actually bottomed in July 2006 at approximately 1x book, and the successive higher lows seen in a number of stocks as well as XHB are encouraging, even as the general consensus says that homebuilders have further to fall.
Centex: Centex likely has, proportionally speaking, more older land than other builders. This will be beneficial for the company down! the line as it needs to expense less-costly land and also incurs less of a risk from asset impairments. The majority of Centex’s exposure to recent expensive land comes in the form of options, which the company can walk away from at a much lesser cost than would be occurred if it had bought the land outright.-Centex currently trades for 1.17x net book value, and because of the company’s wide geographic footprint and land age, we believe that 1.40x current book is a fair multiple — giving CTX a fair value of $54.80, or 19.6% above Monday’s close.
D.R. Horton: D.R. Horton primarily markets its homes to first-time buyers, as well as first-move-up customers. Being in the lower end of the market, the company’s base is more reliant on the availability of easy credit; this should be detrimental to the company over the next several years as we believe interest rates are not likely to decline anytime soon due to various macroeconomic and political factors.-DHI sees a majority of its revenues from Midwestern operations; this area was generally less prone to bubble-type market conditions compared to areas in the Southeast, Southwest, and West. The tradeoff for market growth potential comes at a reduced risk of overpaying for land, so we believe DHI will write-off a lesser proportion of land than average, given its purchasing patterns.
Don Tomnitz, CEO and President at D.R. Horton, recently was quoted as saying “2007 is going to suck” as well as “We may have more impairments coming!.” Given DHI’s business strategy, we admire his honesty and are largely in agreement. In our opinion, DHI should trade at a slight discount to the overall homebuilder group in general, plus the specific-risk of asset impairment must be taken into account. Our fair P/B multiple will be 1.30x current book, and with the company trading at 1.17x book right now we believe it is slightly undervalued - our DHI target is $25.13, or about 11% upside.
KB Home: KBH aims at targeting more entry-level homebuyers, a segment we would prefer homebuilders to have a minimal dependence on. We do, however, believe that KBH has been more conservative in terms of loading up on pricey land, and more aggressive in moving units; both positives. KBH also has exposure to the French market with operations in that country, which will provide much needed market diversity to help the company weather the current downturn - something we feel the market is overlooking.-Because readying land does not add value in terms but is more about minimizing cost, KB Home scores points here for minimizing its involvement with the land development process, which has seen rapid increases in the cost over the past several years.-KB Home’s owned land is fairly old compared to the general homebuilding group; with a large majority of that land being bought in 2004 and before, when land prices were relatively low. KBH does have a significant amount of options which were negotiated in recent years, however, adding to impairment risk there. KBH currently trades at 1.44x current book and we believe that the company should trade at 1.4x current book given the small to moderate impairments we see being likely; this puts KBH as being overvalued by about 3% giving a target price of $42.50.
NVR: NVR is the most conservative homebuilder in terms of how it handles investments in land. NVR exclusively uses options to purchase land and only takes possession when it is ready to develop. NVR is also unique in that it has more cash than debt. Because of this business strategy, NVR typically trades at a premium to the group, currently being at 4.0x net book value.-Another factor in NVR’s superiority to the general homebuilding group has been its lack of involvement in plot development, where the costs of readying land for building have soared. As we noted earlier in talking about KBH, exposure to land development is generally not positive, with the primary exception being in the case of TOL, which has the engineering expertise necessary to lower costs.
Because of NVR’s unique characteristics and the age of its options contracts, which were generally negotiated during years when land was cheaper, we believe 3.5x current book is a fair multiple for NVR; this puts the company’s shares as being worth $680.
Ryland: Ryland pre-announced lower results for Q1 2007, in part because of impairment charges that are being taken. Operationally, however, Ryland’s results were above expectations, and it looks to be one of the better prepared builders with low debt levels and low levels of land inventory. The company should also benefit from having negotiated most of its land and options in 2004 and prior.-We feel that RYL should trade around 1.55x current book (net of the announced impairment) given the company’s generally sound operating procedures; with RYL currently trading for 1.36x book, we see the shares as being worth $52.15 - 14% upside.
Toll Brothers: Toll Bros. maintains the largest land bank in the residential construction industry by a wide margin, with estimates placing land reserves equal to six years of construction. TOL’s market position should allow it to expense more expensive land acquired in recent years over a period of time, allowing the company to maintain its normally high gross margins.-Because TOL focuses on the high-end segment of the housing market, the company should also prove to be more resilient to credit tightening or regulation, as its customers are less dependent on generous financing terms.
Despite the age of TOL’s land, its options contracts are weighted to the most recent (expensive) years. Although the traditionally long carrying process the company uses gives it the possibility that land values will rebound, at some point TOL will either need to use and expense the more-costly land taken from the options, or will have to write the deposits off. TOL will likely be impacted further down the line by the industry changes of the last several years, which could give investors a skeptical view of the stock until the impact of 2005/2006 is completely clear. TOL currently trades at 1.29x book, and we believe a fair multiple for the company is 1.45x current book; from this, we see upside of 12.5% to $32.80.
Lest we be seen as too optimistic about homebuilding stocks, let it be known we have chosen to focus primarily on the higher-quality plays; we have been and are negative on Technical Olympic (TOA), and also believe that stocks like Levitt (LEV), Orleans Homebuilders (OHB) and WCI Communities (WCI) are value traps that should be avoided.The bottom line on housing is that, yes, there do appear to be some values – but investors need to be very selective and go beyond P/B to look at what comprises the actual book values; otherwise, one might end up in a value trap like TOA at $10. Up until last week’s surge, I favored NVR, but now I simply think the stock is too richly valued, leaving CTX my current preferred choice, with RYL a close second.
Although I’m never one for technical analysis, I can’t help but ignore the series of higher lows XHB has been showing, and while the recent run-up might be a bit of a false rally and due for a pullback, if it can once again hold above $32, my confidence in housing stocks will be greatly increased.