On July 23, The Wall Street Transcript interviewed Eric Landry, a Senior Analyst and Associate Director at Morningstar, Inc., covering homebuilders and some diversified industrials. Key excerpts, including his sector outlook, follow:
TWST: It has been a tough couple of quarters. Where do we stand in the housing cycle now?
Mr. Landry: First off, I think it's important to figure out what we're dealing with here, and as a business, we are not great fans of the traditional homebuilding model for several reasons. One, it's extremely capital intensive. Two, there are weak barriers to entry. Three, there are no captive customers. The variable cost model makes for very little scale opportunity (although you heard otherwise during the bubble). And last and most important, incremental returns on capital are always the worst precisely when the traditional homebuilder has the most invested. We saw that very clearly in 2006, and we are living with the ramifications today. It's likely that returns on capital industry-wide aren't going to be much to speak of for the next few years and maybe longer depending upon how long the current slump lasts. Having said that, it's awfully easy to beat up on the homebuilders nowadays, and we think it actually makes more sense to be buying some of these stronger homebuilders than selling them at current prices. Even though the industry ills and headwinds are stiff, it's likely that a lot of that is already reflected in the price of these builders, some of which have done a better job than others preparing themselves for this downturn. When dealing with a highly competitive industry such as this, management matters a lot. Today's conditions are giving the better teams a chance to separate themselves from the pack. You couldn't say that two years ago.
TWST: As you look at the business, where do we stand in the cycle? Is that not important?
Mr. Landry: It's extremely important. The problem is it's not easily figured out. If it were, the industry wouldn't be saddled with all the extra inventory. That said, it's helpful to take a look where the industry's been in terms of supply and demand to get a view of what it's up against. It looks to us like the country as a whole is currently saddled with at least a 1 million-unit oversupply of housing units. How do we arrive at that estimate? There are several avenues, the simplest of which is to look at the housing vacancy survey put out quarterly by the Census Bureau. Currently there are about 2.2 million vacant owned houses for sale, or 2.8% of total owned units. That's an all-time high. We have never seen anything like it before, neither on an absolute nor a percentage basis. Looking back a couple of decades, the series has averaged a vacancy rate of about 1.5%-1.65%. If you assume that's equilibrium and do the simple math, you get somewhere between a 900,000 and 1 million-unit oversupply. This doesn't include homes for sale that are currently occupied, so it may be conservative. Let's assume, though it's accurate. Going forward, household formation is the primary driver of housing demand over the long term. Interest rates and, to a lesser extent, job formation are much more powerful factors over the short to medium term, but both are more difficult to forecast. Simply stated, it's tough to build more houses than households that are formed and expect to stay in equilibrium. So if you look at the demand side, there are several demographers forecasting that somewhere between 1.3 and 1.6 million households will be formed annually over the next decade. This is an increase from the prior 10 years due to the fact that echo boomers will be entering prime headship age and strong immigration. Add to that an estimate for net removals (through disasters like fire, hurricanes as well as dilapidation and teardowns) plus demand for second homes, and you get total housing demand of somewhere between 1.7 and 2.2 million units annually. Starts peaked at almost 2.1 million in 2005, fell to about 1.8 million in 2006 and probably will be down another 20% to 30% this year. So if demand is at the high end of that 1.7 to 2.2 million range, and current production is somewhere around 1.5 million, you can see that oversupply should be soaked up in a relatively short period. If demand is on the lower end of that scale, and production rates stay where they are, it's going to be a squishy market for quite some time. Of course, you've also got to think about the percentage of that total production allocated to single family and town homes, the bread and butter of almost all the builders. Several factors play into that, of which affordability and lending standards are paramount now. Neither is pointing in the right direction, and it's our best guess that purchased homes (as opposed to rental construction) will be a smaller chunk than in the recent past as the homeownership rate backs off of its historic highs of near 70%. Any way you look at it, it is easy to see why these builders are hitting three-year lows right now. Short interest is off the charts and news flow is almost unendingly negative because the headwinds are stiff. There is no way around it. Having said that, we like the prices produced by this extreme amount of pessimism.
TWST: If you were looking for names, where would you start?
Mr. Landry: There are a number of builders that have positioned themselves extremely well to benefit from others' pain. At the top of the food chain is M.D.C. Holdings (MDC). The company owns about 17,500 lots as of March, which is enough to satisfy only about two years worth of production, one of the lowest levels in the business. It also has very few options. So if you look at its total inventory position, it only has land to satisfy about three years worth of work under current conditions. Assuming land will be cheaper going forward (which we do), a short land position is very advantageous. Its net debt, at about 8% of trailing 12-month sales, is lower than any other builder save NVR. (We use debt against sales to eliminate the differences in share repurchase programs.) In this environment, balance sheet strength is paramount. And because M.D.C. has as much of it as anybody, we see opportunities going forward. It can look at land deals while most others can't, and won't be forced to shrink its balance sheet in a destructive manner. It currently trades at a slight premium to book value, so it is not quite as cheap as some other less well prepared builders, but we think M.D.C. is likely to be more profitable quicker when this downturn bottoms. Relative to the group, the company is also producing a tremendous amount of cash as it builds a war chest in anticipation of opportunities farther down the road. So M.D.C. has its financial house in order, and it is entering this downturn with the ability to take advantage of others' pain.
KB Home (KBH) is also a name that is interesting here. It has maintained a strategy all along of only building small communities, usually about 250 homes or less. The benefit is that you get in and out quickly, lowering the risk of getting caught in a downturn with unattractive product. Essentially, because of its lower-risk strategy, KB Home has the ability to retool quicker than the folks who build these massive communities where they are stuck there for 10 years. Consequently, KB Home, which already does sell a very low-cost product, increases the attractiveness of its homes in an environment where affordability is low and getting lower due to an evaporation of funding for marginal credits. In fact, management thinks that about three quarters of KB communities that were open in the spring of last year are going to be cycled through by the end of this fiscal year. They will then have new communities on new cheaper dirt with slightly redesigned products that are going to be more affordable. The company had some easy comparisons in the just-reported second quarter, but its order performance, only down 3%, was impressive to us. Also interesting is that management just sold the company's best performing division, its French homebuilder, for $800 million. The transaction probably means management sees ample investment opportunity here in the States going forward. KB's balance sheet is also pretty strong, with about four and a half years worth of land and pro forma net debt totaling a bit more than 20% of trailing sales. Priced around book value, you are paying nothing for a business that is likely to be in pretty good shape after things shake out.
Lennar (LEN) is a Miami-based homebuilder that is doing as much and probably more than any other builder to innovate its model. On the construction site, it is introducing some Toyota production systems-like methods into its homebuilding operation that are designed to spread its SG&A costs more equally throughout the year. It's also been using some vacant land it owns in California to continuously build and rebuild houses in a controlled environment in an effort to find efficiencies. Of course, efficiencies aren't a terribly sustainable competitive advantage, but it will allow for some cost savings for a few years.
TWST: How about the other side of the coin? Is there anybody that is not going to make it or is going to be dragging along coming out of this?
Mr. Landry: There are several names right now that we have a speculative rating on, which means it's very difficult to tell what is going to happen. Of the companies that we cover, TOUSA, Inc. (TOA), formerly known as Technical Olympic USA, is an obvious choice as a company where it is difficult to tell what is going to happen to equity holders. TOUSA entered into a JV in Florida at the peak of the market in August 2005. The thing was highly levered, and the debt that TOUSA had described in their filings to investors as non-recourse has turned out to indeed be recourse. The end result is that TOUSA has had to consolidate the JV's assets, which are worth about half of its $800 million in liabilities. Debt to cap has climbed to unstable levels, as TOUSA took over the $400 million in senior debt. Further clouding the outlook is the fact that the former mezzanine lenders received convertible TOUSA preferred stock and warrants at favorable terms. It is our view that the company needs to sell some assets here in order to get their capital structure to a more sustainable level. Now, if they are not able to sell these assets, anything could happen. It's our view that they probably will be able to sell assets, but at prices less than book value. The result is that further impairments are in the cards. Current tangible book value is around $10, but likely materially lower on a forward measure.
WCI Communities (WCI) has a lot of debt and it has a receivables balance that is growing due to the nature of its tower business, but there is some acquisition interest there.
Orleans Homebuilders (OHB) has a lot of leverage, with debt to trailing sales of 68%, on top of almost five years of owned land. So they are not nearly as prepared as some of the other builders, and it's our view that they will be trying to pare the balance sheet for some time. Levitt Corp. is a small builder operating mostly in Southeast Florida that hasn't had tremendous operating results for several years. It is much more levered than we are comfortable with, yet there are some intervening circumstances. There is a conditional bid out right now by the majority shareholder, BFC Financial (BFF), for all of the equity. A conservative sum-of-the-parts valuation indicates the net assets are worth much more than what the stock is trading for. It is just a problem of getting over the liquidity hump. If indeed the takeover fails, management is ready to do a rights and debt offering that, while not accretive to shareholders, may remove some of the liquidity fears. Those are a handful of companies that aren't nearly as prepared as those I mentioned prior. There is going to be a little different look coming out of this downturn than going in.