Eric Boughton_

Time to Buy the Homebuilders

A few problems with your analysis, Herb. First, the U.S. Census Bureau estimates that U.S. population grew by only 2.8 mln people between 7/1/07 and 7/1/08. (www.census.gov/popest/...)
Second, even this data is fraught with potential errors, with extremely limited data on net migration leading to reliance on extrapolative techniques.
Third, the net movement of people from single-family houses into multi-family dwellings, which may be starting and may persist on a secular basis for quite some time, could offset any population growth.
Fourth, the total number of families owning multiple houses is likely to decline for some time as well, offsetting new home construction.
Fifth, when viewed over a long period of time, the average age of houses is lower than normal.
Sixth, from about 1997-2006, the total number of new homes was far in EXCESS of the number demanded purely by population increases. So, why would we think population changes going forward over the next 10 years would be at all correlated with the number of new homes built?
Seventh, specifically related to your bullish position on homebuilders, homebuilder stocks are, by and large, already pricing in the return of demand, and the ridiculously high margins achieved at the peak of the bubble. For example, consider TOL. During its best twelve months (5/1/05-4/30/06), TOL achieved $6.4 bln in sales, $1.4 bln in operating income, and $870 mln in net income (approx $5.15 per share with adjustments). This was a 22% operating margin, and a 14% net income margin. Consider, however, that from FY94-97 ("normal years"), TOL's operating margins averaged 14% and NI margins 7%. Which is more representative of TOL's business over the coming decade? You can have your opinion, but mine is that the 14% and 7% are much more likely, and in fact that 10% and 5% would be likelier still. The opulence of the past 20+ years is gone... for good!
In any case, assume for a moment TOL generates a revenue run rate 25% HIGHER THAN its trailing twelve month sales (so from $2.7 bln all the way up to $3.4 bln). Keep in mind, that would EXCEED their average annual sales in 2003-2004! A generous assumption, to say the least! By comparison, analysts expect only $1.6 bln in sales in FY2011.
Now, apply, say, 6%, net income margins to the $3.4 bln, and you get $204 mln of net income. That's a PE of 15.8, several points higher than the S&P 500! With a bunch of generous assumptions. Clearly, the market is already banking on quite a turnaround.
I use TOL as an example simply because it is one of the least leveraged of the homebuilders. Clearly, with several other homebuilders where bondholders own more of the company than shareholders do (9 of the 17 homebuilders I follow have net debt in excess of market cap, and only 3 have investment-grade (BBB-) credit ratings.), the stock represents much more of a call option on survival. Good luck with those!