By Roberta Maynard. With her core group of builders trading at 6.4 times 2003 estimated earnings, Ivy Zelman, of Credit Suisse First Boston, caught more than a few people off guard when she downgraded several builder stocks. In her early November report, she said that despite the stocks' discounted valuation, "which we believe already reflects the more challenging housing market, we have a Neutral view on the home builders, given our increasing inability to adequately defend the bull case."

"Well, she has to fill the pages of her report," remarked one builder CEO soon after hearing the news.

Zelman referred to "negative data" as factors in her decision to downgrade. One bit of data was the increased competition in the mid to lower price points, territory many builders gravitated toward in response to the softening in the luxury segment. She also pointed to the increased use of concessions and incentives by builders in a number of markets, including Atlanta, Charlotte, Raleigh, and Denver.

Summing up, she says, "Although we do not expect the housing market to collapse, the so-called bubble to burst, or expect to cut our 2003 earnings estimates, we no longer feel comfortable telling investors to put new capital in the group."

Good Old Days?

Last April, the picture was different. Builders thought they were making headway in telling their story of breaking out of the business cycle. To everyone's delight, home building had refused to be drawn into the overall economic malaise. Zelman's group had a P/E of 9.0 times earnings — a level that "still offers investors significant upside," she reported.

But public builders weren't satisfied with those numbers, either, given the strength of their performance. And the subsequent drop in valuations — despite healthy backlogs and new order increases that seem to answer the criticism that builders would crumble in a down cycle — has left some vexed and perplexed.

"It's the most disappointing thing that's happened to me in my 25-year career at DHI," says Don Tomnitz, CEO of D.R. Horton, of the valuation doldrums. "After 25 consecutive years of increased growth and profitability, why shouldn't we be selling at 20 P/E?"


Maybe soaring success on Wall Street isn't meant to be. In the hot dotcom days, the argument was that from an investor viewpoint, home building wasn't sexy as technology. "It still isn't," notes Merrill Lynch's Joseph Sroka. Pointing out that the S&P 500 was at 22x in October, down from 26x the previous October, he says builder stocks' decline is in concert with the drop in the rest of the market. "For builders, we think nine times is a reasonable place to be, based on historical information," he says.

Still he acknowledges that the standards for the industry tend to shift. "The market used to say, 'Let's see how they perform in an economic downturn.' Now, assuming the group is being buoyed by low mortgage rates, it's saying, 'Let's see them when interest rates go up.' "

There are still those, he adds, who think builders should be valued on the basis of price to book value, that builders are only worth the value of their land. "The camp that just sees them as land banks hasn't gone away," adds Sroka.

The truth is, Sroka says, it's not that the builders are no longer cyclical. "It's that they're less vulnerable to the cyclicality."

But Chad Dreier, Ryland's CEO, says that builders' relentlessly enthusiastic pitch to Wall Street has fallen on deaf ears. "I don't think Wall Street buys the story that home builders have changed."

Bright Spots

Though naysayers remain, so do cheerleaders. Rick Murray, an analyst with Raymond James & Associates, says the group's fundamentals are positive for the industry, and that demographics should continue to support demand for new homes. "This is a tremendously compelling investment story for me," says Murray. "The group has shown its ability to perform." Though the multiples for this group have been volatile, he says, median has been in the 10x to 12x range. "Assuming their continued performance," Murray says. "it's certainly reasonable that this group should return to that range."

The rate at which the big builders are growing should help that process along. Consolidation — and the leverage that comes with it — he says, is a significant benefit for the public companies' Wall Street success.

Published in BIG BUILDER Magazine, December 2002