HOME BUILDER STOCKS HAVE taken their lumps in recent months. The top five builders saw share prices plunge 25 percent or more in late March and April before recovering modestly in May and June, though remaining well below their first-quarter peaks. But some analysts believe the stage is set for builder stocks to surprise to the upside in the next six to 12 months despite rising interest rates. Their theory: Interest rate concerns will take a back seat to higher earnings, P/E multiple expansion, and industry consolidation in driving share prices.

Greg Gieber, a vice president of equity research at A.G. Edwards & Sons, predicts that “home builder stocks will be higher by next summer although they could still deteriorate further this year.” Gieber says he expects higher interest rates and a downturn in the building cycle to affect share prices adversely in the short run. Longer term, however, Gieber says he believes that “investors will assign higher valuations to those builders that demonstrate they can grow earnings and revenue in a declining housing market through increased penetration.”

Wall Street does not currently recognize this is happening, but will eventually wake up to the fact that these stocks represent a new and different investment proposition—one not tied to the building cycle—and that they warrant higher valuations, he says.

Jack Kasprzak, equity analyst at BB&T Capital Markets, holds similar views. Despite the recent anxiety over interest rates, “we don't see why the housing market gets worse as the economy gets better,” he says. “Interest rates are up, but employment gains and rising incomes are good for housing.”

Kasprzak is “very bullish” on the market share opportunity that exists for the very large public builders. Consolidation is taking hold in the home building industry, he says. “It's getting harder to acquire land and obtain entitlements for development, creating opportunity for large builders to take market share,” he says. “It's not unrealistic to think they could double their shares and grow faster than the industry average,” he says.

Margaret Whelan, executive director at UBS Investment Bank, “agrees fully” that market share consolidation will be a powerful trend driving certain home builder stocks higher in the future, but she focuses primarily on multiple expansions.

Whelan says that home builder stocks are headed “higher for sure” in the next six to 12 months. “I believe they will outperform the market,” she says. P/E multiples are below their historical average and the stocks traded down 30 percent from their peak when a hike in interest rates began to be discussed in May. “The market has already discounted the rate hike,” she says.

Multiples will expand, she says, “because the fundamentals are so strong.” Earnings, not interest rates, will drive share prices going forward because, in Whelan's view, rising interest rates don't cut into demand for housing until they exceed 8 percent (versus 6 percent today) on a 30-year fixed mortgage. She compares the current situation with 1995 and 1997, when multiples on home builder stocks expanded after the mortgage cycle peaked.

Builders not surprisingly remain equally bullish. J. Larry Sorsby, executive vice president and CFO of Hovnanian Enterprises, notes: “Recessions have always been followed by three to four good years for home builders, and we don't know why it would be any different this time.”

“Investors think rising interest rates will crush home builder profits, but nothing could be further from the truth,” Sorsby says. From March to May 2004, 30-year mortgage rates increased 1 percent, but Hovnanian's orders were up 62 percent in dollar terms in April over the prior year and jumped 39 percent in May, Sorsby told BIG BUILDER. “We're already proving we can perform in an uptrending rate environment,” he says. But it will take about three quarterly reports of strong margins and orders for investors to catch on, he says.

The increases in Hovnanian's orders came despite an apparent softening in housing starts and mortgage applications. Big builders are finding ways to increase productivity, making it harder for small- and medium-sized builders to compete, he says. Hovnanian has secured contracts on favorable terms with more than 20 national suppliers for appliances, cabinets, flooring, and other items.

Hovnanian is also testing vertical integration, which would bring some component manufacturing, distribution, and installation in-house. Vertical integration can significantly boost margins, Sorsby says.

If Sorsby and the analysts are right, the home builder group represents significant undiscovered value. Investors who can tune out the chorus lamenting higher interest rates should do very well.