Home building executives and investors alike will remember 2003 not only as a year of record orders, revenues, and earnings, but it was also the year when builders had to confront a mounting dilemma of what should be done with the surge in cash flow.
While most builders saw—and acted on—the opportunity to repurchase shares, the more vexing question was whether to increase dividend payouts to shareholders, and by how much.
Early in 2003, as the Bush administration seized on the flaws of double taxing corporate dividends, Citigroup home building analyst Stephen Kim published a report suggesting builder valuations could illustration: stanford kay benefit from an aggressive distribution of cash to investors while maintaining healthy growth rates. Although many builders could profitably reinvest cash flow in their businesses, Kim argued that slower growth combined with cash distribution would both improve margin and asset turns and lower upward pressure on inventory levels and land prices.
His own survey of institutional investors indicated that 57 percent of them reported a preference for dividends. “We believe such an approach would significantly raise the profile of the builders and could dramatically alter the way in which the group is valued,” wrote Kim. After President Bush's proposed changes to the tax treatment of cash dividends were passed by Congress in May, it wasn't long before builders took action.
Denver-based MDC Holdings announced a 53 percent dividend increase in August to what was then the highest quarterly dividend paid by a home builder. Chairman and CEO Larry Mizel's message at the time was consistent with Kim's thesis. Mizel explained that the move was one part of a program to enhance shareowner value along with “growth through investments in new communities and augmented by our authorized share repurchase program.”
Miami-based Lennar Corp. and KB Home of Los Angeles followed quickly in kind. Carl Reichardt, home building analyst at Charlotte, N.C.-based Wachovia Securities, underscored the implications of Lennar's announcement in a research note, observing the competitive advantage driven by “market share gains [that] have made home builder earnings more stable today than in the past … . This news is a clear positive for Lennar and the sector given the signal it sends.” The message that higher dividends weren't coming at the expense of future growth was echoed by Bruce Karatz, KB Home's chairman and CEO. “Our decision to increase the dividend reflects KB Home's strong financial position, sustainable operating earnings, positive free cash flow, and the overall prospects for our business, without limiting our ability to profitably grow and reinvest in the business,” said Karatz.
While bears doubt the sustainability of margins and free cash flow, Margaret Whelan, home building analyst for UBS Warburg, disagrees. “The business model has changed in that builders are now optioning land, which frees up cash from inventory and allows for a higher free cash flow yield,” she says. According to Ryan Caldwell, investment analyst at Waddell & Reed Investment Management: “Equity investors still haven't caught on to the cash flow in this business. Debt investors have, so to the extent that [increasing dividends] helps, I think it is positive.”
Although home builder dividend increases have been well received, some analysts contend they would generate significantly more interest if the resulting yields met or exceeded market levels. “If your fund mandate is that companies have to have a dividend for you to invest, it helps,” says Caldwell.
“I think the largest, best long-term slot for the builders is in growth and income funds, but they need dividend yield,” says Jim Wilson, director of research at San Francisco-based JMP Securities. “At yields of two [percent] to three percent, I think the institutional and retail pool would open up a lot more.”