A CONTROVERSIAL ANALYST report contends that all is not quiet on the western front for home builder stocks. Entitled “California Gold Rush,” the August 2004 report from Credit Suisse First Boston (CSFB) argues that home builders are not as diversified as their widespread operations may suggest because their profits are concentrated in one or two states, notably California. Steve Scarborough, chairman and CEO of Standard Pacific, disagrees.

But first, let's look at the report. The argument goes like this: Home builders are not as geographically diversified as commonly believed because profitability is concentrated in California where new homes sell for double and triple the average price obtained in other markets. Growth in California is unsustainable. To maintain volume, builders will have to expand to lower margin markets both inside California and beyond. Thus, a downturn in California would negatively affect home builder earnings to a far greater degree than the companies' geographic diversification on an operational basis would imply. California will be the “Achilles' heel” for builders (the builders that CSFB covers) in the event of a housing downturn, the report predicts.

CALIFORNIA DREAMING The report specifically names Hovnanian, Standard Pacific, and KB Home as the least diversified in terms of earnings. Each derived approximately 70 percent of 2003 profits from California or California and one other state (Standard Pacific: California; Hovnanian: California and New Jersey; KB Home: California and Nevada).

Profitability Concentrated in California: “California has generated a disproportionate level of profits relative to units,” the report says. “In 2003, California accounted for approximately 35 percent of builders' aggregate home building operating earnings on average,” but only 17 percent of the units (see chart, left). Further, “Based on our profitability analysis, we believe that Ryland, Pulte, and Toll Brothers are the most diversified builders while Standard Pacific, Hovnanian, and KB Home are the least diversified,” the report says. The report also cites Beazer, Centex, D.R. Horton, and Lennar for inordinate concentration of profits in California. “The bottom line is that builder dependence on California will likely not change in the foreseeable future,” the report concludes.

Growth in California Unsustainable: Home builders have benefited greatly from robust annual volume growth in California of 8 percent in the past five years, but the state has experienced boom-bust cycles in the past, the report notes. Single-family permits declined 42 percent from 1980 to 1982, double the rate in the rest of the country. In addition, California experienced double-digit declines in permits and home prices in the early 1990s and the trend took far longer to reverse there than elsewhere in the country. Moreover, “throughout this past year [2003 to 2004], the state has displayed,” dare we say, “bubble characteristics that are worrisome, such as significant home and land inflation, aggressive financing, and speculative buying,” the report argues.

Low Margin Volume: The report describes California and other high-margin markets such as Nevada and Virginia as “land constrained” and already “fairly consolidated by the large public home builders.” Builders will have to look to lower margin markets “to keep the volume machine cranking.” When California slows down, watch for home builder profits to erode more than expected, the report concludes.

LOOKING DEEPER Scarborough is standing by his company's performance. “We've generated strong profits in the state of California for many years,” he says of Standard Pacific. “We've been straightforward about that.”

“It's not correct to look at the entire state of California as one market,” Scarborough says, adding that there are many different submarkets that are quite diversified and respond to different drivers. The fact that Southern California was unaffected by the 2001 tech slowdown in the northern end of the state is proof of that, he argues. Further, the Inland Empire region responds to different economic fundamentals than the higher-priced coastal areas. (Empire consists of Riverside and San Bernadino counties—the third largest market in the country.) “It's unlikely that a slowdown would affect all of the markets within the state,” he says.

California may be land-constrained, Scarborough says, but that's a good thing. The scarcity of land keeps margins high and makes it unlikely that the market will become overbuilt, he says. “There's strong pent-up demand for housing in California that the industry has not been able to satisfy,” he says. Regarding the assertions in the CSFB report that California has exhibited bubble characteristics, Scarborough says that he does see some demand on the part of investors, but it's difficult to quantify. Standard Pacific discourages speculation by requiring buyers to state that they will actually occupy their units.

Scarborough remains excited about California and says his company is uniquely positioned to take advantage of what remains an attractive market. “We've worked hard to diversify here,” Scarborough says. Additionally, “we have great positions in Florida and Phoenix and a recent expansion in Tucson,” he says, noting that the company has substantial product diversification. “We sell lower-priced attached units, luxury homes, and everything in between,” he says.

Learn more about markets featured in this article: Los Angeles, CA.