With an assist from mortgage industry liquidity, mighty demographic trends enabled the U.S. housing market to cruise with considerable equanimity through two soft landings, in 1994-95, and again in 1998-2000. Since June 2004, the Federal Reserve ratcheted back rates on a typical tightening cycle, with 15 increases of 25 basis points each in the federal funds rate, to the current 4.75 percent. Now, 30-year fixed rates are at 6.5 percent, up over 150 basis points from their low in June 2003. So naturally, housing demand has slowed, and we believe a third soft landing is unfolding.
As trends become clear, questions arise as to how the big builders will navigate through a slowdown in end-market demand. We continue to forecast double-digit earnings per share growth through 2006 and 2007, as we expect these companies to gain share, owing to their vast product breadth and geographic footprints. A few years ago, a similar market downturn in housing in the United Kingdom was deftly managed by its public builders. Investors rewarded them with higher multiples.
QUALITY OVER QUANTITY At the end of 2003, U.K. home building stocks traded at 5.4-times forward earnings, representing a 60 percent discount versus the local stock market. Similar to the environment currently challenging U.S. peers, this discount directly traced to market concerns about the potential for a steep business fall-off, as average home prices had risen by an 18 percent compounded annual rate over the previous three years, and affordability was stretched.
From that point, through the fourth quarter of 2005, total housing transactions, including both new and existing sales, fell 22 percent year-over-year. Acting in response to this decline and the Bank of England's interest rate increases, public U.K. builders exercised constraint and reduced their own sales volumes. As a group, they curbed unit deliveries by 5 percent year-over-year for the six months ended June 2005.
British public home builders focused on stabilizing prices to protect unit profitability, rather than increasing incentives to push volume. As standing inventory was kept to a manageable level, national house pricing remained stable. In fact, house prices for the public builder sector actually rose 2 percent during the first half of 2005. Since the U.S. slowdown has started to unfold, several of the builders, such as KB Home and Pulte, have cut their projected delivery targets, and as a result are discounting less than their peers. This measure can help them insulate their margins.
DISCIPLINE IS KEY Even amid their restraint in pushing sales, the average operating margins for the U.K. builders declined by only 161 basis points for the first half of 2005. A closer company-by-company look reveals a 420 basis point spread between the best and worst performer. Stronger management teams addressed overhead costs proactively at the first sign of the slowdown and were able to insulate their margins more effectively. EPS declined a mere 5 percent in 2005, compared with a 22 percent compounded annual growth rate over the prior five years.
By the end of 2005, U.K. investors started to believe that their anxiousness about a housing bubble was premature. Pricing and margins did contract somewhat, but the decline was not as severe as some feared, in part because the builders course-corrected their operating models to focus on profitability and built only to order. The big reward: U.K. stocks have risen 60 percent since December 2004 to 9.6-times forward estimates. We believe U.S. stocks will be rewarded with higher multiples if they navigate these rougher months with a keen eye on operating disciplines.
Margaret Whelan is an analyst with UBS Investment Bank.
COMPARE & CONTRAST The British housing industry as the cycle peaked in the third quarter of 2004 shows strong similarity to the current U.S. housing market.