LAST YEAR WAS ONE OF SUPERLATIVES for the housing industry as a whole, and big builders in particular. The industry set and then quickly broke new-home sales records with regularity. In turn, public builders produced impressive operating performances, generating substantial revenue growth, high net income, and improved margins.

Investors in builder equities also had ample reason to cheer. In an improving economy with minimal fears about interest rates rising—what one analyst called a “goldilocks environment for home building stocks”—some builder stocks appreciated 150 percent or more. At the year's end, the group as a whole was trading at, or near, the top of its historical price-to-earnings ratios. Credit markets, too, smiled on the big public home builders. Many home builders saw their bond ratings upgraded, in several cases to the “investment-grade” level.

Fiscal 2003 was clearly a year of healthy returns. Among 21 public home builders, virtually all posted returns on equity (ROE) and return on invested capital (ROIC) that were equal to or better than last year's returns—yielding investors an average 28 percent ROE and 15 percent ROIC. With a couple of exceptions, last year's return rates were well above each company's respective five year averages (see Public Builder Report Card chart).

Leading Big Builder's 2003 ROE ranking once again is NVR. The McLean, Va.-based builder's 100 percent reliance on optioned, just-in-time lot inventories continues to give NVR a distinctly favorable-looking balance sheet. As a result, the company's $420 million in net earnings last year represented an 86 percent return on shareholder equity.

NVR, however, remains alone in its approach. Most public builders still believe long-term success depends on investing capital to lock up half or more of their future land supplies. That philosophy still produced impressive equity returns of 32 percent and more for Hovnanian Enterprises, William Lyon Homes, Orleans Homebuilders, and The Ryland Group; and comparably high returns for larger cap builders Lennar Corp., KB Home, and Centex Corp.

Public builders may lament that investors still aren't rewarding builders for their accomplishments, with year-end stock prices for the group still hovering around nine times earnings—well below the 20.3 average for the S&P 500 last year.

However, builders could hardly complain about 2003's run-up in equity prices. As a group, stock prices for the public home builders finished the year 114 percent higher, on average, than where they had started, outperforming the market for the fourth consecutive year—this year by a margin of some 78 percent points versus the S&P 500's reported 26.4 percent gain. Among the big gainers: Hovnanian Enterprises (up 175 percent), William Lyon Homes (up 188 percent), and small-cap Orleans Homebuilders, which appreciated 270 percent (see Stock Appreciation chart).

Measured Performance The public home builders “did very well—as well they should when you reach a 45-year low in mortgage rates,” says Barbara Allen, housing market analyst for Natexis Bleichroeder, a New York international investment bank and brokerage firm. “If you can't make good money in that environment, then there is something seriously wrong,” she said.

Home building industry bulls say the 2003 record indicates that public builders as a group, and certainly those with the greatest capitalization, have reached a new fiscal plateau. They are big enough and financially strong enough; have sufficient access to diversified sources of capital; and have the management structure and operational know-how to survive just about any foreseeable market storm and probably continue to thrive.

Yet in the midst of what amounts to a rosy industry-wide glow of accomplishment and optimism, there are more than a few skeptics who raise underlying questions they say are unanswered. Can the big builders sustain both the sales and the margin growth they currently enjoy and insist can continue? How well armored are they against the rise in interest rates? Are they sufficiently diversified to weather the inevitable cycles in regional housing markets?

Ivy Zelman, housing market analyst for Credit Suisse First Boston, remains wary about the significant cost increases for lots occurring in many key markets where public builders are counting on growth. She also questions whether builders can continue improving margins, especially builders with big footprints in markets where sales are proving sluggish.

Exceeding Expectations Overall, though, the housing bulls appear to have a good case. Last year, housing starts hit a 25-year high. Single-family home sales reached 1.085 million units, setting a new record for the third year in a row and fueled in large part by the nation's high-production builders.

By virtually any measure, the operating performance of the public builders exceeded those of recent memory. Every company on Big Builder's Public Builder Report Card achieved substantial revenue gains versus 2002, collectively growing 22 percent as a group. Net income for the 21 firms increased an even more dramatic 39 percent.

Among the big sales and profit gainers last year: Centex Corp.'s home sales grew the fastest among the big public builders, jumping 33 percent to $7 billion in the 12 months ending Dec. 31. Centex also saw a 31 percent rise in financial services revenues in 2003. The two divisions helped the diversified public builder become the first to surpass the $10 billion revenue threshold in calendar 2003. D.R. Horton, Pulte Homes, and Lennar Corp.—each with total revenues approaching that same threshold—all boosted sales last year by more than 20 percent (see Revenue Chart, page 34). Lennar Corp. led the industry in profits in 2003, generating net income of $751 million, although Centex and D.R. Horton were close behind; and both outpaced Lennar in earnings growth (see Net Profit chart).

D.R. Horton, meanwhile, led the industry again in U.S. housing production, delivering a record 35,954 homes in 2003 (up 21 percent over the prior year), while Pulte Homes delivered 32,693 homes, not including what it built in Latin America. Collectively, the public builders closed on more than 260,300 new homes last year—24 percent of the national total (see Home Closings chart).

Judging by backlogs and orders, big builders are clearly prepared to maintain their sales momentum entering 2004. Pulte Homes, for instance, finished the year with the deepest order backlog, valued at $4.14 billion, a 45 percent increase from the prior year (see Order Backlogs chart).

Pulte also had claim on an inventory of 256,000 additional lots, the highest of any of the public builders (see Lot Inventory chart). Toll Brothers, which ranked fifth last year based on backlog value, reported that its backlog for the first quarter, which ending Jan. 31, jumped 56 percent to $2.9 billion (5,094 homes) versus 2002, a quarterly record for the company.

Disciplined Growth At the same time, gross margins for the public home builders continued to improve in 2003, averaging 20.6 percent, compared to the group's five-year average of 18.5 percent. Net margins for the group also improved, averaging 7.5 percent in 2003 (see Net Profit Margin chart, at left). The increases were due in part to rising home sale prices in 2003; but it also reflected widening discipline to bring more of builders' revenues to the bottom line.

Big builders took a big step forward a decade or more ago when they dropped the “field of dreams, build-it-and-they-will-come model” in favor of a more disciplined “build-to-order” business model, says Lawrence J. Horan, Ph.D., and director of research for Parker Hunter, a Pittsburgh-based investment bank. As a result, builders rarely get caught with excess inventory or too much land today because they use sophisticated contracts to control land without buying it outright until they need it, he explains. “They are managing their capital much better by not getting involved in these risky situations,” Horan adds.

Public builders tend to be financially stronger and better balanced today, according to Jim Wilson, CFA, and director of research for JMP Securities, an investment bank and financial research firm in San Francisco. Lennar is a good example, he says. “They started the last economic expansion in '91 with a $100 million secured line of credit and not a lot of cash. They ended fiscal 2003 with $1 billion in cash and a $1 billion unsecured line of credit with nothing outstanding on it,” he says. The company's liquidity improved by some 20 times, Wilson adds. Lennar is an extreme example, but the pattern holds true for other public builders.

Armed with abundant cash in 2003, big builders further improved their balance sheets and overall financial positions. Many used their strong cash positions to secure more land either directly or by acquiring privately held builders. A number of builders, including Beazer Homes, Centex Corp., D.R. Horton, KB Home, Pulte Home, and The Ryland Group also elected to raise shareholder dividends. Virtually all the big public builders also took advantage of soft spots in the market to repurchase company shares—most notably NVR, which repurchased 15.7 percent of its shares during 2003 (see Share Repurchases chart).

Retail-Like Expansion Joe Sroka, director and equity research analyst at Merrill Lynch in New York, points out a host of factors that together suggest big builders are well positioned to keep growing for many years to come. On the sales side, for example, by continuing to increase the number of their communities, big builders help assure further market share gains, he explains.

“They're selling more units, not necessarily because of changes in the overall number of home sales in the economy, but rather because they have a larger number of locations where prospective home buyers can go and purchase a home,” Sroka says. This is an important piece of the puzzle that equity investors often miss, he adds.

“When I try to understand why these companies have more robust revenue or unit growth than I see in the overall economy, I think it's that they are increasing their base of business, both by building more densely in existing markets and by expanding into new markets,” says Sroka.

Toll Brothers, for instance, boosted its number of active communities from 117 to 200 over the past fiscal year, which ended Oct. 31. This is akin to a retail chain adding stores, Sroka explains. With more locations from which to sell, if sales soften so that you sell fewer units per location, you're still more likely to sell more units (all other things being equal) simply because of the greater number of locations. “This is the way these companies are gaining market share,” adds Sroka.

Geographic diversification affords some protection if the market softens. “Within a reasonable degree of home sales volatility, plus or minus 5 percent year over year, or maybe 10 percent, it gets to the point that these companies will still be growing as long as they are deploying capital,” Sroka argues.

That, in turn, makes the access to capital now enjoyed by the public builders an essential ingredient in the new stability they and the analysts who follow them claim they have. Capital from the bond market also gives them a competitive edge over smaller, privately held builders that rely primarily on bank financing. Bond borrowing is long term, typically five, seven, or 10 years. Bank financing is generally short term. Long-term debt gives big builders better control of borrowing costs and business overall.

“Having this fairly secure base of capital means that more of their growth is in their control than just what the housing market gives them,” Sroka says. “It provides financial flexibility.”

Improved Debt Ratings Jack Kasprzk, managing director of BB&T Capital Markets, an investment bank headquartered in Richmond, Va., echoes that thought. “To me, it is very important that the balance sheets are healthier, not just because the debt levels are lower than they were 10 or 15 year ago, but because of the diversified sources of financing they are using to grow and support their balance sheets. You've never seen builders do this before,” he states.

It's no wonder then that home builders brought a number of new debt issues to market last year. Calendar 2003 was “a great year for the home builders from a bond standpoint,” says John Forrey, managing director of credit research for Merrill Lynch. “Moody's upgraded five home builders during 2003—D.R. Horton, KB Home, Lennar, MDC Holdings, and Ryland—and didn't downgrade anyone,” he says. Horton, Lennar, MDC, and Ryland were upgraded to investment grade by one or more of the rating agencies (leaving some builders “split listed”). Only Centex, Pulte, and Toll, all of which were already rated as investment grade, remained unchanged.

Higher ratings, a low interest rate environment, and strong company earnings have all worked in favor of big builders in the bond market (as they did in equity markets, too). Home builder bonds opened the year with an option-adjusted spread (a common tool for evaluating bond quality) versus 10-year treasury bonds of 224 basis points. By year end, the spread had tightened to 116 basis points, a significantly greater improvement for the corporate bond market as a whole, Forrey explains.

“Without a doubt, the bond market feels the credit profile or credit risk of owning home builder bonds is less than it was. Credit markets are coming to grips with the fact that this industry has changed and that credit metrics have improved,” says Forrey. Score another point for the home building industry bulls.

The home building sector is trending to investment grade because “we see improvement over time, and we believe that it can be sustained. That's very important,” says Robert Curran, senior director for the bond rating service Fitch Ratings, which is based in New York.

Curran cites builder balance sheets “repositioned as to real estate and debt composition,” more sophisticated management information systems, and geographic diversification as some of the significant issues that should help sustain corporate performance, even in a downturn.

Firm Footing There is some evidence that home building is less cyclical today, Curran says, but adds that “the models that the larger public builders are employing today have not been really tested.” Still, the bond rating services lean to industry optimists who see the present as a new era for builders.

“I have no doubt that at some point in time we will have a somewhat more challenging environment for home building and we will see some weakening in credit ratios. Our assessment is that they won't weaken enough so that a company that we have established as investment grade will move out of that category,” Curran says.

Both bond and equity market analysts, for the most part, say they expect 2004 to be another good year for home builders and their equities, if not quite as good as last year. “The fact of the matter is that the business is still growing,” says Kasprzk, of BB&T Capital Markets. “In general, we are still seeing significant double-digit gains by most public builders.”

Like most analysts, Kasprzk says he isn't too concerned about interest rates this year. “If we thought home builders' stocks were behaving as they have and generating the kind of earnings growth that they have just because of low interest rates, we probably wouldn't be all that interested in the group,” he says. Of greater concern are the issues of job creation and consumer confidence, he and other analysts conclude.

“With the expectation that interest rates will go higher, there is a lot of fear that the housing market will go down,” Kasprzk adds. “But we don't see why the housing market will slow down if the economy is getting better. We need to see sustained job growth and see that driving better consumer confidence and a better employment picture,” he says. “If this happens, I don't think it matters if interest rates go up 25, 50, or even 100 basis points. They would still be very low on a historic basis and housing would still be affordable,” says Kasprzk.

Concerns Remain Not everyone agrees. Interest rates remain critical, maintains analyst Allen, who points to last year for evidence: “When interest rates went above 6 percent, orders weakened dramatically, both on a ‘same store' basis and in some cases on a total basis for some of the companies.”

She also doesn't buy the argument that a stronger economy and job picture will offset the impact on home building that an accompanying hike in interest rates might have. “If you're finally employed again after being out of work for a year, are you going to run out and buy a house? No, you'll be paying off your credit cards. That idea is just silly,” Allen asserts.

Allen is equally skeptical of the idea that home building is no longer cyclical; the cycles are just longer and more moderate, she says. The last big increase in mortgage rates, which took place in 1994, she notes, “decimated both the stocks and the earnings of the home builders … and that's the last time they were truly tested.

“I think we're very close to the end of the cycle. The economy is coming in very strong and any time the Federal Reserve has indicated that there's the possibility it will raise rates, the bond market and these builder stocks have reacted very negatively,” she says. “That means investors are very wary about rates moving up. I think at some point, with the economy getting stronger, it may not matter what the Federal Reserve says. The bond market will take the rates up on its own,” Allen explains.

CSFB's Zelman is less pessimistic, but no less cautious. “Although the group may continue to rally roughly another 10 percent in the near future given the pull-back in rates, which should lead to healthy new order growth and potential upward earnings estimate revisions, we maintain our belief that we are in the eighth or ninth inning of this cycle,” she says.

Zelman, however, doesn't paint all home builders with a single economic brush. Beneath the numbers are several factors, from companies' training and development programs, their focus on product quality and potential liability, and the depth of their management, these “will continue to be key variables in differentiating and distinguishing between the A, B, and C players in the industry,” she wrote in a recent report.

Long-term land positions will also play a crucial role in separating the “A” players from the pack. Land and development costs account for 27 percent of builders' cost of goods sold, Zelman estimates. Those costs are unlikely to go anywhere but up as available land becomes more scarce and local governments demand higher development fees.

Whether you're a housing industry bull, or expecting the housing cycle to peak, the future is notoriously unknowable. Whether home builders find themselves in a smooth and steady ascent for years to come or on the old and familiar housing cycle roller coaster, the future almost certainly will have some surprises in store.