Investor interest may mean higher builder valuation. By Lesley Brown Garland

The days of public builders being unappreciated and undervalued may be coming to an end. It's not time to break out the balloons and whistles, but after watching Wall Street turn its back on the home building industry over the past decade, analysts are cautiously optimistic that the Street may be coming around.

A few things may help raise valuations for the public home builders, says Goldman Sachs analyst Christopher Winham. Builders are making what he calls a "credible argument" by weathering the current economic downturn with good profits, thereby showing that the housing industry won't cave in when the going gets tough.

In the past few years, memories of recessions in the 1970s and 1990s frightened away investors, who worried that when the good times ended, builder stock prices would plummet. Now, as public builders continue to post solid numbers in the midst of a recession, some analysts predict that home builder valuations, hovering between seven to 10 times earnings as this issue went to press, could increase up to 12 to 14 times earnings within a few years.

"It's not going to be anything like a straight line, but you're going to see it improve over time," says the New York-based Winham. "Do what you're doing, make money, and the market will come and recognize it."

That's been promised before. Will it happen this time? Joseph Sroka, an analyst with Merrill Lynch in New York, says builders' reduced reliance on expensive bank loans will help investors see building companies as better investments. In the last downturn, 90 percent of builders relied on bank financing, which Sroka says led to many builders going out of business when banks demanded they sell off their land holdings to repay the debts.

"Builders need to go out and execute," Sroka says. "They need to go out and execute their big plans and show that they have advantages accessing capital, maintaining higher productivity, and getting purchasing power through their size, which means they have a sustainable competitive advantage in both good cycles and bad."

And compared to other cyclical industries, such as construction products or manufactured housing, the home builders should be a more comfortable fit for investors, says Arnhold and S. Bleichroeder analyst Barbara Allen. While manufactured housing is touted as growth stock, Allen says that industry's use of subprime lending, combined with its retail distribution network, makes it a risky investment.

Regional focus used to be the traditional stick builder's biggest liability. That's no longer the case. Consider KB Home's heavy California presence during the last downturn, says Banc of America Securities analyst Carl Reichardt. Today, the company is spread out throughout the West, and it recently acquired a company in Florida.

If public builders weather the national recession without an earnings collapse, investors will pay heed. Perhaps the industry will shed it's cyclical image, says Reichardt, adding that investors' attitudes change as slow as continental drift. It will be difficult to win converts.

"What we have said is that these stocks [will] get permanent higher multiples when they grow their numbers in a recession," says the San Francisco-based Reichardt. "The question is if investors will attribute that to the fine management of these companies and changes in the industry."

What's the best course for public builders? Stay focused on the business and let Wall Street be Wall Street, says analyst Scott Campbell of Raymond James amp; Associates. In the past, if builders sent out management teams to complain about valuations, it typically led investors to believe the builder wasn't keeping focused, he says.

"Let the sell-side community dictate what valuations should be, and keep management focused on the business side and not the capital market side," says Campbell, who is based in St. Petersburg, Fla. "There's a tendency to take your eye off the ball if you start focusing on things out of your control."

Rising Tide

Many of the top public home builders improved their price/earnings ratios over the past year, while some exceeded the home builder P/E average of 7.1.

Builder P/E ratio 2001 P/E ratio 2000
Pulte 7.6 8.14
Centex 9.9 8.9
KB Home 7.6 6.43
Lennar 8.6 9.95
D.R. Horton 10 8.7
Ryland 8.5 6.88
NVR 9.1 8.25
Beazer Homes USA 8.8 n/a
M.D.C. Holdings 6.8 5.87
Crossmann Comm. 8.0 6.4

Source: Investing

BIG BUILDER Magazine, March 2002