By Lisa Marquis Jackson. With Morgan Stanley issuing a report on Feb. 14, 2003, upgrading its housing industry view from "in-line" to "attractive", it appears at first glance that Wall Street may finally be listening to public builders' pitches about their growth story. But any builder executive will tell you there is still a long way to go. "A number of analysts have recognized the trends, but haven't given us the appropriate upgrades," says Centex CEO Larry Hirsch. "If two or three of the major shops fall in line, it will certainly give investors more confidence."
The need to boost confidence is a crucial part of the equation for increased valuations. According to John Stanley, formerly of USB Warburg, dealing with investor psychology is a critical hurdle for public builders looking for more respect from Wall Street. "Why they sell at among the lowest P/Es in the market is rooted in human emotion and how it effects investor perceptions of the future."
Case in point: the Commerce Department's report that new home sales fell 15 percent in January -- marking the largest percentage fall in nine years. While this report can be defended as a small portion of a big pie, the investment world sees a headline risk. "Every time you have something come across the ticker tape on investors' screens there's a reaction to it," says Michael Coyne, equity analyst at Columbia Management Co., based in Portland, Ore. "When you have something like 'down 15 percent' come across, those three words together can't be good for anything."
Assessing the Cycle
The center of the controversy lies in the traditionally cyclical nature of the building industry and whether or not that cycle is gone. "I think one fundamental reason that these stocks have low P/Es is the perception that they are pure cyclicals -- classic cyclicals -- that are tied to the future of the housing market," says Carl Reichardt, equity research analyst at Banc of America Securities. "The cycle itself has been strong, so there is still a large amount of skepticism that if the housing market did decline by 40 [percent] or 50 percent, that these companies could continue to hold up from an earnings standpoint -- which they probably couldn't -- but I think they could perform significantly better than they did in the last downturn."
Bears about the cycle have said housing is enjoying a series of happy coincidences and the cycle hasn't changed at all. "This is not a new world," says Barbara Allen, senior housing analyst at N.Y.-based Natexis Bleichroeder. "Valuations have degraded for the better part of a year, in spite of earnings. The market is trying to tell us something; it fears the end of the cycle. It wants to see this group tested by rising interest rates and tighter underwriting standards."
Winning Wall Street's Respect
The biggest issues affecting builder stock valuations are perceived cyclicality and limited size. The solution to winning Wall Street's respect is time. Given time to grow and time to prove good returns during falling demand, the investment community will eventually start listening, say analysts.
Michael Coyne, investment analyst at Columbia management, suggests these additional tactics for CFOs focused on pleasing Wall Street:
1. Lower the goodwill on the books.
"Any time you have a decent amount of goodwill on your books, it raises a red flag. I'm looking at one builder with 10 percent of his assets in goodwill. That's quite a chunk."
2. Option more land instead of owning.
"It's not a productive use of capital."
3. Work to please Wall Street through growth and real returns.
"They have the ability to both grow and return their capital to investors -- they should do both. Not many businesses can do that now in this environment."
Top publics refute that perception by pointing to the transformation of their balance sheets, consistency of earnings, lower risk profiles, and economies of scale, as well as supply-side constraints due to land approval processes. "I don't think people understand the transformation of this industry and the fact we have such a competitive edge over 80 percent of U.S. housing," says D.R. Horton CEO Don Tomnitz. As a result, the true reality of the cycle and its affect may need to be proven by performance through another downturn.
In the meantime, publics may strengthen their position best through actions, not words. Allen says he recommends that builders work to reassure investors they are prepared for decreasing demand. "Let investors know you are constantly aware of a worst-case scenario," says Allen. "Do an analysis that shows how many more houses you need to deliver in order to keep earnings flat. Centex is the only management I have seen that says, 'Here's how much our margins decline when demand weakens. Here's where we are at risk and here's what we are doing to handle that.'"
Will Bigger Make It Better?
One reason investors may not be aware of the industry's transformation appears to be size; of individual companies and the overall size of the industry.
"We're not being heard because even our largest builders are considered relatively small companies," says John Landon, CEO of Meritage Corp., in Plano, Texas. As a result, builders have had trouble getting the platform they need to tell their story.
"This industry has been under-followed and neglected because it's a small part of the market, " says Rick Murray, associate analyst with Raymond James and Assoc., based in St. Petersburg, Fla. "The market cap of this industry is 30 billion dollars. A lot of institutional investors can't play in that arena -- it's too small."
While time allows the fragmented industry to grow to a critical mass, there are positives to consider. "To the extent that investors do find an opportunity in the sector it's not going to take much to make the stocks increase significantly," says Tomnitz. "There just aren't a lot of shares and a lot of market cap to go around." The liquidity of builder stocks also provides benefits more typical of a large cap opportunity. "Horton, Centex, Pulte, and Lennar are all trading over a million shares a day. That's a lot of liquidity for the typical investor," says Tomnitz.
Overall, lower valuations may continue to plague this industry until several things come into alignment: demand falling to lower levels, builders continuing to sell homes, and publics offering a good return based on the size of revenue they can achieve. "Let's say all these things happen, and we still don't get higher valuations," says Landon. "That will be interesting."