Picking Winners: Public Builder Report Card

By Jay Holtzman. America's public home builders ran an impressive race in 2002, demonstrating the class of a field that's clearly bred for stamina over the distance. Whether in terms of equity or operational performance, these thoroughbreds generally finished better than the financial handicappers forecast, based on year-end financials released in recent weeks. Builder equities significantly outperformed the market by any of a number of comparisons, earnings were strong, and so was the financial performance of the field.

"Generally, the group performed extraordinarily well," says Greg Nejmeh, managing director of North American equity research for Deutsche Bank, in New York. "Obviously, markets were under considerable pressure in 2002. Within the context of the extension of the bear market, a lot of these stocks performed admirably in terms of equity performance, and their fundamental operating performance warranted the manner in which the equities behaved."The builder stocks that comprise the Deutsche Bank industry segment outperformed the S&;P 500 index by an aggregate 26.8 percent in 2002, posting an average 3.5 percent gain while the index fell by 23.4 percent, he explains.The selection of 15 public builders tracked by Raymond James & Associates Inc., a regional investment bank in St. Petersburg, Fla., grew an average 1 percent versus the declining S&P index last year, says Rick Murray, associate analyst. "If you look at stock price performance, they did very well," he says. And earnings did even better.From an earnings perspective, the broader group of 24 builders and building subsidiaries -- tracked by big builder -- that report their results saw net earnings increase 25 percent on gross revenues that grew 18 percent. Collectively, the group posted an average return on shareholder equity of 28 percent. That contrasts with a 14 percent return for the S&P 500 as a whole, according to Murray. Builders didn't quite match their collective mark of 30 percent set in 2001. The Samp;P average return was 2 percent lower than the previous year. Front Runners In an overall field that set a brisk pace on the equities track there were a number of standouts.NVR was the leader once again in overall year-end return on shareholder equity, at 88 percent, up 900 basis points from the year before. Hovnanian Enterprises, however, came blazing from deep in the pack to finish the year with the biggest (1430 basis point) improvement in ROE, delivering 34 percent. Weyerhaeuser Real Estate, Orleans Homebuilders, The Ryland Group, and William Lyon Homes all posted better than 30 percent returns on shareholder equity.NVR's stock price continued to run well ahead of the pack gaining 60 percent year over year, based on December finals. Hovnanian Enterprises stock increased 49 percent, Meritage Corp. was up 31 percent, and Lennar Corp. was up more than 10 percent. Why such outstanding performances?"It's hard to say," Murray explains. "Both Hovnanian and Meritage are companies that have been in the acquisition market of late and have continued to deliver very strong returns on invested capital. They're growing profitably, and this is what interests the market," he says.Other builder stocks faltered over the distance, despite thundering performances. Equity prices declined for Beazer Homes USA, D.R. Horton, Centex Corp., Toll Brothers, and The Ryland Group. Investors appeared to be concerned about Beazer's integration of Crossman Communities, or they worried about the company's exposure in potentially softening markets, Murray explains.Yet many of these same builders posted strong gains last year in terms of home sales, gross revenues, net income, and pre-tax net margin gains versus 2001.D.R. Horton set a blistering pace in home sales volume -- propelled by its acquisition of Schuler Homes early last year -- posting a stunning 65 percent increase in new home sales last year, closing a record 31,584 new homes worth $7.1 billion. Horton trailed Pulte by a length, however, as Pulte generated $7.4 billion from 28,903 U.S. and another 7,547 international home closings. Hot on their heals were Lennar and Centex. Lennar finished third with $6.8 billion, from 27,393 closings. Centex posted $5.8 billion in home sales from 28,297 closings in the U.S. and another 1,432 in the United Kingdom.Lennar was the net income leader, with $545 million. But Hovnanian enjoyed the greatest net income percentage gain, a whopping 116 percent. Beazer, D.R. Horton, Dominion Homes, Orleans Homebuilders, and Pulte all ran well, with income gains of 50 percent or better. Outperforming the Market These thoroughbreds outperformed generally low expectations in 2002. But analysts and industry observers hadn't doubted their abilities. It was the condition of the economic track that was so uncertain. "If you go back to the start of 2002, you'll remember that Sept. 11 had been a devastating blow to the collective psyche and no one knew what the future held. I think the reaction of most analysts, and I know my reaction, was one of extreme caution," Nejmeh says. This applied both to equity price and earnings expectations."At the start of 2002 we expected negligible earnings growth, maybe one or two percent year over year," he says. "We expected the first and second quarters to be reasonably strong based on backlogs [from pre Sept. 11 sales] and then the second half to taper off. Fortunately, it did not play out that way."

But consumers proved far more resilient than most people thought likely and low interest rates made for a faster track. As a result, earnings per share growth averaged some 10 percent, "significantly higher than what we expected at the beginning of the year," Nejmeh adds.Although the "secular conditions" of the market were uncertain, its long-term strength was not, says Nejmeh. "Our thesis on the sector remained the same that it has been for some time. We thought we would see considerably more market stability than most observers anticipated and in the context of that market stability we would see large builders gain considerable share." The World Trade Center tragedy didn't change that.In fact, big builders gained market share last year, some of it certainly through mergers and acquisitions. Lennar made a string of acquisitions throughout the summer. Hovnanian, Technical Olympic USA, KB Home, Standard Pacific, and Meritage all closed multiple deals. Concrete share of market figures aren't yet available, but Nejmeh estimates the big builder share of market, "probably exceeded 20 percent in 2002." Sustained Fundamentals To some degree, 2002 was a breakthrough year. Certainly the impact of historically low interest rates can't be discounted. But that's only one factor in real market growth, analysts say.The market had remained static around the 900,000 level since 1998, Murray explains. But new home sales jumped 7.5 percent last year. "This is the first sign of growth we've seen in four or five years, so it isn't indicative of what I would consider a bubble or an unsustainable phenomenon." Driving that increase are some broad demographics and the fact that "the industry hasn't been building homes at the same pace as household formations over the last decade," he adds.The strong fundamentals that made a fast track last year will continue to provide firm footing for the industry. Nejmeh points to four major influences with long-term impact: the renter-to-owner phenomenon; the influence of second home/vacation home buyers; legal immigration; and the intergenerational transfer of wealth now starting to take place as aging baby boomers inherit from their parents.The after-tax cost of homeownership is less than the cost of renting an apartment almost anywhere in the nation. Vacation and second-home sales have proven durable even in the face of recession, weak equities markets, corporate scandals, and the shock of Sept. 11. The transfer of wealth between generations now in progress is probably the biggest ever. Legal immigration promises a continuing, powerful push to the market, Nejmeh says.The longer legal immigrants live here, the more likely they are to own a home. After 20 years, their rate of homeownership, 67 percent, nearly matches the national rate of 68 percent, Nejmeh points out. "The 11 million-plus legal immigrants who entered in the '90s have an ownership rate of 25 percent," he explains, and the Census Bureau has admitted this group was undercounted in the 1990 and 2000 surveys. That adds up to strong demand in the next decade from this population segment alone.These broad trends will affect all builders for years to come. But not equally, according to a Deutche Bank analysis published late last year. The study examined a number of diverse factors to create "an objective scorecard of builder performance and prospects based on largely quantifiable data." The data was used to rank 13 large public builders in a number of categories likely to impact future growth. Each category leader received a score of 13, the last-place company received a scored of one.

One section, for example, looked at the builders regionally to determine, in effect, which builders are in the right places for growth. Based on analysis of two related economic measures -- employment and disposable income -- using trailing one-year and five-year figures plus a 10-year forecast, the study ranked Meritage Corp. in the strongest position, closely trailed by M.D.C. Holdings and KB Home.The study conclusions: "Meritage ranks highest in this category, as its operating regions offer the greater potential for employment and income growth, and thus a greater likelihood of increased demand for housing."However, using population factors as the base, the study ranked M.D.C. Holdings first, Meritage second, and WCI Communities third. The study concluded that the regions in which M.D.C. Holdings operates "offer the greatest potential for population growth and thus housing demand."In terms of regional housing indicators such as state-by-state new-home permits, absolute inventory, and home sales data, the rankings shifted again. D.R. Horton led the category, followed by KB Home and Centex. The study concluded that D.R. Horton's markets possess "the greatest potential for an increase in housing demand based on inventory, permit, and existing sales prospects."Most analysts and builders would agree that there are plenty of reasons to expect long-term strength in the housing market. Yet 2003 has gotten off to a less-than-smooth start. First quarter home sales have fallen further behind last year's pace than initially expected. Interest rates have started moving upward from record lows. The Survey of Professional Forecasters of the Philadelphia Federal Reserve Bank anticipated "an upward trajectory," saying long-term rates would average 4.3 percent this year and rise to 5.1 percent in 2004. But overall loomed the uncertainty of war with Iraq and how that uncertainty will impact the economy, notes Deutsche Bank's Nejmeh. "We are reasonably sure that earnings prospects in 2003 are going to be strong based on guidance from the builders in recent quarters and their strong order patterns and backlogs," Nejmeh says. He points in particular to the broader stability larger home builders now demonstrate in managing inventories. While builders continue to work aggressively to secure lots for future construction, most appear to be keeping the amount of property under direct control in balance with property under option. Nejmeh notes builders are moving toward more "just-in-time" delivery practices. As a result, builders have less stock to work off should economic conditions prove worse than expected.Clearly those calculating handicaps and placing this year's bets are playing the odds a little more conservatively given the current market uncertainties. Repeating the fast-paced growth of 2002 won't be easy. But so long as demand continues to outstrip supply, builders enjoy an enviable position compared to most S&P 500 companies in being able to sustain stronger than average growth well past this year. *Analysts provided Big Builder with detailed disclosure of their firm's ownership interest and/or business relationships, if any, with the builders for which they provided information for this report.Just out! BUILDER magazine's annual ranking of the top 100 builders. Click here to go to the 2002 BUILDER 100.