FOOL ON THE HILL

Homebuilders: Good Investments?

Homebuilders' stocks have zoomed over the last year, while market averages have fallen. It's possible that homebuilders are cyclical businesses that perform according to economic cycles or interest rate movements. One thing is for certain: The price-to-earnings ratio doesn't tell you much. Tom Jacobs will look at structural free cash flow, inventory, cash growth versus debt, and book value for homebuilders in the coming weeks.

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By Tom Jacobs (TMF Tom9)
October 24, 2002

Long ago, when I was a young investor in junior high with two shares of Ford Motor (NYSE: F), I heard a lot about cyclicals: stocks that rise and fall with economic cycles. Ford was certainly one, along with other auto makers, airlines, and steel companies.

Most investors then and now would probably also dub homebuilders as cyclical -- companies such as Hovnanian Enterprises (NYSE: HOV), D.R. Horton (NYSE: DHI), or Pulte Homes (NYSE: PHM), to name a few. The catch is you have to know when the cycles begin and end in order to do well. If you can do this, you aren't reading this article; you're counting your millions.

Now that homebuilders are the financial media's new best buddies, I'm wondering: Are they cyclical, or should I remember that the majority is usually wrong and looks at the markets backward, rather than forward?

Looking in the rearview mirror, homebuilding stocks have performed quite well over the last year. Companies such as Hovnanian Enterprises and D.R. Horton are very familiar to readers of Investor's Business Daily, a business partner of ours that publishes relative strength ratings to help investors follow which stocks and industries outperform others. And with the overall market's recent bump, homebuilding stocks are close to historic highs.

                                  Mkt TTM    
                                  Cap Sales 52-Wk
            Markets;*Geography*   ($ mils.) Retn**
Beazer      EL,1st; S,W,MA         826 2354    48%
Centex      FR,FS; 25 states      2780 7883    27%
D.R. Horton EL,1st; FS 20 states  2896 6109    41%
Hovnanian   FR,FS; NE,DC,CA,TX,MS 1122 2257   209%
KB Home     EL,1st, FS 6 W/SW st. 1956 4799    68%
Lennar      FR,FS; national       3719 6636    65%
M.D.C. 
Holdings    FR,FS; 6 st. W,SW,MA  1027 2224    42%
M/I Schottenstein 
            FR,FS; OH,FL,IN,DC     468 1050    86%
Meritage    FR,TX, AZ, CA          501  873    85%
NVR         FS,DC, MD             2450 3081   104%
Pulte       FR,FS, nationwide     2780 6547    36%
Ryland      FR,FS, 21 markets     1012 2754    59%
Standard Pacific  
            MU; CA, AZ, TX, CO     783 1507    27%
Technical Olympic USA 
            FR; TX, FL, NC, TN     460 1017    70%
Toll Brothers L,MU; 21 states     1502 2279    45%
WCI Communities MU,R,L;            424 1208  (new)
William Lyons EL,MU;  CA, AZ, NV   244  509    81%

                                    S&P 500   -21%
                                    DJIA      -10%
                                    Nasdaq    -28%
Key:
Market Focus*                     Geography*
EL  entry level               MA Mid-Atlantic
1st first time move up        MS Mid-South
MU  move up
FS  provides financial services too
FR  full range
L   luxury
R   retirement
**Without dividends

Breathtaking, isn't it? Yet even with this performance, everywhere you turn, the financial media calls these companies undervalued. Of course, stock performance has nothing to do with a company's intrinsic value, and often stocks at new highs maintain momentum to go higher. But if you're looking for investments to hold for longer-term value creation, most articles I've seen only offer the companies' low price-to-earnings (P/E) ratios. They're all below 12, with earnings per share for the S&P 500 in the high teens or low twenties, depending on whose numbers you use. I'll bet most readers react two ways:  

1. Such low P/Es. Hmmm...
2. As soon as interest rates go up, these stocks are sawdust.

P/E ratios
Are they low? Well, compared to what?

Our readers know that the P/E ratio tells you little or nothing by itself. The "price" is the stock price, and the "earnings" is earnings per share (EPS) based on numbers that appear in the income statement, one of the four financial statements that U.S. companies must file and now certify with the SEC every quarter. Repeat after me: EPS are about accounting, not necessarily the performance of the business.

To know more about the business' real value, we need to know many things. How closely do earnings, taken from the income statement (prepared with the accrual method of accounting), track growth in cash flow from operations, taken from the cash flow statement (prepared using the cash method)? Are the reported earnings pro forma or GAAP (generally accepted accounting principles)? Is the business a good, growing one? Are gross and net margins rising or falling? What's the competition? And so on. In short, the P/E ratio alone is a most overused and overvalued indicator.

Yet even looking at just one small indicator -- each company's most recent quarterly year-over-year earnings growth, as of 10/23/02 -- it does appear that the P/Es for many homebuilders lag their earnings growth:

                             Most Recent Q
                   TTM P/E   EPS v. YOY*
Beazer                 6.4     25%
Centex                 7.1     13%
D.R. Horton            7.5     12%
Hovnanian             11.3     69%
KB Home                7.7     23%
Lennar                 8.4     31%
M.D.C. Holdings        6.7     -4%
M/I Schottenstein      7.7     28%
Meritage               8.2     12% 
NVR                    9.2     46%
Pulte                  7.2      5%
Ryland                 7.0     32%
Standard Pacific       7.3     -5%
Technical Olympic USA 11.2    -33%
Toll Brothers          7.4     -9%
WCI Communities        2.9     34%
William Lyons          6.0    -27%
*For last quarter where Form 10-Q filed with SEC.

This snapshot shows that 11 of 17 are priced well below earnings growth, and if you look back over the years, instead of just one measly quarter, you will find consistent growth for the majority as well. So something must be standing in investors' ways. Does everyone expect interest rates, and then mortgage rates, to rise, choking off demand for housing

Interest rates
Having lived a few decades, I've seen interest rates rise and fall, rise and fall, many times. Until the last few years, mortgage interest rates had never returned to the lows of the early 1970s, and many of us harbored jealousy for friends and family with mortgages dating from then. We also remember the high-teens mortgage rates around 1980, when Paul Volcker's Fed began breaking the back of inflation that some believe began with the federal government's decision in the 1960s to have both guns and butter.

The argument that rising interest rates will affect homebuilders is simple. How much house you can afford depends on your income versus the expected payments for the mortgage principal, interest, taxes, and other debt. All else equal, lower interest rates raise the affordability, and high rates lower it. Various sources compute affordability indexes, and all agree that it is at or near an all-time high overall (your local mileage may vary). As any Econ 101 student knows, when more people can buy more of a house, demand increases, and vice versa.

If homebuilders live and die by the ups and downs of interest rates, they are cyclical -- or counter-cyclical, if interest rates decline in poorer times and increase demand. I'd end this column right now (to everyone's justifiable relief). But an investor who can't predict interest rate wants to know this: Can a well-managed homebuilder generate consistent positive cash flows for the long term, given the vagaries of interest rate fluctuation? We press on.  

Constant inventory supply
Homebuilders are the quintessential growth industry. They depend on growth in population, incomes, average household size -- all sorts of factors that have to do with people's choices to buy more homes. They depend on people wanting new construction instead of old.

They also depend on inventory in the form of land. They build a zillion-unit development called Happy Acres, and when the houses are all sold, it's done. Cash collected, profits counted. Then what? They need to buy more land where there's more demand, then provide a house at the right price for buyers -- but still high enough to profit over their costs of land, materials, and labor.

As the clich� goes, they really aren't making more land. We're also, as a nation, much more concerned about land use and it is subject to extensive state and federal regulation. In this environment, homebuilders have been consolidating like crazy to increase land inventories.

Who cares?
At the very least, recent earnings growth for a number of these companies -- notably Hovnanian Enterprises and NVR Homes (AMEX: NVR) -- is so pronounced that I want to comb the companies' financials and businesses for opportunities. Do they consistently generate structural free cash flow? Do they have enough inventory in areas of high population growth? Is that inventory growing at the right rate for sales (though the company can't buy land like it can buy a widget supply)? Does growth in cash and inventory exceed increase in debt? Is book value a useful number when analyzing a homebuilder? What about management indicators, such as stock option grants?

My next column or two will examine all these clues to arrive at a conclusion about whether any homebuilder is a good business at current prices for the long-term investor.

Please email me, or post on the Fool on the Hill discussion board, if you have any thoughts on how to analyze homebuilders.   

Have a most Foolish weekend!

Each month, Tom Jacobs (TMF Tom9) and The Motley Fool Team provide you the best investment ideas you haven't heard anywhere else in The Motley Fool Select. Don't go another day without it -- sign up for a free 30-day trial today!  At press time, Tom owned no shares of companies mentioned in this article. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.