Nailing the Homebuilders

Homebuilders are all the rage, as exploding demand and industry consolidation have produced boom times for their stocks. But maybe we're just looking in the rear-view mirror. A quick look at inventory versus sales growth, cash to debt, valuation, and stock options leaves Tom Jacobs with nuthin'.

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By Tom Jacobs (TMF Tom9)
November 14, 2002

Ever since homebuilders in the Flintstones' Bedrock first offered casement windows and marble fireplace mantles, they have fascinated investors. (All right. At least in the last three decades, when they have become publicly traded companies in the U.S.)

Yet even that well-known interest didn't prepare me for the flood of information I received after I first looked at homebuilders and asked for feedback. Thanks to everyone! Many of your ideas are included today.

It doesn't take an expert to see that these are boom times for builders. Every quarter, sales increase wildly. Yet if there's any change in the good times, homebuilders' inventory will become a problem. So let's examine inventory first, culling those companies without the best numbers and saving what's left for further research.

When I spoke with Jay Taparia, principal of Sanskar Investments and finance professor at University of Illinois, Chicago, he pointed out the crucial importance of inventory on homebuilders' balance sheets. According to Taparia, when demand is high, homebuilders often don't know when to stop building. When they have too much, they "first start throwing in upgrades for free; we've already started seeing that. Then they drop prices. They hesitate to do that at first because existing buyers around them didn't get the same deal, and it hurts their brand." Finished houses (which usually aren't built without a contract), houses under construction, vacant land, and improved lots that don't sell eat up resources, not least through taxes. Sure, they may someday appreciate, but they aren't liquid.   

To help decide which 10-Ks to consider (the kind of magnifying-glass research that defines a true Fool), let's look at the trends in inventories, sales, and debt for the 16 top publicly traded homebuilders.

Sales vs. inventory
I first want to screen out the companies growing inventory much faster than sales. I use the change between the most recent quarter and the same quarter a year prior. Here's what I found, with the worst cases bolded:

                   Most Recent Q Vs. Year Ago:
Company                       Sales  Inventory
Beazer (NYSE: BZH)             66%      71%
Centex (NYSE: CTX)              8%      29% 
D.R. Horton (NYSE: DHI)        61%      61%
Hovnanian (NYSE: HOV)          39%      36%
KB Homes (NYSE: KBH)            5%      12%
Lennar (NYSE: LEN)             18%      32%
MDC Holdings (NYSE: MDC)       12%      24%
M/I Schottenstein (NYSE: MHO)  16%      -6%
Meritage (NYSE: MTH)           43%      23%
NVR (AMEX: NVR)                25%      18%
Pulte (NYSE: PHM)              25%      85%
Ryland (NYSE: RYL)              3%      18%
Standard Pacific (NYSE: SPF)   38%      27%
Toll Bros. (NYSE: TOL)         -1%      19%
WCI Communities (NYSE: WCI)   -13%      15%
William Lyons (NYSE: WLS)      21%      49%

This snapshot may not tell the full story. A company may have more orders in a quarter or come upon a particularly juicy stretch for a future Levittown. Conversely, inventory that grows too slowly may restrict future profits. But the current housing booms suggest we should worry about ballooning inventories most, and prefer those whose sales exceed inventory growth by some -- but not too much (how's that for science?). According to this measure, M/I Schottenstein, Meritage Homes, NVR, and Standard Pacific look the best.

What about debt?
Many of these companies are increasing total debt (short-term debt plus long-term debt plus preferred stock) rapidly, usually through acquisitions of other builders. In any other industry, investors would cringe at both debt growth and the paltry cash-to-debt ratio they maintain -- none brag cash of more than 0.4 of total debt. Gulp. But this is probably peculiar to the industry because builders should deploy cash into inventory. Indeed, if we add inventory to cash, the companies' cash-to-debt ratios improve.

We already know that illiquid home and land inventory will become more of an albatross in slow times, but it does represent something more valuable than aging toys or last year's clothing styles. So I'm going to do something entirely arbitrary. We like to see at least 1.5 times cash to debt for a dominant Rule Maker company, but for homebuilders, I'm going to include inventory as cash, but raise the requirement by half again to an entirely arbitrary 2.25 times. We find:

           Debt: Most Recent Cash+Inventory/
Company Q Vs. Year Ago Debt MRQ
Beazer 92% 1.8 Centex 36% 0.6 D.R. Horton 66% 1.5 Hovnanian 24% 1.6 KB Homes -3% 1.5 Lennar 10% 2.4 MDC Holdings 41% 2.5 M/I Schottenstein -32% 3.3 Meritage -22% 2.7 NVR 7% 2.3 Pulte 106% 2.1 Ryland -21% 2.3 Standard Pacific 12% 2.1 Toll Bros. 6% 2.4 WCI Communities 9% 1.2 William Lyons 41% 1.5

Of our favored four, Standard Pacific drops out. Its 2.1 is under the arbitrary 2.25 marker.  

Current valuation
Another key indicator for me is current valuation. For this, I'll examine whether the company is growing free cash flow (FCF) at a rate that compares favorably with its enterprise-to-free-cash-flow ratio (EV/FCF). After screening for growth in sales vs. inventory and debt, we have three remaining candidates:

             EV/* FCF**    FCF ($ mils.)
Company  TTM FCF  Y1-Y2 Y1  Y2  Y3  Y4  Y5
M/I Schott'n 5.4  -30%  40  52 -27  13   1
Meritage     (neg.)--  -27   3 -39  -4   7
NVR          8.2  -31% 144 189 206 -16 -18
As of 11/8/02 close
*Enterprise Value
**Free Cash Flow, change most recent year-over-year

Enterprise value is market capitalization plus debt. This is a truer estimate of market value than market capitalization, because a buyer would take on the debt. FCF is net cash from operations minus capital expenditures. Meritage produces negative or piddling FCF, raising questions about the quality of its earnings per share. Both M/I Schottenstein and NVR have declining FCF for the most recent year over the prior, with the former builder showing annual changes all over the map. Their unsteady performance may merit the low EV/FCF multiples.

Still, NVR's strong three years of FCF -- even though they have been arguably the best three years for U.S. housing in decades, and perhaps all time --  merit one more look.   

One final screen: stock options
By many measures, NVR stock has rewarded shareholders phenomenally over the last nine years -- check out its phenomenal chart. Yet a final red flag prevents me from spending more time with NVR today. Review its last three years of stock option grants, net of cancellations:

          ESOs*    Weighted Shares ESOs/
Year Granted Cancelled Outst'ing Shares
2001 1931000 10333 9525960 20.2% 2000 189500 151942 10564215 0.4% 1999 1212100 62000 12088388 9.5% *includes grants to directors

Two things jump out. First, the company is buying back shares like crazy, which is a good thing, as long as the shares are a better investment of company (shareholder) cash than anything else, such as land for houses. The rate of buybacks explains, in part, the astonishing stock appreciation. But NVR is granting stock options net of cancellations at an unconscionable rate -- 9.5% of weighted diluted shares outstanding in 1999 and 20.2% in 2001.

For fun, add the 1999-2001 grants: 25% to 33% of 2001 weighted average shares outstanding, and 42% of the smaller weighted basic shares. Our rule of thumb is 5% for developing companies and 3% for established companies, like NVR. Not only that, but I can't find the tax benefit of granting stock options on the cash flow statement (the tax benefit from exercise appears in the statement of shareholder's equity).

NVR's stock option grants knock over my investing house of cards with a feather. (Block that metaphor!)

None standing
I can't find one homebuilder that merits more research right now, because I'm looking for companies offering strong appreciation in the near term (a special situation) or steady appreciation over many years (a good business with expanding possibilities) -- and that can pass some initial financial management tests. Admittedly, today's column provides very rough first hurdles, but they point out some real problems among homebuilders.

I'm left disagreeing with the many analysts now trumpeting homebuilders, asserting that their historically low price-to-earnings multiples no longer apply and that the stocks "deserve" higher multiples. Nothing "deserves" an investor's money, and there are strong arguments that multiples won't expand in this industry.

That doesn't mean investments in these companies won't reward you. If it's your industry, and you know the ins and out, you may find a company with particular strengths suitable for specific regions or economies. But I'll pass for now. 

Agree or disagree? Hold forth on our Homebuilders discussion board. 

And please, have a most Foolish weekend!

Tom Jacobs (TMF Tom9) and the band of merry Motley Fool analysts bring you the best investment ideas every month 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.