Presentation on theme: "Homebuilding: April Showers Spring 2007 Stephen S. Kim Managing Director U.S. Equity Research 212-816-1666 See page 29–31 for Analyst Certification and."— Presentation transcript:
Homebuilding: April Showers Spring 2007 Stephen S. Kim Managing Director U.S. Equity Research See page 29–31 for Analyst Certification and Important Disclosures Published April 16, 2007 Citigroup Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Non-US research analysts who have prepared this report are not registered/qualified as research analysts with the NYSE and/or NASD. Customers of the Firm in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at (for retail clients) or (for institutional clients) or can call (866) to request a copy of this research.
2 Supply Constraints: The Linchpin to Our Long-Term Thesis The national conversation on housing often dwells on issues such as interest rates, job growth, affordability, population, etc. that we would characterize as DEMAND related. We agree that housing demand was unsustainably strong. However, since our upgrade of the group in 2001, we have urged investors to focus on housing SUPPLY, not demand. While it is easy to get distracted by the flurry of headlines that chronicle housing’s current cyclical decline, we find the most durable feature of the housing market nationwide to be a significant, unrelenting change in the supply of buildable lots in this country. As the current cyclical supply spike is alleviated, the industry’s secular constraint will re-emerge. The charts on the next several pages document a significant shift in many of the industry’s most fundamental metrics – including units produced, inventories and market share. No credible view on the space can ignore such profound changes. We find demand-based analyses are wholly ineffective at explaining these industry shifts, but that they are easily resolved if one factors in the emergence of housing supply constraints in the mid-1990s.
3 Housing Starts Never Reached Prior Peak Levels n Historically, with no barriers to entry, the homebuilding industry was notoriously fragmented and constantly prone to over-building. n This cycle, however, obviously strong demand drivers (low interest rates and record population growth), did not led to a similar surge in production. n Up until 2003, housing starts remained well below 2.0 million, and only reached 2.1 mil at the ’05 peak. Production was considerably higher in the ’70s and ’80s. WHY? The U.S. population was 30% larger than it was in the 1970s and was growing 30% faster, too. n We suggest that demand factors cannot explain these surprisingly low figures.
4 Why Were Spec Levels So Low for So Long? n Unlike the large publics, small builders (<25 units/yr) are eager to build specs. Ø Provides steady work for trade contacts. Ø Specs serve as model homes and mktg tools. n In the mid-90s, spec levels dropped below 4 mos. – a record low – and stayed there. n 4 months is below the industry’s natural or equilibrium level of spec inventory. Ø Avg. time to build homes is roughly 5-6 months. Ø When there is less than 4 mos of spec inventory, builders are selling their spec homes well before they are finished construction – making them eager to start more and more spec homes. Ø This is why the industry’s equilibrium level of spec inventory has historically been 5-6 months. n So, how could inventories remain below equilibrium for so long, without leading to record levels of housing starts? Between ’95 – ’05, spec levels were remarkably low. Historic average = 5.3 months supply
5 A Curious Time for Consolidation n Why did the industry begin to consolidate when it did? Ø Cyclical industries with no barriers to entry typically see consolidation occur during down-cycles, not upswings. n The bulk of the share loss has been sustained by small builders. Ø The top builders lost no share, and the 300 th ranked builder builds only 200 homes. Ø Thus, the losses have been concentrated among very small builders. n Supply constraints in the mid-90s have driven the change. Ø If small builders can’t gain access to land or capital (or both), they lose market share.
6 The Gatekeepers: Money and Land Land constraints continue to tighten. Anti-”sprawl” sentiment has gained significant momentum in recent years. The land approval process has lengthened considerably. That which once took months, now can take several years. Has created a scarcity of buildable lots for sale. Builders must have strong financial backing in order to play. This constraint appears to be extremely durable. Unlike housing demand, which can change suddenly, the shortage of buildable lots in this country is a result of arcane permitting process and human nature, neither of which can change quickly. Process caters to desires of current residents, not commercial interests. “Not In My BackYard!” Which would you rather see outside your bedroom window – birds singing in trees, or people looking back at you? Folks pick the birds every time.
7 Supply Constraints Benefit Public Builders n As supply constraints emerged in the 1990s, so too did competitive advantages for some builders over others. n Public builders have been beneficiaries of this change: Ø Have superior access to capital, at a lower cost. Ø Develop much of their own land. Ø Receive “first look” at lots that are made available by 3rd party developers. Ø Experience across thousands of projects with a range of product types, terrain, and various permitting hurdles gives the public builders negotiating leverage. Ø Market share consolidation has led to lower production costs for publics. n Small Builders: Ø Cannot develop their own land due to cash flow constraints. Ø Choosing from “leftover” lots – overpriced, difficult locations or terrain. Ø Those with strong land acquisition skills typically become land specialists, or work for large builders.
8 A Significant Multiple Expansion Story n Throughout the mid-1990s, the builders traded at an average forward P/E of 10x. Ø Estimates during this period were “normalized” – neither peak nor trough. n We believe the builders are positioned to one day benefit from a major revaluation that takes forward P/E multiples to the 13x-15x range on “normalized” earnings. n Compared to history, the builders are: Ø Considerably larger Ø More geographically diversified Ø Less leveraged, with 7 companies rated investment grade. Ø Positioned for sustained double-digit growth through market share gains alone, Ø Substantially more profitable than in prior downturns. n The building industry warrants a higher relative multiple compared to other sectors: Ø Pricing – home prices have outpaced inflation by 1-2% over 40 yrs. Ø No Int’l competition – the rise of Chinese imports makes homebuilding a “safer harbor” Ø No Big Box threat – immune to deflation from HD, LOW, WMT, COST Ø Pension liabilities – builders have few direct employees. Ø Consolidation – in the early stages of a significant industry consolidation. n An eventual revaluation provides a multi-year opportunity in the stocks, in our view.
9 The Near-Term Outlook: Book values offer a compelling entry point. We predict only modest book value declines of 5-10% over the next year. While headline risk may limit near-term gains, we recommend investors to watch for company-specific buying opportunities in advance of a back-half rally. Land vintage analysis helps isolate those builders with attractive land positions. Write-off risk also varies by builder. Historical relationship between ROE and P/B multiples highlights relative value. We believe order trends will steadily improve and turn positive in 3Q ‘07. Cancellation rates change from being a negative to a positive factor. Easier comparisons coming. This should drive recovering earnings in FY08 and FY09, allowing a return to P/E multiples.
10 Book Value Support n The builders have bottomed near book value 8 times in the past 20 years. n On average, they rallied 22% in the next 3 months, and 67% over the next year. n Only in the ‘90 recession did the stocks fail to rally, and even then they were flat after a year.
11 Land Vintage Analysis n Our “land vintage” analysis shows that the builders’ exposure to land priced at peak ’05-’06 prices was modest. n Almost 50% of the group’s land investment at that time was tied to land priced in 2003 or earlier. n Since then, aggressive option write-offs and renegotiations have further “cleaned up” the builders’ land holdings.
12 Projected Write-Offs n Using the land vintage analysis in the previous slide, we next estimate how large each builder’s write-downs will likely be this year. n We find that MTH, DHI and KBH have the greatest risk for large write-downs, while CTX, LEN and TOL have the least.
13 Minimum Annual P/B Versus ROE n We have observed a strong historical relationship between the builders' returns on equity and their price-to-book multiples. n As shown in the figure above, we find that for each 100bps of ROE deviation from the group's average ROE, an individual builder’s trough price-to-book multiple is approximately.06 multiple points higher or lower than the group's average trough price to book. Source: Stockval
14 The Catalysts: Can Rates and Order Trends n Orders will likely post less severe declines in 1Q07 and post gains beginning in 3Q07, as moderating cancellation rates combine with easier yr/yr comparisons. n Can rates should decline as backlogs shrink in the most troubled markets. n Also, once buyer expectations are sufficiently negative, the can rate should immediately drop back to more normal levels. n As easier yr/yr comparisons arrive, net order trends will likely turn positive in FY07.
15 Historical Price/Book Multiples n We find remarkable similarity in the stocks on a price-to-book basis between this downturn and the 1980’s. n Our new price/book-driven target prices assume that the group trades up to about 1.6x projected book value a year from now. Source: Stockval
16 Role of FHA Insured & VA Guaranteed Loans n There is potential for programs such as FHA/VA to recover some of the share the builders have ceded to sub-prime originations in recent years. n Of course, some homebuilders will inevitably be more exposed to sub-prime buyers than others
ANALYST CERTIFICATION I, Stephen S. Kim, research analyst and the author of this report, hereby certify that all of the views expressed in this presentation accurately reflect my personal views about any and all of the subject issuer(s) or securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this presentation.