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Can home builders handle a chill?
As the once-hot sector cools off, the bears look for long-term misery. But bulls say the business has changed and builders will do well despite a slowdown.
By Michael Brush
When high-end home builder Toll Brothers caught investors off guard last week by announcing a sales slowdown, the Wall Street spin machine wasted little time explaining that the troubles are limited to Toll.
Theyre not. Witness:
- In late October, the nations largest publicly traded housing company, Pulte Homes, cut its forecast for home closings by 4% to 7%.
- Upside earnings surprises in the group fell last quarter. The top 15 home builders beat analyst expectations by just 7.6%, according to Thomson Financial, compared to 13.7% on average for the past five quarters.
- Rates on 30-year mortgages are at their highest levels in 16 months -- and have been above 6% for the past month.
So theres little doubt that sectorwide trouble has arrived. But investors have to grapple with a different issue. After all, these stocks have already taken a 20% to 30% hit since July. The real question: Are they still radioactive? Or have the home builders built businesses mature enough to shrug off a cold housing market? If so, they might finally outgrow their hat-size price-earnings valuations -- rewarding investors who buy now.
Here's a look at both sides of the argument.
The bear case
Skeptics warn that signs of slowdown at Toll Brothers (TOL, news, msgs), NVR (NVR, news, msgs) and Pulte Homes (PHM, news, msgs) show housing has reached the dreaded inflection point.
Once trends stop and reverse, they tend to go in the same direction for a long time, says Jamie Dlugosch, a money manager who also publishes The Rational Investor newsletter and contributes to this Web sites Strategy Lab. I would not be surprised to see softer demand last for many quarters.
Related news and commentary on MSN Money
Dlugosch believes this new phase of weakness will drive the stocks back down to price-earnings ratios of around 4 -- near the low end of their historic range. Most publicly traded housing companies now have forward P/Es of 5 to 6. So if Dlugosch is right, some serious losses lie ahead.
Dlugosch says housing demand has been exhausted after several years of low interest rates. People are satiated, he says. Anyone who wanted or needed to buy a home has had five years to do it. The sector is long overdue for a cyclical downturn.
With rates rising, the cost of owning a home has risen, of course. Indeed, one of the troubling signs in Toll Brothers' Nov. 8 warning was that homebuyers are taking longer to make up their minds. So home-price appreciation has cooled off.
The price increases pre-Katrina were at warp speed, Toll Brothers Chief Executive Robert Toll said in the Nov. 8 conference call. Since Katrina, instead of going up $5,000 or $10,000 every week or two, we have been limited to no price increases or very limited price increases.
There is no question we have hit a price ceiling in several markets around the country, Pulte Chief Executive Richard Dugas Jr. said in an interview. Bears say this means margin growth may remain elusive.
Bears caution that Toll reported a slowdown in many markets around the country. The company saw weakness in Chicago, Washington, D.C., Northern California, several parts of Florida, Detroit, Rhode Island, New Jersey and parts of New York.
I think we are finding that demand can only go so far, and Toll Brothers reduced guidance for 2006 basically said as much, Dlugosch says.
The bull case
Housing sector bulls dont dispute that growth is slowing -- after a few white-hot years in which many home builders posted annual sales gains of 50% or more. They just dont think it will slow enough to matter.
If growth slows down to 10% a year, that may look like a recession in the industry, says value manager Ron Muhlenkamp. But if they are growing at 10% with a return on equity of 20% and a P/E of less than 8, we want to be in that business. Indeed, housing stocks make up 15% to 20% of his Muhlenkamp fund (MUHLX) portfolio, and Muhlenkamp says it makes sense to own any of the 10 biggest builders; take your pick.
Now instead of growing at 80% a year, Toll Brothers is growing at 15%. That is still pretty attractive, agrees John Buckingham, a value manager at the Al Frank fund (VALUX).
The home builders themselves, including Toll Brothers, WCI Communities (WCI, news, msgs) and Meritage Homes (MTH, news, msgs), say they'll grow at roughly 20% a year for the next several years. WCI Chief Executive Jerry Starkey told me he expects 25% annual sales growth and 20% earnings growth on average over the next five years. Pulte has guided for 12% to 15% earnings growth next year.
Not surprisingly, home-building execs think investors have overreacted. I think it is a good time to double-down on home-building stocks, says Starkey at WCI Communities. They are phenomenally cheap. We are observing an irrational despair in the marketplace.
The stocks' declines have put WCI Communities, Meritage Homes and Orleans Homebuilders (OHB, news, msgs) back on the buy list at Buckinghams Prudent Speculator newsletter, which is consistently ranked among the top five newsletters for long-term returns by Hulbert Financial Digest.
An industry grows up
Sure, these stocks look cheap, compared to their growth rates. But the real issue may be whether they can shake the pickup truck Johnny image that has forever dogged them, to use Bob Toll's term from his companys recent conference call. To do so, theyll need to show investors they can put up decent numbers even in a lousy housing market cycle.
If the bears are right, they might soon face the test. And the home builders think they are ready. Builders cite the following improvements:
They now have much better balance sheets. Home builders have a lot less debt, and much of it is in long-term bonds that spread out repayments, easing any potential credit crunch. They are also land banks, as they own several years' supply of properties on which to build. WCI Communities, for example, has a six- or seven-year stock, says Starkey. If sales slow, WCI can cut costs by deferring land purchases.
They now have broad geographic diversity, so weakness in any single market wont tank their businesses. There has never really been a national housing slowdown, says Meritage Homes finance chief Larry Seay. When one market is off a bit, other markets are strong.
They will continue to grow through consolidation. In the 1980s you could make great money in the food industry even though the amount of food being eaten wasnt increasing much, because the industry was consolidating, says Muhlenkamp. A similar dynamic helps home builders now, he believes. Publicly traded home builders control only about 25% of the market, but they have the financial strength to buy smaller operators in tough times.
Demographic trends will help. Solid immigration supports continued demand, and land supplies are limited. Home builders are also targeting aging boomers. Pultes Del Webb communities are a play on an expected 45% increase in the number of people age 55 to 75 by 2020, says Dugas.
The bottom line
We learned during the dot-com bubble that managers can be naively overconfident. But most businesses growing at 10% to 15% with price-earnings ratios of 5 or 6 would seem vastly undervalued. I think home builders have grown up enough that investors should start seeing them this way, too.
But what about interest rates? Will they rise so much that the housing market gets crushed? Muhlenkamp doesnt think so. Historically, long-term rates -- and mortgage rates by implication -- are roughly two-and-a-half to three percentage points above inflation. So as long as inflation stays in the 3% to 4% range, mortgage rates won't go high enough to kill housing demand.
Muhlenkamp has held housing stocks since the final days of the dot-com bubble, when most investors ignored them -- one reason hes up 12.6% a year since then. When will he sell? When other people start thinking they are growth stocks with P/E ratios in 15 to 20 range.
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