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Homebuilders Resting on Stable Foundation

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. The homebuilders have been in focus for years now as the housing crash and subsequent stabilization has been on a lot of investors' minds. I'm here today with associate director Eric Landry and credit analyst Rick Tauber to talk about the state of the homebuilding industry and if there are any opportunities for investors. Gentlemen, thanks for joining me.

Eric Landry and Rick Tauber: Thank you.

Glaser: Eric, has the housing market really stabilized?

Landry: I think so. We've had some help. The Government's been there giving $8,000 credits until last month. The Fed's been in there buying mortgage-backed securities. But there's sort of a hidden stabilization factor here and all the trouble that's happening over in Europe is giving our bond market a big lift.

So mortgage rates right now are as attractive as they've been in a long, long time: so the more trouble that happens over there, the better our mortgage rates look, the cheaper houses look on a monthly payment basis. So I think things are looking OK for the US housing market right now.

Glaser: So the housing starts still are pretty low, and there haven't been a lot of new houses built. Do you think they're at a sustainable level now or will production have to come back up?

Landry: I hope they're well below a sustainable level right now. I mean we've talked about this before, right. You've got somewhere on a million-three to a million and a half households potentially formed every year. If there is a job for each household, those households will be formed instead of shacking up with each other.

So now that we look to be in what might be a sustainable job creation cycle, hopefully that household formation will kick up more to normal levels around that low million, million and a half level. And, you know, with starts at less than 700,000 annually for the last two years, something's got to give here at some point.

Glaser: Have the homebuilders been able to take advantage of the stabilization to clean up their balance sheets or to move into more attractive markets?

Landry: Well, maybe "take advantage" is not the best way to put it but they've definitely done an excellent job throughout the whole downturn of liquidating their balance sheet and in the process, producing significant amounts of cash, paying down debt and really re-liquefying themselves throughout the whole downturn. Not just the last year, which has basically been stable, but from 2006 until today they have been working tirelessly in getting themselves more liquid and they are really in pretty good shape right now.

Glaser: So thinking of the major players, which are some of the ones that you would be most excited about to own stocks of and which are the ones you would avoid?

Landry: Well, as far as owning stocks goes, NVR is a wonderful, wonderful business and you just don't see that a lot in homebuilding. This is a cash-producing machine and management is always in there buying back stock at very, very cheap prices. So they're buying back stock in good times at less than intrinsic value, which is another kicker to equity holders.

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Glaser: But as of today, do their shares look attractive?

Landry: Not so much. I mean I think on any weakness it's probably a decent bet. But it's probably more close to fairly valued today than it was this time last year, for sure.

Glaser: So Rick, when you look at kind of the cash cushions that some of these firms have built, does that give you kind of more confidence in their ability to make their bond payments on the credit side?

Tauber: Sure, absolutely. I think that's kind of the key theme on the debt side, is we've got such large cash balances sitting out there. We don't really need a recovery for bondholders to do reasonably well. So as long as they don't go through and start spending unwisely, I guess, and burning through a lot of cash, they are in pretty good shape.

Glaser: We recently released credit ratings for some of the larger homebuilders. Can you walk us through what some of those were?

Tauber: Sure, yes. Again, we basically just took Eric's work on the equity side and translated that into credit ratings using our four pillar approach. The ratings we have are A for NVR, BBB- at Toll, and those two are the only investment grade rated names and also the only two that we assign a narrow moat to in the industry. Then those are followed by DR Horton at BB+, KB Home and Lennar at BB and Pulte at BB-.

Glaser: Out of any of those issues, do the spreads look attractive for bond investors?

Tauber: Yes. I mean, I guess basically we'd be comfortable owning any of them given the dynamics going on right now and the cash positions but, you know, one that I'd highlight is KB Home. They've got a billion-two of cash. We expect them to be slightly cash flow positive going forward and the next major bond issue is due in 2014. Their total net due through that bond is only about $500 million.

So they have over two times cash to the debt needs that they have over that time period. So we think that's really well positioned in the capital structure. It's yielding about 7.3%, a spread of about 5.50 which is a little bit better than the index for a shorter-dated bond. So we think that's a pretty safe place to hide out.

Glaser: It sounds like the industry is pretty stable right now. What are some of the downside catalysts, what are some of the risks that could put the industry back into a tailspin?

Landry: Well, the credit just went away in April for home orders and we saw permits sort of take a stumble this month. So there's this scenario out there where people don't buy houses because they are not getting eight grand from the government, or $6,500 if you already own the house, so that's for sure a risk. Another one we talked about is if this job creation stalls, family formation compresses again as people start shacking up with each other and we may tumble down a 100,000 or so permits and starts on an annual basis.

But again, that's a different story at this level than when we're doing two million starts. So I think the market has already taken the brunt of what it's going to take, no matter if starts bump around at this level for another couple of quarters or whatever it is.

Glaser: All right. Eric, Rick, thanks for talking with me today.

Tauber: You bet.

Landry: Thanks.

Glaser: For Morningstar.com, I'm Jeremy Glaser.