Are Homebuilders Worth More than Book Value?

As a value investor, you've probably looked at homebuilders a few times over the past several years and marveled at just how cheap these stocks have been. Recently, the reason for such a valuation is glaringly obvious: The next few years' earnings aren't going to come close to what the group made in 2005, and the market is simply doing its job of discounting the forward results of an extremely cyclical group.

True, the next few years are going to be ugly. But there's something more at work here, as builder multiples (price/book, price/earnings, etc.) haven't been anything to speak of since, well, forever. In fact, a look at Morningstar historical data for the top-five builders ( DR Horton (DHI),  Pulte (PHM),  Centex ,  Lennar (LEN), and  KB Home (KBH)) shows the group averaged price/earnings multiples in the high single digits since 1996, or a little more than a third of the S&P 500. Price/book, at about 40% of the market multiple for the past 10 years, is equally descriptive of the market's unwillingness to capitalize earnings that have grown well in excess of almost all other groups.

So what gives? Well, aside from the cyclicality, we think there's another structural reason why builders are rarely awarded anything close to a market multiple, the main one being that they're probably less-than-average-quality businesses. Here's why:

Earnings Quality
Though builder net income grew briskly (to put it mildly) through last year, the earnings are what we term "low quality," meaning they're not backed by cash. The problem isn't of the traditional variety such as an overabundance of accruals. Quite the opposite: With the exception of some off-balance-sheet financing vehicles, builder accounting is very straightforward and allows relatively little room for shenanigans. But a never-ending quest to feed the sector's voracious appetite for land eats up every penny (and then some) of all but a few builders' earnings year in and year out. In fact, over the past 10 years, the abovementioned five builders have collectively garnered more than $20 billion in net earnings, yet put out almost $25 billion in cash for inventory. The result is a cumulative free cash flow loss of a bit more than $1 billion over the period, not including contributions to joint ventures.

One could argue that to pump money back into a growing, profitable business makes perfect sense and is indeed accretive to intrinsic value. I agree. And because most builders have earned returns on invested capital well in excess of their costs of capital for several years, it would seem on the surface they deserve (or, more appropriately, deserved until recently) higher multiples. After all, there are several examples of companies that while growing briskly consumed lots of cash and still enjoyed hefty multiples. For instance,  Home Depot, (HD) consumed over $3 billion in cash over the 10-year period ending January 2001, yet still enjoyed an above-market multiple on the $11 billion it netted over the same period.

The critical difference between Home Depot and homebuilders, however, is that while Home Depot was consuming all that cash, it was building an infrastructure that would produce cash for decades to come. Unfortunately, builders' investments don't enjoy the same long-tail characteristics. Their investment in land and work-in-process inventory, which collectively ranges between about 40% and 80% of total assets for the abovementioned companies, sits on the balance sheet sometimes for years before producing any cash. Once it does, it's gone in a relatively short period of time, leaving them in need of constant reloading. This relative capital intensity is one reason builders haven't gotten the respect their earnings growth and profitability over the past decade would have suggested.

High Inventories
With unit volumes slowing precipitously throughout the industry, high inventories will be even more problematic over the next couple of years. Even though many builders employ innovative financing structures (mostly options and joint ventures) designed to lighten the inventory burden and spread risk, the industry added massive amounts of land to its collective balance sheet in 2005, a year that will mark a cyclical peak for some time. Consequently, builders that were investing to satisfy demand based upon 2004-05 production rates are now stuck with land that won't be needed for several years, if ever. So it's likely that the recent trend of option and land impairments will persist (and possibly accelerate) for some time as builders write down land for which they overpaid and walk away from options that no longer make sense. For an industry so closely associated with book value, this is a big deal, as these write-downs are a direct hit to shareholders' equity.

A couple of builders we like,  MDC Holdings (MDC) and  Meritage (MTH), are two of the more conservative land buyers in the industry, and therefore should weather the storm in good shape. With enough lots to supply less than three years' worth of production, MDC currently holds less land than virtually any other builder in the industry, a considerable advantage in a declining price environment. It's currently trading around book value. And though Meritage has enough lots for over six years' worth of production, it secures this land mostly through options. Though some of these options may be impaired, we like the risk profile of being able to renegotiate or simply walk away (at a cost of 5%-15% of the total land cost) from unwise deals. Both names carry manageable amounts of debt.

Positive Factors
Though the homebuilding industry's cyclicality and capital intensity are obvious negatives on the "wonderful franchise" meter, the industry does enjoy some compelling positives; chief among them, of course, is the impressive returns on capital that most big builders have earned. In fact, all seven of the homebuilders mentioned above have earned returns indicative of a competitive advantage for a while now.

For sure, these returns are in large part due to the huge tailwind of falling interest rates and likely won't look as impressive going forward. Even so, big builders do enjoy some solid advantages. For instance, a builder that buys 20,000 dishwashers annually will get a better deal than one that buys 200. Big builders often get the first crack at juicy land deals. And these days, municipalities often require builders to subsidize the construction of public infrastructure and amenities such as schools, parks, and police and fire stations. Builders who can spread these costs over more units will have a competitive advantage. With desirable areas getting more crowded, these types of advantages will probably grow.

Less obvious, yet still critically important is the nature if the industry's cost structure. Because builders can't really count on captive customers (customers who continually buy a company's product through, say, habit, addiction, or other compulsions like the network effect), their highly variable cost structures are a positive because they don't promote irrational behavior. To illustrate, compare homebuilders to airlines, another industry with relatively low barriers to entry and customers who are not captive. The critical difference is that airlines have cost structures that are largely fixed. This promotes irrational pricing during downturns as each carrier tries to cover its fixed costs, ruining industry profitability. Because builders can quickly cut costs during downturns, they likely won't suffer such behavior for extended periods.

So while the industry is in for some rough sledding over the next several quarters, and will likely remain a tough business for a long time thereafter, we think most of the public builders will survive the current slump in much better shape than the market thinks. Once on the other side, the higher-quality builders will resume generating economic profits. And for that reason, we think the group is worth more than liquidation value, which is where some names are currently priced.