Our Outlook for the Consumer Sector

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Within the consumer sector, we see a number of attractive investment opportunities in the retail and restaurant industries. Among the undervalued industries based on average star ratings and price/fair-value ratios are restaurants, specialty retail, and shoes. (For a full list of industry valuations in the consumer sector, see the bottom of this article.) But given the downturn in the housing market and the possible ripple effects this might have throughout the economy, we're focusing exclusively on the homebuilding industry in our commentary below.

Homebuilders: The Current Situation
To gauge the outlook for the homebuilding industry, it's helpful to examine the recent past, as its excesses are likely to reverberate for years. The year 2005 culminated a multiyear boom with 1.3 million single-family home sales. At 1.04% of total households, that year's sales were the highest percentage in the history of the series going back to 1965. Sales topped 1% of households only one time before--1977's peak of 820,000. Production bottomed at 413,000 units five years later, indicating that 2006's 17% drop is just the beginning.

Yes folks, homebuilders are suffering the aftermath of a bubble, complete with a glut of unsold homes and the beginnings of what's likely to be a severe credit contraction. True, demographic trends are likely to increase demand over the next decade or so. Baby boomers are entering prime second-home-buying age, echo boomers are maturing, and immigration is strong. But these factors are likely to be overwhelmed for the next few years as the industry works off prior excesses. It's likely that 2005 set the high-water mark for new home sales for several years hence.

So what is a reasonable rate of new home sales going forward? Let's start with the headwinds. There were over 2.1 million vacant homes for sale as of the fourth quarter of 2006, a full 2.7% of all owner-occupied homes. This is unprecedented, as the highest annual vacancy rate recorded prior to this cycle was 1.8% in 1985. If one assumes an equilibrium rate of about 1.5% (the average going back to 1965), there's roughly 900,000 extra empty homes waiting for buyers. Combine this with an oversupply of occupied homes for sale, and we think there are more than 1 million extra units out there.

The Subprime Problem
Although individual builders' exposure to subprime borrowers varies widely, the effect on the overall industry will be profound. For instance, the number of these buyers in  Ryland's  current backlog can be counted on one hand, and in  Toll Brother's (TOL) on one finger. Yet even for these companies with little direct exposure, the hit will be felt. The lessening of the bottom tranche of buyers disrupts liquidity throughout the entire homebuilding chain; move-up buyers are less able sell, impeding second move-up buyers' ability to sell, and so on. Our initial analysis suggests that somewhere around 5%-15% of the previously available buyers have been eliminated.

On to Demand
Estimates of household growth, the primary driver of demand, have slowed to about 1% for the past 10 years due, we think, to a lull in births during the 1970s. It's likely the rate won't change significantly until echo boomers enter their prime household formation years early next decade. This, combined with what's likely to be an increasing proportion of multi-family production (due to a declining ownership rate), indicates there's probably underlying demand for somewhere around 1-1.2 million total single-family housing units annually for the next few years. Add to this a guesstimate of annual removals (from fire, other disasters, and dilapidation) and subtract demand likely to be addressed with manufactured housing, and there's likely to be net underlying demand somewhere a bit north of 1.1 million single-family homes annually.

With an overhang that's easily a year's worth of demand (and now probably more given the recent events in subprime), it's easy to see why new home sales have seen their highs for some time. With such an overhang of supply, prices are also likely to remain stagnant to down in most areas. In our models, we're forecasting that unit volumes decline another 25%-40% over the next two years depending on regional exposure, and prices that are down midsingle digits.

Homebuilding Stocks for Your Radar
The good news is that current stock prices reflect an extremely pessimistic scenario, in some cases overly so. Builders' shares have sold off considerably in the quarter and now trade near book value or less. Yet due to the early stages of the cycle, safety is important.

Stocks to Watch--Homebuilders
Company	Star Rating	Fair Value Estimate	Economic Moat	Risk	Price/ Book
MDC Holdings		$60	None	Average	1.1
Meritage Homes		$57	None	Average	0.9
NVR		$575	None	Above Avg	3.6
Lennar		$57	Narrow	Average	1.3
KB Home		$50	Narrow	Average	1.4
Data as of 03-23-07.

One of the safest names, in our opinion,  MDC Holdings  , can be bought at just a slight premium to book value. It maintained one of the most conservative land positions throughout the boom years, indicating there's less to be impaired. A considerably smaller land inventory balance will help it navigate the current malaise more easily than just about any builder.

 NVR (NVR) is an enigma among builders in that it doesn't partake in any of the land development business. Its asset turns are far and away the best in the industry, and its margins are topnotch, defying the skeptics who believe the lack of development returns hurts profitability. The combination has resulted in a builder that produces solid cash and has no net debt. Though we've been unhappy with the company's stock option policies, operations are rock-solid.

One of the very largest,  Lennar (LEN) is going to be around for the long term. Its under-leveraged balance sheet and ability to take on sophisticated joint venture partners indicate it will be active once the cycle bottoms. Coming out of the slump, it should be loaded with cheap land.

Significantly cheaper,  Meritage Homes (MTH) has lots of exposure to problematic regions like Arizona, Nevada, and Florida. Yet it takes an asset-light approach to homebuilding, carrying very little owned land. The flipside, of course, is that it probably has options yet to be written off. Even so, we think the current price of about 90% of book value looks cheap.

Finally,  KB Home (KBH) is one of the few traditional builders to consistently produce cash. And though it's got significant exposure to first-time buyers, it's currently adjusting its product to alleviate affordability problems. With a strict build-to-order model, it's unlikely to be overburdened with spec inventory.

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Consumer Goods/Services Valuations

Consumer Goods/Services Industry Valuations
Segment	Average Star Rating	Average Price/Fair Value	Stocks Covered
Alcoholic Drinks	3.57	0.91	7
Apparel Manufacturers	2.09	1.40	11
Appliance/Furniture Manufacturers	2.33	1.13	6
Audio/Video Equipment	3.00	1.12	5
Beverage Manufacturing	3.80	0.88	10
Clothing Stores	2.64	1.13	22
Department Stores	2.29	1.20	7
Discount Stores	2.70	1.08	10
Education	2.78	1.03	9
Electronics Stores	2.67	1.13	3
Food Manufacturing	2.74	1.11	27
Food Wholesale	3.50	0.94	4
Furniture Retail	2.20	1.18	5
Gambling/Hotel Casinos	3.07	1.02	16
Groceries	2.85	1.02	13
Homebuilding	4.00	0.76	19
Home Supply	3.33	0.95	3
Hotels	2.55	1.14	11
Household and Personal Products	2.76	0.96	17
Jewelry/Accessories	2.25	1.09	4
Office Equipment	3.00	1.00	4
Online Retail	2.92	1.00	12
Personal Services	2.57	1.13	7
Photography/Imaging	3.00	1.08	4
Recreation	3.00	1.00	10
Restaurants	3.37	0.94	19
Shoes	3.71	0.89	7
Specialty Retail	3.20	0.96	15
Textiles	4.00	0.86	2
Tobacco	2.67	1.04	6
Data as of 03-15-07

Other Sector Outlook Articles

• Business Services
• Energy
• Financial Services
• Hardware
• Health Care
• Industrials
• Media
• Software
• Telecom
• Utilities

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