Which Builders Are Best Prepared to Weather the Storm?

It's hard to imagine a group more out of favor in today's market than homebuilders, and for good reason: The headwinds are both well known and strong. Vacant homes for sale are at an all-time high, both in absolute terms and as a percentage of total households. Affordability problems pervade most of the glamour spots such as California, Las Vegas, Arizona, Florida, and Washington, D.C., resulting in a weak pricing environment in the very regions where builders used to make virtually all of their money. Expensive land will flow through the industry's collective income statement for the next couple of years, eliminating the immense profits previously earned through appreciating inventory. Subprime financing has dried up completely, eliminating an entire tranche of buyers that as recently as February was able to obtain financing on relatively easy terms. And several variable-rate Alt-A loans (the category sitting between prime and subprime involving high loan/value loans with little documented income or assets) will soon reset to levels at which the borrower wouldn't have been approved in the first place.

Indeed, it's likely this year's total housing starts of less than 1.5 million will be down by about 30% from the peak of 2.1 million in 2005, and next year's production may even be slightly lower. It's really anybody's guess.

Yet all the problems mentioned above are well known and therefore mostly "in" homebuilders' stock prices. What's not well understood, in our opinion, is how well each builder is positioned to withstand, and even benefit from, the pain inflicted by the current slump.

Survey Says
To gauge the preparedness of each of our 18 domestic builders, we've created an index based upon the following equation.

1 - ((Net debt/Sales) * (Inventory/Sales) * (Total lots in 2006/Total lots in 2003))

The first term, net debt/sales, is important in all cyclical businesses, as it represents a fixed cost that's very hard to restructure or reduce once business has deteriorated. In today's market, those with lots of debt are at the mercy of those with little, as the overlevered builders try to sell assets at fire-sale prices to delever ailing balance sheets. We're using net debt/trailing 12 month  sales instead of the more traditional debt/capital metrics to eliminate the distortions caused by differing stock repurchase decisions.

When land prices are falling, as they are in today's market, high inventory balances are the last thing any builder wants. Consequently, those who stayed lean throughout the boom are in the catbird seat, relatively speaking. In addition, if a juicy land deal presents itself, said builder will have a place to house any new purchases without destroying its returns on capital for the next several years. Hence, our second term, inventory/sales, is a proxy for the current health and future potential of the asset side of each builder's balance sheet. Once again, the lower the better.

Compounding the problem of high inventories is the fact that many builders loaded up at precisely the wrong time--during the 2003-2005 period of skyrocketing land prices. To gauge which builders may have a relatively larger amount of "expensive land" sitting around, we're using the ratio of 2006 homesites to 2003 homesites as the third term in our equation. The ratio is far from a perfect measure, as it makes several assumptions. One of which, that all land is first in-first out, isn't entirely correct because entitlement periods vary across regions. It also penalizes builders that enjoyed outsized growth during the period. Nonetheless, we think that it gives a decent gauge of the builders' relative activity during the critical period of unprecedented land price increases.

By taking the product of the three terms and subtracting from one, we come up with what we call our "Preparedness Index," a simple yet elegant method for ranking the builders' relative ability to comfortably withstand, and ultimately benefit from, the current mess.

Homebuilder Preparedness for the Current Downturn
	Debt/ Sales	Inventory/ Sales	2006 Lots/ 2003 Lots	Preparedness
NVR (NVR)	-6%	19%	1.26	1.01
MDC Holdings	10%	58%	0.96	0.94
Ryland	16%	59%	0.84	0.92
Lennar (LEN)	12%	50%	1.35	0.92
Pulte (PHM)	21%	67%	0.90	0.87
KB Home (KBH)	23%	59%	0.94	0.87
Meritage (MTH)	20%	44%	1.48	0.87
Beazer (BZH)	32%	70%	1.05	0.76
Hovanian (HOV)	38%	70%	1.14	0.70
Centex	36%	86%	1.08	0.67
M/I Homes (MHO)	41%	89%	0.97	0.65
DR Horton (DHI)	31%	77%	1.54	0.63
Toll Brothers (TOL)	30%	105%	1.32	0.58
Technical Olympic	39%	85%	1.45	0.52
Standard Pacific	49%	88%	1.47	0.37
Orleans Homebuilding (OHB)	64%	103%	1.29	0.15
WCI Communities	94%	95%	1.00	0.11
Levitt Corp.	100%	145%	1.00	-0.45
Average	0.29	0.72	1.19	0.71
Note: For those builders that don't have Dec. 31 quarter ends, we chose to use results from the quarter ending nearest to Dec. 31. Beazer's 2003 lot count is from the quarter ending 09-30-03.

Top of the Class
Without question, the builder most prepared to deal with today's realities is  NVR (NVR). Its strategy of using only options to secure dirt and never speculating on land has kept its inventories low and its debt lower. In fact, with slightly more cash than debt, it's the only company on our list to score above 1.  MDC Holdings  also earns very high marks, owing to a similarly conservative strategy. It endured criticism during the boom years for not loading up on land, but will have the last laugh. We like its position.  Ryland  and  Lennar (LEN) are the only other builders to score above 0.9. The former scores well on all three metrics, and the latter on the first two. Lennar also benefits from the fact that much of its inventory and debt is held off the balance sheet in joint ventures in which it shares risk with other parties.  Pulte (PHM),  KB Home (KBH), and  Meritage (MTH) are also well positioned, as the first two stayed pretty disciplined during the bubble years and the latter enjoys slim inventories because of its option-centric strategy. Of the top nine builders in the survey, all carry average risk and six have narrow moats.

Bring Up the Rear
Both  Levitt  and  WCI Communities  are weighed down by high debt and inventory balances, making them the lowest-rated builders in our survey. In our opinion, both will need to seek financing alternatives if left independent. We didn't calculate either company's growth in lot position (setting both to 1), as both utilize nontraditional business models. Even if included in the calculation, however, the rankings wouldn't have changed materially. Just above them,  Orleans Homebuilders (OHB) and  Standard Pacific  both suffer comparatively low scores in all categories, and  Technical Olympic's  problems are well documented. In fact, seven of the nine builders in the bottom half of the survey are rated as having above-average or speculative risks, and only two have moats.

It's important to note that our index isn't intended as a stand-alone valuation tool, but as a starting point in determining which builders are best positioned to deal with today's reality. Nonetheless, we think the list does provide a pretty firm basis on which to analyze the relative prosperity of each builder once the market stabilizes. As they say, it helps to be "prepared."

(Note: In the original version of this article, Beazer's net debt/sales and net inventory/sales ratios were misquoted. The correct net debt/sales ratio is 0.32 and the correct net inventory/sales ratio is 0.70. After accounting for the correct ratio, Beazer moves from the twelfth position in the survey to the eighth position.)