For this blog post I wanted to give you another angle to think about and that will change your investment decisions on builders. We are going to classify this industry and make sure you are valuing builders properly. I think a lot of retail investors and some Wall Street investors have missed and are still missing the boat on what a builder really is. I believe that a lot of big name institutions and funds that bought builders during the so called bottom last Aug-Dec 2006 didn’t understand how to value builders properly. I am basing my assumptions in this blog on 2 conversations, one 2 weeks ago and one 2 months ago. These conversations were with PE guys who have former big builder experience (division president and executive officer) and what they have heard from their connections on the Street. I have no connections on the Street only builder connections. So take what I am saying for what it is worth, but at the very least I think you will have a much clearer picture of this industry.
Based on the software database I utilize (whom I am not giving free advertising for) back in Sept 1996, there were 13 stocks in the residential builder industry, none of which had a market capitalization over 1 billion dollars. The median market cap was $236 million and the industry was in the bottom 10% in total market cap. The median earnings growth rate was 16% and the median sales growth rate was 17%. Zzzzzzzzzzzzzzzzzzzzzzzz
This was a cyclical, non-influential industry that probably nobody on Wall Street cared about, understood or really followed. Obviously the industry was even more un-influential in the previous years too. This is important. Why? Wall Street has had decades to analyze the most influential industries traded and understands how they act and how to value them. Do you think Wall Street figured out builders over night? I am talking about how they operate and how they act during economic cycles and what their strengths and weaknesses are? So when Bill Miller (one of the so called geniuses of Wall Street) bought boat loads of builder stock in the Fall of 2006 what historical knowledge was he basing it on and what did he or anyone for that matter understand about this industry? How come every analyst got it wrong except for Ivy Zellman? You just have to go back to Sept 1996 and see why… No one understood this effing industry!!!!!!!!!
Fast forward to Jan 2000. I stated in a previous blog that this was the beginning of the bull market in housing from a YOY price increase basis. Centex and KB Homes were the only 2 with a market cap over $1 billion but still under $1.5 billion. I looked at several websites and this still doesn’t qualify as a large cap stock. Again ask yourself, what does Wall Street really know about an industry that is still not influential and the biggest company has a $1.3 billion market cap? The median earnings and sales growth rate was 18% and 27% respectively. However, my database shows that all these stocks were trading at a p/e ratio of 3 to 6!!!!!
The median p/e ratio for builders in September for the years 1996 to 1999 were 8.5, 12.6, 8.5, and 5.2… I think anyone reading this blog post can conclude that builders were cyclical stocks that Wall Street ignored even up to the beginning of the boom. At the very peak of the boom the majority of builder stocks were trading between a p/e ratio of 8 to 10. Those earnings were over inflated based on the unprecedented rise in home prices vs. costs and the big variable land cost. Remember, land owned and optioned was fixed and I stated in a previous blog that land owners trailed builders in raising prices. Every CEO will tell you that margins, pretax income, gains in sales price inflation adjusted were unprecedented. Can I be any clearer????? Those profit margins in 2003-2006 are not coming back until the next bubble.
Between 2000 and probably 2006 the homebuilder CEOs and CFOs were pissed because they couldn’t get there p/e ratios above 8 and they were trying to convince Wall Street that it was a “new economy for builders” and that homebuilders were growth stocks and not cyclical. Why is this important? Because if Wall Street values you at 24 times earnings instead of 6 times earnings, it means your cost of capital is significantly less.
Example:
$100m earnings, 100m shares = $1 EPS. If you are trading at a p/e of 6 then your stock price is $6. If you are trading at a p/e of 24 then your stock price is $24. Thus, if you issue 10m new shares you either raise $60m dollars or $240m dollars. Big difference huh?
In fact the Executives at the big builders were so convinced that they were a growth industry that they took on massive amounts of debt to finance that growth because it was cheaper than issuing equity (common stock). Did the light just go on for you? It is almost shocking that I am on blog 13 and I can still introduce a new concept. Again, the reason why a lot of you are reading my blogs is because of what I stated above… no one knows what builders are really about.
So why did the top builder executives think they were a growth industry? (1) They said a higher % of households would own vs. rent, (2) they said immigration and aging society = more households and (3) they said that they were going to take market share from private builders. Let us examine… (1) a higher % of households would own vs. rent… well this was based on easy lending practices and I think we go back to normal… thus, I don’t buy that argument going forward. (2) Demographics? Dude, you can use that argument for any industry… more people in the US means more car sales, more Coke sales, more clothing sales, etc…. And it is not like we are getting 20% YOY growth in population. So this demographic logic is something only an idiot builder CEO would state… (3) Finally, the argument of taking market share from privates… It is true that publics had a small piece of market share in 2000 vs. privates, but I believe that the reason why there are substantially more privates than publics is that homebuilders shouldn’t be public companies! Period! There is a reason why the industry is so fragmented as recent as 2000. So yes, publics gain a lot of market share from 2000 to 2006 from privates but that was the low hanging fruit. Every point of market share going forward will not deliver the same impact to the bottom line. Increasing market share over $10 billion in sales will produce lower earnings on a percentage basis. I will address privates vs. publics in a future blog.
I believe that a lot of retail investors and some pretty smart Wall Street types bought into the growth strategy of builders. I believe that in the Fall of 2006 when the so called bottom was reached, many investors piled into builder stocks assuming that earnings growth would continue the way it did without realizing that this industry is cyclical, it has never been influential, there isn’t a lot of knowledge on the industry, and that the earnings generated during the boom were once in a lifetime and were a result of home prices doubling in the 5 markets that I stressed you need to be in. Am I repetitive? Yes. But these are important points. People, these stocks need to be valued at a p/e ratio of 6-8 and you can expect normalized earnings growth when we come out of this bust period. Not sexy…
So if builders are losing money how do you measure normalized pe ratios… Here is how I did it with DR Horton the largest builder.
Example using DR Horton’s current figures
Sales 12.7 billion and shrinking
Shares 314 million
Normalized EPS ?output?
Normalized earnings = 5% of revenue or $635 million
How did I come up with normalized earnings of 5% of revenue? I went back into my database and did a handful of calculations. This 5% represents the earnings after taxes, option expense, etc that drop into EPS…. If you feel that 5% is too low or too high then do your own fact finding. If you look at builder stocks at the peak of the market boom in 2005 their earnings were around 10-12% of revenue (DHI and RYL were the two I looked at)… again, this % of earnings off revenue was the once in a lifetime peak!!!!!!!!!!!!!
Back to DR Horton. If you take $635 million in earnings and divide it by 314 million shares you get $2.02 EPS. If your p/e ratio should be trading between 6-8 like a cyclical stock should then that means the value of DR Horton in normalized times assuming 12.7 billion in revenue is $12 to $16 a share. What is DR Horton trading at today? $14 a share….. So for those of you who are loading up on DR Horton stock expecting it to double when we get out of the storm you may want to rethink that position. When the builder stocks turn up there is going to be massive short covering for you to take advantage of and after that the dumb money will be piling in pushing builders to 52 weeks and beyond. However, once we get through a year of normalized earnings and new projections come out for future years, these stocks will fall back to a p/e ratio of 6 to 8.
Builders aren’t growth stocks and most shouldn’t be public companies. Only 1 or 2 builders will reward you with a 7 year hold and its not one of the big 5 whales (KBH, PHM, DHI, LEN, CTX). Hey Bill Miller of Legg Mason.... you might be smarter than me and the genius of Wall Street, but you don't know $^%&*# about builders and our industry... I hope your enjoying your crap sandwich.
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