Homebuilder Stocks: Nice Fixer-Uppers?


By Amy Tsao While most other areas of the economy faltered in the last two years, the housing market broke records. The hot streak could cool slightly in 2003, but surprisingly, this should turn out to be a solid year too, and that's good news for homebuilders' stocks.

Investors have been fretting for some time that an end to the boom is near. Shares in homebuilders like Pulte Homes (PHM), Toll Brothers (TOL), Lennar (LEN), and Centex (CTX) reflect the worry. The Standard & Poor's homebuilding index has tumbled 19% since a 52-week high hit in the summer of 2002. Of course, the broader market hasn't done any better in the same period. And short-selling interest has been quite high in at least a few homebuilders, including Lennar and KB Home (KBH), even though S&P believes these are strong stocks (see BW Online, 1/30/03, "S&P's Top Squeeze Plays").

The recent decline may actually represent a buying opportunity for investors interested in a stake in this healthy sector. Many economy watchers predict that low mortgage rates will continue, which would translate into ongoing strength in the housing market in 2003. And homebuilders are promising solid earnings growth this year, around 10% to 15%.

SOLID GROWTH. In recent weeks, several homebuilders have raised earnings guidance. Amid stronger-than-expected earnings for the third quarter ended on Dec. 31, Dallas-based Centex raised its fiscal year (ending March, 2003) profit target to a range of $8.45 to $8.60 per share, up from $8 to $8.30. Analysts forecast fiscal 2004 earning per share of $9.29, which would reflect growth of at least 8%. Centex stock, at $54, is trading at about 6 times those estimates.

Pulte, based in Bloomfield Hills, Mich., recently reaffirmed that it expects year-over-year earnings growth of 10% to 15%. It sees 2003 EPS in the range of $7.85 to $8.25. With analysts projecting $7.91 earnings per share for 2003 and a stock price of $50, its forward p-e ratio is just 6. Meantime, EPS is expected to grow around 10% in 2003.

Further enticing buyers into these stocks is that the recent sell-off leaves valuations depressed at between 5 and 7 times this calendar year's EPS estimates. The sector could appreciate 15% to 20% in the next 12 months, according to Cary Nordan, equity analyst at BB&T Asset Management. "Demand will be supported by flat rates and an improving economy that includes job creation," says Nordan. The stocks could be more volatile in 2003, but Nordan expects the market to reward these companies for solid earnings growth.

SHORT SUPPLIES. Underlying the attractiveness of housing stocks are robust fundamentals in the residential real estate market. The economy is likely to remain sluggish until it becomes clear whether the U.S. is going to war with Iraq, and if so how it will fare. That will likely prevent the Federal Reserve from raising interest rates, which are near 30-year lows, anytime soon. "Given how weak business spending is, rates may stay low or go even lower," says Eric Jemetz, consumer analyst of New Amsterdam Partners. "We could probably see housing continue to be strong."

Low rates aren't the only factor driving strong home sales. Demand over the long term should continue to trump supply. Some 76 million baby boomers are expected to live longer than their parents did, so turnover in houses is falling. That means the supply of homes for some 96 million people in Generation Y (now up to 26 years old) is falling short as they get old enough to buy their first home, figures Michael Schwager, director of private-client research at financial-advisory company Advest in Hartford, Conn.

Housing inventory needs to increase, and overbuilding likely won't be an issue for an 10 or 15 more years, says Nordan. The National Association of Homebuilders (NAHB) projects that 1.31 million single-family houses will be started in 2003, down slightly from a 25-year high of 1.36 million in 2002.

MORE VOLATILE. A further boost to housing stocks: Investors may be drawn to real estate and away from stocks, which have had three consecutive down years. Says David Seiders, chief economist at the NAHB: "The degree to which the household investor has been burned in this three-year collapse of the market is going to stay with them for a long time."

Analysts have varying opinions on how to invest in the dozen or so publicly traded homebuilders. They're all small or mid-cap names so generally they'll be more volatile than more widely held larger-cap names. Mike Jaffe, S&P's director of industrial research, prefers Lennar and KB Home. He likes Lennar, which had $545 million in income on $7.3 billion in revenues in 2002, for its business model, which gives buyers the options of custom or all-in-one homes. He says KB, which reported $315 million in income on $5 billion in revenues in fiscal 2002, does a good job of attracting entry-level buyers in areas like California, where housing supply is particularly low.

Nordan prefers Atlanta-based Beazer Homes USA (BZH) and NVR Inc. (NVR). McLean (Va.)-based NVR, which had $3.1 billion in sales and $331 million in profits in fiscal 2002, has been improving its balance sheet and is focused on building homes in the low- to mid-price range. Beazer is a good play on shifting population to warmer states. It also trades at a lower multiple than others, Nordan points out. Beazer reported income of $122 million on $2.6 billion in sales in fiscal 2002. "Both of these companies are focused on their backlog and making sure they don't exceed demand," says Nordan.

"APPROACH WITH CAUTION." Of course, if the U.S. invades Iraq and military action drags on, that could wreak havoc on all facets of the economy, including housing. Or, if the Iraq situation is resolved quickly and the economy rebounds much faster than anticipated, the central bank might be forced to raise interest rates sooner rather than later, making homebuying less attractive in the near term.

"Investors should approach the sector with caution given how long the up cycle has been going," says S&P's Jaffe. Still, for now, most signals suggest that housing will help keep the economy afloat, and homebuilders' stocks should continue to ride that wave. Tsao covers financial markets for BusinessWeek Online in New York


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