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Homebuilders Are Stretched Thin


To the casual observer, the homebuilding industry appears to be in remarkably good shape this deep into the housing cycle: Most of the large publicly traded builders such as Lennar Corp. (LEN) and KB Home (KBH) are still reporting double-digit gains in both sales and profits. And most also still boast high returns on their investments. Los Angeles-based KB Home, for instance, is on a pace to earn 16% return on capital over the past year. "Other companies only dream about that," says KB Chief Financial Officer Dom Cecere.

Yet despite those solid numbers, cracks are starting to form in the foundations of the nation's largest homebuilders. To maintain their heady growth rates, the big builders are placing ever-bigger bets as they continue adding to their land holdings and the number of houses they have under construction. Even as the Federal Reserve has started raising interest rates -- while signaling that further hikes lie ahead -- builders have continued to throw up new homes at a furious pace. The amount of capital that the 14 largest publicly traded builders have tied up in inventories of unsold homes and land, adjusted for sales, has risen an average 12% over the past year, according to Palladian Research LLC, a New York institutional research firm.

As a result, those inventories now stand at the highest level relative to sales in seven years. And some builders are faring much worse than average. Inventories at Dominion Home Inc. (DHOM) in Dublin, Ohio, for instance, have soared 38.8%., while Ryland Group Inc. (RYL) in Calabasas, Calif., has seen them jump 30.6%. "They are increasingly running their businesses with an 'If we build it, they will come' mindset," says James D. Poyner, a market strategist at Palladian.

BORROWING FRENZY

To fund all this new construction, homebuilders are burning through cash at a furious pace. For the 12 months ended in June, the large publicly traded builders laid out $373 million more cash than they took in, Poyner notes. Compare that with the much more modest $73 million "burn rate" builders went through for the year that ended in June, 2003. That has left builders increasingly resorting to debt and stock issuance to fund their operations: Of the 14 largest publicly traded builders, six now have debt-to-equity ratios of 95% or higher, including Dominion and KB Home.

What concerns critics is that this frenzy of borrowing comes as housing demand is starting to cool: Single-family starts dipped 8.2% in September, to a seasonally adjusted annual rate of 1.54 million units. Some Wall Street experts, such as Jan Hatzius, senior economist at Goldman, Sachs & Co. (GS), predict that single-family starts could slide an additional 10% to 20% in the coming year as higher rates take their bite. "The risks of a serious problem will rise the longer construction activity remains at its current elevated level," Hatzius wrote in an Oct. 15 report.

Builders counter that fears of a housing crash are overblown. They argue that their land purchases are largely in the form of options that often require them to put down less than 10% of the value of the tracts; even then, they say they often build only when firm orders from buyers exist. What's more, builders contend that if demand cools, they'll have the wherewithal to scale back construction quickly -- and turn negative cash flows back into positive territory by simply selling down their existing inventory of finished homes. "When the market does slow down -- and our data doesn't show that it is slowing down -- our earnings might slow, but free cash flow will come in bucketloads at that point," says J. Larry Sorsby, chief financial officer for Hovnanian Enterprises Inc. (HOV), a Red Bank (N.J.) builder.

Still, there's growing evidence that cooling demand already has some builders coming up with novel ways to produce higher profits. To generate a 12% rise in earnings during its third quarter -- less than half the growth rate of recent quarters -- Miami-based Lennar resorted to heavy land sales to other builders. Kathy Shanley, a senior analyst for Gimme Credit, a bond-research firm, estimates that in the quarter that ended on Aug. 31, Lennar generated roughly a quarter of its $225 million in earnings from land sales to other builders. Moreover, with gross margins of 37% -- well above the 22.9% gross margin Lennar generates from its home sales -- such sales also help keep overall margins up. By contrast, land sales contributed less than $2 million to Lennar's bottom line as recently as 2001 and 2002. The company's chief financial officer, Bruce E. Gross, says the land sales occurred only because it saw opportunities to exploit heavy demand for new tracts by other builders. "We're not liquidating our assets to meet a number," he insists.

Maybe not. But Lennar clearly needs land sales to counter weak orders in some markets and to boost profits. In its West Coast markets, new orders fell 6% in its fiscal third quarter. Another potential sign of weakening market conditions: Fully 35% of Lennar buyers took out adjustable-rate mortgages, vs. just 20% a year ago. That suggests that some customers "are straining to afford current price levels, even with low interest rates," says Shanley. Gross says the rising use of adjustable-rate mortgages simply reflects buyers' growing preference for lower-cost, floating rates. "We haven't seen any degradation in credit quality," he says.

CANCELLED ORDERS

In markets that have gotten overheated, some builders are starting to get burned. In Las Vegas, home prices rose an average 41% over the last year, fueled in part by speculators flipping new homes almost as soon as they're finished. With the rise in interest rates, however, the Vegas bubble has burst. Inventories of unsold existing single-family homes in Las Vegas shot up from 1,400 in February to more than 15,000 in September.

That's one reason Pulte Homes Inc. (PHM) in Bloomfield Hills, Mich., announced in early October that its 2004 profits will come in as much as $50 million below expectations. After raising prices in some developments by over 50% over the past year, Pulte is rolling them back 8% to 28%. Still, buyers continue to cancel orders in droves. Some analysts say cancellation rates are running at about 25% throughout Las Vegas. "We overpriced our product relative to the competition," says Pulte Chief Executive Officer Richard J. Dugas Jr. But even with lower prices, Dugas maintains that Vegas remains "among the company's leading markets for margins."

Given the heavy bets builders have placed, a slowdown doesn't auger well. All of a sudden, the housing industry's future is looking more and more like a roll of the dice.

By Dean Foust in Atlanta and David Henry in New York, with Christopher Palmeri in Los Angeles


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