H.J. Huney submits:
There's no sector that people have remained more terrified of
over the past few years than homebuilders. In fact, even if you
bought in at the March '09 market lows, you would still have a
negative return on Pulte (-11%) (
) and a mere 4% return on MDC Holdings (
). While some other homebuilders have fared a bit better, much of
those gains can be attributed to the market realization that
certain builders were solvent and could survive, rather than
bullish prospects on the general housing market. Yet, I believe
that the sector is now attractive for long-term investors.
In early '09, I was bullish on palladium/platinum miners North
American Palladium (
) and Stillwater Mining (
). My rationale for buying was that the prices were so absurdly
low, that even if it took the industry an entire decade to rebound,
it would still be worthwhile to buy in. Over the past 2 years, the
stocks have returned about 300% - 500%, depending on when you
bought in and which of the two you chose to buy. That's a very
spectacular return for 2 years, but even if it had taken 10 years,
a 400% return over 10 years would have yielded a very respectable
annualized return of 17.5%!
Make no mistake about it - homebuilders in late '10 are not as
attractive as palladium miners in early '09. In fact, the
opportunities that came along in '09 will likely be rare in the
future. All the same, the risk/reward balance for the homebuilder
stocks is very favorable. My own estimations suggest that in a
normalized environment, many of the homebuilders should be selling
at prices 100% - 400% higher than they currently sell.
Things have looked dismal for homebuilders over past few years
and the housing market is not going to dramatically rebound in a
year or two the way the palladium miners did. But given the current
state of the market, I feel that even if I have to wait 5 years for
a homebuilder stock to pay off, that this may very well be
worthwhile.My favorite homebuilder over the past month has been
The Case for Public Homebuilders
The biggest problem for the public homebuilders right now is
fixed costs. There are economies of scale involved with the large
homebuilding operations and all the large builders need a certain
amount of volume in order to break-even. As housing starts improve,
we will see homebuilders start to profit again. Of course, the big
question is "when will housing starts improve?" 2 years? 5 years?
10 years? No one really knows.
The figure below examines housing starts, population growth, and
"housing starts per person" over the past 31 years:
(Click charts to expand)
The first thing that should immediately stand out is that aside
from the past three years, we have never even come close to being
at the low levels we are right now. The low-points before the
current crisis were 1981 (1.8 M starts), 1982 (1.06 M starts), and
1991 (1.01 M starts). In spite of the US population base being
approximately 25% higher than it was in 1991, we now have about
half as many housing starts as we did in those depressed
environments. That should tell you just how extremely depressed the
housing market is right now.
The next interesting thing on this table is the average housing
starts. Average housing starts were about 1.450 million. That's
about a 170% increase over the current levels. This figure should
theoretically be weighted down by the lower population levels in
the earlier years, as well.
Finally, the last column is the most interesting one to me. That
column represents "starts per person." The 31-year average is
0.0056 starts per person. Over the past two years, we have been
around 0.0017 starts per person. We would need to see the number
increase about 230% to reach the average. If you apply the average
ratio to the current population, we come up with an expected
"normalized" starts of about 1.725 million, well above the current
level of 540,000 starts.
While we undoubtedly have a lot of excess supply in the market
and there are still numerous foreclosures working their way through
the system, the basic takeaways from this data is that we are far,
far away from normalized production and once we reach more
"normalized" levels, the number of houses needed is going to be
It's based on this premise that I believe the public
homebuilders may be a very good long-term investment. Even if
housing starts were merely to double over the next three years
(still leaving us at semi-depressed levels), the public
homebuilders could reap major benefits.
The pain of the private homebuilders could also mean major gains
for the public homebuilders. The public homebuilders have certainly
suffered significantly over the past few years, but by and large,
the group has remained solvent. Contrast that to private builders,
where we've seen huge numbers of bankruptcies. For this reason, the
publics could see major market share gains over the decade, meaning
that prior levels of profitability in the boom are not necessarily
out of reach even in an average market.
It's for all these reasons that I am so intrigued by the public
homebuilders. While I believe numerous builders will see
significant gains over the next half decade, I have particularly
liked Pulte over the past month.
Pulte is the US's largest homebuilder. In 2009, Pulte completed
the acquisition of competing public homebuilder, Centex. Pulte also
has a small financial services arm that engages in mortgage
Pulte participates in a diverse mix of building activities. Like
most homebuilders, it does build single-family homes with a
primarily suburban emphasis. It also constructs condominium and
townhouse communities. Recently, Pulte has started a few
interesting projects with more mixed use and
designs; we can see examples of this with new communities like
in Alexandria, VA, and
in Fairfax, VA.
The primary reasons why I have favored Pulte recently are that I
like its focus (less oriented toward deep suburban areas than
competitors), recent New Urban projects, and valuation. The last
part is very key, though, because Pulte, in particular, has been
punished over the past two months. After PHM's
in mid-October, the stock dropped from $8.20 to about $6.15 (a 25%
decline), before pushing back up to $7.00. The drop came on no
major news, aside from a major goodwill write-down in the earnings
release. This should have been a non-event for investors.
With that basic thesis out of the way, let's take a look at the
financials for Pulte.
First off, I should note that all my data relating to Pulte is
from after the 2nd Quarter results. While 3rd Quarter results have
been released, I originally conducted my analysis in late September
and have become more bullish as I saw the prices drop further. The
3rd Quarter data would not appear to significantly change any of my
With that said, Pulte's simplified balance sheet is posted
About 28% of Pulte's total assets are in cash, which tells you
that this company has a major amount of dough to pump into the
market if its business picks up. Net tangible assets ((NTA)) for
Pulte were about $5.75 per share after the 2nd Quarter. I view NTA
as a "floor" for PHM, because its competitive position within the
homebuilding industry should always give it a premium. If the price
for PHM's stock were to fall below the NTAs, I would be extremely
bullish. Note that it came fairly close, as it dipped all the way
down to $6.15 very recently.
Note that PHM changed the structure of its income statement
during this period, which is why my gross margin calculations might
seem a bit confusing. The margins are calculated two different ways
for all years after 1999. Pulte originally calculated SG&A with
"cost of revenues," but moved it down the income statement into
operating costs after 2007. Therefore, I calculate gross margins
both with and without SG&A post 1999.
Revenues, Margins, Units Sold, and Average Price
Finally, the chart below attempts to piece together revenues,
margins, average prices, and units sold.
Keep in mind, once again, that margin figures might not be
Piecing Together the Earnings Picture
With all the data above, I have tried to piece together the
earnings picture for Pulte in a less depressed environment. I have
used gross margins (w/o SG&A) as my starting point and looked
at how the potential earnings picture would change with a specified
margin level given a changing number of units sold for Pulte. For
instance, in the first chart, I use a 10% gross margin. If you look
at the first row, you can see that if Pulte sells 25,000 units, it
loses 33 cents per share. If it sells 35,000 units, it will earn 7
cents per share.
All the figures for these projections are annual. I examine
gross margins all the way from 10% - 20%. While I have included a
10%, 12%, and 14%, I view these as somewhat unlikely projections
outside of a depressed environment, and view gross margins from 16%
- 20% as more realistic.
Here are all the scenarios:
Currently, Pulte is selling about 15,000 - 17,000 units
annually. Based on the historic housing starts figure, it seems
likely that starts will at least increase to 1.0 million again at
some point in the next five years. So even if we assume a 16% gross
margin and 27,500 units sold for PHM that gives us potential
earnings of 85 cents per share. Even with a low earnings multiple
of 12, that could suggest that PHM would be worth $10.20, or a bit
more than 40% above where it's trading at now. This seems like a
fairly conservative scenario.
Moving up to an 18% gross margin and 30,000 units sold, we come
up with earnings of about $1.44 per share. With a P/E multiple of
14, that gives us a valuation of about $20, which is about a 190%
increase over the current share price.
While my tables only go up to 40,000 units sold for PHM, if we
get even more aggressive and assume that my normalized production
figure from earlier is correct, that would imply that housing
starts need to triple. If PHM also saw its units sold triple to
about 45,000 units and was able to make an 18% margin, that could
imply earnings upwards of $2.75 per share! With a P/E multiple of
15, it would be possible for PHM to be selling as high as $40.
Even going back to the more conservative 16% gross margins and
30,000 units, PHM could potentially earn around $1.00 per share.
That's still fairly conservative and could imply that the company
could trade at around $15 at some point.
While I do believe that PHM has significant odds of earning over
$2 per share again sometime in the next decade, for now, I will go
with the semi-conservative outlook of 18% margins and 30,000 units
sold, yielding an expected valuation of $20. If we see the housing
market rebound faster than expected, this would be an added bonus.
Even if the housing market stalls for another 5-10 years, I still
believe that this investment could see some decent (but more
subdued) gains of around 50% - 75%.
I like investing with a margin of safety. Pulte does not meet my
traditional definition of "margin of safety," which is a company
selling below NTAs minus write-downs to susceptible asset accounts.
However, with PHM, you really have to consider its competitive
position in the market and cash flow potential based on that. Based
on that, I believe that at $7, PHM has a reasonable margin of
safety for long-term investors.
Pulte (and many other builders) might be very undervalued right
now if you believe that housing will even semi-rebound over the
next half decade. Even if housing starts were to double, we would
still be at relatively depressed levels, and PHM could be earning
$0.50 - $1.00+ per share in that environment. If we were to see
normalized levels again, PHM could be earning $1.50 - $3.00 per
Given this, I believe it's worthwhile strategy to buy into the
builders and sit and wait. For long-term investors with patience,
the builders could turn out to be quite a good buy.
I initiated a position in Pulte under $8.50 and accelerated my
buying as it dipped below $6.75. It is now one of my larger
Author long PHM, TOL and DHI
Rising Employment Set to Drive Growth in GDP,
S&P 500 in 2011