Description

The homebuilding industry is undergoing a complete transformation where the very largest builders are rapidly gaining market share from disadvantaged small bulders. Since 1996, the aggregate market share of the ten largest builders -- and Beazer is one of them -- has increased from about 9% to about 22% -- and this trend is continuing. And, as the largest builders gain market share, they gain efficiencies of scale, bargaining power over their suppliers and sub-contractors, and leverage over fixed costs. Furthermore, the major companies are reducing their costs (and further gaining competitive advantages over small bulders) as they use best practices to modernize what has been a cottage industry into a more efficient, high volume manufacturing business.

An analogy might be WalMart, which has been growing rapidly because its cost structure and other advantages have forced many local merchants to curtail their activites or close their shops.

The gains in market share and the related reduction in costs are, in our opinion, the key long-term determinants of the future value of the large homebuildrs. There are many less important short-term considerations, such as interest rates, employment levels, consumer confidence, recent immigration (recent immigrants are proving to be a major market for the homebuilders), weather, and government policies (which have been favorable). Sure, the demand for new homes could fall some if interest rates rise, but the revenues and profits of the homebuilders grew rapidly in 1999-2000 when interest rates rose moderately -- and, if one works the numbers, if the large homebuilders continue to gain market share at recent rates, they would grow rapidly over the next few years even if rising interest rates trigger a reduction in single-family start to the 1.3-1.4 million level.

Here is Beazer's present situation. In 2001 through mid-2003, the company's business was helped by low interest rates, but hurt by the weak economy and by post September 11 fears. In the latter part of 2003, as the economy turned much stronger, Beazer's order rate and pricing levels strengthened. On December 31, the company's backlog was up 15.3% in terms of units and 16.0% in terms of prices (some of the price increaes are due to a change in product mix toward more expensive homes). While the strong upturn is reflected in Beazer's backlog, it is yet to be reflected in revenues or profits (because it takes roughly six months to build a house and, therefore, for an order to turn into a booked sale).

It is commonly believed that Beazer will earn about $15.00 in its fiscal year to end this September 30, but, if the present order rates continue for another several months, we believe that Beazer's fiscal year 2004 earnings will materially exceed $15.00. The CEOs of a number of other large builders have told us that Wall Street is materially underestimating the profitability in the large builders' backlogs. One CEO recently told us that he is "shocked that Wall Street has not run the numbers -- that most of the analysts simply do not get it".

In the longer-run, we project that mortgage rates will increase to a more normal level, that housing starts will cool some to a normal rate, and that the eanings of the large builders will reflect the more normal conditions, as opposed to the strong sput in earnings that we expect will occur over the next few qarters as the present backogs turn into sales and profits. More specifically, we estimate that the earnings in Beazer's backlog is at a $17.50+ per share annual rate, that the company's current trendline earnings are about $14.00 per share (assumes higher interest rates and a cooler housing market) and that Beazer's normalized earnings, driven by gains in market share and related efficincies of scale, will increase to the $20.00 level in fiscal 2006.

While we are excited about Beazer because of its longer-term potential, many hedge funds and other investors have shorted the shares becasue they believe that the shares will decline when interest rates rise. Currently, the short position equals close to 25% of the outstanding shares (3.4 million out of 13.6 million outstanding). I find this to be a staggering figure -- and I strongly believe that the price of Beazer's shares will increase sharply once the shorts realize that they are wrong and try to cover their positions. First, the shorts have to overcome the better than projected earnings over the next two quarters and then they have to overcome the thrust in the business over the next few years as the large builders continue to gain market share. If history repeats itself, at some point the shorts will realize that the dominant force behind the homebulders is the transition that is going on within the industry -- and not the effect of interest rates on the industry.

We believe that homebuilding is a wonderful business. Foreign competition is not a consideration (you cannot build a home in China and ship it to the US). The companies use sub-contractors to build the homes and therefore they are not burdened with large legacy pension or healthcare liabilities. Because every home is different (especially with respect to location), comparison shopping is not a major problem -- and therefore the industry has been immune from severe price competition. The large companies are well managed (natural selection played a role -- because it tended to be the best managed companies that grew successfully to become the large companies). Given the real estate nature of the homebuilding industry, Beazer and the other large homebuilders have relatively srong balance sheets. Taking the industry's growth potential and other attributes into consideration, we stongly believe that the large homebuilders are worth roughly 20X their current normalized earnings power. However, if in 2006 Beazer sells for only 12-13X earnings, the shares will more than double over the next two years. Furthermore, because the company's book value in mid-2006 should exceed the present price of the shares, we strongly believe that Beazer is a relatively low risk investment.

Catalyst

The short position in Beazer equals close to 25% of the outstanding shares, and yet the company's near-term earnings should positively surprise investors and the company's longer-term earnings outlook is particularly positive due to the rapid consolidation of what still is a highly fragmented business. We believe that the shorts will soon discover that they are wrong and will scramble to cover their positions -- driving up the price of the shares