Description

Two years from now (in the year that ends March 30, 2004), Centex should earn $7.00-8.00 per share in a normal environment for homebuilding - and roughly $9.00 per share if homebuilding margins remain at their present levels. Based on these estimates, I would not be surprised if Centex's shares roughly double in two years - and, if Wall Street becomes convinced that the large homebuilders are growing rapidly as they gain share from small homebuilders, Centex's shares could more than double.
A key consideration is that the large homebuilders do seem to be gaining market share (A UBS Warburg study concluded that the top ten homebuilders had a 10% market share in 1995 and a 16% share in 2000 - and that their share is likely to increase to about 25% in 2005). My recent checks confirm that many smaller builders are having great difficulty obtaining permitting and financing and are losing traffic to the large homebuilders who were aggressively using the Web for marketing. Furthermore, the large builders now are using their buying power to obtain lower prices on materials, supplies, and labor - thus putting smaller builders at a cost disadvantage. In a stagnant homebuilding environment to date this year, the large homebuilders are enjoying moderate increases in orders - thus confirming that they are gaining share in 2001. If the larger homebuilders gain a 25% market share by 2005, if unit industry demand increases at a 1.5% annual rate, and if price increases average 2.5%, then the large homebuilders' revenues will increase at an average annual rate of 14%.
Another key consideration is that the demand for single-family homes might not be materially above "normal" - if above normal at all. In 1999, the Joint Center for Housing Studies of Harvard University concluded that there should be a large demand for new housing in the present decade because of demographics and because of pent up demand from recent immigrants. Single-family housing starts totaled about 1.25 million last year. In the 1993-97 period (the five year period before the current strong market), starts averaged 1.14 million, which I will consider to be "normal". If this 1.14 million were incremented at a 2% rate (to account for population growth, favorable demographics, and immigration) from a 1995 base, then a normal number of single-family starts in 2002 would be 1.30 million. My thesis that housing starts currently may not be above "normal" was supported in a recent (May 15) article in the Wall Street Journal that described the expected demand for first homes from "echo baby boomers" and recent immigrants - as well as from "baby boomers" who desire to purchase a second home for vacations. In the article, John Pitkin, President of Analysis and Forecasting Inc. (a firm that specializes in housing data) said: "there is going to be demand for a lot more housing over the coming decade than was previously assumed; I think there are going to be a lot of things that make it difficult to meet that demand".
Recent conversations with Centex's competitors support my position that: Centex is the "Tiffany" of the industry, management is particularly capable and clever, the company's accounting is ultra-conservative, and the company's land position is "grade A". Because of the ultra-conservative accounting and because of the quality of the land position, Centex's book value is materially understated.
With respect to the risks of owning the shares, if Centex comes close to meeting my earnings projections for the next two years, the company's book value on June 30, 2003 should be above $42 per share (if my estimates are met, the book would be $42.75-44.75 per share). Because Centex's shares rarely trade below their book value (and because the book value is substantially understated), I believe that it is highly unlikely that the shares will sell for less than $40 in 2003.

Projections Behind Earnings Estimate for the Year to End on March 30, 2003

Conventional domestic homebuilding is Centex's key business (it accounts for roughly 70% of total operating earnings). This year, Centex will sell about 23,000 homes in the U.S. My estimate is that, including a few acquisitions, sales will increase to about 27,500 in FY 2004 (management is more optimistic and projects that sales will exceed 30,000). The average sales price this year should be close to $225,000 per home. I project that prices will also average $225,000 in FY 2004. Management predicts that pre-tax margins this year will average 10.5-11.0% - and that margins will remain strong - partially because of cost efficiencies (including the use of Web based and other technologies that will optimize scheduling and therefore reduce labor costs). I project that margins in FY 2004 will average 9.0% if the environment is "normal" and 10¾% (i.e. - flat with this year) if the market remains strong. Therefore, I am projecting that operating earnings from domestic homebuilding will be $525 million in a "normal" market and $665 million if the market remains strong.
Another important business segment is mortgage banking. There are two subsidiaries: (1) CTX Mortgage, which originates first mortgages and sells them (along with servicing rights) on a non-recourse basis to other financial institutions and (2) CHEC, which originates home equity loans and then sells them with recourse (but CHEC keeps the servicing rights). Centex estimates that CTX will originate about 80,000 loans in FY 2004 and earn a profit of about $800 per loan. I cannot argue with these projections. CHEC is more complicated because Centex switched to the ultra-conservative portfolio method of accounting last year - and thus recent earnings, as reported, do not reflect the subsidiary's true earnings power (current earnings are being deferred). As amortization of deferred earnings increases with time, Centex estimates that CHEC should earn about $110 million in FY 2004. I note that CHEC's recent operations have been strong and above expectations. Thus, I project that the two mortgage banking operations will earn a total of $170 million in FY 2004.
Centex is a diverse building company that has a number of smaller operations, including: Fairclough (homebuilding in the UK); Cavco (manufactured homes); construction products (cement, wallboard, and aggregate); contracting; land sales; and services for home owners (security systems, lawn care, etc.). Centex's internal projections are that these businesses will earn a total of $290 million in FY 2004. To be conservative, I will estimate their earnings at only $175 million (note - management argues that my estimates are unrealistically low, but I assume that the wallboard and manufactured homes businesses remain very weak).
Other relevant items are: interest expenses estimated at $100 million; corporate expenses projected at $55 million; an effective tax rate before credits of 38%; tax credits from tax related acquisitions of about $45 million; and 64 million shares outstanding (diluted). With respect to the tax credits, management has been astute in acquiring companies with tax loss carry-forwards that can be utilized by Centex. The company currently owns 49% of Nomas Inc. and will acquire the remaining 51% next March. Nomas has a $380-400 million NOL that will reduce Centex's taxes by $30+ million per year for at least four years.
The attached table projects Centex's FY 2004 (year ends March 2004) EPS based on the above estimates.


EPS Given a "Normal" Market for Homebuilding FY 2004 FY 2003 FY 2002
# of homes sold 27,500 25,000 23,000
average price per house ($) 225,000 225,000 225,000
revenues from US homebuilding ($ mil) 6,188 5,625 5,175
operating margin 8.50% 8.50% 10.50%
operating profit from US homebuilding ($ mil) 526 478 543

op profits ($ mil) - US homebuilding per above 526 478 543
- mortgage banking 170 120 90
- other businesses 175 150 125
- total 871 748 758
interest expense ($ mil) 100 105 105
corporate expenses ($mil) 55 50 42
earning before taxes ($ mil) 716 593 611
taxes at 38% rate (before credits) ($ mil) 272 225 232
net earnings before tax credits ($ mil) 444 368 379
tax credits ($ mil) 45 45 0
net earnings ($ mil) 489 413 379

# of shares outstanding (mil) 64.0 63.0 62.0

EPS 7.64 6.55 6.11


EPS Given a Strong Market for Homebuilding FY 2004 FY 2003 FY 2002
# of homes sold 27,500 25,000 23,000
average price per house ($) 225,000 225,000 225,000
revenues from US homebuilding ($ mil) 6,188 5,625 5,175
operating margin 10.75% 10.75% 10.50%
operating profit from US homebuilding ($ mil) 665 605 543

op profits ($ mil) - US homebuilding per above 665 605 543
- mortgage banking 170 120 90
- other businesses 175 150 125
- total 1,010 875 758
interest expense ($ mil) 100 105 105
corporate expenses ($mil) 55 50 42
earning before taxes ($ mil) 855 720 611
taxes at 38% rate (before credits) ($ mil) 325 273 232
net earnings before tax credits ($ mil) 530 446 379
tax credits ($ mil) 45 45 0
net earnings ($ mil) 575 491 379

# of shares outstanding (mil) 64.0 63.0 62.0

EPS 8.99 7.80 6.11

Catalyst

Shares should appreciate sharply once Wall Street fully realizes that Centex and the other large homebuilders will grow rapidly as they continue to gain market share from disadvantaged small builders.