Description

Sometimes securities become materially mis-priced when investors place undue and undeserved emphasis on a relatively unimportant short-term uncertainty and underestimate the importance of a major positive business trend that will drive the security though the short-term uncertainty and toward longer-term prosperity. Such, we believe, is the case with Centex Corporation, one of the larger and stronger builders of single-family homes. The short-term uncertainty is that the housing market currently is tight and could soften some over the next year or two, especially if mortgage rates continue to increase. However, in our strong opinion, the dominant force behind the larger homebuilders is not mortgage rates, but rather their ability to grow rapidly as they continue to take market share from disadvantaged smaller builders.

In many ways, there is an analogy between the large homebuilders of today and the WalMart of thirty years ago. Thirty years ago, most individuals purchased their small appliances, toiletries, apparel, etc. from local merchants. However, over the years, WalMart and other large format discount stores gained considerable market share as their efficiencies of scale and other advantages permitted them to offer larger varieties of merchandise at lower prices. Many local merchants became uncompetitive – and closed shop. Today, the large homebuilders serve a highly fragmented market (the aggregate market share of the ten largest builders is only about 20%) and have major cost and other advantages over their smaller competitors. Such advantages include: (1) greater access to the capital required to purchase land and finance construction; (2) better legal expertise, knowledge, relationships, and staying power when seeking building permits; (3) the scale required to negotiate large discounts when purchasing materials, appliances, etc.; (4) the scale and mind-set to transform a relatively inefficient “cottage industry” into a much more efficient mass production business; and (5) better abilities to attract potential customers, particularly by using the Internet as a key marketing tool and by using captive mortgage banking arms to offer convenient financing.

As the result of the above advantages, between 1996 and 2002, the aggregate market share of the ten largest builders increased from 9% to 20% – and this trend is continuing and is the key reason why the large homebuilders are growing rapidly. We estimate that the per share revenues of the large builders is growing at a 16% rate, of which roughly 11% comes from market share gains, 1.5% from growth in the demand for housing, 2% from inflation, and the remaining 1.5% or so from a change in mix to larger homes and homes with more content (upgraded features in kitchens and bathrooms, finished attics, etc.). Thus, the gains in market share are the dominant force behind the growth of the homebuilders – and are the reason we are excited about their prospects.

Recently, the housing market has been stronger than normal. Single-family housing starts have been running 3-5% above trend-line—and last year the average price of a new single-family home increased by 2.8% in excess of the inflation rate. When projecting the future earnings of the homebuilders, we assume that the recent strength in demand and pricing will not continue – and that the housing market will return to trend-line (i.e. – normal) conditions.

(Note: some economist believe that our assumptions are too conservative because the demand for houses has accelerated in recent years due to the large number of immigrants who entered the United States in the 1980s and early 1990s who now can afford to own their own home. Also, some economists also point out that the prices of new homes, when adjusted for inflation and size, are not above the long-term trend-line – and actually have declined over the past twenty-five years. For example, the average price per square foot of a new home was $85.33 last year vs. $87.20 (in 2002 dollars) in 1995 and $104.41 (in 2002 dollars) in 1977. For a good analysis of the housing market, including historical data, we recommend Harvard University’s Joint Study on Housing, which can be found on the Internet at www.jchs.harvard.edu).

We believe that Centex’s homebuilding EBIT margins currently are about 13% and that the company currently is earnings at an $11+ per share annual rate. (note – margins would be higher than 13% except that management has used the recent strength as an opportunity to hire and train a substantial number of new employees who are not needed now but who will be needed a few years from now to handle the company’s anticipated growth.) In the 2000-2001 period, which was before the current tight market for housing, Centex’s homebuilding EBIT margins averaged about 10¼%. Since then, the company has gained efficiencies of scale. We believe that Centex’s EBIT margins, given a normal level of housing demand and prices, currently would be about 11%. If we are correct, and if housing demand were 3-5% below its present level, we estimate that Centex would be earning about $8.50 per share. We further believe that Centex’s earnings power is increasing at a 20+% rate – a rate faster than the revenue growth because the company is benefiting from many efficiencies of scale. Thus, if our estimates are correct, Centex’s earnings power will increase from $8.50 per share in the current year to about $15.00 per share in FY 2007 (three years from now).

In our opinion, Centex deserves to sell at 10-15X its normal earnings power. Therefore, we believe that it shares will be worth $150-225 per share three years from now – or 2-3X their recent price. Furthermore, we believe that the shares remain a relatively low risk investment. Two and a half years from now, Centex’s book value should equal the present price of the shares – and homebuilders rarely sell for less than their book values. And, in our opinion, the quality of the company’s management, balance sheet, and business also offer substantial harbor against permanent loss. Another important positive is liquidity – in recent months, average daily trading volume has exceeded one million shares. Every once in a while we have the opportunity to swing for the fences with minimum fear of striking out. In our opinion, Centex is such an opportunity!

Some Wall Street analysts are concerned that the homebuilders’ shares will soften if interest rates continue to rise. We are long-term value investors who are not concerned about short-term weakness in the prices of any shares as long as their long-term fundamentals are exciting. We note that interest rates rose quite sharply in 1999 and 2000 as the Federal Reserve Bank tried to slow the economy – and mortgage rates increased from 6.8% in early 1999 to 8.0 % in mid-2000. Yet, between 1998 and 2000, single-family housing starts declined by only 3%, housing prices continued to increase, and the larger homebuilders continued to gain market share and to prosper. Centex earned $4.22 per share in 2000 vs. $2.36 per share in 1998. Pulte, one of Centex’s competitors, earned $5.18 per share in 2000 vs. $2.30 in 1998. Comparable figures for Lennar, another large homebuilder, were $3.64 vs. $2.49 – and D. R. Horton’s comparison was $1.88 vs. $.92.

Catalyst

Centex and the other large homebuilders reported large earnings increases between 1998 and 2000 at a time when interest rates increased moderately – and they are likely to report large earnings gains this year and next even if interest rates continue to increase by a few hundred basis points. In fact, in spite of the recent rise in mortgage rates, housing demand and prices have remained particularly strong. Once Wall Street realizes that market share gains – and not interest rates – and the driving force behind the growth of the homebuilders, Centex’s shares should appreciate sharply