Description

Pulte Homes (PHM - $50)

When a highly fragmented industry consolidates rapidly because many of the smaller competitors face insurmountable cost and other disadvantages, there often is an opportunity to make large profits by owning the shares of the large, strong competitors as they grow rapidly. Such, we believe, is the case with the large homebuilders – and our favorite large homebuilder is Pulte. Over the past five years (1996-2001), Pulte’s revenues have grown at a 17.6% average annual rate (and EPS has grown even faster). We believe that the company’s earnings will increase by about 16% this year to $7.00 per share (and much of this year’s profits already is in Pulte’s backlog). Given a normal economy, management sees many opportunities to grow rapidly over the next several years – and the company’s projection for 2004 is EPS of $10.00. The shares currently are selling at $50, or only 7.1X this year’s estimated EPS and 5.0X projected EPS in 2004. Whereas many attractive value stocks have small market values, Pulte’s market value is in excess of $3 billion.

As traditional value investors, we are very interested in book values. At year-end 2001, Pulte’s book stated book value was $38.43 per share. If the company earns $7.00 per share this year, $8.50 per share next year, and $10.00 in 2004, then in mid-2004 the book value should be about $58 per share. I note that while the company does have some goodwill and other soft assets on its books, its large holdings of land are worth far in excess of their carrying values.

Because small homebuilders still control about 80% of the market for single-family homes, the longer-term opportunities for the larger builders are enormous. For example, if the consolidation only continues at recent levels (and we believe that it will), Pulte’s earnings should grow at a 15+% rate over the next five to ten years. Given this outlook, we are hopeful that Pulte’s shares will not only benefit from the higher earnings, but also from a higher price-to-earnings ratio. Our goal for mid-2004 is for the shares to sell at 10-15X our projected EPS of $10 – or for the shares to sell in the range of $100-150. Furthermore, because the company’s book value in mid-2004 is expected to exceed the present price of the shares, we believe that Pulte’s shares will prove to be a very low risk investment.

Importantly, there are four key reasons why small homebuilders are disadvantaged and why many are becoming smaller or are leaving the business. One key consideration is financing. Whereas, the large companies are able to sell long-term debt to finance the acquisition of land and the construction of homes, the small builders generally are reliant on short-term bank financing. Especially after the banking crises of the late 1980s and early 1990s, when many thrifts suffered large losses from land development and construction loans, many banks have pulled back from lending to homebuilders. In some cases small builders are being required to supply more equity capital – and in other cases the owners of the business are being asked to risk their personal wealth by signing loan guarantees.

A second consideration is permitting. Before commencing construction, builders must obtain permits from various governmental agencies. In the 1990s, local governments generally became more concerned with protecting the environment and with controlling population densities. Often, local homeowner associations and other citizens’ groups actively try to prevent or delay development. The large homebuilders generally have the experience, high-level contacts, staying-power, legal staffs, and financial resources to successfully fight for permits – and a few setbacks will not materially affect their profitability or financial strength. In contrast, small builders often lack sufficient know-how, resources, and staying-power. One setback after a lengthy and costly legal process can permanently impair the capital of a small builder. For example, if a builder ultimately receives permission to build only twenty-five homes on a tract whose economics was based on a fifty home development, the resulting losses could deprive the builder of the necessary capital to commence his next development.

Use of the Internet is another major consideration. The large homebuilders have web sites that serve as powerful marketing tools. For example, a prospective buyer can log on to the web site of one of the large builders, select a town where he wishes to live, select a neighborhood and community, pick a design that has the desired configuration of rooms and that is in his price range, choose from such options as a finished basement or an extra fireplace, determine if he qualifies for financing, calculate his monthly carrying costs, and take a three dimensional tour through a model of the selected home. In the mid-1990's, most prospective purchasers of new homes worked though real estate agents who would show the prospect many sub-divisions. Now, many prospects are by-passing the real estate agents and instead are focusing their visits on sub-divisions and models that they have identified on the Internet. As a result, many sub-divisions owned by small builders are attracting fewer prospective customers.

As the large builders gain share, they have increasing bargaining power when purchasing materials and supplies. Pulte, which will sell about 28,000 homes this year, can negotiate materially better prices for appliances, lumber, sub-contractors, etc. than a small builder who will be completing only 50 or so homes. Efficiencies of scale are becoming a major advantage for the large builders and are a contributing reason why many small builders are being forced to contract or close.

We estimate that the market share of the ten largest builders will increase from 17.2% last year to about 25% in 2005 (after having increased from 8.1% to 17.2% over the past six years). If these estimates prove true, the revenues of large homebuilders will grow at a 10% rate before giving consideration to the basic demand for new homes or to pricing. If the basic demand for new homes increases at a 1.5% annual rate and if price inflation is at a 2.5% rate, then the projected revenue growth of the large builders will 14% -- and earnings should grow somewhat faster than 14% because some of a homebuilder’s costs are fixed.

Many investors believe that the housing industry has been unusually strong in recent years – and thus deserves to sell at a low multiple of earnings. We strongly disagree with this view. Single-family housing starts are not above trend line – and it is illogical that housing would be unusually strong in 1999 and early 2000 when interest rates were rising sharply and then again in 2001 when the economy was soft and consumer confidence low. Importantly, studies by Harvard University’s Joint Center for Housing Studies and by others indicate that the present demand for single family homes is near a normal level – and that demand should continue to grow at a modest rate due to increasing family formations as well as the increasing housing needs and desires of recent immigrants. While demand could be adversely affected by a sharp increase in interest rates, demand should be helped if the economy and consumer confidence continue to improve. Furthermore, with the availability of variable rate mortgages, the industry is much less cyclic than it was in the past. A test case was 1999 and early 2000, when housing starts held up well in spite of six rate increases by the Fed.

Pulte is the second largest builder of single-family homes. Over the years, the company has enjoyed an excellent reputation for the quality of its management, operations, and balance sheet. On December 31, 2001, Pulte’s net core debt-to-capitalization ratio was about 43% (excludes debt of financial services subsidiary). Because homebuilders finance the construction of homes under contract, any debt-to-capitalization ratio below 50% generally is considered to be very sound.

Catalyst
Once investors realize that Pulte will grow rapidly as the highly fragmented homebuilding industry consolidates, the company’s shares should appreciate sharply.

Catalyst