Description

The highly fragmented homebuilding industry is consolidating rapidly because many of the small builders face serious problems obtaining adequate financing and/or remaining cost competitive. Largely as a result of this consolidation, the large homebuilders are growing rapidly. Over the past five years, Ryland, which currently is our favorite homebuilder, has enjoyed average annual revenue per share growth of 17% (and even much faster EPS growth) – and yet the share currently are selling at only 5.3X estimated 2003 EPS of $7.50. Furthermore, we believe that EPS growth over the next several years will continue to average 15+%.

There are three material factors behind the growth of the large homebuilders: (1) gains in market shares at the expense of disadvantaged small builders; (2) the demand for single family homes in the United States; and (3) pricing. Of the three, the gains in market share is the dominant factor.

Over the 1996-2001 period (2002 data are not completed) the ten largest homebuilders increased their aggregate market share from 8.8% to 17.2%. This means that, if the demand for homes and if home prices had both remained flat, the ten largest builders would have enjoyed 13% average annual growth. Adjusting for the modest issuance of new shares, the ten largest builders would have enjoyed average annual growth of 11% per share. The demand for new homes (which is mainly driven by family formations) has been growing at a 1.5+% annual rate. Therefore, if prices “normally” rise at a 2.5% rate, the basic “normalized” revenue per share growth rate for the large homebuilders has been 15+%. And, because the large homebuilders are gaining efficiencies of scale (especially positive leverage over S,G,&A), their EPS have been growing well in excess of 15%.

Presently, 75-80% of the new single-family homes sold in the United States are built by relatively small, privately owned homebuilders. Of importance, there are several key reasons why many of these small builders are materially disadvantaged. One key consideration is financing. While the large, publicly owned homebuilders are able to sell long-term debt to finance the acquisition of land and the construction of homes, most small builders depend on short-term bank financing. In recent years, many banks have viewed land acquisition loans and construction loans as being increasingly risky (partially because they remember the large loan losses in the late 1980s and early 1990s on real estate loans). Now, many banks are requiring small builders to supply more equity capital and/or to personally guarantee loans – and other banks simply are withdrawing from making land and construction loans. Thus, many small builders are being forced to contract – or leave the business.

A second key consideration is the availability and cost of obtaining building permits. Before a community of homes can be developed, a builder must obtain a series of permits from various governmental agencies. In recent years, governments generally have become more concerned about protecting the environment, controlling population densities, and limiting the increase in automobile traffic. Thus, it has been increasingly difficult for homebuilders to obtain requisite permits. Large homebuilders generally have the financial resources, legal expertise, experience, high-level contacts, and staying power to successfully obtain permits (although often with delays) – and a few setbacks will not impair their ability to continue in the homebuilding business. In contrast, most small builders often lack sufficient expertise, resources, and staying power – and one setback after expensive efforts and delays can impair their capital to the extent that they have to leave the business (they might not have sufficient capital to commence their next development).

The large homebuilders have many important cost advantages over small builders: (1) because they purchase materials (appliances, lumber, wallboard, etc.) in large quantities, they are able to negotiate large volume discounts; (2) they use their size and computers to schedule construction more efficiently, thus saving labor; (3) they use the Internet to draw traffic – and in doing so often save paying sales commissions to brokers; (4) they can transfer best practices from one community to others.

In 2002, the large homebuilders continued to gain market share at a rapid rate – and, for all of the above reasons, we fully expect that this trend will continue.

2002 was a year of strong demand for new homes. More specifically, single-family housing starts last year were 1,355,000 vs. an average of 1,269,000 in the 1999-2001 period. Because basic demand growth (which mainly is driven by family formations and immigration) is 1.5+% per year, normal growth between 2000 and 2002 would have been about 40,000 homes – so, adjusted for normal growth, the 2002 numbers are not much above the 1999-2001 average. Looking ahead, Harvard University’s Joint Center for Housing Studies emphasizes that the demand for new homes should continue strong over the next ten years due to a large number of recent immigrants who now can afford homes and due to a relatively high number of expected family formations. I highly recommend that those interested in the housing industry read Harvard’s recent studies, which are available on the web (search for “Harvard University’s Joint Center for Housing Studies”). Harvard and others conclude that present demand is not far above trend line. Some Wall Street analysts are concerned that housing demand will weaken when mortgage rates rise, but such a rise likely will be accompanied by a stronger economy and higher consumer confidence – and, in times of higher interest rates, new home buyers often can and do opt for variable rate mortgages. In 1999, when mortgage rates increased by about 200 basis points, there was a marked switch to variable rate mortgages – and housing demand hardly declined.

A final consideration is pricing. Again, it is useful to study the data in Harvard’s most recent reports. Harvard’s figures show that the average selling price of a single- family house, in 2001 dollars and adjusted for size and quality, was about the same in 2001 as it was in the 1978-1989 period. Prices started to lag in the early 1990s – and then started catching up in 1999. Importantly, recent price increases vary materially depending on geography. Ryland’s California homes are experiencing 7-8% price increase (California accounts for about 8% of Ryland’s business). Prices in New York, Boston, and some other desirable cities also have been increasing sharply (Ryland does not do business in these areas). On the other hand, prices have been flat or down in Dallas, Austin, Denver, and a number of other markets that are important to the publicly traded homebuilders. Ryland’s average price in the south (which is its key market) has been rising at about a 2% rate – and Ryland’s overall average price is rising a bit over 2%. (The average price realized by Ryland in 2002 was $210,000 vs. $208,000 in 2001, but a greater percentage of the 2002 sales came from areas with lower prices). On balance, I believe that the prices currently being received by the large homebuilders are slightly above trend line – and I have factored this into my projections of normalized earnings.

I like the entire homebuilding industry, but currently am particularly attracted to Ryland because: (1) I project that the company will earn about $7.50 per share this year and $8.50-8.75 next, and thus the shares are selling at less than 5X next year’s estimated EPS; (2) by the end of 2004, the company’s hard book value should be in excess of $40 – and, therefore, the risks in owning the shares should be small (the homebuilders rarely sell below book value for a prolonged period); (3) the company has one of the strongest balance sheets in its industry (on 12/31/02 net debt was $195 vs. shareholder equity of $562 million); (4) because the company is overcapitalized and because management believes that Ryland’s shares are materially undervalued, the company has been aggressively repurchasing shares (the company repurchased 8.7% of its shares last year); and (5) management has been very successful – and, I believe, is very talented and motivated.

I project that Ryland’s EPS will continue to grow at a 15% rate over the next several years. The following is the logic behind my estimate: (1) I believe that home sales per share will continue to grow at a 15+% rate as Ryland continues to gain market share and continues to repurchase its shares; (2) due to efficiencies of scale, etc., costs should lag inflation by 1+% annually; (3) because prices currently are a few percentage points above trend line, I assume that prices will lag inflation by 1% annually. Thus, I project that margins will remain relatively flat and that EPS growth will be 15+%.

Given the Ryland’s recent and projected growth, I believe that the company’s shares deserve to sell at 10-15X earnings. Thus I believe that the shares could double or triple in price over the next few years. The public homebuilder have passed the test of rising interest rates in 1999 and of a slow economy in 2001-2002 – and they generally are selling at roughly what their book values will be 18-24 months form now; thus, I believe that Ryland’s shares are relatively low risk investments. Because I rarely am able to find securities that have the potential to double or triple and yet have substantial protection against permanent loss, I am unusually enthusiastic about Ryland.

The author of this report has substantial holdings in Ryland and other homebuilders. The opinions expressed in this report reflect the author’s current views, which may change in the future. The author has no obligation to update this recommendation should his opinions or views change – and, at any time, the author may decide to buy or sell shares in Ryland for any reason, including: price, fundamentals, personal needs, or personal desires. (note: I have included this disclaimer on advice of counsel.)

Catalyst

In the short run, the stock market may be a voting machine -- but in the long run it is a weighing machine -- and therefore time is the catalyst that should evenually propel Ryland's shares to much higher levels. Furthermore, the company is aggressively repurchasing its shares.