Wall Street Reversal

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The dot-com carnage has the moneymen paying attention to the sticks-and-bricks business of home building.

April 01, 2001

Once considered the redheaded stepchildren of Wall Street, home building stocks have staged a dramatic recovery in the past year. Investors fleeing last summer’s dot-com carnage for the “Old Economy” found housing stocks trading at levels normally only seen during the trough of a recession, even as they continued to deliver record earnings.

For years, investors used the advanced age of the current housing cycle as a rationale for not owning home building stocks. Now they’ve piled back on, driving the share prices of most home builders up more than 100% from last year’s lows and pushing some home building stocks up more than 200%.

The late cycle recovery in home building stocks is somewhat surprising, in that it runs directly counter to an adage oft quoted by industry analysts: “Buy on orders. Sell on earnings.” But money usually follows momentum, and triple-digit returns are especially tempting in a weak stock market. Although valuations are still historically low across this group, they are significantly better than they were a year ago. This turn-of-events has several implications for the off-again, on-again consolidation that the industry has been undergoing for much of the past decade.

 

 

  • Higher stock prices generally give acquirers a stronger currency with which to make acquisitions. This is true whether the company issues new stock directly to the target’s shareholders, or whether it offers the shares to investors and uses the proceeds to make acquisitions for cash.

     

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  • Higher price-earnings (P/E) and price-book ratios are more palatable to acquisition targets, whether the offer is in stock or in cash. Psychologically, targets are more willing to sell if they are offered a higher multiple for their company. Even if they think the acquirer’s stock may be overpriced, they know that this risk can usually be hedged through the effective use of options.

     

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  • An arbitrage opportunity exists for the largest publicly held builders because they continue to receive higher valuations in the market, on average, than do their smaller peers. Investors award these higher valuations to large-capitalization companies for several reasons: lower risk and/or leverage, greater geographic diversification, better analyst coverage and more management depth. Large-cap stocks also have higher daily trading volumes, making it easier for institutional investors such as mutual funds to quickly buy or sell large positions without unduly impacting the stock price.

    As a result, builders with a market capitalization of $1 billion or more trade at an average P/E ratio of 9.2 times earnings versus an average P/E ratio of 7.3 times trailing earnings for small-cap home builders. This implies a 25% valuation premium for large-cap home builders versus small-cap builders. The valuation premium is even wider relative to privately held companies.

    The active acquirers are fully aware of the relationship between market cap and multiples, as are middle-tier companies that want to improve their standing on Wall Street. They also know that concerns about a possible cyclical peak have kept a ceiling on their share prices in the recent past and probably will limit the potential for significantly higher valuations in the near term.

    With the stocks now having returned to more reasonable levels and the Federal Reserve bringing liquidity back into the bond market by lowering interest rates, some builders appear to be positioning themselves to take advantage of the more favorable capital markets.

    Since last fall, several large home builders have filed shelf registration statements with the Securities Exchange Commission, enabling them to move quickly to tap the market should the need arise. For example, Centex Corp. filed a $1.1 billion shelf as housing stocks continued to rise and interest rates fell last November, issuing $250 million in 10-year notes from that shelf in early February. Pulte Homes also registered a $500 million shelf in February, and Toll Brothers Inc. registered $200 million in 10-year notes. All three home building companies listed acquisitions as a possible use of the offering proceeds.

    The filing of shelf registrations doesn’t necessarily indicate that a company is planning an acquisition. But Lennar Corp.’s merger last year with U.S. Home Corp. certainly increases the pressure on the big builders to get bigger. If they don’t, they risk losing investor attention to rapidly growing companies such as Lennar, D.R. Horton Inc. and KB Home Corp., as well as aggressive up-and-comers like Standard Pacific Corp.

    Still, don’t expect to see Pulte acquiring another large publicly traded home builder anytime soon. What the company lacks is a strong enough share price to make such an acquisition pay. There are few public builders trading at lower P/E multiples, and Pulte carries the lowest valuation of its large-cap peers. Pulte does have a clean balance sheet, with ample cash and debt-to-total capitalization ratio of 32% in an industry where debt/cap ratios routinely exceed 50%, and a CEO who has announced retirement plans. Normally, those factors would make Pulte begin to look like an attractive takeover target, were it not for the fact that the company’s operations are so far flung as to make them difficult to digest.

    Rather than looking for a string of mega-mergers among the largest public companies, the gap in valuations between large-cap and small-cap builders should drive the largest builders to continue to buy smaller regional companies and local builders as fill-in acquisitions. This valuation gap should also fuel more deals among small-cap companies that aspire to large-cap multiples. This was a key driver in the recent merger between Hovnanian Enterprises and Washington Homes Inc. Look also for the large volume builders to intensify their efforts to acquire high-quality local builders. Standard Pacific’s purchase of Denver-based The Writer Corp. last August is one such example. MDC Holdings’ acquisition of KE&G Homes in Tucson, Ariz., announced in January is yet another.

    For the record, Standard Pacific registered a $350 million shelf in December and appears poised to break the $1 billion market-cap threshold this year. As a top-quality company now trading at a P/E of more than 8 times trailing earnings, Standard Pacific is one of the few regional builders with the size and currency to make an outright acquisition of another small-cap builder.

    Its acquisition of The Writer Corp. appears to portend things to come.

    David Fralix is President of Valuation Systems, a Charleston, S.C.-based consulting firm specializing in the valuation of privately held home building companies. He can be reached via e-mail at dfralix@charleston.net.

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