Housing's correction–starting in 2005–highlights public companies' strengths and weaknesses as they shift en masse from growth mode to balance sheet discipline. Our 2007 Public Builder Report Card.

Source: BIG BUILDER Magazine
Publication date: 2007-05-10

By BIG BUILDER Staff

• 2006 Public Builder's Financials
• Five Year Trends
• Public Builder Report Card A-D
• Public Builder Report Card H-O
• Public Builder Report Card P-W

Five consecutive years of a broad, global, economic surge have got macro-savants–including former chairman of the Federal Reserve, Alan Greenspan–wondering when, not if, the current run-up will die of old age.

There are those who don't believe for a nanosecond that up-cycles expire in this fashion, but a number of economic data points are beginning to betray the fits-and-starts hesitancy of an engine losing steam, willing but perhaps not able to go on intrepidly into the future. Corporate earnings notching down; capital investment, particularly among industrial companies, declining; job gains increasingly tending to occur in low-paying services areas; and consumer sentiment, heretofore a heroic factor in keeping the economy thumping along, seeming to reveal a growing lack of conviction. Laying the odds on the likelihood that the "R" word will pop into the collective conscious in the next six to 12 months has become an almost obligatory part of every CNBC interview with economists of all stripes.

Photo: David Lawrence "This next year ... has got to be about flawless execution, strategic allocation of our capital where it makes sense, and margin generation. I truly believe we can be a leader in those given what we have done in '06." –Cathy Smith, CFO, Centex Corp.

Were it not for apparently boundless troves of global liquidity–trillions of investment-hungry dollars looking for places to grow at an advantaged pace in private equity and hedge funds–and a presidential election year ahead, one might think therewas nothing to keep the economy in positive territory except home builders' most earnest prayers that they can extract themselves from this funk before we hit gross domestic negative-land.

Yes, there's housing, whose year-plus-old woes have already taken a good two points or more out of the GDP. Housing, which enjoyed a protracted surge cycle of its own that got underway with a housing recovery in the mid-1990s, appeared intent on surfing demographic destiny and economic strength into the next decade without so much as a breather. All went as planned for almost 10 years. Then toward the end of the summer in 2005, everyone seemed to wake up at one time and arrive at the same conclusion: There was a far greater number of people buying new homes to turn around to sell than there were people buying homes to live in than anyone had previously counted on. This phenomenon began to make housing too expensive for the many people who bought houses to live in.

Mortgage lenders, in turn, provided an easy-money Band-Aid that would crescendo over the past three years, giving a lot of executives promotions and bonuses for keeping capacity running with demand before it unraveled. "Never mind that practically anyone with a pulse could get a loan," wrote Eric Belsky, executive director of the Joint Center for Housing Studies at Harvard University, in our pages last November. "Why worry that easy credit standards and rising interest rates could put homeowners at risk of losing their homes?"

Warning salvos that rang out in the summer of 2005–Sacramento, Calif.; Washington, D.C.; Fort Myers, Fla., to name a few markets that suddenly became a big problem early–offered clear, bellwether intelligence that should have, by all rights, guided strategic plans and operational and financial management tactics for 2006.

All the telltale signals showed that there was too much supply for too high a price for too few people. But housing's last big run-up didn't pass away with time to process, grieve, and mourn. Its demise was shocking and deeply paralyzing–seeming to catch the entire industry mid-sentence talking ever optimistically about ways to increase capacity and speed up the machine.

In all candor, "our biggest mistake was [that] we just didn't pick up the effect of the speculator" dimension of home buyer demand, admitted The Ryland Group CEO and president Chad Dreier to Wall Street professionals at a UBS Investment Research forum on home building hosted by managing director Margaret Whelan in late November 2006.

If, and what a huge "if" it is, our universe of 22 public home builders had known what lay ahead for housing around the time Hurricane Katrina hit–namely, that a $30 billion to $40 billion chunk of their delivered home sales would vanish from the market by 2007–would they have crafted dramatically different strategies and tactics? Would speculative starts have ceased altogether? Would back-of-the-envelope calculations have revealed that between zero sales to speculators and the restoration of modicum of lending standards that they would have about 300,000 excess new homes to work through (about three consecutive years worth) on top of starts, on top of the backlog absorbing cancellations, and on top of the "accidental specs" that occur when flippers flip?

Could or would anyone among home builders' top management have behaved any differently? Maybe not.

As he explained to the Wall Street investment community last November why Hovnanian Enterprises would eventually take fourth-quarter land write-downs of more than $300 million against 2006 earnings, president and CEO Ara Hovnanian said, "We found it primarily on–the majority of it, really, coincides to properties where the contract was signed and/or closed in 2005. I mean, that was the challenging year in hindsight, and I wish I went on a long vacation in 2005. But we didn't. We've been in the market. And you have to be in the market. But there are times when the market hiccups and you find yourself with some land at a cost basis that you wish wasn't there, and we just have to deal with it."

From an outsider's perspective, it looks as if what senior management at most of the companies did was to lay out a strategy for 2006 that looked a lot like that of the previous few years, less one out of 20 houses or so. Depending on how well each of them course corrected tactically, that's what set one apart from another in performance. Some builders chose a massive margin compression route to work through as much inventory as possible. Others leveraged less exposure to expensive land positions to focus on taking other operational costs out, seeking top line margin protection. Some jumped into discounting and concessions action, while others were slow to react. Hindsight is 20/20, but did anyone pay enough heed to the omens of 2005 and drastically cut output, stop taking down lots, or look to bring affordability back in line beginning last year?

• 2006 Public Builder's Financials
• Five Year Trends
• Public Builder Report Card A-D
• Public Builder Report Card H-O
• Public Builder Report Card P-W

In retrospect, it would have been impossible to develop a fundamentally counterintuitive strategy toward the end of 2005, especially since the universe's collective backlog of sold homes going into 2006 was worth more than $66 billion on a total of more than 188,000 homes. The only correct strategy at that moment would have been to ramp up capacity and slow it down at the same time, which accounts for the schizophrenic front-half-back-half year that the group had.

"No one in their wildest dreams could have imagined as strong a swing as we had," says Cathy Smith, CFO at Centex Corp., as she looks both backward and forward at the challenges for home builders, echoing the sentiments of most of her public builder strategic level colleagues.

Ivy Zelman, managing director and senior analyst for Credit Suisse, wasn't dreaming when she made the following observation based on a trip to Orlando, Fla., in January 2005: "On the tip of everyone's tongue was the increasing presence of real estate investor/speculators in the market. … It appears that cheap money and the lure of real estate riches has created an unusual interest from second-home buyers not using the home as a primary residence. In most cases, the public builders have instituted contractual clauses to discourage investment buying; however, few went as far as to say they would not sell to an investor."

And, as it turns out, those few had to have been kidding themselves. Everybody was selling to investors, and later, they found themselves competing with those same investors selling those almost-new homes against them in their own communities.

When you step back and look at how public home builders performed in 2006, their relative financial and operational management executions developed the previous year more often than not appear to have assumed that deterioration would stop, pricing would normalize, and sales pace would stabilize, if not by the end of 2006, then by spring 2007. As we know now, that's not what happened.

Tim Eller, Centex's chairman and CEO, "put us on a very tactical path when the time called for it," Smith says. "In hindsight you always can say, 'I'd like to have done that another quarter or two quarters earlier.' But that said, we're pleased with what we did do in 2006. We had kind of a phase one approach–we've got to react to the current market. which means reduce our costs to the current reality and get to our fighting weight. We've done that. We've taken out a significant portion of our head count. We've got to reduce our land position, and we've done that. We did adjust to the market realities. We've got to generate cash. You'll see that, too. We as a company have done what we said we'd do. We right-sized our balance sheet with our land and got our inventory down and generated cash. And we set our cost structure for the near term to the current market realities by renegotiating with our vendors to take out significant costs there and just reducing our heads."

The job of grading public builders for 2006 behavior, then, means trying to evaluate them from three different vantage points: How well did the 2006 plan address the market conditions challenges that were visible in late 2005? How well did each builder respond to the deeper, faster slowdown than most people had anticipated? And, this one is still playing out, how skillfully did each builder reckon with market intelligence and controllable operational processes to position the company to thrive amid continued challenges in 2007?

"This next year, given all that we've done, we are poised for where we are going next–which has got to be about flawless execution, strategic allocation of our capital where it makes sense, margin generation, and cash flow," Smith says. "I truly believe we can be a leader in those given what we have done in 2006."

Not surprisingly, those companies that were charging the hardest through 2005 to rise to the top of the heap–the "we'll double in size by 2010" group–are the ones whose 2006 reflects the sharpest adjustments. Those whose land and capital structure strategies are either voluntarily or involuntarily more restricted tend to stand as the best-managed companies last year.

Two things become clear as uncertainties around the duration and eventual depth of the downturn linger. One is that, with minor exceptions, Wall Street investors still tend to see builders as a cycle-bound collective whose risks and opportunities run in lockstep. The other is that nearly everybody else tends to recognize each of the 22 companies as an operator with varying skill levels, each challenged by a different geographical footprint, land pipeline, product portfolio, talent base, and organizational structure.

They say tough times make good builders better. They also say that a bad market can make a good builder look bad. At Big Builder we're betting that the first statement is truer than the second and that we'll see some higher grades next year, whatever the market conditions.

The Big Builder Public Builder Report Card is an annual data presentation that aggregates original and researched information into its analysis. Our home builder universe includes 22 companies traded on the U.S. stock exchange whose primary business is that of building homes. We use key financial and operational reports available through Securities and Exchange Commission filings and investor presentations. In addition, we incorporate feedback from investor relations and senior financial officers. We reconcile fiscal year results with our reporting period to provide a more comparable representation of the 2006 calendar year activity. Finally, we supplement our own original research with analysis based on ongoing relationships and conversations with industry executives and management as well as the analyst community.

This year's evaluation breaks key quantitative data into four categories: financial, land, sales and marketing, and operations. Data reflects company performance as it relates to the category. For the land and the sales and marketing categories, more subjective nuances not reflected in data are explained.

In each category, line items are evaluated by assessing the performance of the company itself and comparing it to the public builder universe. Based on that analysis, each category is then assigned a numeric score. Category scores* are added to reach a total score for overall 2006 performance. The total score translates to a letter grade.**

This report's structure, metric determination, and data development process was developed by Big Builder in conjunction with former analyst Barbara Allen. Big Builder editorial staff–John McManus, Lisa Marquis Jackson, Teresa Burney, and Sarah Yaussi–evaluated the data. Barbara Allen compiled the data.