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A Tricky Time for Homebuilders' Stocks

By Eric Wahlgren By most accounts, 2001 was a bum year for stocks. Among the few exceptions were the shares of the largest U.S. homebuilders: They rose 27% on average as Americans said "So what?" to the downtrodden economy. Instead, they took advantage of rock-bottom mortgage rates to buy 909,000 new homes, a record. While homebuilders' stocks flourished, the Standard & Poor's 500-stock index -- a yardstick of market performance -- fell 13% in 2001.

This year, new-home sales are expected to fall off from 2001's record levels, but not by much. National Association of Realtors (NAR) economists are predicting a 4.4% decline, to 869,000 units, still a strong pace by historical standards. Mortgage rates, while expected to creep up this year from the current 6.8% or so for 30-year fixed loans, are not seen rising to levels that would prompt potential home buyers to give up.

Even though Wall Street is forecasting another year of solid results for top homebuilders, it could be trickier these days investing in this economically sensitive sector. The stocks are unlikely to produce gains as fat as last year's. As of Apr. 12, the S&P Homebuilding Index was up only 4.8% year-to-date, although that was still better than the S&P 500, which was down 3.2%. A number of forces will be in play this year, leaving the trajectory of homebuilding stocks somewhat uncertain. Despite some select opportunities, unless your portfolio can handle some additional risk, you might want to steer clear of this area.

THE DOWNSIDE. On the negative side, institutional investors, such as mutual and pension funds, could begin selling their holdings in these stocks to capture some of the big gains they've recorded in the past year or so, says Michael Jaffe, an S&P equity analyst. "They are going to take their profits rather than sit on them," he says.

Although the Federal Reserve may not raise interest rates for a while, the threat of higher borrowing costs could tamp down homebuilder stocks, Jaffe says. "Because of the interest rate jitters, the stocks may not perform as well as what the economic performance [of the homebuilders] warrants," Jaffe says.

Further, it's unclear what exactly will happen with new-home prices, which can be a factor in homebuilders' profits. The NAR sees them rising 6.1%, to a median of $184,700, making the new home nearly $30,000 more expensive than the median existing home. If prospective home buyers begin to think shelling out that much for a new home is a stretch, it could dent homebuilders' business.

The need for them to hand out incentives to secure buyers for these pricier homes, as was the case shortly after the September 11 terrorist attacks, could hurt, too. Home buyers' "income growth has not kept pace with the growth in home prices," says NAR Senior Economist Lawrence Yun. "If you combine that with rising mortgage rates, this could disqualify some potential home buyers."

THE UPSIDE. On the plus side for homebuilders is that buyers in many parts of the country continue to be able to afford new homes. True, prices have risen to obscene levels in regions like New York's Tri-State area and the San Francisco Bay area. The Palo Alto (Calif.) two-bedroom cottage in the $1 million neighborhood has become legend.

Overall, however, prices are saner -- though still climbing. The housing-affordability index, measuring a typical family's ability to qualify for a loan on a typical new or existing home, was highest in the Western region, at 103.8, according to the NAR. That means households earning that region's median income of $52,031 would have 103.8% of the income needed to buy a $196,200 home -- the median price for an existing home in the Western region.

Also working in the homebuilders' favor: a continued a shortage of new homes. The current inventory is about 4.3 months, meaning it would take that time to deplete the stock at current sales levels, says Michael Carliner, an economist with the National Association of Homebuilders in Washington, D.C. That's not as low as the all-time inventory bottom of 3.6 months in December, 2000, but it does indicate a shortage, he says. "For homebuilders, the long-term trend is increasing new-home sales," says Carl Reichardt, an equity research analyst with Banc of America Securities in San Francisco. "There is a very short supply of new homes right now."

LOGGING ONTO LENNAR. Despite the countervailing trends affecting homebuilders, Reichardt and other analysts argue that investors who are determined to have a presence in this sector can find some opportunities. For many analysts, the top pick is Miami-based Lennar (LEN), which rang up $418 million in 2001 net income, or $6.01 per share, on about $6 billion in revenues, making it one of the nation's largest homebuilders.

For its fiscal first quarter of 2002 ended Feb. 28, Lennar topped Wall Street expectations with net income of $71.9 million, or $1.03 a share, on revenues of $1.25 billion, vs. the year-ago quarter of $51.3 million in net income, or $0.75 a share, on $1.1 billion of revenue. The company said it was on track to post EPS in the range of $6.10 to $6.50 a share for the full year.

Reichardt says he likes the company's balance sheet -- it has a debt-to-market cap ratio of only about 37% -- and its strong position in key markets such as Florida, California, and Texas. "They are in very deep in some of the fastest-growing states," says Reichardt, who has a buy rating on the stock. His 12-month price target of $65 suggests that he believes the stock could appreciate nearly 21% from its Apr. 17 closing price of $53.91. That's not quite the 29% it gained in 2001, but still not too shabby.

Even Jaffe, who for macroeconomic reasons is bearish on the sector overall, has an accumulate rating on Lennar. He plays up its acquisition of U.S. Homes in May, 2000, which gives Lennar the ability to offer standardized and customized homes in the same communities. "I like its business model," Jaffe says. Lennar did not respond to a call seeking comment.

OTHER BUYS. Another favorite is Los Angeles-based KB Home (KBH). In fiscal 2001 ended Nov. 30, it recorded net income of $214 million, or $5.50 per share, on $4.6 billion in revenues. For its fiscal first quarter ended Feb. 28, KB posted a 65% rise in profits to $42.7 million, or $0.95 a share, on revenues of $915.6 million, up 11%. That compares to the year-ago quarter's profit of $25.8 million, or $0.70 a share, on revenue of $821 million. Wall Street analysts expect KB to earn $5.99 a share in fiscal 2002, representing a 9% increase over prior-year EPS.

KB Home has been the largest single-family homebuilder in California but is aggressively expanding in other key states, including Texas and Florida. "The company concentrates over a third of its business on minorities and immigrants, which are really going to be the backbone of growth going forward," says Timothy Jones, senior analyst at H.C. Wainwright & Co. in New York.

Jones has a buy rating on the stock and a price target of $52, which would represent a 13% increase from its Apr. 17 closing price of $46.21. A KB spokeswoman says the company "did have to provide some initiatives" to buyers after the terrorist strikes in the U.S. but that the company in October was "back to business as usual."

Other names carrying buy ratings include Arlington (Tex.)-based D.R. Horton (DHI), with 2001 net income of $254 million, or $2.21 a share, on sales of $4.4 billion; and Atlanta-based Beazer Homes USA (BZH), which posted net income of $75 million, or $8.26 a share, on sales of $1.8 billion last year.

QUESTION MARKS. However, a couple of the biggest companies in the sector aren't expected to post major stock-price gains this year, some analysts say. Bloomfield Hills (Mich.)-based Pulte Homes (PHM), with 2001 net income of $301.4 million, or $5.99 a share, on $5.4 billion in sales, is expected to report 2002 earnings of $6.58 a share, a 9% increase over last year. Although Reichardt says Pulte's July, 2001, acquisition of Del Webb -- a homebuilder in the "active adult," or retirement, market -- will be good for long-term business, he says it presents "near-term challenges of integration."

Pulte spokesman Jim Zeumer disputes this opinion, saying "we should clearly demonstrate the leverage...of the strong Del Webb brand names -- Del Webb and Sun City -- and the well-positioned land assets of Del Webb as we move through 2002."

In fiscal 2001 ended Mar. 31, 2001, Dallas-based Centex (CTX) had net income of $282 million, or $4.65 a share, on $6.7 billion in revenues. It's another top name that may not see its stock appreciate much this year, according to some analysts. Wall Street expects its earnings, which are more diversified than those of other builders -- with about 40% of its operations in financial services, construction products, and other areas -- to jump 30% this year, to $6.06 a share. But analysts say its greater exposure to financial services could make Centex more volatile than pure-play homebuilders.

However, Centex chairman and CEO Larry Hirsch says volatility is a thing of the past. "The growth in the subprime [home-equity lending] business should substantially offset any reduction in the other side of the mortgage business."

MORE BUILDING AHEAD. Analysts, though, are expecting many of these stocks to swing wildly in 2002 as the economy searches for its footing. Jones says the more fearless investors may be attracted to the low valuations of homebuilders: Most of the top companies are trading at only 8 to 11 times next year's earnings. And, he says, the 10 largest homebuilders, which have about 16% market share, will continue to take share from smaller builders as they benefit from better access to land, stronger balance sheets, and lower borrowing costs.

At this point, 2003 is looking more promising than 2002 for investors who hang in there. "All companies are expected to have double-digit earnings and revenue growth next year," Jones says. That may end up being a better time for investors to move into the homebuilding sector. Wahlgren covers financial markets for BusinessWeek Online in New York

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