What's Grounding Builders' Stocks

As the industry thrives, investors fear earnings will stall if mortgage rates rise

Rodney Dangerfield would understand. After a year when homebuilders saw their stocks double in price, they still feel they don't get no respect. Twelve of the biggest outfits have even banded together to form the Public Home Building Council of America to talk up their stocks with Wall Street and the financial press.

What bugs them is that they deliver record results year after year, while the market keeps their price-earnings ratios anchored firmly in single digits. Although earnings have grown at a 29% annual lick during the past five years, their p-e ratios haven't budged much above 7 -- just one-third of the 22 p-e's of the Standard & Poor's 500-stock index for the same period. Execs argue they deserve much more. Says Joel H. Rassman, chief financial officer at council member Toll Brothers Inc. (TOL ) in Huntingdon Valley, Pa.: "In any other industry, this would be ridiculous."

Do the builders have a case? In a world where tech companies that have never earned a penny can command premium prices, you might think a business as solid as homebuilding should attract more attention. But Wall Street doesn't see it that way. Shares rise when expectations are high -- and investors just don't expect homebuilders to stay hot.

For a start, rock-bottom mortgage rates have fueled home sales and rising house prices, as well as windfall profits on the land homebuilders own. And the next move for rates is probably up. Already, rate worries have sliced about 11% off the stocks since Dec. 1. David D. Weaver, an analyst at brokerage Legg Mason Wood Walker Inc. (LM ), doubts the market will change its mind until builders prove they can make big money when rates are high.


Rising land prices aren't all good news, either. To keep growing, builders must buy more land at an increasing cost. That cuts deeply into operating cash flow, which was less than $300 million last year, even though the industry reported earnings of $4.6 billion, says StockDiagnostics.com, a Wall Street data cruncher. Pulte Homes Inc. (PHM ), for example, spent $782 million to boost its stockpile of land by 23% in the first nine months of last year. In the same period, its operations drained $433 million of cash. "We are acquiring land to grow," says Chief Executive Richard J. Dugas Jr. "We're looking to invest another $1.5 billion-plus." But even if Pulte and others aren't engaging in the rank land speculation that once tarnished the industry, their inventory costs will soar if sales slow, analysts say.

Investors fret that gains on land that builders already owned are still propping up profits. Builders don't disclose how much their land is worth or how much of their record earnings are windfall gains. Skeptics are concluding that "their margins can't continue like this unless land prices keep going through the roof," says value investor Richard S. Pzena, founder of Pzena Investment Management LLC.

Investors don't believe that much of the other good news for builders will persist, either. As the economy picks up, the lower costs for materials, labor, and their own borrowing are likely to rise. "These have been the best of times for the industry," says Kenneth T. Rosen, professor of real estate finance at the University of California at Berkeley.

The builders have a few friends on the Street. The Al Frank Fund owns 13 of the stocks. Manager John Buckingham says their earnings will grow by 15% or more each year through the end of the decade. The builders say they can cope with a rise in mortgage rates of one, or even two, percentage points -- because it would probably come with a stronger economy that lifts consumer incomes. And they expect to keep boosting earnings through price increases on scarce lots, skilled marketing, cost-cutting, and economies of scale as they take market share from smaller builders. But the market doesn't have much respect for that line.

By David Henry in New York

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