Mr. Landry: First off, I think it's important to figure out what we're dealing with here, and as a business, we are not great fans of the traditional homebuilding model for several reasons. One, it's extremely capital intensive. Two, there are weak barriers to entry. Three, there are no captive customers. The variable cost model makes for very little scale opportunity (although you heard otherwise during the bubble). And last and most important, incremental returns on capital are always the worst precisely when the traditional homebuilder has the most invested. We saw that very clearly in 2006, and we are living with the ramifications today. It's likely that returns on capital industry-wide aren't going to be much to speak of for the next few years and maybe longer depending upon how long the current slump lasts. Having said that, it's awfully easy to beat up on the homebuilders nowadays, and we think it actually makes more sense to be buying some of these stronger homebuilders than selling them at current prices. Even though the industry ills and headwinds are stiff, it's likely that a lot of that is already reflected in the price of these builders, some of which have done a better job than others preparing themselves for this downturn. When dealing with a highly competitive industry such as this, management matters a lot. Today's conditions are giving the better teams a chance to separate themselves from the pack. You couldn't say that two years ago.
TWST: You mentioned the point about returns. What's the issue there? Why don't
they get appropriate returns?
Mr. Landry: We did a study here recently where we looked at returns on capital
of the top 10 builders plus Toll Brothers (TOL) over the latest up cycle, which
was from the early 1990s through 2006. The period, which was the strongest in
decades, included only three down years. It looks like the big builders
returned about 12% on invested capital over the period if you include the land
profits. If you take out the land profit, which is an estimate, our best guess
is that the industry averaged about 10% over the period. The point is that if
the biggest and most advantaged builders only managed to earn those returns over
an extended up cycle, there isn't much competitive advantage.
When you ask more specifically about the incremental returns on capital, land is
the lifeblood of these builders. There is really only one builder that has
figured out how to operate its model without taking any ownership of the land,
and that's NVR (NVR). So we'll take out NVR and just talk about the rest here.
Land is put into inventory before they can build a house. Unfortunately, you
need to make a decision about likely returns on land one to five years (in most
cases) before you build on that land. You are placing the capital today and
making decisions about demand well into the future. As we saw, things can change
quickly.
When builders looked at the absorption rates and how their communities were
doing in 2004, 2005 and the early part of 2006, almost without exception they
were conditioned to be investing in more land because nobody knew when it would
end. The worst outcome would have been to be stuck short of land while the rest
of the group displayed impressive growth. Lo and behold, investor demand went
away, second home demand diminished, and people who should be renters and were
buying houses due to low interest rates (and lax lending standards) went away.
Now we are sitting with a production rate somewhere between 30% and 40% below
those peak rates, and at the same time, you have all that land sitting on the
industry's collective balance sheet. So you can see what happens to capital
returns and margins and why we say what we do about the incremental returns on
capital.
Tickers included in this excerpt: KBH, LEN, LEV, MDC, MTH, NVR, OHB, TOA, WCI
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