Builder Uses Its Size To Hammer Out Growth

Investor’s Business Daily
Thursday, January 20, 2005

By Steve Watkins

Given the stellar numbers home builders have put up over the past few
years, you might think the industry is surging.

That’s not the case. Sure, the industry has seen steady growth. Housing
starts were on track to gain 6% in 2004, with December figures still to
come, according to the Mortgage Bankers Association.

But the really big gains have come from large, publicly traded builders
rather than their smaller, independent counterparts.

Earnings for the top players have grown 34% the past five years, says
Banc of America analyst Daniel Oppenheim.

The nation’s ninth largest builder, Hovnanian Enterprises (NYSE:HOV –
News), has seen housing orders rise 35% the past few years — in part
because it’s grabbing business from smaller rivals.

“The industry’s growth hasn’t been spectacular, but the large builders
are taking market share,” said Hovnanian Chief Financial Officer Larry
Sorsby.

Big builders still control only about 25% of the market, says analyst
Craig Kucera of Friedman, Billings, Ramsey & Co. But that’s up from 10%
five years ago.

Consolidation is causing a lot of that change. It’s getting tough for
small builders to compete.

Tight controls on land development now give the big boys a huge
advantage. They have the financial resources and expertise to work their
way through approval processes that in some cases can take years.

In Hovnanian’s home state of New Jersey, the approval process can take
five years. Hovnanian has 15 lawyers on staff whose sole job is to work
through New Jersey’s system, Sorsby says.

The company actually does better in strongly regulated markets such as
New Jersey, California and Washington, D.C., Sorsby says. Once approvals
to develop land are obtained and the houses get built, prices are higher
because demand outstrips supply.

“You have to invest a lot of people, time and money,” Sorsby said.

Hovnanian’s cash flow and balance sheet give it the prowess to do that.
It posted $4.2 million in sales for fiscal 2004, which ended in October.
That was up 30% from the prior year. Earnings gained 36% to $5.35 a share.

Analysts polled by First Call expect earnings this fiscal year to rise
25% to $6.64 a share, then move up 18% to $7.85 in fiscal 2006.

Despite concerns that big home builders are due to hit a wall at some
point, Sorsby sounds optimistic about the future.

“I think we’ll see three, four or five years of very smooth sailing for
home builders,” Sorsby said.

Hovnanian operates in about half of the nation’s major markets. It
builds in 15 states, mostly on the coasts.

It’s the top builder in New Jersey and ranks second in Washington, D.C.,
and North Carolina. It has a top-five share in Southern California.

“They’re well-positioned in some of the best growth markets in the
country,” analyst Kucera said.

Hovnanian holds more than six years’ worth of land. It has 100,000 home
sites.

The company is always on the prowl for more land, especially in new
markets. Hovnanian has been one of the more aggressive acquirers among
home builders in the past few years, Kucera says.

In late 2003 it used acquisitions to establish operations in Phoenix,
Tampa and Ohio.

Hovnanian didn’t do any large deals in the past year, but that didn’t
hamper growth. About 96% of its earnings growth was organic.

Hovnanian will be more likely to do a deal this year, Kucera adds.

“They can use that to offset the slower (projected earnings) growth
rate,” he said.

Though Hovnanian looked at more than 100 potential deals last year, it
shied away from them because of high asking prices.

“We’re committed to doing deals that make economic sense and are a good
cultural fit,” Sorsby said.

The company typically uses acquisitions to get into new markets. By
doing so it picks up managers who know the region. In the past dozen
acquisitions, Sorsby says, Hovnanian kept all the top managers.

Meanwhile, the firm is getting more money for its homes. Its average
selling price in the fiscal fourth quarter was $301,000, up from
$278,000 the prior year.

Price strength could come back to bite Hovnanian, says analyst Ivy
Zelman of Credit Suisse First Boston. She’s concerned that high prices
in Southern California will make homes too costly for most people.

“The company could be challenged to offset rising land costs, implying
that current margins could prove unsustainable,” Zelman wrote in a
recent research report.

She figures Hovnanian gets about 45% of its profit from California.

Interest rates are another concern. Mortgage rates didn’t climb much in
the past year, with 30-year mortgages at 5.74% on Jan. 13, according to
Freddie Mac (NYSE:FRE – News). But the Mortgage Bankers Association
expects 30-year rates to reach 6.4% by year-end.

“That is a concern,” Kucera said. “You might lose some people who would
buy.”

The economy plays a bigger role, however. Fewer jobs would have a
greater impact on builders than rising interest rates, Kucera says.

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