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Note From Edward Hemmelgarn

Given the strength of the current economic recovery, the reemergence of inflation and higher interest rates has always been a matter of when, not if. For some equity investors, the first indications of inflation are reason enough to shave their equity allocations. However, history suggests that this can be shortsighted, as a strong economy leads to continued growth in corporate profits. In addition, factors such as much better inventory management are causing longer economic cycles and longer periods of profit growth for companies. Broad projections on how particular sectors and companies will respond in a higher inflation and interest rate environment often prove to be off the mark.

A case in point is the home building industry. Traditionally, this industry is thought to be vulnerable to rising interest rates, because the borrowing costs increase for builders and consumers alike. However, as Monika Vatali points out in this issue’s Analyst’s View, the large public homebuilders may fare rather well if inflation and interest rates rise by more moderate amounts. This is due to a salutary combination of demographics, the continued availability of mortgage capital, and improvements in the operating model of the large builders. This issue also includes an interview with Don Tomnitz, the CEO of DR Horton, currently one of our two homebuilding holdings.

At Shaker Investments, fundamental research continues to be the best edge we have in our pursuit of outperformance.

Long Term Supply/Demand Trends and Market Share Gains Fuel Growth in the Homebuilding Industry
By Monika Vatali - Research Analyst

The $208 billion homebuilding industry has grown at a 9.3% compound annual rate in the past 13 years. 5.6% of this growth was due to an increase in the number of homes sold, and 3.5% was due to increased prices. With 80,000 private builders, the industry is highly fragmented, and this provides an opportunity for continued consolidation by the large public builders.

Demographics are favorable for continued strength in demand. New household formations are growing at a stable 1.0%-1.5% annual rate. The number of households between the age of 45 and 64 will increase by 30% between 2000 and 2010. This age group, dominated by Baby Boomers, represents growing demand for second move-up homes and active adult communities. Immigration in the 1990s was the strongest since the turn of the century. These immigrants will provide stable demand for entry level housing through the first decade of the 21st century. Furthermore the Echo Boomers, i.e., children of the Baby Boomers will soon start purchasing entry level homes.

Since the late 1980s, mortgage capital has been widely available. The increased ability to sell mortgages on the secondary market has created a continuous stream of new mortgages. Various loan types with different rates, terms and down payment requirements, and the availability of capital for previously poorly served groups provide broader access to home ownership. As a result, home ownership rates are at all time highs and continue to rise.

While demand is strong, new home inventories are low, mostly due to structural changes in the industry. After the S&L crisis of the 80s the weak players disappeared, and the strong ones became even stronger. The builders changed their strategy from investing heavily in land and building speculative inventory, to optioning lots and building-to-order. Builders today construct very few homes without a buy order from a customer. This new strategy helps the companies allocate cash more effectively, generates higher returns on investments, strengthens their Balance Sheet and lowers their risk. At the same time this has lowered finished new home inventories. Inventory levels have also declined due to the increasing difficulty of getting building permits in land constrained markets. These changes on the supply side made the industry less cyclical and more demand driven. Large builders with superior business models have achieved high debt ratings and constant access to low cost development capital. This entry barrier makes them even stronger as lower cost of capital and significant economies of scale provide them with an up to 8% cost advantage over smaller builders. In addition, the geographic diversity achieved by large builders mitigates risk and offers more capital allocation options. These competitive advantages allow the large builders to take market share from the small ones.

Due to consolidation and general strength in demand, the public builders have grown sales at a 17% median rate in the past 13 years. Since 1990, the group has increased operating margins from 7% to 13.8% (2003) and generated compound annual EPS growth of above 20% during this period. Increasing scale and efficiencies should continue to result in margin expansion, which will drive EPS growth to 15% or higher in the near future. Considering this growth rate, the group is valued at single digit PE ratios.

Shaker Investments holds the shares of two public builders: Pulte Homes and DR Horton. Pulte Homes focuses on the active adult market and should benefit from the favorable demographics of this segment. DR Horton targets the entry level buyer, and through its emphasis on value and operating efficiencies has been the fastest growing homebuilder.

Rising interest rates are likely to cause a decrease in the growth rate of new home sales. However, increasing employment and the secular changes in the industry should mitigate the negative effect of rising interest rates relative to past cycles. We believe that by growing their market share, the large builders will be able to grow through this economic cycle.

Executive Insights
Don Tomnitz, CEO
DR Horton, Inc. [NASDAQ: DHI]

Q: Don, what is D.R. Horton’s share of the home building industry?
A: The home building industry in the U.S. is extremely fragmented. On a single family permit basis, D.R. Horton’s market share of about 3.5% makes us the industry leader. Our goal is to achieve 10% share by 2010.

Q: Will smaller home builders become an endangered species?
A: That appears to be a likely outcome, if current trends persist. A decade ago, the top 10 home builders represented only 5% of the U.S. home building market. At the end of last year, their share was 26%. The long term projections are 40-50%.

Q: Does size matter?
A: Scale is essential in this business. When we went public in 1992, we were building 899 units. When you seek to buy that number of refrigerators from a leading appliance manufacturer, you can’t expect much of a discount or rebate. Nor will you receive much attention. Today, when we are building 14,000 units, there’s no question that we will receive favorable terms. That enables us to offer name-brand appliances to our customers and still keep our home prices affordable. Additionally, our ability to borrow at lower cost than smaller competitors is a major competitive advantage when it comes to pricing.

Q: Do you have plans to expand outside of the 21 states that are now your footprint?
A: Not at this time. Our existing geographical diversification helps to ensure that we are not overly vulnerable to regional cycles. Also, we already have a presence in all of the higher growth states. D.R. Horton’s game plan now is to increase our penetration in those states, primarily by taking advantage of our scale. Our cost structure is so low relative to 90% of the home builders in our industry that we can offer the same house in the same location with a more competitive warranty and price. As a result, we believe that we can grow 15-20% a year in our existing footprint.

Q: What role have acquisitions played in D.R. Horton’s growth?
A: D.R. Horton has enjoyed considerable organic growth, but acquisitions have been an important strategy for us. We pursued our first acquisition in 1994, to-date, we have completed 17. We had two choices in key markets where we weren’t embedded. One was to open undeveloped land and wait two to three years to achieve scale, revenues and profitability. The second was to purchase a company that could provide immediate revenues and profits. In many cases, the second option has worked well for us.

Q: Integrating an acquired company can be difficult in any industry. How has D.R. Horton been able to make this work?
A: In some regards, we are more decentralized than many of our major competitors. Our 53 profit center managers are entrepreneurially oriented and run their businesses in their local markets. They have wide authority to make decisions that are germane to their particular region. Our respect for local management helps to ease an acquired company’s transition
into our corporate family.

Q: Is decentralization common among your major competitors?
A: From that perspective, we’re in the minority. D.R. Horton has been criticized for this, but we’re convinced that decentralization is a prime reason why we’ve become the dominant player in our industry. We believe that home building is a local business. The heads of our local office in San Antonio, for example, can decide what wallpaper works best in that market. Our larger competitors may have a division president who has to ship wallpaper samples to the corporate office for approval! We don’t believe that our management wonks at corporate headquarters in Arlington, Texas know anything about what kind of wallpaper belongs in a model home in San Antonio.

Q: What does your corporate staff oversee?
A: We control business risk elements, the financing, cash, a centralized IT system, and the final approval of land and lot decisions.

Q: Is there consistency in your products across the 21 states?
A: Our national focus is to create product for the first and second home buyer. Typically, 45% of our customers are first-time home buyers and 45% are purchasing their second home. However, in terms of our products and their regional aesthetic, we’re a national company with a local sensibility. From locale to locale, the price range, design and square footage varies. In Albuquerque, a 1000-square foot home may cost $80,000, while an 800-square foot loft in California may run $250,000.

Q: Don, if interest rates begin to rise, will that have an impact on D.R. Horton’s earnings growth?
A: Yes, and it will be positive. We don’t think interest rates will rise in a vacuum. An increase would be accompanied by a stronger economy, new job growth and median wage increases. In addition, for the first- and second-time buyer the decision to buy a home is generally driven by life changes (a new job, relocation to a new city, changes in marital status or the birth of a child) rather than interest rates. We find that our buyers are more focused on the monthly payment than the interest rate. Since we offer flexible home designs across many price points, we can continue to offer homes at affordable prices.

Q: Do you expect the industry to slow down?
A: No. Our projections for the next 10 years anticipate that single family permits will be no less strong than they’ve been for the past 10 years. The land entitlement process has become increasingly difficult in many cities, and homebuilders have not been able to keep up with the current demand for housing. And we don’t see that demand slacking. The demographics for housing are very strong. Add to all of that a governmental commitment to encouraging home ownership, and you have a continuing positive operating environment for D.R. Horton.