Centex (CTX)

TOP CONTRIBUTORS

Michael Francis

Centex is a leading US homebuilder. The company sold over 35,000 homes in 2006 at an average selling price of $307,000, higher than the national median of around $210,000.^[1] Offerings range anywhere from under $80,000 to over $1.5 million, and the company operates in 25 states and in all areas of the United States (see chart below). Most homes are single-family detached units, which accounted for approximately 80% of the units sold last year.^[2] The company also offers, to a lesser degree, attached, multi-family homes.

The company operates in a highly cyclical industry. New home construction, home prices and new home sales volume are heavily dependent upon job growth, interest rates, and the business cycle at large. Low interest rates and high job growth bode well for homebuilding, but as the recent subprime lending crisis and depressed housing market has illustrated, things can sour quickly and the business can be difficult to predict. Key homebuilding numbers, such as housing starts and existing home sales have continued to come in weak of late. Homebuilding is highly competitive and marked by few barriers to entry, low profit margins, and high financial leverage.

Financial Information and Operating Metrics

Below is a breakdown of company revenue by region, along with a chart depicting the company's revenue and operating profit. Recently, the company's operating profit has been hit largely by falling home prices. As discussed below, when home prices in the company's geographic operating areas fall, the company must either write down the value of its unsold home inventory or, when it does sell the inventory, take a substantial hit to its margins. This is largely because of the lag time between constructing and then selling a new home -- if the company builds a home at $150,000 and expects to sell it at $200,000 given market prices, any change in the market value of the home erodes the originally anticipated $50,000 profit because the construction expense is largely fixed. Indeed, in fiscal 2006, the company took write-offs and impairments of nearly $650 million related to declining inventory values and canceled options because of market conditions.^[3]

Below is a table of relevant operating metrics for the company. In fiscal 2007, the company's average home price, for the most part, stagnated, while the number of home sold decreased. This had a negative impact on margins and results from operations.

^[6]

Notes on Homebuilder Accounting

The accepted accounting principles for homebuilders can be a bit convoluted, and it is important that investors understand certain non-intuitive accounting methodologies. Here are a few notable accounting conventions for builders that may not be immediately clear to investors:

• Interest expense and other costs directly associated with construction incurred from home building activities are capitalized until the sale of the home. When the home is sold, these interest expenses, etc. are then incurred as part of the cost of goods sold, and not as separate operating or interest expense.
• As such, land and unsold homes owned are not included as part of company property, plant, and equipment, but rather as inventory. The difference is that this land is up for sale as a regular part of the operating business whereas corporate offices and the like are fixed assets not held with the intention of a sale.
• Inventory is typically evaluated for impairment by considering relative market data and the anticipated cash flows from the property. If management estimates that the expected sum of future cash flows for their inventory is lower than originally modeled, they will write down the value of the inventory. As housing prices across the country fell in 2007, many homebuilders took such write downs.
• For financial services/mortgage arms, companies generally include one line item for financial service revenue and one for financial service expenses. Builders generally operate as most mortgage originators do today, by issuing a loan to buyers and then selling loans in packages to investors in the form of a mortgage-backed security. Revenue generally includes any interest rate spread earned on the mortgage before it is sold and any servicing fees for those already sold. Similarly, the debt of the financial services arm, used as capital for the company to issue its mortgages, is generally not consolidated on the company's balance sheet. Instead the assets and liabilities of the segment are accounted for using the equity method.

Trends & Drivers

• The subprime crisis and home prices. Home prices and the level of new home construction are driven by macroeconomic variables like GDP growth, interest rates and employment. In a favorable economic environment, rising housing prices can lead to lax lending standards and, sometimes, exuberance as collateral values rise, which further fuels price increases. As has happened recently, however, home prices across the country can also experience sharp declines when this exuberance catches up to buyers and lenders. Currently, in part because of a vicious cycle fed by the subprime mortgage crisis, in which mortgage borrowers with poor credit histories or little documentation have struggled to meet payments, home prices in many areas have been in a whirlwind of decline. This, in turn, further exacerbates default rates since these borrowers cannot refinance mortgages given deterioration of collateral. The company, of course, assumes the risk of continued price declines and hampered demand in its areas of operations. Indeed, Centex has recently written down the value of its homes or has been selling them off at heavy discounts. The company is also focusing on reducing its land and home inventory, having done so more quickly than competitors looking to free themselves up from the troubled housing market.

• As one of the largest homebuilders, geographic diversity and size can benefit Centex. Developing sustainable competitive advantages of scale can be difficult for homebuilders. Centex, for instance, uses independent contractors for construction activities,^[7] so there are limits to the level of volume discounts they might be able to extract. Nonetheless, as a national player and larger homebuilder, the company may be more readily able to benefit from economies of scale within its geographic regions and by spreading corporate overhead across a wider base of homes sold. Centex has expressed a desire to exit markets where it does not believe they can gain advantages of scale, and it wishes to focus its efforts in markets that reward larger market share.^[8] Furthermore, the geographic diversity of the firm relative to some smaller competitors limits the risk of isolated housing depressions in any one market. The company's strategy is to limit local housing market risk and volatility by maintaining geographically diverse operations.^[9]

• Interest Rates. Interest rates have several critical effects on the company.^[10] In general, rising rates spell bad news for all homebuilders for several reasons:
  • 1) As interest rates increase, home owners with floating rate debt or adjustable rate mortgages become more likely to default on their loans and foreclose on their homes. This, in turn, increases the inventory of available homes for sales, lowering prices and increasing options for potential buyers. Also, though the company sells most of the mortgages it originates through its financing segment to investors, it assumes a higher default probability on the mortgages is does hold.
  • 2) As interest rates and/or default rates increase, lenders are more likely to demand greater compensation in the form of higher mortgage rates. When buyer financing is less attractive, purchasing a home becomes less appealing and the company can experience greater difficulty unloading its inventory.
  • 3) When rates are higher, available and existing financing for the company itself becomes less attractive. Getting favorable terms on any new debt to finance construction is more difficult. Also, the company’s interest expense on its floating rate debt increases, pressuring margins and increasing financial risk.

• The U.S. Housing Market Cyclicality. Homebuilding is a highly cyclical business and is often a beneficiary and victim of business cycles. Demand for homes is dependent upon the strength of the job market, growth in gross and per capita GDP, the level of interest rates and the availability of mortgage financing.^[11] When growth is strong, interest rates are low, and employment is robust, potential first time homeowners and those wishing to relocate can pursue new homes more readily. Thus, more people buy homes, which drives the volume and pricing at which the company can sell its home inventory. On the other hand, high rates, high unemployment and slowing GDP growth hamper demand for new homes, in which case the company can struggle to unload existing inventory and may have to cut back on new home construction.

Competition and Market Share

The company competes against a highly fragmented base of other homebuilders. These companies may be national or local players and given the highly competitive nature of the industry, competition is stiff and often marked by low margins and low returns on capital. The company also competes for buyers with existing homes that have hit the market, and competes more broadly with other housing alternatives such as apartments, condominiums, and mobile homes.

Below is a table comparing metrics from several competing publicly traded homebuilders. Note that no company has anything close to a dominant national market share, and the industry generally is marked by low operating margins (and high debt to finance construction expenses).^[12]

Footnotes

1. ↑ Data from CTX 2006 10-K, "Business," and National Association of Realtors
2. ↑ CTX 2006 10-K, "Business," pg 4
3. ↑ CTX 2006 10-K, "MD&A," pg 21
4. ↑ CTX 2006 10-K, "MD&A," pg 24
5. ↑ CTX 2006 10-K, "Selected Financial Data," pg 20
6. ↑ Data compiled from company annual reports, 2004-2006.
7. ↑ CTX 2006 10-K, "Business," pg 4
8. ↑ CTX Investor Presentation to Wachovia, Feb 2008, pg 13
9. ↑ CTX 2006 10-K, "Business," pg 2
10. ↑ CTX 2006 10-K, "Risk Factors," pg 10
11. ↑ CTX 2006 10-K, "Risk Factors," pg 9
12. ↑ All data compiled from companies' annual and, where applicable, quarterly reports
13. ↑ BUILDER Online, Builder 100 Listing 2006