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Krishna K

Bret Holmes

DHI AT A GLANCE

P/E ► -3.68   EV/EBITDA ► -6.91   ROA ► -13.5% AVG ROE ► -36.2% AVG Debt to Equity ► 1.71 AVG Current Ratio ► 6.18 AVG Interest Coverage Ratio ► -16.1 AVG

 

 

 

 

 

 

D.R. Horton (NYSE: DHI) is the largest homebuilder in the United States, based on homes closed in 2007. DHI constructs single-family homes, mostly for entry-level and first-time home buyers. The company's average home price in 2007 was $259,200. ^[1] DHI also has a small financial services division which provides mortgages and title agency services to homebuyers.

While DHI's national scope can provide it with some protection from regional fluctuations in the U.S. housing market, its focus on middle-income homebuyers makes it particularly exposed to a national housing slump. As a result of a slumping housing market and the exacerbating influence of the subprime lending crisis, the company's 2007 revenue and homes closed fell 25% and 22%, respectively, from the year before. Order cancellations in 2007 were 38% -- significantly higher than DHI's historical cancellation rate of approximately 20%. ^[2]

Business Overview

Business Segments

DHI's two primary segments include:

• Home Building: DHI builds and sells homes in 27 states and 83 metropolitan markets of the United States. The company's homes generally range in size from 1,000 to 5,000 square feet and in price from $90,000 to $900,000, with an average closing sales price of approximately $259,200. In 2007, this segment accounted for 98% of the firm's revenue.

• Financial Services: DHI provides mortgage banking and title agency services primarily to homebuyers of D.R. Horton homes. After DHI makes a loan, it generally does not hold on to the loan or service it -- it instead sells the loan to other investors. DHI title company provide title insurance, home examination, and closing services, which are all required during the home purchase process.

DHI 2007 Annual Report^[3]

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 income. Recently, DHI's operating income 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. For example, 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. In 2007, DHI wrote down $1,222 million in inventory impairments. ^[4]

DHI 2007 Annual Report^[5]

While DHI's revenues were down 25%, different regions of the US experienced different conditions. Although every geographic segment reported lower sales, US Southwest was the strongest with 1% decline and California was the weakest with a 38% decline. As seen in the graph below, California is the company's single largest market, and the large decline there had an especially significant impact. ^[6]

DHI 2007 Annual Report^[7]

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:

• 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.
• 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.

Key Trends & Forces

Interest Rates

Interest rates have several critical effects on the company. 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 within 30 days, 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. In 2007, DHI had nearly $4B in homebuilding debt and close to $400 million of debt associated with its financial services division.

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. When growth is strong, interest rates are low, and employment is robust, potential first time homeowners (DHI's target market) and those wishing to relocate can pursue new homes more affordably. Thus, more people buy homes, which drives the volume and pricing at which the company can sell its home inventory. With strong economic conditions, DHI's homebuilding revenues grew nearly 28% annually from 2001 - 2006. On the other hand, high rates, high unemployment and slowing GDP growth hamper demand for new homes, in which case DHI can struggle to unload existing inventory and may have to cut back on new home construction, as it has in 2007. In 2007, DHI's new home order cancellations surged to 38% due to the downturn in the cycle.

The subprime crisis and home prices

As mentioned above, home prices and the level of new home construction are driven by macroeconomic variables like GDP growth, interest rates and employment. In this 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 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 declined. This, in turn, exacerbates default rates since these borrowers cannot refinance mortgages given deterioration of collateral. Homebuilders such as DHI assume the risk of continued price declines and hampered demand. If home prices stay depressed for extended periods, the company may have to write down the value of its properties or sell them off at losses. As mentioned above, the company wrote down $1,222 million in property value in 2007, up from just $146 million in 2006. ^[8]

D.R. Horton Inc. (DHI) reported a $1.3 billion fiscal second quarter loss in 2008, and slashed its dividend by half as the United States continues to suffer through the worst housing recession in a generation. The largest U.S. homebuilder has been hard hit by the troubles in the domestic housing market and was forced to write down $834.1 million of land and inventory as home prices continue to decline. The resulting $1.3 billion loss, or $4.14 per share far exceeded analyst expectations of a loss of 64 cents per share. Despite the U.S. Federal Reserve’s rate-slashing campaign and continued efforts to boost liquidity in the credit markets, lending standards remain tight. Banks scarred by the subprime crisis remain wary of lending as they look to maintain comfortable levels of cash reserves to prove their own financial viability. Homeowners facing higher mortgage-rate resets are therefore unable to refinance, and as prices continue to decline the value their homes are no longer high enough to cover their mortgage balances. Unable to meet the higher payments, more homes are going into foreclosure.

Competition

DHI competes against a highly fragmented base of other homebuilders. In most of DHI's markets, it is either the largest or one of the five largest builders. ^[9]

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).

References

1. ↑ DHI 10k 2007,Pg. 1
2. ↑ DHI 10k 2007, Pg. 8
3. ↑ DHI 10k 2007, Pg. 20
4. ↑ DHI 10k 2007, Pg. 25
5. ↑ DHI 10k 2007, Pg. 20
6. ↑ DHI 10k 2007, Pg. 24
7. ↑ DHI 10k 2007, Pg. 24
8. ↑ DHI 10k 2007, Pg. 25
9. ↑ DHI 10k 2007, Pg. 20
10. ↑ Builder Online