Your stock is undervalued? Join the club - Chief Concern - home building industry

Chief Executive, The, Jan-Feb, 2003 by Bruce Karatz

Too many CEOs in industries with relatively small market capitalizations have to spend too much of their time trying to educate the investment community. Unfortunately, analysts often fail to devote time to understanding the complex changes taking place in such industries. They end up badly undervaluing--and undermining-individual stocks.

This is especially true in the homebuilding field. It helps explain why, after 29 consecutive quarters of beating analysts' estimates, and after regularly earning some 25 percent on equity, KB Home's stock is selling at only six times earnings. Yet, we finished 2002 with more than $5 billion in sales and a return on total capital invested of more than 17 percent. That compares with an average return on invested capital for the S&P 500 of only 6 percent--where the average P/E multiple is approximately 17 times.

The investment community fails to recognize that, for the biggest players, the building industry has changed dramatically over the past 20 years. The market has been punishing us because it expects a bust to follow years of boom. But it does not take into account that the big builders-building 25,000 or more units a year -- are far more risk-adverse than they have ever been.

Big builders also are getting stronger as the highly fragmented industry consolidates. Taking a page from the banking, insurance and retailing industries, the largest building companies are acquiring smaller ones, or those that build between 100 and 500 homes a year.

Another point that seems to elude analysts is that big builders have important competitive advantages. They can use their market power to get the best prices from top-quality subcontractors in local areas. They have the market power to squeeze rebates out of construction material vendors. Their persale advertising costs are lower because they can market over a broader area. And big builders get land, their raw material, much less expensively because they can invest in large parcels, reducing costs on a per-lot basis.

Perhaps most important, the largest companies no longer build speculatively. Some 15 years ago, builders wouldn't start selling homes until they were already under construction. At KB Home we don't do that anymore. First we take an order; then we give the buyer more than 5,000 options to personalize the home. Following that, we arrange for mortgage financing through our mortgage company--and only then do we start building. This enables us to maintain a substantial backlog, providing an increased level of stability and predictability.

The level of our stock price fails to reflect these realities. It has been discounted so steeply it would take a drop in home construction of 50 percent or more to justify the level at which we now trade. The likelihood of a drop of that magnitude is practically nil. Most economists who track the industry expect any decline to be limited to 10 or 15 percent.

It's always difficult to say where a stock should be trading, but six times earnings is not appropriate for us. Historically, good homebuilders have sold at 12 to 15 times earnings. Clearly, we've been bucking the market's poor performance over the last three years. And while we acknowledge that the 30 percent compounded growth rate that we've experienced in per-share earnings is not sustainable, EPS growth of 15 percent is. Low interest rates will continue to support housing production at levels similar to those seen over the past four or five years.

About 75 percent of our shareholders are institutions, and one of the problems for large builders is that most institutional investors are based in New York, Boston and those parts of California that have been experiencing slowdowns in home building. These investors are very much influenced by what they see in their own neighborhoods, which is quite different from what actually goes on across America.

Unfortunately, the lack of information on the part of analysts and shareholders--across all industries--is bad news not just for our individual companies, but for the health of the entire system. As long as analysts continue to undervalue solid companies, the market will fail to attract the capital, at realistic prices, that is required to keep American business growing.

Bruce Karatz is chairman and CEO of KB Home, a $5 billion home-building company based in Los Angeles.