November 30, 2007

Home Builders are not a value idea!

I have discussed home builders as value idea, but I was wrong.

I have been researching the industry and its economics and I have arrived to the conclusion that home builder may have gotten cheap but I do not see any value in the long run. I base my conclusion on the premise that Home Builders have no sustainable competitive advantage and do not display any characteristic of being a franchise business, ala Buffet definition. In addition all players in the industry have no barriers to entry against competition. Some may have limited barriers to entry to a specific location but it is very costly to reproduce on consistently.

I will go through some of the competitive advantages that can lead to a franchise with wide moats:

  • Commodity Business: Houses can be argued to be commodities with no particular builder offering a unique and compelling proposition to customers, except for location, otherwise it is a commodity.
  • No economies of scale: Real Estate is very localized so size and economies of scale is not a factor to compete. A local property developer can compete equally with a national business. Both will have the same cost to acquire new customers, as national businesses can't leverage advertising and therefore must localize to each market at the same rate as the local builder. In addition, their cost will be similar to produce as labour is localized as well and supply and demand will determine their wages rather than bargaining power.
  • No network Effect: The network effect wide moat is established when you create a business where the more people use your product, the more valuable that service becomes for other customers. If i buy a house from a builder it does not make the second house they sell any more valuable to customers.
  • Brad Name: There are no Brand name loyalty in this industry. consumers will value the home and location only rather than the builder. They will not display any loyalty to any brand name. Houses from a local builder and national builder will have similar traits and value. What is important is location and no builder have a monopoly over locations.
  • No buying habits: customers are not locked or prefer any specific builder for their next home. And more importantly it is a very infrequent purchase.
  • Patent and Trademarks: none.

As further quantitative evidence, I have calculated Home Builders Return on Invested Capital (ROIC) for the last 10 years, see chart below. I have adjusted for depreciation by using Earning before Interest taxes depreciation and Amortization (EBITDA) and also used the enterprise value as the denominator rather than total assets. As a group, the result was not a surprise, their ROIC is very anemic and very sensitive to the economy and the cyclical nature of the industry. The average ROIC for home builders over 10 years is just 11%. The industry invest a lot in fixed assets and working capital to produce its products. And in many circumstances, it sits on loads of land with no economic benefit derived from it during downturns. Also, the investment in assets is not turned quickly as builders have to wait months and months to deliver and close on new developed products. The heavy investment in fixed assets combined with learning ow margins tend to produce lower ROIC.

However, to get a proper picture of home builders true economic value we have to combine ROIC with their cost of capital. ROIC by it self is not sufficient to judge the health of a business. however, I did not want to go through the research and time to do the calculation as it is not needed. Suffice to say that any business operating in today's environment will not have a cost of capital less than 9-12%, and that's being generous. Home builders will have higher cost of capital as they are higher beta group and very cyclical. therefore, the economic value generated by home builders is not worthy of investing in this business and I suspect that in many years home builders would have destroyed shareholder value.

Some builders may rally, actually today they have rallied in a big way. Some may be are trading below breakup value and that may attract some investors. However they lack what is needed to be franchise in my analysis. Do you think differently?

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