David Tepper of Appaloosa Management is hedge fund manager who specializes in distressed assets and rose to fame and prodigious fortune investing in financials during the credit crisis. Tepper tends to choose stocks in sectors others are fleeing. In 2009 he bought large stakes in banks, betting against popular opinion that the government would nationalize them, which resulted in 132% returns that added $7 billion to his fund. This quarter, he has reduced or sold out of his financial holdings and instead opted for investments in one of the most distressed industries around – home building. In the first quarter of 2011, he bought into KB Homes (KBH), D.R. Horton Inc. (DHI), Pulte Group Inc. (PHM), Beazer Homes USA Inc. (BZH), Ryland Group Inc. (RYL), and Masco Corp. (MAS).
The residential construction sector’s stock returns are down 12.7% over the last three years, 13.6% over the last year, and 8.8% year to date. Recent construction data reflects the fragility of the struggling industry. New home construction exceeded expectations in March, with the number of new homes being built rising 7.2% and the number of issued building permits up 11%. In April, however, the number of new homes being constructed dropped 10.6%, falling far short of expectations, and the number of permits issued fell 4%.
Despite all of the grim news about the industry, a Fannie Mae housing survey in February found that 78% of respondents believe housing price will hold steady or increase in the next 12 months, and a recent Pew Research survey found that 81% of respondents believe owning a home is the best investment a person can make.
Most investors are apprehensive of home builder stocks, making them quite cheap. KB Homes has fallen 33.3% over the last year and 81% in the last five years to about $10 per share. PulteGroup Inc. data is almost the same. Beazer Homes USA Inc., down 13.8% for the year and 60% over the last five years, is trading at $3.66 per share.
In spite of the low stock prices, some homebuilding companies have solid enough financials to place them at low risk for bankruptcy in the near future. KB Home, Tepper’s largest home builder holding, has $1 billion in cash on its balance sheet, which is actually more than it had in any year from 2001-2006, and $2.4 billion in debt. In 2010, it reported its first negative cash flow in five years, losing $134 million. Kb Home has a market cap of $859 million, and it has a P/S ratio of 0.5. and dividend yield of 2.2%.
KB Home’s home deliveries have decreased 28% year-over-year although average selling prices have increased 4% year-over-year. The company reported that comparisons of the first quarter of 2010 with the year-earlier period were negatively impacted by a temporary elevation in home sales last year due to the federal homebuyer tax credit available then.
In a May 2011 NBC interview, KB Home Chairman Jeff Mezger said, “We’re very bullish, we like how our company is positioned. There’s many of ht emarkets that we operate in that are showing signs of recovery, so as things stabilize, we actually think that there’s better days ahead, and I don’t react too much to just the 30-day number.”
He noted that homebuilding data is national and that certain pockets of the country are recovering much faster.
D.R. Horton Inc.
D.R. Horton Inc. is Tepper’s second largest home construction holding and the largest homebuilder in the United States. D.R. Horton Inc. has a market cap of $3.73 billion. It has a P/E ratio of 389, P/S ratio of 0.9 and a dividend yield of 1.3%. The company’s free cash flow has fallen for the third consecutive year to $690 million, and it had positive net income of $245 million, up from a loss of $545 million in 2009. D.R. Horton has almost $2 million in cash on its balance sheet and $3.3 billion in debt. Last year, its gross operating margins jumped to 17.5% from 3.2% in 2009.
In the second quarter of 2011, D.R. Horton’s net income rose to $27.8 million from $11.4 million a year earlier, helped by a $59.2 million one-time tax benefit. Home orders decreased in the quarter to 4,942 compared to 6,438 a year ago.
“Market conditions in the homebuilding industry are still challenging, with high foreclosures, significant existing home inventory, high unemployment, tight mortgage lending standards and weak consumer confidence,” Chairman Donald R. Horton said in the statement.
Pulte Homes, for instance, has about $1.5 billion of cash on its balance sheet and about $5.6 billion of debt. It had $580 million in free cash flow in 2010, down from $739 million in 2009, and has had four straight years of positive cash flow. PulteGroup Inc. has a market cap of $2.91 billion and a P/S ratio of 0.6.
The company said that last quarter traffic and orders increased month-to-month, and that they exceeded internal forecasts for business drivers such as net new home orders margins. With these results, they expect to return to profitability by the latter half of 2011. Analysts at Goldman Sachs (GS) gave Pulte a “buy” rating in March.
Another stock Tepper bought, Masco Corp., manufactures brand-name products for the home improvement and new home construction markets such as insulation, faucets, and bath and shower fixtures. The company made $346 million in free cash flow last year, and has not reported negative cash flow in the last 10 years. Net income dropped to a loss of $1 billion in 2010 from a loss of $183 million in 2009, and it has $1.5 billion in cash and $6.7 billion in debt.
In a New York Magazine profile on Tepper, his colleague, Jonathan Kolatch that, “He takes a macro perspective on something, for instance this European sovereign crisis, which is that ‘it’s not going to be that bad,’ and then he takes that an applies it to a micro idea, a particular stock.” It is hard to find data supporting a positive short-term macro view for homebuilding. There is evidence Tepper is hoping for a recovery in the long term though. In a January 2011 NBC interview discussing unemployment, he mentioned that one reason rates might not return to normal for years or even decades is because, “You’re not going to have the structure where it was, you’re not going to have housing where it was, and a lot of that was housing driven.”
David Tepper’s plunge into home construction in some ways parallels his investment in banks during the credit crisis. He was one of the first to invest in banks when many were on the brink of bankruptcy and the consensus was to expect their collapse or nationalization. Only five gurus own shares of KB Homes stock, and only one other initiated a position in the last two quarters. Similarly, only one other guru bought into Pulte Homes in the first quarter, and two others sold out in the fourth quarter of 2010; three others still hold the stock.