The broad economic headwinds still facing builders, highlighted in my recent report (“Housing: No Worse, But No Better”), suggests a cautious approach to homebuilders. This riskaverse view is based primarily on the following general industry assumptions:
1. existing home sales at 5m pace
2. new home sales at 300k rate
3. overall home prices flat in 2011 (ex distressed sales)
Below I recommend the three homebuilder stocks, NVR, Toll Brothers (TOL), and MDC, that I consider best positioned for this lowdemand environment. Each of these builders has unique competitive advantages (discussed individually below), along with characteristics I consider key to thriving in, or at least ridingout, the downcycle:
1. little to no debt
2. rising prices in backlog
3. prospective profits in 2011
4. attractive valuations
NVR
This builder owns no land outright, purchasing all its (finished) lots through options. (Please see table below.)
 Homesites (2010) 
 Total  Owned 
Beazer Homes  28,996  23,176 
DR Horton  119,400  89,700 
K Hovnanian  32,055  14,379 
KB Home  39,540  30,227 
Lennar  104,456  84,482 
MDC  12,194  8,035 
Meritage  15,224  12,940 
NVR Inc.  52,300   
Pulte Homes  149,253  133,380 
Ryland  24,539  16,300 
Standard Pacific  23,549  17,650 
Toll Brothers  34,852  28,891 
Source: SEC filings.
This unique, assetzero approach, while heavily dependent on development partners, allows significant returns on investment (near 100%) in good times. In difficult times negligible inventory limits carrying costs (and associated risk of depreciating land) and helps ensure substantial profitability. (Please see table below.)
 GrossProfit 
 Pretax Profit 
 11E  10  09 
 11E  10  09 
Beazer Homes  47  86  21 
 (192)  (148)  (187) 
DR Horton  566  682  65 
 25  100  (552) 
K Hovnanian  24  9  (565) 
 (285)  (295)  (672) 
KB Home  254  273  114 
 (41)  (76)  (311) 
Lennar  533  539  284 
 101  95  (760) 
MDC  161  146  150 
 30  (71)  (107) 
Meritage  151  168  4 
 23  3  (155) 
NVR Inc.  574  543  497 
 362  322  298 
Pulte Homes  249  343  (400) 
 (272)  (351)  (1,975) 
Ryland  98  122  (35) 
 15  (85)  (260) 
Standard Pacific  183  217  142 
 (18)  (12)  (110) 
Toll Brothers  85  112  (197) 
 26  (117)  (496) 
Source: SEC filings.
In fact NVR is the only large builder to post profits each year through the downturn. Nearly half its revenues and the majority of its profits arise from the
Washington, D.C. and Baltimore, markets which continue to buck weak national housing trends. For example, in March (the most recent measurement period),
Washington D.C. was the only metro to have higher average sales prices in the Case Shiller 20 index.
NVR is the most expensive homebuilder, if based on book value, at around 2.2x. However this measure gives the company little credit for its huge net cash position (about $1.2 billion) or its buyback program – by which its has reduced share count by 5% in the past year. More appropriate, is EV/BV, which at 1.7x for NVR, is a discount to the group’s 1.8x (Please see Valuation at the end of this report.)
Toll Brothers (TOL)
At about $550,000, TOL’s average home price exceeds all builders’. (Please see table below.) Having a nearmonopoly among production builders aimed at high end buyers, gives TOL considerable advantage, in good times and bad. In 2010, options on its (single family) homes averaged $145,000, and generated gross margins that I estimate between 30% and 40%.
 Average Selling Price ($000) 

 11E  10  09  08  07  06 
Beazer Homes  205  215  231  253  287  285 
DR Horton  211  206  213  234  259  274 
K Hovnanian  283  290  289  305  343  329 
KB Home  221  215  207  236  262  278 
Lennar  258  246  247  271  292  300 
MDC  291  284  278  303  338  354 
Meritage  259  254  238  268  304  324 
NVR Inc.  306  297  296  338  373  399 
Pulte Homes  259  259  258  284  322  337 
Ryland  242  242  245  201  235  295 
Standard Pacific  348  346  313  336  390  380 
Toll Brothers  552  566  592  655  672  692 
Average  286  285  284  307  340  354 
Source: SEC filings.
Toll Brothers’ luxury skew attracts buyers with relatively attractive credit profiles and lower average loan to value ratios. Meanwhile, TOL’s own balance sheet is investment grade, rare among builders. Finally, insiders own 16% of the shares.
Only half of TOL’s sales volumes (measured by unit sales) in 2010 is derived from single family, with a growing portion of turnover driven by lower risk areas, including multifamily (28% of units), active adult (13%) and high rise (9%).
One caveat: because TOL participates in its own development activities, it tends to carry a large amount of inventory, i.e., more than $3 billion, or 2.3x 2011 estimated sales, the highest ratio among all builders.
MDC
The company is inventory lean, with yearend 2010 inventories, representing less than half of the sales I expect for the current year. MDC’s owned lot position (in the previous table) rarely exceeds more than 70% of all its controlled land. Its low inventory levels free up cash that it distributes to shareholders through a dividend yielding a grouphigh 4%.
 Inventory / Sales 
 11E  10  09  08 
Beazer Homes  1.7x  1.3x  1.6x  1.5x 
DR Horton  0.9x  0.9x  1.3x  1.4x 
K Hovnanian  0.8x  0.8x  1.4x  1.1x 
KB Home  1.0x  0.9x  1.2x  1.1x 
Lennar  1.5x  1.5x  1.6x  1.0x 
MDC  0.4x  0.6x  0.7x  1.0x 
Meritage  0.8x  0.7x  0.9x  0.8x 
NVR Inc.  0.1x  0.1x  0.1x  0.2x 
Pulte Homes  1.1x  1.0x  1.0x  1.1x 
Ryland  0.8x  0.6x  0.9x  0.9x 
Standard Pacific  1.3x  1.0x  1.1x  1.4x 
Toll Brothers  2.3x  2.1x  2.4x  1.8x 
Average  1.1x  1.0x  1.2x  1.1x 
Source: SEC filings.
Note: 11E represents 2010 actual inventory dividend by 2011 estimated home sales.
About 80% of MDC’s land inventory represents purchases made since 2009, implying favorable lot costs and few impairments. In fact, the company has the secondbest record for impairments (after NVR) and, thanks in part to minimal land charges, has consistently among the highest gross margins in the group.
MDC’s debt is investment grade. Its net cash (after debt) is around $300 million, about onefourth of today’s $1.2 billion market capitalization, or about $6 per share.
Valuation
Assetbased multiples are the best valuation method for builders. Underlying book values – mostly land inventories – are relatively solid, for two main reasons:
 few material land impairments have occurred since big revaluations ended in 2009
 most of land on existing books – bought since 2009 – reflects today’s depressed values
 industry profitability is linked to home prices, which are stabilizing
 Price / Book 
 EV/Book 
 11E  10  09  08  07  06 
 11E  10  09  08  07  06 
Beazer Homes  0.8x  1.0x  1.0x  0.2x  0.2x  1.1x 
 2.5x  2.5x  5.9x  3.1x  1.2x  2.0x 
DR Horton  1.2x  1.4x  0.9x  0.5x  0.4x  0.7x 
 1.5x  1.6x  1.3x  1.0x  0.9x  1.1x 
K Hovnanian  nmf  nmf  nmf  0.4x  0.3x  1.0x 
 nmf  nmf  nmf  5.3x  2.0x  2.1x 
KB Home  1.2x  1.4x  1.5x  1.3x  0.9x  1.4x 
 2.5x  2.8x  2.4x  2.2x  1.4x  2.1x 
Lennar  1.1x  1.3x  0.9x  0.5x  0.7x  1.4x 
 1.9x  2.0x  1.5x  1.0x  1.2x  1.8x 
MDC  1.1x  1.2x  1.1x  1.0x  1.2x  1.2x 
 0.9x  0.9x  1.5x  1.3x  1.1x  1.4x 
Meritage  1.3x  1.5x  1.3x  0.7x  0.4x  1.5x 
 1.8x  1.9x  1.7x  1.5x  1.1x  2.3x 
NVR Inc.  2.2x  2.5x  2.4x  1.8x  2.4x  3.1x 
 1.7x  1.8x  3.2x  2.5x  3.8x  2.9x 
Pulte Homes  1.1x  1.3x  1.2x  1.0x  0.6x  1.3x 
 1.9x  2.0x  2.0x  1.5x  1.2x  1.7x 
Ryland  1.1x  1.5x  1.5x  1.0x  1.0x  1.4x 
 1.7x  1.8x  1.7x  1.6x  1.5x  1.8x 
Standard Pacific  1.1x  1.2x  0.9x  0.4x  0.2x  0.9x 
 2.2x  2.2x  2.3x  2.7x  1.9x  2.1x 
Toll Brothers  1.3x  1.4x  1.2x  1.1x  0.9x  1.4x 
 1.5x  1.5x  1.3x  1.2x  0.7x  1.8x 
Average  1.3x  1.4x  1.3x  0.8x  0.8x  1.4x 
 1.8x  1.9x  2.2x  2.1x  1.5x  1.9x 
Source: SEC filings.