Home Builder Trying to Turn Sales Into Profit

For three years, the depressed California housing market has been driving builders away--and driving them under.

All the while, Los Angeles-based Kaufman & Broad Home has used the misfortune of the majority to engineer a stunning market-share heist.

K&B;, the state’s biggest and most aggressive builder, accounted for eight of every 100 new single-family homes sold in California last year, up from just two out of every 100 in 1989.

By focusing on the once-ignored first-time buyer, K&B; delivered a record 5,745 homes in California in 1993, up 46% from 3,944 in ’92.

Now, K&B; Chief Executive Bruce Karatz is trying to turn his market-share victory into an earnings triumph as well. After sacrificing significant profitability to snare buyers at other builders’ expense, Karatz is trying to push through the company’s first substantial price increase on new homes in four years.

But the planned 3% average price hike--an attempt by K&B; to boost margins and thus reward patient shareholders, whose stock price has been stalled since 1992--comes at a time when competition in the California housing market has again begun to blossom.

An increasing number of builders from outside California are crossing the border to hunt for land. While the conventional wisdom is that Southern California in particular remains a severely depressed economy, many outsiders no longer see it that way:

* Del Webb Corp. of Phoenix, which until now built only retirement communities in the Southland, announced last month that it has teamed with Costa Mesa-based Meeker Cos. to pursue non-retirement housing in the region.

“We believe the time is right to get into Southern California,” says Ken Plonski, a Webb spokesman.

* Dallas-based Centex Corp., the nation’s largest builder, last month outbid K&B; for a choice parcel of 915 lots in the Foothill Ranch development of Orange County. Reported price: $45 million.

* Toll Bros., an East Coast builder, has come West for the first time with a December land purchase in Yorba Linda. Another big Eastern builder, Hovnanian Enterprises, is rumored to be searching for Southland sites.

More important to K&B;, many California builders that had targeted the move-up market of more expensive homes are now shifting their focus to lower-priced homes (usually under $200,000) for first-time buyers--K&B;’s bread and butter since 1990.

Castle & Cooke Homes, for example, is downscaling to accommodate more first-time buyers in Bakersfield, where it dominates the market. And Columbia, Md.-based Ryland Group, which builds under the Brock and Larchmont names in California, announced in mid-January that it will focus almost entirely on entry-level buyers from now on, instead of its traditional move-up market.

Ryland, the nation’s fourth-largest home builder overall, could pose a particularly interesting threat to K&B; long term. In November, K&B;’s chief financial officer and executive vice president, R. Chad Dreier, stunned Karatz and the building industry by leaving K&B; to take over as Ryland’s chief executive.

While Dreier says that Karatz wished him well, Wall Streeters say Dreier’s abrupt departure was a blow to the 48-year-old Karatz. Dreier, 46, had worked for Karatz for eight years and was second in command at K&B.; Dreier says it was a difficult decision, but that the CEO post at Ryland was an opportunity he couldn’t pass up.

If his departure was a shocker, analysts say Dreier’s decision to refocus Ryland on the entry-level home market in California was no surprise at all, given K&B;’s dramatic success in that market since 1989.

“I think what Dreier’s going to do is create ‘K&B; Jr.’ at Ryland,” says Ira Norris, chief executive of Inco Homes, one of K&B;’s main competitors in the entry-level market in the Southland.

What puzzles some analysts is why it has taken so long for K&B;’s rivals to see the potential in the first-time buyer market.

Karatz is credited with recognizing in 1989 that the California housing market was turning and that disaster loomed for builders of high-priced move-up homes. And indeed, as the state economy sank, move-up purchases dwindled. Prices collapsed, and many builders stuck with high-priced inventory ended up in bankruptcy.

K&B; was hurt in the price plunge; earnings tumbled from $2.44 a share in 1989 to 78 cents a share in 1992, dragged down not only by California but by K&B;’s large commercial and residential construction business in France, its other principal market.

But by heavily gearing its new developments in California toward first-time buyers, K&B; found a huge market of frustrated renters waiting to be served.

K&B;’s average selling price in California was $163,100 last year, down from $196,200 in 1990. In that same time frame, the number of K&B; homes delivered in California rocketed to 5,745 from 3,026. Three out of four K&B; customers last year were first-time buyers.

The numbers make K&B;’s transition look simple, but it wasn’t. Designing and marketing affordable single-family housing, especially in California, is no simple feat, analysts say.

“Karatz repositioned everything about the company,” says Steve Johnson, partner at the Meyers Group, a real estate consulting firm in Corona.

To cut prices, K&B; had to control expenses far more tightly than it ever had. On that count, analysts say Karatz and Dreier may have surprised even themselves. Using centralized purchasing for its far-flung developments, K&B; held construction costs to a 12% increase last year, below the company’s 14% rise in construction revenue.

“K&B; has been extremely aggressive on costs, and the results have been very impressive,” admits Steven R. Muller, who heads rival Centex’s West Coast arm.

Analysts also believe K&B; has lowered its cost structure without harming the quality of its homes. The company says its sales numbers speak for themselves. In entry-level housing, “they make a silk purse out of a sow’s ear,” marvels Burland East, a real estate industry analyst at Kemper Securities in Chicago.

Still, Wall Street has been pressuring K&B; to do more for its bottom line. Despite its sales volume in California, the company’s profit margins on its entry-level homes haven’t thrilled investors. While earnings rose 23% last year, to 96 cents a share, analysts’ consensus 1994 estimate of $1.78 a share is predicated in part on better margins.

That means price increases. In recent weeks, Karatz has called together his division chiefs and laid out plans for price hikes of 1% to 5%, averaging 3%, on K&B;’s California homes. Karatz admits that he faces opposition from some of his people, who fear jeopardizing K&B;’s market-share juggernaut.

Karatz agrees that California remains a market where “we have to offer more house for less money.” But he also says, “We still ought to be getting higher margins” for shareholders.

The question now is whether K&B;’s price increases can stick, especially as competition increases--and as mortgage rates rise, threatening the other side of the affordability equation.

Barbara Allen, housing analyst at Donaldson, Lufkin & Jenrette Securities in New York, argues that the time is right for a K&B; price hike. She believes that a price increase by the state’s largest builder will send a message that the market has finally bottomed. Psychologically, that’s good for everybody, she contends.

“If people become aware that prices are going up instead of the other way, you get a more confident consumer overall,” she says.

And despite the flurry of recent land purchases by outside builders, Allen doubts that California is in danger of becoming overbuilt again anytime soon. “The builders coming in now are just replacing those who have disappeared” in the recession, she says.

Karatz, while never condescending toward his competition, says the rising number of builders targeting California “just tells me that the new-housing market here isn’t as dead as some people thought.” Even the Northridge earthquake, severe as it was, hasn’t deterred buyers this year, he says. (In fact, some analysts believe the quake may be encouraging home purchases by renters who would rather be living in something that passes the most up-to-date construction standards.)

For K&B; investors, the important issue is how much potential is left in the stock, which at $22.625 is no higher than it was two years ago. The price is only 13 times estimated 1994 earnings per share (versus 16 times earnings for the average blue-chip stock), but builders’ stocks traditionally trade for low multiples because of the cyclical nature of the business.

Allen believes K&B;’s annual earnings could top $4 a share in the current housing cycle, with the peak occurring perhaps in 1996.

If that estimate is on target, she says, the stock could reach $40--about double today’s price.

But that will require a recovery in K&B;’s still-depressed French operations, which lost money last year for the first time.

And K&B; will also have to succeed in the new markets that it began targeting last year: Essentially following fleeing Californians, K&B; has begun building homes in Las Vegas, Phoenix and Denver. The firm also has launched a development in Mexico City.

Analysts see all of those ventures, while still small, as natural extensions of K&B;’s success formula in California. For the time being, however, K&B;’s fortunes will depend almost exclusively on the continued willingness of California’s renters to take that first big plunge into homeownership.

Karatz, while unwilling to give earnings forecasts for K&B;, has as much incentive as anyone to beat Wall Street’s numbers: Including options, he owns 1.22 million K&B; shares, or 4.1% of the total outstanding.

How the Builders Stack Up

Here are the major publicly traded home-building companies, their estimated 1994 earnings per share, or EPS (analysts’ consensus estimates), and the stocks’ price-to-earnings (P-E) ratios based on 1994 estimated earnings. They are ranked by estimated 1994 revenue.

52-week Fri. Est. ’94 P-E on Stock high/low close EPS ’94 EPS Centex Corp. 45 3/4-26 3/4 35 $3.04 12 Pulte Corp. 41 3/8-23 1/2 32 1/4 $3.17 10 Kaufman & Broad 25 1/2-16 1/4 22 5/8 $1.78 13 Ryland Group 25 5/8-15 7/8 22 1/4 $2.02 11 Hovnanian Ent. 18 1/8-10 1/2 12 5/8 $1.40 9 Lennar 37 3/4-27 32 1/2 $2.70 12 Toll Bros. 19 3/4-8 7/8 16 5/8 $1.26 13 Del Webb 18 1/2-11 5/8 15 1/2 $1.03* 15 Castle & Cooke 15 3/4-11 1/8 13 1/4 $1.23 11 Standard Pacific 12 7/8-6 1/4 11 $0.50 22 Inco Homes 10 1/2-6 1/4 6 3/4 $0.73 9

Est. ’94 Stock rev. (mills.) Centex Corp. $3,350 Pulte Corp. $1,710 Kaufman & Broad $1,390 Ryland Group $1,230 Hovnanian Ent. $750 Lennar $650 Toll Bros. $500 Del Webb $480 Castle & Cooke $265 Standard Pacific $255 Inco Homes $110

* year ending June 30. All stocks trade on NYSE except Hovnanian (Amex) and Inco (Nasdaq).

Source: Zacks Investment Research; Value Line Investment Survey

Turnaround for K & B

Kaufman & Broad Home Corp., California’s largest home builder, posted a sharp rebound in earnings last year, helped by record sales in the Golden State--despite the Southland economy’s deep recession. But the company’s challenge now is to restore results to peak levels of 1989, Wall Street analysts say.

K & B Shareholders: Still Waiting

Kaufman and Broad’s stock has zoomed from its lowest levels of 1990, but recently, as investors have turned cautious, the price hasn’t traded much above the peak levels of 1992.