May 6, 2010
(Reuters) – No one rode the U.S. housing bubble higher than the company that calls itself “America’s Builder,” D.R. Horton Inc (DHI.N).
During the boom years, Horton and its peers sprawled across the map, opening new divisions and buying up smaller fry in an industry-wide frenzy of expansion and acquisition.
In 2006, the year home prices peaked, D.R. Horton’s sales did as well, with 53,099 home sales closed. Its founder predicted the company would break the 100,000-unit barrier by 2010.
That will not happen — not this year, not anytime soon.
Horton sold just 16,703 homes in 2009. Since the depths of the downturn in 2007, the company has lost more than $3.9 billion and laid off 53 percent of its workers.
But Horton has seen robust growth in one area: executive pay. The company’s founder and chairman, D.R. Horton, made $17.6 million from 2007 to 2009, as his annual compensation jumped from $2 million to $7.6 million, according to Equilar, a research firm that specializes in pay.
His chief executive, Donald Tomnitz, received a similar pay hike. Both will receive raises in base salary this year.
The two were not the only ones who profited handsomely during the most perilous stretch in their industry’s history, when homebuilders fired nearly half their workforce and lost more than half their market cap.
While Wall Street bankers have received far more scrutiny — and grief — for their fat paychecks, homebuilder executives have been doing quite well for themselves. In 2007 and 2008, the CEOs of the 10 biggest U.S. homebuilders earned an average of about $6 million a year each in total compensation.
And although banks and automakers got bigger bailouts from the government, homebuilders certainly got their share. This came in the form of tax benefits for buyers, tax refunds for builders and policies that kept mortgage rates low and foreclosures off the market.
“Without the government’s support, in all likelihood we would have seen more failures among the builders,” said Mark Zandi, chief economist at Moody’s Economy.com. “It’s almost hard to list all the things that have been done to support homebuilding either directly or indirectly.”
The federal homebuyer tax credit, which has provided up to $8,000 for homebuyers, cost taxpayers about $25 billion, Zandi said, while the tax refund amounted to a $5 billion cash cushion for big builders’ balance sheets. Individual states, such as California, helped out, too, offering their own baskets of tax benefits and breaks for homebuyers.
Of course, homebuilding executive pay — including that of Horton and Tomnitz — isn’t what it was at the top of the market, when predatory lenders pushed few-questions-asked loans on people who could not afford them. In 2005 alone, for example, Horton and Tomnitz each took home cash bonuses of almost $13 million.
Then again, some investors say homebuilders were overpaid during the boom, when Bob Toll of Toll Brothers Inc (TOL.N), R. Chad Dreier of Ryland Group (RYL.N) and Larry Mizel of MDC Holdings Inc (MDC.N) took home compensation and stock sales in the hundreds of millions.
“Homebuilding is highly cyclical. You can’t blame that on corporate management nor should you give them credit when there is an upturn,” said Eric Marshall, director of research for Hodges Capital Management, which owns shares of No. 1 builder PulteGroup Inc (PHM.N). “CEO compensation needs to be better balanced, especially in cyclical industries.”
D.R. Horton declined to comment for this article.
LOCATION, LOCATION, LOCATION
Homebuilding falls in a sector known as consumer durables. That’s the technical term for the big-ticket items that cost consumers not just money but often sleep — such as houses and some of the stuff inside them. Besides homebuilders, the sector includes companies like appliance maker Whirlpool Corp (WHR.N) and furniture retailer Ethan Allen Interiors Inc (ETH.N).
But CEOs whose companies build homes make more money — four to five times more — than their counterparts who manufacture couches and washing machines, said Robin Ferracone, executive chair at compensation consultant Farient Advisors. She and others attribute homebuilders’ outsized pay to a quirk of the industry: the involvement of founders and their sons in companies such as Horton, Toll Brothers, MDC Holdings, Lennar Corp (LEN.N) and Hovnanian Enterprises (HOV.N).
“When a homebuilding company goes public, it often doesn’t make that psychological transition to being a public company,” Ferracone said. “They pay themselves as if they were private.”
For example, MDC Holdings gave Larry Mizel a $2 million bonus, plus restricted stock, in 2007, when the company lost $636.9 million. An income-based formula was “unfair and inappropriate” given Mizel’s ability to preserve the company and position it for future success, according to the proxy.
Mizel’s compensation dipped in 2008, but by 2009, at $7.8 million, was starting to recover and had rebounded almost to its 2007 level.
MDC Holdings also declined to comment for this article.
Unlike Mizel, Hovnanian’s chief executive did not receive a discretionary bonus, or indeed any bonus, in 2007. Instead, he went without until the next year, when his board revised its bonus program to peg his award to the reduction of debt, much of which accumulated on his watch.
Long the most leveraged homebuilder, Hovnanian also fired 60 percent of its workers between 2007 and 2009. It lost $2.47 billion during that time. Its share price was hammered, falling from a high of $73.40 in July 2005 to a low of $0.52 in March of last year.
CEO and Chairman Ara Hovnanian did manage to cut debt from $2.47 billion in 2008 to $1.77 billion in 2009. He did so by buying out some bondholders at a loss and then issuing more debt at a discount and higher interest rates, said bond analyst Vicki Bryan of Gimme Credit. Standard & Poor’s, the ratings agency, called the action “tantamount to a default” and a “de facto debt restructuring.”
For this, he received $1.5 million in 2008, and $699,500 the next year. The company also paid his country club fees, and let him use its plane and cars for personal use. Unlike its peers, Hovnanian has not purged its compensation of such perks.
The company’s compensation committee said it wanted Ara Hovnanian to focus on debt reduction because it wanted sufficient liquidity to exploit opportunities during the recovery, Chief Financial Officer Larry Sorsby said.
The company also froze Hovnanian’s salary at a little over $1 million, and cut his total compensation to $2.7 million in 2009, from $5.4 million in 2007.
Not every homebuilder executive sought to grow, or at least maintain, his pay during the downturn. Meritage Homes Corp (MTH.N) Chief Executive Steven Hilton took a voluntary pay cut and turned down his bonus during the worst years.
His total compensation, already at the lower end compared to his counterparts at comparable builders, fell 29 percent between 2007 and 2009 to $2.5 million.
But Meritage is one of the few exceptions.
FOR WHOM THE BELL TOLLS
At Toll, the board revamped its entire CEO bonus plan in 2007 “to develop a bonus program that would work effectively in all economic climates,” according to the proxy. The plan had generated excessive compensation during the boom and eliminated bonuses altogether during the bust, Chief Financial Officer Joel Rassman explained.
Under the revised plan, Bob Toll technically earned bonuses of $5.2 million in both 2008 and 2009, years the company lost about $1 billion. But the board canceled them “due to overall economic conditions” and gave him restricted stock instead.
Of course, even $5.2 million is only 2.5 percent of the $212.9 million Toll took in between 2006 and 2010 selling shares of his company, according to Ben Silverman of InsiderScore.com.
Toll and Hovnanian’s prominence complicates the industry’s image because they represent housing to Congress and to the public, said John McManus, editorial director for a slate of homebuilding trade publications, including Big Builder.
“Is this guy a greedy banker or a good guy who tries to build housing for people who can’t afford it?” McManus said.
The growth of his company generated wealth for shareholders as well as Toll, Rassman said: “As the CEO of a company he needs to do what is right for the industry, and what is right for America.”
Toll focused his lobbying efforts on policies that would generate jobs, such as a tax credit for only newly constructed homes that never passed, Rassman said.
Like MDC Holdings, KB Home’s (KBH.N) board exercised its discretion in 2007 — but on a far grander scale, handing a $6 million bonus to CEO Jeffrey Mezger in his first year on the job for cutting debt and headcount and improving the company’s customer satisfaction levels. The company lost $929.4 million that year.
KB, too, declined to comment for this story.
Other builders simply revised their compensation metrics.
Horton, Pulte, Ryland, and Beazer Homes USA Inc (BZH.N) opted in 2007 to reward cash generation in addition to income with the result that their CEOs did not go without bonuses in 2008 or 2009.
Beazer could not be reached for comment on this story. KB and Pulte declined to comment.
Ryland’s Dreier got a $2.5 million bonus in 2008, when his total compensation was $8.1 million, virtually unchanged from 2007.
In 2009, Horton and Tomnitz each received $2.3 million.
Ryland said the bonus was intended to motivate Dreier to ramp up its cash position. If profits proved elusive that year, the company would need to have funds on hand to make money once the industry recovered, said Ryland spokesman Eric Elder.
But investors who understand cash’s importance questioned the need for a bonus in such dire times.
“They’re being selective and self-serving,” said Todd Lowenstein, portfolio manager for the HighMark Value Momentum Fund, which used to own Pulte shares. “In an environment like this, you don’t need to shower CEOs with additional compensation. The environment is going to motivate them.”
What’s more, Washington helped CEOs secure those bonuses. An accounting change known as the “net operating loss lookback” was particularly helpful here.
The lookback, which has been on the books for years and was extended in 2009, allows businesses to recoup old taxes by reducing a past profit by the amount of a current loss.
And the policy will ultimately give builders back $4.8 billion, according to Deutsche Bank analyst Nishu Sood.
The lookback aims to smooth distortions caused by the annual accounting period and was not designed with homebuilders in mind, said Deloitte Tax Principal Clint Stretch.
“If they weren’t profitable, why should the government have gotten any income tax?” Stretch asked.
But the government’s 2009 decision to extend the policy will greatly benefit builders and applies most neatly to them, said Douglas Shackelford, a professor of tax at the University of North Carolina’s Kenan-Flagler Business School.
Few other companies can apply large losses incurred in 2007 through 2009 to large profits made in 2004 through 2006, Shackelford said.
“Every time there’s a downturn, there’s some group that gets hit harder than anybody else. But it doesn’t follow that they should get more help than anybody else,” he said.
LOOK BACK IN ANGER
In recent quarters, tax refunds from the lookback extension made the difference between profit and loss, enabling most of the builders to post their first paper profits in years.
“It’s like you’re walking down the street and you see a bag of money and you get an award because your bank account balance went up,” said Bryan of Gimme Credit.
The lookback also gave big builders an extra edge over smaller rivals.
Selling land was one of the easiest ways to book a loss that would generate a refund, so the lookback motivated them to dump inventory bought at peak-era prices. They then used the cash refund to buy choice parcels on the cheap.
Smaller builders protested that those land sales further hurt land and home prices, and that big builders’ refunds bought coveted land positions that will translate into competitive advantage and marketshare.
Many of the big builders made the lookback a big priority. In early 2009, Hovnanian’s CEO was spending 70 percent of his time lobbying for it, Sorsby told investors at the time. It even helped precipitate a split in the industry, with the bigger players forming an alternative trade organization.
The government hoped that the main beneficiaries would start hiring, and there is some evidence that is happening.
Miami-based Lennar, which laid off 44.7 percent of its workforce between 2007 and 2009, says it has already hired 50 people and plans to hire more in the near future.
Lennar and indeed most homebuilders are feeling more optimistic these days than they have in years as the U.S. economy gradually improves and the wobbly housing recovery shows signs of solidifying.
Nationally, sales of new homes rose 26.9 percent in March, the largest increase since April 1963. The heightened demand boosted orders across the sector. Meritage, Horton and Beazer all reported surprise profits.
Horton is so confident it can make money in 2010 it has revised its bonus metric back to pre-tax income, “a performance goal we had historically used before the housing downturn,” according to the company’s most recent proxy.
But given the stubbornly high unemployment rate, most recently reported by the Labor Department at 9.7 percent, the housing recovery could yet stall as the government withdraws its supports for the industry.
In March, the Federal Reserve terminated its program of purchasing mortgage-related debt, which had helped keep interest rates low and homes more affordable, as did the homebuyer tax credit that expired on April 30.
“The economic backdrop remains difficult. Foreclosure rates remain at record levels, which keeps home values down and depresses potential demand,” Bryan said.
Optimism based on March’s new home sales number is a mistake, said real estate consultant John Burns, whose eponymous firm is located in Irvine, California.
March “was still one of the worst month’s of all time,” he said. “We survey approximately 2,000 communities every month, and sales were not that robust.”
Estimates on the recovery’s timing vary, but even the more sanguine prognosticators say builders might have to wait another year or more to really make money. That means investors might again take a hit as their share prices, up 27 percent this year according to the Dow Jones U.S. Home Construction Index .DJUSHB, deflate.
In that event, homebuilder CEO pay may come to reflect the industry’s travails.
“On Wall Street, if you’re managing money and you have a loss for the year you’re not likely to see a large bonus. That’s the way the world works,” Hodges Capital Management’s Marshall said. “They should participate in the downturn just like the shareholders.”
(Additional reporting by Steve Eder, editing by Jim Impoco and Claudia Parsons)
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