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Donald Tomnitz of Dr Horton: Master builder

Fueled by the buoyant housing market, homebuilder DR Horton has turned in spectacular gains and says it's set to weather the next downturn. Investors aren't so sure.

In the early 1980s, Donald Tomnitz was in the unenviable position of trying to sell land to homebuilders at a time when mortgage rates were above 20 percent and home prices were sliding. But he found one builder he could do business with: Donald R. Horton, who ran a tiny construction company in Dallas. "Basically, we gave him a heck of a deal," remembers Tomnitz.

Tomnitz, a former U.S. Army captain and onetime corporate lending officer with RepublicBank Dallas, got along so well with his client that he quit his sales job with Trammell Crow Co. in 1982 to help Horton expand his family business. In 1998 he succeeded Horton as chief executive.

Tomnitz has been blessed with a far friendlier environment than the one he and Horton confronted more than two decades ago. Interest rates have hovered near all-time lows since the mid-1990s, fueling one of the strongest housing booms in history.

Since DR Horton went public in April 1992, its shares have skyrocketed 1,200 percent, compared with a 179 percent increase for the Standard & Poor's 500 index. The company has made 18 acquisitions in 13 years, growing into a nationwide enterprise with $10.8 billion in sales and 8,000 employees. Horton primarily builds single-family homes and is known for allowing buyers to customize from standard blueprints.

But as concern spreads that the housing market is a bubble ready to burst, Tomnitz must persuade investors that he can keep DR Horton growing even in a downturn. Homebuilders tend to get hammered in cyclical corrections. In the 1994 downturn some went bankrupt and the whole sector was awash in debt amid declining revenues.

DR Horton and other big builders, determined to show that they've learned from that experience, have held down debt, lined up more buyers before building homes and reinforced their balance sheets by acquiring smaller rivals. Tomnitz says DR Horton will be fine even if interest rates rise and home prices slump.

But the market remains skeptical. Despite having increased profits for a decade at a compounded annual rate of more than 30 percent, DR Horton trades at a paltry 7.4 times projected 2005 earnings, in line with other builders.

During a recent visit to New York, Tomnitz pressed his case with Institutional Investor Senior Editor Justin Schack.

Institutional Investor: Is there a housing bubble?

Tomnitz: Not at all. There's a lot of attention being paid to very hot markets like Boston, Las Vegas and California, where you've had 30 to 40 percent appreciation in median home prices in the past year. But nationwide in the past 20 to 30 years, you've had about a 3 to 5 percent annual appreciation in the median price of a home. The past couple of years, it has been higher, maybe 5 to 7 percent, but that's not unhealthy.

The National Association of Realtors says 36 percent of all U.S. home purchases are vacation or investment properties. Doesn't that kind of speculation worry you?

We define up front, community by community, how many investors we want to sell to. I recently stopped into our Naples, Florida, sales office unannounced. I asked our salesperson there about how she's doing business, and I was very happy to hear that they permit only one investor for every six units we sell. We try to limit investor purchases because we want to make sure we have a high degree of confidence that the sales in our backlog are going to close.

But what if there is a major correction in the housing market?

The home business in the past couple of years has been a classic supply-and-demand situation. The supply is constrained because of the lengthy entitlements process, whereby local governments authorize us to buy land and build homes on it. But on the demand side, you have 30 million immigrants that have come into the country in the past 30 years and 30 million baby boomers looking for their last house or a second home. Then there are about 20 million "echo boomers" who are now in their first-home-buying years. Demand far exceeds supply.

Can such demand sustain your revenue growth even if interest rates rise and home prices decline?

I think so. The other story is that about 75 percent of new construction is in the hands of small and medium-size individual builders, not companies like ours. These builders are inefficient and undercapitalized. They don't have the access to land that we do. So even in a decreasing new-single-family-construction environment, the top ten homebuilders will still take market share and grow.

Do you regularly make surprise visits to sales offices?

I try to do it about ten or 12 times a year. It's the only way to know for sure what's going on. If you sit down and talk to the salespeople, you get a really good feel for how the regional and divisional profit-center managers are running their businesses.

Has it been tough to manage growth?

We have very little bureaucracy. As we've grown we've divided the management of the company into smaller and smaller pieces. We now build in 63 markets in the U.S., and we have 63 profit-center managers. We deploy assets with them and expect them to get us back a return. It's a lot simpler now than when we were making lots of acquisitions and dealing with all the issues and problems you face in integrating them. In terms of controls and finances, we keep a separate profit-and-loss statement on every home that we build. We don't look to build a thousand-home subdivision and see what we make after the thousandth one is sold. We manage on a unit-by-unit basis.

So do you have financial people in every market reporting to the CFO?

We have a CFO in every profit center and in every one of our six regions, in addition to our corporate CFO. Every profit center also has local purchasing, land and accounting departments. We manage risk companywide from the corporate office, but almost everything else is left to the local people. If you're a division president or a profit-center manager and you expect us to come out to where you are and tell you where, what, how and with whom you should be building, you're not going to be with us for long. We hire entrepreneurs. We control them to ensure that they don't get in trouble. And we incentivize them to work as entrepreneurs.

How?

We pay a ridiculously low base salary of $100,000 to $150,000 per year, but if you manage a division, your bonus is 2.75 percent of pretax income. And we have several divisions making $100 million in pretax income. Also, 20 percent of our stock is held by management and insiders. Our people think and act like shareholders. That helps us grow rapidly but soundly.

Does the stock market's short-term orientation frustrate you?

It is somewhat frustrating -- perhaps more disappointing than frustrating. But that's part of the business, and you have to get used to it. There are going to be times when you're calling on investors and your stock has reached a plateau, or when it's selling for a lot less than you might like. But if you look at our stock price over the past ten years and the past five years, the lesson is that if you stick with us, you're going to make money.

But aren't investors discounting your stock because they're uncertain how you'll perform once the cycle turns?

It's important to remember that interest rates don't go up in a vacuum. If they go up, it usually means that the economy is improving, and that helps our business. I don't worry about the sustainability of our earnings. What I do worry about is convincing investors of that. We've been growing at 32 percent a year, compounded, over the past ten years. That should put us in the same league with Microsoft, Dell and General Electric in terms of earnings multiples.

Are you just going to have to earn a higher multiple the hard way -- by growing through a downturn?

It's going to come from a combination of things. We do have to continue to perform. But our biggest challenge is getting the analyst community out of the box they've been in, where their target multiples are based on historical ranges, not the reality of the business today. They just say, "When rates go up, these stocks are going to trade down," with no correlation to earnings. I'm not sure we can get them out of that box, because if they do come out with price targets that are out of a certain range, the research directors start asking them, "Why are you taking such a risky position?" So we have to try to convince investors ourselves, one at a time.

Why are Wall Street firms so cautious?

Clearly, all the controversy and all the scandals of the past few years have affected them. They're in a risky position and they have to ask themselves, "What's in it for me?" I'd hate to be in that job. i

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