Homebuilding: April ShowersSpring 2007

Stephen S. Kim Managing Director

U.S. Equity Research

212-816-1666

See page 29–31 for Analyst Certification and Important Disclosures

Published April 16, 2007

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2

Supply Constraints:The Linchpin to Our Long-Term Thesis

• The national conversation on housing often dwells on issues such as interest rates, job growth, affordability, population, etc. that we would characterize as DEMAND related.

• We agree that housing demand was unsustainably strong. However, since our upgrade of the group in 2001, we have urged investors to focus on housing SUPPLY, not demand.

• While it is easy to get distracted by the flurry of headlines that chronicle housing’s current cyclical decline, we find the most durable feature of the housing market nationwide to be a significant, unrelenting change in the supply of buildable lots in this country. As the current cyclical supply spike is alleviated, the industry’s secular constraint will re-emerge.

• The charts on the next several pages document a significant shift in many of the industry’s most fundamental metrics – including units produced, inventories and market share. No credible view on the space can ignore such profound changes.

• We find demand-based analyses are wholly ineffective at explaining these industry shifts, but that they are easily resolved if one factors in the emergence of housing supply constraints in the mid-1990s.

3

Housing Starts Never Reached Prior Peak Levels

Historically, with no barriers to entry, the homebuilding industry was notoriously fragmented and constantly prone to over-building.

This cycle, however, obviously strong demand drivers (low interest rates and record population growth), did not led to a similar surge in production.

Up until 2003, housing starts remained well below 2.0 million, and only reached 2.1 mil at the ’05 peak. Production was considerably higher in the ’70s and ’80s. WHY? The U.S. population was 30% larger than it was in the 1970s and was growing 30% faster, too.

We suggest that demand factors cannot explain these surprisingly low figures.

Fifty Years of Total Housing Starts vs. Population

Source: U.S Census Bureau

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1950 1960 1970 1980 1990 2000

mill

ion

s o

f st

arts

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3.8

4.5

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Total Housing Starts (left axis, in mlns) US Annual Estimated Population Growth (right axis, in mlns)

4

Why Were Spec Levels So Low for So Long?

Unlike the large publics, small builders (<25 units/yr) are eager to build specs. Provides steady work for trade contacts. Specs serve as model homes and mktg tools.

In the mid-90s, spec levels dropped below 4 mos. – a record low – and stayed there.

4 months is below the industry’s natural or equilibrium level of spec inventory. Avg. time to build homes is roughly 5-6 months. When there is less than 4 mos of spec inventory,

builders are selling their spec homes well before they are finished construction – making them eager to start more and more spec homes.

This is why the industry’s equilibrium level of spec inventory has historically been 5-6 months.

So, how could inventories remain below equilibrium for so long, without leading to record levels of housing starts?

Speculative Inventory Months' Supply

Source: US Census Report

-

2

4

6

8

10

12

1980 1985 1990 1995 2000 2005

Between ’95 – ’05, spec levels were remarkably low.

Historic average = 5.3 months supply

5

A Curious Time for Consolidation

Why did the industry begin to consolidate when it did? Cyclical industries with no barriers to entry typically see consolidation occur during down-cycles, not upswings.

The bulk of the share loss has been sustained by small builders. The top 100-300 builders lost no share, and the 300th ranked builder builds only 200 homes. Thus, the losses have been concentrated among very small builders.

Supply constraints in the mid-90s have driven the change. If small builders can’t gain access to land or capital (or both), they lose market share.

Builder Market Shares vs. Total Starts

Source: NAHB, Professional Builder, U.S. Census, Citigroup Investment Research estimates and Builder Magazine

0%

3%

6%

9%

12%

15%

1974 1982 1985 1988 1991 1994 1997 2000 2003

Top 10 Top 11-100 Top 101-300

Before the mid-1990s, the homebuilding industry remained stubbornly fragmented. Yet in the past decade, our research indicates the top 10 builders have driven a remarkable consolidation that still has ample headroom.

6

The Gatekeepers: Money and Land

Land constraints continue to tighten. Anti-”sprawl” sentiment has gained significant momentum in recent

years. The land approval process has lengthened considerably.

That which once took months, now can take several years. Has created a scarcity of buildable lots for sale. Builders must have strong financial backing in order to play.

This constraint appears to be extremely durable. Unlike housing demand, which can change suddenly, the shortage

of buildable lots in this country is a result of arcane permitting process and human nature, neither of which can change quickly.

Process caters to desires of current residents, not commercial interests. “Not In My BackYard!”

Which would you rather see outside your bedroom window – birds singing in trees, or people looking back at you?

Folks pick the birds every time.

7

Supply Constraints Benefit Public Builders

As supply constraints emerged in the 1990s, so too did competitive advantages for some builders over others.

Public builders have been beneficiaries of this change: Have superior access to capital, at a lower cost. Develop much of their own land. Receive “first look” at lots that are made available by 3rd party developers. Experience across thousands of projects with a range of product types, terrain,

and various permitting hurdles gives the public builders negotiating leverage. Market share consolidation has led to lower production costs for publics.

Small Builders: Cannot develop their own land due to cash flow constraints. Choosing from “leftover” lots – overpriced, difficult locations or terrain. Those with strong land acquisition skills typically become land specialists, or

work for large builders.

8

A Significant Multiple Expansion Story

Throughout the mid-1990s, the builders traded at an average forward P/E of 10x.

Estimates during this period were “normalized” – neither peak nor trough.

We believe the builders are positioned to one day benefit from a major revaluation that takes forward P/E multiples to the 13x-15x range on “normalized” earnings.

Compared to history, the builders are: Considerably larger More geographically diversified

Less leveraged, with 7 companies rated investment grade. Positioned for sustained double-digit growth through market share gains alone, Substantially more profitable than in prior downturns.

The building industry warrants a higher relative multiple compared to other sectors: Pricing – home prices have outpaced inflation by 1-2% over 40 yrs. No Int’l competition – the rise of Chinese imports makes homebuilding a “safer harbor” No Big Box threat – immune to deflation from HD, LOW, WMT, COST Pension liabilities – builders have few direct employees. Consolidation – in the early stages of a significant industry consolidation.

An eventual revaluation provides a multi-year opportunity in the stocks, in our view.

Homebuilder Fwd P/E Multiples

Source: Stockval

Notes: Companies included: BZH, CTX, DHI, HOV, KBH, LEN, MDC, MTH, PHM, RYL, SPF, TOL

4x

6x

8x

10x

12x

14x

16x

18x

20x

1993 1995 1997 1999 Future

Longer-term, we believe multiples in the 13-15x range are more appropriate.

In the past, the homebuilders traded at an average PE of 10x.

LT Target

9

The Near-Term Outlook:

• Book values offer a compelling entry point.• We predict only modest book value declines of 5-10% over the next year.

• While headline risk may limit near-term gains, we recommend investors to watch for company-specific buying opportunities in advance of a back-half rally.

• Land vintage analysis helps isolate those builders with attractive land positions.• Write-off risk also varies by builder.• Historical relationship between ROE and P/B multiples highlights relative value.

• We believe order trends will steadily improve and turn positive in 3Q ‘07.• Cancellation rates change from being a negative to a positive factor.• Easier comparisons coming.

• This should drive recovering earnings in FY08 and FY09, allowing a return to P/E multiples.

10

Book Value Support

The builders have bottomed near book value 8 times in the past 20 years.

On average, they rallied 22% in the next 3 months, and 67% over the next year.

Only in the ‘90 recession did the stocks fail to rally, and even then they were flat after a year.

Homebuilding Stocks Historical Price PerformanceAfter Trading Near Book Value

Trough Trough % Return after Max. TimeDate P/B Price 3 mos 6mos Return to Max

12/4/87 0.9 2.71 22% 20% 53% 13 months1/26/90 1.0 3.32 2% -4% -1% 13 months10/9/92 1.1 3.68 30% 28% 76% 15 months

11/25/94 0.9 3.55 14% 23% 50% 12 months11/1/96 1.0 4.49 18% 14% 73% 11 months1/28/00 0.9 5.79 13% 12% 133% 13 months9/21/01 1.2 10.47 59% 87% 116% 9 months7/21/06 1.0 32.98 17% 38% 38% 6 months

Average: 22% 27% 67%Notes: Companies included: BZH, CTX, DHI, HOV, KBH, LEN, MDC, MTH, PHM, RYL, SPF, TOL, TOA.

Source: Stockval

HBUNIVERSE Price Vs. Price-to-Book (1985 - 1994)

HBUNIVERSE Price Vs. Price-to-Book (1995 - Present)

Notes: Companies included: BZH, CTX, DHI, HOV, KBH, LEN, MDC, MTH, PHM, RYL, SPF, TOL, TOA.

Source: Stockval

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

3.5x

4.0x

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

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Price/Book Price

Price

Pri

ce/B

oo

k

The builders have bottomed near book value 8 times in the past 20 years. On average, they rallied 22% in the next 3 months, and 71% over the next year. Only in the 1990 recession did the stocks fail to

rally, and even then were flat after a year.

0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

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15

30

45

60

75

90

Price/Book Price

Price

Pri

ce/B

oo

k

11

Land Vintage Analysis Our “land vintage” analysis

shows that the builders’ exposure to land priced at peak ’05-’06 prices was modest.

Almost 50% of the group’s land investment at that time was tied to land priced in 2003 or earlier.

Since then, aggressive option write-offs and renegotiations have further “cleaned up” the builders’ land holdings.

Land Vintage Analysis, Group Average (as of 12/06-2/07)Percent of Dollars invested, by Year Negotiated

Owned Optioned Total LandYear lots $ weight lots 8% deposit Investment

2001 9 $9 - $0 1%2002 61 $61 - $0 7%2003 358 $358 - $0 41%2004 358 $358 312 $23 44%2005 29 $29 385 $31 7%2006 - $0 3 $0 0%

Source: Company Reports, Citigroup Investment Research estimates.

We believe only 7% of the builders' land investment is tied to land that was priced in 2005 or later, while nearly 50% was priced in 2003 or

earlier. In the past year, most of the options struck in '06 have been eliminated.

Land Vintage Analysis, By Company (as of 12/06-2/07)Percent of Dollars Invested, by Year

Year TOL CTX PHM BZH LEN RYL HOV KBH DHI MTH SPF MDC

2001 21% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%2002 28% 19% 11% 21% 0% 0% 0% 0% 0% 0% 0% 0%2003 44% 72% 68% 53% 73% 48% 36% 26% 22% 0% 13% 0%2004 4% 7% 21% 19% 17% 51% 56% 66% 71% 81% 45% 70%2005 0% 2% 0% 7% 10% 0% 8% 8% 7% 19% 42% 30%2006 0% 0% 0% 0% 1% 1% 0% 0% 0% 0% 0% 0%

Pre-'04 92% 91% 79% 73% 73% 48% 36% 26% 22% 0% 13% 0%Post '04 0% 2% 0% 7% 11% 1% 8% 8% 7% 19% 42% 30%

Diff 92% 89% 79% 66% 62% 47% 28% 18% 15% -19% -29% -30%

Oldest Youngest

Source: Company Reports, Citigroup Investment Research estimates.

Based on our analysis, TOL, CTX, and PHM appear to have the oldest land investments. MDC, SPF and MTH appear to have the most recently priced positions.

12

Projected Write-Offs

Using the land vintage analysis in the previous slide, we next estimate how large each builder’s write-downs will likely be this year.

We find that MTH, DHI and KBH have the greatest risk for large write-downs, while CTX, LEN and TOL have the least.

Projected Future Write-OffsTotal Land Write-Offs Writeoffs Projected Future Write-Offs

Land % of 3/06 % of 3/06 to Date Land Land as Goodwill Total Percent of Current$ MM Inventory Equity* $MM $ MM % of Equity $ MM

Remaining Inventory Equity

BZH $314 10% 13% $156 $159 6.3% $61 $219 7.3% 8.7%CTX $796 9% 10% $602 $193 2.6% $110 $303 3.1% 4.0%DHI $1,174 11% 13% $334 $840 8.4% $290 $1,130 10.1% 11.3%HOV $522 13% 17% $420 $102 3.5% $56 $158 4.0% 5.5%KBH $765 11% 18% $412 $353 7.8% $117 $470 7.3% 10.4%LEN $946 11% 11% $716 $230 2.6% $127 $357 4.5% 4.0%MDC $354 11% 11% $137 $217 6.5% $0 $217 7.9% 6.5%MTH $200 12% 15% $78 $122 7.8% $65 $187 11.0% 12.0%PHM $881 9% 9% $520 $361 3.6% $248 $609 6.5% 6.0%RYL $260 10% 12% $154 $105 4.5% $9 $114 4.6% 4.9%SPF $456 13% 17% $366 $90 3.3% $52 $142 4.2% 5.2%TOL $416 7% 9% $245 $171 3.2% $6 $177 2.9% 3.3%

Total $7,084 10.3% 12% $389 $205 4.1% $88 $260 5.5% 5.7%

Source: Citigroup Investment Research, Company Reports

13

Minimum Annual P/B Versus ROE

We have observed a strong historical relationship between the builders' returns on equity and their price-to-book multiples.

As shown in the figure above, we find that for each 100bps of ROE deviation from the group's average ROE, an individual builder’s trough price-to-book multiple is approximately .06 multiple points higher or lower than the group's average trough price to book.

20 Years of Minimum Annual P/B vs. ROE (Ex. Charges)

Lowest Annual P/B vs. ROE (ex. Charges)Figures Represent Deviation from Group Average

-1.0x

-0.8x

-0.6x

-0.4x

-0.2x

0.0x

0.2x

0.4x

0.6x

0.8x

1.0x

-2000 -1500 -1000 -500 0 500 1000 1500 2000Difference in ROE vs. Group (Bps)

Each 100bps deviation in ROE vs. Group = 0.06x deviation in minimum P/B.

Deviat

ion in P/B

Source: Stockval

14

The Catalysts: Can Rates and Order Trends

Orders will likely post less severe declines in 1Q07 and post gains beginning in 3Q07, as moderating cancellation rates combine with easier yr/yr comparisons.

Can rates should decline as backlogs shrink in the most troubled markets.

Also, once buyer expectations are sufficiently negative, the can rate should immediately drop back to more normal levels.

As easier yr/yr comparisons arrive, net order trends will likely turn positive in FY07.

Impact of Cancellation Rates on Net OrdersHomebuilding Group Average BZH

Net Orders

Gross Orders Cans

Ending Backlog

Backlog Can. Rate

Order Can. Rate

Gross Order Chg.

Net Order Chg.

CIR Order Ests

Dec-02 3,532 4,613 973 6,594 21%

Mar-03 5,244 6,534 1,289 8,766 20%

Jun-03 5,697 7,306 1,609 9,768 18% 22%

Sep-03 5,221 6,806 1,586 9,918 16% 23%

Dec-03 4,506 5,942 1,436 8,956 14% 24% 29% 28%

Mar-04 6,481 7,917 1,436 10,715 16% 18% 21% 24%

Jun-04 6,658 8,257 1,599 12,305 15% 19% 13% 17%

Sep-04 5,773 7,383 1,609 12,211 13% 22% 8% 11%

Dec-04 5,186 6,836 1,650 11,083 14% 24% 15% 15%

Mar-05 7,067 8,716 1,650 13,004 15% 19% 10% 9%

Jun-05 7,579 9,357 1,778 14,685 14% 19% 13% 14%

Sep-05 6,928 8,754 1,826 14,799 12% 21% 19% 20%

Dec-05 5,619 7,567 1,948 13,208 13% 26% 11% 8%

Mar-06 6,487 8,823 2,335 13,567 18% 26% 1% -8%

Jun-06 5,997 8,780 2,784 13,165 21% 32% -6% -21%

Sep-06 4,561 7,693 3,131 10,772 24% 41% -12% -34%

Dec-06 3,962 6,486 2,524 8,297 23% 39% -14% -29%

Mar-07E 5,356 7,175 1,818 9,082 22% 25% -19% -17% -18%

Jun-07E 5,358 7,521 2,163 9,769 24% 29% -14% -11% -10%

Sep-07E 4,725 7,039 2,314 9,213 24% 33% -8% 4% 3%

Dec-07E 4,328 6,318 1,990 8,503 22% 31% -3% 9% 10%

Source: Citigroup Investment Research.

Our new order assumptions factor in the potential for a moderate increase in cancellation rates and continued gross order declines. Nevertheless, net order trends should still turn positive by 3Q.

15

Historical Price/Book Multiples

We find remarkable similarity in the stocks on a price-to-book basis between this downturn and the 1980’s.

Our new price/book-driven target prices assume that the group trades up to about 1.6x projected book value a year from now.

It's Like Deja-Vu All Over Again!Historic Price/Book Multiples

The 1980s Downturn

1

1.25

1.5

1.75

2

2.25

Mar-87 Sep-87 Mar-88 Sep-88 Mar-89 Sep-89 Mar-90

Double-dip

The Current Downturn

1

1.25

1.5

1.75

2

2.25

Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08

X

12-month targetDouble-dip

Source: Stockval

16

Role of FHA Insured & VA Guaranteed Loans

There is potential for programs such as FHA/VA to recover some of the share the builders have ceded to sub-prime originations in recent years.

Of course, some homebuilders will inevitably be more exposed to sub-prime buyers than others

Percentage of New Home Sales Financed with FHA Insured and VA Guaranteed Loans

Source: Mortgage Bankers Association, Haver Analytics

2%

4%

6%

8%

10%

12%

14%

16%

Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

FHA

1%

2%

4%

5%

6%

7%

9%

10%

Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06

VA

New homes sold financed with FHA insured and VA guaranteed loans have decreased significantly in recent years.

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