If the housing market slows down, how will the homebuilders grow? The bulls say through acquisitions, but that makes the sector's future growth a lot less clear for investors.

The bulls' argument is that even if the housing market is set to slow down -- which certainly looks to be the case -- then public builders can use their lower cost of capital to muscle out the competition and buy whatever good private builders they can't force out of business.

It's a compelling proposition. Most private builders, beyond the very large ones, rely on higher-cost variable-rate bank financing, in which loans often are secured against individual plots of land. Large public builders, on the other hand, can issue multiyear, fixed-rate debt and pay lower, investment-grade rates.

"If the market is viewed to be topping out in a bear sense, then some of the private players will say, 'I can't compete. I'm going to sell out now,'" says Sam Lieber, portfolio manager of the ( EUEYX) Alpine US Real Estate fund. "Ultimately, that's the Wal-Mart ( WMT) story. You take the competition out."

However, even if the argument has some validity, the risk is that Wall Street might not care.

"Personally, I think that if the Street really thought (builders') order growth was mostly coming from consolidation, they would kill these stocks," says James Poyner, an analyst with Palladian Research. "Growth through acquisition in any industry will generally give you a lower multiple," since most acquisitions don't go that smoothly, he says.

More and more, investors appear to be getting nervous about builders' guidance for 2006 and 2007. The sector got hammered last week after Federal Reserve officials hinted several times that the Fed would continue raising interest rates. Two of the industry's darlings, Toll Brothers ( TOL) and Pulte Homes ( PHM), each fell more than 10% last week. William Lyon Homes ( WLS) shed 15% for the week after the company reported that its third-quarter net order growth was 27%, lower than analyst estimates.

In the background hovers the latest Census Bureau data. Those numbers show that sales of new homes fell 9.9% to an annual rate of 1.237 million in August from 1.373 million in July. Economists expected a 1.350 million new-sales rate. While builders are likely to continue reporting decent results for the third quarter, the future is becoming more important with all the bearish housing data coming in.

"Investors are no longer concerned with the current year's results for homebuilders, rather the focus for valuation has shifted to the coming year," AG Edwards analyst Greg Gieber wrote in a recent research report.

Gieber expects the group to grow earnings by 30% this year. Much of that profit is already in the bag, given builders' strong first-half backlogs of homes sold but not closed on.

But for 2006, Gieber projects the group's EPS growth to be in the low-to-mid teens. His projection assumes a modest decline in housing activity during the coming year, but he anticipates the better public builders can show growth due to market share gains and consolidation. "Good smart builders can grow through consolidation," Gieber says, but he's not sure everyone can do it.

Going from 30% growth to the low teens could be viewed as disappointing by Wall Street, Gieber says, even though this growth will likely be better than the S&P 500. Plus you can buy the builders much cheaper, given the recent multiple contraction.

The growth by consolidation story is already starting to play out. Look at Hovnanian Enterprises ( HOV). Last week, the builder reported that its net order numbers for September were up 61.5% over last year. The bulk of the growth came in the Southeast, where the company recently purchased First Home Builders of Florida, the largest private builder in the Fort Myers-Cape Coral market, and Cambridge Homes. The company did not break out how many of the orders were from the newly purchased companies. Hovnanian's Northeast orders were also boosted by the purchase of Oster Homes.

One of the problems with boosting orders through acquisitions is that it doesn't help earnings right away and can make guidance murkier. Generally, to get a feel for a builder's future revenue and earnings growth, you look at its backlog and order growth. But that's when growth is organic and not through acquisitions.

As JMP Securities analyst James Wilson wrote in a recent report, "Due to purchase accounting adjustments, which require a builder to adjust the book value of acquired backlog and lots to market value, most builders get to book the revenue but very little, if any, profit for homes delivered from acquisitions over the first 6-12 months. Thus, although HOV should show strong order growth coming from acquisitions and joint ventures in FY06, in addition to its organic operations, we do not expect earnings to meaningfully surpass the company's guidance.

"In addition, the company's policy of amortizing acquisition premiums further negatively impacts earnings over the first couple of years but should result in higher returns on capital in future years," Wilson wrote.

If acquisitions become a bigger piece of homebuilders' growth going forward, doing the math on guidance gets more complicated.

So the bottom line seems to be that growth by acquisitions might be a realistic possibility. But it changes the homebuilders into a much different story -- one the Street might not care to listen to.

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