Homebuilders Rise on a Shaky Foundation

Unlike much of the market, most of the homebuilder stocks have continued to rally this year, albeit bumpily, despite renewed concerns about the pace of economic recovery amid fear of contagion from the European sovereign debt morass. The rally is primarily due to the stronger-than-expected earnings that many of the companies have reported this season, which is giving investors some hope that these stocks will be good bets in 2010.

While new home orders have increased in recent months and the pace of housing starts is expected to accelerate, the reality is that the housing market continues to be heavily reliant on government stimulus initiatives affecting everything from mortgage rates, sales of homes to first-time home buyers, and the pace of bank foreclosures. One example: Demand for new homes dipped temporarily in late 2009, until prospective home buyers heard that a tax credit aimed at stimulating home sales had been extended into the first half of 2010.

In a Feb. 12 research note, Daniel Oppenheim, an analyst at Credit Suisse Equity Research, predicted that orders for new homes would be concentrated in the February-to-April period, with the extended tax credit creating urgency among buyers. He estimated a 21% increase in orders in the first quarter, slowing to 5% growth in the second quarter, a decline of 4% in the third quarter, and then growth of 13% in the fourth quarter. Mortgage rates will probably climb modestly after the Federal Reserve stops purchasing mortgage-backed securities at the end of March, according to his note.

Overhang of Foreclosures

Oppenheim's biggest concern is that a recovery in the housing market will be muted by a continuing flow of foreclosure sales.

"We don't necessarily need to see the economy worsen that much," he says. "We just need to see more of those homes that are delinquent or in the early stages of foreclosure go fully through the foreclosure process." Oppenheim estimates there are five million homes for which owners are either severely delinquent in mortgage payments or that are already in the foreclosure process. "The challenge is that this pent-up supply will limit pricing upside in the next several years," he says.

Macquarie Equities Research analyst Kenneth Zener says he expects distressed home sales to be kept near the 2009 pace—1.8 million—over the next three years, because of efforts by the government and banks. But he believes government programs, such as the Federal Home Affordable Modification Program (HAMP), have only delayed and not solved issues around negative equity, which require some principal forgiveness.

Zener, in a Jan. 19 research note, reaffirmed his outperform rating on the homebuilder sector, based on his assumption that housing starts will rise off the record low in 2009, to around 900,000 by 2012. That's likely to occur as long as a slow job recovery helps the market absorb about 5 million foreclosures over the next two years, he said. His top picks for 2010 are D.R. Horton (DHI) and Ryland Group (RYL), which he expects to post more robust earnings than their peers, largely on lower general and administrative (G&A) costs.

Telling Homebuilders Apart

Zener says he plans to use three tests to differentiate between homebuilders over the next two years: How successfully they cycle out of legacy assets, how effectively they use their surplus cash, and the extent to which increases in sales volume help them absorb G&A costs. He expects net debt levels for the group to fall from the current 33% to 26% by 2012 as modest growth rates limit capital spending. Margin growth for most builders will come from nearly equal parts gross margin and G&A absorption, his report said.

Meanwhile, Credit Suisse's Oppenheim says he has seen a shift in strategy by homebuilders in response to the availability of home-buyer tax credits. Over the past few years, the goal of builders has been to reduce the number of homes they build on speculation—without a signed contract—to avoid price wars with competitors. But in 2009, builders that didn't have a supply of spec homes available in October or early November saw their orders drop dramatically, because buyers needed homes that would be ready to close on by Nov. 30 in order to qualify for the tax credit, says Oppenheim.

That's one reason for D.R. Horton's better-than-expected earnings in the first quarter of fiscal 2010, since the company had the largest supply of spec homes, he adds.

This year, most builders are talking about erecting more spec homes in order to meet demand by buyers eager to take advantage of the extended tax credit, says Oppenheim. "Some builders don't want to build too many spec homes, but they will build and stop at the drywall stage, so buyers can still choose the finishes they want" to personalize their homes, he says. "Homes can be finished fairly quickly."

Most Attractive Shares

Oppenheim's top stock picks are KB Home (KBH), Lennar (LEN), and NVR (NVR), all of which he expects to benefit disproportionately from demand from first-time home buyers spurred by the tax credit. He upgraded NVR to outperform from neutral and raised his rating on D.R. Horton to neutral from underperform on Feb. 12.

KB Home's advantage is that roughly 80% of its customers are first-time buyers. To compete better against foreclosure sales in certain markets, the company is building smaller homes, hoping to push sales prices down close to those of foreclosures, says Oppenheim. While the tactic has generated some orders, new home construction overall is down sharply from where it was before the housing slump, due to competition from sales of existing homes, including foreclosures, he says.

Lennar has a fairly low price point, while 50% to 60% of NVR's exposure is in the mid-Atlantic area, which is still considered strong. NVR's market-share gains in that region will help boost its margins, he adds.

In the Phoenix metro market, one of those hardest hit by the downturn, home builders have shifted toward lower-priced homes. Builders are also making a big play to boost their market share in that market, according to Jim Belfiore, president of Belfiore Real Estate Consulting, a market research firm in Phoenix.

He sees companies such as Meritage Homes (MTH), Beazer (BZH), Lennar, Hovnanian (HOV), and KB Home aggressively buying up subdivisions now that a lot of small and midsize privately held builders have gone out of business due to bankruptcy or site foreclosures. Prices of lots in these subdivisions have been bid up aggressively in recent months, he says.

Keeping Their Names Visible

"Prices are phenomenally low. [A home buyer] can buy a $80,000 to $90,000 house brand new on the outskirts [of Phoenix]—1,000 to 1,200 square feet—and you haven't been able to do that in a very long time," says Belfiore.

Builders are saying they don't expect to turn a profit on any of the homes they build in these subdivisions in the first year, but the activity keeps their names visible in the market, which is important for gaining market share once the recovery comes.

The builders are more likely to be able to sell out their homes in new subdivisions in view of the plunge in the number of active new subdivisions in the metropolitan Phoenix area. The number fell to 414 at the end of 2009, from 1,250 in early 2006, when the housing decline began, says Belfiore.

"They're keeping their division people on board—division presidents and land acquisition personnel, the business people who run the operation," he says.

While the economic recovery holds out hope for homebuilders, the wild card will be the rate of foreclosures. And that's likely to become more volatile as the government withdraws its massive liquidity on signs that the economy is finding its footing again.

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