Homebuilders in a Hole

Weaker new and existing home sales, plus quarterly losses reported by D.R. Horton, Beazer Homes, and Ryland send the stocks to new lows for the year

Homebuilder stocks took another hit on July 26 after a fresh batch of poor quarterly financial results and new economic data reinforced investors’ concerns about a deepening slump in the U.S. housing market.

Sales of new homes fell 6.6% in June to an annualized rate of 834,000, after a revised 2.2% decline in May to 893,000. The drop was more than three times what was expected and the biggest decrease since January.

Inventory was unchanged from May at 537,000 units, which represents a supply of 7.8 months. The median price of a new home continued to fall to $237,000 from $241,000 the previous month.

The data followed a July 25 report showing that existing home sales fell 3.8% in June to an adjusted annual rate of 5.75 million, lower than expected. This sparked worry that housing would take much longer to recover than people had anticipated.

Wider quarterly losses reported by some homebuilders also attested to further deterioration in the housing market. D.R. Horton (DHI) reported a net loss of $2.62 a share for the fiscal third quarter, nearly triple its $0.93 loss from a year ago, on a 29% drop in revenue.

The company had pre-tax charges of $835.8 million for inventory impairments, $16.2 million for write-offs related to abandoned land option contracts and $425.6 million for goodwill impairment. For the rest of this year, D.R. Horton plans to focus on generating cash, reducing inventory, and paying down outstanding debt to maintain a strong balance sheet.

Beazer Homes USA (BZH) posted a fiscal third quarter loss of $3.20 a share, vs. $2.37 a share in the year-ago period, on 37% lower revenue. The latest results included pre-tax charges totaling $188.5 million for inventory impairments, abandonment of land option contracts and goodwill impairments.

Beazer also opened a new $500 million revolving credit facility, scaling back from a previous facility for $1 billion. On a conference call to discuss the results, the company said it was preparing for static building activity for the remainder of 2007, but hoped to have a need for cash to start building out its backlog of orders sometime next year.

The Atlanta homebuilder said new orders fell 30.2% to 3,055 homes from the year-ago period.

In its second quarter, Ryland Group (RYL) swung to a net loss of $1.25 a share from a profit of $2.03 a share a year ago, but beat the $1.31-a-share loss that Wall Street analysts had projected. Revenue fell 38% to $739.7 million. The latest results included pre-tax charges of $147.1 million for revalued inventory and write-offs.

Pre-announced warnings earlier this month helped Ryland and D.R. Horton shares stand up to some of the selling pressure. Ryland fell 2% to $32.27 and D.R. Horton lost 3.4% to $16.88, while Beazer shares dropped 11.9% to $15.02. All three of them hit a new 52-week low on July 26.

In a July 26 research note, J.P. Morgan Securities attributed the 7% increase in Ryland’s orders in the western U.S. from a year ago to aggressive price discounts and said tighter subprime and Alt-A credit requirements drove a 28% drop in orders in Texas.

The company’s inventory trend is encouraging, however, 18% below the peak in the third quarter of 2006 on solid declines of 15% from a year ago and 6% from the first quarter, J.P. Morgan said.

The charges Ryland took were essentially in-line with those of other homebuilders, and excluding charges, Ryland has maintained a solid level of profitability between 70 and 80 cents a share, compared with near-breakeven results from some of its peers, J.P. Morgan said.

Standard & Poor's said it had low expectations of Ryland’s near-term prospects, given the $80 million in charges it took in the first quarter for asset impairment and goodwill writedowns, and preliminary second-quarter charges of $145 million to $155 million.

It said it expected pressure on revenue and margins to continue to mount, as credit standards for mortgage applicants have tightened since March and mortgage interest rates rose in June.

D.R. Horton’ land charges of $852 million, or $1.68 a share, were substantially larger than J.P. Morgan’s estimate, but investors were prepared for a larger number after Pulte Homes (PHM) warned last week that it would take around $750 million in charges, the bank said.

Excluding charges, D.R. Horton’s gross margin of 16.7% was only slightly lower than in the first quarter, while its control over sales, general and administrative costs, which fell 10% from the first quarter, may be the best in the sector, according to J.P. Morgan. The company also generated positive operating cash flow for the fourth quarter in a row.

In a separate research note, J.P. Morgan gave Beazer credit for a solid 38% drop in total unsold homes, but pointed out the sharp 30% decline in orders despite promotional efforts during the quarter. Excluding charges, the core gross margin of 16.9% was slightly lower than the bank’s estimate, while SG&A costs rose more than expected.

During the conference call, Beazer said its focus right now is much more on cash, citing a need for real liquidity, and it isn’t making long-term business decisions based on its current low margins. It’s also working to prevent a further buildup in inventory.

Beazer’s cumulative land charges are 17.3% of equity, above the 14% average for its peers. In view of that, plus negative sentiment due to the federal investigations into its mortgage business, the stock is likely to fare worse than other homebuilders over the next few quarters and deserves an underweight rating, J.P. Morgan said in a note.

In a July 21 research note, Standard & Poor’s predicted that Beazer’s financial results will be more sensitive to higher mortgage rates and slower job growth than those of its competitors, as more than 40% of its homes are sold to entry-level or first-time move-up buyers.

Citigroup Global Markets said in a July 25 research note that it expects new home orders across the industry to continue slip in the third quarter and that signs of improvement in the resale market need to be seen before investors will be willing to pay much more than 1.0 times book value for the homebuilders.

However, since the stocks are substantially undervalued on a longer-term basis, investors with a two-year time frame will do very well buying them at current levels, while shorter term-focused investors should wait, Citigroup said.

(J.P. Morgan or its affiliates expects to receive, or intend to seek, compensation for investment banking services in the next three months from D.R. Horton and have done investment banking for Beazer and Ryland within the past 12 months. It or its affiliates also owns 1% or more of Beazer’s common stock. Citigroup or its affiliates own at least 1% of Ryland common stock and have done investment banking with the company within the past 12 months.)

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