Battered Builders

Some Wall Street pros are piling back into homebuilding stocks, despite a bleak outlook. What on earth are they thinking?

Is it time to call the bottom in homebuilder stocks? The sector showed some signs of life after one of the Street's top-rated housing analysts, Citigroup's (C) Stephen Kim, released a new research report on Oct. 1 saying the worst was over. If the past three decades of downturns are any indication, Kim figures, a three-month decline in homebuilder stocks greater than 30% typical leads to an average return over the next three months of 31%. As a result, Kim upgraded all the biggies: Centex (CTX), D.R. Horton (DHI), Lennar (LEN), Pulte Homes (PHM), and Ryland Group (RYL) to a buy recommendation, up from hold.

But a week's rally, or even three months of gains, won't be enough to recoup the year-long drubbing of the sector, which has wiped out more than $30 billion in value for the top 20 stocks. Investors should take their cues from builders' chief executives. After a universally lousy showing in third-quarter results, no builder's CEO was willing to offer investors any upbeat messages about a recovery.

"These continue to be very difficult times for the home-building industry. In fact, there are times when the market speaks loudly and clearly and gives an indication that it is time to pull back, to retrench, and to wait for another day," said Stuart Miller, president and chief executive of Lennar—which had its worst quarterly results in its 53-year history—at the Sept. 25 earnings conference call. "These are those times."

No Turnaround in Sight

The lists of builders' woes are many. Buyers aren't motivated. Cutthroat competition is eating away at profits, and an unprecedented overhang of inventory, accumulated after years of rampant overbuilding and faulty forecasting looms large. It gets worse: Some $1.2 trillion of adjustable-rate mortgages will reset to higher monthly payments this year and next, most likely adding to the increase of troubled borrowers and foreclosures already clogging the market. Even without factoring in the record foreclosures and resets, the homebuilding industry already has some 10 months' worth of housing supply to work through.

"You've got to go back to the early 1980s when it was that bad—and it took four years to work that off," says Jeffrey Laverty, head of high-yield and distressed debt research at J. Giordano Securities in Stamford, Conn. "I don't agree that there's a turnaround in sight. It's ugly out there."

Those seeing an imminent turnaround in homebuilder stocks are relying on the predictive value of one key metric: book value. Right now, homebuilder stocks are trading at about 0.5% to book value, a level that has been reached only twice in three decades. They've traded down to that level because many on Wall Street figure residential builders still face aggressive writedowns of their inventory, which includes the model homes, the subdivisions in the middle stage of construction, raw land holdings, and so on. "If you have some stocks trading at 0.3 or 0.4 times the book value, you are assuming that they are going to have 60% to 70% writedowns," says Joshua Spencer, a research analyst at T. Rowe Price (TROW). "That might be right, but it might not be. I think that's a draconian estimate."

Keeping a Cash Cushion

Maybe so. But until investors start to see a dent in those excessive inventory levels, the prospects for builders are going to remain bleak. Homebuilding analyst Daniel Oppenheim of Banc of America Securities in New York notes that although the top five builders, for instance, have seen an $8 billion decline in inventory since peak levels of $49 billion last year, half of that decline comes from write-offs. So it's not as if they have unloaded this stuff. "They've impaired the value of the inventory, but the inventory relative to sales which are falling hasn't changed," says Oppenheim. "They still have to work themselves out of that mess."

If they can't get rid of the inventory overhang, they're not going to be able to generate cash. And that's a builder's worst problem. "The inability to generate positive cash flow from operations would be a huge negative for credit risk; this is one of the more important factors considered by the rating agencies when ratings are assessed," says Frank Lee, a fixed-income analyst at New York's CreditSights, an independent research shop. "Having a cash cushion is extremely prudent, given that this downturn can get much worse."

By slashing prices and announcing nationwide fire sales, the builders are doing their level best to get houses off their books: Irvine (Calif.)-based Standard Pacific (SPF) raised $322 million of positive operating cash flow in the first half of 2007 vs. a burn of $360 million in the first half of last year, for example.

Obstacles Outside Builders' Control

So investors who want to tough it out would be better served by gravitating toward the bigger players with enough cash stockpiled to get them through the next several years, whether they can dump inventory or not. KB Homes (KBH), for example, has $650 million in cash and only $500 million in debt that comes due between now and 2010. "You have to make a rock-solid survivability case through the worst of markets," says T. Rowe Price's Spencer. "If a company has enough cash to pay off obligations and wait out the market, they might have the staying power to wait it out."

Of course, some builders just won't make it through the tough times, especially if buyers remain on the sidelines. Jim Belfiore, president of Belfiore Real Estate Consulting in Phoenix, a national real estate market research company, says there are plenty of obstacles outside the builders' control that are curtailing sales. Appraisers no longer want to value houses at prices at which many owners would want to sell, and bankers no longer want to lend to buyers with poor credit ratings.

There's No In-Between

"We've seen an unprecedented drop in traffic levels," says Belfiore. Fire-sale discounts aren't "stimulating a significant number of sales overall. The majority of homebuilders are struggling, and I think you are going to see some serious changes in the industry. Some of these builders will be bought out, or merge in the next four to six months. Smaller and midsize builders will go bankrupt."

Even deep-value investors who have been dabbling in the sector say it's way too early to call a bottom. One Midwest investment house, which declined to comment for the record, has put 10% of its $350 million under management into four big builders' names. These holdings have taken a beating, but as deep-value investors, they're hanging on to the stocks for now. "Anyone who can attempt to forecast where this thing is going to bottom is drinking something. I just think it's very cloudy and very uncertain," says the company's chief investment officer. "We'll either make 100% on our money in three years, or we'll lose it all. There's not going to be an in-between."

To see how badly U.S. homebuilders are faring, check out the slide show.

    Before it's here, it's on the Bloomberg Terminal.