Homebuilders' Profit Prospects Stymie Analysts

Analysts can't agree on whether prominent homebuilders such as Pulte Group (PHM), Ryland Group (RYL), KB Home (KBH), and M.D.C. Holdings (MDC) will lose money or make money in 2011.

For example, analysts surveyed by Bloomberg say mid-cap builder Ryland Group can report anywhere from 91 cents per share in profit in 2011 to 60 cents per share in losses. Eight of 11 analysts surveyed believe the Calabasas (Calif.)-based company will be profitable, but three predict losses.

Analysts' estimates for Pulte, a large-cap builder based in Bloomfield Hills, Mich., range from a loss of 2 cents per share to earnings of 21 cents per share in 2011. A similar disagreement can be found in analyst estimates for mid-cap builders KB Home and M.D.C. Holdings, which builds under the name Richmond American Homes.

Analysts agree some other homebuilders will post profits, but their estimates for their size can vary widely. One way of tracking the divergence of analyst estimates is standard deviation; according to this statistical measure, the adjusted earnings-per-share estimates for NVR Inc. (NVR) are the most widely divergent in the broad Russell 3000 index. NVR builds homes under names including Ryan Homes.

Slumping Industry

Analysts who follow homebuilding stocks have a tough task: estimating the earnings potential for an industry stuck in a slump deeper and longer than any since the Great Depression.

For homebuilders, "tomorrow is especially difficult to predict," says UBS (UBS) analyst David Goldberg.

"Everybody is kind of scratching their heads," says Alan Tarver, a fund manager and senior equity analyst at Frost Investment Advisors in San Antonio. Widely varying earnings estimates for homebuilders are emblematic of the problem facing many trying to forecast trends in 2011, he says. "They're such a microcosm of what's going on in the economy," he says.

Analysts aren't predicting losses for homebuilders DR Horton (DHI) and Lennar (LEN)—which are listed in the large-cap Standard & Poor's 500-stock index along with Pulte—but their estimates still clash. Earnings estimates for DR Horton's fiscal 2011 range from a break-even zero cents to 80 cents per share, while fiscal 2011 estimates for Lennar stretch from 13 cents to 87 cents per share.

Vexing analysts is a "depression in housing" unprecedented in its length and severity, says Michael Gaiden, an analyst at investment research firm Morningstar (MORN) in Chicago.

"We don't know when it will end," Gaiden says. "We know it will end, but it's not clear if that's going to be a near-term, intermediate, or long-term phenomenon."

Investor Unease

This uncertainty is scaring away investors, like Peter Andersen, a senior portfolio manager at Congress Asset Management in Boston, who won't buy homebuilding stocks. "It's one of the most difficult sectors to have any visibility on," he says, adding he sees "limited recovery potential" for the industry until 2012.

The Standard & Poor's 500 Homebuilding index, which includes the three largest public U.S. builders, is down 2.6 percent since the start of 2010. The Standard & Poor's Midcap Homebuilding index, which includes five other companies, is off 8.7 percent this year.

The Standard & Poor's 500 index is up 5.3 percent year-to-date.

The gap between the homebuilders and the rest of the stock market has widened this month. Since Oct. 1, the S&P 500 is up 2.4 percent, but the index's homebuilding stocks are off 4.1 percent and the mid-cap builders have lost 1.4 percent.

Foreclosure Mess

The confusion about the state of the U.S. housing market has been heightened by a joint investigation by attorneys general in 50 states into alleged irregularities in bank foreclosures, says Michael Cuggino, president and portfolio manager of the Permanent Portfolio Family of Funds. Banks have slowed or reviewed foreclosures in response to the allegations. Bank of America (BAC) said on Oct. 8 it would halt foreclosures entirely but on Oct. 18 said it would restart some next week.

The foreclosure mess could have a significant impact on a housing market where in September sales of distressed properties, including foreclosures, accounted for almost a third of all U.S. property sales, according to RealtyTrac. Lenders foreclosed on 102,134 properties in September, a record high since the firm began tracking the data in 2005.

The main factors for homebuilders and the housing market, however, are broad economic trends, analysts and investors say. "People need jobs before they can buy a house," Cuggino says. The U.S. unemployment rate has remained at or above 9.5 percent since August 2009, according to the Bureau of Labor Statistics.

The weakness in demand for housing is demonstrated in the fact that low mortgage rates don't seem to be boosting home sales, says First American Funds Chief Economist Keith Hembre. "Demand is pretty much insensitive to mortgage costs at this point," he says. Homebuilders have also found that discounts don't attract more buyers, UBS's Goldberg says.

A tax credit for first-time home buyers did help stimulate demand in early 2010, but buyers have been scarce ever since it expired in April. The U.S. Census Bureau estimates new single-family homes were sold at a seasonally adjusted annual rate of 288,000 in August, 28.9 percent below the rate of a year earlier. The estimated 414,000 annual rate in April, just before the tax credit expired, was the highest since September 2008.

Recovery Outlook

Big changes in the housing and mortgage markets make it difficult to imagine what a housing recovery will look like even when it arrives. "What is a normal level of sales?" Frost's Tarver says. "That is the uncertainty."

Builders sold 375,000 new single-family homes in 2009, compared with the 1.3 million houses sold in 2005.

FBN Securities analyst Joel Locker notes that the number of unoccupied housing units in the U.S. remains high, with a 14.4 percent housing vacancy rate in the second quarter compared with a historical average—from 1965 to 2005—of 10.5 percent. "Based on vacancy rates," he says he expects "an oversupply of housing for at least three years—[and] maybe five or six."

UBS's Goldberg predicts "two years of healing" for the housing market, with a "strong recovery" three years or more into the future.

Until such evidence of a recovery arrives, analysts will find predictions difficult and investors like Congress Asset Management's Andersen will stay away. "Nothing is aligned to help the homebuilder crawl out of this situation," he says.

Value Stocks?

Investors seeking value in homebuilding stocks can be heartened by the fact that bankruptcy risk is low for those homebuilders that have survived so far, says Morningstar's Gaiden. Even if they post big losses, homebuilders can sell off land to raise capital, he says.

Cuggino, of the Permanent Portfolio, owns shares of Ryland Group, which he says he likes for its offering of homes at various price points and its diversification in many real estate markets across the U.S.

"These stocks will reflect [the housing] recovery when it happens," Cuggino says. Investors must be patient, he adds. "The one good thing about these stocks is they're cheap right now."

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