The Heat is On Homebuilders

We have run a series of pieces with Wayne Nef from Nef Value Research.  He has been right on the money with his calls on this group. We have been talking about homebuilder valuations extensively in the series, and an article today in the Wall Street Journal discussed the topic as well.

The Heat is on the Builder Bulls. Will their resolve melt faster than the stocks? Or is it time to bottom-fish? 

This interview was done on June 28th, and all valuation data is as of that date.

Most stocks are close enough to their closing prices on that date that the calculations below are still accurate. Adjust as necessary.

Be forewarned, It might be 100 degrees outside, but Wayne cannot even make a case for Beach Houses.

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Thanks for joining us again Wayne.

Analysts typically raise price targets when stock go up and hit them. Are you lowering yours?

On certain stocks I am lowering my price targets, while on others I am not. Some stocks have gotten hit much harder than others due to worse balance sheets, less geographic diversification or due to other factors.

In general, I remain bearish on the homebuilders, as I believe conditions will get worse before they get better.  A large number of ARMs are set to reset between now and November and I expect many more properties to hit the market across the U.S.  Prices are dropping and sellers are finding it takes much longer to sell a home now compared to last year.  As sellers become impatient, we should see more price discounting in both the new and pre-owned markets.

There are three things that are driving me to lower my 12-month price targets on a number of the homebuilders.

1) Most of the homebuilders are trading nowhere near their deep trough multiples. An article on Bloomberg the other day said that many of the homebuilders are trading near 1x book value and that they may be Buys for patient investors here.  I disagree with this premise.  In 2000 many of these stocks traded to “true” trough multiples. The table below shows where these stocks traded at the trough in 2000 and 1990 and where they are trading now.

Book Value At Trough in 2000 Versus Today, and in 1990 if applicable

BZH

.54x-----.70x in June 2007

CTX

.61x-----..97x in June 2007-----.60x in 1990

DHI

.70x-----1.01x in June 2007

HOV

.43x-----.64x in June 2007------.33x in 1990

KBH

.65x-----.97x in June 2007-----.64 in 1990

LEN

.78x-----1.12x in June 2007-----.35x in 1990

NVR

1.50x-----3.55x

PHM

.51x-----.94x in June 2007-----.45x in 1990

RYL

.45x-----1.09x in June 2007-----.67x in 1990

TOL

.78x-----1.12x in June 2007-----.72x

2) The second point that is leading me to lower my price targets for many of these stocks is that at this point Book Value is still a moving target.  Since March 6 the consensus book value estimate is down 6.3%.  The drop in book value was spread across 7 out of the top 10 homebuilders.

3) The third point that leads me to believe that these stocks are headed lower is fear.  Fear about interest rates, fear about falling home prices, fear about credit risk and rising inventories.  All of this fear will combine to drive stock prices lower.  I pointed out to my clients in November that the pain likely won’t be contained to the homebuilders only.  Consumers will begin to feel the pain and that will likely impact autos and retail as well.  In my opinion, we are already starting to see some of this change. Retail sales have been sluggish over the past couple of months and I expect weakness to persist in June also.  Meanwhile the Bear Stearns Mortgage Backed Loan debacle has frightened investors even further.  The year 2000 was mild in my opinion, compared to current conditions and risks.

That certainly is sobering.  What builders might do better given their geographic mix and exposure? Same questions with price points.

Geographically, I would think areas that didn’t get overbuilt might fair better. Areas where employment is less cyclical such as the Washington D.C. area may hold up better too.  Areas that may be in for an extended downturn include: Florida, California, maybe Arizona and Nevada.  By price point, I think the lower end homes may recover first. In my area of New Jersey, lower end homes have continued to sell better than the midpoint and higher end homes. Sales are down and listings are up in these price points.  FHA mortgages has helped to mitigate the tighter credit markets to some extent, but these aren’t really available for upper end houses.

With that said, I still believe that the homebuilders as a group are in for a rough time. In late August I suspect we will hear the first cheers from the sellside that the market will turn in 2008.  Many of the analysts were burned with that call this year, but the stocks still rallied from August to December.  I think this year the calls for a rebound won’t be as loud and any rally will be more muted.  I would use any strength in the group, absent a marked decline of homes on the market or government intervention into the credit markets as a shorting opportunity.

What would it take to turn you postive on these stocks?

For me to turn positive, I think if these stocks hit my stretch targets, they would be buys absent a housing crash.  What we are experiencing here is not yet a crash, but more of an expected pullback after an extended bull run.  If we went to over one year’s supply of inventory and prices declining by 25%, I would certainly not try to catch a falling knife.  However, if inventories remain in the 6 to 9 month range, then I think long-term investors can start to nibble at this group.  The stock is volatile and usually after hitting a reactionary low the stocks get too cheap and the begin a gradual multi-year rally. At this point, it is unclear to me which scenario is going to pan out, the crash or the painful pullback.

Can you share your stretch price targets with us?

I think if you go back to the earlier data, those historical mutliples will give you some idea of the types of multiples you might see.  I have two sets of price targets for the homebuilders right now.  My targets and my stretch targets.  Both sets of targets are 12-month projections. To reach my stretch targets, everything has to go to hell in a hand basket.

DHI: Target $19, stretch $16.

KBH: Target $27, stretch $16.

BZH: Target $27, stretch $22.

RYL: Target $26, stretch $17

CTX: Target $33, stretch $24

LEN: Target $25, stretch $17

TOL: Target $21, stretch $17

Thanks, Wayne. I think going to the beach today is a better idea than initiating a long position in these out-of-favor names. Lets revisit them again when you get a little more constructive.

Nef Value Research
Homepage

Sign(s) of the Times
12/7/06

Homebuilders for Sale
3/6/07
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The content contained represent the opinions of 1440 Wall Street. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author. No position in securities mentioned

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