ARE HOMEBUILDING STOCK PRICE INCREASES PREMATURE?

Implications: Recently, stock prices of most public homebuilders have increased 20-30 percent.  This despite no visible signs of improvement in the overall housing industry.  It seems early in the cycle for these stock price upward movements, as it appears the housing market has not yet found bottom.  Equity buyers at the present stock prices must be patient and have a mid- to long-term perspective on their investments. There may be several reasons for the recent price appreciation including: 1. Short sellers covering positions as hedge funds encounter increasing risks in other parts of their portfolios or simply decide to concentrate their efforts in another sector. 2. A perception the government enacted or proposed initiatives will cause significant improvement in homebuilding activities, including sales and financing of homes. 3. A belief the housing downturn is at or nearing bottom and this is the appropriate time to purchase homebuilder stocks.

Analysis: There are many signs that do not suggest a bottom has been achieved thus far.  This is particularly true when considering recent home sale and sale backlog announcements from public homebuilders.  For the last quarter, KBH sales declined 75%, while sales backlog was down 60%.  LEN sales were down 57%, while sales backlog declined 65%; just to mention two. Home foreclosures are escalating in many markets causing additional pressure on the market.  These foreclosed homes likely will sell first as financial institutions are willing to accept large discounts in an effort to remove the foreclosure wave from their books.  Auctions are becoming commonplace in certain markets as a way to deal with the excessive inventory levels.  This removes many potential buyers from the new home market. Recent bulk sales of homes (TOUSA – Cape Coral), (MHO – Palm Beach) with large losses, land sales approaching 30-40% of cost (CTX, LEN), and departures from certain markets (BZH – Cincinnati, KBH – Chicago, New Mexico, SPF – San Antonio, Tucson) suggest a level of desperation still exists among homebuilders. Several large homebuilders are in bankruptcy (TOUSA, Levitt, Newman, Kimball Hill) or approaching it (WCI, SPF), which may cause inventories to be liquidated at low prices further straining the market. The mortgage market continues to be very difficult, strangling access to capital.  Homebuyers with marginal credit will have increased difficulty in obtaining financing. Several homebuilders who have indicated they are participants in some very large joint ventures involving the Focus Group and other situations are experiencing financial difficulties.  The outcome of these issues is unknown at the moment, but could result in significant losses and additional pressure on inventories as lenders attempt to liquefy recently acquired portfolios. There will be an excellent opportunity for a rebound in the stocks of homebuilders.  However, with the current gross margins, revenue contraction and high overhead rates, homebuilders cannot operate profitably.  When sales information and operating results for the first quarter are announced, there may be widespread disappointment, resulting in the stock prices backpedaling.  If you elect to buy homebuilder stocks at the present levels, you must be patient to be rewarded.