WHEN WILL HOUSING RECOVER?

Implications: There is widespread interest in the housing industry, housing stocks and bonds, etc.  This impacts many industries and companies.  The article offers my point of view about the current state of the homebuilding industry and suggests when and why things will turn around. 

Analysis: WHEN WILL HOUSING RECOVER?

Recently, Pulte Homes announced a restructuring where they are eliminating a significant number of their work force.  This follows similar actions across the homebuilding industry.  Additionally, homebuilders continue to report inventory impairments and losses.  Newspaper articles suggest home sales will continue to languish for some time.  Such announcements have become and will continue to be commonplace for at least the next year.   This article offers support behind the current situation and suggests future outcomes for the overall homebuilding industry.

Current finished, unsold housing inventory levels should peak around the end of June.  This is due to several factors, the most significant of which is the is the homebuilders starting many homes last fall in anticipation of the Spring selling season.  The "selling season" has been a bust and by March, the homebuilders realized they should reduce their starts and many did so.  However, the speculative homes that were already under construction are nearing completion, which will result in unsold finished homes peaking around the end of June.  Other factors contributing to the high home inventory levels include: lack of consumer confidence that home prices have stabilized, continuing inventory writedowns, investors attempting to exit speculative properties and ongoing pressure on the mortgage approval process, especially in the subprime area.  Additionally, there is uncertainty about the extent of upcoming foreclosures adding to the current glut.

This all means homebuilders will continue to be very aggressive in trying to move unsold, finished homes over the next six months and heavy discounting will occur.  This point should be further accentuated by homebuilders that did not understand the status of the industry initially and continued to start speculative homes.  By now, everyone should understand the solution is to reduce the current excessive supply of finished homes and new starts should continue to decline.

Gross margins on new home sales will continue to decline at least through the end of 2007.  Assuming some contraction in inventory levels by early 2008, pricing will only begin to improve in the second and third calendar quarters of 2008.  By the end of 2008, some normalization of gross margins to around 22% should begin to occur.  However, the industry has changed significantly and a return to the robust gross margines exceeding 30% that were experienced in the early 2000's is very unlikely.

During the next year and a half homebuilders will find it very difficult to make money, ignoring the likelihood of further deposit writeoffs and inventory impairments.   This is due to the rampant discounting  of current and future home prices.  Homebuilding gross margins for the next 18 months are anticipated to be in the mid teens, before consideration of selling and overhead expenses.  Selling expenses have risen dramatically as the cost of external and internal sales commissions have risen significantly, in an effort to capture the modest customer traffic.  Additionally, marketing efforts have been increased and are being absorbed by fewer sales.  For the near term, it is possible sales and marketing costs will average 8-10% of revenues. Combined with the inability and/or unwillingness to reduce overhead, selling, general and administrative costs could approach the gross margin level of 15% resulting in no earnings.

The challenge at hand is to convert inventory to cash, maintain just enough overhead to remain a viable player in desirable markets and to manage cash outflows, particularly situations with land bankers where decisions must be made about buying lots under option contracts.

In summary,  do not expect real improvement in homebuilding earnings for over a year.  Additionally, the days of high gross margins may not return.