What is the 2008 outlook for homebuilding?

Implications: What will happen in 2008 for the homebuilding industry? Will cash be generated? Will there be failures? Will there be profits?

Analysis: 2008 OUTLOOK FOR HOMEBUILDING

The homebuilding industry continues to struggle. What will happen in 2008, to this industry? This article expresses a view on the near term future.The homebuilding industry has not yet hit bottom as housing inventory levels are high, foreclosures are looming, mortgages continue to be in turmoil and home sales are languishing (existing home sales for November declined 27 percent year over year in major markets). 2008 will see continued decline in revenues and operating losses for the major homebuilders. Losses may not be as large as 2007, because the magnitude of impairments likely will decline. Cash flows should develop and improve for some and company failures in the larger builder ranks are on the horizon.

Revenues

Beginning sales backlog levels at the beginning of the current quarter are much smaller for most homebuilders than the same point a year ago. PHM has not experienced as large a decline as most ($5.8 b to $4.1b). Others (DHI $5.2b to $2.7b, CTX $5.1b to $$2.7b, MDC $2.1b to $1.2b, RYL $1.7b to $1.2b, etc.) have beginning backlogs approaching half of the prior year. This clearly indicates a reduction in near term (2008) revenues. And, recent sales rates are not good. These factors indicated 2008 revenues for most large homebuilders will decline by 30 percent or more. Average home sale prices are declining due to competitive factors and homebuilders' efforts to make homes more affordable. Homes are becoming smaller, simpler to build and have lower quality cabinets, carpet, fixtures and other components in an effort at reducing the price. Granite countertops are being replaced with less expensive alternatives. Thus, as the average sales price declines, the homebuilder must sell more homes to maintain revenues constant, which is not happening.

Profitability

A by-product of the battle for home sales is that competition is causing reduced gross margins. As sales become even more difficult, further deterioration in already low gross margins in anticipated.Homebuilders have not been able to reduce their infrastructure as rapidly as revenues have declined as evidenced by 2007 overhead costs around 15 percent. Considering the anticipated reduction in 2008 revenues, it becomes more problematic and suggests it will not be possible for most homebuilders to operate profitability. If anything, overhead costs are likely to increase as a percentage of revenues in 2008. The easier cost reductions have been made, increasing the difficulty for future cost savings.One bright spot is the amount of inventory impairments taken to date will likely abate somewhat. Although there will be continued impairments, the magnitude of these writeoffs should decline. In other cases, some homebuilders will show improved gross margins due to the recovery of previous impairments. Overall, this impact will be spread out over a number of years, although there are selected homebuilders where the impact will be significant (refer to article Homebuilding Gross Margins May Not Be What They Seem).

Cash Flows

Lennar created a rush to do tax motivated inventory sales at the end of 2007 as they realized an income tax loss that allowed them to recover previously paid income taxes. (see article Income Tax Update for Homebuilders). MHI, Orleans and several other homebuilders consummated year-end transactions with the same objective. More of these transactions are likely, but the window to carryback tax losses and recover cash generally is limited to income taxes paid in 2006. Some large homebuilders are beginning to generate significant cash flows from inventory reductions and asset sales. For most, this should accelerate in 2008. However, several homebuilders have large cash commitments to joint ventures, option contract takedowns, debt maturities, etc. that will make it difficult to retain cash that is generated. Operating losses that are expected across the industry will reduce cash availability for other purposes.

Failures

Several large homebuilders will be forced to undergo restructurings and or bankruptcy filings in 2008. Depending upon how these transactions occur, they could put further pressure on weak demand for homes.Several large joint ventures are having difficulty and defaults on debt covenants are likely. Some joint ventures will require capital infusions that all joint venture partners may not be able to make.Future compounding all the stress on home and land prices is the deterioration of financial capacity of land bankers that financed option contracts. Those land banks that were leveraged by third parties will receive increased pressure for debt repayment, when many projects are not cash flowing. As a result, there will be additional land/finished lots for sale.

Summary

The homebuilding industry is experiencing a crises and 2008 will not be easy. However, there will be cash generation by some and clarification that other industry participants will not survive. Ultimately, the best-managed and capitalized companies will emerge with increased market share.