Stop Bottom-Fishing the Homebuilders!

By Chip Hanlon | October 22, 2007 | 1:50 PM | 8 Comments

 

I can't believe how many people are still looking at the homebuilders, trying to figure out when they'll be a good buy.

Exact timing (and today's rally in the group) aside, the short answer to that question is: not yet.

Normally, I'd like the idea of buying the down-and-out sector from a contrarian standpoint, but the fact that so many people are asking whether homebuilders are worth trading suggests a real negative sentiment extreme hasn't yet been reached in this group, as amazing as that sounds.

Fundamentally, I've made a point of talking with some high-end real estate attorneys in our area, folks who have seen a few real estate cycles and know these businesses intimately.  The biggest takeaway from those conversations?

In real estate downturns, many homebuilders simply go out of business.

I don't think most investors truly appreciate this fact since such outcomes weren't so visible in last real estate down turn in the early 1990's--this is the first housing bear market in which there have so many publicly traded homebuilders.

Case in point: Standard Pacific Homes (SPF), which has seen its stock get clobbered from a high of $50 two years ago down to $5 today.  Down 90%, shouldn't it be a great buy right now?   The rumor around here among industry pros is that the company is not going to make it, and I suspect that rumor might be good; last month's convertible debt issuance by Standard Pacific to meet obligations on a credit facility was an emergency move of such significance that it can't be ignored.

Regardless, expect more such moves from other homebuilders, as I believe a close look at the balance sheets of most of these builders suggests we may see more liquidity problems in this space.

The challenge builders face is that ultimately they're selling widgets.  They're not developing a commercial property which, if it underperforms its cap-rate targets, still generates cash.  The homebuilders need to put up a house, sell it to generate cash, then move on to the next one which has to be sold, etc.  With the pace of home sales still plummeting, it's not going to be a matter of growing earnings for these companies, which obviously isn't happening, it's going to be a matter of survival.

And here's the line on their balance sheets which worries me: current assets.  A current asset is defined as any defined as cash, cash equivalents or any other balance sheet asset which can reasonably be expected to be converted to cash in a short period of time, usually a year.   Further, a quick way to size up a company's health from a liquidity standpoint is to look at its current ratio, which is derived by dividing current assets by current liabilities (which are liabilities that are to be settled in cash within the fiscal year).  By that measure, the current ratios of most homebuilders today might look pretty solid at first glance.

Let's look at Toll Brothers (TOL) as a representative example of what I mean.  With current assets of $6.85BB and current liabilities of $1.9BB as of its most recent quarterly report (July), its current ratio of 3.6 looks pretty healthy.

But here's the catch: only $770 Million of those current assets are made up of cash and cash equivalents--little more than 1/3 the company's current liabilities.  The bulk of the remaining current asset line includes inventories, which mean something completely different to homebuilders than to other types of companies. 

Again looking at Toll Brothers, $5.95BB of its total claimed current assets (86%) are made up of inventories such as land, development costs, construction in progress, sample homes and land deposits.  Are these things that can realistically turned to cash within a year?  Well, in its own 10Q the company states, "Once a parcel of land has been approved for development, it generally takes four to five years to fully develop, sell and deliver all the homes in one of our typical communities," and that it can take even longer for larger developments.  Including these in current assets, then, would seem dubious given today's real estate market.

To be fair, the company acknowledges this fact and accounting standards are in place for all homebuilders to account for a community's declining carrying value, but are these companies accurately accounting for the nature of such impairments to truly reflect today's awful market?  Perhaps, but not likely.  And news like we saw last week--that sales in the San Francisco area collapsed by 40%!--suggests that this housing bear market is still gaining strength.

I'm fully aware that shares of these homebuilders are already heavily shorted and that they've already come down in price a great deal.  Again, I'd normally appreciate the idea of buying such a group (save for the relative weakness in these stocks... they have failed to rally at all along with the rest of the market since the August lows--not good).   In the case of the homebuilders, however, it's too early to think they represent a valuable investment.

Bottom fishers who just can't help themselves ought to keep their trades very short-term in nature and religiously employ stop-losses.  Investors, meanwhile, may end up being surprised to see how much further homebuilding stocks still have to fall.

Finally, my use of Toll Brothers above was merely an example and wasn't meant to suggest they're the worst stock in the group.  To the contrary, while the company's balance sheet is representative of what concerns me, I looked at it and a number of its competitors, including Ryland (RYL), Lennar (LEN), KB Home (KBH), Centex (CTX), Pulte (PHM) and DR Horton (DHI), and Toll's numbers were generally healthier than the rest.  These companies' cash and cash equivalents tended to represent less than 10% of their stated current assets and measure as less than 1/3 their current liabilities--in some cases much less.  Thus, it wouldn't surprise me one bit to see more dilutive, emergency-type offerings from some of these homebuilders like we saw last month from Standard Pacific.

And it wouldn't surprise me if some ended up simply going under.

There will be bounces in their shares along the way, to be sure, but in general why bother with the dangerous game of trading the homebuilders?  I just don't see the point.

Positions: none

look again the thing you have to look at is backlog. if you notice Toll has converted its backlog to cash. once you stop buying land, you become a cash machine. 1.2 bil-cash for toll last quarter. btw, publicly traded builders are almost "too big to fail" what Bank can manage the assets on the balance sheets? who better to do it? these builders will be tough to see fail until the market capitulates. then your problems will be bigger than Tol. seems like a short-sighted article. do some more homework. Submitted by kkernahan on Tue, 2008/07/29 - 12:32am » reply |

where to bottom fishing No one knows when home building will recover. What is your opinion on the saving/loan banks? Right now several of them are attractive in terms of dividend yields and valuation. E.g., Washington Mutual or Indymac Bank. I think saving/loan banks have more income streams and should not go bankrupt so easily as home builders. Indymac bank is dropping to to 1993 price level. Can not image that Indymac Bank's income for the past 13 years does not contribute to its stock price at all. With current yield over 10%, this bank looks attractive. Any opinion is appreciated. Submitted by goodday on Wed, 2007/10/24 - 1:42pm » reply |

Housing Sector Technicals The figure below is a weekly chart of the Philadelphia Housing Sector Index (symbol: $HGX). 1) Point 1 marks the 2005 high. 2) Since that time $HGX has travelled lower in a nice channel, and with last week's poor price action prices have broken below the lower channel line. 3) Points 2, 3, and 4 mark positive divergence bars between price and an oscillator (pick one).  Past counter trend rallies started in Oct. 2005 and Aug. 2006; the positive divergence bar marked the low for the price move.  Now turn your attention to point 4.  This is also a positive divergence bar in this area yet prices have already closed below the low of this positive divergence bar.  With regard to positive divergences, my own technical work suggests that they tend to define a price range; so a close above the highs of the bar generally leads to higher prices and closes below the low of the bar lead to lower prices- as in there has been a price failure.  Last week was a close below both the lower channel line and the positive divergence bar.  Technically, $HGX remains weak. Another reason to suggest why this won't be like Oct. 2005 or Aug. 2006 is that the market back drop has deteriorated significantly last week, and it is likely that this will remain a headwind for shares.  Can you see housing going higher while the market goes lower?  I can't. A close above the 160 level on a weekly closing basis on the $HGX would be a reason to consider the homebuilders for a trade; the highs of the recent positive divergence bar are at 172 and this area is likely to be resistance. Submitted by Guy Lerner on Mon, 2007/10/22 - 3:59pm » reply |

For whom does the bell Toll I find myself agreeing with you more and more. Contrarian investing seems to be all the rage lately and that goes for bottom fishing in the homebuilding sector as well as U.S.D. bottom feeding. With so many contrarians out there it seems prudent to stick with long term fundamentals rather than trading capriciously. Submitted by Michael Pento on Mon, 2007/10/22 - 2:49pm » reply |

Re: Homebuilders I think you make a good point about the misconceptions people have about what constitutes liquidity and solvency. The Quick Ratio tends to measure the ability of these companies to cover their short term liabilities in a more accurate manner. As well, many of these companies have significant trouble with their ability to cover interest expenses here in the short term. Obviously this is more of a problem with the smaller names, but relevant to any analysis of the sector nonetheless. Lastly, you make an interesting point about the public's perception of this housing correction with respect to that of the 1990's as not only has the proliferation of publicly traded homebuilders influenced this reaction, the number of publicly traded lenders has also compounded this reaction. I think you can say that part of the "pain" of this housing correction is the higher preponderance of both publicly traded homebuilders and lenders/asset backers. Submitted by Paul Baiocchi on Mon, 2007/10/22 - 2:45pm » reply |

nice work thank you for that analysis it was very interesting. you will probably be wrong in the short term, which makes me ingterested in buying these for a trade, but i really likie your reasoning longer term and havelittle doubt you will be correct. more people should read this Submitted by jriles on Mon, 2007/10/22 - 2:08pm » reply |