Homebuilders destroyed... buying opportunity?

[Ed Miller]

The stock prices of homebuilders like KB Homes and Ryland have tanked this year, with the average loss in the 40% range since Jan 1st. P/E's are now in the 4-5 range.

I suspect this month's sell-off coupled with fears of higher interest rates and "bubbles" have caused these companies to be way oversold.

I'm going to look into this further, but I wanted to throw it out there now so you guys could think about it too.

[James Boston]

Ed,

I'm not a savy investor, so this may be a captain-obvious, and/or idiotic, statement I'm about to make.

I took a brief glance at KB Homes, and they look clearly undervalued. However, this is going to be the case when their financials reflect unpresidented earnings compared to a share price that reflects expected earnings.

To me, predicting their value is like predicting the real estate market. Their success is a mirror of the amount of homes being built. By all accounts, we are entering into a buyer's market, so we won't see as many homes being built.

Without a good forecast of what their future earning will be, it's hard to truely call them undervalued at a time when we're still valuing the stock at it's current price, but based on financials that will most likely be weaker this time next year.

How off base am I?

[icetonez]

RYL was good enough for Bill Miller at $70.

[SuitedPair]

Some quick thoughts I have regarding the homebuilders.

I looked at the data series from the GDP report of residential investment and graphed it going back to the 40s. There is a definite channel that this series zigzags through. We are currently above the top trend-line. This also happened in the early 70s and early 80s. After both these periods residential investment dropped by about 30% back to the bottom trend-line. I have access to old value lines and I went back to see what happened to the homebuilders following the previous booms. Long story short, homebuilder’s valuations went to about 3.5x peak earnings, and 0.6x book value. This suggests homebuilders could still be 20% overvalued.

I’ve also modeled in a 30% reduction in revenues and a 500 basis point contraction in margins (roughly the margin expansion of the group over the past 3-4 years), then put a 10x multiple on those earnings (just a guess on the cycle low multiple, with some justification). Under this scenario there is a wide discrepancy. Lennar is 26% overvalued and MDC is 20% undervalued. But as a group, they are about fairly valued. I’m in the process of fine tuning this framework by adjusting sales and margins based more on the company instead of the group.

The main question has to be if the boom was greater than usual. It is easy to think it was due to the easy financing over the past few years. In that regard, a parallel can be drawn to the tech boom of the late 1990s. If that is the case will there be a larger revenue drop and a larger contraction in margins. Margins for KBH went as low as 5% in 1992, and were between 5% and 8% from 1992 to 2000, I modeled in 9.4%. If you use a longer-term average of 6.5% instead of the 9.4% and leave everything else the same, KBH is about 26% overvalued.

My conclusion is, I’m not covering my shorts yet, although I have taken some money off the table.

[SteveOMS]

I like homebuilders now such as TOL, they own large tracts of land over the US and as long as they don't overproduce new housing should weather whatever downturn people are claiming will come. Most of the actual contruction is sub-ed out so cutting costs with with slower production hopefully won't be too bad

Steve

[hawk59]

Ed,

A couple important things. First, look at how earnings have varied over past cycles. Just randomly picking TOL you see over the past 5 years they earned $145mm, $214mm, $220mm, $409mm, $806mm. Should the P/E be based on $800mm in earnings or $145mm in earnings?

Second, look at how industry practice varies in terms of using options to buy land and how this has affected their profitability as land prices have risen. Some have made the argument that many of the homebuilders have effectively been speculating on increasing land prices and that the homebuilding ops themselves aren't as profitable as they may seem.

[NoTalent]

[ QUOTE ]
P/E's are now in the 4-5 range.

[/ QUOTE ]

Be careful with this--maybe not now, but in the next few quarters I feel that the homebuilders will have a lot of competition selling their homes (from each other and the oversupply that has been built over the last few years). When the earnings drop significantly that PE will jump.

[Jcrew]

[ QUOTE ]
look at how industry practice varies in terms of using options to buy land

[/ QUOTE ]

I would agree that this is a very salient point. Looking at the P/E ratio is a necessary but insufficent part of an analysis. You look at the earnings and ask:

1.) Where are they coming from?
2.) Are they sustainable?
3.) How likely that they will rise/fall?

Homebuilders are super leveraged, and can be(probably are) carrying earnings forward from past quarters. Look at order numbers,sales projections, etc. to try to project future earnings. Personally I do not see how they can sustain 2005 earnings in a rapidly deteriorating market, in addition with adverse macro factors.

[Groty]

The attached article was written by a senior exec at PIMCO, a firm that runs literally hundreds of billions in fixed income investments. He analyzes the current and future state of the housing market and assesses its impact on the economy. It's interesting that he recently sold his home to become a renter.

http://www.pimco.com/LeftNav/Regional+Ma...ale_06+2005.htm

And the guy in this article has spent the past 20 years building a real estate empire. (The Colorado Santa Fe website says he personally owns over $200 million of real estate). He expects next year's recession to contract GDP by over 3%. He claims he plans to sell all his real estate holdings and short the homebuilders, REITS, mortgage companies, copper, and other stuff peripherially related to homebuilding. He thinks the shakeout will present some outstanding buying opportunities in 2008 thru 2010. FWIW, my best case scenario pretty much matches his.

http://www.financialsense.com/editor...2006/0609.html

Finally, earlier this week Cramer touted homebuilder WCI as a stock that couldn't go down any more, in part because it's trading at 4x earnings and in part because they are buying back their own shares. Just for kicks, I pulled up their most recent 10Q. Levered over 5x on a funded debt/EBITDA basis (I took actual 1Q EBITDA and annualized it). Way too much leverage for a cyclical industry going into a recession. Next I went to the cash flow statement. They USED $144 million in cash in operations during the quarter, mostly to finance receiveables and inventory. My gripe about the homebuilders is that they print these phenomenal EPS numbers quarter after quarter, but CFO is always negative. As Cramer mentioned, they did buy back some stock, but to finance it they had to lever their balance sheet even more. My stomach isn't strong enough to be at the bottom of this capital structure when there is absolutely no sign the industry is ready to turn.

If you decide to buy into the HBs, I'd urge you to do exhaustive credit work. At the very least, make sure they have very long dated debt maturities and plenty of undrawn, easily accessible capacity (i.e., loose covenants) on their bank lines. The capital markets will seize up during next year's recession, making it difficult for risky borrowers like WCI to refinance their debt.

Good luck.

[Groty]

MS downgraded several HBs today, including KBH. I have the report saved on my hard drive. If someone can explain how to include a file saved on my HD in a post, I'm happy to share it. (I've tried "save to clipboard", but the "paste" option is disabled when I try to paste it.)