August 26, 2006 at 9:39 PM #7334LA_RenterParticipant
Just when you think the term soft landing term was on its last gasp, Barron’s repackages it in the “Big Ripple”. They are making the assumption that RE will rebound next year and HB’s and housing related stocks will soar to moon. Below is a classic pump and dump article designed for the wall street insiders up to their eyeballs in HB stocks.
By ANDREW BARY
IT’S HARDLY NEWS THE HOUSING MARKET IS WEAKENING after a long bull run. The litany of woes is familiar: Home sales are down, inventories of unsold houses stand at record levels, prices are falling in some parts of the country and orders for new homes are off sharply at the major builders. Stocks of home builders are down an average of 35% in 2006, making them one of the worst groups in the stock market. Since last summer, the home builders are off as much as 65% from their highs, one of the severest setbacks ever for this always volatile industry.
The ripple effect from the weakening housing market has been wide, affecting home-improvement retailers, real-estate brokers, lenders and producers of everything from carpeting to appliances and bathroom fixtures. As the table, A House With Many Rooms, shows, most housing-related stocks are down this year and are considerably below their 52-week highs.
While the housing market may not turn up soon, there’s cause for optimism about housing-related stocks because prices for many companies look pretty reasonable. The investment community seems to be buying the argument of housing bears that the slump will be long and deep. If the downturn turns out to be shallow and the housing market stabilizes in 2007, the stocks could do well in the next 12 months as investors anticipate a recovery. Take the hardest-hit group — home builders. Many now trade around book value, and some, like MDC Holdings (ticker: MDC), Hovnanian Enterprises (HOV)and WCI Communities (WCI), languish at a discount to book value, which is stockholder equity divided by shares outstanding. Book value generally has acted as a floor for the stocks, and have given investors a buying opportunity. And home builders have the lowest price/earnings ratios of any stock group — about six times projected earnings for 2006.
“There is a fear of bankruptcy out there and I don’t think it’s based on reason,” says Robert Toll, the co-founder and chief executive of Toll Brothers (TOL), the country’s largest luxury home builder. Toll says he’s frustrated that large well-capitalized builders still get associated with rough-and-tumble independent builders who may have just bought their “first boat or Cadillac.”
Other housing-related stocks have suffered but not as much as the home builders. Home Depot (HD), the country’s largest home-improvement retailer, has seen its shares drop 17% this year to 33. No. 2 Lowe’s (LOW) is down 21% to 26. Home Depot fetches just 11 times this year’s earnings, while the faster-growing Lowe’s trades for 13 times this year’s expected profits. Mohawk Industries (MHK), the No. 2 carpet maker in the country, is off 21% this year to 69 and trades for 11 times this year’s projected net (Shaw Industries, owned by Berkshire Hathaway, is No. 1 in carpets). Virtually every housing-related stock trades below a market multiple, which is about 15 for the S&P 500 this year.
Countrywide Financial (CFC), the nation’s leading mortgage originator, has come under pressure lately, falling to 33 from 42 in May. Countrywide looks tempting because it now trades for just seven times projected 2006 profits of $4.40 a share and for 1.4 times book value, giving it the lowest valuation among major financial stocks. Countrywide has long been mentioned as a takeover target.
Bad housing news, which dominated the headlines and evening news broadcasts last week, is apt to continue. Yet it often pays to buy economically sensitive stocks when business conditions are weak. When valuations get low enough, stocks often stop declining on more bad news. That time could be approaching.
Table: A House With Many Rooms
Because declining orders translate into revenues and profits within nine to 12 months for home builders, it’s all but certain that the major builders will report a drop in profits next year. Barring a housing catastrophe, however, they should stay in the black. “We expect to remain quite profitable,” says Toll. “Our stock is trading near liquidation value. It’s pricing in a risk that we may not stay in business. That seems kind of silly.”
Toll shares, at 25, trade for 5.5 times estimated profits of $4.50 a share in its fiscal year ending in October, eight times projected profits of $3 a share next year and a 20% premium to its book value.
There has been little consolidation among the publicly traded builders in the past decade, but Robert Toll thinks the downturn could prompt some deals. He says there is some benefit to greater size because bigger home builders can take on larger projects. “We’re not talking to anyone and we’re happy with what we’re doing, but there are some builders out there that we know would like to be bought,” Toll says, declining to name names.
For all the attention it generates, the home-building sector is relatively small, with the top 10 publicly traded builders commanding a combined market value of about $40 billion. That’s about the same size as the market cap of Lowe’s. The home builders show up high on the list of a monthly screen of leveraged buyout candidates done by Morgan Stanley credit strategist Greg Peters. Home- builder LBOs may be tough to pull off, however, because most companies already carry moderate debt loads and face an uncertain operating environment — factors that turn off private-equity types.
Home-building bulls have taken their lumps — and lost credibility — because they failed to anticipate the sharp drop in orders and profits, as well as the massive selloff in the stocks this year. Buying home builders too early is one reason that Bill Miller, who manages the Legg Mason Value Trust (LMVTX) mutual fund, is having a terrible year and likely will see the end of his 15-year streak of beating the S&P 500 in 2006.
Stephen Kim, the bullish home-building analyst at Citigroup, argues there likely is little downside and plenty of upside potential with the stocks. “There’s no reason that book value shouldn’t hold,” Kim says. He notes that buying home builders at or close to book value has usually been a winning strategy. Over the past 20 years, the stocks have had a median return of 70% in the year after they traded down to book value. The downside? Back in 2000, the group traded down to 80% of book value, which suggests 20% downside risk from current levels. One benefit to lower home-builder profits will be a drop in the outsized pay packages earned by industry CEOs. Toll earned $28 million last year, while the chairman of DR Horton (DHI), Donald Horton, earned $13 million.
Kim argues the home builders are much stronger than they were in such downturns as 1990 because they have higher returns, better balance sheets and greater combined market share. The top 10 builders still account for just 15% of a still fragmented market, even after doubling their share in the past decade. Unlike other industries, the home builders face no threat from abroad. Their ability to navigate the long approval process needed to develop properties in many parts of the country gives them an advantage over their smaller rivals.
Book value, in theory, is liquidation value. So why should the still-profitable home builders trade around book or below? The Street fears asset writedowns, including financial hits from walking away from option contracts on land. In those deals, builders pay the seller a non-refundable fee of about 5% upfront and then pay the balance when the land is approved for building. As land prices fall, builders are walking away from some land deals and taking modest financial losses.
Kim believes the writedown fears are overblown. He did an analysis earlier this summer of the builders’ land inventories and concluded that only 9% of land on their books at the end of March was priced in 2005 or later, and that 60% was priced in 2003 and earlier. Given that land prices likely are appreciably higher than they were in 2003, Kim thinks builders’ land assets are understated on their balance sheets.
Toll also dismisses the land writeoff concerns. “Even in this bad market, I believe I could sell my land in one fell swoop for what I paid in a heartbeat,” he says. His company did write off some land options in its latest quarter, depressing earnings, but the company still earned over $1 a share. If Toll had to write off all its option contracts — an extreme scenario — it would cut shareholder equity by a relatively modest 8%, before any tax benefits.
In a letter to fund shareholders last month, Legg Mason’s Miller admitted he was “wrong” and early on the group, but said he’s sticking with such stocks as Centex (CTX) and Pulte (PHM) “because we think the bottom is near or within squinting distance.” Miller expects the companies to convert 100% of their earnings into free cash flow in the coming year, reducing leverage and freeing up money for stock buybacks. One of the knocks against the builders in the past was that they produced strong earnings but little free cash because they plowed their profits into new land purchases and housing developments.
Kim notes that many investors view the home-building stocks as “dead money” because the housing market may not stabilize for another year or two. He favors Lennar (LEN), KB Home (KBH) and Toll, but notes that investors tend not to differentiate much in both bull and bear markets.
The bear case is that the housing boom of the past five years resembled the tech-stock bubble of the late 1990s and that a similar bust will ensue. Bears now have the upper hand and their principal concerns include the negative impact of higher interest rates on cash-out refinancing activity and on the trillions of dollars of adjustable-rate mortgages. Bears also argue that the housing boom was facilitated by easy credit, including interest-only and payment-option adjustable-rate loans. As housing weakens, lenders may tighten their standards, exacerbating the downturn.
Nationally, home prices rose just 0.9% in the 12 months ended July and may start showing outright declines starting in the fall. This has rarely happened in the past few decades.
Bulls counter that the housing downturn is apt to be shallow and that such factors as relatively low rates, a still-expanding economy and positive demographic factors, including immigration, bode well for the sector. Home builders do very little speculative building, meaning that unsold inventories aren’t likely to pile up. While cancellation rates have risen as buyers back out of contracts, that isn’t expected to have a material financial impact on most builders.
The Street is somewhat concerned by builders’ use of leverage, which averages about 50% of total capital. This means the typical large home builder has about a dollar in debt for every dollar of equity.
Some risk-averse investors prefer home builders that have less leverage, including MDC, Lennar and Toll Brothers. Those with above-average leverage include KB Home, Hovnanian and WCI have above-average leverage (see table).
Levitt (LEV) is an intriguing, low-profile Florida builder whose shares now trade for around 11, just 63% of its book value of $17.50 a share. “This company takes orange groves and turns them into small towns,” says Alan Fournier, head of Pennant Capital, a Chatham, N.J.-based investment fund that holds Levitt shares.
The two chief knocks against Levitt are that its hasn’t been as profitable as other home builders and that it operates in Florida, one of the hardest-hit states. The good news is that its book value looks solid, with 30% consisting of publicly traded equity in Bluegreen (BXG), a time-share developer. Fournier figures that Levitt trades for about half its liquidation value. The company is controlled by its chief executive, Alan Levan, through super-voting stock. Fournier says Levitt may require a little patience. “I tell people that if the weather in Florida stays nice and people continue to get old, Levitt should work.”
WCI is perhaps the riskiest play in the sector because of the combination of its exposure to Florida, a special focus on high-priced condominium towers and its financial leverage. At 14, WCI trades for a fraction of its book value of $24 a share. WCI has steadily cut its profit forecasts this year and now expects to earn about $3 a share this year, down from around $4.75 in May.
The Street sees profits falling to perhaps $1 a share next year, but investors, who’ve sold short half the available float, clearly are betting on big, looming writedowns. Bulls note WCI’s towers under construction are about 85% sold and that buyers typically make non-refundable 20% deposits.
For investors who want to bet on the whole sector, there are several exchange-traded funds. The largest and most liquid is the StreetTRACKS SPDR Homebuilders (XHB).
Other housing-related stocks are inexpensive but not as cheap as the home builders because their profit outlook is less grim. The biggest of the bunch, Home Depot, is struggling with a weakening housing market, as well as Street complaints about a lackluster retailing strategy and an imperious chief executive, Bob Nardelli, who earned a steep $31 million last year. The cavernous, often thinly staffed Home Depots hardly make for an ideal shopping experience, so the company has room to improve its stores. Home Depot remains the industry leader, with a great balance sheet and is a formidable generator of cash.
At 33, Home Depot trades for 11 times projected 2006 profits, one of the lowest P/Es for a major retailer. Home Depot remains an active buyer of its stock and is likely to retire 5% this year.
Whirlpool (WHR) completed its $2.8 billion purchase of Maytag earlier this year, creating the dominant U.S. appliance maker. Its stock has come down to 78 from a March peak of 96. If Whirlpool is right about its ability to manage the Maytag operations better and achieve targeted cost savings, the stock looks inexpensive because it trades for less than 10 times the $9 a share in profits that Whirlpool is projecting for next year.
Cendant (CD), the conglomerate assembled by Henry Silverman, has been a long-time investor disappointment. Faced with a weak stock price, a frustrated Silverman decided to split Cendant into three parts: real- estate services, lodging and time shares, and car rentals. The strategy has been a bust so far with the three pieces, Realogy (H), Wyndham Worldwide (WYN) and new Cendant (the Avis auto rental business) trading about 20% below where the old stock traded prior to the split-up a month ago.
Silverman is hardly beloved by investors these days, but depressed Realogy, the country’s dominant real-estate brokerage company, could be attractive trading at 21, down from 26 a month ago. Realogy, which controls such brands as Century 21 and Coldwell Banker, is the country’s largest real-estate broker, accounting for 25% of all closings. It derives the bulk of its profits from franchise fees paid by real-estate brokers, an attractive, high-margin revenue source.
Reflecting the weak real-estate market, Realogy last week cut its 2006 cash flow guidance to a range of $800 million to $900 million from about $950 million — and considerably below last year’s $1.2 billion — but it cheered investors with plans to buy back about 20% of its stock. The stock trades for 14 times projected 2006 profits of $1.50 a share and for a modest eight times pre-tax cash flow. If its stock languishes, the company could be taken private in a few years.
It may be early for housing-related stocks, but valuations look attractive and it’s possible the housing market could bottom sooner rather than later. The “later” scenario seems to be reflected in the stock market. If signs of a recovery emerge in 2007, or if the Federal Reserves starts cutting rates, these battered stocks could be up sharply — way before any upturn in profits. Investors may need a little patience, but they can take comfort that housing is one industry that isn’t going away — and isn’t going to be outsourced to India or China.
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