The Wall Street Transcript recently interviewed Kenneth M. Leon, Senior Director of Standard & Poor's Equity Services, regarding his outlook for homebuilding stocks. Key excerpts follow:
TWST: Ken, have we reached the bottom yet for the homebuilding sector?
Mr. Leon: We define the bottom as when both the average selling price and the pace of total homes sold have reached the bottom. We believe we are beginning to stabilize in terms of the number of units sold that are reported each month. But pricing, as we monitor it with the S&P Case-Shiller Home Price Index, from peak to trough for this housing cycle still has a ways to go. To be more specific, from the peak of the housing market, which we think was sometime in June or July 2005, to the bottom, which we think will be the middle or end of 2009, we expect pricing to be down, on average, slightly more than 30%.
TWST: What brings about the bottom? Is it help from something like this rescue package that's been passed?
Mr. Leon: We think the federal bailout will help, number one, buyers' confidence. Number two is the ability to reduce sizable inventory of existing and new homes in the market. The average is typically five to six months of total home inventory. We are about 10 months right now, which is still quite high but is beginning to come down each month. Number three, homebuilders, which are roughly one out of every seven or eight housing transactions, are pretty much on the sidelines. They have reduced most of their speculative building of homes, and they have significantly written off lots of inventory for improvement and land option contracts. The top 13 public homebuilders have written off, since the beginning of 2006, $25.6 billion through August 30, 2008.
TWST: We touched on the homebuilders and the write-offs they've taken. Where are they at this point? What does the industry balance sheet look like at this juncture?
Mr. Leon: Now this is where we are talking about homebuilders, not the broader housing market. Some of the key metrics to look at are, first, if homebuilders have stabilized, which we think they have, and second, if they are showing signs of recovery. Of course, homebuilders as early cyclical stage stocks may tend to move ahead six to nine months before you see a full flung economic recovery. So during the economic downturn, we first monitor asset impairments or write-offs, second might be cancellation rates and order delivery, and third would be backlog number and contract value.
First on write-offs, the peak quarter was September 2007. Write-offs, as I mentioned, were $25.6 billion for the top 13 homebuilders since the beginning of 2006. It used to be top 15, but two publicly traded homebuilders went bankrupt. In the September 2007 quarter, write-offs were $6 billion. In the recent June quarter of 2008, it was $1.7 billion, and we expect that write-downs will continually go down. So that's an early sign that homebuilders have kind of cleared away a lot of inventory, joint venture investments, goodwill, etc. They have pretty much cleaned the field and are ready for the next housing upturn. In addition to write-offs, the homebuilding industry is actually producing about 25% of the total new homes it did in the peak 2005 period. Homebuilders have substantially cut their bank credit lines or loan facilities simply because they don't need it at this point, and they've also raised cash. So I would say many of the top 13 public homebuilders are sitting pretty with much stronger balance sheets with more cash than they had just six months ago, and that's a good thing.
The second major item to look at is cancellation rates. As we look at it year over year, they're coming down, but they are still in the upper teens or 20% range. They were as high as 30% or 40%.
And third, in terms of backlog, the level of backlog that these companies have today is small; it's 20% to 25% of their peak period. And that could provide a sense of what sales will be for the next two quarters or so. You want to see some new orders and stabilization or an increase of backlog contracts and value, but we believe we are not there yet.
TWST: As we do begin to come out of this, is the business model for the industry going to be different from what it was going into this?
Mr. Leon: That's a very good question. And again, there are about six states that drive two-thirds of new homebuilding: California, Florida, Texas, Arizona, Nevada and I believe Colorado. Mentioning that, we're seeing homebuilders offering for first starter and first move up home categories smaller homes, smaller square footage. This was seen in an announcement by KB Home (KBH) (sell, $18) of their earnings results; they are introducing smaller homes that are priced 5% to 10% above foreclosed homes in the market in California in what is called the Inland Empire, which is a region mainly located in the Riverside and San Bernardino counties of Southern California and which generally encompasses the urbanized, western areas of those counties. The Inland Empire is centered in the region's oldest cities — Ontario, San Bernardino and Riverside.
TWST: In the good times, the industry built up a tremendous amount of property inventory, and I guess they have written most of that off. Where are they going to build coming out of this if they don't have the property inventory?
Mr. Leon: Land is probably going to be abundant. Attractive land in strategic locations where there are municipal restrictions, those will likely be the exceptions, but generally you are seeing capitulation by landholders. In many cases now, it is land investors that own the land, and they certainly don't want to hold it. So there is an opportunity that homebuilders can come back and buy property, raw land, or even improved land at 15 or 20 cents on the dollar. Another alternative that NVR (NVR) (hold, $560), which is one of the homebuilders, practices is not to own land until you are ready to build and develop communities. So they have, if you will, a just-in-time business model of buying land when they are ready to build homes, which works when you have access to land. It doesn't work when markets are in high demand. Toll Brothers' (TOL) (buy, $21) philosophy is different from NVR's, and it's almost the opposite where they feel if they have good land property, they will hold on to it as dormant until markets or economies get stronger again. And they feel they are buying strategic locations that will do well when the economy improves.
TWST: As we look out, are we going to see a general downsizing in this market? Are we going to see more shrinkage in the home building market?
Mr. Leon: That's the reality, in our view, and actually the ones that I said went bankrupt are from the larger, publicly traded homebuilders. The public homebuilders today still only have, I am going to say, approximately 22% to 24% share of the total US new homebuilding market. We think the private builders in the industry are actually going through a quiet death filing for Chapter 11. Some are quite large and only have access to bank borrowings, not the public debt market. So in those cases, you are going to see the market share of the public homebuilders probably go up well above 30% in the next two years.
TWST: As some of these private builders go bankrupt, is that an opportunity for the public companies to grow?
Mr. Leon: It gets back to fundamental drivers like whether you want more land if you've been writing off so much in the last three years. And if the economy is not changing so quickly, you probably want to wait, but there will likely be a good opportunity, because many of the top 13 homebuilders have significant cash compared to private homebuilders. So there could be that chance to buy these at steep discounts to prices in a more stable housing market. And that would be the land inventory, probably not the assets and all the tangible assets that a private homebuilder may have, which are less attractive.
TWST: Given what's going on and the low level of activity, what are the companies doing at this point?
Mr. Leon: They're essentially trying in each community to which they keep going to build one to two houses a month. If they're in a location or metropolitan area where they have multiple communities, they may be streamlining their sales location to one community site. And in instances where they have low market share versus their competitors in such metropolitan markets, we've seen a number of homebuilders exit those types of markets or states. We are also seeing them continually looking to cut costs and raise cash. So that's what they've been doing and they will probably continue to do so over the next six to nine months.
TWST: What is the level of interest on the part of investors in this space at this point?
Mr. Leon: The homebuilding sub-industry, for which we have a neutral fundamental outlook, is an early cyclical play in the stock market. What that means is if we see any changes toward an economic recovery in 2009, this will be one of the first industries within the consumer discretionary sector to go up, in our opinion. We still think it is way too premature to make a positive call on the homebuilding stocks.
TWST: But it looks like it's already bounced a bit off the bottom.
Mr. Leon: They're bouncing off the bottom of their 52-week lows. If you look at some of the ETF securities like the S&P Homebuilders SPDR (XHB), it looks like there is pretty good support in the mid-teens right now, but things can change.
TWST: Are there any names that you really worry about or have the sick players been shaken out already?
Mr. Leon: Those that tend to be under more tenuous conditions for access to capital or borrowing, those that have small market caps in terms of stocks also are more exposed, as we've seen with those that did go bankrupt — plus those that have high concentrations in the bust real estate markets in California, Nevada and Florida. So those key attributes make us more negative on some homebuilders than others.
We have a sell recommendation on Standard Pacific (SPF) (sell, $5), which has a market cap near $275 million now. We have a sell on Hovnanian Homes (HOV) (sell, $6), whose market cap is just under $400 million. We also have a sell on KB Home, believing that things will not improve for most of 2009, and since it has a high concentration in the Sun Belt states like California. And we have one other sell on Ryland Group (RYL) (sell, $23), which is another California Sun Belt homebuilder.
TWST: And those are just because of location, location, location?
Mr. Leon: Location helps, but our buy recommendations are defined as follows. Homebuilders that have strong balance sheets with significant cash flow and maturities of debt outstanding well beyond the next two or three years would be Toll Brothers and M.D.C. Holdings (MDC) (buy, $33). Toll Brothers is a buy. And M.D.C. is a buy as well; it has a very conservative balance sheet, is very well managed, and has a strong product in markets that it services, in our view. We also still have a buy on D.R. Horton (DHI) (buy, $10), which is the largest homebuilder. We thought it was like Southwest Airlines, where it had a low cost advantage, but the tsunami of the real estate and housing market has hurt that company as well. I think we should be revisiting the housing market and homebuilders in about six months.