This is the final article in this series about why Ryland (RYL) is a great short. The first two articles focused on valuation and ongoing benefits from the downsizing and land impairments taken during the prolonged housing downturn. In the second of the two articles, I noted that Ryland was trading at about $40 per share, and I was looking for a spike higher in the stock and would be entering a OTM Put trade, which I did enter when the stock hit $43 in late January after reporting earnings. Today, the stock went below $37 for an almost 15% correction in less than a month, and I closed the position for about a 150% gain in that time. I continue to advocate Ryland as the best short opportunity of the group because it is the most overvalued on a Price to Book value metric. However, I do think there will be positive headlines from the spring selling season, and I think the stock could go back up in the near term. However, the summer and fall will be where it becomes tougher to show year over year growth in signups, and that should spook the market and send the stock lower, as it is widely believed today that housing is fully recovering and that there is nowhere to go but up and away.
New Communities Sound Good, But Financially Are Going to Hurt
Usually not a day goes buy without a press release from a builder about a grand opening at a new community or the purchase of a new land position. As noted in the previous articles Ryland, like Lennar (LEN), Toll Brothers (TOL), KB Homes (KBH) and all the other big builders, are still sitting on land today that they impaired to significantly below their original cost when the bottom fell out of the market. So the strategy today must be to raise prices, because the builders know that they CAN NOT buy land at prices at or below what the land on their balance sheets is valued at today. So they need to maximize every bit of profit they can out of their current communities. They also need to pray that price increases continue to materialize because without them, the land they are buying today and underwriting with assumed price increases is going to lead to lower gross margins in the future, which no analyst or pundit is expecting. So don't buy the hype and get excited to see the builders buying land. Yes, it is a positive that demand exists, but the land sellers are acutely aware of this as well, and they are forcing the builders to pay prices that will be dilutive to future profitability compared to the levels of profit being realized today (without 3-5% annual price increases).
Payback Time For Material And Labor Suppliers
When the housing market went south, all parties (builders, suppliers, and labor trades) went into survival mode. For builders, this meant conserving cash, downsizing their operations, and praying that the government would bail them out (which they did with lower interest rates, numerous programs to help underwater borrowers, and extending tax loss carryback rules, which added billions of dollars of much needed cash to the balance sheets of all homebuilders). For suppliers, this meant closing lumber yards and basically drastically reducing what they could charge for their materials to the point where they were losing money, with many going out of business. For laborers, this meant laying off thousands of workers who were no longer needed to do carpentry work, hand drywall, or paint homes. You have probably read about the first documented net migration of immigrants back to Mexico, which many correctly attribute to the loss of jobs in the construction industry.
Fast forward 4 years, and you have fewer supplies and laborers and increasing demand for new homes. Economics 101 tells you that the supply/demand equation has shifted, and in this case, in a big way to favor the material and labor suppliers. So the builders are now dealing with significant price increases.
As the chairman of the National Homebuilders Association pointed out in the release today of homebuilder sentiment, which fell for the first time in 12 months, there are actually some headwinds facing the industry, although until recently, the stock prices would lead you to believe otherwise. With regards to the fall in the sentiment:
This is partly due to ongoing uncertainties about job growth and consumer access to mortgage credit, but it's also a reflection of the fact that builders are now confronting rising costs for building materials and, in some markets, limited availability of labor and lots as demand for new homes strengthens
What this means is that for profitability to expand, builders will not only have to lap higher land costs, but they will also have to cover significant increases in construction costs, all to generate incremental profitability in years to come.
What Does This Mean For Ryland And The New Home Industry?
For Ryland specifically, this means that you should be valuing the company using today's metrics from a Price to Book and even Price to Earnings standpoint. Do not assume increases in EPS, because they will not materialize. Yes, 2013 will probably be more profitable than 2012, but it is going to take price increases on a magnitude (5% minimum) that no pundits are suggesting for profitability to continue rising in 2014 and beyond.
There is a fundamental reason that builders will not be able to raise prices much more than they already have. That is because there will not be enough qualified buyers and thus, demand. Let's assume that the cost of materials and labor rise 5% annually. Well, wages across the U.S. are rising only 3% annually. So to simply be as profitable from one year to the next, builders have to raise prices by 5% to cover their cost increases. Yet if wages are only rising by 3%, then at a very high level, there is a subset of buyers who will not be able to afford those higher prices from a Debt to Income or a Down Payment standpoint. Add in the double whammy of rising interest rates and all of a sudden, you lose even more potential buyers. So maybe now you have to lower prices to make sure you are at a price point where your buyers can get a mortgage.
Before listening to everyone shouting from the mountain tops that housing has recovered, step back and look at the fundamentals of the industry, and you will see limited potential upside with significant risks to the downside.