Homebuilder Stocks Not The Bargain They Seem

Includes: KBH, PHM, TOL
by: Marc Gerstein

Interest rates have stopped rising but homebuilder stocks continue to fall, with peers like Toll Brothers Inc. (NYSE:TOL), Pulte Homes Inc. (NYSE:PHM) and KB Home (NYSE:KBH) shedding as much as 11 percent in the last two days. Some fear the Federal Reserve may be leaving the market primed for more rate hikes down the road. Red flags in an industry report suggest estimates may still be too high and that single-digit homebuilder price/earnings ratios may be less of a bargain than some believe.

Investors might be willing to tolerate the 2006 declines forecast by the National Association of Realtors for various metrics — 6.5 percent for existing home sales, 12.8 percent for new home sales, and 9.1 percent for housing starts — if they were confident that last week's rebound in mortgage applications spelled better days for 2007 and beyond.

But the NRA's Housing Affordability Index trends for existing single-family homes suggest the stock sell-off may reflect earnings concerns that won't necessarily be cured by lower or stable interest rates.

An Affordability Index of 100 means that median family income is exactly equal to the income it would take to qualify for a mortgage on a median-priced home, assuming a 20 percent down payment and that debt service would be 25 percent of income. An Affordability Index of, say, 120, would indicate that the median family income is 20 percent higher than the mortgage-qualifying income. An Index value below 100 means there's not enough income; that a mortgage would be attainable only if the lender is willing to tolerate a smaller down payment and/or a bigger (than 25 percent) debt-service burden.

Table A shows recent tallies for the Composite (fixed and adjustable rate mortgages) Affordability Index, along with key data-points upon which it is based.

The latest one-week pickup in mortgage applications occurred in response to a decline in the mortgage rate to 6.45 percent. Assuming no change in the median home price and plugging this lower rate into the NAR's Affordability Index formulas would result in a modest increase in the Index from 103.7 to 106.3. That is hardly enough to make much of a difference in the standard of living of a qualifying family; a family that is presumably also wrestling with higher fuel prices and in some cases, uncertainties surrounding future payments that would be incurred as rates on adjustable mortgages shift.

It might be argued that given where home prices are, there's little chance of mortgage rates falling enough to make much of a difference.

Even if we assume mortgage rates will fall to their 2003 average, the Affordability Index remains much tighter than it actually was at that time, 114.6 versus 130.7, because the median home price is up 28 percent.

Housing activity would likely recover if prices were to fall. That may happen. Indeed, the present price "curves" for housing futures, based on the numeric value of the S&P/Case-Shiller Home Price Index, suggest derivatives traders are preparing for this scenario. Table C shows the relationship between housing futures and their "fair values."

The underlying index is based on recorded values in home sales transactions. Because of the lag between negotiation and closing, the May 2007 contracts probably reflect expectations of where pricing will be in late 2006, when contracts for sale will probably be signed for deals whose completion is likely to be reflected in the May 2007 index.

It's hard to say whether the housing market is likely to give ground in terms of volume, price, or some combination of both. Regardless of what occurs, though, it seems likely homebuilder revenue will be impacted. And there is reason to wonder if analysts, despite having already reduced estimates, have really gotten a full handle on the potential vulnerability of industry sales trends.

Table D shows fiscal 2007 consensus revenue estimates for a small sample of builders — Pulte, Toll and KB Home — in the context of recent historical results.

Bear in mind 2005 was an exceptional year for volume, with nearly 2.1 million housing starts, up from 1.85 million in 2003, and a strong year for pricing with the median home priced 21.5 percent higher than in 2003.

If median prices were to fall 20 percent by 2007, the Composite Affordability Index would be 132.6 if mortgage rates stay at 6.45 percent. If rates drop to 5.74 percent, the 2003 average, a price decline of that magnitude would bring the AI to 143.3. At those levels, we probably can experience acceptable, but possibly not record, levels of housing activity. But even if we were to assume housing starts in 2007 could match the 2005 level, price declines at or near the 20 percent level would make it difficult for the companies to deliver the revenues expected by analysts.

Note, too, that publicly traded homebuilders, including the three shown here, tend to conduct a lot of activity in the Northeast and in the West. June 2006 Affordability Index figures for those regions were 86.7 and 70.0 respectively (versus 145.4 for the Midwest and 113.3 for the South). That might make the major homebuilders vulnerable to steeper-than-average price declines. (Among the three mentioned here, Pulte has the biggest exposure to the Midwest and South, and, perhaps not surprisingly, the highest price/earnings ratios).

While we would hesitate, based on this back-of-the-envelope inquiry, to propose our own detailed revenue forecasts for these companies, considering the data and the full context of how high housing soared, revenue declines of 20 percent or more — plausible if we were to assume that affordability levels will eventually retreat from present skin-of-the-teeth levels — don't seem out of the question. Yet even that outcome would still leave the companies at levels that, in a big-picture sense, remain quite high.

If revenues do wind up falling that much, the impact on EPS could be larger. Table E shows how gross margins for the homebuilders sampled here have widened in the recent past as sales soared.

If sales contract significantly, it's reasonable to assume at least some of the recent gross-margin gains may wither.

This wouldn't automatically translate to a dollar-for-dollar impact on earnings per share. There are other factors impacting the bottom line including share buybacks, as William Miller, manager of the Legg Mason Value trust, points out. But it's hard to say how much stock companies will actually repurchase if they see revenue and cash flows coming in substantially below expectations.

Single-digit P/E ratios are not generally sustainable in the modern era. But the homebuilder situation reminds us that rising share prices aren't the only antidote. Continuing reductions in earnings estimates can also move P/Es to more normal levels.

At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

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