By Author Ramsey Su
Back in May, I wondered if "Is it Time to Short the Home Builders"
It is earnings season again. Most builders have reported. Listening to the conference calls reminded me of the movie Groundhog Day. Every conference was the same. Bottom line, they all reported fantastic year-to-year and quarter-to-quarter growth, with strong earnings mostly exceeding analysts' estimates. The builders' stock prices, however, moved in reverse. This begs a re-examination:
Is it Time to Short the Home Builders?
Builders have been blowing the cover off all the analysts' estimates for a few quarters now. What are the underlying reasons? Is this a trend that is going to continue?
Recent quarters: year-on-year comparisons had been easy. New home sales were a measly 306,000 in 2011, improving to a still lowly 368,000 in 2012. Year to date, 2013 is up 38% y-o-y to an annualized pace of 459,000.
Current and upcoming quarters: The comps are becoming more difficult now. Even if there is real demand, the builders are going to have a tough time with supply.
Recent quarters: Most builders have land that was purchased at rock-bottom prices after the sub-prime crash. At today's much improved prices for the finished product, profit margins are very healthy and growing, especially when compared to the miserable years of 2011 and early 2012.
Current and upcoming quarters: The low cost finished lot inventory is dwindling. As builders try to replace their finished lot holdings, they find competition is fierce. Margins will be compressed in the immediate future.
Recent quarters: As builders build and sell more homes, SG&A expenses, as a percentage of revenue, will naturally decline. That has been the case for all builders during the last few quarters, even for the most incompetent.
Current and upcoming quarters: The rise from the trough is likely over. Unless builders can figure out how to build more, sell more and still reduce cost, SG&A is not likely to decline any further.
Recent quarters: Wall Street money was cheap and easy. Most builders have refinanced, issued secondaries, convertibles or other means of securing cheap money to finance more building and land acquisitions.
Current and upcoming quarters: With recent hints of tapering, debt is not as cheap as before. Though builders are not in need of money immediately, in the future their cost of funds will be higher.
Recent quarters: Mortgage rates have been steadily declining from the 5% range during Jan 2011 to 3.5% around May of 2013.
Current and upcoming quarters: Mortgage applications locked in at the low rate during May have either closed or expired by now. Rates have gone up 100 basis points since May. QE3 may be able to keep rates from going up further, but it does not appear to be enough to drive rates lower. A new and improved QE is needed if the intention is to drive the rates back down. That is unlikely.
Recent quarters: Analysts and economists have been projecting a housing recovery, endless growth, more sales and higher margins. Stock prices reflect a premium to value in anticipation of this robust growth.
Current and upcoming quarters: Reality is setting in. The new housing bubble is already running out of air.
In summary, home builders benefited from improving conditions as they built out the land purchased during the trough. That advantage no longer exists. For builders to keep up the momentum and profit growth, they need to find more cheap finished lots, build more, sell more and do so at higher prices. I think the froth will first come out of stock prices, then they will continue down to reflect a much tougher environment – but don't listen to me, do your own due diligence.
(Click to enlarge)
The Philadelphia home builders index HGX. That seems to be a nasty looking head and shoulders top – and prices have been rejected by the recently declining 50-day moving average on three different occasions already