Homebuilders: Time to Short Again?

Yesterday's existing home sales numbers - down

... and the new home sales number today - up less than one point

... and KB Homes (KBH) outlook - not so good, guys

... shook some people up, especially those unwilling to use third grade math or read a balance sheet.

Shorting the homebuilders made my subscribers a fortune and then took some of those gains away when irrationality, tax policy ad traders pushed the stocks up. And now, since all I recommend is puts, I avoid them due to volatility and outstanding short interest in many home building names. That being said, today's housing data may be the beginning of a readjustment on Wall Street - and as reality sinks in, the homebuilders should fall and a couple could - should - go bankrupt.

Where to start? How about some quotes that have been common on the Street for the past 25 years: "When new home starts fall below a million, they are at a bottom, cannot get worse." Housing starts have been at a half million and change for a long time. How about this one: "When inventories are above six months, the home builders will start to fall." Inventories are at nine and a half months, not including all the foreclosed homes not on the market, and the stocks have not really fallen. So, conflicting data based on historical norms.

And that is the thing to base your short position on: historical normals do not count any more (at least not any from the past twenty years, perhaps more). Here is why.

• Home prices have never fallen this far, or this fast, and I believe that they will continue to fall another 15%. Banking analyst Meredith Whitney and housing analyst Ivy Zelman are also still very bearish.
• Foreclosures have never been so high, and they are still climbing. Based on mortgage origination data they will not peak until the middle of 2011, and that means....
•Inventories will continue near all time highs and prices will continue to fall.
• Oh, did I mention, one third of all Americans would like to sell their house if they could get the right price. Makes sense - about one sixth of homeowners decide to sell every year and the market has been frozen for at least a year, more in many places.
• Combine all this with the tightest mortgage standards in living memory and you have the next chapter of home builder Armageddon.

Let's do this with some detail.

Supply

Inventory - Like all markets, the housing market for new homes is driven by the supply of new and existing homes and the demand for these homes. The supply of homes, despite two years of very low rates of home building, is still way above historical norms despite the headlines. Drops in inventory do not account for the number of homes yet to hit the market but already foreclosed or in the foreclosure process. The 3.6 million existing homes in inventory represents and 8.5 month supply. Add foreclosures being held off the market - my estimate is 600,000, minimum - and the 8.5 month supply increased to 10 months, near historical highs.

Foreclosures - The blow-dried experts on CNBC, with a coupe of exceptions, are all saying we are nearing a bottom - we must be, new home starts are so low! They have it backwards: New home starts are low because inventories show no sign of bottoming due to foreclosures, many of them of relatively new homes. Foreclosures are accelerating as moratoriums on foreclosures, resets, and unemployment hit home owners harder and harder.

To quote my favorite housing analyst, Ivy Zelman (on the CNBC blog Realty Check): "Over the past several months, we have witnessed many data points indicating stabilization and improvement in the housing market. While these data points are certainly a welcome reprieve after three long years into the housing downturn, we cannot help but focus on the elephant in the room - the ever-growing pent-up supply of foreclosures in-process... the next wave of foreclosures is not a myth, but is instead the key to the direction of the housing market over the next 6-12 months..... In total, foreclosures in-process are 88% higher than the year ago, led by prime non-jumbo (up 159%) and prime jumbo (up 152%) mortgages."

Actually, this is going to go on far longer than 6-12 months. According to Amherst Capital, seven million homes are going to be foreclosed on in the coming year or two - 16 months supply at the current rate of sale, not including all other homes to go up for sale. And if you trace mortgage originations by type of mortgage, geographic area, and classification - subprime, Alt-A, prime, etc - it is easy to see that foreclosures will not peak until the middle of 2011. Even if I am off by six months, that is a year longer than most optimists. Once a house is foreclosed on, it takes 3-12 months to get it on the market. Right now it is taking longer, but I am assuming this speeds up, so let's assume six months. That puts peak foreclosed homes into the market around the middle or end of 2011, and with 3-6 months to sell them you are looking for a market bottom in the first half of 2012 and inventories will not adjust until the end of that year. Maybe.

Back to Inventories - As foreclosures peak, then begin to decline, and prices firm, pent up demand to sell existing homes will hit the market. Remember that one third number? By 2011-2012 it will be 40% or more - four in ten Americans that own a home will want to sell it. This will add homes to inventories, depressing demand for new homes and home prices for five to ten years.

Demand

These inventories will face vastly reduced demand for homes across the United States due to an end to massive speculation in second homes, a slowdown in new household formation due to lingering unemployment, tightened credit standards and a much smaller shadow market for jumbo mortgages. The little blip up in home sales this past summer was due, in part, to the $8K tax credit you and I are providing to people. Some analysts estimate one third of demand these past four months has been due to this credit.

Speculators: In 2006, using Freddie and Fannie and third party data, more than 40% of mortgages were for subprime and/or second homes, most of them speculative. That market is gone for at least a decade, maybe more.

Credit Standards: At present, credit standards for mortgages other than those originated through the FHA - our money - are the toughest in a generation, perhaps more. And that is for conventional or conforming loans insured by those two paragons of financial management: Freddie Mac and Fannie Mae. The jumbo mortgage market has completely disappeared when the shadow banking market evaporated after Lehman collapsed. It ain't coming back any time soon.

A few days ago the world's most highly paid cry baby, John Stumpf, asked the Feds to leave him and his bank alone and he would figure out to how to pay them back, doggoneit. But, he told them, please use Fed and taxpayer money to buy jumbos because I need the mortgage origination fees... fast. I know a two times seven figure a year attorney who cannot get a home renovation loan. This tightening of credit will cut another 10%-20% from core demand for homes from the 2006 level.

Core Demand: Real demand - people that want to buy homes - is also shrinking as unemployment takes its toll on hopes and dreams, not to mention national income. Forget the affordability index that the real estate industry mouthpieces tout on TV. It is not just what you can afford based on government statistics, it is also what you can afford if you think you might lose your job, have your hours reduced, your commissions cut or your health insurance premiums increased. It is also based on what you can put down. And if you have less equity in your current house, have less ability to save because of the recession, well, the house you want is not as affordable as the real estate flacks are saying they are "RIGHT NOW!." I think reduced demand by customers is about 10% of the demand we saw in 2006 for homes.

Bottom line: Core demand for housing - new homes - by people who qualify for a mortgage will be less than half of peak demand in 2006 for 3-5 years.

Home Prices

Too much supply and too little demand means fewer new homes built and lower margins. Meredith Whitney says home prices will fall another 25% and she has been right about everything else, so why not now? Barclays says 13%. Split the difference and you get 19%, or the median home price falling to roughly $145K. That is a very low target for many home builders. In August, home prices for new homes fell 12% year over year.

The Builders

The builders' problems can be found in operating earnings - or lack thereof - and their balance sheets.

Earnings: In the last quarter of published financial data, the seven largest publicly held home builders lost $1.2 billion, and that includes $376 million in tax rebates from Uncle Sam. Since they have all refinanced recently, it is hard to measure real cash flow from operations and after-interest expense. That being said, the long term debt is $16.72 billion and this should cost them at least $500 billion - perhaps more than twice that - in interest expense per year.

Balance Sheets: The balance sheets are much worse. They are, simply put, a wreck.

• The balance sheets of seven publicly held home builders shows $16.72 billion in long term against $5.4 billion in cash (cash plus AR minus AP). The current market cap is $13.96 billion, so these seven companies are worth, in the market, about $30 billion. As I mentioned, debt service will soon rise significantly - at current rates - and will rise again as rates rise. A good deal of this debt has been re-done recently but a good deal needs to be re-financed in the next 1-3 years.
• Many home builders are now carrying land on their books at the price they paid for it because this land is supposedly under development. Drive to a home site near you and take a look at what accounting driven development looks like - three people with the names Mo, Larry and Curly are working on a fence surrounding a 500 home site plot with two homes built and a model home that has no electricity. And they have been working on that fence for two years. I have seen this three summers in a row at the same home sites in North Myrtle Beach, in Ft. Myers, in Orlando. Someday this land has to be written down to its real value and the builders will not only take a hit on their balance sheet but stand a good chance of violating loan covenants.
• Since you and I as happy taxpayers love paying for greed and incompetence, Congress and the IRS obliged us by letting the home builders apply for tax rebates for taxes on profits they made during the boom. These rebates supplied vital cash in 2009 and are ending. No more free cash from illusory profits made by selling homes financed by mortgages we, as taxpayers, now also own!
• The bottom line: Many home builders are nearing a point in time where write downs and operating losses will lead to negative equity and to an end to liquidity. And home builders, like banks, need to borrow to build and to survive.

Of course, Wall Street traders have ignored most of this as green shoots (scallions to my mind) and momentum and technical indicators and flashing technical indicators have primed the Buy side of trades in home building stocks. Well, as Bob Zimmerman and now Will I Am sing, the Times They Are-A Changin'. It may be a good time to short the home builders.

Let's go back to the market cap plus long term debt number of $30 billion. Value analysts (and other people that think Winston Churchill is still alive) say this is a low price for their collective assets. Sure, right. These assets are being held at inflated values and no one knows what their current holdings are worth in the real world. These same analysts are ignoring the reality of not just a lack of current earnings but no earning power going forward ... not to mention a coming rise in interest payments, more write offs against current assets and falling demand for homes for a long time.

Biggest Losers

Which ones? Balance sheets and high end homes point out the first potential losers and/or bankruptcies. I measure balance sheet like the simpleton I am - long term debt divided by net cash. Hovnanian (HOV) has nine times long term debt to net cash, Pulte (PHM) 6 to 1, KB Homes (KBH) 5.5/1, Beazer (BZH) is at 3 to 1, DR Horton (DHI) at 2.5 to 1, Toll Brothers (TOL) at 2.2 to 1 and Lennar (LEN) at 1.8 to 1.

And Hovnanian has a focus on high end homes. Best place to go short (as in short term).

Other candidates: Companies who have lived and breathed in the starter market, which will be dominated by foreclosed homes in the coming 1-3 years. That puts Pulte and Beazer in harms way, medium and long term.

Longer term, the XHB, the home builders index (which does include building suppliers and like companies) should go down.

Comments

[LIVE FREE O...:]

I have been in the mortgage/banking business for 25 years and never experienced a market like this (the last 3 year in REO management). This situation is horrible and we will not see the light at the end of the tunnel for years.

Bob Toll, CEO of Toll Brothers, seems to disagree with "all the pie in the sky optimism". 9/16/09 he sold 452,180 shares of Toll Brothers stock raising more than $33,000,000. YTD he has sold 4,400,000 shares of his company stock, providing himself with proceeds of approximately $83,000,000.

www.reuters.com/articl...

Company insider transactions, over the past 2 months, on any given week indicate the seller to buyer ratio is 40-100 sellers to every 1 buyer. If that is not an eye opener, I don't know what is.

www.finviz.com/insider...

Sep 26 09:56 AM

[dansocalguy:]

Thanks Michael .... Excellent article although I think you go overboard somewhat ... there is a recovery going on, come-on, and confidence will return if it is sustained .. you know that ... so the jobs issue will work itseld out. With regard to homebuilders they are really paying for those goods times a few years back, arn't they? Forcing the survivors to really make product people want. Obviusly the longer this goes the stronger will be the bounce back ... perhpas 2011 - 12. Perhaps Lennar is the best of the worst?

Sep 26 10:31 AM

[teamlysol:]

Isn't about half the global Con Me problem we're having these days because of run-amok real estate speculators? Everybody wants to be Donald Trump, and now it's gotten so bad that we're paying taxes AND rent to entities overseas. The job of the 'real estate industry' is to put a roof over people's heads, not to play speculation and extortion games. Reverse mortgages and other forms of exotic property finance have helped drive a lot, no, make that a LOT of people, into the poorhouse, the outhouse, or even in some cases, into tents and cars. I would never invest in any kind of real estate company, nor will I ever sign mortgage papers. Those people never seem to stop, and playing their game is just kind of aiding/abetting, and encouraging them. This isn't Monopoly, it's real life, and stuff, and they don't know when to say 'when'. But, whatever.

Sep 26 01:22 PM

[John Ryskamp:]

I hate to tell you this but "shadow inventory" no longer serves as an indicator. Why not? Because people AREN'T paying their mortgages and the banks AREN'T foreclosing. Shadow inventory is foreclosed homes kept off the market. But this is an entirely new category of housing: "limbo" housing. It's VERY difficult to get hands around this, because the banks don't talk about it.

Nevertheless, I can report (I'm in the Bay Area) that the concept is spreading to commercial real estate: no payments on notes and NO foreclosure.

Where's it coming from? Washington. They don't want ANY more losses on bank books. Most community banks invested in CRE, and if that goes into foreclosure 2000 banks will fail. Can't have that.

So look for a new stimulus bill--prboably around $2 trillion in February 2010. This will simply be more fingers in the dike--no new fundamental premises here, just a continuation of the privatizing of gains and the socializing of losses.

However, it DOES mean you should think 19 times before buying a home, because the Federal Government is once again fiddling around with the statistics.

How much limbo housing is there. Someone I know who works in repo at Wells said simply, "A lot."

Sep 26 01:26 PM

[Tom Armistead:]

KBH has 100 million of notes coming due in 2011 and the next hurdle is 250 million in 2014. Against that they have 997 million in unrestricted cash and equivalents.

The earnings and conference call apparently upset many investors. What I saw and heard was a compnay that is very close to breaking even on its actal operations and has been increasing revenue sequentially, even when accounting for seasonality. They have been successfully competing against foreclosures in the starter home market.

They were successful in issuing 250 million of notes in July this year, due 2017. They have an unused credit line and they are in compliance with the covenants. Their writeoffs have been large enough that it has improved their gross margin on new sales - the assets sold have already been written down.

I am long KBH and could make similar arguments in favor of TOL and Ryland (RYL) which I also own. The homebuilders have been able to generate cash going through this and the stronger among them can tread water for a very long time.

I have been paring back my homebuilders as the rally has proceeded and right now I have sold calls over all my remaining holdings. The market has been ahead of itself on this group but I think predictions of their demise are premature.

Sep 26 02:41 PM

[bigbear4511:]

What does confidence mean with no money and no credit. The recovery is completely artificial due to the government manipulating the GDP equation through spending and getting the public to go into more debt (cash for junkers). Sure we may have a positive GDP in the third quarter, but it is highly possible it could return to negative after the government stimulus is used up. If 40% of all housing purchases are done through the tax credit imagine the dip that will occur after Nov 30.


On Sep 26 10:31 AM dansocalguy wrote:

> Thanks Michael .... Excellent article although I think you go overboard
> somewhat ... there is a recovery going on, come-on, and confidence
> will return if it is sustained .. you know that ... so the jobs issue
> will work itseld out. With regard to homebuilders they are really
> paying for those goods times a few years back, arn't they? Forcing
> the survivors to really make product people want. Obviusly the longer
> this goes the stronger will be the bounce back ... perhpas 2011 -
> 12. Perhaps Lennar is the best of the worst?

Sep 26 03:18 PM

[Michael Clark:]

I ran some charts on KBH, DHI, CUT (Lumber ETF), and HGX (Housing Index). I'd sell KBH and DHI. I don't short until the long-trend turns negative....none of these have.

seekingalpha.com/insta...

Sep 26 03:53 PM

[goober1:]

Good read - I could not agree more. Given the tax gifts they have received one would expect them to be solvent, given wht has been put out by the MSM? When are we going to stop bailing the failed entities?
I am short HOV/DHI/RYL all puts ITM and getting better by the day. I may ad some more this coming week? I would not consider owning any homebuilder now for any reason right now. They are insolvent and they have no immediate future potential to recoup.
I have wondered if this administration will come up with another bailout for them. I don't think it is politically feasible any more, many people are seeing thru the ILLUSIONS to reality.

Sep 27 01:25 AM

[goober1:]

Another thing I considered was this. If you are going to short them, now is the time before a new scheme is manifested to save them and we will have some notice before that can happen.

Sep 27 01:28 AM

[Michael Clark:]

I added a chart for HOV to the instablog above (and below): HOV, KBH and DHI all seem to be making modified head-and-shoulders top patterns. Not to positive at the moment.

seekingalpha.com/insta...

Sep 27 04:32 AM