With consistently disappointing data releases regarding the US housing market, I have decided the time has come to short homebuilders, and frankly, the entire housing market. This commentary will serve as a top down analysis of the overall US economy right down to some specific homebuilders which I think could be hurt by a second downturn in the housing market. Let us begin with the Fed and move on to their large-scale asset purchases, or better-known as QE2.
The Federal Reserve has 2 mandated goals: price stability and maximum employment. The latter of the two is one of the most important macro-economic indicators for the housing market. With unemployment way above its long-term average, it is not likely that Americans will be looking to purchase a new home or refinancing their current dwelling any time soon. As the unemployment rate remains elevated into 2012, any type of positive turn in the housing industry will be limited.
In order to fulfill its dual mandate, the Federal Reserve decided it would be best to purchase Treasury securities. Since the Fed began buying the $600 billion of Treasury securities back on November 12, interest rates have increased quite noticeably (and yes the employment rate has moved 0.8% lower). The idea behind low rates is to spur investment and consumption by businesses across the country. However, with rates rising close to 100 basis points (or 1%) across the nominal curve, investment is likely to remain subdued. The graph below shows the changes in rates and the yield curve since November 3, the day QE2 was announced.
Mortgage rates are based off the 10-year Treasury note, which as we noted earlier has increased sharply over the past 3 months. Forecasts are putting this rate at 4% or above by year-end (a 40 basis point increase from today). This in turn, will become an inherent barrier for the housing market. As mortgage rates continue to push higher, purchasing or even refinancing will become extremely difficult for homeowners. The chart below shows the recent 0.88% increase in mortgage rates since November.
Since we mentioned refinancing in the prior paragraph, I figured it would be supportive of my view for a dismal housing market to show a graph of the Mortgage Bankers Association's refinancing applications index. This past Wednesday's release came in at -11.5% compared to the prior week. There appears to be no signs of growth in this series, especially with mortgage rates climbing.
While we are looking at MBA data, it seemed appropriate to display their purchase index, down 6% on a week over week basis. The chart below tells the story.
With demand for housing tepid at best, it will be tough for a recovery within the industry to take hold. While the new home sales series may have found a bottom, there are no signs of growth. The chart below displays new home sales for single families.
One last macro-factor that will limit any improvement in the housing industry is the price of a home. The large amount of foreclosures still on the market coupled with the supply of empty homes will continue to put downward pressure on home prices. The chart below displays the 20 city composite Case/Shiller Home Price Index.
Now that we have a grasp of the overall US economy and the housing market, let's move on to the homebuilders themselves. I will begin with, in my opinion, some troubling financial data. Many of these homebuilders are working at a negative operating margin, most likely due to net income in the red. The ratio below is from the latest filings of financial statements available. How can a company be profitable with negative margins with a bleak outlook for the housing market? With a large supply of foreclosures and weak demand putting downward pressure on prices, revenue is going to be limited as well.
The two biggest inputs into housing are lumber and copper. The rising costs of these inputs will continue to hurt homebuilders' profitability. With no way to pass these costs down to the consumer, given extremely low prices and demand, these companies will be forced to take the hit themselves. The graph below displays the contracts for both commodities. The lumber contract is in white and the copper contract is the darker line.
The following are some excerpts from recently reported financial performance:
Net income was 3% lower than the net income reported for the 2009 fourth quarter..."New orders in the fourth quarter of 2010 decreased 12% to 1,765 units, compared to 2,000 units in the fourth quarter of 2009. The cancellation rate in the quarter ended December 31, 2010 was 18% compared to 15% in the fourth quarter of 2009 and 18% in the third quarter of 2010.
NVR has a tremendous amount of debt, along with debt covenants, which will also bound profits to the lower end of the spectrum.
Toll Brothers (NYSE:TOL):
FY 2010's fourth quarter revenues and home building deliveries of $402.6 million and 700 units declined 17% in dollars and 19% in units compared to FY 2009's fourth quarter results.
DH Horton (NYSE:DHI)::
Net sales orders for the first quarter ended December 31, 2010 totaled 3,363 homes ($705.6 million), compared to 4,037 homes ($850.1 million) for the same quarter of fiscal 2010. The Company's cancellation rate (cancelled sales orders divided by gross sales orders) for the first quarter of fiscal 2011 was 28%.
As you can see, I have clearly outlined the current state of the housing market in the United States and the future outlook should speak for itself. High unemployment and rising mortgage rates will keep demand in check. This in turn keeps housing prices down, which hurts the profits of homebuilders. Finally, the share prices of these companies will move lower once the dreary prospects of housing are fully grasped by shareholders. A few notes: I do realize housing starts soared today, most likely from rise in permits from last month. Additionally, the entire rise can be attributed to the always-volatile multi-family component.