Finding Value in Hammered Housing Stocks: Eye on Orleans Homebuilders

After being hammered with the housing slowdown, some homebuilding stocks are now looking like nice values. In particular, Orleans Homebuilders (OHB) carries a compelling story and valuation.

With operations in just eight states and 85 community developments, OHB is relatively small compared to many stocks in its peer group. The company ranks as the 14th largest homebuilder in the U.S.

OHB concentrates its operations along the eastern part of the U.S., including Florida, Virginia, North Carolina, and New York, as well as the Chicago area.

Orleans builds single-family homes and condominiums. The firm targets just about every imaginable market segment, ranging from relatively low-cost houses for first-time buyers to luxury homes. Although the company currently operates in just eight different states, Orleans has been expanding rapidly into new markets in recent years.

Competitive Advantages

OHB's primary competitive advantages are its excellent geographical locations. Specifically, OHB has a strong competitive and land position in fast-growing markets such as Florida and North Carolina.

The long-term demographic trend in the U.S. is for retirees from the Northeast to move south to sunnier locales such as Florida. That's precisely why Florida's population is among the fastest growing in the U.S. With the massive Baby Boomer generation nearing retirement age, we expect this migration to continue for some time to come.

That said, some previously red-hot markets -- Florida in particular -- are seeing extreme weakness in the near-term. This is primarily the result of excess speculation -- small builders and investors built homes in an attempt to capitalize on rapidly rising prices. When the housing market slowed, these speculative sellers couldn't move their inventory and were forced to drastically cut prices.

That said, OHB was among the first builders to offer incentives and focus on clearing their speculative inventories in Florida. This leaves them well prepared to weather the current downturn.

Meanwhile, several builders have remarked that North Carolina remains one of the strongest markets in the U.S. OHB's strong position in this market is another advantage.

Growth Drivers

Near-term, OHB, like most homebuilders, will remain in defense mode. The focus of the company will remain clearing excess inventories of unsold homes by using incentives and discounts. In addition, management noted in its third-quarter conference call that it saw some stabilization in markets like North Carolina -- OHB will likely try to hold prices or even raise prices slightly in such markets. It's unlikely OHB will continue to expand rapidly in such a weak environment.

Long-term, however, the primary growth driver for OHB remains its small size and ability to expand into neighboring markets. OHB operates in only eight states and only about 12 important markets within those states. In recent years, the company has expanded very rapidly, entering the Chicago market via a small acquisition in 2005 and expanding its presence in North Carolina and Georgia gradually over the past few years. However, there remain plenty of new, unexploited markets that OHB could target in coming years.

For example, as of now the company has a small operation in the Orlando, Florida area. Given strong population growth in Florida, we wouldn't be at all surprised to see OHB expand its footprint there once the market begins to stabilize. In addition, the company has no presence right now in states like California, Nevada, or Arizona -- all of which are fast-growing markets for homebuilders.

Valuation and Outlook

OHB currently trades at 26 times forward earnings. But this valuation metric doesn't reflect the company's true valuation. The P/E ratio is based on unusually depressed earnings forecasts for 2007. On a trailing twelve month [TTM] basis, the stock is trading at less than eight times earnings.

Some analysts like to calculate normalized earnings for companies like OHB -- such measures smooth out extreme up-and-down cycles -- to provide a more realistic valuation picture. On that basis, most analysts have OHB trading around 12-17 times normalized earnings power. With long-term growth of about +11%, OHB is a cheap stock.

In addition, expectations for OHB's earnings this year are ultra-low. Just one quarter ago, analysts expected OHB to earn $1.34 this fiscal year (ending in June). Now, consensus estimates are for earnings of just $0.73. Estimates for next fiscal year have also plummeted recently. Any stabilization of the housing market would make those numbers overly pessimistic, leaving room for an upside surprise over the next two years.

OHB 1-yr chart

Disclosure: Author has no position in OHB.