No Point in Bottom-Fishing the Homebuilders

I can't believe how many people are still looking at the homebuilders, trying to figure out when they'll be a good buy.

Exact timing (and yesterday's rally in the group) aside, the short answer to that question is: not yet.

Normally, I'd like the idea of buying the down-and-out sector from a contrarian standpoint, but the fact that so many people are asking whether homebuilders are worth trading suggests a real negative sentiment extreme hasn't yet been reached in this group, as amazing as that sounds.

Fundamentally, I've made a point of talking with some high-end real estate attorneys in our area, folks who have seen a few real estate cycles and know these businesses intimately. The biggest takeaway from those conversations?

In real estate downturns, many homebuilders simply go out of business.

I don't think most investors truly appreciate this fact since such outcomes weren't so visible in last real estate down turn in the early 1990's--this is the first housing bear market in which there have so many publicly traded homebuilders.

Case in point: Standard Pacific Homes (SPF), which has seen its stock get clobbered from a high of $50 two years ago down to $5.25 today. Down 90%, shouldn't it be a great buy right now? The rumor around here among industry pros is that the company is not going to make it, and I suspect that rumor might be good; last month's convertible debt issuance by Standard Pacific to meet obligations on a credit facility was an emergency move of such significance that it can't be ignored.

Regardless, expect more such moves from other homebuilders, as I believe a close look at the balance sheets of most of these builders suggests we may see more liquidity problems in this space.

The challenge builders face is that ultimately they're selling widgets. They're not developing a commercial property which, if it underperforms its cap-rate targets, still generates cash. The homebuilders need to put up a house, sell it to generate cash, then move on to the next one which has to be sold, etc. With the pace of home sales still plummeting, it's not going to be a matter of growing earnings for these companies, which obviously isn't happening, it's going to be a matter of survival.

And here's the line on their balance sheets which worries me: current assets. A current asset is defined as any defined as cash, cash equivalents or any other balance sheet asset which can reasonably be expected to be converted to cash in a short period of time, usually a year. Further, a quick way to size up a company's health from a liquidity standpoint is to look at its current ratio, which is derived by dividing current assets by current liabilities (which are liabilities that are to be settled in cash within the fiscal year). By that measure, the current ratios of most homebuilders today might look pretty solid at first glance.

Let's look at Toll Brothers (TOL) as a representative example of what I mean. With current assets of $6.85BB and current liabilities of $1.9BB as of its most recent quarterly report (July), its current ratio of 3.6 looks pretty healthy.

But here's the catch: only $770 Million of those current assets are made up of cash and cash equivalents--little more than 1/3 the company's current liabilities. The bulk of the remaining current asset line includes inventories, which mean something completely different to homebuilders than to other types of companies.

Again looking at Toll Brothers, $5.95BB of its total claimed current assets (86%) are made up of inventories such as land, development costs, construction in progress, sample homes and land deposits. Are these things that can realistically turned to cash within a year? Well, in its own 10Q the company states, "Once a parcel of land has been approved for development, it generally takes four to five years to fully develop, sell and deliver all the homes in one of our typical communities," and that it can take even longer for larger developments. Including these in current assets, then, would seem dubious given today's real estate market.

To be fair, the company acknowledges this fact and accounting standards are in place for all homebuilders to account for a community's declining carrying value, but are these companies accurately accounting for the nature of such impairments to truly reflect today's awful market? Perhaps, but not likely. And news like we saw last week--that sales in the San Francisco area collapsed by 40%!--suggests that this housing bear market is still gaining strength.

I'm fully aware that shares of these homebuilders are already heavily shorted and that they've already come down in price a great deal. Again, I'd normally appreciate the idea of buying such a group (save for the relative weakness in these stocks... they have failed to rally at all along with the rest of the market since the August lows-not good). In the case of the homebuilders, however, it's too early to think they represent a valuable investment.

Bottom fishers who just can't help themselves ought to keep their trades very short-term in nature and religiously employ stop-losses. Investors, meanwhile, may end up being surprised to see how much further homebuilding stocks still have to fall.

Finally, my use of Toll Brothers above was merely an example and wasn't meant to suggest they're the worst stock in the group. To the contrary, while the company's balance sheet is representative of what concerns me, I looked at it and a number of its competitors, including Ryland (RYL), Lennar (LEN), KB Home (KBH), Centex (CTX), Pulte (PHM) and DR Horton (DHI), and Toll's numbers were generally healthier than the rest. These companies' cash and cash equivalents tended to represent less than 10% of their stated current assets and measure as less than 1/3 their current liabilities--in some cases much less. Thus, it wouldn't surprise me one bit to see more dilutive, emergency-type offerings from some of these homebuilders like we saw last month from Standard Pacific.

And it wouldn't surprise me if some ended up simply going under.

There will be bounces in their shares along the way, to be sure, but in general why bother with the dangerous game of trading the homebuilders? I just don't see the point.

Disclosure: none

Comments

[timjowers]

Excellent article. The barrier for entry into homebuilding is low. A homebuilder conglomerate has very limited intrinsic value. Not like Intel or AMD for instance. An estimated 1M new homes are needed per year for our current population growth. 2M are presently on the market and the builders are still overbuilding. Oops.

[the_Bird]

There's so much inventory out there right now, it's going to be a LONG time before it all gets cleared out - so the illiquid assets on their books are even more illiquid that they would be in a "normal" environment. Moreover, the severe pullback in availablity of subprime/alt-A mortgages means that most of the people who might typical "upgrade" from being renters to homeowners just are not going to be able to do so; how's that inventory going to get absorbed? And - this is all in the context of an economy and jobs market that remains, if not great, *reasonably* robust? How does all of this look if we go into a recession? I don't think one is imminent, but I would say there's probably a 30% or so chance we see a recession develop in the next 12-18 months.

So yeah - homebuilders will have little rallies, mostly short-covering. There are a handful of stocks out there I've found where 80% - 90% of the float has been sold short; there's some real short-term danger there, SPF rallying from $3.71 to $5.72 in a week and a half looks like a classic squeeze. But - there's a lot of these companies that you'll never have to cover (if you can find any shares to short!)