Three Views of the Housing Market and Homebuilder Stocks

| About: Toll Brothers (TOL)
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One of my wise friends made an interesting comment about homebuilders and why he's always avoided them: every year they have to recreate their entire revenue stream. In other words, if most companies didn't reinvest a penny in the business for a year -- no new PP&E, slashed advertising to nothing, etc. -- their business would suffer, but only gradually; for some period, they can run on autopilot and be milked for cash during tough times. In contrast, if homebuilders don't build new houses, their revenues quickly fall off a cliff.

Another thought: as of the end of last year, Toll Brothers (NYSE:TOL) had 487 days of inventory, accounting for 84% of its assets (net property and equipment accounted for 1%). This is fine when houses are selling, but what happens when the price of your inventory is plunging AND you can't move it? Granted, most of the houses are under contract and customers have made deposits on them -- the high inventory levels simply reflect how long it takes to build the house -- but customers are now walking away from deposits.

Paul Krugman on the housing bust -- and its potential implications...

...with prices falling in many areas, the speculative demand for houses has gone into reverse, as people try to get out with a profit while they still can. There’s now a rapidly growing glut of unsold houses. This is a recipe for a major bust, not a soft landing.

Moreover, it could be both a deep and a prolonged bust. Since 2000, much of the nation has experienced a rise in home prices comparable to the boom in Southern California during the late 1980’s. After that bubble popped, Los Angeles house prices began a slow, grinding deflation, eventually falling 20 percent (34 percent after adjusting for inflation). Prices didn’t begin a sustained recovery until 1996, more than six years after the downturn began.

Now imagine the same thing happening across a large part of the United States. It’s an ugly picture, and not just for people and companies in the construction business. Many homeowners — especially those who bought their houses with interest-only loans or with minimal down payments — will find themselves in financial distress. And the economy as a whole will take a hit.

Herb Greenberg's take on housing:

On one hand, housing companies are in the commodity business of construction; on the other, they're in the trickier business of land, which can be quite different, and lead to different outcomes from company to company. Do they own the land? Do they have options on the land? That's all part of the equation, but in the end the stocks are likely to continue to be influenced by psychology, which will be determined by earnings, which are not likely to be rising anytime soon.

Just as they overshot on the upside, there's no law -- regardless of book value -- that says stocks can't overshoot on the downside, as well.

How low can they go? Just look at charts for most of these companies a few years ago for a clue.