New Home Sales: Which Homebuilders to Avoid and Which to Buy?

Includes: KBH, LEN, TOL
by: Rash Menaria

New homes data for December positively surprised many with sales up 17.5% sequentially from November. A major boost to the numbers numbers came from a 72% sequential increase in the West. And the main reason for it was California tax credit. Buyers of new houses in California could qualify for a tax incentive worth as much as $10,000 if they signed a contract between May 1 and the end of 2010. Thus, there was a good jump in the December as buyers rushed to sign the contracts.

So, how to trade the data? Should one buy KB Home (NYSE:KBH) and Lennar Corp. (NYSE:LEN) which have most exposure towards the west?

No, not really in my opinion. And if history is any indicator one should actually avoid KBH and LEN. There have been three instances in the past (2009 Federal tax credit, 2009 California tax credit, 2010 extension of Federal tax credit) when sales dropped precipitously in the months following the expiration of the tax credit. So, it is likely that home buyers this time also will take a pause after tax credit.

Lennar and KB Home have already posted their results and talked about the trends early in the January. Investors are already pricing the positives in their stock price. From here onwards, trends might be a difficult for them. While tax credit helped sales on the upside, it essentially shifted some demand from spring selling season to November-December timeframe. Thus, with tax incentive ending these companies are likely see a slow down in order rates going forwards and investor should avoid them.

So which home
builders to buy?
One interesting thing in new home sales data was increased contribution from high-end home sales
. The mix of $400,000+ homes rose to 18% of aggregate contract signings in December, its highest level in more than a year. For context, the mix of home sales from this $400,000+ price point was 17% last month, and for all of 2010 it was 13%. It potentially suggests that buyers in some move-up and second move-up came off the sidelines in December. Thus, a likely long candidate would be Toll Brothers (TOL) which is more exposed to the high end homes in move-up and second move-up markets.

Overall, homebuilder stocks have started outperforming from mid December on investor optimism regarding the upcoming spring selling season. However, investors need to keep in mind that traditionally, November-January is the seasonally slowest home buying period, and its prudent to wait until early February before actually sizing up the positions as trends would become more clearer then.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.