An End To Seven Years Of Bad Luck For Builders?


Call it seven years of bad luck. At just about this time of year, in 2005, homebuilders rode over the falls and into the industry's longest, steepest decline in a generation.

Over the past several quarters, housing and real estate markets have begun flickering to life. Housing starts, building permits, builder confidence and other monthly data continue to saw back and forth. But some positive trends appear to be emerging.

There is much debate over whether those trends constitute a recovery, but economists and analysts have begun to agree that the correcting market has at least put in place a floor.

"If you look at the actual raw numbers on a year-to-date basis and take out monthly swings, there's no doubt we are better than a year ago," said analyst Megan McGrath of MKM Partners. "We're still at historically low levels vs. any kind of measure of long-term averages. But we have clearly come off the bottom."

The recovery has been stubborn, not holding to the industry tradition of a quick rebound off housing-market lows. It's true that new-home starts across the first two quarters were 15% higher than a year ago; new-home sales are up 20%, McGrath says. But the rebound is less bouncy than previous cyclical upturns.

"It doesn't look to be as dramatic this go-around," said Fitch Ratings managing director Robert Curran. "Typically in new construction, recoveries tend to be V-shaped. This so far is a sloping U."

The homebuilding industry struggling to crawl out of that U-shaped slump also looks very different than it did going in. With cash cushions and access to capital, and by managing labor costs and real estate strategies, the leading publicly traded builders survived. Countless ranks of smaller and regional builders perished.

That new command of market share might possibly be gaining traction. Eight of 15 U.S. builders topped analyst earnings projections for the second quarter, most by triple-digit margins. On the revenue side, nearly all fell short of forecasts.

Investors, for the most part, didn't seem to mind. Rising share prices of publicly owned builders, includingD.R. Horton ( DHI ),PulteGroup ( PHM ),Lennar ( LEN ) andToll Bros. ( TOL ), have kept the Building Residential-Commercial industry group in a top five ranking among IBD's 197 industry groups since June.

1. Business

Beazer Homes ( BZH ) andRyland Group (RYL) were among the few publicly traded builders to fall short of Wall Street's second-quarter earnings expectations.

Lennar and D.R. Horton swept past expectations -- with a little boost from the IRS. Both qualified, through relatively healthy orders and profits, for a break called a "tax asset valuation allowance."

"It wasn't that they earned that much extra cash," said Greg Harrison, research analyst at Thomson Reuters. But "even though it's not all cash earnings, it's still a positive sign."

Without the tax break, D.R. Horton would have earned 23 cents a share instead of $2.23, beating estimates by 3 cents instead of by more than $2. Of the $2.06 reported by Lennar, $1.85 came from the tax benefit. Even without the benefit, Lennar would have beat by 4 cents.

Revenue is another thing. Of 13 U.S. homebuilders in IBD's industry group, nine missed Wall Street revenue views in Q2, according to Thomson Reuters. The four that beat: Lennar,Meritage (MTH),KB Home (KBH) andHovnanian (HOV).

"The earnings beat rate is slightly higher than normal," Harrison said. "The revenue beat rate is far below normal."

The builders are adept at paring labor forces and other cost-cutting measures to bolster earnings. On the flip side, that can leave them shorthanded when it comes to churning out new homes.

Revenues were light during the quarter, in part, because it's taking builders longer to complete homes. As new orders start to rise, builders report rising backlogs.

Another factor: Builders are putting up fewer homes on speculation. The industry is geared to raising entire subdivisions on speculation, then selling into a healthy market. Building homes only after a contract is signed, and according to customer specifications, is less efficient, piecemeal work. Such homes can take at least 90 days to deliver.

This is why revenue in the building industry is a lagging indicator, says Wells Fargo Securities analyst Adam Rudiger.

"Orders come first and revenue follows," Rudiger said. "Revenue is a reflection of order activity from three months ago."

Cancellations also figure into the mix.

NVR 's (NVR) 16% cancel rate in Q2 stood out. Its shares fell 14% on July 19, the day quarterly results were reported. Rudiger says NVR's order growth of 6% -- slow vs. its peers -- was a larger factor in the sell-off. Shares have since recovered to 5% below their July 16 high.

In June, Lennar also reported a 16% cancellation rate for the quarter, but vs. a 40% increase in new orders. On July 26, Pulte put its cancellation rate at 14%, down from 19% a year earlier and vs. a 32% gain in new orders in the second quarter.

2. Market

The major builders saw markets blip to life two years ago when the homebuyer's tax credit generated a surge in demand. But first-time homebuyers retreated when the credit ended in April 2010. Move-up buyers are now the more active customers for publicly traded builders.

Interest rates are at record lows. But first-time buyers continue to have trouble qualifying for mortgages and scraping together the down payments to meet tougher lending requirements.

Move-up buyers often use proceeds from the sale of their home to buy a larger one. They generally have better credit histories, and qualify for lower-interest mortgages.

Tougher appraisal standards have become a hurdle across the industry. When appraisals come in well below the sale price of a home, as they often do these days, mortgage lenders may require borrowers to make up the difference with larger down payments. Move-up buyers are typically more able than first-time buyers to meet such demands.

First-time buyers typically make up close to 40% of home sales. The tax credit briefly lifted that share to near 50%, Curran says. First-time buyers now account for just over 30% of the total market.

"In Texas first-time buyers tend to be more prominent, particularly because of low prices and population and job growth," Curran said.

First-time buyers have a tougher time cracking pricey markets such as the Washington, D.C., area. D.C. typically holds up better than others in downturns because of steady federal government-related employment.

But Curran says orders for new homes in the D.C. market were not as robust in the second quarter as in the first quarter. Uncertainty over the upcoming presidential election, and potential staffing changes, could be a factor.

New homes compete with existing-home sales, the latter a far larger market and now larger still counting distressed inventory.

"Normally, the existing home market is 5-1/2 times the size of the new-home market. Presently it's more than 10 times higher," Curran said.

And if distressed inventory isn't enough to keep a lid on home prices, the ability of existing homeowners to sell their home is hampered by first-time homebuyers' inability to buy one.

"Who does the trade-up buyer sell their house to? Oftentimes it's a first-time buyer," said Curran.

3. Outlook

The big question for homebuilders, Rudiger says, is "where do you go from here?

"A lot of the demand we've seen this year is low-hanging fruit from qualified buyers," he said. "So growth rates could slow a bit."

A strong recovery won't likely take hold until employment improves, he says. In July, the jobless rate ticked up a notch to 8.3%.

Fitch Ratings predicts that single-family housing starts will rise 12% this year over last and go up another 14% next year. In new-home sales, the ratings agency forecasts a 10.5% gain in 2012 and 12% in 2013.

But an uptick in foreclosures looms as the system works through the backlog. "It's sort of like the pig (being swallowed by) the snake," Curran said.

McGrath added: "We have this big overhang of foreclosed properties and underwater homes that may be slowing the pace of the recovery."

She says it could take another two years to absorb excess inventory.

And macroeconomic uncertainties in the U.S. and overseas persist.

"We're keeping a watchful eye on the macro trends, which ultimately need to turn more positive for the recovery to expand further," said Pulte CEO Richard Dugas in a Q2 conference call in late July.

Toll Bros.' CEO Doug Yearley told analysts and investors in a second-quarter earnings call that Europe remained a big question mark hanging over the market.

"We're one really big European headline away from buyers going back under a rock," he said.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Investing Ideas

Referenced Stocks: BZH , DHI , LEN , PHM , TOL

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