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Housebuilders: Is The Party Over?

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Homebuilders: Is the Party Over?

Though valuations have come down for many companies, S&P analyst William Mack says recent financials show that investors should be cautious
Those who think the housing boom will never end should think again
. Last year, William Mack, an industry analyst for Standard & Poor's Equity Research, was positive on the homebuilders group, but he warned that higher short-term interest rates, if met by higher long-term rates, would likely pressure home buying demand.
That's what happened in the first quarter of 2006, which was not so kind to the homebuilders group. Financial results showed a negative trend, Mack says.
"New home demand is weakening, due to interest rates seen going higher and diminished affordability,"
he says. "For virtually every public builder, new home orders declined in the March quarter."
Homebuiders have responded to this operational dilemma in different ways. Some have increased incentives on homes, expanded advertising campaigns, and are using more outside brokers. Others have allowed option contracts for land purchases to expire and are writing down the value of certain assets, mainly land. Community openings have also been delayed.
"Financial responses include increased share repurchases and the repayment of relatively high-yielding debt," according to Mack. "If demand remains weak, there is a possibility that community counts will flatten."
PRICE DECLINES. According to the U.S. Census Bureau, March housing starts declined 7.8% from February to a seasonally adjusted annual rate of 1.96 million. But the March numbers increased 6.9% from March, 2005. S&P expects housing starts of 1.92 million this year and 1.75 million in 2007, compared with 2.07 million in 2005.
Homebuilding stocks have dropped 11.6% on average this year
(through May 5), according to S&P. The recent weakness caused Mack to upgrade a few names on May 12. He raised Beazer Homes (BZH) and Ryland Group (RYL) to hold from sell, and NVR (NVR) to sell from strong sell. However, he did not change his price targets and earnings forecasts, which were recently lowered. "Sharp recent declines in the price of the shares offset some of our concern about demand for homes, which we think will continue to weaken overall," Mack says of all three stocks.
After Hovnanian (HOV) cut its earnings guidance for the second quarter and fiscal 2006 (ending October) on May 2, Mack lowered his fiscal 2006 profit estimate to $6.75 a share from $7.75 a share, and kept his sell recommendation on the stock.
CONTINUING PRESSURES. Hovnanian President and CEO Ara Hovnanian stated: "Our anticipated results for our second quarter and the remainder of fiscal 2006 reflect smaller year-over-year increases in earnings than we had anticipated, primarily due to continuing production delays in several markets that have postponed deliveries,
a slower recent sales pace, higher cancellation rates, more pronounced use of concessions and incentives, and material price increases."
Mack believes even the hottest markets Hovnanian operates in are losing support because of
higher interest rates, which are limiting demand
, and a tighter regulatory environment, which is hurting supply. "We see these pressures continuing to yearend at least," Mack says.
Beazer Homes beat S&P's revenue, gross margin, and earnings estimates,
but it also reported a 20% decline in unit orders,
which is viewed as a key indicator of ongoing demand, notes Mack. The declines were seen in almost every region where Beazer operates. In late April, Mack trimmed the 12-month price target to $57 a share from $60.

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