1/14/2010
By David Urani, Research Analyst

I am often asked if I think housing is on the way back up, and whether homebuilders are a worthy investment. We currently have buy recommendations on a number of stronger homebuilders (upgraded Lennar last week, although it isn't one of our favorites), but it is important to note that when we say "buy" it doesn't mean that everything is fine and dandy. We are confident these stocks will be higher a year from now, largely as a result of the many backstops the government has put in place to keep conditions stable (or at least from getting too much worse). However, keeping the industry stable over the next two, five, or even ten years is another story. The truth is, there are two perspectives to consider when judging the housing market: that of the analyst and that of the economist.

The Analyst

There is no doubt conditions are gradually improving, with sales showing broad improvements across almost all regions. KB Home (KBH) issued its fiscal fourth quarter financials on Tuesday, January 12 and, similar to Lennar (LEN) last week, the result was higher than expected sales accompanied by a huge tax benefit ($191.7 million) driving the company to a profit. This benefit was the result of changes in accounting rules to allow for larger loss carry backs. Before tax, similar to Lennar, KB Home still reported a loss from operations, largely as a result of $77.2 million worth of impairment charges. In the same manner as Lennar, these charges were larger than in previous quarters, but are also reflective of management's year end book cleaning (a.k.a. kitchen sink quarter). Excluding those impairments, KBH ran at an operating loss of approximately $14.0 million. That's an improvement over the $35.0 million loss in the previous quarter.

In a nutshell, although these companies are still running at losses (minus the tax benefits), conditions on the ground are slowly improving. KB's gross margin on home sales (excluding charges) improved to 19.0% from 14.6% sequentially (q/q firming is a consistent trend within the industry) as a result of firming prices and fewer incentives offered on home sales. In the case of KB Home, it has also started to build smaller, more inexpensive homes to attract the "new" realities; these homes also carry higher margins. New orders for the end of the year are generally higher than those of last year as sales cycle over last year's market crash and rise from a trough.

If you also exclude land sales that KB Home unloaded at a $38 million loss during the fourth quarter, its core homebuilding operations posted a profit of approximately $24 million. As it stands, so long as the market doesn't hit anymore speed bumps, it is conceivable that a few select homebuilders can actually record a profit in 2010. We are wary of a number of said speed bumps (explained below), particularly in the first half of the year. However, in the second half, volumes and pricing should be on an uptrend. As a result, homebuilders' stocks should be higher a year from now.

The Economist

The economy has gone to hell and back, with housing on the front lines. As we all know, it was loose lending and overleveraged consumers that created a massive bubble in home sales and prices. The eventually bursting of that bubble put prices and sales into a freefall and left the market with a vast oversupply of vacant homes. With home values well below the peak years and jobs being lost across the country foreclosures were, and continue to be, a major concern.  In a sense, the market is naturally deflating and returning to "normal" levels of home ownership and pricing. The only way to stop the housing market, and the economy for that matter, from crumbling further was for the government to step in and add some multibillion dollar backstops such as the housing tax credit, the HAMP mortgage modification program and lower lending rates. These actions, while effective, are also re-inflating the housing market with artificial money. While we do agree that these actions were necessary to cushion us from further calamity, we must acknowledge that we are still sitting on a bubble (albeit smaller).

If we were to unwind these programs now, the housing market would most likely fall back into deflation mode. The administration is aware of that, and consequentially, we expect these programs to remain in place until the housing market is well on its way to natural growth. This is one of the main reasons we believe homebuilding stocks will be higher a year from now.

We are content with having a small bubble in housing for the sake of getting the economy back up and running, but we must eventually stop giving it air and allow the market to naturally grow.  If we are to sustain healthy growth in the housing market for the long term, it is clear that the emergency housing programs need to be removed and certain policies need to be put in place. Such policies may include putting Fannie Mae and Freddie Mac out of their misery; there's a reason they became insolvent, that's because they were highly active in creating the housing bubble. Policies at lending institutions also need to change. Obviously, mortgage lenders need to more closely manage how much they are lending and to whom.

On such a massive scale, all of these changes will be very difficult to manage and of course they would not go as smoothly as we all would like, if they were even done in the first place. In addition, we are not convinced that the Obama Administration intends to stop inflating the housing market. Eventually the government's housing measures may take different forms than they currently do, but it seems as though this is the kind of administration that will manipulate the housing market to provide the highest rate of home ownership that it can for the long term (which could include an official government takeover Fannie and Freddie as opposed to a breakup or whatever the term for the current situation would be). These things may work for a while, possibly even years, but we are not so sure this bubble won't pop again down the road.

The Bottom Line

You can trade these stocks for a profit but it's not the type of investment you want to put in your 401K and rest your future on. You can certainly invest in homebuilding stocks, but keep a close eye on them; they are by no means on solid footing.