4/23/2008

Housing stocks: Rising with reason
By David Urani

The latest round of homebuilding data suggests (shocker) there is continued weakness, with demand refusing to budge despite vastly lower home prices and low mortgage rates. The slumping sales reflect a lack of desire to buy homes that are losing value as well as an inability to secure loans under restrictive lending standards. The situation is very worrisome indeed, yet it will not play out like this forever, and investors know there is a fortune to be made in housing stocks upon the eventual turnaround. Homebuilders, such as of Ryland (ticker: RYL), KB Home (ticker: KBH), Hovnanian (ticker: HOV), and D.R. Horton (ticker: DHI) have already appreciated more than 50% from the low points in January as the outlook has become far more optimistic, with investors lining up to jump aboard when the good news begins to flow. The question is, will we ever see this good news or has the market become unnecessarily hopeful? The reality is improvements are on the way and to take advantage of its eventual arrival, one must look past the conditions directly in front of them and focus on the capacity for a turnaround. This is easier said than done given that the bottom always occurs when the situation appears most dire and the pundits are most critical.

The National Association of Realtors’ existing home sales index released on April 22 demonstrated continued slowness, with sales slowing 2% month-to-month in March and inventory rising 1% amidst increasing foreclosures; slowing in the South and Midwest offset gains in the West and Northeast. Annually adjusted housing starts dropped 5.8% in March, which could be viewed as a good sign as homebuilders try to alleviate the overhang in inventory. Meanwhile, pending home sales also dropped 1.9%. None of this data suggest any sort of improvement yet, but homebuilding stocks have remained resilient upon the news as investors wonder if the worst has already been seen in terms of loss of income.

In the back half of the year, we should begin to see some results from the changes in Federal monetary policy as well, as rate cuts slowly take effect to add liquidity to the lending process, and raised portfolio limits on Fannie Mae and Freddie Mac make more lenient FHA loans more readily available to consumers who otherwise would not qualify. On the negative side, foreclosures are still mounting, but looking at a schedule of ARM rate resets, one can see that a peak is achieved in the middle of this year, followed by a steep drop off, which marks the point at which lenders and banks realized risky ARMs were not worth the investment. After this point, the ARM market follows a whole new policy in which risk is greatly reduced. The residual effect of the final wave of resets will take several months to hit a peak in foreclosures.  It will take time for delinquencies to be filed under the newly raised rates, but realistically the worst could be over at year end, though still ongoing.

Though sales are poor for homebuilders, inventory is being sold off while much of the inventory left on the books has already been proactively written down to mitigate future losses. It is very probable that the homebuilders will begin to be increasingly more profitable, even before there is any actual industry improvement. Lennar Corp. (ticker: LEN) illustrated this idea by recording a $0.56 loss in its first quarter while the consensus estimate called for a loss of $1.12; the surprise was due to reduced write downs following formerly proactive inventory impairments. Lennar’s management commented that it expects the worst of its write downs are now over as a result. Meanwhile, the homebuilders are also nimbly seeking out investments in cheap real estate to take advantage of markets that are more likely to improve before the others.

Listed below are a few promising homebuilding stocks:

Hovnanian Enterprises (ticker: HOV): One of the more volatile stocks, the Company is still dealing with some debt pressure. However, its recent performance suggests it has redeemed itself and its probability of default now seems very low. In its first quarter, it achieved excellent sales results, while also looking to exploit potential growth markets and take market share from smaller, weaker competitors. This stock should be considered as a more risky play, but we like the stock’s value appreciation potential.

KB Home (ticker: KBH): Though the Company’s sales results were slow in its first quarter, the Company held a respectable cash balance that will keep its debt obligations fully in check. Its newly constructed homes are smaller and cheaper, with 95% of its communities priced within FHA loan limits. The Company is actively streamlining its operations to mitigate losses and has also seemingly written down a majority of its impairments.

Ryland Group (ticker: RYL): The Company ended its fourth quarter with excellent sales results and a rock solid balance sheet. Management expects it will not have to tap into its credit line in 2008 due to its strong cash flow.