Before You Buy Into the Homebuilder Rally …

by James Brumley | March 8, 2012 8:57 am

If the recent strength from the homebuilders stocks is any indication, investors finally are bullish on residential construction again. The SPDR S&P Homebuilders ETF (NYSE:XHB[1]) is up 57% since its early October low, and the group was up 2.33% alone on Wednesday following Hovnanian’s (NYSE:HOV[2]) earnings announcement for the previous quarter. They were … better. Year-over-year revenue was up 6.7%, and the per-share loss of 82 cents a year earlier was whittled down to only 17 cents this time around.

Though traders extrapolated Hovnanian’s relative success out to other homebuilders[3] like Beazer Homes (NYSE:BZH[4]) and Lennar (NYSE:LEN[5]) — both of which closed more than 5% higher on Wednesday — it wasn’t Hovnanian’s numbers that were doing all the prodding. Another solid payroll number (jobs growth) fanned the flames too. Payroll processing company ADP (NASDAQ:ADP[6]) said the private sector added 216,000 new jobs in February, underscoring the budding idea that folks might be able to afford to buy houses again at some point in the foreseeable future.

Homebuilders don’t disagree, either. Hovnanian was pretty clear about its expectations for wider margins and revenue growth this year. Douglas Yearly, CEO of Toll Brothers (NYSE:TOL[7]), said of the construction market, “We feel about the best we have in five years … We’re really seeing improvement everywhere.” (It’s a pretty gutsy comment considering the company swung to a loss last quarter on fewer deliveries and more cancellations.) January’s pending home sales figure was higher than anticipated, and the available inventory shrunk last month, too, implying the demand and need for new construction is falling into place.

Stronger homebuilder results? Rising homebuilder stocks? Optimism? More sales and fewer houses to choose from? Even Standard & Poor’s is starting to talk (albeit tepidly) about a construction rebound. It all points to better days ahead. But before you put the blindfold on and dive in …

Facts are Facts

While it’s fun to dream of the day the housing market is off of life support and thriving again, it might be too soon to start dreaming those dreams. There are some numbers, charts and a reality check you might want to digest first.

startspermits 300x268 Before You Buy Into the Homebuilder Rally ...
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1. Starts and permits aren’t that much better, if at all.

To be fair, the seasonally adjusted (and annualized) building permits and construction starts have been a tad stronger than the recent norm in January. Don’t get too excited, though — the readings usually surge in January. In the grand scheme, the residential construction market is simply not getting worse.

2. Standard & Poor’s Has Been Wrong Before

In early February, Standard & Poor’s issued a relatively bullish outlook for residential construction in 2012[8], though it explicitly noted the bulk of the improvement wouldn’t be evident until late this year and early next year. Even so, forward-thinking investors could avoid a potential rush later by getting in now before these stocks hit their full stride.

There’s a slight problem with embracing S&P’s outlook, though — the research firm has been wrong before. In fact, it was wrong in its optimism for the housing market in 2011. Yes, one could make the case that Europe’s sovereign debt crisis, the Fukushima disaster and a downgrade in the United States’ credit-worthiness were contributing factors, but none of those tripwires held back corporate profit growth or the equity market’s value. Standard & Poor’s just overestimated construction demand last year. It could happen again.

3. The builders have been wrong, too.

The industry as a whole is expecting better days in 2012? Shocking … not.

As a group, the homebuilders’ CEOs might be among the market’s most ridiculously bullish on themselves. The National Association of Homebuilders was “very optimistic” about 2011’s demand, looking for 575,000 new single-family homes to be built. Only 513,000 were started. The outrageous forecast mirrored 2010’s in which the NAHB planned on seeing 610,000 new homes. Only 475,000 were built.

Bottom Line

The residential construction market will recover — eventually. And as more and more players drop out, the remaining winners will capture a bigger piece of that pie. As it stands right now, though, that pie still is shrinking — and shrinking despite record-low interest rates and record-low home prices that are supposed to be spurring home ownership.

The latest stumbling block is growing illiquidity. While most of the major homebuilder names had enough cash on hand to weather the storm of the recession, a few years of losses are taking a toll on balance sheets. That’s going to make it difficult for these companies and nasty for shareholders.

As an example, Hovnanian already has warned that if its business continues to falter, it might issue stock to raise money. Toll Brothers issued $300 million in debt a few weeks ago. The homebuilder group’s total debt won’t hit peak maturity levels until 2015, according to Standard & Poor’s, which means these names still are in for a four-year fiscal grind unless the new housing market gets very, very strong.

Don’t hold your breath.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Endnotes:
  1. XHB: http://studio-5.financialcontent.com/investplace/quote?Symbol=XHB
  2. HOV: http://studio-5.financialcontent.com/investplace/quote?Symbol=HOV
  3. extrapolated Hovnanian’s relative success out to other homebuilders: http://investorplace.com/2012/03/apple-aapl-new-ipad-pandora-homebuilders-hov/
  4. BZH: http://studio-5.financialcontent.com/investplace/quote?Symbol=BZH
  5. LEN: http://studio-5.financialcontent.com/investplace/quote?Symbol=LEN
  6. ADP: http://studio-5.financialcontent.com/investplace/quote?Symbol=ADP
  7. TOL: http://studio-5.financialcontent.com/investplace/quote?Symbol=TOL
  8. relatively bullish outlook for residential construction in 2012: http://www.standardandpoors.com/ratings/articles/en/us/?articleType=HTML&assetID=1245328409642

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