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Home-Builder Hopes Demolished?

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HOME-BUILDER STOCKS ARE having a rough go of it.

On Tuesday morning, analysts from Credit Suisse and Stifel Nicolaus published notes that were skeptical of the group's prospects. Stifel Nicolaus' Michael Widner estimated that the companies would not return to normalized earnings until 2014 and that the recovery would be a choppy one. Credit Suisse's Daniel Oppenheim wrote that the April 30 expiration of the government's home-buyer tax credit will meaningfully crimp demand after a relatively upbeat spring cycle at a time when home builders are already trading near the top of their recent range.

Weakness in the sector was widespread. Toll Brothers (ticker: TOL) was down 1.2%, to $20.55; NVR Inc. (NVR) was off 2.1%, to $722.35; Pulte Homes (PHM) was down 2.8%, to $11.12; and D.R. Horton (DHI) was 1.9% lower to $12.35.

Yet as Barrons.com has warned in the past, investors shouldn't buy the dip.

The companies that comprise the home-building sector have balance sheets of varying strength and are geographically unique. Yet, while some may have been able to limit the fallout from the subprime mortgage crisis, none are in a particularly enviable position.

Unlike other former downtrodden stocks that have come roaring back during the past year's rally, home builders haven't seen triple-digit gains in the last year, inking more modest gains (or in a few cases, single-digit losses).

Moreover, very few still offer a dividend or are even expected to be profitable in the coming year, and most have negative margins as well as returns on equity and assets. Most have expected only three- to five-year earnings growth in the mid-single digits.

Therefore, fundamentals (high unemployment, excess inventory) strongly suggest that the struggling industry as a whole will be hard pressed to outperform the market for some time, as Barrons.com has noted before. (See Barron's Take, "Hovnanian's Weakening Foundation," Dec. 17, 2009; Barron's Take, "Don't Be Courtin' D.R. Horton," Nov. 20, 2009 html; and Up and Down Wall Street Daily, "Housing Recovery Built on Sand," Nov. 19, 2009.)

The expiration of the government tax credit, already extended once, is a real blow, especially coinciding with the end of the traditionally strong spring selling season. Credit Suisse's Oppenheim notes that it will likely take until the autumn for home builders to start to "establish a normal pace without government involvement," crucial for any real recovery in the sector -- although again, profits will take some time to follow.

Given the price sensitivity of many consumers, Oppenheim also says that home builders that cater to the lower end of the market will suffer most. He lowered NVR and KB Home (KBH) to Neutral, noting that they already trade at a discount to the group and thus may have less room to fall, and downgraded Pulte to Underperform, due to its premium valuation. Given that Pulte is trading at 41 times forward earnings, its $4 billion debt load and negative margins and returns are reason enough to be wary.

Additionally, Stifel Nicolaus' Widner sees the group continuing to be range-bound, given slowly recovering volumes and profits, volatility, the inability of margins and home prices to rebound to precrisis levels, and the lack of visibility that comes with companies still unable to produce normalized earnings.

Anemic growth will likely keep the stocks in check. As Widner writes, "While we see some long-term winners and losers, we expect the sector as a whole to return about 3% annually through 2013." He has a Sell rating on three of the eight home builders in his coverage universe -- D. R. Horton, Pulte, and M.D.C. Holdings (MDC) -- with Hold ratings on the rest.

In sum, Barrons.com has been skeptical of home builders in the past and remains so. With so many fundamental headwinds, the stocks aren't set to outperform given the long ramp to recovery in demand and profits.

The expiration of the tax credit and a sluggish summer season should give investors a chance to buy lower before any real normalcy returns to the market.

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