Homebuilders: Waiting for the Thaw

With home prices continuing to drop and the pace of home sales slowing further, nobody has been looking for encouraging results from homebuilders.

On May 6, D.R. Horton (DHI), the last of the major homebuilders to report earnings for the March quarter, posted a larger-than-expected net loss of $1.3 billion, or $4.14 per diluted share, compared with a profit of $51.7 million, or 16% per share, a year ago. Revenue dropped 38.5% a year ago to $1.6 billion.

The results fell far short of analysts' estimate of a net loss of 43% per share for the second quarter on revenue of $1.36 billion. The shares were trading 2.1% lower at 15.63.

The quarterly results included $834.1 million in pre-tax charges to cost of sales for inventory impairments and write-offs of deposits and pre-acquisition costs related to land option contracts that Horton doesn't plan to pursue. While the charges were larger than expected -- and more than triple the $245.5 million in charges taken in the first quarter -- the bulk of them consisted of a $714.3 million valuation allowance against the company's deferred tax assets. Of that, $385.0 million relates to the deferred tax assets existing at the start of the fiscal year, while the remainder represents a valuation allowance for deferred tax assets created during the six months ended Mar. 31.

The company also declared a quarterly cash dividend of 7.5% per share, payable on May 29 to stockholders of record on May 19.

Inventory Down
The latest impairments take Horton's total impairments to date to $2.7 billion, or 31.6% of its assets, according to a research note by Soleil Equity Research on May 6. While the company will probably have to take additional impairments in future quarters, Soleil analyst Anna Torma said she expects their size to begin to decline. But she warned that the write-offs could be substantially higher if economic conditions continue to deteriorate. She maintained her hold rating on the stock.

Horton isn't the only homebuilder to record higher-than-expected impairment charges in the latest period. On Apr. 30, Centex (CTX) reported $740 million in charges for the March quarter, but $379 million of that was probably accelerated by aggressive pricing, Deutsche Bank Securities (DB) said in an Apr. 30 research note. On a conference call with analysts, Centex said it had reduced its unsold inventory of homes by 64% from a year ago by selling 6,700 homes during the quarter and returning to its prior model of selling homes before building them.

"Although market conditions in the homebuilding industry remain challenging, we continue to focus on reducing inventory and generating cash flow from operations," D.R. Horton Chairman Donald Horton said in a news release.

Horton reduced its residential inventory to about 15,100 homes at the end of March, down roughly 13% from the end of December. That reduction was in line with what Robin Diedrich, an analyst at Edward Jones in St. Louis, was looking for.

"Horton has been pretty strict on not building until they get a contract. They've been doing that for a while," she says. "Their speculative inventory really was pretty high, but once the downturn in housing started, they corrected that pretty quickly."

Investors Eye Free Cash Flow
Except for some of the bigger markets where prices got the most overheated, such as California and Florida, home prices have already fallen to reasonable levels in most markets, says Diedrich. She estimates that 30%-40% of Horton's business comes from markets where prices got overbaked.

Horton generated roughly $450 million of cash flow from operations in the second quarter, exceeding its fiscal-year goal of at least $1 billion in only six months. It also cut its sales, general, and administrative costs by $88 million from the prior-year period and ended the quarter with a homebuilding cash balance of $519 million.

With sales as anemic as they are, investors have been watching to see how much free cash flow the homebuilders have been able to accumulate, both to reduce their debt and to keep funding operations until sales return to healthier levels.

Diedrich says that Horton has been doing a good job of managing its debt and has been conservative in spending -- not buying additional land, for example. The company had reduced its debt by $647 million during the three months ended Dec. 31.

James McCanless, an analyst at FTN Midwest Securities in Nashville, says he sees the homebuilders accumulating fairly significant cash balances of $600 million to $2 billion. While the market is still concerned about how much they're saving for what promises to be another difficult year ahead, he says the pace of sales should be better than over the past two years. McCanless has a buy rating on Horton's shares.

Market Expected to Get Worse
Though Horton continues to struggle through the housing slump, it's viewed as better positioned than some of its peers to benefit from the wider availability of conforming mortgages -- up to $417,000 -- being guaranteed by government programs, since it attracts first- and second-time home buyers, who tend to be interested in less expensive homes.

That said, with mortgage rates very slow to track the federal funds rate lower and banks skittish about making further loans amid rising default and delinquency rates, the housing market is expected to get worse before it begins to improve.

New home sales fell 8.5% to an annual pace of 526,000 in March, from 575,000 in February. Eleven months' worth of new homes are now sitting on the market, the largest inventory in nearly 27 years, and the median sales price dropped from $244,200 to $227,600.

The average price of homes in the 20 largest U.S. metropolitan areas, as measured by the S&P/Case-Shiller index, fell 12.7% in February from a year ago, the biggest drop since 2001.

McCanless says a bigger concern than inventories to him and most investors is how strong the homebuilders' order backlogs will be in the second half of this year and the first half of 2009.

"Are people showing up and taking advantage of the increased affordability we're seeing in the market?" he wonders.

Sales Traffic May Be Improving
While the 15% decline in sales orders since a year ago reported by Centex isn't all that positive, it's much better than the average declines of 50%-60% reported across the industry this time last year, he says.

The company's sales backlog of homes under contract at the end of March was 8,947 homes, or $2.1 billion, compared with 16,885 homes, or $4.8 billion, a year earlier. Net sales orders for the second quarter fell to 7,528 homes, or $1.7 billion, from 9,983 homes, or $2.6 billion, in the year-ago period. The cancellation rate -- canceled sales orders divided by gross sales orders -- was 33%, vs. 44% in the fiscal 2008 first quarter. Home closings totaled 6,719, down 31.4% from 9,792 homes closed in the fiscal 2007 second quarter.

There is some hope that traffic may be picking up as prices come down, with people shopping for bargains, and Horton recently said it had seen improvement in traffic in February, says Diedrich at Edward Jones.

Home sales are likely to remain slow since financing, which has improved modestly, will still be an issue for the first-time home buyers that Horton attracts.

"[Lending] standards are much tighter, they don't have a track record, they tend to have lower income, they're usually younger buyers," Diedrich notes. "All those things are making it a little more difficult for first-time buyers."

Mergers Not in the Cards
As bad as this market is for the homebuilders, McCanless says he doesn't think there will be any consolidation taking place in the industry. Mergers in this sector tend to be driven by a desire for more land to develop. With regional banks expected to sell a substantial amount of finished and nearly finished lots at reduced prices by the end of this year, the builders would rather buy some of those properties and develop them internally than through acquisitions of other outfits, says McCanless.

The discounts for these lots could match historic levels of 30%-40% seen in previous down markets, especially in some of the bigger markets such as Phoenix that have had the biggest runups in prices, he says.