Homebuilders in a Hole

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It said it expected pressure on revenue and margins to continue to mount, as credit standards for mortgage applicants have tightened since March and mortgage interest rates rose in June.

D.R. Horton’ land charges of $852 million, or $1.68 a share, were substantially larger than J.P. Morgan’s estimate, but investors were prepared for a larger number after Pulte Homes (PHM) warned last week that it would take around $750 million in charges, the bank said.

Excluding charges, D.R. Horton’s gross margin of 16.7% was only slightly lower than in the first quarter, while its control over sales, general and administrative costs, which fell 10% from the first quarter, may be the best in the sector, according to J.P. Morgan. The company also generated positive operating cash flow for the fourth quarter in a row.

In a separate research note, J.P. Morgan gave Beazer credit for a solid 38% drop in total unsold homes, but pointed out the sharp 30% decline in orders despite promotional efforts during the quarter. Excluding charges, the core gross margin of 16.9% was slightly lower than the bank’s estimate, while SG&A costs rose more than expected.

During the conference call, Beazer said its focus right now is much more on cash, citing a need for real liquidity, and it isn’t making long-term business decisions based on its current low margins. It’s also working to prevent a further buildup in inventory.

Beazer’s cumulative land charges are 17.3% of equity, above the 14% average for its peers. In view of that, plus negative sentiment due to the federal investigations into its mortgage business, the stock is likely to fare worse than other homebuilders over the next few quarters and deserves an underweight rating, J.P. Morgan said in a note.

In a July 21 research note, Standard & Poor’s predicted that Beazer’s financial results will be more sensitive to higher mortgage rates and slower job growth than those of its competitors, as more than 40% of its homes are sold to entry-level or first-time move-up buyers.

Citigroup Global Markets said in a July 25 research note that it expects new home orders across the industry to continue slip in the third quarter and that signs of improvement in the resale market need to be seen before investors will be willing to pay much more than 1.0 times book value for the homebuilders.

However, since the stocks are substantially undervalued on a longer-term basis, investors with a two-year time frame will do very well buying them at current levels, while shorter term-focused investors should wait, Citigroup said.

(J.P. Morgan or its affiliates expects to receive, or intend to seek, compensation for investment banking services in the next three months from D.R. Horton and have done investment banking for Beazer and Ryland within the past 12 months. It or its affiliates also owns 1% or more of Beazer’s common stock. Citigroup or its affiliates own at least 1% of Ryland common stock and have done investment banking with the company within the past 12 months.)

Bogoslaw is a reporter for BusinessWeek's Investing channel.