Standard & Poor's thinks builders' asset writedowns may have peaked
From Standard & Poor's Equity ResearchFrom the Federal Reserve to the average investor, the unraveling of the U.S. housing market has the country transfixed. Shares in the largest U.S. homebuilders have been pummeled this year, as demand for new homes slumps and access to credit dries up in the wake of the subprime mortgage situation. The downturn has forced homebuilders to report huge operating losses in the second and third quarters.
Is the situation getting worse? Or, is it time to start moving back into these stocks now that they've lost half their value since the end of 2006? One way to tell is to look at the industry's impairment charges. What they reveal are declines in the value of land or unsold homes a builder owns from previous estimates of worth.
Asset writedowns have skyrocketed in 2007, dashing hopes of a quick recovery. Twelve of the top 14 publicly-traded homebuilders reported collective charges of about $5.1 billion during the third quarter of 2007 alone, according to Standard & Poor's. That's up 41% from the second quarter and more than all of what was reported in 2006. While impairments may be at their peak, S&P thinks homebuilding stocks won't begin to recover until mid-2008. A rally could be delayed further if high oil prices or an economic slowdown reduce consumer confidence.
"This one stroke tells you that the magnitude of the downturn is pretty significant," says Ken Leon, an S&P equity analyst. Impairment charges "may be hitting their peak right now."
Impairments have highlighted the risks and rewards of each homebuilder's operating strategy, Leon says.
"You've got companies that have gotten killed, like Standard Pacific (SPF; 3 STARS, hold; $2.88), because they have an overweighting in California, where the dollars involved per unit are much higher," he says. Others have faired much better, such as NVR (NVR; 3 STARS; $441).
"NVR doesn't buy land until it is ready to build. It will pay more for land that's ready for development," rather than buy land cheaply hoping to develop it later. "NVR still has operating losses, but the impairments have been less significant," Leon says.
Toll Brothers' (TOL; 4 STARS, buy; $20) leading position in more expensive and luxury homes and its strong balance sheet has helped its financial results, though higher priced homes have begun to be affected too.
Profits for homebuilders won't return until orders (gross and net), backlog value, and average selling prices begin to improve, both on a sequential and year-to-year basis. "My gut tells me that's probably going to begin by June, more likely September, because the comparisons get easier," Leon says, adding, however, those stocks "may be a 'show me' story before we see any rally."
Depending on how well homebuilders do in the fourth quarter - results will be released in late January and early February - investors will start looking ahead to a possible recovery. A real recovery in housing probably won't occur until the second half of 2008, Leon says, but homebuilding stocks "have historically begun to move in anticipation of a housing recovery."
However, even if impairment charges do decline in the fourth quarter of 2007, homebuilding stocks will still be under pressure until there is some evidence that things will get better in the future. "We have a negative outlook on homebuilding stocks," says Leon. That outlook won't change until companies report quarterly results that exceed expectations.
In the meantime, a key issue is whether an economic slowdown or big discounts on home prices act to further erode confidence.
"What hovers over this industry more than others in the consumer discretionary sector is just buyer confidence," Leon says. "Homebuilders have come in with 'Deals of the Century' and 'Specials for the Weekend.' They were cutting prices by 25%, 30%, sometimes more. That makes people wonder: 'If I buy today, am I buying too high? Three months from now, someone could be paying less than I did today on the list price.' So, buyer confidence is really the wild card."