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What's
Really Wrong With Homebuilder Stocks? |
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After
yet-another disappointing building permits and housing starts update
on Tuesday of this week, we were inundated with yet-another salvo
of news commentaries stating the obvious.... with headlines such as "Home
Builders Continue to Struggle...", and "Housing Starts Still Weak".
Fair enough.
 The
most amusingly-obvious (yet also irritating) story came from U.S. News
& World Report ... "Home Builders Not Driving Economic Recovery".
Really? Thanks
for the warning.
There's little
doubt that homebuilders aren't driving the recovery. The question is, are
they even participating in the recovery? So far it seems as if they're
not - at least not in a meaningful way. Unfortunately, none of the recent
news has quantified where homebuilders are now, versus where they were
then, versus where they should be. That, however, comes as no real
surprise, as that kind of journalism requires actual research beyond the
latest economic report.
Since no other
media members seem willing to paint a 'big picture' of the homebuilder
plight, we will.
A final good/bad
assessment of the industry is below, but a trio of explanations is in order
to explain the "why" of our digging before we get into the "what".
Let's all first understand that:
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We know the peak
of the real estate bubble was in 2005, but we need to know the relative
size of the bubble before we start drawing comparisons to it.... something
the media has yet to describe.
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We need to define
an earnings-based 'norm' for homebuilder stocks if we're going to say they're
overvalued or undervalued now.
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We need to understand
the correlation between earnings and capacity of demand; we can't reclaim
2005's earnings levels on 2008's demand for new homes.
See where this
is going? Great. Then let's get on with it.
At first glance
all seems like it's getting back to normal for the homebuilders. Though
there are still plenty of them struggling, and presumably some of them
won't survive, we also see a few of these stocks limping their way
back into profitability. Hope at last?
 The
'value' argument lies in their current and forward-looking price/earnings
ratio. Meritage Homes Corp. (NYSE:MTH), for instance, boasts a trailing
P/E of 17.6, while NVR Inc. (NYSE:NVR) is priced at 17.08 times earnings
over the last twelve months. Their projected (2011) price/earnings ratios
are in the same high-teen area, as is D.R. Horton (NYSE:DHI) with a forecasted
(2011) P/E of 19.5.
While not exactly
on the cheap side, the figures are at least palatable, eh?
Well, no, not
really. Were it any other industry we could say yes. For homebuilders though,
that's nearly four times the average pre-bubble (pre-2006) P/E of 5.17.
(And yes, you read that right - the 'normal' price/earnings ratio range
for homebuilders is between the number five the number six.)
How can it be
so? There are a handful of reasons this group has traditionally been priced
at the extreme low end of 'reasonable', most of which are beyond the scope
of our discussion today. At the heart of the matter, however, is the reality
of traditionally slim margins... in the 3% to 6% range.
Barring some
sort of bizarre miracle, the normal profit margins in homebuilding aren't
suddenly going to improve, which in turns means investors are paying far
more for profitability here than they ever have before - and they're not
being paid for the risk they're assuming.
Strike one.
OK, fine, homebuilder
stocks are expensive right now. But, what if these companies could at least
start making a fraction of the kind of money they were making before
the bubble started to deflate in 2005?
 Well,
that's actually part of the problem.... they are doing much better
now than they were doing three years ago, and it's still only a
fraction of the kind of money being made in 2005. See, 2005 wasn't just
a very good year for homebuilding - it was stunningly good year,
on the same scale as the tech bubble in 1999 (though at least the homebuilders
performed an actual service and did actually make real money for a short
time).
The nearby chart
puts it all into perspective. It shows the average earnings-per-share for
the top eight - by market cap - stocks in the industry going all
the way back to 2000. Between then and 2003, annual homebuilder earnings
nearly doubled. By 2007 though, the losses being taken on an annual basis
were bigger than the annual gains being made just four years earlier. In
fact, in the aggregate, the industry is still losing money.
A few bad
apples spoiling it for everybody? Nope, and just to prove it, we also
added an earnings trend line just for the companies that were on pace to
be profitable this year and next year (NVR, D.R. Horton, Pulte, Lennar,
Standard Pacific). Even these 'good' ones are still well off their
peak income levels. They'll have to quintuple 2011's expected earnings
to match 2003's records. The industry as a whole will need to do about
ten times better than it's on pace to do in 2010 to revisit 2003's record
earnings levels.
Yes, things
are
improving, but when you start taking about earnings being multiplied by
a factor of five, ten, or more, it's time for a reality check. That's just
not in the cards for years to come.
Strike two.
While the recession
has been named as the bulk of the problem with homebuilding, there's another
largely
unspoken reality that's not been addressed, and it's a much
bigger problem the industry has been and will contend with forever... houses
aren't consumables.
 When
you run out of food, you buy more. When your car wears out, you buy another
one. You don't pay for cable television once and get it forever; you have
to keep paying the bill to keep getting the service.
A house, however,
is (for the most part) a one-time sale, and the demand for new homes
is finite, as is the population.
See the illogical
nature of a 'high growth' homebuilding industry? The more houses that
are built now, the less we'll need built later. And, considering the inordinate
number of houses built between 2001 and 2006, we may have adequate supply
to last us for many, many more years.
That's a slightly
different message than the one the media is spewing. They're suggesting
the huge supply of real estate is the result of would-be buyers being unable
to get a loan. We're saying the huge supply of real estate is just the
result of a huge supply of real estate, and even an easier-credit environment
can't do a lot to solve that problem.
Though there
is some data in support of the idea, conclusional cause/effect data
is tough to muster. On the other hand, the media has only presumed
that crimped credit is the underlying reason for the housing glut. Regardless,
housing demand is finite by default, and the closer that demand is to being
100% met, the worse it gets for new home builders.
Strike three.
Is there
anything earth-shattering or surprising about these numbers? Probably
not, though it's always better to talk specifics when money is at stake.....
something the media hasn't done yet.
Either way ,
it's an important discussion to have, as the chatter surrounding a homebuilder
recovery has become louder and more frequent. You may want to consider
the facts presented above before jumping to any conclusions. Homebuilding
stocks' best potential results going forward are still apt to pale
in comparison to the sector's past, even if these companies do everything
right.
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Updated: 8:15 pm PDT (03:15 GMT), November 2, 2010
