The economy is doing well….right? Gross domestic product grew at a healthy 3.9% annual rate in the third quarter, following an equally strong 3.8% reported for the second quarter. The bright spots were consumer spending, business investment and exports. According to the payroll report, 166,000 net jobs were created in October, well ahead of the 93,000 expected. Wages gained .6% in September. The economy is growing; people are working and making money. Well, sort of….
Housing keeps going down. The GDP report included a 20.1% drop in housing investment on top of an 11.8% decline in the second quarter. September housing starts and existing home sales were down 30.8% and 19.1%, respectively, from a year ago.
Roiling the credit markets, the subprime – mortgage crisis has taken no prisoners. The heads of Merrill Lynch and Citigroup were forced to resign after those financial institutions sustained huge write-offs. And it is not over yet for the financial services industry.
The Dow is up about 4% year-to-date (11/19/07). Among the best performing Dow Jones U.S. industry groups in the last three months were economically sensitive basic materials (+12.1%), heavy construction (+25.6%) and computer hardware (+11.7%), which would seem to be forecasting a growing economy. Maybe, but….
Homebuilding stocks have been mauled. The Dow Jones home construction industry index has fallen 54% year-to-date and 23% in the last three months, making it the worst performing sector this year. Housing is integral to our economy, so these stocks may be telling us a recession is up ahead.
Wait! Starbucks reported a 1% drop in transactions in the U.S. for the September quarter. Could this mean we are in recession now?
No wonder investors are nervous. Uncertainty breeds difficult markets and high volatility, a market environment that I expect to persist, at least in the near-term.
I’m always interested in the downtrodden, the rubble pile as I call it. Homebuilding stocks are at the bottom of the heap.
I put together this list of major homebuilders: Centex (CTX), D.R. Horton (DHI), Pulte Homes (PHM), Toll Brothers (TOL), Lennar (LEN), M.D.C. Holdings (MDC), The Ryland Group (RYL), and Kb Home (KBH). I used the Company Stock Risk Profile Fast Track™ to do a quick study. Here’s what I found:
Cash on the balance sheets of this group of companies has plummeted. However, I was surprised that cash balances held up at Kb Home, Toll Brothers and M.D.C. Holdings.
Long-term debt to total capital averaged 32.7% for the group. M.D.C. was able to pay down all of its long-term debt. Excluding M.D.C., the average was 37.4%, within a range of 36.8% for Pulte to 51.7% for Centex.
Free cash flow has been highly erratic, even when the industry was doing well. Last year half of these companies posted negative free cash flow, and three were negative so far this year.
Reported earnings have been disappointing the Street. Trying to catch up, analysts have been adjusting their estimates sharply lower.
Deficit earnings, both reported and projected, negated using earnings based valuation methods. So I turned to book value, and found that the group is selling for an average price / book value of .77 within a range of .61 for Lennar to .97 for Kb Home.
I was intrigued to find high insider ownership at seven companies, ranging from 11% of outstanding shares at Ryland to 23% at M.D.C. Holdings.
Street analysts are carrying 85 ratings for these eight stocks. Forty-two are rated hold and 13 sell.
All eight stocks failed Fast Track™, and I would not be buying homebuilding stocks now. The only positive I found for the group, which is important, is that managements’ interests are aligned with those of shareholders. Otherwise: (1) Debt is too high, particularly for this phase of the homebuilding cycle. (2) Cash flow is not stable. (3) Price / book values appear to be reasonable, but book values are vulnerable as long as home and land values continue to decline. (4) Because of the lack of any solid fundamental underpinnings, I would need the Street to be a lot more negative to begin to pique my interest.
