Bottom Falling Out of the Housing Bottom - Meritage vs Centex

By Dr. Duru written for One-Twenty

May 1, 2006


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Homebuilder stocks have put up a good fight in 2006, but, slowly but surely, these favorite whipping boys of the bears on the U.S. economy are slipping away. One-by-one I am noticing that the stocks I follow in this industry are making new lows for 2006. When such a thing occurs, you can be sure that more pain is ahead. Even more ominous is that these failures portend more trouble for the housing economy. The market tries to be forward-looking, and the market is providing us a more definitive vote against the overall health of the housing industry. I have been writing about a potential bottom all year, and this story has unfolded with many thrills and chills. As interest rates continue to creep forward, as inflationary pressures continue to build, and even as pending immigration legislation may create labor shortages in the indsutry, it is time to cut the losses on this story!

Now, mind you. I have not given up. My theme this year has been to provide counter-points to despair in the financial markets, so I am still looking for the glimmers of hope even as the general outlook dims. Last week's housing hope was Meritage Homes (MTH). MTH blew past earnings expectations and defied the pessimists by issuing a relatively bullish outlook. The bottom for homebuilders finally looked in place. In February, I used action in Meritage stock as an indicator that we had seen peak negativity. Meritage seemed like one of the the worst in the bunch, so when it apparently surged off its bottom, all seemed well in hand. MTH proceeded to disappoint, but it has spent the last two months making a bottom seem real again. Anyway, numerous homebuilder stocks responded to MTH's good news by soaring on the news but most completely faded by the end of the trading day (April 26, 2006). MTH held on for an 8% gain on the day.

The market wasted no time in following through on that fade - somehow sensing that fresh bad news was right around the corner. Sure enough, Centex (CTX) delivered. CTX completely ruined the party by issuing the kind of awful report that the housing bears have been expecting from the homebuilders: missed earnings expectations by 19 cents (6%), slashed guidance for the current quarter to $1.35 - $1.45 versus the $2.16 analyst consensus, and finally issued a ridiculously large range for the 2006 fiscal year of $8.50 - $10.00 (consensus at $9.72). It seems that despite CTX's persistent reassurance that their firesales would have no material financial impact, I strongly suspect that the heavy promotions finally caught up with them. I will have to check out the conference call sometime soon. While MTH survived the fresh waves of despair, most homebuilder stocks promptly swung just as sharply down as they had swung up the day before. Homebuilder stocks like CTX, KBH, DHI, RYL, LEN, HOV, and BZH all made fresh lows for 2006. In fact, only TOL and PHM avoided the stain...and PHM looks ready to give up any day now (TOL has been the stock that I have played as a part of this housing bottom theme. See ). And so the rollercoaster at the housing "bottom" continues. This time, however, I think the optimists, bulls, and other buyers of these stocks are finally getting tired. The potential positive catalysts are thinning out, and the negative catalysts are weighing more and more heavily. The Fed next meets on May 10th. While I think the Fed recognizes that they have finally succeeded in cooling off the housing market, I think any bounce in homebuilder stocks from any benign Fed-speak will again be short-lived.

In the meantime, let's take a closer look at what Meritage had to say about its earnings prospects. I listened to
the conference call to get a better idea of what was supposedly so good. The executives painted a very pretty face on the outlook, but it seemed most of the analysts on the call were at best wary and more likely skeptical. Here are the highlights I noted mainly from the question and answer session with analysts:

  1. Management bragged that Forbes listed them as one of the top-managed companies in the country.
  2. Competitive advantage over smaller builders
  3. Use low-risk, conservative management style
  4. Some housing markets are returning to normal levels while others are getting stronger. They call this part of their diversification strategy.
  5. Speculation has now subsisded
  6. Northern California has stabilized somewhat after suffering declines
  7. Tuscon is strong, but Phoenix is down
  8. Southern California is strong
  9. Texas is very strong, especially Houston. MTH has had 20 years of success in Texas
  10. Florida orders are flat - prime state for homebuilding: 5 of top 20 cities for building are in Florida
  11. Still getting good margins in all markets
  12. 19th consecutive year of record revenues and earnings
  13. Don't know how long it will take for California and Florida to improve
  14. Will suffer margin erosion
  15. Cost increases seen in concrete and some labor
  16. Keeping an eye on speculators in Texas, but so far they are seeing normal rate of relocations. Thinks there is too much land in Texas to support wild price appreciation
  17. Have flushed through most cancellations. Cancellations are down because folks are factoring in market conditions in their purchasing decisions.
  18. Even with incentives, margins higher than their 5-year average in California and Arizona (in other words, they have been making a killing in these hyper-active markets!)
  19. Will buy moreland when prices come down (in other words, they expect land prices to come down!)
  20. Incetives in California and Florida - trying to hold it only where needed: balance incentives with profitability (uh oh! Do not forget that Centex's management tried a very similar message!)
  21. Looking for acquisitions in the Southeast, particularly in Florida
As usual, I strongly encourage you to check out the earnings report for yourself. Regardless, be very careful out there. The housing bottom is a-creaking and a-cracking!

DrDuru, 2006