Finally, A Warning Taken Seriously - Centex

By Dr. Duru written for One-Twenty

October 15, 2006


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It has been 3 months since an apparent bottom was achieved in the stocks of homebuilders. These stocks have been able to ride along with the bottom and recovery the market made in June/July. There was no trumpet or announcement that the coast is clear. Heck, precious few homebuilders dare even suggest a bottom can be seen in the near future for their businesses or the industry. Instead, a strong shift in sentiment has occured where market participants have chosen to believe that a bottom for the industry is near enough to justify loading up the truck with stock. We have seen this shift in various rallies that have looked like short squeezes. We have most clearly seen this shift when traders and investors have bought more stock every time a homebuilder announces more bad news....until Friday.

On Thursday evening, Centex (CTX) announced about a 50% cut in its earnings guidance for this quarter, from $1.40 per share to 65-75 cents a share. OK - so that meant another signal to buy, right? After all, the market seems to take little interest in sending homebuilder stocks higher until more bad news drops. Well, not this time. CTX dropped 5.5% as selling persisted pretty much the entire day while the general market had yet another up day. Homebuilder stocks fell in sympathy across the board, almost all on higher than average volume. Was this news finally the straw that broke the floorboards of the bottom fishing? Perhaps...

Analysts can often provide clues to sentiment. From my read, the analysts who have become bullish on this sector somehow found solace in Centex's report, and the bearish analysts took this news as confirmation that the housing sector has much more downside ahead of it. The key difference in this news is that CTX took a very large writedown in its land holdings, mainly in the form of options to buy. In almost every earnings conference call I have listened to in 2006, analysts have pressed homebuilder executives about the prospects for just this very thing. usually, the executives complimented themselves on how well they are managing their land and how these options have significantly reduced financial risk. But now that a major homebuilder has announced a sizeable write-down on these options, one must wonder how close a bottom in the industry can really be. After all, you do not write off these kinds of valuable assets if you think you can turn them into profitable investments in the near future. In particular, the WSJ claimed that "It was land write-downs that pulled many builders under water during the late 1980s/early 1990s crash." More importantly, a lot of the homebuilder optimists have been buying these stocks based on value - that is, after hitting book value, these stocks became too cheap to resist. But asset write-offs also reduce book value and these cheap companies then become a bit expensive again. Then again, the homebuilder executives have been telling us in recent warning after warning that they cannot see an imminent bottom. They have even described conditions as worsening (such as increasing cancellation rates). The market can continue to ignore these warnings at its own peril.

For reference, let's review what the various analysts had to say about this potentially game-changing news. These quotes come from a variety of sources, including WSJ, briefing.com, Reuters, and AP:

THE OPTIMISTS
  1. Lehman reiterates its "overweight" rating.
  2. Deutsche Bank initiates with a "buy." Deutsche rolled out a bunch of positive ratings on homebuilders, so it is possible Deutsche issued its call on CTX in spite of the ill-timed news. The rationale: CTX has a "...lesser degree of exposure to high-risk markets [that] should make its earnings more resilient than other builders."
  3. Susquehanna Financial lowered its estimates but declared that CTX was simply taking "strategic pain" (my paraphrase). Susquehana let its "neutral" rating stand. Given its commentary, I take this as a neutral that means "don't sell" as opposed to "sell."

THE PESSIMISTS
  1. Banc of America had this to say: "...Centex's news shows the deterioration in the housing market is getting worse."
  2. Raymond James & Associates Inc. remains "...convinced that current trends are still in the early stages of a more meaningful slowdown."

In addition, Merrill Lynch tells us to prepare "...to see land charges from other builders as companies lower the amount of land they have on their books."

As you can see, there remains enough fodder for the bulls and bears to crow about. For now, the homebuilder stocks have been able to ride the coattails of the impressive rally in the market. So far, the shorts have been forced to slowly but surely cover their big bets against housing. To date, homebuilder stocks have shown no fear. And I continue to avoid joining the calls for a bottom. I do recognize that the alarming headlines in the mass media about a coming crash in the housing market created the element of fear and despair that was missing when I speculated on a bottom back in February. But now, I think the market is betting too heavily on the "soft landing" scenario and over-discounting the nearly contradictory potential for the Fed to start dropping interest rates next year. Regardless, the charts sure do suggest a bottom is in the making for the stocks. Friday's declines have barely put a dent on the current bounce from depths of despair. Time will tell whether this is merely an optical illusion. More on this in missives to come!

In the meantime, be careful out there!

DrDuru, 2006