Housing Deflation Growing Roots - MTH, SPF

By Dr. Duru written for One-Twenty

June 12, 2007

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It is probably time to prepare for another leg down in housing stocks. These bad boys are cheap and are getting cheaper as earnings power continues to deteriorate with no imminent signs of relief. Last week, Hovnanian slapped an exclamation point on another disappointing spring selling season. Right after that, Meritage (MTH) reversed the optimism of their last earnings report, and warned the market that now it seems things are still getting worse: "Weaker Trends in Home Sales Cause Meritage Homes to Revise Its Outlook for 2007." The ominous title was well-placed. Here is the key section from the warning (emphasis mine):

Preliminary net sales for the first two months of the second quarter were approximately 21% lower than the same period last year, and cancellations increased to a rate of 36% of gross orders, from 27% reported in the first quarter 2007.
"We were encouraged by sales and cancellation rates that improved each month of the first quarter, leading us to anticipate relatively stronger second quarter sales results," said Steven J. Hilton, chairman and CEO of Meritage. "But these positive trends ended at the beginning of April, as demand slowed and cancellations rose. The weaker conditions we noted in April when we reported our first quarter results, continued through May. Order cancellations increased after widely-reported concerns over credit tightening and difficulties in the subprime markets, which appeared to dampen consumers' confidence and demand for homes." Mr. Hilton continued, "Weaker demand has predictably led to further price competition and margin deterioration, which we believe will prevent us from achieving the guidance we provided on April 25 for total home closings, revenue and earnings for 2007. It also increases the risk for larger associated write-offs of options and impairment charges, which could significantly impact our near-term profitability."

Housing analysts have been wringing their hands about lower home prices (housing optimists have cited lower prices as a potential catalyst for re-igniting housing demand). The homebuilders are now coming around to admit that prices must go ever lower in order to clear inventory and liquidate holdings. Raising cash is going to be important for homebuilders to survive an extended sales drought, and the actions of homebuilders are speaking louder than anything else: they will slash and burn in order to protect their own balance sheets even if it means a price war. Just check on the kinds of incentives builders are offering in your own neighborhood!

MTH promptly dropped 5.6% the following day on a day where the overall market got interest rate jitters. With the stock struggling at three-year lows, the writing is on the wall for lower stock prices to go along with the lower home prices.

Standard Pacific (SPF) provided some additional confirmation that we should expect the roots of housing deflation to get deeper. SPF reported that results from the last two months are coming in below plan:

Overall, net new home orders for the first two months of the 2007 second quarter were down 16% from the year earlier period and nearly 20% below the Company's business plan for the two-month period. The Company's cancellation rate for the 2007 two-month period was 28% compared to 35% in the year earlier period. The overall decrease in orders was driven by continued weakness in Florida and Arizona, while order activity was up over 13% year over year in California. The improvement in the California order comparisons was primarily a result of an increase in the number of active selling communities. Orders were flat in the Carolinas, while down in Texas. The Company's cancellation rate in California was 29% for the first two months of the quarter compared to 42% during the same period last year. The Company's Florida cancellation rate for April and May was up year over year, while it was down modestly in Arizona.

The struggles continue. Reuters reported that former housing bear, Bank of America Securities analyst Daniel Oppenheim, thinks that "...management began to respond with further price cuts in May and will continue to adjust price to improve sales." In other words, expect more housing deflation to come. Particularly noteworthy is the weakness cited in Texas. To date, homebuilders have held up Texas as a market where results have been good. A downturn in Texas would all but guarantee that homebuilder stocks are about to take another leg down. SPF is now struggling at FOUR year lows. With an "expensive" forward P/E of 21, we should expect even further weakness ahead.

The earnings of hombuilders continue to shrink and some have gone negative. Prices have trickled downward and look lower for the future as buyer sentiment continues to sour and credit tightens ever so slowly. So, book values should also continue to decline. These are all signs that lower stock prices are in the cards for the homebuilders. If the homebuilders ETF (XHB) breaks the low for the year - only 3% away - it will be time to step back and let the bears do their damage before picking at any additional opportunities! Next stop after that is the major low from 2006 - a little over 10% away...

Be careful out there!

DR. DURU®, 2007