Perfectly Awful Storm Building - The Latest Pinpricks for Housing
By Dr. Duru written for One-Twenty
August 10, 2006
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Ever since I chose to start following the housing industry and homebuilder stocks in early 2005, the drama has been building around the saga of the housing boom, bubble, and bust. I largely stood by and watched these stocks soar into their summer peaks, I "bought" into the bubble when I purchased my own abode even as I chided homebuilders for their misplaced optimism, I tried to nail a bottom in the slide, and I finally (mercifully) got back on the downtrend and bearish bandwagon.
Even with everything I have written in such a short time, it seems like I can never quite keep up with the drama. In the past week, I notified you late of a nice relief rally in the homebuilder stocks that started around July 21st. The best part of the move came right after that, and, as we should expect, the buyers finally exhausted themselves and the overall downtrend re-exerted itself. Some homebuilders like HOV, BHS, and DHI are already hurtling right back to their 52-week lows on drops of 10% and more for recent highs off the latest relief rally. But the drama continues and now happens so fast, I feel like I need to act like a sports announcer to keep up. In the past few days Hovnanian and Toll Brothers added their two cents to the never-ending flow of broken promises. Even worse, we heard bad news from the lending institutions that supply large chunks of mortgage financing. Why is this news even worse? Well, the housing industry moves on money even more than it moves on land and materials. Money is the initiator of the supply. And the lenders are telling us that things are looking grim. In other words, as hard as it may be for some of you to believe, the pain will continue in the homebuilder stocks. A perfectly awful storm is brewing and building. More storms and no land in sight. I highly recommend you catch up on all the details if you can. I will try to summarize the latest with some of my own observations and commentary:
- Hovnanian Enterprises Inc., (HOV: August 4)
HOV dropped guidance again. This time a whopping 20% from the high end. 3rd quarter guidance has gone from $1.40 - $1.50 per share to $1.10 - $1.20. Fiscal 2006 guidance completely crumbled from $7.20 - $7.40 to $5.00 - $5.75. Does it even matter whether they hit the lower or the higher end? The trend remains down! Here is the most important quote from the warning:
"Predicting short-term financial performance in today's homebuilding market has become increasingly challenging," commented Ara Hovnanian, President and Chief Executive Officer of Hovnanian Enterprises, Inc. "Our anticipated financial results for the remainder of 2006 continue to be negatively impacted by a slower sales pace, high cancellation rates on contracts in backlog that were projected to close this year, and more pronounced use of concessions and incentives, particularly on the resale of those homes which have experienced contract cancellations," Mr. Hovnanian said. "We are also renegotiating a significant number of our land option contracts, and we are likely to incur walk-away costs in conjunction with some of these situations.
It's basically the same story we have been hearing from all the homebuilders that have finally started crying uncle. One important note of interest here is that Hovnanian is admitting that incentives are having a material impact on results. Back in January, Centex adamantly insisted that the firesales they were throwing in certain markets would not have a material impact on financials. And next they have a bridge to sell to us in Manhattan!
Despite Hovnanian's disappointment, the stock actually jumped in morning trade before settling in for a "small" 1.4% loss on the day. The only reason why HOV got off so easy is that the relief rally was still underway. The news mattered less than the existing buying momentum and short-covering. Needless to say, the sellers got back to work in a big way in the past two days. HOV has lost over 11% in value in two days and is rapidly approaching its 52-week lows again. Relief rally over!
- Countrywide Financial, (CFC: August 8)
The Wall Street Journal ran a great story describing Countrywide's shifting strategy amid the slowdown in the housing industry. A few short quotes are enough to reveal to you how dim and grim things are looking. I think the observations of the money man behind CFC are more timely and accurate than the homebuilders who pretend to be blind to the bad news until it has already flattened them. I just wish I had paid attention to the analyst call when it went down a month ago!
CEO Angelo R. Mozilo told analysts last month that "I've never seen a soft landing in 53 years."
When asked how low housing prices will go: "It's hard to tell. But the trend is down."
The CEO also said his closest competitor, Wells Fargo, is moving full steam ahead in the mortgage business while his company is exercising more caution. The CEO commented that newcomers to the business, Lehman Brothers Holdings and Bear Stearns Cos. "...don't know anything about the mortgage business, which makes them a dangerous competitor."
Finally, the CEO candidly (and ominously) admitted that "I'm not sure exactly what will happen then" when referring to the imminent resets of option ARMS. These mortgage vehicles comprise 45% of the banking division's loans. When they reset, they typically result in higher payments for the borrower. Yikes all around!
- Accredited Home Lenders, (LEND: August 9)
During LEND's morning earnings report, the company dropkicked their fiscal year 2006 earnings guidance from $7.70 - $8.00 to $4.50 - $5.50 for 31% shrinkage on the high end. Analyst consensus was $6.67, so the investing community was already skeptical, but LEND did them one better. LEND cited "lower than anticipated origination volume" and "net gain on whole loan sales below previous expectations" as explanation for the lowered forecasts. They are also assuming: "implementation of more competitive pricing in the company's wholesale platform resulting in: Lower net gains on whole loan sales, year-over-year volume growth, and steady net cost to originate." In other words, the mortgage business is shrinking and getting less profitable. Although LEND is a sub-prime lender, you can bet that this forecast reflects poorly on the sales expectations of homebuilders.
- Toll Brothers, (TOL: August 9)
You would think that by the time TOL announced yet another round of its own bad news, the market would have already anticipated and priced in the dim and grim. This was probably true about three weeks ago, but the relief rally built up expectations. Again, the news mattered much less than the buying momentum and short-covering. TOL was one of the first builders to begin admitting that something was awry in the housing market. Unfortunately, every quarter they tell us things are even worse than their most conservative guesstimations. And it has taken almost a year for the execs to go from stubborn optimism to outright pessimism.
Anyway, TOL put a smackdown on guidance for upcoming earnings. Next quarter, TOL expects to deliver 2500 - 2800 homes instead of the 2900 - 3300 originally expected. Analysts dutifully dropped their earnings expectations, but TOL did not oblige with its own revisions. Given recent history amongst the homebuilders, the analysts are likely not trimming estimates enough! TOL also provided a very detailed explanation of the challenges they face:
"It appears that the current housing slowdown, which we first saw in September 2005, is somewhat unique: It is the first downturn in the forty years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors. Instead, it seems to be the result of an oversupply of inventory and a decline in confidence: Speculative buyers who spurred demand in 2004 and 2005 are now sellers; builders that built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction. The resulting excess supply has exacerbated the drop in consumer confidence, which first appeared last September, that was already a drag on new home sales.
"Because much of the overhang of finished and near-finished product is being marketed using advertised price reductions and increased sales incentives, many anxious consumers are delaying their purchase decisions as they wonder about the direction of home prices. With interest rates still relatively low, the economy basically healthy and household formations still increasing, we believe that once the current oversupply of homes is absorbed and buyers become confident that home prices have stabilized, the market will return to firm footing. While we cannot predict when this will occur, we do believe the laws of supply and demand have not changed and the demographics are still very favorable. With the growth in households over the next ten years projected to outpace the record totals of the past ten years, demand for housing should remain strong. With many potential buyers on the sidelines right now, we believe there is growing pent-up demand that will come into the market once buyer sentiment improves.
"In addition, because many builders are abandoning lots under option, we expect land developers and land sellers may be less aggressive in pushing new lots through the approval process. This could result in a shortage of available home sites in many markets once demand rebounds. Faced with heavy discounting by many other builders, we generally have chosen to allow sales paces to slow rather than aggressively discount our home prices. Other than in our multi-family communities, in which we start a building after having sold some but not all of its units, we rarely start a single detached home without a buyer’s signed agreement and a substantial down payment. Because we build few specs, we feel less pressure to discount homes to be built.
"Since we have taken most of the lots we now own through the entitlement process, we believe we’ve created significant value. On certain land deals that no longer work due to today’s weaker market conditions and slower sales paces, we are willing to let options expire if we are unable to renegotiate the land purchase. When we announce earnings on August 22, 2006, we will announce our write-downs related to such options.
"We have seen an increase in our cancellation rates in a number of markets, including Orlando, Northern California, Palm Springs, Las Vegas, and Phoenix. While our current cancellation rate is significantly higher than our historical levels, we believe it is still the lowest in the industry, primarily because we require a significant non-refundable down payment before we start a buyer’s home.
“We have a fantastic team that has managed through several past downturns. Our team was able to grow revenues and profits significantly coming out of the downturn of 1988-1990 thanks to opportunistic land buying and financial discipline during that period. Now, with a much deeper capital base, a national geographic presence, a well-established brand name and a much wider range of product lines to serve luxury buyers, we believe we are even better positioned to prosper in the future."
Obviously, TOL has decided to continue to paste on a brave face admist the darkness. From all the other news, I think their stubborn confidence is misplaced for now. I am particularly skeptical of their attribution of blame to lower consumer confidence. The problem certainly sounds easy to solve if all we need to do is get confidence back up, right? And of course demand will return someday, but this tale implies recovery could be right around the corner. TOL is relying on strong demographic trends and a coming shrinking of supply. Remember apartments? Folks can still rent those, and in many of TOL's hottest markets, it can be cheaper to rent than buy. I am officially putting TOL on the "it will be going much lower" list. You prospective buyers should also take heed: do not go to TOL expecting bargains. TOL would rather hold onto its inventory than let it go at lower prices. This reflects similar behavior amongst many thousands of eager individual home-sellers across the country...
Be careful out there and bring plenty of band-aids!