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Prudently Prune Homebuilders

Richard Suttmeier

01/19/06 - 03:13 PM EST

In the long term, I believe the housing market will be healthy, but the boom has ended.

Shares in the homebuilders are close to the upper end of their trading ranges and are unlikely to break through to new highs soon. For investors who have ridden the stocks up, it's time for some prudent pruning.

Longer term, my model rates many of the homebuilders as strong buys. If you don't own them, you might want to buy the ones that are most undervalued on the list below. Demand from the baby boomers should increase as they relocate over the next 10 to 20 years to retirement areas, with Florida high on the list.

However, if we take a look at the case of Florida, we can see some of the risks for near-term weakness. According to the business magazine Florida Trend, homes in Miami and Tampa are overvalued by at least 20%. Developers must pay more for land, materials and labor and some projects are likely to be put on hold. Resources are needed for rebuilding in the areas hit by hurricanes Katrina and Wilma.

Rising interest rates will be a factor as well. About 46% of condo loans in Florida are adjustable-rate mortgages, and another 17% are interest-rate only loans. Only 37% are traditional fixed-rate loans. Also troubling for real estate and housing are the high levels of consumer debt, with banks tightening credit standards. Homeowners are facing higher property taxes, higher insurance rates and increased heating and cooling costs.

All of this will slow appreciation in home prices, but the downside should be limited to 20%. This is a plateau the boomers will take advantage of.

Recent Data and Earnings

MBA new mortgage applications fell 3% last week, but are up 0.6% year over year, which supports my steady outlook. Also supportive is the NAHB Homebuilders Index, which is unchanged in January at a reading of 57. Wall Street analysts are quite favorable towards the homebuilders, with median price targets well above where shares closed Wednesday. This makes this industry group vulnerable to downgrades, such as Banc of America's drop of Toll Brothers to sell from neutral Tuesday.

Premarket Thursday morning, Beazer Homes (BZH Quote - Cramer on BZH - Stock Picks) reported that quarterly profit rose 29% on higher sales in the Southeast, Arizona and Colorado. EPS was $2, above the consensus of $1.97. Beazer indicated that there was lower demand in overheated markets in Nevada and California. It also cited permit delays in Northern California and delays in the opening of new developments. Beazer reiterated its 2006 forecast of $10.50 per share, below the consensus of $10.64.

Beazer's stock has been the strongest among the homebuilders, reaching a new 52-week high of $82.14 on Jan. 11, but it's also the most overvalued, by 14.6%. Long-term investors should consider reducing holdings on strength to my quarterly pivot at $70.88. If it falls to my quarterly and semiannual value levels of $66.24 and $62.68, take the opportunity to add to long positions.

D.R. Horton (DHI Quote - Cramer on DHI - Stock Picks), the nation's largest homebuilder, said Thursday morning that its first-quarter profit grew 29% on improved sales and margins. The company reported EPS of 98 cents, beating the consensus of 94 cents. D.R. Horton upped its full-year EPS guidance to $5.25-$5.35 from $5.22-$5.32 per share.

Horton is trading 5% below its fair value. Investors should wait to add to positions on weakness to my semiannual value level of $35.26 and reduce positions if it rises to my quarterly risky level of $42.24.

Offsetting higher premarket prices for Beazer and Horton was weaker-than-expected housing data for December. Housing starts declined 8.9% to a 1.933 million annual rate, while building permits fell 4.4% to a 2.068 million annual rate. This supports my bias to reduce holdings and trade the ranges for the homebuilders.

The homebuilders are all rated a strong buy according to ValuEngine, but given the headwinds we've discussed, investors should add to holdings only on weakness to the value levels in the table below. Long-term investors should also consider booking some profits on strength to the risky levels. For example, if you had $10,000 invested in the homebuilders at the end of 2004, I would recommend realizing gains and bringing your allocation back to $10,000.

Key Metrics for the Homebuilders
The Homebuilders
Company Name 		Price Rating (-UV) / OV By Fair Value Value Levels Pivots Risky Levels
Beazer Homes $77.59 S Buy 14.60% $67.72 $66.24 Q / $62.68 S $70.88 Q $81.23 M
Centex $75.89 S Buy -0.90% $76.55 $69.86 S / $61.24 A $78.22 Q $83.74 Q
DR Horton $39.81 S Buy -5.00% $41.92 $35.26 S / $30.83 A $37.80 S $42.24 Q
KB Home $78.66 S Buy -3.60% $81.62 $66.51 S / $59.59 A $78.44 Q / $80.56 Q $88.23 M
Lennar $63.36 S Buy -11.80% $71.25 $57.35 A $64.57 Q / $65.92 Q $73.24 S
Pulte Homes $41.92 S Buy -12.70% $48.03 $37.26 S / $34.88 A $43.04 S $49.90 Q
Ryland Group $77.70 S Buy -7.20% $83.68 $70.16 A $78.64 A / $78.96 Q $99.48 S
Toll Brothers $36.83 S Buy -10.90% $41.34 $29.99 A / $25.59 A $36.98 S / $41.09 S $49.40 Q
Source: Global Market Consultants

Since all of these stocks appear range-bound, I will ignore their weekly chart profiles, as this measure works best in trending markets.

Centex (CTX Quote - Cramer on CTX - Stock Picks) is trading right around its fair value. Investors should wait to add to positions on weakness to my semiannual value level at $69.86 and reduce positions on strength to my quarterly pivot at $78.22.

KB Home (KBH Quote - Cramer on KBH - Stock Picks) is trading 3.6% below its fair value. Investors should wait to add to positions on weakness to my semiannual value level at $66.51 and reduce positions on strength to my monthly risky level at $88.23.

Lennar (LEN Quote - Cramer on LEN - Stock Picks) is trading 11.8% below its fair value. Investors should wait to add to positions on weakness to my annual value level at $57.35 and reduce positions on strength to my semiannual risky at $73.24.

Pulte Homes (PHM Quote - Cramer on PHM - Stock Picks) is trading 12.7% below its fair value. Investors should wait to add to positions on weakness to my semiannual value level at $37.26 and reduce positions on strength to my quarterly risky level at $49.90.

Ryland Group (RYL Quote - Cramer on RYL - Stock Picks) is trading 7.2% below its fair value. Investors should wait to add to positions on weakness to my annual value level at $70.16 and reduce positions on strength to my semiannual risky level at $99.48.

Toll Brothers (TOL Quote - Cramer on TOL - Stock Picks) is trading 10.9% below its fair value. Investors should wait to add to positions on weakness to my annual value level at $29.99 and reduce positions on strength to my quarterly risky level at $49.40.