Rethinking Builder Bargains

Investors looking at the weak earnings report from Centex (CTX) are now left wondering if all the bad news is already priced into the stock.

The short answer is that no one knows, but anyone thinking that Centex is cheap could be setting himself up for a value trap.

Homebuilder bulls and long-term value investors in the sector have been pounding the cheap-valuation argument for months now, as builder stocks trade at about 6 to 6.5 times expected 2006 earnings. Their basic thesis is that the housing market is slowing, but builders are priced so cheap that they're still a bargain because they'll eventually return to growth.

But the situation isn't as simple as it looks, given Centex's clues about the dubious outlook for 2007.

Centex shares fell more than 8% Thursday after the company's fiscal fourth-quarter profit missed analyst estimates. Centex also reported an 11% order drop and slashed its guidance for fiscal 2007, which ends next March.

Centex now sees fiscal 2007 earnings of $8.50 to $10 a share amid slowing housing conditions. Centex's previous forecast was for earnings of $10.75 to $11.25 per share, while analysts had been projecting earnings of $10.50 a share.

"The significance of the Centex news was that it gave you your first peek of what 2007 earnings would look like" for the builders, says one hedge fund manager who has played the sector both long and short.

So far, homebuilder management teams have been pretty mum about next year. Pulte Homes (PHM), on its call Thursday, had enough trouble trying to convince analysts about the soundness of its 2006 guidance, and skipped addressing 2007 altogether.

But Centex was forced to talk about next year because it is currently in the first month of its fiscal 2007. Most other builders haven't gotten that far.