Rethinking Builder Bargains

"The bottom line is the fundamentals that drive our business continue to be strong," Centex CEO Timothy Eller said on the conference call. But he added that the company has seen excess supply in some markets, which is leading it to a use conservative approach for its guidance.

Questions Build

There are a multitude of questions regarding 2007 for all builders. One is what the quality of earnings will be, as large, geographically diverse builders rely less on high-margin states like California and Florida and shift toward more volume-driven states like Texas.

There is another major issue looming. By now, most market watchers have moved on from the "bubble bursting" scenario and bought into the "soft landing" scenario for the U.S. housing market.

But can the U.S. housing market have a soft landing while the homebuilders' performance looks even worse than the general housing market?

Lower margins, higher costs, growing incentives and slower sales could start eating into builder profits. The builders aren't paying any less for land, labor, taxes or materials -- and all this is coming at a time when they're throwing in more and more incentives to sell homes.

"How bad is '07 going to be, and is '07 the bottom?" the fund manager asks.

If you want a very bearish take on things from a Wall Street analyst, look no further than Banc of America analyst Daniel Oppenheim, who expects builders' earnings to trough in either 2008 or 2009. He agrees a value trap might be emerging for investors looking at the sector and thinking it's currently cheap.

As for Centex, which he rates neutral, Oppenheim says the company is "being more honest than others" but "the reality is that it is going to be pretty difficult for everyone." He expects the group to report deteriorating fundamentals as they move into 2007.

If you're looking to go long on the builders, it all comes back to whether there is really value in place. If a builder is trading at a forward P/E of 6, which is basically where the sector stands now, then a 10% to 15% earnings drop in 2007 isn't a big deal, the fund manager says. But if a 20% to 40% decline is coming, then there's a problem. The other issue, of course, remains whether 2007 is the trough year.

The lesson to be learned from Centex is not that builders are facing a tough time this year -- everyone already knows that. It's that the news on 2007 -- the year that really matters -- is just starting to come in. If you think there's a chance that 2007 could be really bad, and that the ugliness will continue into 2008, then buying now opens up the possibility for entering a bad trap.

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