Builders Still No Bargains

Value hunters, beware: Homebuilders may be cheap, but you need to be comfortable with two years of potentially rocky fundamentals.

The super-bear case calls for some builders to see a 50% to 90% drop in earnings from now until 2008, as higher land expenses crush margins.

Such doomsday numbers come from Bank of America analyst Daniel Oppenheim, who has been one of the most bearish homebuilder analysts of the past year.

For instance, Oppenheim projects that KB Home(KBH), which he rates neutral, will earn $1.15 a share in 2008. Last week, the company reduced its guidance for 2006, saying it should post earnings of $10 a share for the year.

KB's stock trades around $45, which appears cheap at 4.5 times this year's projected earnings. But if Oppenheim is to be believed about 2008, then the stock is trading at 39 times his estimates for that year. (He expects EPS to fall to $4.50 in 2007.)

Oppenheim's pessimism stems from his belief that builders' margins will deteriorate significantly from the double whammy of home-price erosion and higher land costs that will be expensed over the next few years.

Most builders have yet to acknowledge this issue, Oppenheim says.

When a public builder purchases land, it typically capitalizes the cost on its balance sheet, but most of the cost doesn't get expensed on the income statement until houses that are located on that land are sold. From 2003 to 2005, the housing boom resulted in ballooning housing prices (a good thing for builders) but also lofty land prices (not such a good thing). During this time, builders bought a significant amount of land at high prices, although it's not easy to tell how much because such investments are usually not broken out in financial filings.