Builder Margin Stall: Cause for Concern? - TheStreet

Builder Margin Stall: Cause for Concern?

NVR reports a profit, but its gross margins stall in the fourth quarter, sending the shares of the homebuilding sector's best company down.
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) -- If


(NVR) - Get Report

is a leading indicator of the homebuilding sector, its fourth quarter earnings may not have been the indicator homebuilder stocks were hoping to see on Wednesday.

The indications were mixed in the NVR fourth quarter earnings, yet at the same time, performance of homebuilding stocks on Wednesday was fairly positive overall.

Is there a disconnect between the market's reaction to the NVR earnings and some of the biggest homebuilders trading up on Wednesday?

Even though NVR increased orders -- one of the most important signals of a better outlook in the operating data -- its shares were down close to 2.5% on Wednesday at the close.

NVR has been the best of the homebuilding stocks through the worst of the homebuilding crisis. A geographic focus on the Atlantic states, as well as first-time homebuyers, and the lack of an aggressive land acquisition strategy that now plagues other homebuilding stocks, have all allowed NVR to avoid the fate of homebuilding peers.

However, investors were selling NVR today, and at $687 per share, NVR is an expensive stock on which to stake hopes of a quick turnaround in the homebuilding sector.

Michael Widner, analyst at Stifel Nicolaus, sees the homebuilding outlook in terms of gross margin improvement after the NVR report. While there has been much focus in this earnings season on the homebuilder operating data -- new orders going up while cancellations go down -- Widner was most struck by NVR's gross margin number in today's earnings report.

NVR's new order number of 2,000 units was solid, and in line with Stifel Nicolaus' estimate. NVR's cancellation rate, however, was basically flat. However, Widner was most bothered by the gross margin drop at NVR.

NVR only noted in its earnings report that gross margins were up year over year, with the fourth quarter 2009 gross margin at 18.9%, versus 2.6% in the fourth quarter 2008.

What NVR did not indicate, but Widner noted, is the gross margin comparison between the fourth quarter level of 18.9% and the third quarter 2009 gross margin level of 19.7% -- notably, a step backwards, as opposed to an improvement.

Meritage Homes

(MTH) - Get Report

reported on Tuesday improvements in its operating data, also -- a 24% increase in orders.

However, the Meritage earnings per share of $1.35 was only achieved by a one-time tax benefit of $90 million, which had also been the case with recent profits at


(LEN) - Get Report


KB Home

(KBH) - Get Report


Widner explained that the one-time, tax gain-based earnings can be thrown out the window. Also, NVR operates in the least-stressed geographic region, the first-time home buyer tax credit and the Federal Housing Authority are doing everything they can to stimulate home sales, and NVR's gross margin still stalled.

"If gross margins are stalling here in the 18% to 19% range, rather than going up, while we have the tax credits and all the other positives, and NVR can't break into the 20% range, it's foreboding. It doesn't give me great confidence" Widner said.

Still, Lennar, KB Home and

D.R. Horton

(DHI) - Get Report

were all up between 3% and 4% on Wednesday at the close, leading homebuilder returns.

Toll Brothers

(TOL) - Get Report

was up to a lesser extent on Wednesday.

Widner noted that NVR had been above 19% gross margins in the past two quarters, and more generally, homebuilders have been telling investors to expect gross margins between 18% to 22% in the next few years.

"If we strip out the one-timers in Meritage and the rest of the homebuilder profits, if this quarter is the operating performance that we can look forward to over the next three years, most of the homebuilding stocks are overvalued," Widner argued.

That doesn't dovetail with what Hovnanian Enterprises CEO Ara Hovnanian told


on Tuesday. Hovnanian -- whose company is about as far away from NVR's balance sheet strength as any public homebuilder -- told


that the housing stocks have bottomed out and, what's more, there has been an over-correction.

Stifel Nicolaus' Widner doesn't see it, and the fact that NVR is down on Wednesday even after reporting the improved operating numbers doesn't support the bull argument for homebuilding stocks either.

The Stifel Nicolaus analyst says that it comes down to what the Street has built into its models, and the NVR stall on gross margins is an impediment to those expectations. "If this is what we can expect from Horton, Ryland, Toll and the rest, the sector is overvalued, unless we see the gross margins continue to improve. It doesn't have to happen this quarter, but it has to keep improving," Widner argued.

Meritage Homes' gross margins improved slightly from 14.5% in the third quarter to 14.9% in the fourth quarter.

Lennar's gross margin increased to 11.1%, or an increase of 3.3% in the fourth quarter.

KB Home's gross margins were 19% in the fourth quarter.

The homebuilding sector still has a huge supply overhang, and the supposed land grab -- during which homebuilders have been expected to snatch land for pennies on the dollar -- hasn't happened yet, leading the Stifel Nicolaus analyst to read NVR's inability to break the 20% gross margin hurdle as a sign that homebuilders may stall around the low end of the 18%-22% gross margin range for the next few years.

"That's healthy for this sector, but it makes stocks overvalued, and I don't know how anyone could make a claim of a widespread over-correction in homebuilding stocks," Widner argued.

Widner said he expected gross margin improvement from Ryland Group, also. Just after the market close, Ryland Group reported a gross margin level of 14.2%, up from 10.8% in the prior quarter. Ryland shares closed up 3% on Wednesday, before its earnings report.

Notably, NVR is trading at 22 times earnings based on Wednesday's share price, and that's after a down day. It has recently been trading as high as 25 times earnings.

The Stifel Nicolaus analyst noted that as a group, the homebuilders are currently trading at 1.2 times adjusted book value -- current book value plus net present value of deferred tax assets -- which is above the pricing that the homebuilding sector had throughout the 1990s.

"We went through most of 90s at one-times earnings, so I'm not sure how you can justify the sector being undervalued," Widner asks, though he added that some individual stocks are trading at discounts.

On Tuesday, UBS analyst David Goldberg recommended that investors look for a short-term dip in homebuilding stocks and opportunities to buy on the cheap. Maybe the UBS recommendation had some impact on the homebuilding shares being up on Wednesday.

Maybe the disconnect between the selloff in NVR and the positive market call on the other homebuilders is also a sign that the homebuilding sector's most insulated stock during the worst of the market crisis, now has more to prove.

The best performing stocks in sectors often selloff after earnings that don't meet what have become big expectations relative to peers.

-- Reported by Eric Rosenbaum in New York.


>>Lennar Bull Puzzled By Extent of Share Rise

>>Homebuilders Drop on KB Disappointment

>>Hovnanian Shares Collapse on Earnings

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