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Builders Crumble Under Pressure

Weak second-quarter order numbers start to take their toll.

The second quarter is proving to be troublesome for homebuilders. They have been cutting their full-year earnings projections in droves as orders look weak and cancellation rates rise.

The latest salvo came Monday after

Standard Pacific



Technical Olympic


announced weak order numbers, sending builder shares lower across the board. The selloff suggests that investors are having trouble seeing a bottom for the group and would rather not buy into a sector that may represent a

value trap.

"If it is not already painfully apparent, the soft-landing thesis for the homebuilding industry is dead," wrote A.G. Edwards analyst Greg Gieber in a research note in which in he cut Standard Pacific from buy to hold.

Standard Pacific said new orders in April and May fell 41%, largely because of increased cancellation rates and continued softening of demand in markets such as California, Florida and Arizona. Because of the disappointing orders, Standard Pacific said it expects to lower its earnings guidance for the year when it reports second-quarter numbers in late July.

Technical Olympic, a Florida-based small-cap builder, said it expects net orders to be down 25% to 40% in the second quarter, though it didn't adjust its full-year guidance.

Technical Olympic shares dropped 8.9% Monday, while Standard Pacific shares fell 8.7%. Meanwhile,



dropped 8.1%,

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Pulte Homes

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fell 5% and

Toll Brothers

(TOL) - Get Toll Brothers Inc. Report

shed 4.3%.

Ryland, Toll and Pulte all recently cut their earnings guidance for the year due to weak order numbers in the second quarter.

One hedge fund manager, who plays the sector long and short, said that Monday's selloff could point to a worse-than-expected downside scenario for builder stocks, where the news gets bad at a very fast pace, rather than a slow shakeout over an extended time frame.

"If things get really bad at the time when the


will not bail out (and stop raising rates), people might just say, I'm not catching anything with a falling knife," the manager says. "People are saying, 'I don't see this thing turning anytime soon.' "

One question is whether these huge daily swings in the group will continue every time one builder reports disappointing news. One can argue that not all the bad news for the sector has been announced yet, and hedge funds' large exposure to the group adds to volatility.

Toll Brothers was one of the earliest builders to cut its earnings guidance for the current year and to report weak orders. Even though the stock was punished initially and is now down about 20% this year, the shares have hovered around $28 of late, improving from a 52-week low of $26.46 in May.

"Toll came clean early. There are still some that haven't come clean yet, which is scary," the fund manager says.

As the builder stocks continue to drop, they are looking cheap. But gauging a trough for earnings isn't an easy task. For example, Bank of America analyst Daniel Oppenheim estimates that Standard Pacific will post earnings of $5 a share for 2006, down from $6.15 in 2005. But by 2008, his earnings estimate for the company drops to $1.50 a share.

Oppenheim is considered to be among the most bearish Wall Street analysts covering homebuilders. But the mere thought of buying a stock at a P/E multiple where the "E" keeps falling isn't easy for investors' stomachs. Most investors like to buy for value when they can see the bottom. With this group, the bottom keeps moving out another year.

"The problem is a significant inventory overhang

at least a half million units that are vacant and for sale -- and growing -- per our estimates based on Census Bureau data and falling fundamental demand that should continue to trail downwards in a likely forthcoming environment of a weakening economy and rising longer-term mortgage rates," Gieber wrote in his note Monday.

However, not everyone is negative on the sector.

A number of noted value investors continue to go long builders. The largest buyer of homebuilder stocks in the first quarter was Bill Miller at Legg Mason Capital Management, followed by Jeffrey Gendell at hedge fund Tontine Associates, according to a research report from Oppenheim, the Bank of America analyst.

Miller and Gendell are considered to be some of the wisest investors around. However, Gendell's SEC filings, as is the case with all hedge fund managers, say nothing about what his firm might be shorting in the sector. Still, there appears to be a feeling that the stocks could very well reach an inflection point one of these days.

"(Homebuilders) were easy shorts at one point," says another hedge fund manager who plays the sector, but "we're looking at covering our shorts here."

"It's an interesting point to start looking at the group" from the long side, the manager says.

Anyone who believes that thesis should remember that the group likely will be very volatile over the next six months, as the U.S. housing market continues to slow. Eventually, the bulk of the bad news will be reported, and the value case for the stocks may eventually prove correct in the long term. But it will be a bumpy ride until then.