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Land Prices Bury Margins

Builder earnings will look a lot different than in the boom years.

Land writedowns, along with continued aggressive discounting of homes, helped cut Pulte Homes (PHM) - Get PulteGroup, Inc. Report and Centex's (CTX) quarterly earnings in half last week.

But another looming hit to gross margins has yet to fully materialize in the homebuilding sector.

As prices for new homes soared during the recent U.S. housing boom, homebuilders enjoyed record profit margins because they were generally building on cheap land that was priced before the boom.

This phenomenon is known as "inventory profits." But the problem with inventory profits is that they're not sustainable in the long run.

Eventually, builders have to replenish their land inventory. And in the boom years, the companies did so by purchasing land at spiking prices.

Builders are currently "working off all their old cheap land, but eventually they've got nothing but the more recent stuff," says A.G. Edwards analyst Greg Gieber.

"If you look at land controlled by homebuilders, either owned or optioned, of the group I follow, 35% of those lots were priced in 2005," Gieber says.

And a year ago, land prices remained high because there was still a growth market for housing sales.

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Now builders are taking charges and walking away from options on that more expensive land, as Pulte and Centex did last week. But much of that newer land is still on the builders' books, and the companies will soon face a significant margin squeeze from dropping home prices and higher land costs flowing through the income statement.

This creates a tough dilemma for the companies. They can either build on their most recently purchased land and possibly lose money as housing prices fall or go flat over coming years. Or the companies can continue to write down their land and walk away from option contracts, as builders like Pulte and Centex continue to do.

One of the major difficulties in analyzing builder stocks is that it's hard to tell how much of the older, cheap land is left on the companies' balance sheets. Builders do a poor job of breaking out which land has been used.

"You don't know exactly what vintage of land they're building on today," says JMP Securities analyst Alex Barron.

If you're looking for good short-sale candidates in the sector, just find the companies that bought the most land in recent years, says one hedge fund manager who invests in the sector. (Of course, the lack of clarity on this topic in builders' financial statements makes this is a difficult task.)

In general, though, it's important to not conflate a housing recovery with an automatic recovery in builder fundamentals.

"The housing market can recover and stabilize, but the public homebuilders may be looking at significantly lower margins in their business going forward," the manager says. "Public builders will outperform in a (housing) bull market and underperform in a bear market."

The problem is compounded by the fact that many builders loaded up on land in hot markets like Florida and California, which are now experiencing corrections. Eventually housing prices will correct, along with land prices, several industry watchers predict.

So even if homebuilders' operations do eventually pick up steam in late 2007 or early 2008, as some are forecasting, the companies' new earnings streams will look a lot different than in the boom years.