Updated from 10:08 a.m. EDT

Lennar

(LEN) - Get Report

offered its most negative view yet about the U.S. housing market Tuesday, signaling that the market could get even worse than investors expect.

The possibility that the market still has further to fall, coupled with the fact that the recent rally in builder stocks may have simply been due to a dropping 10-year note yield, means there could still be more pain in store for homebuilders' shares.

Lennar, noting "it is not clear that the homebuilding downturn has yet found a floor," said it now expects a fourth-quarter profit of $1 to $1.30 a share, well below the $1.60 mean analyst estimate. For the third quarter, Lennar posted earnings of $1.30 a share, matching the midpoint of its reduced targets released earlier this month.

"The U.S. housing market has continued to deteriorate, trailing down further and faster than anticipated," said CEO Stuart Miller. "Under these difficult conditions, we remain focused on our strategy of carefully managing inventory, reducing construction costs and overhead, methodically tapering back production and emphasizing cash generation. We have limited our land purchases and reduced standing inventory through strategic asset management."

On the company's earnings call, Miller said August was the worst month yet of the housing downturn and added that things haven't gotten any better since. He also refused to rule out the possibility of the company posting quarterly losses at some point next year.

One staggering figure from the earnings call: Lennar currently has 22,000 homes under construction, but only half of those have been sold.

That's largely because the company is focusing on "even flow production" during the housing downturn, meaning the builder essentially starts a new home as soon as it closes out on one in inventory.

This activity burns off inventories and creates cash flow at the expense of gross margins. In the third quarter, Lennar's gross margin fell to 18.7% from 26.3% a year ago.

Lennar earned $207 million, or $1.30 a share, in the period, down from the year-ago $337 million, or $2.06 a share. Sales rose to $4.18 billion from $3.5 billion a year earlier.

The average sales price of homes delivered increased to $316,000 from $306,000 in 2005. New orders decreased to 11,056, from 11,614 homes last year; quarter-end backlog was 16,008 homes valued at $5.6 billion, compared to 21,818 homes valued at $8.1 billion a year ago. Lennar's backlog at Aug. 31 was 17,990 homes valued at $6.5 billion.

Still Pricey

Lennar has no guidance for 2007, but UBS analyst Margaret Whelan, one of the more bullish housing analysts, has her own forecast -- and it's not pretty.

In a research note Tuesday, Whelan predicted that Lennar would earn $2.40 a share next year, down from her previous estimate of $4.40. Her new figure would amount to a 59% earnings drop for Lennar next year, based on current estimates for fiscal 2006.

Using this projection, Lennar is currently trading at nearly 20 times next year's earnings. The shares recently were up 28 cents to $47.16.

Assuming next year is the earnings trough, Lennar's stock might look reasonable. The problem, however, is that management has given no indication that fundamentals will get better soon.

If 2008 is going to be even worse than next year, then 20 times earnings doesn't look so cheap. As well, Lennar is currently trading 30% above book value. (Many have argued that the stocks were cheap when they were at book value.)

Builder shares have rallied since mid-July, with many investors largely

ignoring bad news and believing the stocks may offer compelling value. Lennar is up 21% since then.

One hedge fund manager who invests in the space says the rally was largely due to the falling yield on the 10-year note, which has gone from above 5.2% in July to 4.59% Tuesday.

The manager's gut feeling is that large hedge funds and mutual funds who were underweight the builders saw the dropping 10-year yield and decided to punish the shorts, especially over recent weeks when the Treasuries rallied.

But if the 10-year yield gets back above 4.75%, builder stocks could correct downward again, the manager says.

Most builder stocks Tuesday were adding to recent gains.

Centex

(CTX)

was up 3.2% to $55.29,

Hovnanian

(HOV) - Get Report

jumped 4% to $31.41 and

Ryland

(RYL)

advanced 2.5% to $46.34.

To view Robert Martorana's video take on Lennar's results, click here

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