Rethinking Builder Bargains

Centex's dismal earnings punished the stock, but a tough 2007 could make it a value trap.
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Investors looking at the weak earnings report from

Centex

(CTX)

are now left wondering if all the bad news is already priced into the stock.

The short answer is that no one knows, but anyone thinking that Centex is cheap could be setting himself up for a value trap.

Homebuilder bulls and long-term value investors in the sector have been pounding the cheap-valuation argument for months now, as builder stocks trade at about 6 to 6.5 times expected 2006 earnings. Their basic thesis is that the housing market is slowing, but builders are priced so cheap that they're still a bargain because they'll eventually return to growth.

But the situation isn't as simple as it looks, given Centex's clues about the dubious outlook for 2007.

Centex shares fell more than 8% Thursday after the company's

fiscal fourth-quarter profit missed analyst estimates. Centex also reported an 11% order drop and slashed its guidance for fiscal 2007, which ends next March.

Centex now sees fiscal 2007 earnings of $8.50 to $10 a share amid slowing housing conditions. Centex's previous forecast was for earnings of $10.75 to $11.25 per share, while analysts had been projecting earnings of $10.50 a share.

"The significance of the Centex news was that it gave you your first peek of what 2007 earnings would look like" for the builders, says one hedge fund manager who has played the sector both long and short.

So far, homebuilder management teams have been pretty mum about next year.

Pulte Homes

(PHM) - Get Report

, on

its call Thursday, had enough trouble trying to convince analysts about the soundness of its 2006 guidance, and skipped addressing 2007 altogether.

But Centex was forced to talk about next year because it is currently in the first month of its fiscal 2007. Most other builders haven't gotten that far.

"The bottom line is the fundamentals that drive our business continue to be strong," Centex CEO Timothy Eller said on the conference call. But he added that the company has seen excess supply in some markets, which is leading it to a use conservative approach for its guidance.

Questions Build

There are a multitude of questions regarding 2007 for all builders. One is what the quality of earnings will be, as large, geographically diverse builders rely less on high-margin states like California and Florida and shift toward more volume-driven states like Texas.

There is another major issue looming. By now, most market watchers have moved on from the "bubble bursting" scenario and bought into the "soft landing" scenario for the U.S. housing market.

But can the U.S. housing market have a soft landing while the homebuilders' performance looks even worse than the general housing market?

Lower margins, higher costs, growing incentives and slower sales could start eating into builder profits. The builders aren't paying any less for land, labor, taxes or materials -- and all this is coming at a time when they're throwing in more and more incentives to sell homes.

"How bad is '07 going to be, and is '07 the bottom?" the fund manager asks.

If you want a very bearish take on things from a Wall Street analyst, look no further than Banc of America analyst Daniel Oppenheim, who expects builders' earnings to trough in either 2008 or 2009. He agrees a value trap might be emerging for investors looking at the sector and thinking it's currently cheap.

As for Centex, which he rates neutral, Oppenheim says the company is "being more honest than others" but "the reality is that it is going to be pretty difficult for everyone." He expects the group to report deteriorating fundamentals as they move into 2007.

If you're looking to go long on the builders, it all comes back to whether there is really value in place. If a builder is trading at a forward P/E of 6, which is basically where the sector stands now, then a 10% to 15% earnings drop in 2007 isn't a big deal, the fund manager says. But if a 20% to 40% decline is coming, then there's a problem. The other issue, of course, remains whether 2007 is the trough year.

The lesson to be learned from Centex is not that builders are facing a tough time this year -- everyone already knows that. It's that the news on 2007 -- the year that really matters -- is just starting to come in. If you think there's a chance that 2007 could be really bad, and that the ugliness will continue into 2008, then buying now opens up the possibility for entering a bad trap.