Homebuilder stocks continue to be slammed, and gauging just how far they may fall is getting ever-more difficult.

In the past, the thinking was that you should buy homebuilder stocks when they trade near book value, because historically the stocks head up from there. So long as builders made money from selling homes, or land values went up, the book value would also increase and so would stock prices, the theory held.

That model has been blown up.

The entire homebuilding sector is in danger of reporting losses for the year because of falling housing prices and high inventory levels. At the same time, land values continue to drop, requiring builders to record large impairment charges. Both issues further cut book value at the companies.

(As a reminder, a stock's book value is simply the stated value of shareholders equity on the balance sheet, divided by the number of shares.)

"These stocks could have a 10% to 15% leg down again because book value keeps falling. It is a moving target," says an analyst at a hedge fund that is shorting the sector.

Last week, Lennar ( LEN) and KB Home ( KBH) set the tone for the ugly results ahead for the sector, as both firms reported unexpected quarterly losses because of large land impairments, which eroded book value.

As the national housing market remains plagued by high inventory levels of new and existing homes, builders are cutting prices to clear product, which creates near-term cash at the expense of profits.

"It's going to get uglier. As Stuart Miller at Lennar said, nobody knows where the bottom is," the hedge fund analyst says.

Impairments Multiply

Investors who thought at the beginning of the year that the worse was behind the homebuilder sector "are getting a rude awakening," says Alex Barron, senior housing analyst with Agency Trading Group.

"The tidal wave of impairments has started," Barron says. "They will continue at a high level through the end of the year, and maybe into next year."

To date, the top 19 public builders have recorded a total of nearly $7 billion in impairments, Barron says. He is not sure if builders are even halfway through the impairment process yet.

This signals further gloom ahead for the stocks.

In a research note last week, Bank of America analyst Daniel Oppenheim reduced his price targets on the homebuilding sector by 8%, because he expects the companies to record more impairments in the future that will amount to another 13% hit to equity. Already, impairments have cut about 8% of builders' equity.

Oppenheim estimates homebuilder stocks are already trading at 20% premiums to book value after adjusting for these future impairments. He rates the sector neutral.

Cash Concerns

The concept of book value has been key for homebuilders, since otherwise the stocks are trading at ridiculously high price-to-earnings ratios.

Those P/E ratios are set jump further, since Wall Street estimates could end up being very wrong this year. According to Thomson Financial, most analysts still expect builders to be in the black for the year.

But analysts were already very wrong about Lennar and KB Home, as each were expected to report profits last week. Barron expects most builders to be unprofitable this year.

Negative earnings translate into negative free cash flow, which can get ugly at a time when many builders' debt loads are high.

"If all these companies were unlevered, you could hold them for five years and they would be OK investments," says a hedge fund manager who remains bearish on housing and is mostly short the sector. But that's not the case.

Take Hovnanian ( HOV).

At the end of the first quarter, Hovnanian had stockholder equity of $1.86 billion and long-term debt of $2.67 billion. The amounts to a 1.4 debt-to-equity ratio, one of the highest in the industry.

Oppenheim expects the company to record a 20% future drop in book value. With such a hit, the debt-to-equity ratio moves to 1.8.

Put another way, under this scenario, debt would amount 64% of Hovnanian's permanent capital structure.

Of course, if book value erodes further, Hovnanian could always preserve its existing debt-to-equity ratio by redeeming outstanding debt. In order to do that, the company needs cash, but the company had only $30.8 million of cash at the end of the first quarter.

Over the last 12 months, Hovnanian had negative free cash flow of $284 million. If the company loses money this year, it won't produce free cash flow. Thus there is a reason the stock trades at a 38% discount to stated book value.

Most other builders are facing similar issues with impairments and leverage. Lennar is an example of a better capitalized builder, with a debt-to-equity ratio of 0.46 -- one of the lowest in the sector. But what happens if you fully impair the company's inventories, raw land, and many joint ventures? The short answer is that it's very difficult to quantify how much risk is left in the balance sheet, and debt-to-capital ratios would balloon further with more impairments.

In fairness, most industry sources do not expect any builder to face bankruptcy, with the exception of possible liquidity crises at two small-cap firms: Tarragon Corp ( TARR) and Comstock Homebuilding ( CHCI). Tarragon is facing questions as it prepares to split into two companies, and Comstock has had delayed closing on a major condo conversion project that has raised concerns about problems with lenders.

And some builders aren't facing major negative headwinds.

Two stocks with the balance sheets best positioned to ride out the downturn in housing are NVR ( NVR) and MDC Holdings ( MDC), Barron says. NVR already has more cash than debt on its balance sheet. MDC should be in that position by the end of the year, he says.

While Barron likes both companies' business models, he doesn't recommend buying either because he sees another leg down for the entire homebuilder sector, and the stocks tend to trade in line with each other.

"The whole group will see new lows," says Barron, adding that a 10% to 15% drop might be too conservative, since the stocks tend to overshoot on the downside or upside.

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