Builders Have New Reason for Worry

Updated from 11:06 a.m. EDT

The scariest piece of Pulte Homes' ( PHM) earnings call Thursday? Slashing prices on new homes isn't universally translating into increased demand from homebuyers.

This phenomenon, in economic terms, is called the inelasticity of demand. Typically, demand is elastic with respect to price, meaning that demand increases in some proportion to a drop in prices.

Demand is inelastic when prices for goods fall but the quantity demanded barely changes or doesn't change at all. With homebuilders like Pulte trying to clear record inventories of homes, inelastic demand is particularly bad news.

Pulte, which reported a $788 million loss for the third quarter, is the first homebuilder to highlight this problem amid the ongoing housing downturn.

The company's management told investors on its conference call that in certain communities, "price is not moving product a lot" and the situation is "getting a bit inelastic."

Pulte's orders for the third quarter fell 37%, even though the company had been cutting prices aggressively in recent months. Last weekend, the company held a nationwide "Monster Sale" that offered additional 5% to 7% price cuts on certain homes.

The falling housing prices played a big role in Pulte's quarterly loss. The company was forced to record $1.18 billion of inventory impairment charges, largely to reflect that its land and housing inventory is no longer profitable.

Pulte said the "inelastic" pricing problem is broad-based and not just an issue of geography.

"Earlier this year as you lowered pricing, you got something for it. Now it seems like you're not getting so much volume," Pulte executives said on the call. As a result, Pulte is focusing on offering other incentives to homebuyers rather than just price cuts, the company said.

Ryland ( RYL) CEO Chad Dreier echoed this sentiment on his company's conference call when asked about the matter.

"I would agree in general principle that prices are reasonably inelastic at this point," he said. "If you're selling a home for $300,000 and offer 10% off, I don't think you will sell any more houses."

Pulte's price cuts on closings averaged 6% to 12% in the quarter. Including reduced sales commissions and other incentives, the total discount ran 14% to 15%, up from 11% a year ago.

In coming quarters, these incentives could get even higher, putting further pressure on margins.

"The operating environment continues to be challenged with elevated levels of new and resale home inventory, tightening of mortgage liquidity, and weak consumer sentiment for housing," said Richard Dugas, Pulte's president and CEO.

Meanwhile, new-home sales data from the government appear to tell a conflicting story in which price cuts are luring in buyers. The numbers, however, don't give a complete picture of the market.

Sales of new homes in September reached an annualized rate of 770,000 units, up 4.8% from August but down 23.3% from a year earlier, the Census Bureau reported Thursday.

The average sales price of a new home fell 3% from a month earlier to $288,000.

Total new-home inventory fell slightly to 523,000 units at the end of the month, representing 8.3 months of supply at the current sales pace. That is down slightly from 531,000 units at the end of August, or nine months of supply.

Homebuilder stocks were climbing on the news, with Ryland rising 3.8% to $27.26, and Beazer Homes ( BZH) jumping 2.9% to $10.30.

Pulte, however, was down 1.8% to $14.72.

While the data suggest some improvement in the market, housing analysts have continually said that the government's new-home sales data is misleading.

The government tracks the sale of a new home, but once a contract is entered, the deal is considered final. That number isn't changed if the contract is canceled, nor does it change if the contract is canceled and then resold later on.

"We put extremely little faith in the data given the consistent comments from builders about weakening trends throughout the third quarter," wrote Bank of America analyst Daniel Oppenheim in a research note.

"In addition, the September pace is overstated given that the Census Bureau methodology excludes cancellations, which increased during the month. We expect new home sales to fall toward a 700,000 annualized pace in the coming months, based on the fallout from less loan availability," he wrote.

The methodology also is underestimating the true amount of inventory in the market, Oppenheim said, given the cancellations.

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