Editor's note: "Bricks and Mortar" is a mock portfolio created by reporter Nicholas Yulico that is meant to help generate real estate and gaming-related stock ideas. In keeping with TSC's editorial policy, Yulico doesn't own or short individual stocks.

Homebuilder stocks have rallied way too fast on the recent rounds of Federal Reserve interest rate cuts.

I'm going to use this move to flag Pulte Homes ( PHM) in the "Bricks and Mortar" portfolio as one of the most overvalued stocks in the sector. Shares soared 20% Thursday even after the company's report of a massive loss, and they have now almost doubled off their 52-week low in less than a month.

The problem with the entire homebuilder group right now is that future revenue and earnings estimates from Wall Street analysts are much too high. This phenomenon occurred a year ago as well, and ultimately builder stocks plunged.

Pulte reported an $875 million loss in its latest quarter, while new orders fell 29%. The company is managing to generate cash from selling homes, but land impairment charges continue to ravage earnings and book value. Even backing out the massive charges, there is barely any margin left in the homebuilding business.

Analyst estimates project Pulte will book revenue of $7.3 billion and earnings before interest, taxes, depreciation and amortization of $286.7 million in 2008, according to Reuters Knowledge. That implies a 3.9% EBITDA margin.

I think these forecasts are aggressive, particularly the top-line number.

A good way to estimate future revenue is to look at a homebuilder's backlog of homes sold but not yet delivered (and thus not yet booked as revenue). Pulte reported a backlog of $2.5 billion at the end of 2007.

Pulte's backlog as a percentage of estimated 2008 revenue is 34% -- lower than its historical number. This means that analysts believe the company will make up a significant portion of revenue this year through new orders that have not yet been placed.

The same issue applies with Ryland ( RYL), another homebuilder I've flagged as overvalued in the "Bricks and Mortar" portfolio.

The following table shows the historical relationship between backlog at the end of one year and the future revenue in the year ahead.

Backlog/2005 Revenue Backlog/2006 Revenue Backlog/2007 Revenue 3-year Average
Ryland 43.6% 54.7% 42.9% 47.0%
Pulte 35.1% 44.1% 38.6% 39.3%

But analysts are assuming lower backlog/revenue ratios, which makes little sense since the housing market is substantially worse than the earlier years.

If we apply the historical backlog/future revenue ratios to Pulte's backlog at the end of 2007, then revenue next year should be about $6.3 billion. That's nearly $1 billion less than the consensus number.

As Pulte's revenue fall off a cliff in 2008, I also expect the company will have trouble getting margin expansion. As management mentioned on the company's conference call Thursday, Pulte has already laid off a very large piece of its workforce. With revenues falling, and employment expenses remaining somewhat fixed, margins should weaken further.

As well, builders continue to offer price cuts to move homes, which will continue to pressure home prices and margins.

(millions) 4Q07 Backlog 2008 Revenue Estimate Backlog/Revenue Avg Backlog/Revenue 2005 to 2007 Adjusted revenue 2008
Builder 4Q07 Backlog 2008 Revenue Estimate Backlog/Revenue Avg Backlog/Revenue 2005 to 2007 Adjusted Revenue 2008
Ryland $786.4 $2,256.0 34.9% 47.0% $1,673.2
Pulte $2,500.0 $7,317.0 34.2% 39.3% $6,361.3

In the fourth quarter and for all of 2007, Pulte's pretax operating income margin (excluding the big impairment charges) was 3%.

Using my $6.3 billion revenue estimate and the 3% pre-tax margin, then Pulte is set to post EBITDA of $190 million, compared with the analyst consensus estimate of $287 million.

What happens in 2009? My guess is that revenue starts improving, and EBITDA margins slowly head back to the 7% levels of the late 1990s.

The result is that maybe Pulte can do $489 million of EBITDA in 2009. Analysts estimate is $589 million in EBITDA.

The stock at around $15.50 has an enterprise value (the sum of debt and stock) of $7.37 billion. That means it is trading at 15 times my estimate of 2009 EBITDA. That's a pretty rich valuation.

Casino owner MGM Mirage ( MGM), which offers both growth and relatively steady cash flow at the same time, is trading at 12.5 times 2009 EBITDA.

I think 10 times EBITDA is a reasonable estimate for Pulte. Incidentally, the stock today is trading at 10.5 times the 2009 EBITDA estimate from Wall Street analysts.

Starwood Heats Up

Shares of Starwood ( HOT), a "Bricks and Mortar" buy, jumped 5.5% Thursday after the hotel operator reported better-than-expected earnings. More importantly, Starwood said it expects earnings of $2.32 to $2.57 per share in 2008, in line with analysts' $2.48 estimate.

It's nice to see Starwood get some love. I still like the company's ability to generate a ton of free cash flow and I'm a believer in Starwood's long-term growth plans for expanding its hotel brands internationally.

However, I suspect shares may remain in limbo after this earnings pop today as investors continue to fret about the slowing economy and real estate valuations.

Bricks and Mortar Portfolio
A Look at How Nicholas Yulico's Picks Have Performed
Rating Date Price at Rating Rating Current Price* Total Return** year end 07 price 2008 YTD Return
Brookfield Properties (BPO) 1/23/2007 28.67 Own 20.34 -29.1% 19.25 5.7%
Global Real Estate ETF (RWX) 1/23/2007 64.00 Own 53.63 -16.2% 56.95 -5.8%
Ryland (RYL) 1/23/2007 56.00 Flag 33.77 39.7% 27.41 -23.2%
Trump (TRMP) 1/23/2007 17.50 Flag 4.43 74.7% 4.30 -3.0%
Penn National (PENN) 2/6/2007 45.56 Own 52.15 14.5% 59.55 -12.4%
Melco PBL (MPEL) 3/12/2007 15.46 Own 12.06 -22.0% 11.56 4.3%
Starwood Hotels (HOT) 7/12/2007 72.37 Own 45.24 -37.5% 44.03 2.7%
Home Depot (HD) 1/30/2008 29.71 Own 30.64 3.1% 3.1%
Average Total Portfolio Return, Unweighted, (including closed ratings) 18.3% 0.6%
Closed Ratings Rating Date Price at Rating Rating Closing Price*** Return**
Hilton (HLT) 3/2/2007 34.69 Own 47.50 36.9%
Home Solutions of America (HSOA) 4/24/2007 4.98 Flag 1.06 78.7%
Standard Pacific (SPF) 10/26/2007 5.25 Flag 2.20 58.1% 3.35 34.3%
Close At Start of Portfolio Current Value*
S&P 500 1427.99 1,378.37 -3.5% 1468.36 -6.1%
U.S. MSCI REIT Index 1140.36 862.99 -24.3% 870.64 -0.9%
*(1/31/08 closing prices)
**For "flagged" stocks, a drop in price is tracked as a positive for the portfolio, and a rise in price is a negative.
***Hilton closed out of portfolio on 10/26/07 because Blackstone Group completed purchase of firm.
HSOA closed out of portfolio on 12/26/07 at day's closing price
SPF closed out of portfolio on 1/11/07 at day's closing price

If you liked this article you might like

Large Homebuilder May Be Near Bankruptcy

Large Homebuilder May Be Near Bankruptcy

Housing Data Suggest Bottoming (Update)

Housing Data Suggest Bottoming (Update)

Home Sales Rise in July as Prices Fall

Home Sales Rise in July as Prices Fall

Sovereign Could Feel Fannie, Freddie Pain

Sovereign Could Feel Fannie, Freddie Pain

Stimulus Checks Lessen Home Depot Pain

Stimulus Checks Lessen Home Depot Pain