4 Top Homebuilder Stocks: Life After the Tax Credit

NEW YORK ( TheStreet) -- The springtime expiration of federal tax credits for homebuyers created more uncertainty in the already-unstable housing market. Industry players like D.R. Horton ( DHI) and M.D.C. Holdings ( MDC) seemed to benefit the most from new home sale volumes in the run-up to the April 30 deadline, but there is still time for the patient investor to reap the benefits.

D.R. Horton and M.D.C. Holdings outpaced sector peers on volume, primarily because the two homebuilders were willing to go out and build spec homes, explained Stifel Nicolaus analyst Michael R. Widner. In other words, they were willing to take the risk of building new home inventory without contracted buyers in place. The bet paid off when hoards of homebuyers showed up in April wanting to take advantage of the credits, and were willing to make a rushed deal to qualify for the incentives.

While spec building helped D.R. Horton and M.D.C. Holdings grow closed sales volume by 60% to 6,805 homes and 71% to 1,135 homes, respectively, in the second quarter, the pair may now face a new risk of having overbuilt, potentially overexposing themselves to excess inventory now flooding the market.

"They both have more inventory than I'd like them to have, but I'm not overly negative," Widner told TheStreet. "It just means they slow down on spec building for a couple months and hope the market bounces back a little bit."
VOTE: Do We Need Another Homebuyer Tax Credit?
Would a new round of credits help or hurt the economy?

The Commerce Department estimated 210,000 new homes were on the market nationwide at the end of June, the lowest level of inventory in more than 40 years. Still, it would take 7.6 months to sell through that inventory at the current sales pace, down from 9.6 months in May. Six months of inventory is considered normal market conditions.

Sales of newly built homes rose 23.6% in June to a seasonally adjusted rate of 330,000, ahead of expectations, from a revised record-low rate 267,000 units sold in May.

While any increase in the rate of home sales is seen as a good sign for the economy and housing market in general, the uptick in June home sales still represented the second-weakest month on record after May's depressed figures. It was also 76.3% lower than the 1.4 million-peak in July 2005, at the height of the housing bubble.

>>Home Prices Weaken, Sales Rise

The still-struggling housing market saw sales ramp up in March and April as consumers rushed to take advantage of the federal tax credits that offered as much as $8,000 for first-time homebuyers. Those credits expired April 30, leading to a dramatic decline in demand for the month of May. Some of that weakening clearly spilled over into June but not as severely as in the prior month. Lawmakers later extended the deadline to close on a home purchase and still qualify for the tax credit to Sept. 30.


Many industry watchers, including Widner, were surprised at how far home sales, and specifically new home sales, fell after the tax credits expired. The pull-forward effect was clear -- potential buyers rushed to close on their purchases in time to qualify for the credit. The sector was left with a void of sorts on May 1, and continues to work its way back toward some level of sustainability even when taking into account current economic conditions, high unemployment and negative equity on nearly a quarter of all U.S. homes.

The consensus among analysts and homebuilders is that the June figures were "unsustainably low," Widner said, but the question of how long the current pace of sales will last, or how much higher a sustainable rate of sales would need to be, remains.

He estimated a longer term norm would be around 800,000 new home sales per year, more than double the U.S. housing market's recently reported pace. Based on excess vacancies currently in the market, Widner doesn't believe the pace of new home sales will return to that ideal level until around 2014, more than three years from now. Clearly, it's not a simple or quick fix.

Puzzling to Widner, and to many sector watchers, was why an $8,000 tax credit -- a small chunk of change relative to the $213,400 median price of new houses sold in June -- was such a tremendous draw for homebuyers at all. Based on his conversations with builders, the analyst deduced that it was mostly young, first-time buyers who, with financing from the Federal Housing Administration, were able to buy with essentially no money down. The FHA normally requires a 3.5% down payment. The credit equaled 3.7% of the median new home price, and in some states buyers got an advance on the credit to put toward their down payment.
VOTE: Do We Need Another Homebuyer Tax Credit?
Would a new round of credits help or hurt the economy?

"If you're 25 years old with a good job and can get a loan, you could capture the upside" of the credit with "minimal negative impact and perceptibly no downside," he said. "So why not speculate?"

Unfortunately the government does not track the data that would allow us to determine the number of FHA-financed home purchases relative to other forms of financing or outright purchases. However, as the housing crisis inevitably drags on, surveys from special interest groups are likely to look for just such findings.

And let us not discount the all-important effect of consumer psyche. The housing sector faced stiff economic headwinds heading into late spring and summer that did little to spur potential spending on big-ticket items like new homes. Data released in early May showed the nationwide unemployment rose to 9.9%, from 9.7%, and consumer sentiment started to wane. By June, the Conference Board's index of consumer attitudes had fallen to 52.9 from a downwardly revised 62.7 in May, sharply below forecasts. Sales at U.S. retailers unexpectedly fell in May for the first time in eight months, and trailed expectations through July. Throughout the spring the European debt crisis threatened to send the global economy back into a tailspin. Plus, the overall equity market essentially flattened out year-to-date in a correction that began in May and bottomed in early July.

Consumers took a noticeable step back from the recovery and had more doubts about their future after April than they did before. And while it's difficult to pinpoint exactly how much the drop-off in home sales was related to those other environmental and economic setbacks, the tax credit's expiration undoubtedly played its part.


With the equity markets beginning to grind back upward, many investors turned to the heavily-traded homebuilders sector as a tool for expressing their view on the shape of the economic recovery in general, Widner said. "When investors think we're in a V-shape recovery, they buy homebuilder stocks, and if they think we're headed for a double-dip recession, they sell."

Most of the homebuilders are essentially in the same boat, the analyst said, with the biggest differentiating factor from a balance sheet standpoint being how much debt and land inventory each has. Most homebuilders' land portfolios are marketed to reasonably relative values and are geographically diversified. None have significant scale advantage. And most recognize the best target market is first-time buyers. All this makes it difficult to pick out obvious winners.

Still, Widner has a buy rating on sector players KB Home ( KBH) and The Ryland Group ( RYL), based purely on valuation of expected normalized earnings.

"KBH and RYL have strong balance sheets. They are the clear survivors," he said.
VOTE: Do We Need Another Homebuyer Tax Credit?
Would a new round of credits help or hurt the economy?

Earlier this week, Deutsche Bank analyst Nishu Sood issued upgrades on D.R. Horton, Ryland and Meritage Homes ( MTH) to buy from hold, joining the ranks of M.D.C. Holdings, on the view that their simpler strategies and land pipelines will outpace sector peers.

>>Horton, Ryland Upgrades Lift Homebuilders

Focus on first-time homebuyers also contributed to the upgrade.

Sood said the current housing downturn was the worst in recorded history reflecting "the enormous imbalances that built up such as excess inventory, foreclosures and the home price bubble." While the problems are not yet fully resolved, Sood expects the situation will not get any worse, though home prices are likely to continue to fall in the mid- to upper-end of the market.

"These historic issues may cause recovery to be slow, but will no longer prevent it from happening," he said.

While new home demand remains at "abysmal" levels relative to the sharp fall-off experienced during the recession, homebuilders' profitability and liquidity positions strengthened dramatically, Sood continued. He attributed the improvements to the companies' ability to cut expenses, limit spec builds and redesign products.

Sood conceded that a double-dip recession could render his sentiments a premature call for recovery, but "nevertheless, we think long-term risk-reward is attractive for select names such as DHI, RYL & MTH."
D.R. Horton's Stock Rating Report
(DHI) Rating and Financial Analysis

Even so, the homebuilder group tends to move together in a tight band when it comes to stock price, with few outliers. That trend lends weight toward investing in sector-matched exchange-traded funds like the SPDR S&P Homebuilders ( XHB), which counts Ryland among its top holdings, and the iShares Dow Jones US Home Construction ( ITB), which counts Ryland and D.R. Horton among its top holdings.
VOTE: Do We Need Another Homebuyer Tax Credit?
Would a new round of credits help or hurt the economy?

The ITB concentrates more exclusively in homebuilders, while the XHB is a bit more diversified with 12.5% of its portfolio in consumer goods stocks. Though Widner has no official position on ETF plays, he agreed that sector ETFs tend to offer retail investors a good option for equity diversity.

"For most of the financial universe, investors stopped focusing on price-to-book and turned to normalized earnings," Widner said, as he waits for that valuation shift to happen in the homebuilder sector.

"That's an investment thesis for the patient."

-- Reported by Miriam Marcus Reimer from New York.

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