The case for taking a chance with SPF

California home sales have been going up for a year now. Median prices have been creeping up too. Most of the sales are coming from foreclosures and other distress sales. They've also been helped by government policies and low mortgage rates.

Inventory has shrunk to a 5 year low, according to a recent Wall Street Journal article:

The supply of unsold single-family homes dropped to 3.8 months from 5.6 months a year ago and 16.6 months in January 2008, when inventories were at a peak, according to estimates released Friday by the California Association of Realtors. The inventory levels are now at their lowest level since 2005, resulting in frenzied sales with multiple offers in some cities.

Is it time to give the California housing market a chance? Is it time to buy shares of home builders?

Home builders as a group provide a way to participate early on the economic recovery. Over the last few years, most of these companies have all been losing money. Their stocks have plunged for good reasons. Some have gone out of business. Many of these names were our shorts two years ago. We think it's time now to take a close look at the survivors as long candidates. Against all the headwinds one can list, we think a positive case can be made based on these factors:

• They have been shrinking inventories
• They have been repairing balance sheets, in some cases buying back debts using cash
• They've been building cash, cutting down costs, shrinking workforce
• They've been writing down assets, to the point that there is little to be written down further
• Most can now refinance their debts either with banks, debt market, or with private lenders
• The housing resale market has been bottoming in parts of the country, e.g. California
• Land and construction costs are now much more reasonable
• In some cases, distress land sales create economical opportunities
• At least some people still like new homes, and more will as jobs improve

Yes, unemployment rate is still very high in Cal at over 12%. Without reliable income, who wants to buy new homes? Yes, more foreclosures may be coming to the market, and they will compete with new homes. Great points. That's probably why these stocks are selling close to book, and in some cases are selling below cash value per share. SPF is a good case in point. It is reporting earnings this Wednesday. Some analysts are now expecting a profitable quarter. That's possible, given the precedence of KBH and LEN, which were benefiting mostly from tax credits.

We think SPF may be more undervalued than most. The company has over $500M in cash. Its cash flow has been positive. It has a large concentration in California which is improving. Margin has been steady. Yet, the market cap is about $400M. Leverage is still a bit high, with total asset at $2B and total debt over $1.4B. But most of the debts won't come due before 2013. The equity infusion from MatlinPatterson in 2008 saved the company from a deadly cash crunch. The new management installed by the private equity firm appears to be jelling. While the cash infusion played a critical role in stabilizing the company, much of it is sitting there. The real test of the turnaround will be how well the company can identify and acquire profitable lots and sell more finished homes above costs in this challenging environment.

Judging from the California home sale reports in recent months, we think there is a reasonable chance that SPF can surprise on the upside this Wednesday. But more importantly, we want to see how well the company has positioned itself for the expiration of government tax credit and the very slow recovery ahead.