Looking for value in home builders

Last week saw earnings releases from many of the nation’s largest home builders including DHI, MDC, SPF, MHO and BZH. It was a busy week. All reported the first profit, largely due to loss carry-back tax credit, since the downturn. Without the tax credit, most builders would still have been producing a loss. But by and large the amount of loss and the amount of asset write-down appeared to have come to an end.

New home sales are at the lowest point in two decades. Against the backdrop of foreclosures and short sales, new home inventory is also at a depressed level. An army of private builders have gone out of business, due to lack of refinancing. The remaining group of public builders now has ample cash reserve, lean workforce, much reduced balance sheet, much lower level of leverage, and lower level of competition than before. If you think economic recovery is likely to materialize, unemployment rate is likely to improve from this point on, and banks are about to increase their lending activities, and that home builder is one of the first pro-cyclical industries to benefit from the upturn, then it is perhaps the best time to look into this group and see where the value and potential is.

This article takes the first step to examine the value aspect of the group by comparing some common metrics among 8 builders. Since they’re still not making positive incomes without the tax credit, we will ignore P/E ratio. Instead we’ll look at price-to-book ratio, price-to-sale ratio and price-to-cash ratio. The table below lists the closing price, market cap, book equity and the three ratios based on data gathered from the latest earnings releases. The data is not guaranteed to be accurate, but they should give us a good ground for comparison analysis.

I also included a leverage ratio measure, total asset to total equity ratio (A/E), to give us a sense for their balance sheet strength.

Hovnanian still hasn’t reported yet, the data is based on the last release. It is one of the weakest companies with about $350M negative equity. It is amazing that it has managed to survive the credit crunch. Market gives it one of the lowest valuations, based on P/Sale and P/Cash ratio. The only other company that looks that bad is Beazer Homes, which still sports an excessive level of leverage.

Because of their debt problem, these two stocks will continue to be very volatile and may not represent risks worth taking.

MHO just reported a good quarter. It was profitable even excluding the tax credit. Its balance sheet is very healthy. It has raised a good chunk of cash and left the year 2009 with $132M of cash. There is no liquidity problem. This stock has a very low P/B and P/Sale ratios. It represents a good value.

SPF is one of the risks I like. With the shares trading in mid-3, all three valuation ratios are among the lowest. Yet, after asset sale and equity infusion, its leverage ratio is now quite normal (for a point of reference, a 20% down home purchase would give you an A/E ratio of 5 for that house). Standard Pacific’s gross margin is consistently among the highest in the industry. The company appears not very interested in competing with the mountain of foreclosed homes out there. Last quarter it mothballed 52 communities, taking a wait-and-see attitude. That was probably the main reason why it did not increase orders by much year-over-year in its 4Q. They might have overdone it, but it was a reasonable tradeoff. The company also appears not geared towards first-time home buyers who are keen on taking advantage of the federal tax credit. Most other companies analyzed here were heavily geared towards that group of home buyers. The silver-lining in this is that when the tax credit expires, SPF can perform relatively well.

Investors who had hoped for a blow-out quarter from Standard were disappointed and quickly drove down the shares from above $4 to mid-3. At this price level, it represents a great value. I also like the fact that the market cap is only 60% of the company's cash, most of it is unrestricted.
KB Home, another Southern California based builder, appears quite expensive at 1.6 P/B. Its leverage level is manageable, but higher than that of Standard Pacific.

MDC reported an unimpressive quarter. It has a healthy balance sheet, but on the expensive side.

Both DHI and LEN have reported pre-tax profits last quarter. Both are well-positioned to take advantage of the home-buyer tax credit. They have strong balance sheets, and are priced reasonably. These are good choices for investors interested in larger companies.

For a hedged strategy, investors may consider going long MHO, SPF and DHI, against shorts in HOV, BZH and KBH. Of course, for a more sophisticated hedged play, more quantitative and qualitative factors should be included.