Saturday, February 27, 2010

Weekend reading: Real economy, not financial, the key for 2010

This last week saw some mixed economic data: Q4 GDP was revised upward from 5.7% to 5.9%, durable good order surged, but consumer confidence dropped, along with dismal new and existing home sales.

Growth in GDP is likely to slow after the big spurt.
Unlike past rebounds driven by the spending of shoppers, this one is hinging more on spending by businesses and foreigners. Businesses boosted spending on equipment and software at a sizzling 18.2 percent pace, the fastest in nine years.
And foreigners snapped up U.S.-made goods and services, which propelled exports to grow at 22.4 pace, the most in 13 years.
According to the GDP release from the commerce department, here is the broad makeup of the US economy:

Personal consumption expenditure 71%
Private domestic investment 11%
Government consumption and investment 20%
Net export -2%

Government has already stepped up its role, and may not be able to do much this year. Business investment can probably go up more. Technology sector is most promising. Foreign demand is likely to stay robust, as emerging market consumer spending has already overtaken US to become the largest spender in the world economy. But to grow, US will still need domestic consumers to open their wallets more. That hinges on jobs and assets (mostly home values and financial asset values). US needs both the income and wealth effects working.

All of these point to the essential need for interest rate to stay low, and US dollar to stay weak. In other words, the global rebalancing compells US to act more like China and vice versa.

The banking system is more or less stabilized. FDIC is still mopping up the mess and will continue to do so for the rest of the year. If the real economy improves, banks are likely to lend more, especially given the record yield spread. That's when the positive feedback loop will start working and growth will accelerate. Bet on that.

Thursday, February 25, 2010

Is the Market Ignoring the Dismal New Home Sales?

What's the matter with this market? Just one day after we learned that the January new home sales has hit a half-century record low, the stocks for homebuilders have mostly recovered?


In fact, some have shown a gain today. HOV is up 1%. KBH is up a fraction. Most outrageous of all: SPF is up by 5%. How can that be?

Is the market just ignoring the gloomy employment picture and the dismal sales data indicative of a housing market ready to fall off a cliff again?

Some have argued that millions of "shadow inventory" are on their way to foreclosure, which is bound to put a downward pressure on home prices over the next quarters or years. There won't be any housing recovery and homebuilders and banks are logical candidates for short sale. If that's the case, perhaps many more "John Paulsons" are about to be made!

Trouble is, we all have learned that the real John Paulson has been buying banks (BAC, C). That's a bet that the housing problem and the commercial real estate problem will at least be contained.

Perhaps the market is right to ignore the new home sales statistic, as long as it has confidence in the Fed to keep the interest rate low. After all, the statistic comes with a huge standard error that you can almost run a horse through it: + or - 15% for that 11.2% decline. That means, you may as well believe there was an increase from December if you'd like. Investors can't really make much out of the striking headline, can they?

We should probably pay more attention to the earnings releases and conference calls from the builders. Many of them, including Toll Brothers (TOL) today, have reported improved operating data for recent months. Most have also cautioned about the very challenging environment ahead, with the expected high unemployment rate and high foreclosures.

SPF's market reaction today is particularly interesting. The only news is that their Carolina division has announced an acquisition of a condo community called Glenmore. The size and the term were not disclosed. We only know that the floor plans have been downsized. This is likely a good move: picking up some stalled developments and remaking it at lower price points. But that would not justify a 5% move for the stock.

Perhaps this last sentence is what's catching investors' attention: "Glenmore is the first of several new Standard Pacific Homes communities to be announced in the Charlotte and Raleigh markets in the very near future."

North Carolina remains a relatively healthy sub-market, dominated by Pulte Homes (PHM). SPF has some presence, but not as much as in California. The expansion looks like a major ramp-up effort consistent with the company's turnaround strategy. While Pulte is still busy integrating with the old Centex, Standard is able to pick up or start a series of communities that fit its criteria.

Hmm, so much for the headline statistic. Mr. Alpha lies elsewhere.


Disclosure: Long SPF, LEN

Wednesday, February 24, 2010

Invest in housing recovery

January's new home sales was only 309,000 units, down 11.2% from Dec. That's a new record low in recent decades. Home buyers are not buying. It may have something to do with bad weather in the Northeast region, but most likely it's because of the grim outlook in employment. Jobs are scarce. The millions of unemployed don't have a chance. The still employed may fear losing their jobs. It's not the time to go shop for new homes.

Yet, the bad news argues for the case of investing in the housing recovery. And buying stocks in publicly traded home builders may be the best way to go. I have argued elsewhere why these builders deserve a close look, mostly because they have survived the downturn and look ready to take advantage of the low costs and the eventual return of a healthier market.

If 2009 was the year to invest in credit market turnaround, 2010 is the year to invest in companies that are in the best positions to take advantage of housing and economic recovery.

The Fed will continue to keep the rates low and steady. Inflation is not going to be a threat this year. Banks may be reluctantly starting to lend more. Government will cease to be the leading force in job creation. The positive feedback loop will turn when certain leading sectors start to add jobs. Manufacturing and technology are likely candidates. Financial sector may add more jobs. Only more jobs will help new home sales. That may happen in the second half of 2010.

Home builders that are best positioned may not be the ones who are working very hard to take advantage of the soon-to-expire federal tax credit. They are the ones that have great capital and human positions, which will allow them to move to promising sub-markets and/or take advantage of land opportunities.

We do not necessarily look for great recent sales. The last few months are not the best time to pound on sales and marketing. We want to invest in builders that have been methodically building its capital and portfolio. We've picked up some LEN shares because of its capital position and its ability to work with distressed assets on a large scale.

Friday, February 19, 2010

What might be in store when government supports have run its course?

So far in the first two months of 2010, the stock market performance looks eerily similar to what happened during June and July of 2009: It ran up and then drop abruptly for nearly 10% before it recovers rapidly.

There are a lot of well-supported pessimism in the market sentiment: Housing is still in a slump, more foreclosures are on the rise, there may be anywhere from 3 million to 7 million "shadow inventory" of homes in or near default that are on their way to foreclosure over the next couple of years. Unemployment is going to stay near 10% for at least the rest of the year. Consumers are tapped-out or shell-shocked to spend. They're saving more, which is going to limit the GDP growth. Government's deficit spending is a painful medicine. Where are the trillions of dollars are going to come from? The unavoidable tax increase is going to suck the life out of consumer spending and corporate spending if the federal deficit is to be dealt with...... All powerful dark forces.

The stock market and the leading inconomic indicators however are pointing to a much more bullish picture. Manufactoring is picking up steam, helped not just by inventory restocking. Export is surging. Technology sector has been strong. Retailers have seen improved results... not to mention that credit market has stabilized, banks are making money and may be on the verge of increasing their lending activities, even the housing market seems to have shown some signs of recovery, home builders and home improvement companies have seen improved earnings and sales.

When the stock market was rebounding powerfully last year, investors were focusing on normalization trades, betting that corporate profits would be protected. Companies moved aggressively to cut costs. Profit surged, at the expense of millions of unemployed. Many questioned how long that can last with out improving revenue. Well, so far in this earnings season, nearly 68% of companies reported fourth-quarter profits that beat estimates, while 71% topped revenue targets. Clearly the results are not all coming from cost cutting anymore.
Question remains though, how much of that improved profitability and sales is the result of government supports? And hence can this uptrend continue when all the government supports have run its course?

Investors will have to find an answer or take a position on this critical question.

We will continue to look for signs in the real economy for cues of a sustainable recovery. Financial sector is all important, but by itself recovery will not happen. The sector looks ready to provide the necessary fuel, should the real economy starts to pick up.

Tuesday, February 16, 2010

Wise to Invest Alongside Governments?

(This article has been published and distributed by Seeking Alpha.)

Recent events from China’s tightening, Euro-zone sovereign risk, to US policy towards banks have illustrated just how important it has become for investors to consider this question: is it wise to invest alongside the governments, or not?


This question is relevant not just for bond investors and credit investors, but also for equity investors.

PIMCO was known to invest alongside the US government when the government was trying to contain the financial crisis, and ripped huge benefits by doing so. However, it is clear from Bill Gross’ Investment Outlooks in recent months that the bond shop has changed its tune:

If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector. If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.

PIMCO’s New Normal has an inherent bias against equities. It argues that in this post-crisis world of de-leveraging, re-regulation, and de-globalization, there will be little growth, and hence little upside for equities. This is the year to preserve capital.

Sweeping arguments of this sort appear more self-serving than helpful to individual investors, however. If you’re an equity investor, we think the government factor will continue to play a large role. Investing in equities in 2010, by and large, is investing in economic recovery alongside the government efforts to spur growth and create jobs. No doubt, government actions also represent a great source of risk.

The US will in the foreseeable future have to focus on getting credit to flow, stabilizing the all-too-important housing sector, creating jobs either by directly expanding the public sector or by encouraging private hiring. This focus places a great importance on banking industry, housing industry and the industrial sector.

Banks are healing. Investors who invested alongside the government efforts in 2009 were rewarded. Despite the risk of new regulation and finger-pointing, credit creation remains to be the key for economic recovery. The remaining banks, especially the well-run ones such as Wells Fargo (WFC) and JP Morgan (JPM), continue to represent good opportunities to invest alongside the government.

The battered home building industry enjoys unusual government supports, yet it has caused much less controversy over bailout. The generosity from the government is beyond belief. Take the loss carry-back tax break, for example. Many commentators say it’s a one-time effect. But the fact is home builders are able to collect this benefit over many years. And the government, from the Fed, to the Administration, to the Congress, to agencies like FDIC, all appears determined to put a floor on property prices.

One recent example: The FDIC has chosen Lennar (LEN) as a co-investor in a $3.1 billion portfolio of distressed loans from failed banks seized by the agency. These loans are linked to both commercial and residential properties. The two parties will pay a combined $1.2 billion, or about 40 cents on a dollar. Lennar will contribute $243 million for a 40% equity stake in the venture, while the FDIC will pay $365 million for the rest. The remaining $627 million is seven-year interest-free debt provided by the FDIC. So if these loans, backed by land, developed lots, and other real properties, appreciate in value, Lennar stands to benefit alongside the government and the tax payer. On top of that, Lennar will collect a management fee from FDIC for overseeing the portfolio and loan work-out.

Success is not guaranteed, but with such generous financing terms and a determined government as co-investor, the odd is more than good.

By taking a 60% equity stake, FDIC appears to be sending a strong signal to the real estate market that there will be no fire-sale, and that a bottom has in all likelihood been reached, or supported.

Other builders, if nothing else, should benefit from the price support.

If Uncle Sam is becoming more of a shareholder, shouldn’t individual investors?


Disclosure: Long WFC, JPM, SPF

Sunday, February 14, 2010

Weekend reading: Up and up!

The new year has brought about a pervasive bearish tone on the stock market and among commentators. So it's rather refreshing to read Barron's interview with an informed optimist, James Paulsen, the Chief Strategist of Wells Capital Management.

A warning is in order. Many of these economists and strategists, once have taken a position, will be hard pressed to change their perspectives. Because they've built up a vested interest in that view, they often have to defend it, over and over again. Another reason for doing so is, if you change your view too often, the listeners get confused and get lost. The ability to sort through many of these rather conflicting views and opinions can be crucial for investment decisions. This ability is something we have come to define as "Interpretation Quotient" at IQR. This blog strives to increase our investment IQ this way.

With that in mind, let us see what Mr.Paulsen has to say about the US economic recovery.

After noting the pervasiveness and the support for the pessimism in our conventional wisdom, Mr.Paulsen comes to the first substantive statement about why corporations will have a leading role to play in this recovery: "Companies have the greatest profit leverage that they've had in decades. Right now, the level of cash flow relative to capital spending on corporate balance sheets is at a 50-year high."

Couple that with the fact that there is more than $1 trillion of cash sitting on corporations balance sheet, and the favorable financing condition, we can see why companies are ready to charge ahead.

Next logical question is then why would companies increase their production and hiring, if demand for their products are not there? This is of course one of the main arguments in many pessimists' views, that the consumer's psychic has been seared forever by the devastating financial crisis which has knocked down his wealth and income somewhat permanently through home value decrease, 401k erosion, restrictive borrowing and unemployment. Given that 70% of the US GDP is US consumption, the conventional wisdom has it that we'll see at best sub-par growth for the years to come.

To this question, Mr. Paulsen comes to the second substantive statement: "Household-debt levels remain a problem. But I think the issue has been overdramatized. During the bust, the biggest problem wasn't so much the people who lost their jobs as unemployment surged from 5% to 10%; it was the other 90% of the folks who had a job but were scared out of their wits. They just quit spending. Now, however, their paralysis is abating."

He goes on to observe some tentative signs why US consumers are likely to return to the mall, more so than expected. Add to that the contributions from inventory rebuild, stabilization of the housing and auto industries, government spending, and export growth, he makes his case that we could see real GDP growth at above 5% level for 2010. That's 1-2% more than many expect. Greater growth bodes well for the stock market.

Additionally, the demand for risk assets are likely to increase gradually, because "Liquid-asset holdings of households and businesses now stand at around $10 trillion. That's a record, relative to GDP. This money is likely to act as a slow-release Tylenol tablet over the next several years, leeching into the market and driving stock prices higher." 

That's the third substantive statement.

The mother of all challenges facing the US is the huge budget deficits hanging over our heads. To that Mr. Paulsen makes his fourth, rather surprising statement: "I don't think we're in an Armageddon situation. We've run large deficits as a percentage of GDP in the past, such as in 1975, when the deficit blew out to 6.5% of GDP and people thought the world had come an end. If you look back in U.S. economic history, the five years after the deficit peaks invariably have torrid growth. Same for the peak in unemployment, which we recently hit. Remeber: President Clinton left us in the late 1990s with budget surpluses and low unemployment, yet the succeeding decade was nothing to write home about in terms of either growth or stock-market performance." 

That is a powerful contrarian argument.

It will be most interesting to analyze these arguments alongside PIMCO's thesis of the New Normal, that we're entering a post-crisis era of slow-growth because of de-leveraging, re-regulation and de-globalization.

Both will need to be taken with a grain of salt.

Saturday, February 13, 2010

Happy Chinese New Year!

May the year of Tiger bring vigor and power to the global economic recovery.

Monday, February 8, 2010

What precious metal market might be telling us?

Vanguard's precious metal fund (VGPMX) is one of my personal holdings since 2008. It was among the best performing funds of the fund family for 2009, returning 77%. For the first week this year, it shot up 10%, ranked at the very top. But by Feb.8, it had become the worst performing fund in the family, returning -10% YTD.

Gold ETF GLD and gold miner ETF GDX behaved similarly. These are driven by the gold spot price which went from the recent peak above $1200/oz to about $1065/oz as we speak over the last one and half month. The most important factor appeared to be China's announced intention to tighten its monetary policy to comeback over-heated property market and the blewing inflationary pressure. Recent sovereign debt anxiety has added to the dollar strength, helping to bring down the gold price.

What does this reversal tell us? Is precious metal on the secular way down?

The bullish case for precious metal has two sides to it. One dominant thesis is that gold is a good hedge against pending inflation or inflationary expectations. We don't see much inflationary pressure in the TIPs. In fact, economists are expecting deflation in the US as the nation battles the high unemployment rate. How does one square with that observation?

Another theory is that gold is a great store of value, a de facto reserve currency. When US dollar or other major currencies are debased, gold should shine. This argument has gained more support recently. For instance, at the height of the credit crisis of 2008, USD actually strengthened due to flight-to-quality effect (other major currencies such as Euro were even weaker). Gold prices went down briefly as a result, before the global stimulus efforts were kicked into gear. Similarly this last week when Greece's debt crisis resurfaced, dollar strengthened and gold saw a big selloff.

We think the reversal is not something new. The market is telling us what it has been telling us all along: there are deep concerns about future inflation that are coming from global economic growth. That often manifests itself with price increases of commodities. This concern is now compounded by government deficit spending on an unprecedented levels. Market has also been concerned with governments' ability to trim back these spendings when it is time to do it. If there are signs that the governments of major economies will act responsibly, then gold prices have less reason to go up.

When China tightened, the market appeared to be surprised that the pro-growth regime was not as headstrong as many had come to expect. Thus the selloff.

The strengthening of USD due to Euro zone problems may have pulled down the gold price some, but it is only temporary. US deficit spending will either continue to weaken US dollar, or threaten to usher in an era of runaway inflation. Either case is gold bullish. This long term picture may be punctuated by some short term reversals, as we have just seen.

Sunday, February 7, 2010

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.

Saturday, February 6, 2010

Weekend reading: What might Wall Street become?

East Coast is experiencing a heavy snow storm. Washington and Philadelphia metro areas got more than 20 inches. Power is down for some areas. My area is relatively light. We had about 5-6 inches today, but more is on the way. Not very enjoyable, for sure. Can't really go out, so I have more time to read.

I have a few things to look into this weekend, but let's talk about Wall Street, because Barron's has a cover story about Wall Street's Rising Stars. No, it's not the top-prized bankers in the remaining bulge-bracket firms like Goldman, JP Morgan, etc., but the up-and-coming small- to mid-size banking and trading firms that are filling the void left by the collapse of firms like Lehman and Bear Stearns. These much smaller outfits saw a great opportunity amid the turmoil between 2007 and 2008, and they acted on it by recruiting talents away from the big firms that they normally would not have a chance to do.

It was step-up time. And these smaller firms are flying under Washington's radar screen. They don't have the legacy problems the big guys have: Look at the public outrage on bonuses.

A good friend of mine who used to work at Bear has been telling me how tiring it has become at JP Morgan, and lamented about the days when Bear was just about the right size for a senior professional like him. Perhaps opportunities are on the way, if they have not already arrived.

During the credit crisis, Washington took control. But even after the firms paid back the bail-out money, the politicians still don't want to let go of their heavy hands. Wall Street has become a very political place. Well, it is so only if you're too big.

The reality is, for the economic recovery to take hold, financial services will need to come back in a big way. Credit needs to flow more, and more freely, to the most productive places and the most credit-worthy individuals and businesses. The shadow-banking system will somehow need to be repaired or replaced. You can curse about CDS and CDO, but they play an important economic function by redistributing credit risks. The issues for regulators are probably not so much about limiting size and lines of businesses, but more about measuring and regulating the aggregate risks, and promoting competition.

The "too-big-to-fail" problem can't be solved by the "Volker Rule." Size per se is unlikely the issue, the  concentration of credit risk is. Concentration of risk can happen within a small firm too, for instance, LTCM. By breaking up the remaining banks, regulators may very well get more lost as to where the risks are actually concentrated.

Regardless of what the politicains are going to do, Wall Street is rebuilding itself. Yes, the "fat cats" must get leaner and serve the shareholder interests better. But, that should be done via more competition and shareholder activitism.

The age of more diverse players on Wall Street should be good for the economic recovery and good for the industry. May be.

Thursday, February 4, 2010

Quant strategies should have a fundamental tilt

Many quant strategies broke down over the last two years. An important reason may be that these strategies rely on historical data and backtesting. The resulting strategy that passes these tests can only work if the underlying markets stay structurally similar. So when the credit market went chaotic, or anything systematic happens, some of these strategies can run into difficulties. What you thought as market neutral may no longer be the case, as new systematic risks emerge.

By design, a quant strategy has a strong "momentum" flavor built in. You hope that the strategy carries enough momentum to work in the next period. So when there is a structural turn, the strategy may get you exactly where you don't want to be.

This is not to say that these strategies should all be abandoned. Far from it.

We should improve by at least trying something new, something that's not so commonly done. Regardless, we think having a way to incorporate certain "value" element based on outlook or expectations is a good balancing act. But, you don't want to rely on analysts forecasts. They're often too tied up to that particular industry.

A good quant analyst should become a fundmental analyst himself/herself.

Why these sell-side analysts?

Listening to conference calls in the earnings season sometimes gives me a funny feeling: Why are the managements  talking to the analysts who get paid by producing estimates these companies need to beat next quarter?

These are all sell-side analysts. You almost never hear buy-side analysts getting onto the calls and ask questions on behalf of shareholders. Why is that the case?

Wednesday, February 3, 2010

Acting Cautiously: Standard Pacific’s Net Sales Up By Only 1% Yoy

Standard Pacific (SPF) reported $0.31 per share net income on revenue of $339.8M for 4Q of 2009. The net income of $82.7 million included an income tax benefit of $94.1 million. Without the tax benefit, the company would have reported a small operating loss. This result is less appealing than the pre-tax profit reported from M/I Homes (MHO) this morning. It is also much less so than the result from D.R. Horton (DHI) reported yesterday.

Its gross margin improved to 20.3% from 18.6% in the third quarter, excluding the relatively small impairments. This is one of the company’s strong areas, and it is getting stronger. The company’s cash position has continued to increase due to land sales and tax refund.

Community counts are down sequentially from 139 average selling communities in the third quarter to 128. Net new orders totaled 554, down from 922 in the third quarter. Compared to 2008, the net new orders are up by only 1%. But on the “same store” basis, they’re actually up by 40%. The dynamics is very different from the “brisk” sales activities reported by D.R. Horton. Horton’s net sales orders were up 45% year over year.

This is an important point for analysis. Since the margin is healthy and steady. Profitability rests on increasing sales. Horton appeared to be completely out there to take advantage of the federal tax credit for the first time home buyers, and was able to generate sales profitably. There is an important question as to how long it can last with the pending expiration of that credit.

Standard Pacific appeared to be getting at it much more cautiously. It has increased land acquisition with small steps. It is still consolidating its balance sheet. No question, Horton’s balance sheet is much stronger, and can afford to be more aggressive.

The question for investors though is, given the state of the economy and the eventual withdrawal of the federal tax credit, which approach seems more beneficial for the long term? And for what price? DHI shares are priced richly at nearly 2 times book, while SPF is trading at about its book.

We hope to gain more insights from the conference call on Thursday.

Tuesday, February 2, 2010

Option traders make a beeline for Standard Pacific upside calls

Huge unusual option activities on SPF today, after DR Horton earnings report.
CHICAGO, Feb 2 (Reuters) - Many bullish option investors on Tuesday appear to be betting that shares of homebuilder Standard Pacific Corp (SPF) will jump at least 25 percent within the next few weeks.

It's been a big day for options trading in Standard Pacific, as traders exchanged about 11,000 contracts by early afternoon, 49 times greater than its recent average daily turnover, according to option analytics firm Trade Alert.

Trade Alert data show that directional sentiment based on order flow was 68 percent bullish with roughly 11,000 calls traded against only 158 puts.

Investors made a beeline for the March, June and September call options, giving them the right to buy shares at $5 apiece -- a strike price above the current value of the stock.
On the New York Stock Exchange, Standard Pacific shares rose 8.07 percent, or 31 cents to $4.15.

Earlier in the session bullish players paid 20 cents per contract to buy roughly 5,000 March $5 call strikes, said Interactive Brokers Group equity options analyst Caitlin Duffy.

Call buyers enjoy profits if Standard Pacific's shares rally at least another 25 percent from the current price to surpass the break-even point at $5.20 by March expiration.

The bullish action comes one day before Standard Pacific is due to release quarterly results and after homebuilder D.R. Horton Inc (DHI.N) on Tuesday posted its first quarterly profit in almost three years.

D.R. Horton shares jumped 10.5 percent to $13.16. The rally in home builder stocks, driven by pending home sales and D.R. Horton results, pushed the Dow Jones home construction index .DJUSHB up more than 6 percent.

Pending sales of existing U.S. homes edged up as expected in December, the National Association of Realtors said Tuesday. Still, home vacancies rose in the fourth quarter, pointing to a slow recovery for the housing market.

IQR take: it's not unusual for SPF to move 25% up or down after an event, or for no reason. We took a bullish stand recently, and our article yesterday stated our reasoning. After today's runup, it'll take a really great earnings report this quarter to go up 20% or so from here. The company is well positioned. Orange County's housing market is now probably a seller's market. Its median price has gone up the most in SoCal in recent months. Can the company take advantage of its cash and geographical position? We'll have to see tomorrow. Looks like the option traders agree with our bullish stance.


Monday, February 1, 2010

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.