Unlike much of the market, most of the homebuilder stocks have continued to rally this year, albeit bumpily, despite renewed concerns about the pace of economic recovery amid fear of contagion from the European sovereign debt morass. The rally is primarily due to the stronger-than-expected earnings that many of the companies have reported this season, which is giving investors some hope that these stocks will be good bets in 2010.
While new home orders have increased in recent months and the pace of housing starts is expected to accelerate, the reality is that the housing market continues to be heavily reliant on government stimulus initiatives affecting everything from mortgage rates, sales of homes to first-time home buyers, and the pace of bank foreclosures. One example: Demand for new homes dipped temporarily in late 2009, until prospective home buyers heard that a tax credit aimed at stimulating home sales had been extended into the first half of 2010.
In a Feb. 12 research note, Daniel Oppenheim, an analyst at Credit Suisse Equity Research, predicted that orders for new homes would be concentrated in the February-to-April period, with the extended tax credit creating urgency among buyers. He estimated a 21% increase in orders in the first quarter, slowing to 5% growth in the second quarter, a decline of 4% in the third quarter, and then growth of 13% in the fourth quarter. Mortgage rates will probably climb modestly after the Federal Reserve stops purchasing mortgage-backed securities at the end of March, according to his note.
Oppenheim's biggest concern is that a recovery in the housing market will be muted by a continuing flow of foreclosure sales.
"We don't necessarily need to see the economy worsen that much," he says. "We just need to see more of those homes that are delinquent or in the early stages of foreclosure go fully through the foreclosure process." Oppenheim estimates there are five million homes for which owners are either severely delinquent in mortgage payments or that are already in the foreclosure process. "The challenge is that this pent-up supply will limit pricing upside in the next several years," he says.
Macquarie Equities Research analyst Kenneth Zener says he expects distressed home sales to be kept near the 2009 pace—1.8 million—over the next three years, because of efforts by the government and banks. But he believes government programs, such as the Federal Home Affordable Modification Program (HAMP), have only delayed and not solved issues around negative equity, which require some principal forgiveness.
Zener, in a Jan. 19 research note, reaffirmed his outperform rating on the homebuilder sector, based on his assumption that housing starts will rise off the record low in 2009, to around 900,000 by 2012. That's likely to occur as long as a slow job recovery helps the market absorb about 5 million foreclosures over the next two years, he said. His top picks for 2010 are D.R. Horton (DHI) and Ryland Group (RYL), which he expects to post more robust earnings than their peers, largely on lower general and administrative (G&A) costs.
Zener says he plans to use three tests to differentiate between homebuilders over the next two years: How successfully they cycle out of legacy assets, how effectively they use their surplus cash, and the extent to which increases in sales volume help them absorb G&A costs. He expects net debt levels for the group to fall from the current 33% to 26% by 2012 as modest growth rates limit capital spending. Margin growth for most builders will come from nearly equal parts gross margin and G&A absorption, his report said.
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