A Follow-up On Housing…

| March 9, 2010 | 0 Comments

In early February, I reported on two big movers in the homebuilding industry… DR Horton (DHI) and Beazer (BZH).  Both companies were announcing huge blockbuster earnings.

The earnings were all fake.

They were created by accounting and tax gimmicks.  Anyone looking closely at the numbers could see it clearly.  Regardless, both companies reported huge earnings and the stocks moved higher.

But there was a problem.  These fake earnings were clouding the real status of the homebuilding industry.

At the same time these fake earnings were announced, a number of positive news announcements were hitting the press.  These data points have nothing to do with company performance… but they have potential to drive the entire industry higher.

One key data point is mortgage applications.

The number of new applications jumped in January… due in part to the government’s generous $8,000 tax credit.

As a result, pending home sales also rose sharply.

But here’s the thing that sold me on the potential recovery… many of the homebuilders said cancellations fell and new home orders rose.  This showed a significant trend change over what had been happening in the prior 24 months.

I’m not the only one seeing a major change in trend.  Just look at the industry performance… it’s been spectacular.

XHB vs. SPX Chart

This chart shows the performance of the homebuilders as a group since the beginning of the year.  I also added the S&P 500 index as a comparison.  As you can see, the homebuilders are up 10.8% since the beginning for the year… while the S&P 500 is up just 2.2%.

Homebuilders are outperforming the general market by a whopping 4.9 times!

Remember, the stock market is always forward looking.  Clearly, investors are expecting big improvements in the homebuilders industry… otherwise they’d put their money elsewhere.

Even Warren Buffett is a believer in housing.  In his most recent letter to shareholders, Buffett said housing industry problems “should largely be behind us” within the next year.

Now I told you I’d identify my favorite play in this industry.

Believe me, it wasn’t easy.

Most of the big homebuilders cluster around a Price/Sales valuation of 1.0x.  The high end of 1.9x was Toll Brothers (TOL) and the low end was KB Homes (KBH) at 0.73x.

None of the companies had cash to debt ratios that were out of whack. Some were at the .50 level… meaning cash was half of long term debt… and a number had even higher ratios.  But none drew my attention.

Now you’ll note I only focused on stocks over $1.0 billion in market cap.

While smaller companies may offer bigger potential gains, this industry is risky enough.  I’m looking for a combination of big potential gains and low downside risk… hence the focus on cash and debt.

I had to dig a little deeper since no company really stood out.

When I dug deeper on Pulte Homes (PHM), I found what I was looking for.  The company has a middle of the road Price/Sales ratio (1.05x) and a conservative cash to debt ratio (0.50x).

In the heart of the collapse, Pulte bought a big competitor.  Their acquisition of Centex gives them a much needed exposure to entry-level and first time home buyers.  It allows the company to diversify away from the adult communities that were a primary focus.

In addition to expanding the market opportunity, the company is estimating $440 million in expense savings from the merger.  They’ll get an additional $150 to $200 million in purchase savings as well.

Estimates call for top line revenue growth of over 30% in 2010.

Despite all these positives, analysts still expect the company to generate a net loss of ($0.44) per share for the year.  I think this estimate might be overly aggressive to the down side given all the positive momentum, cost savings, and industry improvements.  The estimates look too soft to me.

Nevertheless, a low estimate can work to your advantage.

It puts Pulte in the perfect position to deliver an upside surprise.  All in all, I think the homebuilders are setting the stage for another run.  My favorite way to play the trend is with the homebuilder ETF.  But if you’re looking for just one stock to play, give Pulte a closer look.

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Category: Real Estate

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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