After yet-another disappointing building permits and housing starts update on Tuesday of this week, we were inundated with yet-another salvo of news commentaries stating the obvious…. with headlines such as Home Builders Continue to Struggle…”, and “Housing Starts Still Weak”. Fair enough.
The most amusingly-obvious (yet also irritating) story came from U.S. News & World Report … “Home Builders Not Driving Economic Recovery”.
There’s little doubt that homebuilders aren’t driving the recovery. The question is, are they even participating in the recovery? So far it seems as if they’re not - at least not in a meaningful way. Unfortunately, none of the recent news has quantified where homebuilders are now, versus where they were then, versus where they should be. That, however, comes as no real surprise, as that kind of journalism requires actual research beyond the latest economic report.
Since no other media members seem willing to paint a ‘big picture’ of the homebuilder plight, we will.
First Things First
A final good/bad assessment of the industry is below, but a couple of explanations are in order to explain the “why” of our digging before we get into the “what”. Let’s all first understand that:
- We know the peak of the real estate bubble was in 2005, but we need to know the relative size of the bubble before we start drawing comparisons to it…. something the media has yet to describe.
- We need to define an earnings-based ‘norm’ for homebuilder stocks if we’re going to say they’re overvalued or undervalued now.
- We need to understand the correlation between earnings and capacity of demand; we can’t reclaim 2005’s earnings levels on 2008’s demand for new homes.
See where this is going? Great. Then let’s get on with it.
At first glance all seems like it’s getting back to normal for the homebuilders. Though there are still plenty of them struggling, and presumably some of them won’t survive, we also see a few of these stocks limping their way back into profitability. Hope at last?
The ‘value’ argument lies in their current and forward-looking price/earnings ratio. Meritage Homes Corp. (NYSE:MTH), for instance, boasts a trailing P/E of 17.6, while NVR Inc. (NYSE:NVR) is priced at 17.08 times earnings over the last twelve months. Their projected (2011) price/earnings ratios are in the same high-teen area, as is D.R. Horton (NYSE:DHI) with a forecasted (2011) P/E of 19.5.
While not exactly on the cheap side, the figures are at least palatable, eh?
Well, no, not really. Were it any other industry we could say yes. For homebuilders though, that’s nearly four times the average pre-bubble (pre-2006) P/E of 5.17. (And yes, you read that right - the ‘normal’ price/earnings ratio range for homebuilders is between the number five the number six.)
How can it be so? There are a handful of reasons this group has traditionally been priced at the extreme low end of ‘reasonable’, most of which are beyond the scope of our discussion today. At the heart of the matter, however, is the reality of traditionally slim margins… in the 3% to 6% range.
Barring some sort of bizarre miracle, the normal profit margins in homebuilding aren’t suddenly going to improve, which in turns means investors are paying far more for profitability here than they ever have before - and they’re not being paid for the risk they’re assuming.
OK, fine, homebuilder stocks are expensive right now. But, what if these companies could at least start making a fraction of the kind of money they were making before the bubble started to deflate in 2006?
Well, that’s actually part of the problem…. they are doing much better now than they were doing three years ago, and it’s still only a fraction of the kind of money being made in 2005. See, 2005 wasn’t just a very good year for homebuilding - it was stunningly good year, on the same scale as the tech bubble in 1999 (though at least the homebuilders performed an actual service and did actually make real money for a short time).
The nearby chart puts it all into perspective. It shows the average earnings-per-share for the top eight - by market cap - stocks in the industry going all the way back to 2000. Between then and 2003, homebuilder earnings nearly doubled. By 2007 though, the losses being taken on an annual basis were bigger than the annual gains being made just four years earlier. In fact, in the aggregate, the industry is still losing money.
A few bad apples spoiling it for everybody? Nope, and just to prove it, we also added an earnings trend line just for the companies that were on pace to be profitable this year and next year (NVR, D.R. Horton, Pulte, Lennar, Standard Pacific). Even these ‘good’ ones are still well off their peak income levels. They’ll have to quintuple 2011’s expected earnings to match 2003’s records. The industry as a whole will need to do about ten times better than its on pace to do in 2010 to revisit 2003’s record earnings levels.
Yes, things are improving, but when you start taking about earning being multiplied by a factor of five, ten, or more, it’s time for a reality check. That’s just not in the cards for years to come.
There’s a Limit
While the recession has been named as the bulk of the problem with homebuilding, there’s another, largely unspoken, reality that’s not been addressed ….and it’s a much bigger problem the industry has been and will contend with forever - houses aren’t consumables.
When you run out of food, you buy more. When your car wears out, you buy another one. You don’t pay for cable televisions once and get it forever; you have to keep paying the bull to keep getting the service.
See the illogical nature of a ‘high growth’ homebuilding industry? The more houses that are built now, the less we’ll need built later. And, considering the inordinate number of houses built between 2001 and 2006, we may have adequate supply to last us for many, many more years.
That’s a slightly different message that what the media is spewing. They’re suggesting the huge supply of real estate is the result of would-be buyers being unable to get a loan. We’re saying the huge supply of real estate is just the result of a huge supply of real estate, and even an easier-credit environment can’t do a lot to solve that problem.
Though there is some data in support of the idea, conclusional cause/effect data is tough to muster. On the other hand, the media has only presumed that crimped credit is the underlying reason for the housing glut. Either way, housing demand is finite by default, and the closer that demand is to being 100% met, the worse it gets for new home builders.
Is there anything earth-shattering or surprising about these numbers? Probably not, though it’s always better to talk specifics when money is at stake….. something the media hasn’t done yet.
Regardless, it’s an important discussion to have, as the chatter surrounding a homebuilder recovery has become louder and more frequent. You may want to consider the facts presented above before jumping to any conclusions. Homebuilding stocks’ best potential results going forward are still apt top pale in comparison to the sector’s past, even if these companies do everything right.
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