Street Patrol
Recent articles:
• BlackBerry maker's stock is ripe for picking, 12/1/2005
• A hot retailer on sale for Christmas, 11/30/2005
• What bankruptcy would mean to GM, 11/23/2005
More...
| | Street Patrol
A last hurrah for the home-building rally?
Toll Brothers posted blowout numbers for the fourth quarter, but the future isn't quite as rosy. It might be time to cash out.
By Robert Walberg
In what is becoming a familiar refrain, Toll Brothers posted blowout earnings in the fourth quarter only to sound a cautionary note on fiscal year 2006 sales and earnings. Another leading home builder, Hovnanian Enterprises (HOV, news, msgs), issued similar news earlier in the week.
While the sector managed to rally a bit in response to Toll Brothers' (TOL, news, msgs) earnings, investors are beginning to wonder whether the five-year rally in the home building sector is finally nearing an end.
From the numbers alone it's tough to make a strong case against the housing sector, at least now. Toll's earnings rose by nearly 90% in fiscal 2005 on a 50% rise in sales, and its backlog rose 36% to a record $6 billion, or 8,805 homes. It was the company's 13th straight year of record profitability. The rest of the sector has posted similarly strong numbers.
Even looking forward, the sector doesn't appear to be in bad shape. At the high end of Toll's earnings range for next year, the company would grow its bottom line by 10.3%. As for the overall industry, the Street expects earnings to grow by an average of 12.6% next year. Not bad, especially considering that the average multiple on forward earnings estimates is a relatively modest 6.3 times -- well below the market multiple even though growth rates are similar.
What's the bad news, then?
So, why all the negativity surrounding the housing sector these days? Well, for one, the growth rate is slowing considerably. While next year's projected earnings growth of 12.6% is good, it's a far cry from the 41% estimated for fiscal year 2005. More importantly, the estimates for fiscal year 2006 are starting to come down a bit, marking a reversal of the pattern of rising earnings estimates seen throughout the industry over the last several years.
More from MSN Money
What's causing the industry to adopt a more cautious tone going forward? The simple answer is that demand is finally beginning to wane. Whether you blame it on the Fed rate hikes, higher oil prices, the hurricanes, the ongoing war in Iraq and/or mounting consumer debt, the fact is that housing demand is slowing. Just the other day, the National Association of Realtors indicated that pending home sales in the U.S. fell 3.2% in October and was at the lowest level since March.
One contributing factor to the drop-off in demand is reduced speculation in the housing market. Softer demand in recent weeks, particularly in once red-hot markets such as Phoenix and Las Vegas, has made it more difficult for speculators to flip houses quickly and profitably.
Consequently, there's mounting anecdotal evidence to suggest that the rapid pace of real estate speculation is finally beginning to slow. While speculators account for a relatively small percentage of sales, any reduction will hit the sector on the margins and could cause still generally optimistic sales and earnings forecasts for next year to be adjusted lower.
Reduced speculation will also take some of the pricing premium out of the market. We're already seeing prices flatten out or decline slightly in formerly hot areas such as the Northeast and Pacific Northwest. Major metropolitan areas are also reporting a leveling off in the rate of price growth after nearly three years of unprecedented increases.
Profit margins could take a hit
The gradual erosion in home pricing, combined with rising costs of building materials, has begun to take a toll on profit margins. Operating margins at Toll Brothers were weaker than expected, as were Hovanian's gross margins. Should margins continue to come under pressure, earnings estimates for next year will continue to come down.
Slowing demand, rising inventories and steadily higher interest rates do not make for a compelling investment story, regardless of the group's potential profit growth and discounted valuations. The housing sector is at an inflection point and from this point forward the news cycle is likely to lean negative rather than positive.
Relatively low valuations might keep the sector from entering a freefall off current levels, but investors should note two things. One, during downturns valuations for the sector traditionally fall to the mid-single digits. This suggests that there's still room on the downside even at today's profit estimates. Two, if pricing continues to erode and margins come under additional pressure, earnings estimates will be coming down. Consequently, either valuations will go up or stock prices will fall -- and in a sector being hit with more bad news than good I think it's relatively easy to predict which of these is the more likely outcome.
So while the market is bidding the home construction sector higher in the aftermath of Toll Brothers earnings report, the smart move is to sell into the gains as the glory days are over and tougher times are ahead. Those stocks likely to get hit the hardest over the next few months because of the combination of decelerating growth and deteriorating technicals include Pulte Home (PHM, news, msgs), Centex (CTX, news, msgs) and The Ryland Group (RYL, news, msgs).
At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.
|
