Temple-Inland, Inc. (TIN), which makes paper, packaging and building products, was put on credit rating watch with a positive outlook by Standard & Poor’s.  The stock is up nearly 10% on the news Wednesday and it is also giving a boost to some of Temple-Inland’s competitors’ stocks.  S&P credits the company will reducing its debt load by $440 million over the last year, and said that if it can continue with its debt reduction plans it would be eligible for a credit upgrade to “BBB”.  While their efforts to reduce debt should be commended, it is a bit surprising that this announcement would be met with such enthusiasm by the market.

Temple-Inland was able to shave its debt in an environment that was certainly not hospitable to an important business segment, building products such as lumber and particle board.  Clearly, this segment is heavily correlated to the strength of US housing starts, which have been at extremely low levels over the past two years.  The company was able to utilize $175 million in alternative-fuels tax credits as well as $335 million in free cash flow in fiscal 2009, and rolled the majority of that into cutting down its debt.  What makes this especially impressive is that the company devoted these resources even though they did not have any significant amount of debt maturing until 2012.  It is clear that there were not a lot of great opportunities for TIN to invest in growth over the last year, so they were content to bide their time and strengthen their balance sheet.  This may not be the sexiest strategy for investors, but it should give them greater flexibility to pursue growth as better opportunities present themselves in the years ahead.

The company’s strong and disciplined execution over the last year as well as stabilization in economic conditions has allowed the stock to return over 400% over the last 52-weeks.  However, even after its impressive run, we are not yet concerned over its current valuation.  Aggressive cost cutting should make a quick rebound in profitability possible once housing starts do begin to pick up.  Its corrugated packaging business segment is somewhat more stabile, but it is still subject to commodity (lumber) price fluctuations which weigh heavily on margins.  An improvement in economic activity would increase the demand for Temple-Inland’s packaging products and would prove to benefit the bottom-line.

Both price-to-cash earnings and price-to-sales are currently well within their historically normal ranges, so as of yet, no red flags there.  Based on the current fundamentals, we see a price range of $18 to $26 as a reasonable to expect over the coming year, barring considerable further weakening housing environment or a double-dip hampering the US economy.  Temple-Inland has done a good job managing costs and lowering debt in a difficult environment, but after today’s appreciation the stock remains Fairly Valued.  There are certainly more attractive stocks available for value investors, but it is good to see a company getting credit for strong, conservative management in a tough market environment.

Residential construction firm Hovnanian Enterprisies (HOV) reported earnings after the close on Wednesday and reported a worse than expected loss.  Earlier in the day, Hovnanian rose more than 11% in Thursday trading in reaction to slightly better than expected housing starts data this morning.  Housing starts rose 8.9% to an annual rate of 574,000 homes, as the government extended and expanded the home buyers’ tax credit in the month.  However, the NAHB/Wells Fargo index of homebuilder confidence unexpectedly dropped from 17 to 16 in the month of November, which seems to fly in the face of the somewhat encouraging housing starts data.  Any reading under 50 on the index suggests pessimism on the part of builders, and of the 50 economists surveyed by Bloomberg, not a single one was predicting a decline in November.

Unfortunately for Hovnanian, they also had to report earnings on the day following this major advance in the stock and as a result the market was expecting to see improvement at 12 straight quarterly losses.  In fact, the results were far worse than analysts had expected, and HOV fell like a stone after hours.  Analysts set the bar relatively low, expecting revenue to fall 37% from a year ago contributing to a loss of $1.40 per share.  Actual results showed revenue slumped nearly 40% for a net loss of $250.8 million or $3.21 per share.  This setback confirms our fears that a recovery will not be as rapid for homebuilders as some would hope.

Management was quick to point out that the quarter showed some improving trends as net contracts improved from a year ago by 60%.  Furthermore, they believe they have purchased some attractive land at depressed prices.  The cancellation rate was 24% in the quarter, which is still high but improved from 42% a year ago. 

However, in the here and now, we cannot see anything to be encouraged by in the results as of the close of fiscal 2009.  Fundamentals have been crushed with revenue dropping by more than half and the company taking massive losses due primarily to impairment charges.  Ockham’s current stance on HOV is Fairly Valued largely due to the low price, and HOV is among our best rated in the residential construction industry as you can see from the chart to the right.  We continue to believe there is no reason in the fundamentals of these homebuilders that should encourage value investors to dive in.  From our view, these are mostly tools for speculators looking to play a rebound in the housing market.

On Wednesday we wrote a piece talking about the strange upgrade of Pulte Homes (PHM) by an analyst at Citigroup (C).  At that time (Upgrade Trumps Macro-Economics for Homebuilders), we reiterated our Overvalued stance on Pulte, the largest in the group thanks to its acquisition of Centex, as we have that stance on most homebuilder stocks right now.  In the analysts’ note he said that Pulte is “undeservedly out of favor,” but that seems to ignore the fact that their fundamentals have been decimated over the last two-plus years.  Furthermore, the recovery may come especially slowly to homebuilders in particular, as the supply overhang is just now starting to abate.  On Thursday’s Mad Money, Jim Cramer issued his own warning against the stock and put it in the sell-block.

“…Of the homebuilders, the worst house in a bad neighborhood is Pulte Homes. The largest homebuilder America now with Centex, into the sell block.… Yesterday morning Pulte was upgraded from Citigroup from a Hold to a Buy. Hence triggering why I wanted to do this piece tonight. I think that upgrade is totally nuts and I should know…

These homebuilders are still on very shaky foundations and business.” — CNBC’s Mad Money 11/20/2009

Cramer agrees with Ockham that even with the nascent recovery in the housing market, homebuilder stocks are still in a very tough environment.  He says that Pulte paid too much for its merger with Centex which only harms an already strained balance sheet.  Furthermore, he points out that Pulte’s target market, retirees, are probably the most spend thrift of any demographic right now with their retirement accounts getting whacked during the recession.  The picture only gets worse when you combine these factors with a worse than expected loss and cancellation rates high and only rising.

The day of the Citi upgrade all homebuilder stocks got a boost despite much worse than expected housing starts data.  However, Pulte has already given all of those short lived gains back and then some in just two trading days.  Clearly, this is one stock that both Ockham and Cramer agree cannot be bought at this time, and the upgrade from Citi is odd and lacks any bite.  See the chart to the right for a view of all the residential construction stocks that we cover.  It is clearly not a pretty picture as all of these have seen earnings and revenues fallen off a cliff, and asset values have been written down substantially to the detriment of shareholder’s equity.

This morning the Commerce Department released figures that homebuilding activity in the U.S. had unexpectedly fallen in October.  The reasoning was that increased joblessness in addition to doubts that the homebuyer tax credit would be renewed weighed on homebuilders.  Homebuilders slipped to an annual pace of only 529,000 homes which is 11% lower than last year and the lowest result since April.  Multifamily homes such as condos and townhouses slumped 35 percent, far more than single family homes.  Economists had expected to see a slight rise in homebuilding activity in the month, which only adds to the surprise.  Economists, always ready with an answer, pointed out that the wettest October in century could have been a factor.  Building permits also saw an unexpected drop to only 552,000 annual rate.

Homebuilder stocks were mostly unscathed by the news as investors took solace in the fact that the tax credits were indeed renewed which will hopeful further induce buyers into the market.  Pulte Homes (PHM) was among the most active of homebuilder stocks following an upgrade to Buy at Citigroup (C).  Citi raised their price target to $12 as the recent acquisition of Centex is a positive for the company and they were “undeservedly out of favor.”  The stock is trading 4% higher in afternoon trading on this gutsy call.

At Ockham we are reaffirming our Overvalued stance on Pulte Homes as well as many others in that peer group.  The company has seen new orders improve in the most recent quarter thanks in part to their merger with Centex, but there still remains a lot of risk in all of these homebuilders.  Pulte’s CEO Richard Dugas said that “the housing market is still choppy.”  He also said that he expects operating conditions will continue to be difficult through at least 2010. 

This month may be an aberration in the general trend of improvement in the housing market, and we sincerely hope that is the case.  However, we cannot ignore the fact that homebuilders enjoyed very profitable times as the rode the housing bubble up for better part of the decade.  During that time many parts of the country were overbuilt, and that supply overhang is only beginning to clear itself.  Foreclosures remain extremely elevated only adding to the supply glut.  At this time, we just do not see a compelling reason to invest in homebuilder stocks.

Today’s little bit of economic news which could be construed to indicate that the economy is “climbing out of the ditch” was a far better than expected jump in home construction for May.  According to the Wall Street Journal:

Housing starts increased 17.2% to a seasonally adjusted 532,000 annual rate compared to the prior month, the Commerce Department said Tuesday. Building permits rose; apartment construction surged. The 17.2% increase was much bigger than expected. Economists surveyed by Dow Jones Newswires forecast a 7.0% increase to an annual rate of 490,000.  Tuesday’s report on housing showed building permits in May increased 4.0% to a 518,000 annual rate. Economists had expected permits to rise by 2.4% to a rate of 510,000. April permits fell 2.5% to 498,000.

On the surface, while better than forecast results are to be welcomed in a struggling economy, a look behind the headline numbers indicates that it might be too early to declare and end to the problems facing the housing market.  While the decline in new housing completions fell in May for the third consecutive month and is down 29% year-over-year, in many parts of the nation, there remains a massive inventory of unsold homes (both single and multifamily).  Adding to this inventory glut–even modestly–is not necessarily helpful.  Furthermore, foreclosures continue at a record pace and it appears that this trend will only continue in many states for some time.  As more foreclosed homes come on the market, the inventory glut only worsens.  Also, mortgage interest rates have ticked up recently, which will likely have a negative impact on sales going forward.

Many builders report that any recovery in housing demand seen over the past few months is predominantly coming from the low end of the market, where government programs and tax incentives for first times buyers coupled with very low interest rates have brought out buyers.  However, in the upper end of the market, rising unemployment (which likely will continue for some time), a huge oversupply of units, tougher mortgage terms and higher rates for jumbo mortgages (above $470,000) make it highly likely that more pain is ahead.  Also, in many parts of the country, the glut of unsold multifamily units either on the market or soon to be is so extensive that it will take years to work through.

We do not wish to be overly negative in our assessment of the present economic situation, but the housing crisis, which played such a central role in driving the U.S. and global economy into the abyss, is not going to magically clear up overnight.  Too many Americans remain trapped in homes on which they owe more than they are worth.  The myth that homes always appreciate in value and residential real estate represents a solid path to wealth creation has been shattered, likely for a generation.  Like an athlete on steroids, over the last eight years, the U.S. housing market has been playing well beyond its natural means.  With those steroids now purged from the system, the artificially-induced excesses of the past are going to be more glaringly apparent as the housing market seeks its equilibrium over the next decade.

Governmental efforts to ameliorate this problem can only go so far and, to date, have made little to no impact.  Indeed, mortgage rates have inched up recently because of weakness in the dollar and U.S. Treasury bonds, which was sparked by concerns over excessive government spending.  Rising tax rates at the federal, state and local levels will only further diminish the consumer’s willingness to purchase a home.  Lastly, so long as unemployment numbers keep worsening–which many economists expect well into 2010–home values will remain under pressure and the beleaguered housing market will remain in a rut.