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.

Centex Corp. (CTX) reported an EPS from continuing operations of $.68, but the results were greatly improved by a $3.31 per share tax benefit.  Revenue was down 49% overall, and 47% in the home building operations.  Analysts had been predicting a loss of $1.17 on revenue that expectation was for a 50% drop from last year.  Technically, Centex beat estimates and after surging at first, shares are settling right about even in after hours trading.  Cost cutting saved the day yet again as the company said that it was able to lower SG&A costs by a whopping 47% or $135 million, the company reported net income of only $85 million in the quarter.  So, without the extreme cost cutting Centex would have certainly lost money in the quarter, even with the huge tax gain.

Centex has entered into a definitive agreement with Pulte Homes (PHM), which would have Pulte acquire all of Centex shares for .975 of PHM for each 1 share of Centex.  At the time, the merger was valued at $3.1 billion, including $1.8 billion of debt.  Also, this deal represented a 32.6% premium to the 20-day volume weighted average price.  Since April 8th when the two firms announced this agreement, it is not surprising that the stocks have traded pretty much in the same fashion.  The two firms have set the date of August 18th for a vote of shareholders on the proposed merger.  If accepted Pulte shareholders would own 68% of the company, while Centex owners would get 32%.

Over the last quarter, it appears Centex tried to make themselves as attractive to Pulte as possible.  As discussed earlier, they slashed costs and tried to horde as much cash as possible to lessen the impact of the debt that the combined company would incur.  They know these results will be fresh on the minds of both shareholders voting in two weeks.  According to our methodology both Centex and Pulte are Overvalued at this time, there has been simply too much destruction to earnings and revenue for us to stand behind either of these companies at this point.  We are starting to see some really positive signs that housing is stabilizing, but in our view there are certainly more attractive stocks in this market.

It is an interesting spot to be in for the shareholders of Centex.  Centex easily beat what the street had called for, and in the process was able to generate positive cash flow from home building operations, and yet the stock has not moved in after hours trading after an initial spike.  The reason is that Pulte also reported earnings that did not meet earnings expectations, but the quarter was not a loss as they were able to work through 42% of inventory.  The stocks are so intimately tied right now, and neither one has budged more than an hour after results were released.  Unless you foresee Pulte rising higher over the next two weeks after an uninspiring quarter, I would probably drop the shares now.  Especially if, as an owner of Centex, you think there is a chance that the merger will not be approved by Pulte shareholders, thus removing the 32% premium.

The National Association of Realtors pending home sales index increased by 6.7% to 90.3 in April.  This marks the largest increase in that measure in more than seven years and continues a streak of three straight months of strengthening data.  Pending home sales is regarded as a leading indicator because it tracks the number of contracts signed, however this does not always translate to a completed transaction.  Polling of industry analysts had yielded consensus expectations for a gain of only .5%.  Housing is comparatively more affordable now than any time in recent history as housing prices have fallen, mortgage rates hit historic lows, and the $8,000 tax credit for first time home buyers contained within the stimulus plan have all made buying a home more attractive.

Even though pending home sales have improved consistently over the past few months, as of yet existing home sales (recorded when the sale closes) have been much more volatile.  Existing home sales were lower in February, increased in March and only slightly increased in April by about 2.5%.  The disparity between the pending home sales and existing home sales suggests that mortgages are tougher to come buy as banks have tightened their lending standards.  This seems to correlate with recent data suggesting that lenders have not yet resumed lending at a historically normal pace.  Either potential home buyers are taking longer to approve or are not being approved at all.  However, as Brian S. Wesbury and Robert Stein of First Trust Advisors suggest bank lending is a lagging indicator, but their analysis focuses on commercial and industrial loans to businesses rather than mortgage loans.  It would make sense that banks would be more conservative in their mortgage lending practices as well, as capital preservation is still at a premium right now.

The important point in this data is that it shows demand is starting to be pulled back into the housing market.  It is on this news that homebuilders are getting a boost; as Hovnanian  (HOV) leads the pack up 10% while DR Horton (DHI), Toll Brothers (TOL), Pulte Homes (PHM) are all up as well.  However, as you can see from our chart of the Residential Construction sector, we are not at all positive on the stocks in this sector.  There has simply been to much of a degradation in earnings and too many balance sheet damaging write-downs that shares have not fallen enough to justify us getting more positive on them.

Furthermore, there is still a huge overhang of supply of housing in the market, and the combination of housing starts having declined very rapidly and this renewed demand is the only way to bring the market back into something of equilibrium and stop the destruction of housing prices.  In April, fueled by a record month for foreclosures housing inventory increased 8.8% to almost 4 million existing homes available for sale.  That represents more than 10 months of supply given current pace of sales, but the initial buyer’s interest is being drawn into the market which is at least an encouraging sign. 

It will be very interesting to see how the rise in mortgage rates will effect these developments going forward.  The average 30-year mortgage rate has increased to 5.32% from 4.94% just a month ago.  This data is an good sign, but it is still too early to tell if housing is turning a corner.  Either way, the earnings potential of homebuilders in an environment where supply is still hanging over the market, makes us want to steer clear of those stocks.

The housing crisis is where the financial meltdown started and some analysts speculate housing is where the recovery must begin. Implosion of the subprime and “Alt A” mortgage markets (loans made to lower-quality borrowers) began the painful decline in property values that continues as many regions of the country have a gross oversupply of housing inventory. Until this imbalance in the supply and demand equation is brought down to more reasonable levels, expect continued downward pressure on residential real estate values and continued pain for the overall economy.

The crisis that started in housing has rippled out into nearly every facet of our economy—and that of the world as a global recession appears underway. It should come as a surprise that while the S&P 500 is down 38% for the year and the Dow Jones Industrial Average has lost a third of its value, the stock of luxury homebuilder Toll Brothers (TOL) is down only 9% during the same time period. Seriously, just 9%! TOL has swung wildly over the last year but somehow has largely remained relatively unscathed. It’s not that business has been booming, far from it: Toll Brothers reported earnings today that show just how bad things are. Revenue dropped 41% from last year and the company declined to give any sort of earnings guidance going forward. With housing starts at multi-year lows, the company reported that its backlog of business fell 54% to $1.33 billion from $2.85 billion. Total contracts also fell 27% since last year. While everyone would like to see a bottom in the housing market, judging from TOL’s latest quarter, we are not going to see one anytime soon.

^{In a blog posted June 4th}, we wrote about the CEO of Toll Brothers calling for government action to stem the misery in the residential real estate market. He is still waiting for a “bail out” and conditions continue to deteriorate. Today, Robert Toll called again for a government lifeline (take a number!!!) saying, “We believe the government’s attention should be focused on shoring up the housing market, which is the root of the current financial crisis.” We said it then and we will repeat it now, it is doubtful that the government is going to bail out homebuilders. The origins of this crisis are many but builders like Mr. Toll must take some of the blame as overbuilding created the overhand of inventory which is so problematic now. Thus, builders should have to endure some tough quarters and not encourage government action which will only delay the inevitable reckoning in the marketplace.

Frankly, it is a surprise to us that Toll Brother’s stock has not been hit harder considering its abysmal results and no guidance going forward. The stock didn’t even react negatively to today’s results and is actually up slightly versus the broader indices, which are negative. To be fair, the stock did take a nose dive from mid 2005 through the middle of 2006, but its performance has been virtually flat since then. Is it possible that the market accurately priced in a meltdown in the housing market almost two years ago? We think not, which is one of the factors which led us to downgrade TOL to an Overvalued rating in this week’s report.

We believe that the fundamentals simply do not justify this price, especially in this bear market. It is certainly uncommon in this market for a stock to be trading at levels that are above its historical valuation metrics. For example, over the last 10 years TOL has normally traded between .61-1.17 times revenue, but its current price-to-sales number is slightly higher at 1.18x. This overvalued condition is more pronounced when looking at price-to-cash flow. Historically speaking Toll Brothers has traded in the range of 13.47x to 25.7x for price-to-cash flow but the current level is 28.6x.

Generally, we are contrarian investors and believe that the market has overreacted negatively to many of the stocks we follow. However, we believe that in the case of Toll Brothers and other overvalued homebuilders (PHM, LEN, DHI) that the market has not dealt with them harshly enough for their severely crippled businesses with little near term hope of recovery.