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Tickers in this Article: MTH, TOL, DHI, BAC, CHCI, LEN, MDC, NVR, SPF, WCI
After a truly amazing run for homebuilders in the wake of the Greenspan Federal Reserve's "Great Money Giveaway" of 2002 with 1% fed funds, homebuilder stocks began to take pause last fall. Even in the presence of this decline, Scottsdale, AZ-based builder Meritage Homes (MTH) encouraged significant analyst bullishness, as it expected to increase revenues by almost 30% to $3.9 billion and pushed 2006 EPS estimates up to $11.25-11.50. Government statistics reported a 10% rise in average home prices in the U.S. during 2005 and prices continued to be reported as "rising" even as late as Q2 2006.


Since last fall, Meritage shares dropped by two thirds through the summer sell-off, but its recent rebound to the $45.00 level was a signal to sell off the stock, as it appears to be overvalued.

What's apparent with this sector is that the "hard landing" scenario is unfolding. In mid-August, Bank of America (BAC) warned that housing affordability was more stretched in Q2 than it has been since 1990, and said that many homebuilders such as Comstock (CHCI), Lennar (LEN), MDC Holdings (MDC), NVR (NVR), Standard Pacific (SPF), WCI Communities (WCI) and Meritage Homes have the most exposure to housing markets with "stretched affordability".

Meritage is particularly vulnerable as a California and Southwest-focused builder, as for-sale inventory has surged in those regions and average housing prices have wildly exceeded local incomes in key MTH markets such as Phoenix and northern California. The builder's response of offering incentives to buyers such as rate subsidies, free televisions or media rooms, leased autos or appliance upgrades have amounted to up to 10% of selling prices, but are not factored into reported new home sale prices. This type of artificial stimulus failed to prop the U.S. truck market in 2005 and it's failing miserably in the resale housing market as cancellation rates soar.

MTH has cash flow and governance problems on multiple fronts. First, its co-CEO John Landon resigned in May after MTH increased its credit facility by a third to $800 million and added an additional $250 million "accordion" facility. In mid June, MTH bought back 1 million shares from Mr. Landon for $52 million and another director, Bill Campbell, who resigned that same day, in advance of a company warning of a sharp business slowdown.

MTH announced a $100 million share buyback two months later, just days after it expanded its revolving credit facility to $850 million. On September 18th, MTH again warned for the current quarter just two months into it. Net new orders for 1,261 homes were off 38% compared to July and August a year ago, as order cancellations of 38% compounded a 21% decline in gross orders during the two months.

Order backlog at August 31, 2006 stood at 5,451 homes, down 23% from the prior year, and falling fast. MTH's CEO Steven J. Hilton told only part of the story when he explained that, "demand has slowed and resale inventories have risen in many markets, making it more difficult for our buyers to sell their existing homes, and in turn causing higher cancellations and inventories industry-wide."

Moreover, a loser's game cycle is now underway, "home builders are offering greater incentives to reduce resulting inventories, pressuring prices and margins on top of slower sales," Hilton warned. New home supply increases are finally slowing as the Commerce Department reported this week that annualized home starts fell a deeper-than-expected 6% in August to the lowest rate since April 2003.

The ominous reality for the homebuilders' "value buyer" cheerleaders is that impending deep writedowns of homebuilder inventories will chop the book values that supposedly support the current stock prices. By accumulating unplanned for and unwanted inventory as their backlog diminishes, these "homies" are suffering from a collapse in gross orders, foreshadowing a significant erosion of revenues and net income and continued negative cash flow through the foreseeable future. And the more vertically-integrated homebuilders that are "land bankers" will have to write down the carrying value of the land and land purchase options on their balance sheets.


Recently, the executives of two other high-end builders, Toll Brothers (TOL) and D.R. Horton (DHI) lamented. Robert Toll, CEO of Toll Brothers said at the early September Credit Suisse housing conference that "the market got ahead of itself in recent years," citing "greed on the part of buyers and sellers, and that the current level of speculative inventory is probably the largest ever." Don Tomnitz, CEO of D.R. Horton elaborated, "We have never seen housing prices and demand slow as quickly as they have during this down cycle."

Uh oh! The fallout of the desperate mortgage brokers, real estate attorneys, insurance brokers, title companies and subcontractors trying to return to 2005 business levels will be that many will fail and many will close up shop. This week, the National Association of Home Builders said its confidence index declined for the eighth straight month in September to the lowest level in 15 years.

An eighth of sub-prime credit borrowers were late payers on their mortgages during Q2, the highest level in three years, while foreclosures on sub-prime adjustable rate mortgage (ARM) borrowers are now in double digits in the Midwest. This is called "the multiplier effect" and it works in reverse -- the U.S. will officially "enter" a recession in mid 2007 as the ramifications of these job losses hits. So with this in mind, I'd hold off on this sector until the smoke clears before trying to "bottom fish" the homebuilder stocks.

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