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As industry participants and observers well know, for most builders, the spring selling season makes or breaks the year. After the meltdown in housing demand over the past year, this year's spring selling season is the most critical season in many years. If downward trends in both demand and pricing continue through this February-to-May period, and if swollen cancellation rates and heavy incentives don't moderate, it could well make or break entire companies.

For the large public builders, the stakes are obviously less perilous than for smaller, less well-capitalized private builders, but this is a critical time nonetheless. Deliveries for the Big Five–Centex Corp., D.R. Horton, KB Home, Lennar Corp., and Pulte Homes–have grown about 85 percent in the last five years (in excess of 13 percent a year).

Unfortunately, virtually all the big builders accumulated land positions at an even faster rate because they began assuming that the unprecedented sales rates would continue for several more years. This land grab turned out to be the classic bubble mentality among its participants, who fell prey to the belief that absorption and price appreciation rates never achieved before were the new paradigm, validating massive land purchases at exorbitant prices.

And just as the land buying frenzy reached its peak, orders slowed precipitously as cancellation rates skyrocketed. The Big Five's unit-order rates declined a whopping 25.8 percent in the most recent calendar fourth quarter versus the prior year, while the cancellation rate jumped to 37.4 percent from 24.4 percent the prior year. Industry watchers needed neck braces as builders raced to dump land deals that just a year or so earlier were priceless. Consequently, investors have been treated to large and repetitive land charges.


So what does all that have to do with the vaunted spring selling season that's just underway? Well, it sets the stage for a potentially mediocre four-month patch.

First, the largest builders worry that they still control too much land. Many will deliberately burn through lots at virtually any price. Second, cancellation rates have produced a surplus of finished inventory that builders are also apt to discount significantly to convert to cash. Currently, among the largest builders, anywhere from 25 percent to 50 percent of vertical inventory, finished or unfinished, is speculative inventory. Third, the very weak order rates of prior quarters not only trace back to high cancellation rates but also reflect weak underlying demand from consumers. (Gross orders are down 9.2 percent in the fourth quarter.) If consumers don't move faster off the sidelines, it is easy to envision negative order rates throughout the selling season, even if cancellation rates come back to earth.

Stephen East One big concern? A slow start to the season. It's quite possible that a slow start could stimulate a fresh round of price cuts and increased incentives. This action would once again squeeze profitability for large and small alike, producing another tidal -wave of land charges that could completely wipe out earnings for several bigs and cause financial distress among smaller builders.


So now that we've painted that "bright' picture, we want home builders–especially their management teams–to recognize the above scenario does not have to unfold. If the largest builders in various local markets recognize that their assets do contain significant embedded value and consumers do treasure quality and value, then competing on something other than price will keep the markets stable, while still allowing builders to convert assets to cash in a rational way.

As bad as the fourth quarter was for the large publics, it was still slightly better than the third quarter. So far in 2007, the general trends are ever so slightly improving. It's up to the market participants.

–Stephen East is former securities analyst at Susquehanna Financial Group. E-mail: