As weather forecasters call for another active hurricane season this year, national home building company executives have to wonder whether the headwinds pounding the industry are getting stronger as well, leaving potential devastation in their wake. The laundry list of problems facing builders literally grows monthly and given the height from which the housing industry is falling, we view the carnage as far from complete.
Managements have done a respectable job navigating through the travails, some of which were self-inflicted, some not. Unfortunately, for many home builders out there, the worst is yet to come as high legacy costs combined with excess inventory, falling prices, and weak demand will squeeze operations mightily for the rest of 2007, and possibly into 2008. While the largest public builders talk incessantly about generating significant free cash flow during this period, the recent order trends call into question whether the cash flows will be as robust as discussed after the current backlogs are depleted and replaced with significantly smaller delivery volumes.
In other words, most builders are roughly cash flow neutral throughout a typical cycle, however, this cycle was not normal. Artificial demand levels caused builders to disregard capital discipline resulting in excessive land purchases at excessive prices, burning a tremendous amount of cash during the expansion phase of the cycle. As we are now firmly in the contraction phase of the cycle, demand could well fall farther than normal, thanks to the prior speculation, while the excessive land positions could cause development and carrying costs to be outsized versus normal downturns. In a nutshell, expect most large builders to be cash flow negative for this entire cycle.
To us, it seems inevitable that some large builders–including a few public home builders–become so financially stressed that managements either close the doors or sell to stronger, better capitalized builders. Land and communities will be sold at severely distressed prices, builders will violate debt covenants, liquidity crises will emerge and builders will be forced to sell out. In fact, we envision the overwhelming percentage of deals in 2007 will be deals of duress. It is also likely that many industry veterans from the baby boom generation will pack it in as the reality of 'it will never be that good again' sinks in. After prospering to an unimaginable degree during the first half of this decade, the time, effort, and sacrifice needed over the next several years to generate returns that are a fraction of previous years will likely be very unappealing to mature owners and senior executives, ultimately providing opportunities for merger and acquisition activity, though primarily in 2008.
As always, we are interested in the stock prices of the public home builders. It's often said that psychology moves the markets and that was definitely the case for the home builders over the last few months as the value destruction has been palpable.
Investors are painfully aware of all the headwinds we listed above, the culmination of which is a weak selling season and a weak equity performance by the group. We see no catalyst for the shares through the summertime and in fact believe that we could see valuations as low as any over the last 15 years if recessionary fears grow. However, we do hold out a modicum of hope that the fall will bring a focus on the possibilities of 2008 along with the anticipation of industry deal-making.
–Stephen East is former securities analyst at Susquehanna Financial Group. E-mail: firstname.lastname@example.org.