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Home Builder Stocks Are No Bargain

Five Home Builders to Avoid

By

As the New Year begins, it's worth pointing out that it wasn't that long ago that all of the housing bulls could fit into a telephone booth... and there would have been plenty of room to spare.

Today is a different story.

Now that housing has "stabilized," it seems as though the housing bulls have begun to poke their heads out of their holes again.

Fresh off of some decent data points in the Case-Shiller Index, they insist that housing has finally bottomed.

Never mind that the index still shows a year-over-year decline of 7.3%. The ninth consecutive month of improvement is what has them pounding the table that home prices won't go lower.

It has these bulls all giddy, looking to re-inflate the bubble.

As a result, that has put home builder stocks back at the top of their buy lists, as they scramble to put Humpty Dumpy back together again in 2010.

Unfortunately, this is still a sector where even all of the king's horses and all of the king's men won't be much help, since the fundamentals of the industry still leave these stocks heavily overvalued.

That actually makes the homebuilding industry one of the worst sectors for investors in 2010 — not one of the brightest.

Home Builder Stocks Are No Bargain

You see, beaten down or not, home builders aren't exactly a bargain these days — even at their current depressed levels.

Here's why: At the height of the housing bubble, home builder stocks reached the zenith of this fantasy, much like certain tech stocks of an earlier bubble. As such, they carried P/Es and profit margins that were simply off the charts.

Take Lennar Corporation (NYSE: LEN), for instance.

One of the nation's biggest builders, Lennar Corp. carried a P/E as sky-high as 14.10 at its peak. What's more, fast rising prices allowed the company to book margins as high as 9.7% during the run-up.

Those are numbers are historically unheard of, but were typical of what was going on in the industry as Wall Street touted these companies as growth stocks instead of the cyclical companies they have always been.

However, when you eliminate the distorting effects of the housing bubble on these companies, home builder stocks have historically carried price-to-earnings ratios of 5-8 on margins of 3%-6%.

Those are "normal" valuation metrics the housing bulls would have you ignore, as they work to pump up these value traps. The result has been an overvaluation of these companies that continues to this day... even though these stocks are once again being touted by some as "bargains."

Meanwhile, according to the historical analysis, the sector still has an average risk of about 30% to the downside as gross revenues stagnate, margins shrink, and their P/E's return to "normal."

5 Home Builder Stocks To Avoid

In fact, here's what that same historical analysis shows using these metrics when it's applied to five of the nation's biggest home builders.

In short, it leaves you wondering...where's the value? And for kicks, I even worked under the assumption that these companies would turn a profit in 2010, which is about as likely as the DOW returning to 14,000.

Here's the breakdown:

Hovnanian Enterprises, Inc. (NYSE: HOV) — $3.92/share

  • Avg. 5 yr. Pre-Bubble Profit Margin...........................3.62%
  • Avg. Pre-Bubble PE................................................5.84
  • Estimated 2010 sales.............................................$1,500,000,000
  • Estimated Net Profit 2010 @ 3.62% margins...............$54,300,000
  • Estimated EPS 2010..............................................$0.70*

Implied 2010 Share Price........................................$4.11

* Analysts currently estimate HOV be -3.61/share in 2010 and -2.24 in 2011

Lennar Corporation (NYSE: LEN) — $13.56/share

  • Avg. 5 yr. Pre-Bubble Profit Margin...........................6.18%
  • Avg. Pre-Bubble PE................................................7.47
  • Estimated 2010 sales.............................................$3,170,000,000
  • Estimated Net Profit 2010 @ 6.18% margins...............$195,906,000
  • Estimated EPS 2010...............................................$1.07*

Implied 2010 Share Price........................................$7.99

* Analysts currently estimate LEN be -0.80/share in 2010

Pulte Homes, Inc. (NYSE: PHM) — $10.35/share

  • Avg. 5 yr. Pre-Bubble Profit Margin...........................4.18%
  • Avg. Pre-Bubble PE...............................................5.95
  • Estimated 2010 sales............................................$5,480,000,000
  • Estimated Net Profit 2010 @ 4.18% margins..............$229,064,000
  • Estimated EPS 2010..............................................$0.60*

Implied 2010 Share Price.......................................$3.58

* Analysts currently estimate PHM be -0.46/share in 2010

DR Horton, Inc. (NYSE: DHI) — $11.50/share

  • Avg. 5 yr. Pre-Bubble Profit Margin..........................5.26%
  • Avg. Pre-Bubble PE...............................................6.4
  • Estimated 2010 sales............................................$4,040,000,000
  • Estimated Net Profit 2010 @ 5.26% margins..............$212,504,000
  • Estimated EPS 2010.............................................$0.66*

Implied 2010 Share Price.......................................$4.28

* Analysts currently estimate DHI be -0.43/share in 2010 and +0.55 in 2011

Beazer Homes USA, Inc. (NYSE: BZH) — $4.82/share

  • Avg. 5 yr. Pre-Bubble Profit Margin.........................3.2%
  • Avg. Pre-Bubble PE..............................................6.06
  • Estimated 2010 sales...........................................$1,010,000,000
  • Estimated Net Profit 2010 @ 5.26% margins.............$53,126,000
  • Estimated EPS 2010.............................................$0.93*

Implied 2010 Share Price......................................$5.64

* Analysts currently estimate BZH be -2.72/share in 2010 and -0.80 in 2011

So are the home builders attractive at current levels?

Well, hardly... if you take a realistic look at their future numbers.

In fact, at this point they still look like they are nothing more than dead money value traps.

And that doesn't even take into consideration the fact that interest rates have no where to go but up; the shadow inventory that is about to be dumped on the market; and persistent double-digit unemployment.

Maybe that's why confidence among U.S. homebuilders unexpectedly fell in December to 16 on the index — its lowest level since June. That's a long way from its earlier peak of 72.

Besides, the path to profits usually isn't found anywhere in the rubble of the last bubble.

After all, it's a lot easier to create bubbles than it is to pump them back up again — although I'm sure the bulls will keep on trying.

Your bargain hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

P.S. If you want to jump on the next bandwagon instead of the last one, the biotech sector is one of my top industries for the next decade. And this is a bull market that is just beginning — not one that has seen better days. To learn more about how to cash in on the next wave, click here.

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