Initiating Coverage on Homebuilders, Positive View on Sector

3/14 - "We have initiated coverage of the homebuilders with a 1-Positive sector rating. We have initiated with 1-Overweight ratings on D.R. Horton (DHI - price target of $18), Ryland (RYL - price target of $31), and Toll Brothers (TOL - price target of $27), with 2-Equal weight ratings on Centex (CTX - price target of $23), KB Home (KBH - price target of $24), Lennar (LEN - price target of $20), and Pulte (PHM - price target of $15), and a 3-Underweight rating on Hovnanian (HOV - price target of $8)."

"We expect homebuilding stocks to continue to be volatile for the next few months, as we do not believe that home sales have reached a bottom. However, we are forecasting new home sales trends to improve in mid-2008. As such, we believe there is meaningful upside potential for several stocks in our coverage during the next 12 months...we suggest that investors be selective and choose companies with healthier, conservative balance sheets and proven return histories."

"We believe that the key positive trends for the homebuilders include improving affordability, strong balance sheets and cash flow generation, and what we believe to be compelling valuation levels, even if more asset write-downs are on the way...Risks do remain in the sector, the foremost of which we see as the inventory oversupply in new and existing homes. We also expect 2008 to continue to be challenging for the builders from an earnings perspective, as orders and backlog signal a tough first half of the year."

"The average debt-to-capital ratio of the
builders is 42%, with several builders near or less than 30% net debt-to-capital ratios...With declining pricing and falling mortgage rates, affordability is improving...Homebuilders are trading at roughly 0.8x current book value (and 1.1x our 1-year forward estimated book value), roughly 50% less than their historical average...We believe that inventory oversupply is the largest problem facing the real estate market today. We estimate that there are a minimum of 800,000 excess homes (new and existing) in existence today. We estimate that it could take until early 2009 to work down new home inventories to historical equilibrium levels and until mid- to late 2009 to work down existing home inventories."

"We like Centex’s geographic diversification and the fact that it is pursuing a transparent pricing strategy, which we believe could be a positive not only for itself but for the industry, if successful...D.R. Horton (Horton) is the largest homebuilder in the United States (by closings) and has positioned itself as the low-cost provider of product in the space. We believe that this focus could help the company to recover to profitability faster than some other builders, given the company’s lower SG&A base...We have several concerns involving Hovnanian. First and foremost is the company’s balance sheet. At a roughly 69% debt to capital as of January 2008 and a low cash balance we are concerned about the company’s ability to maintain good standing with its banks and generate cash flow."

"KB has one of the strongest balance sheets in our coverage universe, with over $1.3 billion in cash on its balance sheet and a net debt to capital ratio of 32%. The company has a low supply of controlled land, which we believe could allow it to achieve more favorable margins in the next few years if the company is able to acquire land at depressed valuations sooner than other builders. On the negative side we are concerned about the company’s cancellation rate, which has been one of the highest in the space, and that its low land position could force it to enter the market for land before prices have an opportunity to adjust downward...Although Lennar is trading much less than its historical average multiple of roughly 2x book value, we believe it could continue to trade below historical averages for some time, given weak homebuilding fundamentals coupled with what we expect will continue to be a cautious view by the market around Lennar’s joint venture exposure. On the positive side, Lennar has recently been able to generate significant cash through its land sales and tax management strategies."

"Pulte Homes (Pulte) currently has more than $1 billion in cash on its balance sheet and no near-term debt maturities, providing us confidence that it can weather any near-term erosion in the market. We also like Pulte’s higher exposure to the active adult segment, which we believe has strong long-term growth potential. On the negative side, despite having taken the second-largest amount of charges in our coverage universe, the company maintains one of the longest owned land positions."

"Ryland has a relatively low land supply and we believe cut down on its land acquisitions ahead of some of the other builders, which has allowed it to take relatively fewer inventory write-downs thus far. We expect that the company’s conservative approach to land management is likely to be rewarded by investors over the next year or so, as the market slowly begins to recover...Thus far in the downturn, Toll has been able to maintain its pre-impairment gross margins at relatively high levels, which we believe will be a key differentiator once home sales begin to recover. In addition, we believe that the company’s balance sheet remains in solid shape, with a net debt to capital ratio below 30%. Given its focus on the luxury market, we believe that Toll’s pricing and inventory reduction strategy has not been as aggressive as many of the other builders but the company has still been able to generate positive cash flow."