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September 29, 2006

Housing Remains Under Pressure
by Chad Hudson

Existing home sales dropped slightly in August to a 6.3 million unit annualized pace. The median price dropped to $225,000, 1.7% less than last year. This was the first drop in the median price since the data series started in 2000. Inventory continued to climb. The number of homes for sale increased 57,000 to just over 3.9 million. This represents 7.5 months of supply. Most of the sales weakness was in the West where sales fell 2.3%. Interestingly, the West was the only region where the median price increased from the previous year, albeit 0.3%.

New home sales in August rebounded from July, but July's sales were revised lower. August sales were at a 1.05 million annualize rate, slightly higher than the 1.04 million expected, but July sales were revised to 1.009 million from the 1.072 million previously reported. The weakest area was the West with sales falling 18%. The number of homes available for sale fell by 2,000 units, but remains 19% higher than last year. Similar to the existing home price, the median new home price fell 1.3%. This was the first drop since December 2003. Lower prices have likely kept home sales from faller further.

Lennar reported third-quarter results that exceeded analysts' estimates, but were 37% lower than last year. Sales increased 20%, which was comprised of a 19% increase in deliveries and a 3% increase in price. While deliveries increased, net orders dropped 5%. The West experienced that largest drop in net orders, down 18% year-over-year. Lennar's cancellation rate jumped to 30.5% from 16.5% last year. The backlog also declined. The number of homes in the backlog dropped 11% and the value of the backlog dropped 14%. The average price of a home in backlog fell 6% from a year ago and 3.5% from the previous quarter. Additionally, the company said that the average price of a home thats contract was signed during the quarter dropped about 16% from last year. Higher use of incentives caused gross margin to drop 760 basis points to 18.7%. The company did lower fourth quarter guidance to $1.00 to $1.30 per share, significantly below the consensus estimate of $1.60 per share. During the conference call, the company provided color on the market.

Primary purchasers are either on the sideline or demanding better pricing before purchasing. Customers in backlog are also demanding concessions or are walking from deposits.

Furthermore, it is unclear today whether or not there is another shoe to drop. Questions remain as to whether the economy will weaken in a housing-led recession or perhaps the supply and inventory overhang can be - will be exacerbated by the resetting of mortgage rates on the many adjustable rate mortgages that have fueled the market over the past years. Rate adjustments are creating payment stress concurrent with home prices falling and equity evaporating, but with interest rates now trending downward, it's hard to say what lies around the corner.

What is clear is that supply and demand have shifted and are shifting in many markets more rapidly than expected and the inventory overhang will have to be absorbed before conditions normalize. Home pricing is in the process of being recalibrated in many markets through the use of incentives, broker commissions, and price reductions, and the industry is being challenged to recalibrate home prices and land values as well.

While earnings have obviously been impacted from the slowdown in residential housing, future earnings have become much more risky. Over the past several years, each of the homebuilders had a backlog that was equal to two-to- three quarters worth of projected sales. Lennar's most recent backlog does not cover the sales projected over the next two quarter. Analysts expect revenue to total $6.6 billion over the next two quarters and the backlog equals only $5.6 billion. Last year, analysts were anticipating revenue of $8.0 billion and the backlog was $8.1 billion.

Lennar is not the only homebuilder that is lowering prices. On Wednesday, Bloomberg ran a story that citied a National Association of Home Builders that found 44% of home builders have cut prices and 55% are offering free upgrades. Other incentives include free cars and vacations, both were cited by 4% of the respondents.

We have previously discussed that the retailers that are closest to the residential housing market have experienced the most weakness. Lowes' announced that its earnings for the year will be on the low end of it's previously announced range of $2.00 to $2.07. Consensus estimates were already at $2.00. The company said that "current sales are trending below its prior expectations." The company cited "the backdrop of declining housing turnover, elevated energy costs and difficult comparisons resulting from active 2004 and 2005 hurricane season." Ethan Allan was another company that is close to the residential housing market that also announced sales are falling short of expectations. The company said that, "We are seeing a softening of consumer confidence and we're also seeing the impact of higher interest rates."

Consumer confidence increased in September by 4.3 points to 104.5. Both the present situation and future expectations were higher. The increase was the largest jump in confidence since March. Plans to buy a home dropped to the lowest level since December 2005. With those expecting to purchase an existing home dropping to 1.0%, the lowest since October 2005. Additionally, plans to make a major purchase fell to 27.3%, the lowest since October 2005. It was also notable that inflation expectations fell to 4.9% from 5.5% last month. This was the lowest expected inflation rate since March and is welcome news to Fed officials.

Adding confirmation that consumers are more optimistic as the increase in the ABC News/Washington Post Consumer Comfort survey. The headline index increased 3 points to -12, the highest level since August 7. It is interesting that while both indexes reported that consumers were more optimistic, there is a discrepancy on consumers attitudes toward spending. The largest increase was in the Buying Climate, which jumped six points. The proclivity to purchase durable goods might be less than consumers' appetite for spending in general. The Conference Board's survey specifically asks about purchases of major appliances whereas the ABC News survey is more general. The recent surveys from the ICSC indicate that consumer spending has rebounded from this summer. Last week was the second consecutive week that the ICSC reported that chain store sales increased more than 4%. While retail sales have appeared to have rebounded according to the ICSC, the consumer confidence report didn't share the same trend.

There are several undercurrents affecting the economy. It appears that the slowdown in residential housing has impacting consumer spending habits. Spending on household items has come under pressure, but sales at most apparel and general merchandisers have remained buoyant. The recent durable goods orders report revealed that the manufacturing sector experienced slower activity than economists were expecting. The recent drop in interest rates and energy prices has likely helped consumer confidence rebound and will likely spill over into spending. In order to gauge the health of the economy, it will be important to pay close attention to the economic data for September. Additionally, companies will provide valuable insight when third quarter results are reported next month.

Chad Hudson
Mid-Week Analysis
PrudentBear.com

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