Here’s my latest trading idea: short the homebuilders. It’s not the most original idea – more like the pink elephant in the room – but where there’s opportunity, doesn’t hurt to coin it. I’m currently shorting KB Homes (KBH) and Toll Brothers (TOL).

Stock and technical analysis wise, the group looks ugly. Both KBH and TOL’s charts are “broken”, ie their meteoric rise is over. They’ve broken through important moving averages and support. No need to go into details, the charts are pretty clear.

Rates are rising, and it looks like the housing market is finally slowing. Simple supply and demand, when inventories go up, prices come down. It will take a while for the housing market to play itself out. But the stock market usually anticipates these things faster, so I think the price decline in the homebuilder stocks will be faster than having to wait out the actual decline in home prices. Worst case scenario is the housing market implodes. If that happens, I think we will have many more things to worry about than trying to make a few bucks shorting stocks. It is what it is. Personally, I think the US economy is strong enough to withstand even that shock, but that’s a different discussion.

I think the homebuilders are making the same mistakes they made in the 1980’s, which is to take on a ton of debt based on the value of their inventory. Looking at KBH’s financials, a few things stood out. Cash flow from operations is negative $554 million for the 9 months YTD. They financed that through issuing $748 million in notes payable, ie debt. Based on those figures, they’re averaging operating cash burn of $2 million per day for the year, and around $2.6 million per day for the latest quarter, so cash burn is accelerating. Cash on hand at the end of Q3 is $60 million. I’m no expert in the homebuilding business, but this tells me they have to borrow more money to finance operations, which is not a good thing.

Mortgages & notes payable on the books at the end of Q3 is $2.7 billion. Total liabilities are around $4.5 billion. The cynic in me says half their market cap is debt.

Inventories (houses) total $5.7 billion.

Construction is obviously a capital intensive business, but something doesn’t smell right here.

I’m betting they are heading towards a cash crunch, or at least cash is getting expensive.

Insiders have dumped stock hand over fist the past year, especially this summer, which is telling in itself. If they don’t think it’s worth holding, why should outside investors.

So here are some main reasons from my hypothesis.

Update: I smell a rat. I don’t think there’s outright fraud yet. But usually with any booming sector – where the stock zooms from nothing to the stratosphere – there are those who will take advantage of it, either to milk more out of it or to keep it going. Think high tech or Enron. It would not surprise me if there turns out to be some bad apples in the barrel. A good indication of the temptation would be the massive insider selling.

5 thoughts on “Homebuilders”

  1. Makes sense. Also, rising rates here, combined with continued slow growth and low rates abroad, are going to keep putting pressure on European currencies. That will take some of the marginal demand out of our housing market, since dollar weakness has made US housing relatively cheap for Europeans.

  2. Fantastic chart for a short! Is that charting service available online, or is that a –er– what, private package? Stands to reason, anyway, as JG says above.

  3. Sam S, I’m not a big fan of paying for bells and whistles in trading. So I get my charts straight from Yahoo Finance for the low low price of $0.

    Good point Jonathan, I didn’t think of the effect of foreigners. The bulk of my thinking in terms of buyers is the last wave of ARM and interest only buyers.

    I have a pet theory that a large reason for the boom in Californian real estate from the early 90’s to now is the influx of immigrants from the Asian Tigers. It started with the Japanese, and then the Taiwanese, now followed by the mainland Chinese. I think they provided the influx of new cash that helped gun the market up.

  4. Whoa! KBH has the cart way ahead of the horse! I would never have imagined that their financials are in that kind of shape. I wonder how much of their expected revenue is based upon contracted sales as opposed to forcast sales.
    They’re also going to get hit by rising labor and material costs as the Katrina/Rita rebuilding begins; increasing that cash burn (and I bet they haven’t hedged).
    I know if I were swinging a hammer for KBH, the money for government funded rebuilding would sure look a lot more like a sure thing right now.
    How much do you plan on shorting them?

  5. I figure “’til the cows come home”… market is ugly, and I’m not inclined to go long. So short it is.

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