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July 27, 2006

Homebuilders Start Fessing Up
by Chad Hudson

Corporate earnings have continued to exceed analysts' expectations. With just over half of the companies in the S&P 500 having reported second quarter earnings, 69% have exceeded analysts' estimates. Earnings are now expected to increase over 13% for the second quarter.

While most companies have exceeded expectations, there have been several that have fallen short. United Parcel Service reported that second quarter earnings were $0.97 per shares, up 10% from last year. This was three cents below analysts' estimates and the company also said third quarter earnings per share would be $0.87 to $0.91, lower than analysts' estimates of $0.97 per share. Even though earnings missed estimates, revenue was actually higher than consensus estimates due to higher volume and higher rates. Results were negatively impacted due to higher fuel costs along higher rail and health care cost as well. During the conference call, CFO Scott Davis, said that UPS is a "very good real time indicator of the economy" and is forecasting the economy to soften marginally during the second-half of the year to 3% or just under.

Norfolk Southern revenue jumped 11% due to a 4% increase in shipments combined with a 7% increase in rates, mostly fuel surcharges. Steel shipments increased 10%, while the autos and chemicals segments were weaker. However, higher costs caused net income to drop by 12%. Diesel fuel costs in the second quarter surged 60% to $260 million compared to last year. The company said that the benefit from fuel hedges was $35 million less this quarter than last year and totally wound down the hedges in May. The company is utilizing surcharges more, similar to several other companies. We have discussed how hedging activity was able to prevent higher costs from being passed through to end users last year when energy and raw materials costs started rising. We have also pointed out that as prices remained elevated, companies have decided to diminish the amount of hedging activity for various reasons. This leaves companies more exposed to higher input prices and they will have raise prices or will experience lower margins and thus lower earnings. Figuring which companies have pricing power and those that have the power to push back will gain importance over the rest of the year.

Existing home sales fell slightly in June to 6.62 million annualized units. This was slightly higher than economists were forecasting, but was 8.9% lower than last year. Additionally, the median price only increased by 0.9% over the past year. This was the slowest pace of appreciation since the data series started in 2000. The number of houses on the market continued to rise, up another 136,000 units to 3.725 million homes, almost 40% higher than last June.

Consumer confidence was also slightly stronger than economists expected, rising 1.1 points in July to 106.5. The only significant change was the number that said they planned on purchasing a new home. The number of consumers that plan on purchasing a home actually increased to 3.4% from 3.2% last month, but the number that said it would be a new home fell to 0.5%, down from 0.6% last month. This was the fewest number of respondents that planned to purchase a new home since November 2003. Additionally, it was as high as 1.5% just four months ago and was 1.2% last July.

Several of the homebuilders have reported second quarter earnings over the past week. During the first quarter, most homebuilders started experiencing a challenging market. At the time they were not concerned because the winter is normally a slower period and they felt that activity would rebound during the spring selling season. It has not quite worked out as planned. Orders have continued to drop, while cancellations have increased. Most homebuilders have reduced forward earnings guidance and the tone of the conference calls have definitely changed.

I have included sections of the various conference calls below.

From D.R. Horton:
"...right now I truly believe that there are a lot of fence-sitters out there. They don't have to buy because of the fact that the appreciation is not like it has been over the last two or three years, so if they don't buy today, they're not going to miss an uptick in the house price, so there's not really much motivation for them to buy unless they really need a home.

"And also we have significantly higher cancellation rates, which all builders are experiencing. So when we look at our fourth quarter, what we're trying to do is give you an absolute bottom line number that we can hit or exceed. And I guess I don't want to get in to any other builders on this conference call, but I get confused when I look at some of the numbers that I'm hearing other builders produce and report, and it reflects margins staying the same in the next two quarters. And that's just not out there, and if it's out there, we'll be glad to be the beneficiary of that, but we're not going to assume that.

On the Phoenix market - "I can tell you that market is going to get softer going forward, so we're looking at this future market with very, very clear vision - with no rose colored glasses on - and we don't want to paint a picture of anything else other than what we're actually seeing in the market place out there. And if we're going to get punished and we're going to get pummeled because of the fact that we're being more accurate than some people think we need to be, so be it.

On the California market - "So I think really, clearly, what's affecting the demand in a number of our markets is simply we've depleted the pool of affordable buyers by escalating real estate prices in a number of our market, and then that has been somewhat aggravated by the fact that interest rates have worked their way up, although I will tell you that interest rates don't have a hill of beans to do with our business in a large way. If you - listening to somebody this morning - if you look at the 30 year mortgage rate, it's still one of the lowest it's been in the history of the U.S., so it's not the fact that a less than 7% 30 year mortgage rate is not available out there. I think it's a function of the fact that median homes price - median price of homes - especially, look at Las Vegas. Two years ago, the median price of homes went up 50%. The next year it went up 25%. What happened? Pool of buyers dissipated.

From Ryland:
"The slowdown is broad based but more pronounced in areas that experience significant price appreciation over the last few years In conclusion, conditions in most markets have not improved and buyers remain cautious. While we knew that eventually there would be slowdown in housing, this downturn happened quicker than expected.

From MDC Holdings
"Our cancellation rate, as we mentioned in the release, is 43%. That's up significantly from 19%. In terms of absolute cancellations, every market except Texas and Colorado was up over where it was last year. And our can rates are up over 1,000BPS in every market except Texas and Utah, primarily due to the high supply of new homes and the competitive environment in all of these markets.

"And while we try to work these buyers very hard, they're also out there looking at the competition and we've had a lot of buyers who have been canceling late in the process. I mean that's one of the trends that's been most alarming for the company is that it used to be that we'd see half of our cans come in before we even started the house. That's where we were at Q2 last year. This year in Q2, only a quarter of our cans occurred before we started the house. And that's primarily driven by what's going on in Arizona, because we are seeing them - and in some cases, waiting right until the closing date to actually cancel, because they've got another opportunity out here and there's really no motivation for them.

Chad Hudson
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