Homebuilders Haven't Hit Bottom Yet

07/25/2007 12:00 am EST

Focus:

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says the homebuilding sector will continue to struggle, and he identifies a couple of short-selling candidates.

As bad as the sector is, I have been pounding the table that the homebuilders have yet to hit a bottom. And recently, evidence hit the markets hard that they are, indeed, not yet there.

D.R. Horton (NYSE: DHI), the nation's largest homebuilder, had absolutely awful earnings to pre-announce a 40% drop in orders based on volume and a 47% drop based on revenue, which means prices are falling pretty fast. These numbers translate into new orders for 8,559 homes compared with 14,316 homes in the same quarter last year.

During the past nine months of its 2007 fiscal year, the company has had orders for 27,313 homes, worth just under $7 billion. This compares with 41,550 homes, worth $11.4 billion, for the same period in FY 2006. Oops.

The company also said it would be profitable on an operating basis in the coming quarter, but will have significant write-downs of existing inventory that will impair shareholder value.

For Wall Street analysts and professional investors, this is a no-no—much of the optimism about homebuilders and the popular belief that they had hit a bottom was based on their share prices reflecting book value. Well, when book values fall—yes, you guessed it—the stock will fall, too. 

Technically, the stock is teetering at the edge of a cliff—it's trading at the bottom seen last August (the stock closed at $17.50 Tuesday)—and a break here could send it to $10-$12. If you want to speculate, this is the time to get into our DHI Jan 17.50 Puts (DHIMW).

Home Depot (NYSE: HD) made its tender offer for $10 billion of its own shares in a range from $39 to $44. The offer expires August 16, effectively putting a floor under the stock price [until then]. The company also preannounced earnings and it means we are going to punch through that floor.

Why? HD downgraded its financial targets for the year—and I think it's being optimistic based on data I've gotten from ChangeWave Alliance surveys. Profits will be down 15%, same-stores sales down 4%-6% and revenue down 1%-2%—all while the company is opening more than 100 new stores.

And, worst of all its operating margins are falling 120 to 150 basis points—a big number for a retailer—reflecting declining same-store sales, while it's in the process of a new program to make stores more attractive and customer-friendly. It's like putting lipstick on a pig.

Bottom line: The stock will hold above $39 through mid-August, so build your position in the HD Feb 37.50 Puts (HDNU) with this in mind, as these are trading right at our $1.50 Buy Under price. If it hits $39 and stays there, pile in. (The stock closed below $38 Tuesday—Editor.)

(Editor’s note: Short selling is appropriate only for very risk-tolerant investors who can afford to take large losses from those investments.)

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