The house rules are simple in this weekly column.

  • I bash a stock that I think is heading lower.
  • I offset the sting by recommending three stocks as portfolio replacements.

Who gets tossed out this week? Come on down, Hovnanian Enterprises (NYSE: HOV).

You can't go home again
Homebuilders stink, but some stink more than the others. Hovnanian's latest quarter might just make you close your nostrils with a clothespin. Revenue slipped 20% to $255.1 million, and the real estate developer's deficit widened to a bloodier-than-expected $0.69 a share.

Nearly everything that could have gone wrong did, in fact, go wrong. Gross margins shrank. Net contracts and the contract backlog suffered double-digit percentage dips. The cancellation rate inched higher.

No one was expecting a good quarter out of Hovnanian. The industry fell off a cliff after the homebuyer tax credits were discontinued last April, so the comparisons were going to be painful. However, it's truly puzzling to see Hovnanian buy new lots and plots of land when it already has years of inventory that it's struggling to sell.

We don't need more new construction. There are plenty of foreclosed homes sitting vacant out there. Prices continue to fall, despite the unsustainably low mortgage rates.

The outlook is grim, folks. Credit agency TransUnion recently reported that 6.19% of all borrowers were at least 60 days late on their mortgage payments. Real-estate data firm CoreLogic reported this week that 38% of the folks who took out second mortgages and home-equity loans are currently underwater. Of those without those loans, nearly a fifth owe more on their homes than they're worth.

The inevitable rise in mortgage rates will force home prices even lower, right?  

I'm not suggesting that there should be a moratorium on all new residential construction, but it's clear that there won't be as many homebuilders around in a couple of years. Where will Hovnanian be? Many of its peers are holding up better in this climate. NVR (NYSE: NVR) is profitable. Toll Brothers (NYSE: HOL) is carving a reasonable niche in the higher end of the cookie-cutter-communities market.

Hovnanian, on the other hand, has posted just one profitable quarter over the past four years. Its balance sheet is as bloated as some of its underwater homeowners, with nearly $350 million in negative shareholder equity.

It will take years for the housing glut to clear, and I'm not sure Hovnanian will be one of the few still standing when that happens.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave ho. Let's go over the three fill-ins.

  • Gafisa (NYSE: GFA): There are better domestic homebuilders, but I can't recommend one with a clear conscience. Last year's homebuyer tax credit was a sham, tricking more people into buying overpriced houses. If you want a developer, pack a passport. Gafisa is a profitable homebuilder in Brazil, trading for just 8 times this year's projected profitability and a mere 7 times next year's earnings target of $1.50 a share.
  • Homex (NYSE: HXM): If you don't want to go to Rio, how about going south of the border? Homex is a profitable homebuilder in Mexico. Remember the nasty quarter that Hovnanian posted this week? In its latest quarter, Homex posted growth in revenue, earnings, and adjusted EBITDA. Gross margins also refreshingly expanded during the period. Homex joins Gafisa in the realm of single-digits earnings multiples, fetching 8 times this year's forecast and just 6 times next year's bottom-line estimate.
  • Trex (Nasdaq: TREX): Closer to home, Trex is the top dog in alternative decking. It's not easy to warm up to the home-improvement players. Who wants to build a new weather-resistant outdoor deck in an underwater home that the bank may take away? However, Trex did marginally grow its revenue in its latest quarter, which is notable since the two big home-improvement superstore chains and hardwood flooring specialist Lumber Liquidators (NYSE: LL) all posted negative store comps in their latest quarter. Trex's profit of $0.15 a share was also nearly twice as much as analysts were expecting.

I hope I'm wrong about Hovnanian, though I prefer to build on a stronger foundation.

The Motley Fool owns shares of Lumber Liquidators, and Motley Fool newsletter services have recommended buying shares of Lumber Liquidators. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Rick Munarriz doesn't mind taking out the garbage every so often. He owns none of the stocks in this story and is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Motley Fool has a disclosure policy.