If you are looking for cracks in what has been a solid market for new housing, look no further than Dominion Homes (NASDAQ:DHOM). This homebuilder in Central Ohio, with developments in Kentucky and Indiana, announced after the market closed on Friday that its third-quarter sales fell 25% and the dollar backlog of sales contracts fell 6.9%.
The stock was down more than 16% by the end of trading Monday -- a fall that placed it among the leading percentage losers on the Nasdaq -- and has lost roughly half its value from where it was trading 52 weeks ago. So does that mean it's time to buy into a battered stock? Well, let's first take a look at the factors leading up to this quarter's announcement.
The first trouble with sales appeared in June 2004, when the company lowered sales expectations after posting record first-quarter results. At the time, Dominion cited rising interest rates as hurting its target market -- first-time homebuyers. And that made sense. Interest rates on national fixed-rate 30-year mortgages had zoomed from an average of 5.59% in March to 6.42% in June 2004. But June proved to be the peak, and rates have zigzagged between 5.8% and 6% since September 2004.
When the company reported sales for 2004's third quarter (which ended on Sept. 30), revenue had increased 6% compared with the comparable year-ago quarter, but net income had plunged by 18%. The company blamed the earnings shortfall on higher building-material costs and its effort to reduce its number of inventory homes.
By November 2004, the company was concerned enough about soft housing sales in its Midwest region that it announced staffing reductions and made plans to carefully look at every nook and cranny of its operation. When fourth-quarter results were announced, sales were down 30.6% and net income came crashing down by 89.3%.
At the end of 2004, even after that disastrous fourth quarter, the company earned $2.47 per fully diluted share, down from $3.94 in 2003. The company did not give any earnings guidance for 2005 other than to say that results would be lower than analyst expectations. Analysts had been expecting earnings of $0.38 for the coming quarter and $1.15 for 2005.
Looking forward, we'd do well to recognize that the better part of these concerns persist -- rising building and materials costs, relatively higher mortgage rates, and regional softness (at least comparatively) in Midwestern states -- as evidenced by weakness in reported results for the first six months of 2005, when net income declined 72.9% to $3.2 million. Trailing annual profit margins are 2.46%, and that's mighty slim for a company with debt of $215.1 million and cash of $7.5 million. (Interest coverage has declined over the trailing 12-month period.) Remember, housing is a big-money business, and when the cycle goes against it, the well-financed are the ones that will survive.
So, which companies might you consider in this market? Homebuilder NVR (NYSE:NVR), with a wider geographical spread, has operations that focus on the first-time homebuyer and the first-time move-up buyer. Better yet, there is $265.1 million in cash to balance against its $331.2 million in total debt -- and the stock is selling for 7.5 times expected 2006 earnings.
I'd advise care when looking into the biggest homebuilders for investments. DR Horton (NYSE:DHI), Pulte (NYSE:PHM), Lennar (NYSE:LEN), and Centex (NYSE:CTX) all carry heavy net debts (total debt minus cash). While that debt has value in land and buildings, and even though it can rise very profitably in a ballooning housing market (as it has in recent years), it is also subject to declining value in a falling housing market. If you're going to invest in this market, tread carefully. You might not want to make Dominion your domain.
Are you looking for great companies selling for less than intrinsic value? Let the Motley Fool Inside Value newsletter bring you two selections to consider each month. Try a free trial subscription today.
Fool contributor W.D. Crotty does not own shares in any of the companies mentioned. Click here to see The Motley Fool's disclosure policy.
