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Tuesday, August 22, 2006

The Goods on Capital Goods

By William Trent, CFA of Stock Market Beat

The signs of a housing slowdown are mounting. The question is how long and how deep it will be, as well as the extent to which it will impact consumer spending. The slowdown has impacted Home Depot, and housing prices have begun to fall in 59 of 151 measured markets.

Watch List member Orleans Homebuilders Inc. (OHB), following other national homebuilders, has cut its outlook for its current fiscal year as it experiences a rise in cancellations for new houses as well as other signs of a softening residential market. Orleans had a 58 percent cancellation rate in Florida for the year, with many investors simply backing out of buying. Overall, new orders dropped 13 percent and the cancellation rate was 23 percent, up from 14 percent from a year ago.

On their recent conference call, Watch List member Toll Brothers (TOL) had several discouraging words.

Third quarter revenues were $1.53 billion, compared to 1.54 billion in fiscal year ‘05.
Backlog was $5.59 billion, compared to 6.43 billion in fiscal year ‘05, and signed contracts were 1.05 billion, compared to 1.92 billion in fiscal year ‘05.

We believe we will deliver between 2,500 and 2,800 homes in the fourth quarter of fiscal year ‘06, compared to the 2,900 to 3,300 homes of our previous guidance.It appears that the current housing slowdown, which we first saw in September ‘05, is somewhat unique: It is the first downturn in forty years – in the forty years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors.

Instead, it seems to be the result of an oversupply of inventory and a decline in confidence.
Speculative buyers who spurred demand in ‘04 and ‘05 are now sellers; builders who built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction. Because much of the overhang of finished and near-finished product is being marketed using advertised price reductions and increased sales incentives, many anxious consumers are delaying their purchase decisions as they wonder about the direction of home prices.

Faced with heavy discounting by many other builders, we generally have chosen to allow sales phases to slow rather than aggressively discount our home prices. Other than in our multi-family communities, in which we start a building after having sold some but not all of the units, we rarely start a single detached home without a buyer’s signed agreement and a substantial down payment.

We are willing to walk away from land deals under option that no longer work due to today’s weaker market conditions and slower sales paces, if we are unable to renegotiate the land purchases. When we announce earnings on Aug 22, ‘06, we will announce our write-downs related to such options.

We have seen an increase in our cancellation rates in a number of markets, including Orlando, Northern California, Palm Springs, Las Vegas, and Phoenix.
Given that the consumer accounts for roughly two thirds of GDP, a slowdown in consumer spending would have a far greater impact on GDP than the relatively mild business-led recession of earlier in the decade.

Other than the homebuilders, however, Capital Goods providers have been doing well. Ceradyne (CRDN) raised their guidance, though the growth rate in orders is tailing off in line with our expectations.

We also think Embraer (ERJ) is in the right place at the right time.

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