More Trouble Ahead for Builders

Warren Buffett once said, "When an industry with a reputation for difficult economics meets a manager with a reputation for excellence, it is usually the industry that keeps its reputation intact."

That wisdom could prove particularly useful for investors eyeing homebuilder stocks.

The lesson is that the industry in which a business operates dictates much of the company's profit potential. And when competition is intense, profitability is destroyed.

That's exactly what is happening with homebuilder companies today. Supply exceeds demand, and the aggressive price-cutting of homes from big builders such as Lennar(LEN:NYSE) will eventually cause serious ripple effects among rivals.

Lately, builder stocks have rebounded on hopes that the worst is over for the companies. But one method of analysis provides a healthy dose of reality about the dire situation the homebuilding industry is still facing.

The "Five Forces Framework," a method developed by Harvard economist Michael Porter in the mid-1970s, is widely taught in MBA programs and used by corporate strategists.

It's also a powerful tool for investors to use when deciding whether to buy stocks in a certain sector, and it highlights issues that will continue to erode profitability for homebuilders.

Rivalry among companies is one of the most obvious forces in an industry. "It influences the extent to which the value created by an industry will be dissipated through direct competition," writes Harvard Business School Professor Pankaj Ghemawat in his book , which outlines Porter's framework.

There is no doubt that homebuilders created a lot of value in recent years when the housing boom was rampant. Now, however, the rivalry is intense. The result is shrinking home prices and eroding profitability.

Lennar remains the biggest bully in many markets, cutting prices and aggravating fellow builders such as Meritage(MTH:NYSE) and Ryland(RYL:NYSE), which are trying to hold prices and margins steady.

Lennar announced this week that orders were down 6% in its latest quarter, but its backlog of homes fell 42% year over year in dollar terms.

JMP Securities analyst Alex Barron says those numbers imply the prices of Lennar's new orders fell at least 30%.

"If that is remotely true, I don't see how or why any builder -- public or private -- will just sit there and not eventually have to begin cutting prices down to match or beat that," Barron says.

The only real way to hold steady on prices in such a market is to offer a differentiated product. But with the exception of luxury-home builder Toll Brothers(TOL:NYSE), it's hard to say any builder has an edge on product.

If you travel around the country, you'll find Lennar's homes similar to those of D.R. Horton(DHI:NYSE), Beazer(BZH:NYSE), Ryland and other builders, Barron says.

"There is not a huge noticeable difference from one to the next," he says.

In an ideal situation, companies compete in an industry where it's difficult for new rivals to enter.

One of the reasons that builders trade above book value these days is that investors believe the land that the firms have amassed is worth something and cannot easily be replaced. Thus, perhaps entry barriers are high.

Toll Brothers is called a great company for the long haul -- even by hedge fund managers who are bearish about the sector right now -- because the firm controls land that it has entitled in areas of the country where new development is difficult.

However, the problem for all builders, including Toll, is that they bought too much land in recent years, and the value of the land is now being written down. Lennar is forecasting $400 million to $500 million of land writedowns in the fourth quarter.

The threat of entry may be low right now, but then again, the current housing inventory levels are already so high that any barriers to entry aren't helping.