lumber

The commodities crunch hits homebuilders hard

April 11, 2011: 11:32 AM ET

Rising prices of oil, copper, and lumber are only going to make a bad environment even worse for homebuilders.

By Joshua Steiner, Hedgeye

FORTUNE -- Commodities around the globe are seeing rapid price inflation. Simply put, when input prices increase, companies must raise prices or see their margins suffer. However, the homebuilders are in a particularly difficult situation when it comes to raising prices. They are competing not just against each other, but also against the inventory of existing homes, where prices continue to fall. As of January, the most recent data available, the Case-Shiller Index was falling in 19 of 20 cities.

How severe is commodity inflation for the builders? We show charts below of copper, oil, and lumber. Looking at the year to date versus the comparable period in 2010, oil is up 36%, copper is up 32%, and lumber is up 17%.

Turning to the impact on the income statement, we look at the cost breakdown of a new home according to the NAHB 2009 Construction Cost Survey: 59% of the sales price of a new home is construction costs (materials and labor), while 9% is profit. The items circled in red are related to oil, copper, and lumber. These circled items total 35% of construction costs, or 21% of total costs. This 21% includes some labor costs, so it's not merely raw materials, but in spite of this we would submit that its share of total costs is significant. With an average 9% profit margin, the builders don't have much room for error. While builders may have hedging or escalation clauses in contracts, these are temporary measures that will only delay the onset of margin pressure, not eliminate it.

Taking a step back, we believe that the new home sales market will not recover quickly -- in fact, our cumulative displacement theory sales will be quite low for years to come. KB Homes' (KBH) dismal quarterly report last week was only the beginning. Between volume pressure, pricing pressure, and margin pressure, we expect the homebuilders will be in for a bumpy ride in the months to come, especially considering the run-up in homebuilding stocks over the past few months on speculation about a strong spring selling season.

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