With home prices continuing to drop and the pace of home sales slowing further, nobody has been looking for encouraging results from homebuilders.

D.R. Horton (NYSE:DHI - News), the last of the major homebuilders to report earnings for the March quarter, is scheduled to post results for its fiscal 2008 second quarter before the market opens on May 6. The company is viewed as better positioned than some of its peers to benefit from the wider availability of conforming mortgages up to $417,000 -- being guaranteed by government programs, since it attracts first- and second-time home buyers, who tend to be interested in less expensive homes.

That said, with mortgage rates very slow to track the Fed funds rate lower and banks skittish about making further loans amid rising default and delinquency rates, the housing market is expected to get worse before it begins to improve.

New home sales fell 8.5% to an annual pace of 526,000 in March, from 575,000 in February. Eleven months worth of new homes are now sitting on the market, the largest inventory in nearly 27 years, and the median sales price dropped from $244,200 to $227,600.

The average price of homes in the 20 largest U.S. metropolitan areas, as measured by the S&P/Case-Shiller index, fell 12.7% in February from a year ago, the biggest drop since 2001.

The weakness should be apparent in Hortons results. Analysts expect Horton to post a net loss of 43 cents per share for the second quarter, compared with a 16-cent profit a year ago, on $1.36 billion in revenue.

In the first quarter, which ended on Dec. 31, the Fort Worth, Tex.-based company posted a net loss of $128.8 million, or 41 cents per share. That included $245.5 million in pre-tax charges for inventory impairments and write-offs of costs related to land option contracts that the company doesnt plan to pursue. In the first quarter, home closings fell to 6,549 from 10,202 in the prior-year period

Lehman Brothers said that while it expects Hortons home closings, net orders and revenues to remain under pressure, it doesnt think the companys year-over-year trends will be as weak as those recently reported by KB Home (KBH) and Lennar (LEN), which reported order declines of 57% and 56%, respectively.

In an Apr. 21 research note, Lehman analyst Megan Talbott McGrath said she expects Horton to take $350 million in inventory-related charges for the March quarter, resulting in a net loss of 70 cents per share on a 39% drop in revenue. She also predicted a 34% drop in orders from the year-ago period and a 29% decline in home closings. In spite of that, however, she reaffirmed her overweight rating on the stock. (Lehman Brothers does and seeks to do banking business with the companies it covers in its research reports and it and/or its affiliates owns 1% or more of Hortons common stock.)

James McCanless, an analyst at FTN Midwest Securities in Nashville, Tenn., says he believes Hortons gross margins improved slightly since the first quarter.

I expect to hear they reduced lots (of undeveloped land) through normal (activity) and expect to hear they were an active land seller during the quarter, says McCanless, who has a buy rating on the stock.

While he expects to see charges for losses on Hortons land holdings, he thinks they wont be as high as in the first quarter. But he says hes not sure whether the charges will include write-downs of the deferred tax valuations that Horton carries on its balance sheet.

On Apr. 30, Centex (NYSE:CTX - News) reported a larger-than-expected $740 million in impairment charges for the March quarter, but $379 million of that was probably accelerated by aggressive pricing, Deutsche Bank Securities said in an Apr. 30 research note. On a conference call with analysts, Centex said it had reduced its unsold inventory of homes by 64% from a year ago by selling 6,700 homes during the quarter and returning to its prior model of selling homes before building them.

Robin Diedrich, an analyst at Edward Jones in St. Louis, Mo., says shed like to see Horton reduce its inventory of homes for sale from 17,000 at the end of the December quarter to about 15,000 at the end of March.

Horton has been pretty strict on not building until they get a contract. Theyve been doing that for a while, she says. Their speculative inventory really was pretty high, but once the downturn in housing started, they corrected that pretty quickly.

Except for some of the bigger markets where prices got the most overheated, such as California and Florida, home prices have already fallen to reasonable levels in most markets, says Diedrich. She estimates that 30% to 40% of Hortons business comes from markets where prices got over-baked.

McCanless says a bigger concern than inventories to him and most investors is how strong the homebuilders order backlogs will be in the second half of this year and the first half of 2009.

Are people showing up and taking advantage of the increased affordability were seeing in the market? he wonders.

While the 15% decline in sales orders since a year ago reported by Centex isnt all that positive, its much better than the average declines of between 50% to 60% reported across the industry this time last year, he says.

Hortons backlog of sales orders was 8,138, or $2.0 billion, at the end of December, vs. 16,694, or $4.7 billion, a year earlier. Net sales orders for the December quarter fell nearly 52% to 4,245 homes, or $900 million, from 8,771 homes, or $2.3 billion a year earlier. The company reported a cancellation rate -- cancelled sales orders divided by gross sales orders of 44% for the first quarter.

There is some hope that traffic may be picking up as prices come down, with people shopping for bargains, and Horton recently said it had seen improvement in traffic in February, says Diedrich at Edward Jones.

Home sales are likely to remain slow since financing, which has improved modestly, will still be an issue for the first-time homebuyers that Horton attracts.

(Lending) standards are much tighter, they dont have a track record, they tend to have lower income, theyre usually younger buyers, Diedrich notes. All those things are making it a little more difficult for first-time buyer.

Another sensitive point for the homebuilders is how much free cash flow they have been able to accumulate, both to reduce their debt and to keep funding operations until sales return to healthier levels.

Diedrich says that Horton has been doing a good job of managing its debt and has been conservative in spending, not buying additional land, for example. The company accrued over $1 billion in free cash flow in 2007 and will easily make their goal this year, she predicts.

Horton said it had $558 million in net cash provided by operations and had reduced debt by $647 million during the three months ended Dec. 31.

Talbott McGrath at Lehman said she sees Horton making progress toward its goal of $1 billion in cash flow generated from operations and also thinks the company has a healthy net debt to capital ratio, which she expects to edge up to 41% in the latest quarter.

McCanless says he sees the homebuilders accumulating fairly significant cash balances of $600 million to $2 billion. While the market is still concerned about how much theyre saving for what promises to be another difficult year ahead, he says the pace of sales should be better than over the past two years.

As bad as this market is for the homebuilders, McCanless says he doesnt think there will be any consolidation taking place in the industry. Mergers in this sector tend to be driven by a desire for more land to develop. With regional banks expected to sell a substantial amount of finished and nearly finished lots at reduced prices by the end of this year, the builders would rather buy some of those properties and develop them internally than through acquisitions of other outfits, says McCanless.

The discounts for these lots could match historic levels of 30% to 40% seen in previous down markets, especially in some of the bigger markets such as Phoenix that have had the biggest runups in prices, he says.