Homebuilding Stock Review & Outlook - May 2012
With a gradual recovery in the overall economy, the homebuilding industry is finally seeing signs of stabilization in 2012. The downturn during 2006-2007 had hIt the homebuilding sector hard.
We believe that the housing market is starting to benefit from an increase in employment rates and higher consumer confidence. Houses are more affordable now as mortgage loans come with relatively low interest rates while renting becomes more expensive.
Thus, most homebuilding companies are witnessing better year-over-year growth in revenues, driven by an increase in new home orders and average selling prices. Backlogs (number of homes under sales contracts at the end of the year) and homes delivered are also climbing year over year.
Moreover, improving homebuilding revenues combined with tight cost control by most homebuilders are boosting margins. The large discounts and incentives offered in response to declining demand and an oversupply glut are gradually being called back.
The National Association of Home Builders/Wells Fargo Housing Market Index (:HMI) rose by five points to 29 in May 2012 from the previous month, its strongest reading since May 2007. The improvement in this index suggests an increased demand for housing driven by high consumer confidence, an improving job market and low interest rates.
Housing Recovery Slow
The last few years have seen a very fragile housing market. The downturn in housing -- aggravated by an overall weak economy, high unemployment rates, low consumer confidence, rising interest rates and tightened mortgage-lending standards -- weighed down on homebuilders.
Declining demand for new homes and an excess of supply in the market in 2011 drove homebuilders to make large concessions in prices, largely hurting profitability. Homebuilders' sales and profit margins had dropped dramatically from peak levels in 2006.
As discussed above, there have been signs of a nascent improvement in the housing market so far in 2012. However, homebuilders have cautioned that the process of stabilization is at best erratic and not adequately broad-based.
The housing market improvement has been uneven across the country. Most of the gains have, by and large, been observed in high-end communities. Moreover, the industry still faces significant challenges from an oversupply of foreclosed homes and short-sale homes. Overall demand still remains constrained due to tight credit standards which make it difficult to obtain loans for home buying. A speedy housing recovery is unlikely and it will take some time before the markets fully recover.
Progress in High-End Communities
The average selling prices (ASPs) are improving for most large-cap homebuilders due to changes in the community/product mix. ASPs have gained from increased sales in high-end communities of California, Arizona, Colorado and Florida where home prices are generally higher.
Given the scenario, large builders are taking away share from other undercapitalized small/medium-sized private builders on the back of overall housing demand, stronger capital and better land positions.
Lennar Corporation (LEN) strategically focuses on acquiring new home sites that would boost margins and percolate down to the bottom line. The company focuses on high-margin, well-positioned communities and avoids fringe or tertiary markets where price is the only driver. The company's focus on quality instead of quantity is benefiting margins and boosting new sales orders.
KB Home (KBH) has started rolling out communities in highly desirable submarkets, which allows it to sell larger, higher-priced homes, driving up the ASP. KB Home is also targeting higher income, first-time and move-up buyers -- all of whom are more inclined toward buying a new home rather than buying a foreclosure.
PulteGroup Inc. ([url=http://www.zacks.com/stock/quote/phm]PHM[/url]) is continuously evaluating its assets and prioritizing markets and projects in order to appropriately allocate capital. The company is divesting lower-margined projects and exiting non-performing communities which no longer fit in the company's operating strategy. Such a policy frees up cash to invest in other potential opportunities which generate higher returns.
Cost Saving Initiatives
Most housing companies resorted to cost reduction strategies in order to cope with the challenging industry conditions like a sluggish US homebuilding industry and raw material cost inflation. Most of these companies have taken action to improve their operating and financial performance.
PulteGroup made significant workforce reductions and is also aggressively working to reduce overhead costs. In 2011, the company consolidated its field organization and select corporate functions. It also consolidated its regional operations in Arizona, Florida, New York and New Jersey and merged its West and Central area.
Management's concerted efforts to reduce overhead costs pulled down selling, general and administrative (SG&A) expenses substantially in 2011. This subsequently acted as a tailwind for margins. The company is also adjusting the contents of its homes and building smaller floor plans to suit the needs of cash-constrained Americans.
Home improvement products-maker Masco Corporation (MAS) took initiatives like business consolidation, system implementations, plant closures, improvement in the global supply chain and headcount reductions to contain costs. These initiatives are expected to result in about $150 million of gross cost reduction before inflation in 2012.
Construction aggregates maker Vulcan Materials Corp. (VMC) has invested in a new Oracle-based ERP and Shared Services platform which allowed the consolidation of the company's eight divisions into four regions. The system also streamlined its support functions, thereby reducing related positions and overhead costs.
The company has also announced two other initiatives: a Profit Enhancement Plan and planned asset sales, in order to improve earnings and cash flows, pay off debts and thereby strengthen its overall credit profile.
The Profit Enhancement Plan is designed to reduce costs as well as enhance profitability by streamlining the management structure over the next 18 months. The plan is expected to improve EBITDA by $100 million on an annual basis by 2014.
Under the planned asset sale, the company plans to divest its non-core assets over a period of 12 to 18 months in order to improve the company's liquidity position and earnings. These sales are expected to generate after-tax net proceeds of $500 million.
Though cost-saving initiatives will hurt earnings in the near term, the overall growth profile of the homebuilding companies will get a boost over the long haul when the housing market fully recovers.
OPPORTUNITIES
We do not have an Outperform recommendation on any housing company. Despite the Neutral recommendations, we have a positive view on large homebuilders like Lennar (LEN), DR Horton, Inc. (DHI) and Pulte Group (PHM) which are showing impressive improvement in tandem with a stabilizing housing industry.
DR Horton has started the financial year on a strong note despite macroeconomic uncertainties and housing conditions remaining soft. Growth in double digits was observed in net sales orders, homes closed and sales order backlog in both the first and second quarters of 2012. Management expects stronger home closings in the third and fourth quarters of fiscal 2012 as demand for new homes historically ramp in the latter half of the year.
The company's efforts to date in investing capital in growth projects, managing inventory levels efficiently, improving gross margins and controlling SG&A and interest costs are expected to reap rewards. DR Horton's strong cash flows can be used to pay back outstanding debts and lower interest costs.
The company's strong cash position and low debt/capital ratio also allow it to make opportunistic land purchases even during a downturn, thus giving it a significant competitive advantage. The stock carries a Zacks #2 Rank (short-term Buy rating).
Lennar also witnessed increased homebuilding revenues in the first quarter of 2012, driven by price increases and improved net order growth. We believe the company is performing better than its peers by increasing sales prices, reducing incentives, improving volumes and investing in well-positioned, high-margined communities. The company offers a diversified line of homes for first-time, move-up and active adult homebuyers which can be availed in a variety of environments ranging from urban infill communities to golf course communities.
The Rialto business wing is progressing well and has untapped growth opportunities as the market continues to improve. Rialto Investments is involved in the acquisition of portfolios of, or has interests in portfolios of, distressed debt instruments and foreclosed properties. The stock carries a Zacks #2 Rank (short-term Buy rating).
Regarding Pulte Group, we are encouraged by the company's initiatives to improve its operating and financial performance. These initiatives include managing margins, overhead and inventory, and improved capital allocation for more efficient use of funds. The strong cash balance allows the company to retire its outstanding debt, thereby improving the company's leverage.
Pulte, which includes brands like Pulte Homes, Centex and Del Webb, also reported improvement in net orders and average selling prices in the first quarter of 2012 and boasted of a better product mix, comprising increased home closings of steeply priced move-up homes. The stock carries a Zacks #3 Rank (short-term Hold rating).
Other than the large homebuilders, we have a favorable opinion on Masco (MAS), which holds a leading position in the home improvement market. We are encouraged by Masco's leadership brands (like KraftMaid and Merillat cabinets, Delta and Hansgrohe faucets, Behr paint and Milgard windows), continued focus on product innovation and cost improvements.
We also like the company's initiative to restructure its business by exiting less profitable and
underperforming assets. We are encouraged by the company's strong first quarter results. The stock carries a Zacks #3 Rank (short-term Hold rating).
Vulcan Materials (VMC), which is the largest producer of construction aggregates in the US, derives more than half its revenues from public sector construction projects, such as bridges, dams and roads. Generally, public sector spending is much more stable than the private sector because these are less affected by general economic cycles, thus giving Vulcan a significant competitive advantage.
We are encouraged by the company's better-than-forecasted results in the first quarter, in particular the impressive performance of the Aggregates segment, which is slowly gaining momentum. We also like the company's expanded cost initiatives which will improve the overall credit profile of the company in the long run. The stock carries a Zacks #3 Rank (short-term Hold rating).
WEAKNESSES
We advise investors to avoid names that have reported net order declines in the latest quarter. These homebuilders also show signs of slackening profitability.
Going by this rule, it is best to avoid KB Home (KBH) even though we have a Neutral recommendation on the stock. A decline in net orders and compressed gross margins widened KB Home's loss in the first quarter of 2012. Housing revenues, homes delivered and average selling prices declined significantly from prior-quarter levels. Net orders declined due to mortgage delays which triggered order cancellations.
We believe that KB Home's mortgage financing issues create a short-term overhang for the company and will hurt net orders and backlog conversions at least for the next 2-3 quarters. The stock carries a Zacks #3 Rank (short-term Hold rating).
Another company which announced unimpressive results this quarter was Meritage Homes Corporation (MTH). The company recorded lower-than-expected revenues and wider-than-forecast loss in the quarter. The stock carries a Zacks #3 Rank (short-term Hold rating).
MERITAGE HOMES (MTH): Free Stock Analysis Report
KB HOME (KBH): Free Stock Analysis Report
LENNAR CORP -A (LEN): Free Stock Analysis Report
MASCO (MAS): Free Stock Analysis Report
PULTE GROUP ONC (PHM): Free Stock Analysis Report
VULCAN MATLS CO (VMC): Free Stock Analysis Report
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