Homebuilding Stock Review & Outlook - Sept. 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 improving at a moderate pace, benefiting from an increase in employment rates, higher consumer confidence and several years of pent-up demand. Houses are more affordable now as home prices stabilize, mortgage loans come with relatively low interest rates and renting becomes more expensive.
Thus, homebuilders are witnessing increasing traffic levels due to heightened consumer demand. Inventory of foreclosed homes and short sale homes is declining, thus stabilizing prices of new homes. Additionally, buyers are selecting larger and much more upgraded homes with energy-efficient features, which will eventually help increase average sale prices.
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 for the fourth consecutive month in August, improving by 2 points to 37. This is a significant improvement from the depths of the housing downturn and is the index's highest level since February 2007. The improvement in this index suggests an increased demand for housing and better sales prospects for the next few months.
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 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 gradual strengthening in the housing market in the first half of 2012. However, homebuilders have cautioned that the process of stabilization is 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. In addition, homebuilders are still facing impediments in raising prices in some markets. The overall demand remains constrained due to tight credit standards, which make it difficult to obtain home loans. 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 eating into the share of 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.
PulteGroup, Inc. (PHM) is also shifting its focus towards high-priced Pulte-branded move-up homes, which improve the overall ASP. A better mix of sales, particularly Pulte-branded move-up homes, as well as addition of new higher margin communities, is consistently boosting the company's margins.
Small homebuilders like KB Home (KBH) has started rolling out communities in highly desirable submarkets primarily in the Central and West Coast regions, 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.
Another small homebuilder, Meritage Homes Corporation (MTH) is investing in well-positioned and high-priced land and new communities in the most desirable submarkets, which should ensure profits as the market gets stronger.
Cost Saving and Strategic Initiatives
Most housing companies resorted to cost reduction and other strategic initiatives in order to cope with the housing downturn and raw material cost inflation. Most of these companies have been taking action to improve their operating and financial performance.
Pulte is continuously evaluating its assets and prioritizing markets and projects in order to allocate capital appropriately and invest selectively in high-return projects. The company is divesting lower-margin projects and exiting non-performing communities and lower margin land lots, which no longer fit into their operating strategy.
Subsequently, the company is freeing up cash to invest in other potential opportunities, which could generate higher returns. Pulte is also using its existing land assets more efficiently and lowering its unsold inventory levels more aggressively, which in turn are benefiting the working capital and margins.
In addition, Pulte made significant workforce reductions and is also aggressively working to reduce overhead costs. In 2011, the company consolidated its field organization and certain corporate functions. It also consolidated its regional operations in Arizona, Florida, New York and New Jersey and merged its West and Central areas.
Home improvement products-maker Masco Corporation (MAS) took initiatives to improve underperforming businesses like Installation and Cabinet, leveraging its brands and continued innovation, and reducing costs. The company's cost-saving initiatives included business consolidations, system implementations, plant closures, improvement in the global supply chain and headcount reductions. The restructuring initiatives are expected to result in total cost reduction of about $150 million in 2012.
Construction aggregates maker Vulcan Materials Company (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. The plan is expected to improve EBITDA by $100 million on an annual basis by 2014 at current volumes.
Under the planned asset sale, the company plans to divest its non-core assets in order to focus on the higher-growth Aggregates business. These sales will improve the company's liquidity position and earnings and are expected to generate after-tax net proceeds of $500 million by mid-2013.
Other smaller homebuilders like KB Home significantly reduced its overhead, inventory and community count levels to better align operations with the reduced housing activity. Consequently, the company exited underperforming markets like South Carolina, downsized operations in Arizona and Charlotte, NC, disposed of unnecessary land and reduced exposure to risky joint ventures.
Further, KB Home is activating communities in stabilizing markets, increasing revenues per community, redesigning products to make them more affordable to cash-constrained consumers, lowering production costs and strengthening management teams with additional resources to improve its operating performance in the second half.
Most homebuilders are expecting these restructuring and strategic initiatives, combined with the housing recovery, to help them achieve profitability in the second half of 2012.
OPPORTUNITIES
The improved business backdrop is showing up in positive earnings momentum for homebuilders, resulting in Zacks #2 Rank (Buy) for Toll Brothers (TOL), Zacks #1 Rank (Strong Buy) for Lennar (LEN), Zacks #2 Rank for Hovnanian (HOV), and Zacks #2 Rank for Meritage Homes (MTH). The
trend in earnings estimates revisions for Louisiana-Pacific Corporation (LPX) is also positive, as reflected in its Zacks #2 Rank.
Toll Brothers enjoys the competitive advantage of being the largest luxury home builder in the country with little competition in this niche sector. Toll Brothers delivered solid results in both the second and third quarters of fiscal 2012 (ended July 31). The company has delivered double-digit growth in net orders in every quarter of fiscal 2012 so far and provided an optimistic outlook for the fourth quarter.
We believe this luxury homebuilder will be able to outperform the market, given its well-located communities and strong land positions, along with stabilizing home prices, improving consumer confidence and the overall economic recovery. The stock carries a Zacks #2 Rank (short-term Buy rating).
Lennar's first half results have been impressive, driven by price increases and improved net order growth with the housing market stabilizing. We believe the company is performing better than its peers by increasing sales prices, reducing incentives, improving volumes and investing in well-positioned, high-margin 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 stock carries a Zacks #2 Rank (short-term Buy rating).
Regarding Pulte Group, we are encouraged by its solid second quarter results and bullish growth projection for the second half, backed by the gradually recovering homebuilding market. Pulte Group rebounded from a loss in the first quarter to post an earnings surprise of 160% in the second quarter. Improved homebuilding revenues, expanded margins, and the company's cost reduction and operating efficiency initiatives boosted earnings in the quarter.
We believe that homebuilders like Pulte, which have significant land positions, broad geographic and product diversity, and better capital positions will benefit the most as market conditions recover.
Louisiana-Pacific delivered impressive earnings and revenue growth in the first half of 2012, driven by strong performance of its two segments, Oriental Strand Board (:OSB) and Siding. Both segments benefited from volume growth as overall housing activity improved. Management believes that Louisiana-Pacific's excess manufacturing capacity in each of the business segments will allow it to cash in on the opportunity provided by growing demand while the market recovers.
Meritage Homes delivered solid first half results, owing to robust new order growth and improved pricing. The company saw significant growth in closings, average sales prices, revenue, orders, backlog, gross margin and net earnings in the second quarter. Its new order growth in the second quarter was the strongest since the second quarter of 2008. We believe the company's focus on acquiring new communities in the most desirable submarkets will generate profit in the long run.
WEAKNESSES
With the housing market showing recovery, we are not generally bearish on any housing company. However, we advise investors to avoid names that have reported lower-than-expected results in the latest quarter.
Fastenal Company (FAST), a national distributor of industrial and construction supplies, witnessed a slowdown in sales to manufacturing customers who represent almost 50% of revenues in the second quarter of 2012. Daily sales growth rates declined sharply in the quarter due to sluggish end markets as well as foreign currency headwinds. The sequential change in daily sales for the first half of 2012 was also below historical averages, highlighting the rising uncertainty in the growth outlook of Fastenal's end markets.
Moreover, Fastenal's 'pathway to profit' strategy has failed to achieve the desired results. The strategy called for a slowdown in the pace of store openings and instead uses the resultant
savings to increase the headcount in stores. Other than that, the company's strategy of new store openings significantly hurt near-term profitability due to the start-up costs involved in opening a new store. The stock carries a Zacks #3 Rank (Hold), reflecting its lack of earnings momentum.
Another company which announced unimpressive results this quarter was Masco (MAS). Masco's second quarter 2012 earnings as well as revenue missed the Zacks Consensus Estimates due to currency headwinds and a sluggish global economy. Overall, the company anticipates weaker-than-expected growth in the second half of 2012, owing to slower-than-expected recovery of the U.S economy and Euro-zone crisis. The stock carries a Zacks #3 Rank (short-term Hold rating).
Vulcan (VMC) reported lackluster earnings in the second quarter due to a decline in revenue and volumes. Revenues declined from the prior-year quarter levels mainly due to a decline in shipments and an unfavorable geographic mix in its flagship Aggregates segment, which produces construction aggregates.
Vulcan expects the second half results to be better than the first half banking upon cost reduction efforts and better earnings in the Aggregates, Concrete and Asphalt segments. We, however, prefer to wait and see if the company actually meets the bullish second half outlook. The stock carries a Zacks #3 Rank (short-term Hold rating).
Read the analyst report on LEN
Read the analyst report on KBH
Read the analyst report on PHM
Read the analyst report on MAS
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Read the analyst report on MTH
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