After a long period of enthusiasm for homebuilders’ stocks during the post-financial crisis recovery, the market has closed the door on this group, explains value investing expert George Putnam, money manager and editor of The Turnaround Letter.
A major worry is that the housing cycle may be ending, partly due to recession fears and partly due to rising mortgage interest rates (approaching 5%), increasing home prices and new limits on the deductibility of property taxes that all make affordability a challenge to many potential buyers.
Adding to the revenue pressures are higher labor, materials and land costs that combine to threaten profits. However, unlike the excesses that built up during the 2006-2008 housing crisis, there is little evidence of an impending collapse.
The overall rate of home ownership remains subdued, and new housing starts have only recently risen above the low rates typically seen in recessions (looking back as far as 1960). Demand for housing in this cycle is supported by a robust economy growing at 3.5% with unemployment at the lowest rate in generations.
Meanwhile, homebuilder shares trade at discounted valuations. Many trade below their tangible book value, indicating recession-like levels. Most of a homebuilder’s assets are inventories of homes under-construction and land held for development, and therefore assets reflect current market values — or even less if they have owned the land for some time.
A builder trading at tangible book value is essentially trading at liquidation value. It might not take much good news to lift this group. Listed below are six homebuilder stocks that appear well-positioned for investors looking to take a contrarian stance:
Hovnanian Enterprises (HOV)
Founded in 1959 by Kevork Hovnanian, whose family still holds a controlling stake, this company builds homes for buyers ranging from first-timers to luxury. Its primary markets include California, Texas, Arizona and the mid/south Atlantic region. Hovnanian’s heavy debt burden held back its ability to acquire and develop land, and its shares remain near their 2009 lows.
A controversial financing package that involved a technical but essentially meaningless default earlier this year spooked investors but provided Hovnanian with cheaper and more accommodating financing. Legacy losses have kept its book value negative. Hovnanian’s debt gives it one of the industry’s highest risk profiles, but should it return to healthy profitability, its shares have among the highest potential returns.
KB Homes (KBH)
KB Homes, in business since the 1950s, has a heavy presence in Florida, Texas and California. The company offers an attractive build-to-order program which allows a degree of customization yet captures the benefits of volume and standardization.
In recent quarters, KB Homes has produced steadily rising margins and profits per unit. While the company has debt due in each of the upcoming years, it has plenty of liquidity plus a recently upgraded BB- credit rating, which should allow the debt to be refinanced at reasonable terms.
Lennar Corporation (LEN)
A public company since 1971, Lennar is by far the largest of the publicly traded homebuilders. Its operations span the entire West Coast as well as Texas, most of the East Coast and much of the upper Midwest. Lennar has completed some sizeable acquisitions recently, including the $6 billion deal for CalAtlantic Homes in 2018.
Debt levels have jumped, yet Lennar’s use of shares combined with plenty of pre-deal financial flexibility has kept its credit rating at a relatively high BB+. The company announced plans to sell its Rialto commercial real estate investment and mortgage business, helping to further reduce its debt and its financial risks.
M/I Homes (MHO)
A previous Turnaround Letter recommendation, M/I Homes shares have dropped 35% from our Sell price of 36.16 in December 2016 after producing a 75% gain during the period we recommended it. This company builds homes for a range of buyers, from starter to luxury homes, emphasizing the Midwest, Florida, Texas and Mid-Atlantic markets.
While its profit margins are a bit below-average, the company is well-positioned to benefit from higher revenues and earnings next year. Its recently announced $50 million share repurchase program equals nearly 8% of its market capitalization. The balance sheet has a lower-than-average debt level. M/I Homes’ share price has retreated to its late-2012 price.
Taylor Morrison Home Corporation (TMHC)
One of the larger homebuilders, with revenues of about $4 billion, Taylor Morrison operates in eight states including major markets like California, Texas, Florida and Arizona. Its homes sell for an average of $480,000, reflecting its emphasis on “move-up” houses — a segment more vulnerable to weaker orders recently.
Taylor Morrison was created in 2011 when British homebuilder Taylor Wimpey sold its North American operations to a private equity consortium. Two years later, it completed its initial public offering, followed by rapid growth from a series of acquisitions.
In 2018, the private equity sponsors sold their remaining stake, making Taylor Morrison now 100% publicly owned. The company has a reasonable 3x debt/EBITDA, and its first debt maturity is in 2021, providing it with staying power.
William Lyon Homes (WLH)
After its brief journey through bankruptcy following the housing crisis, William Lyon Homes emerged in 2012 and returned to public ownership with its 2013 initial public offering. Investors have fled its shares this year, however, so that they now trade at just over half the $25 IPO price.
William Lyon Homes focuses on the western United States as well as Colorado and Texas, gaining access to the latter with its $460 million acquisition of RSI Communities in February.
About half of its unit sales are to first time buyers, but its significant business in higher price ranges brings its average selling price to $479,000. Its high debt, at 5.5x EBITDA, makes this a riskier stock, but with its first maturity more than three years away, the company has plenty of financial runway.
