Housing Sector's Alternative Mathematics
12/19/2013 11:00 am EST
After the better than expected numbers for November housing starts were announced yesterday, MoneyShow's Jim Jubak, also of Jubak's Picks, crunched the numbers and found some possible solutions for how to play this upwards movement.
I think the market added two plus two and got five yesterday, after the release of better than expected numbers for November housing starts. That doesn't mean, however, that two plus two equals four isn't impressive enough to warrant a look from investors at specific stocks in the housing sector. Two that I think are attractive here are homebuilder Lennar (LEN) and flooring retailer Lumber Liquidators (LL).
In numbers reported yesterday morning, housing starts jumped 22.7% to 1.1 million in November from October levels. That was at well above the 950,000 starts expected by economists surveyed by Briefing.com.
That led to huge gains in housing stocks. Lennar climbed 6.3% on the day. D.R. Horton (DHI) closed up 6.4%. Lumber Liquidators rose 6.1%.
The direction of that move is correct, in my opinion. Housing starts now look likely to run at an average rate of one million a month. The relatively modest extent of the Federal Reserve's taper—a drop of just $5 billion a month, to $35 billion from $40 billion, in its purchases of mortgage-backed securities—isn't likely to push mortgage rates up significantly. And with short-term rates likely, the Fed said on December 18, to stay near 0% into 2015, and with inflation running at less than 2%, there just isn't much upward pressure on interest rates in general, and mortgage rates in particular.
In addition, the December 18 announcement of the beginning of a taper in asset purchases from the Fed, removes a good bit of the uncertainty that has been driving volatility in the housing sector for months. Lennar, for example, has bounced from low to high to low to high with every shift in the market's interpretation of the odds of a Fed taper. For example, on November 11, Lennar traded at $32.58 a share. That was down from $37.38 on October 29. In the December 18 rally, the shares recovered all the way to $37.43.
But there are problems in the sector that say to me, “Watch that math.”
For example, the November 1.1 million starts was likely inflated by the uncertainty in September and October over the budget and the debt ceiling. A return to one million starts in December wouldn't be surprising. And it seems like homebuilders, especially, are looking at stagnant or declining margins in 2014. Lennar has told Wall Street that gross margins won't expand further in 2014 and are likely to remain flat at around 25%. That would be a drop from the 26.8% gross margins in the company's fiscal fourth quarter that ended in November 2013.
Those projections from Lennar say watch valuations across the sector. Lennar invested heavily in buying land early in this cycle, so the company is relatively less likely to feel pressure on margins from rising land costs as the housing cycle continues. I calculate a $40 a share target price for Lennar by July 2014. That's only a 7% gain from the December 18 close, so this stock would be much more attractive on the dip. (Investors might see that dip with the slower winter season, but spring weather usually pushes up prices in this sector.)
If you're looking for a dip in a housing related stock, I'd suggest Lumber Liquidators. The shares dropped from $119.44 on November 15 to $89.49 on December 13, before recovering to close at $99.50 on December 18. That's a 17% drop and it makes the gain to my target price of $129 by October 2014 an attractive 30%.
You should certainly ask why a stock with Lumber Liquidator's growth story shows such a steep decline. In its most recent earnings report, the company projected 25% earnings growth on continued remodeling of existing stores (toward a showroom approach more attractive to retail customers) and the addition of new stores. Company guidance was for 2014 earnings of $3.25 to $3.60 a share, for a growth rate of 19.5% to 32.4%. The Wall Street consensus is at $3.50, so the bottom of the company's range is somewhat below the Wall Street consensus of 28.9% growth, but since Lumber Liquidators almost always beats guidance, this gap isn't a big enough deal to explain the recent sell off.
For that—and to understand the risk you're taking on with this stock and why it might deliver 30% by October 2014—you have to look at the September 27 reports of a raid on the company's Virginia offices by customs and Fish and Wildlife Service agents. The company was served warrants alleging that it had illegally imported wood from the protected habitat of the Siberian tiger. Claims that the wood came from other sources were false, the warrants alleged. (The wood originates in Russia and is processed in China.)
Although the looting of Russian forests, and the laundering of this wood through China, is a very big deal, this particular incident wouldn't have been such a big deal, as far as the financial markets were concerned—the financial impact on Lumber Liquidators would seem to be limited, since no single hardwood supplier accounts for more than 1% of the company's sales mix, the company has said, and since the penalty for a violation of the Lacey Act is just $500,000 per violation—except that hedge fund manager Whitney Tilson raised questions at an investment conference about gross margins at the company. Tilson, who recommended shorting the stock, questioned whether there was a connection between the company's high gross margins and the importation of illegal lumber.
The investigation is likely to center on one of the company' long-term Chinese suppliers, Suifenhe Xingji Economic and Trade Company. And, certainly, an initial investigation by the environmental group, Environmental Investigation Agency, suggests that at least the Chinese company knew that the wood was from illegal sources. The environmental group says that executives at the Chinese company have said that Lumber Liquidators knew that some of the wood came from illegal sources.
If any of that is true, I hope they nail the pelts of the guilty to the barn door and I hope that the case, no matter the validity of the charges, leads Lumber Liquidators to tighten up its sourcing procedures and supply chain monitoring.
But the math of a connection between gross margins at Lumber Liquidators and illegally sourced Russian timber seems dubious. Lumber Liquidator's margins have been rising, as the company builds scale, and as it increases the efficiency of its supply chain by becoming a direct importer. Product margins for direct importers can easily hit 50% or more, so Lumber Liquidators' projected gross margins, of a little over 40%, don't have to be the product of cheating and illegal imports. And unless Lumber Liquidators is involved in an elaborate scheme to disguise big purchases of illegal lumber under multiple supplier shell entities, I don't see how the small percentage of its product the company says is supplied by any single supplier, could have a huge effect on margins.
But that is, indeed, the very messy situation that has led to the sell off in shares of Lumber Liquidators and the reason that shares carry such an attractive potential gain.
It's up to you to calculate where this risk/reward scenario falls on your personal scale.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June see the fund's portfolio here.