"Upside" in Two Homebuilders

04/16/2018 5:00 am EST

Focus: REAL ESTATE

Richard Moroney

Editor, Dow Theory Forecasts

Following a scorching 2017 that saw the S&P 1500 Homebuilding Index soar 75%, the sector has been relegated to the basement with a 9% year-to-date decline, nots Richard Moroney in his specialized small and mid cap advisory service, Upside.

What’s changed? Because the 30-year fixed mortgage rate is near 4.45%, up from 3.99% at the start of the year, investors fear rising rates will crimp demand.

The gloom seems overdone, in our view. To be sure, tax code changes that limit deductions for mortgage interest and property taxes could weigh on demand, especially in high-priced regions. But we remain optimisitic on the outlook for homebuilders, for several reasons.

Fueled by a growing economy, low unemployment, and gains in household wealth, Americans are increasingly buying homes after a prolonged stretch that favored renting.

Millennials, the largest generation since the baby boomers, are entering their prime household-formation years. Despite their strong run over the past year, the stocks remain reasonably valued.

For homebuilders, the average price/earnings ratio is only 14 based on expected current-year earnings, versus the five-year average of 16.

KB Home (KBH) operates in seven states and targets first-time and trade-up home buyers. On Feb. 28, the order backlog stood at $1.97 billion, up 10% from a year earlier. Strong cash flow helps fund land investment to sustain growth.

The company owns or controls roughly 46,000 lots. Roughly 50% of home deliveries are to first-time buyers, positioning the company well with millennials, who are the now the largest group of home buyers. KB earns an impressive Overall score of 92, supported by an 80 in Value.

In the February quarter, KB reported adjusted per-share earnings of $0.40, up from $0.15 and above the consensus of $0.28. Sales rose 6% but were slightly below expectations. Deliveries were flat; average selling price rose 7% to $390,000; and net orders increased a healthy 8% to 2,784 units.

Adjusted housing gross profit margin rose more than a percentage point to 21.4%. CEO Jeffrey Mezger said: “Our solid start to the year reflects our effective operational execution as well as strong housing demand.” KB Home, an attractive rebound play, is a Best Buy.

William Lyon Homes (WLH) builds single-family homes in eight states, with its core markets including Los Angeles, San Francisco, Portland, and Seattle. Despite rising mortgage rates and worries about higher costs, we are upbeat on the housing industry, reflecting solid demand, tight inventory, and a healthy U.S. economy.

On Dec. 31, the company’s order backlog stood at $433 million, up 5% from a year earlier. An expanding footprint should help drive growth. On March 9, the company completed the $460 million acquisition of RSI Communities, marking its first entry into Texas. Shares look cheap at 12 times trailing earnings, versus the median of 14 for peers in the S&P 1500.

An improved balance sheet and surging cash flow should help sustain growth. For full-year 2018, the consensus calls for per-share earnings to jump 71% to $3.14. We are initiating coverage of William Lyon Homes as a Buy.

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