It seems there’s more to that caution than just a chilly winter. Homebuilders are having trouble finding buildable lots and skilled workers. Many have tempered their sales expectations for the next six months.
Investors, take notice.
The housing market isn’t firing on all cylinders. Any investments at the moment should be made with care. Although there are better industries to be investing at the moment — banking and casinos are two names that come to mind — these three homebuilders are worth serious consideration.
Homebuilders to Buy: KB Home (KBH)
KB Home (KBH) delivered its first Q1 profit since 2007 last week on the back of strong price increases across all four of its regions. Chief among the increases was its West Coast region which saw the average sale price increase 30% year-over-year to $525,000. The bad news is that only 346 homes were delivered on the West Coast in Q1 compared to 509 a year earlier.
That decline would be killer if you didn’t look more closely at its backlog. The West Coast’s average selling price on the 580 homes still to be built is $567,000 — $159,000 higher than the backlog from a year ago. The West Coast is generating more revenue from less homes. That’s a problem homebuilders can live with. KBH stock will benefit down the line should the company move all of its backlog through the pipeline.
In 2013, KB Home delivered its first annual profit since 2006. Back then, its book value was $3 billion, more than double today’s market cap and six times its current book value. Those were clearly better days. However, its Q1 2014 adjusted housing gross margin of 17.8% — 260 basis points higher than Q1 2013 — is a sure sign its business is improving on the West Coast where it generates more than 40% of its overall revenue.
As California goes, so goes KBH stock. Should KBH’s adjusted housing gross margin hit 20% in 2014 along with a 12% selling, general and administrative margin, KBH’s bottom line profit should be greater than $100 million come the end of November.
If so, you could value KBH stock at $2 billion or more. With KBH stock down 19% over the past 52 weeks, I like its chances of reversing that trend.
Homebuilders to Buy: Lennar (LEN)
You usually can’t go wrong betting on the biggest operators in any industry. New home development is no different. If its Q1 results are any indication, Miami-based Lennar (LEN) is a good bet when it comes to housing.
Although there are indications things might not be so cheery in housing right now, CEO Steve Miller believes the industry is heading in the right direction, stating:
“Although it is still too early to predict the strength of the spring selling season, we are optimistic that the housing market is continuing to recover, and that the fundamental drivers of that recovery remain intact. We believe that the housing market is still in the early stages of recovery.”
That’s good news for LEN stock and all the other homebuilders.
Lennar’s Q1 earnings before interest and taxes increased 65% to $165 million on $1.36 billion in revenue. That’s an EBIT margin of 12.1%, a full two percentage points higher than in the same period a year earlier. Drivers of this margin expansion include an 18% increase in average sales price combined with increased deliveries in five of its six operating regions.
Its western region (California, Nevada) experienced large increases in both the number of homes delivered and the average price paid for those homes. The West contributed 27% of the 3,609 homes delivered by Lennar in Q1, and while the improvement in California is impressive, the East is where its future revenue generation lies, with 39% of its backlog in seven states up and down the Atlantic. With all the excitement on both coasts, investors can expect Lennar to generate more than $1 billion in operating income in fiscal 2014, something it hasn’t done since 2005.
Whatever happens in the next three quarters, you can rest assured that Lennar is going to be one of the main beneficiaries of any spring thaw. LEN stock, like most homebuilders, hasn’t done well in the past year. Given its strong earnings, I don’t see any reason why that can’t change as we move into the summer selling season.
Homebuilders to Buy: PulteGroup (PHM)
KeyBanc analyst Kenneth Zener downgraded LEN stock from buy to hold in early March. At the same time, the analyst upgraded PulteGroup (PHM) from hold to buy citing its measured growth combined with an attractive valuation as reasons for buying PHM stock.
Zener believes “defensive” investors will find PulteGroup’s focus on “profitability over volume” very attractive at a time when gains in home prices are likely to slow considerably. For those not as confident about the near-term future of homebuilders, owning PHM stock could be the safest play at the moment.
Nothing in PHM’s 10-K jumps out at you when it comes to top-line revenue. Its average selling price increased 11% in 2013 to $305,000 while the number of closings increased by 1,261 units or 7.6%. The combination of these two numbers produced an increase in home sale revenue of $872 million or 19%.
While that home sale revenue is solid, its 430 basis point increase in adjusted home sale gross margin is what made the difference in 2013. In fact, its 23.2% home sale gross margin in the final quarter of 2013 was the highest it has been on a quarterly basis since 2005. This achievement allowed it to generate a pre-tax profit of $528 million in 2013, 187% higher than in 2012. As a result, it retired $461 million in debt and sits with a debt-to-capitalization rate of 31% compared to 53% at the end of 2012.
PulteGroup, as Zener describes, is a good bet if you’re not sure that 2014 will be a banner year for new home construction. Of the big homebuilders, PHM stock is the most conservatively financed of the bunch while its valuation (EV/EBITDA) is also the least expensive. For these two reasons, I would recommend PHM stock over both Lennar and KB Home.
As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.