3 Homebuilding Stocks: High Value Plays, I Expect Over 50% Upside
Over the past few months, I’ve recommended three homebuilders for purchase on Seeking Alpha – PulteGroup (NYSE:PHM), M/I fireplaces (NYSE: MHO) and Hovnanian companies (NYSE:HOV). Investors continue to have very little confidence in the earning power of these companies:
- Let’s start with Pulte. Wall Street analysts, according to Seeking Alpha, expect this $52 stock to earn $9.19 per share in 2022. That’s a pittance. 5.6 P/E ratio, a sad 30% of the market multiple.
- M/I fireplaces? This $51 stock should earn $14.16 per share, for an even more ridiculous price 3.6 P/E, and an even sadder 20% of the market multiple.
- Hovnanian? I blush writing this. This $97 stock doesn’t have Wall Street coverage (interesting, does it?), but the company gave a forecast for 2022 in its fiscal fourth quarter earnings release with a midpoint of $29.25 per share. It’s a 3.3 many. Possibly the lowest NYSE multiple.
These astonishing P/E ratios obviously indicate that investors are expecting very bad things to happen to homebuilder earnings – steep and sustained declines, possible bankruptcy risk, and so on. P/E, i.e. an earnings yield of 15% (E/P). I bet you would be okay with a 15% return. So the market is implying a far worse outcome than a 50% drop in EPS.
Is this fear realistic? To see, in this report I will present to you:
- The outlook for 2022
- The longer-term supply and demand story
- A liquidation valuation
Spoiler alert – Pulte, M/I and Hovnanian are really cheap. 50%+ benefits are reasonable.
The 2022 outlook – the backlog tells the story
A home builder’s backlog is a great predictor of homes closed for the coming year and therefore revenue. For example, over the past decade, Pulte’s backlog at the start of the year explained 90% of that year’s sales. So pay close attention to this graph, which shows the combined backlog history of the three manufacturers:
The 2021 numbers actually underestimate the revenue potential for builders. Supply chain disruptions have caused homebuilders to delay the development and sale of homes until managements are more confident they can deliver finished homes in a timely manner. Thus, the arrears of 21 could have been even higher.
To further highlight the bright prospects of builders in 22, here are some tips from peer KB (NYSE: KBH) from two weeks ago (my additions in brackets):
“Housing income is between $7.2 billion and $7.6 billion. (compared to $5.7 billion in 21)
“Average sale price in the range of $480,000 to $490,000”. (from $422,700 in 21)
“Housing gross profit margin between 25.4% and 26.2%” (compared to 24.4% in 21)
“Return on equity greater than 26%.” (from 20% in ’21)
Net/net, I am not worried that Pulte, M/I or Hovnanian will meet earnings expectations for this year.
The longer-term supply and demand story
Like any business, homebuilders’ revenue prospects depend on the demand and supply prospects for their product. So I’m going to go over the supply and demand stories and then put them together to see how earnings should go.
Net/net, I expect Pulte, M/I and Hovnanian to roughly maintain their EPS levels over the next five years.
The supply outlook – stable as it goes.
The business of home builders is to provide new housing to the existing housing stock. This graph shows a history of industry housing starts as a percentage of housing stock at that time, to arrive at a “housing stock growth” figure:
The graph shows that the supply of new homes is very low at present, outside of the post-’07 housing crisis era. Is the direction of demand likely to make this supply too high, too low, or about right?
Housing demand outlook – crosswinds
I believe the most important measure of housing demand is the number of vacant units. Luckily for us, the Census Bureau is on the case; they track vacancy data since 1965. Here are their numbers:
Vacant housing, both for single-family families and for the housing market as a whole, is currently at its lowest level in 56 years! That’s why we keep getting stories like this:
“The latest reading of housing inventory levels does not look good for potential buyers. In December, there were only one million homes for sale on Zillow. That’s down 18% from December 2020 and 38% from December 2019, when there were nearly 1.7 million homes for sale. This means the housing market is tighter right now than it was heading into the hypercompetitive spring 2021 market.(Fortune magazine, January 18, 2022)
I will quantify the shortfall. This graph shows the housing surplus or deficit compared to a “normal” vacancy rate of 3.5%:
A shortage of 1.5 million households! By the way, if you think the United States is about to suffer another real estate crisis like during the financial crisis, think again. At the start of the 2008 crisis, the country was sitting on one million housing units excess. It is far, very far from the current 1.5 million shortage.
I am not unaware of the reasons to be concerned about the demand for housing. Two keys are:
- Demographic slowdown growth, at less than 0.5% currently. Fewer people added means less demand for new housing. This fact is partially offset by the fact that the large cohort of millennials have entered their peak home buying years.
- Housing has become less affordable recently. Affordability is a function of household income, house prices and mortgage rates. Here is how these three factors have come together over the past 30 years:
This data is the NAHB estimate of the percentage of US households that can afford an average home. Chart shows affordability was currently at the lower end of the range for Q3 21. I estimate mortgage payments are now 13% higher than Q3 due to further price increases houses and a sharp increase in the mortgage rate. As a result, the affordability index is much lower than in the third quarter, which of course compresses demand.
Putting supply and demand together, I expect more of the same construction activity.
Over the past year and a half, homebuilders have built at a rate of about 1.1 million units. Considering the ups and downs of demand, I expect builders to be able to maintain roughly that 1.1 million rate for the foreseeable future, say the next five years. I also expect house price growth to slow sharply, to perhaps 2-4% per year.
This is a far cry from the steep decline investors have been anticipating in these stocks, and confirms my belief that Pulte, M/I and Hovnanian can sustain their EPS levels of 22 for the next five years or so. My other two major assumptions behind my longer-term PSE vision are:
- Gross margins will be squeezed somewhat as house prices rise moderately and labor costs rise.
- Builders will use the large free cash flow they generate to buy back large amounts of stock (Pulte and M/I) or pay off a lot of debt (Hovnanian).
I have examined these assumptions in detail in the Seeking Alpha articles I linked to above.
Evaluation. A liquidation analysis.
I’ve noted the builders’ low barrel P/E ratios before. To highlight what market prices implicitly imply, here is a liquidation analysis. I add four values:
- Book value
- Market value above book value of homes under construction, assuming the 25% gross margin that builders currently earn
- Market value above book value for owned and optioned land. I assume that Pulte and M/I land has an average life of 3 years which has appreciated by 40%, while the land position of Hovnanian has an average life of 2 years with an appreciation of 30 %.
- Hovnanian has tax loss carryforwards with a present value of $150 million.
Here are my results:
M/I and Hovnanian are already selling well below their liquidation values. But remember that these companies also have value as operating companies – they will be buying land and selling homes for many years to come. This value of the operating company is not reflected in the liquidation calculation. And that has value. For example, Toll Brothers peers (NYSE:TOL) has achieved a median return on equity of 18% over the past 30 years, with 24% expected this year. You would certainly pay well above face value for an investment that returns 18%, even if this return varies with real estate cycles.
Net/net, these stocks are pretty cheap. I add the value investor caveat that I have no idea when investors will agree with me. But returns of over 50% are usually worth the wait.