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The housing market has steadily made a comeback from the lows witnessed from the severe and widespread downturn. However, the housing momentum seen in 2012 and in the first half of 2013 seems to have moderated somewhat with the recent spike in mortgage rates, tight credit availability and a limited supply of land and labor.

In spite of the recently rising interest rates, they are still below historical levels and housing is still very much affordable. Thus, high affordability levels, increased rentals and historically low interest rates are driving the housing momentum. In addition, accelerating job growth and increasing consumer confidence are boosting demand for new homes.

Supply, however, is constrained by low home inventories, both for new and existing homes. A shortage of land and labor is restricting the construction of homes, both single and multifamily. Home prices have thus started to move up with market demand gaining momentum and supply remaining limited. In fact, rising home prices and thinning home inventories have created a sense of urgency among homebuyers who are now more anxious to buy a house before prices shoot up further.

Most homebuilding companies are resultantly witnessing a significant growth in both volumes and average selling prices (ASPs). New home orders, backlogs (number of homes under sales contracts at the end of the year) and homes delivered continue to climb year over year.

Moreover, improving homebuilding revenues combined with tight cost control and better overhead leverage (as volumes improve) are boosting margins for most homebuilders. Most homebuilders believe the housing momentum will continue into 2014.

The National Association of Home Builders/Wells Fargo Housing Market Index (HMI), known as the homebuilder sentiment index, jumped 3 points to 59 in August from 56 in July. This was the fourth consecutive monthly increase in the index and was also the strongest increase in almost eight years. The jump in the index shows that the recent interest rate hikes have not dampened the housing recovery.

How Did the Big Players Perform This Quarter?

It was a mixed Q2 for the homebuilders. Among the big homebuilders Lennar Corp. (LEN - Analyst Report) and Meritage Homes Corp. (MTH - Snapshot Report) beat the Zacks Consensus Estimate for both revenues and earnings; KB Home (KB) beat on revenues and incurred a narrower loss. All the three companies saw increasing demand and pricing in most housing markets despite rising interest rates.

While D.R. Horton, Inc. (DHI) and The Ryland Group Inc. (RYL - Snapshot Report) beat the Zacks Consensus Estimate for earnings on the back of pricing and margin gains, they missed the expectations for revenue. Rising interest rates slowed down the order growth for DHI in the latter half of the quarter, which we believe hurt the top line.

PulteGroup, Inc. (PHM - Analyst Report) was the worst performer this quarter, missing the Zacks Consensus Estimate for both earnings and revenues due to declining net order growth.

OPPORTUNITIES

Land as Native Strength


Homebuilders like Lennar which have a solid land position are better placed to meet the rising demand for homes during the upturn. This gives these companies a competitive edge over peers like Pulte which are facing land availability constraints.

During the downturn, Lennar strategically focused on acquiring new home sites in well positioned markets. The company thus has enough land now to satisfy deliveries till through 2014 and is now pursuing land opportunities for 2015 and beyond. Its net orders jumped 27% in the second quarter.

However, net orders at Pulte declined 12% in the quarter. Pulte’s net orders were weak due to a decline in the number of communities. The company has been intentionally slowing down sales in the face of land development constraints and a scarcity of finished lots. The company is focusing more on driving price and margins rather than pushing up unit volumes. Such a strategy we believe has affected net order growth in the quarter.

Other homebuilders are speeding up their land investments. Ryland Group has spent $269 million on land acquisition and $108 million on site development in the first half of 2013. California-based homebuilder KB Home invested $575 million in land and land development in the first half, nearly three times the investment made in the year-ago period. The company plans to shell out $1.2 billion and more in land investment in fiscal 2013.

Texas-based D.R. Horton’s investments in homes under construction, land development and finished lots have increased by more than $1.1 billion during the first half of fiscal 2013 following the improved liquidity position from solid sales growth in 2012.

High End Homes Driving Prices

Most homebuilders like Lennar, KB Home and Toll Brothers, Inc. (TOL - Analyst Report) have shifted their focus on high-end communities, primarily of California, Arizona, Colorado and Florida, which allow them to sell larger, higher-priced homes, driving the ASPs up.

Homebuilders like KB Home also target the higher income, move-up buyers who are more likely to qualify for home loans. Pulte is shifting its focus towards its high-priced Pulte-branded move-up homes, which improve the overall ASP. Another small homebuilder, Meritage Homes, is also seeing improving selling prices from a mix shift towards move-up homes in higher priced communities and states. Luxury home-builder Toll Brothers is focused on raising the quality and the luxury quotient of its homes, thus giving it a competitive advantage.

Strategic Restructuring & Cost Saving Initiatives

Most housing companies are striving to improve their operating and financial performance through strategic and restructuring initiatives. The initiatives taken include workforce reductions, improving overhead leverage, managing inventory tightly and implementing new pricing strategies. Most homebuilders expect these cost reduction and operating efficiency improvement plans combined with positive housing demand to further boost profitability in the second half of 2013 and 2014.

Ancillary Companies Also Stand to Gain

Construction material companies, Vulcan Materials Company (VMC - Analyst Report) and Eagle Materials Inc. (EXP) and building product makers Masco Corp. (MAS - Analyst Report) and Louisiana-Pacific Corp. (LPX - Snapshot Report) are slowly gaining momentum from improving new home demand. These companies are also seeing a concomitant rise in demand and volume.

WEAKNESSES

Rising Interest Rates

Since mid-2012 homebuilders have largely benefited from historically low interest rates, eventually leading to the sharp increase in home buying activity. With the recent improvement in economic conditions and the housing market in general, mortgage/interest rates are edging upwards to more normalized levels since May 2013. This has raised concerns among some analysts. According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate has risen from 3.59% on May 23 to 4.40% as of Aug 15.

High interest rates dilute demand for new homes, as mortgage loans become expensive. This lowers a buyer’s purchasing power. As a result we found the share prices of most housing stocks after having peaked in May consequently hurtling down. The better-than-expected earnings at most homebuilders in the reported quarter could not prevent the share slide.

Rising interest rates notwithstanding, some companies like Lennar and KB Home witnessed increasing demand in all their housing markets and were able to push pricing further. However, others showed some concern. D.R. Horton noted at its fiscal third quarter conference call that the spike in interest rates slowed orders in the back half of its quarter. Meritage Homes said it saw a little bit of cooling in July due to higher rates, but indicated that demand remained stronger than July 2012.

We believe that while interest rates are an important part of the home-buying business, sustainable increases in housing and housing demand for the long term will require the overall economy to strengthen. This means further job growth, improving household incomes, rising consumer confidence and easing of credit availability. None of these factors have shown any substantial improvement so far, putting in question the sustainability of the housing momentum.

Changes in Federal Lending Process

Any change in federal lending procedure could also hurt demand for new homes. The Federal Reserve is currently buying $85 billion in government bonds and mortgage-backed securities per month, known as quantitative easing (QE), to keep interest rates low and boost economic growth.

However, the Fed plans to scale back this bond-buying plan by next year and instead adopt a tighter monetary policy to avoid deflation. The U.S. markets tumbled on the news. Investor confidence in the overall housing recovery was especially shaken due to concerns of rising interest rates if a tighter monetary policy were to have been implemented.

However, Fed Chairman, Ben Bernanke announced plans in July to keep interest rates low for longer. The Fed plans to keep the short-term interest rates at record lows even if the unemployment rate falls below 6.5%, which is the Fed’s current benchmark to consider a tighter monetary policy. Though Bernanke’s comments have put the above concerns to rest, at least for some time, the overhang still remains.

Rising Input Costs

Rising input costs are a concern due to increasing costs of building material and labor. As housing starts accelerate, both labor and construction material costs would continue to experience upward pricing pressure, impeding margins in the future.

Interestingly, though overall housing starts for multifamily construction rose 5.9% in the month of July, those for single-family construction declined 2.2%. Though unusually wet weather in the South and West pulled down the single family starts, rising interest rates, tight credit availability and a limited supply of land and labor also had a role to play.

Zacks Industry Rank

Within the Zacks Industry classification, we rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The Zacks Industry Rank for the construction industry is currently #185. This is in the bottom 1/3rd of all industries ranked, highlighting the group’s near-term Negative outlook given the current market situation. Even though the housing sector is doing well, the negative outlook highlights the increasing concerns over the recent hike in interest/mortgage rates and the resultant volatility in the housing sector.

Earnings Trends

The Construction sector depicts stable earnings trends. The second quarter 2013 results for the sector have been average in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 54.5%, while the revenue "beat ratio" was 36.4%. Total earnings for this sector increased 53.3%, reflecting a sharp moderation from 105.2% growth registered in the first quarter. We note that comparisons have become difficult considering that the housing industry started to improve steadily from the second quarter of 2012. Total revenue grew 10.1% in the quarter versus a 13.9% jump in the previous quarter.

The consensus earnings expectations for the rest of the year look encouraging with earnings projected to grow 19.6% in the third quarter of 2013 and 2.6% in the fourth quarter, thereby pegging the full-year 2013 growth outlook at 38.3%. For revenue, growth will likely be 10.0% in the September quarter, followed by 8.6% in the fourth quarter. Full-year revenue will likely increase 10.9%.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

Bottom Line

Overall the performance of the housing sector was essentially satisfactory. Our proprietary Zacks Ranks indicate the movement of the stocks over the short term (1 to 3 months). At present, respectively 21%, 58% and 21% stocks sport a positive, neutral and negative outlook.

Stocks which will likely outperform the broader market and currently hold a favorable Zacks Rank #2 (Buy) include Hovnanian Enterprises Inc. (HOV - Snapshot Report), Ryland Group, Meritage Homes and TRI Pointe Homes, Inc. (TPH - Snapshot Report). We currently are not too enthusiastic on the four stocks in our universe that hold a Zacks Rank #4 (Sell) or Zacks Rank #5 (Strong Sell). These stocks include Pulte, Consorcio ARA, S. A. B. de C. V. (CNRFF), M/I Homes, Inc. (MHO - Snapshot Report) and Gafisa S.A. (GFA).

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