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On Jan 15, we maintained a Neutral recommendation on D.R. Horton Inc. (DHI - Analyst Report). Though the company reported dismal fourth-quarter fiscal 2013 results, its fundamentals remain strong.

Why Back to Neutral?

On Nov 12, 2013, D.R. Horton reported dismal fourth-quarter fiscal 2013 results missing the Zacks Consensus Estimate for both revenues and earnings as net orders declined. Earnings grew 33.3% year over year driven by margin expansion and lower interest expense than the last year. Homebuilding revenues climbed 40% year over year due to pricing gains.

Net sales orders declined 2% in the fourth quarter as housing demand slowed. The net order trend was weaker than 12%, 34% and 39% growth reported in the third, second and first quarters, respectively. The cancellation rate stood at 31%, significantly higher than 24% in the third quarter and 19% in the second. In fact, the company’s net orders have slowed down in the second half of 2013 as the recent increase in interest/mortgage rates and increasing home prices slowed order pace and traffic. We believe that the sharp increase in interest rates shocked many customers and a few put off their purchase decisions; thus increasing cancellation rates and lowering orders.

Encouragingly, order trends improved in Oct 2013. Also, the company’s strong land position keeps it well positioned to meet demand in fiscal 2014 and 2015.

Moreover, pricing gains and better fixed cost leverage boosted profits in the quarter. Despite a slowdown in orders in the second half of fiscal 2013, D.R. Horton’s profitability remained intact due to its cost control and productivity improvement efforts. Its pre-tax margins have almost doubled from 5.6% in 2012 to 10.5% in fiscal 2013.

Despite improving profits, we prefer to remain on the sidelines until we see a rebound in volumes. Moreover, the recent increases in interest rates is concerning. The mortgage rates have started increasing from May 2013. High interest rates decrease the demand for new homes as mortgage loans become expensive, thus lowering the buyers’ purchasing power. This can hurt volumes, revenues and profits of homebuilders.

Moreover, sustainable increases in housing and housing demand for the long term will require the overall economy to strengthen. Until there is more robust economic recovery, the new home sales could remain below historical levels. Rising input costs, due to increasing costs of raw material and labor, is also a concern.

Other Stocks to Consider

D.R. Horton carries a Zacks Rank #4 (Sell). Some better-ranked homebuilders include Standard Pacific Corp. (SPF - Snapshot Report), PulteGroup, Inc. (PHM - Analyst Report) and Toll Brothers, Inc. (TOL - Analyst Report). All these companies carry a Zacks Rank #2 (Buy).

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