PulteGroup Down to Neutral

We recently downgraded our rating on PulteGroup Inc. ( PHM - Analyst Report ) from Outperform to Neutral due to continued weakness in the homebuilding market.

PulteGroup reported earnings per share of 11 cents in the fourth quarter of 2011, exceeding the Zacks Consensus Estimate of 8 cents and the year-ago figure of 1 cent per share. Improved gross margins and reduced overhead costs boosted earnings, despite a nominal increase in revenue.

Pulte’s homebuilding revenues rose marginally by 1% to $1.2 billion from the fourth quarter of 2010. The increase in revenues was attributable to a 3% increase in average selling prices to $271,000, which was partially offset by a 2% decrease in closings to 4,303 homes. The adjusted gross margin expanded 200 basis points in the quarter to 18.6% of home sale revenues, driven by a better mix of sales, particularly of move-up homes, as well as the addition of newer higher margin communities.

We are encouraged by the company’s initiatives to improve its operating and financial performance. These initiatives include steps to manage margins, overhead and inventory; initiating new pricing strategies and reweighing its market position. These strategies would better place the company over the long haul once the homebuilding market fully recovers.

As part of its cost reduction program, Pulte has made significant workforce reductions and is also aggressively working to reduce overhead costs. In 2011, the company consolidated its field organization and select corporate functions. It has also consolidated its regional operations in Arizona, Florida, New York and New Jersey and merged its West and Central area. The continued reduction in overhead costs has pulled down the company’s Selling, General and Administrative (SG&A) expenses substantially in 2011 and subsequently increased margins.

The company is also continuously evaluating its assets and prioritizing markets and projects in order to allocate capital appropriately and to invest selectively in high return projects. The company is divesting lower margin projects and exiting non-performing communities which no longer fit into the company’s operating strategy. This helps free up cash to invest in other potential opportunities which generate higher returns.

However, the homebuilding industry has been fragile, which has largely affected operations of the company in all its markets in the last few years. The company, like its compatriots DR Horton, Inc. ( DHI - Analyst Report ) , KB Home ( KBH - Analyst Report ) and Lennar Corporation ( LEN - Analyst Report ) , has witnessed declining demand for new homes due to high unemployment rates, low consumer confidence, rising interest rates and tightened mortgage lending standards.

Other than that, the housing market has become extremely aggressive and the company’s new homes faced tough competition from housing alternatives, including resale homes, foreclosed homes, short sale homes and rental housing. In the US, new home sales were approximately $0.3 million in 2011. This reflects a sharp decline from the 2005 peak of 1.3 million new homes sales.

The weakened demand heightened pricing pressures on new and existing home sales, which when combined with the changes in a geographic mix of homes closed, resulted in significant decreases in the average unit selling price from peak 2007 levels.

The company maintains a cautious outlook for 2012 due to uncertainty in the timing of recovery in the homebuilding industry. The community count is expected to continue to decline between 5% and 10% during 2012 which could convert into below-average order growth in the year. We prefer to remain on the sidelines until we see any meaningful recovery in the broader homebuilding market.