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Homebuilding Stocks: Has Spring Sprung?

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The housing slowdown that began in the second half of 2013 was aggravated by a harsh winter. This took a toll on the homebuilders in the December quarter, delaying construction and raising serious doubts as to the strength of the housing market.
The weather has no doubt been a major spoilsport for the sector in the past quarter. However, there are other pressing issues for the builders as well. Shortage of lots and skilled labor, rising cost of materials and a declining level of new homes in inventory are not making things easier for these builders. Moreover, the recent spike in mortgage rates and rising home prices are hurting demand. As a result, many companies saw declining order trends in the last reported quarter.
Orders declined around 18% at PulteGroup, Inc. (PHM - Free Report) , 6% at Toll Brothers, Inc. (TOL - Free Report) and 4% at Ryland Group, Inc. (RYL) in the last reported quarter. Though order trends improved year over year for others like Lennar Corp. (LEN - Free Report) , it slowed down from the past quarter.
A slew of data released recently clearly shows that the housing sector has had it tough in the recent past.
Homebuilder confidence, as indicated by the National Association of Home Builders (NAHB)/Wells Fargo housing market index, dropped to 47 in both April and March and 46 in February from 56 in January indicating increasing builder concerns about meeting ongoing and future demand thanks to a shortage of lots and labor.
Further, housing starts declined 0.2% to an annualized rate of 907,000 in February from the prior month, weighed down by lower multi-family starts. Meanwhile, single-family homes and apartments rose only slightly. The February data was a continuation of the January trend when starts dropped 16%. New home sales also dipped 3.3% in February as the weather remained bitter and supply constraints continued to plague homebuilders.  
However, as the winter chill subsides and builders prepare for the upcoming spring selling season, improving trends may well be in the cards.  Builders are increasing their inventories of homes as they anticipate a relatively strong spring buying season. This might propel homebuilder stocks higher in the months ahead as demand for new homes rise.
Although interest rates are rising, they are currently doing so below historical levels; housing is still affordable. In addition, accelerating job growth, an improving economy and unlocking pent-up demand will likely boost demand for new homes for the rest of the year.
Building permits, a measure of future construction, rose 7.7% in February, the highest rate since October last year and, more importantly, the second highest rate since the middle of 2009. The strong permits show that we can expect steady gains in construction activities over the spring and summer months. NAHB also expects 2014 to be a strong year for housing, expecting a big increase in single-family construction.
Land as Native Strength

Homebuilders like Lennar and Toll Brothers with a solid land position have been able to better capitalize on the rising demand for homes during the upturn. This gave these companies a competitive edge over peers like Pulte which faced land availability constraints.
During the downturn, Lennar strategically focused on acquiring new home sites in well-positioned markets. The company thus has enough land in all major markets to satisfy deliveries well into 2015.
However, others like Pulte have intentionally slowed down the sales pace across some of their communities (thus lowering the community count) due to a lack of land development and scarcity of finished lots. Housing inventory, both existing and new homes, remains tight in most markets. Instead, Pulte has been more focused on driving price and margin in most communities. This strategy hurt net order growth significantly, with orders declining around 10% in fiscal 2013 -- a stark contrast to the increase enjoyed by most of its peers.
California-based homebuilder KB Home (KBH) is also emphasizing on price and margin improvement to optimize returns from its land assets. This slowed down its sales pace and resulted in lower order growth in 2013. Though the price optimization initiatives of Pulte and KB Home have boosted profits in the past, the companies need to increase their volumes consistently to boost long-term top-line growth.
Other homebuilders have realized the importance of land investments. Ryland Group has spent $689 million on land acquisition and $257 million on site development in 2013. Texas-based D.R. Horton, Inc. (DHI) invested $2.6 billion in land, lots and development in 2013, positioning it well to meet demand for fiscal years 2014 and 2015.  KB Home spent $1.14 billion in land investment in fiscal 2013, significantly more than $564.9 million spent in 2012. In fact, aggressive land investments helped KB Home record better order trends in its last reported quarter, Q1 of fiscal 2014.
High-End Homes Driving Prices
Despite the softness in the market, pricing remained strong in the back half of the year. Home prices began moving up sharply from 2013 with market demand gaining momentum and supply remaining limited.
Many homebuilders like Lennar, KB Home and Toll Brothers have shifted their focus on high-end communities, primarily in 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. Also, Pulte is building some new commonly-managed communities that represent homes that have been constructed under the company’s more efficient design, cost and build processes and thus generate better margins and volumes than the non-commonly-managed communities.

Another small homebuilder, Meritage Homes Corporation (MTH - Free Report) , 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 improving the quality and the luxury quotient of its homes, thus giving it a competitive advantage.
Margins Remain Strong
Despite slowing volumes in the second half, pricing remained strong, which along with tight cost control and improved efficiencies boosted the overall margins for many homebuilders.
Most housing companies are striving to improve their operating and financial performance through strategic restructuring initiatives. The initiatives taken include workforce reductions, improving overhead leverage, managing inventory tightly and implementing new pricing strategies. The homebuilders expect these cost reduction and operating efficiency improvement plans combined with positive housing demand to continue to boost profitability in 2014.
Ancillary Companies Seeing Strong Momentum
Construction material companies Vulcan Materials Company (VMC - Free Report) and Eagle Materials Inc. (EXP), and building product makers Masco Corp. (MAS - Free Report) and Louisiana-Pacific Corp. (LPX - Free Report) , have gained momentum from improving new home demand. These companies also saw a concomitant rise in demand and volume for their products.
In fact, Vulcan Materials’ second-half revenues and profits improved significantly from the first half as improving private construction activity and better weather conditions markedly raised volumes. Positive trends in new home construction activity and improvement in repair/remodel activity in North America significantly improved Masco’s top line in the second half of 2013.
Fed to Keep Interest Rates Low
For most of 2013, the Federal Reserve bought $85 billion in government bonds and mortgage backed securities a month, known as quantitative easing, to keep interest rates low and boost economic growth. However, the Fed scaled back the bond buying program thrice by $10 billion each as economic growth picked up.

At present, the Fed is buying $55 billion in bonds per month. Ideally, tapering of the bond-buying plan would have put pressure on interest/mortgage rates. However, the Fed has maintained tight control on interest rates and they have been kept low, irrespective of the reduction in the bond buying program. This has removed a major overhang for homebuilders.
Supply Constraints

A shortage of approved home sites, labor constraints in some markets and a lack of available capital for smaller builders are lowering the supply of homes, both new and existing. The supply of homes is still not meeting current demand leave alone pent-up demand. If the supply picture does not improve, home prices could shoot up further, causing many homebuyers to hold back on their purchase decisions.
Rising Interest Rates
Since the middle of 2012, homebuilders have largely benefited from historically low interest rates, eventually leading to the sharp increase in home buying activity. However, mortgage/interest rates are edging upwards to more normalized levels since May 2013. According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate has risen from 3.59% on May 23 to 4.34% as of Apr 10.
High interest rates dilute demand for new homes, as mortgage loans become expensive. This lowers a buyer’s purchasing power. This can hurt volumes, revenues and profits at the homebuilders.
Homebuilders at large admitted that higher interest rates have eaten into volumes since the second half of 2013. But the homebuilders are also convinced that sluggish demand is only a fleeting phenomenon and buyers would soon return to the market overcoming their inhibitions of rising rates and climbing home prices. As discussed above, the Fed has also assured of a stable interest rate.
In fact, 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. The economy, while still improving slowly, is far from a full-fledged recovery. Until there is a more robust economic recovery, new home sales would continue to lag historical levels.
Interestingly, with the rise in mortgage rates, lenders are beginning to ease credit standards to more normalized levels, which could in fact have a modest positive impact on demand.
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 future margins.
Latest Performance of Key Players
Despite rising interest rates and harsh weather, important housing companies like D.R. Horton and Pulte beat the Zacks Consensus Estimate for both revenue and earnings in the December quarter. This was largely due to aggressive pricing and margin growth, which made up for slowing order growth.

However, New Jersey based Hovnanian Enterprises Inc. missed expectations on both counts due to delays in deliveries caused by severe weather, interruption of cabinet supply and construction labor shortages. Others like Toll Brothers beat earnings expectations on the back of strong margins, while missing out on the revenue consensus due to soft order growth and difficult year-ago comparisons.
Among those which have already reported their results for the March quarter, Lennar and KB Home beat the Zacks Consensus Estimates for both revenue and earnings helped by better order trends, price increases and strong gross margins.
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 at #141. This is in the middle 1/3rd of all industries ranked, highlighting the group’s near-term neutral outlook. The cautious stance reflects an albeit temporary pause after a harsh winter and the threat of rising interest rates before demand picks up in the upcoming spring selling season.
Earnings Trends
Looking at the overall results of the Construction sector, earnings shot up 13.9% in the December quarter, due mostly to pricing gains and strong margins -- a major decline from a 32.1% rise in the September quarter due to slower volumes. Total revenues were up 6.3% in the quarter versus a 9.2% rise a quarter ago. The sector racked up an earnings beat ratio (the percentage of companies coming out with positive surprises) of 63.6% and revenue beat ratio of 72.7% in the December quarter.
In the first quarter, earnings and revenues are expected to grow 2.5% and 4.9%, respectively, with better growth rates expected in quarters thereafter as the sector regains momentum.
For 2014, earnings are expected to show a 12.3% increase. Revenues are forecast to expand 8.1%.
For more details about earnings for this sector and others, please read our latest ‘Earnings Trends.’

Bottom Line
Though the harsh winter and rising home prices did put the brakes on a housing recovery last quarter, homebuilders are increasingly optimistic of improving demand in the upcoming spring selling season. Many homebuilders noticed that both traffic and sales volume showed a steady improvement in January and February as they left the seasonally slowest months behind them.
Our proprietary Zacks Ranks indicate the movement of stocks over the short term (1 to 3 months). At present, 16% of the stocks sport a bullish outlook while 62% are neutral. The remaining 22% are bearish.
Stocks which will likely outperform the broader market and currently hold a favorable Zacks Rank #1 (Strong Buy) include William Lyon Homes (WLH - Free Report) , while Taylor Morrison Home Corporation (TMHC - Free Report) and NVR, Inc. (NVR - Free Report) carry a Zacks Rank #2 (Buy). We are currently not enthusiastic on Zacks Ranked #5 (Strong Sell) MDC Holdings Inc. (MDC - Free Report) and Zacks Rank #4 (Sell) Hovnanian Enterprises and Ryland Group, due to weak order trends in the last reported quarter.

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