The housing recovery seems to be picking up after a softer-than-expected spring selling season. The buyers are back in the market now that they are more confident of a recovering economy and an improving job market. Still-low interest rates act as a further stimulus for home buying in spite of the Fed scaling back its bond-buying program.
The housing slowdown that began in the second half of 2013 was further handicapped by severe weather conditions, a biting winter and declining demand for homes in the first half of 2014. This raised serious doubts about the strength of the housing market.
Moreover, shortage of lots and skilled labor, rising costs of materials and declining inventory of new homes were not making things easier for the builders. Also, the spike in mortgage rates and rising home prices were hurting demand, which further added to the woes. As a result, many homebuilders witnessed declining order trends in the December quarter.
As the winter chill subsided, several homebuilders recorded improving order trends in the March quarter. However, the spring selling season failed to deliver on its promise as large homebuilders like Lennar Corp. (LEN - Free Report) and PulteGroup, Inc. (PHM) saw a sequential decline in order growth in the June 2014 quarter.
Also, some negative housing reports around that time indicated skepticism among home buyers. Pending home sales, new home sales (single-family houses) and housing starts as well as building permits all declined in June.
However, a slew of data released in August raises hope that that the housing market recovery might finally be back on track. Housing starts surged to an 8-month high in July, growing 15.7% from the prior month to an annualized rate of 1.093 million units. The July increase beat market expectations and came as a breather from the declines seen in the past two months.
Building permits, a gauge of future construction, also bucked the previous trend. After declining in June, building permits grew 8.1% in July.
Homebuilder confidence data for August hit its highest level since January, clearly indicating that builders are upbeat about their prospects for future sales. Homebuilders’ confidence, as indicated by the National Association of Home Builders (NAHB)/Wells Fargo housing market index, rose 2 points to 55 in August.
New homes inventory for sale rose 4.1% to 205,000 units in July. This is a 6-month supply at the current sales pace — the highest so far this year — which suggests that the supply picture is also improving.
Sale of existing homes rose 2.4% in July, for the fourth consecutive month this year. Pending home sales rose 3.3% in July after declining in June, having risen now in four of the past five months.
However, sales of new single-family homes in the U.S. dipped 2.4% in July. The decline was below market expectations and was quite a surprise considering that other housing indicators have been on the rise.
Kevin Kelly, chairman of NAHB, resonated that new-home sales is a “volatile metric that can fluctuate significantly from month to month.” According to Kelly, the higher inventory levels suggest that builders are improving their inventory anticipating improvement in new home sales through the balance of the year.
It is generally believed that the construction gains should continue through the rest of the year driven by rising home demand, stabilizing mortgage rates this year, improving job market, good pricing environment and rising inventory levels.
Firming Home Prices & Stabilized Mortgage Rates Can Spur Demand
Home prices have been rising in 2014 albeit at moderating rates. The median home price increased 4.9% year over year in July, down from a 13.1% gain last year.
Another report from the S&P/Case-Shiller home price data for June also showed a persistent slowdown in price increases. The year-over-year reading for the 20-city index showed price increases of 8.1%, well below the 9.3% increase in the year-ago month. Each of the 20 cities saw annual price growth slowdown for the first time since early 2008.
Meanwhile, mortgage rates have remained low this year even though the Fed continues to withdraw support from the system by scaling back its bond-buying program. According to the Freddie Mac mortgage survey, the 30-year fixed mortgage rate has gone down from 4.43% in January to 4.13% in July.
Though mortgage rates are higher than the average rate in 2013, they are still below historical levels, making housing affordable. The rising inventory, low mortgage rates and moderating home prices are expected to give homebuyers much-needed confidence, paving the way for higher home demand in the second half of the year.
Land as Native Strength
Homebuilders like Lennar and Toll Brothers, Inc. (TOL - Free Report) with solid land positions, have been able to better capitalize on rising demand for homes during the upturn. This gave these companies a competitive edge over the likes of Pulte, which faced land availability constraints.
Toll Brothers has secured some of the most sought-after urban locations in the country – New York City, Northern New Jersey, Philadelphia and Washington D.C. – where land is scarce and approvals are not easy to obtain. Lennar 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. 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 – as against the increase enjoyed by most of its peers. Pulte’s orders declined a further 4% in the first half of 2014. Though the price optimization initiatives are improving Pulte’s pricing and profits, the below-average order growth raises concerns about the soundness of its strategy.
Other homebuilders have realized the importance of land investments. Small homebuilder Ryland Group, Inc. (RYL) has spent $258 million on land acquisition and $166 million on site development in the first half of 2014. Texas-based D.R. Horton, Inc (DHI - Free Report) invested $2.6 billion in land, lots and development in 2013 and $1.7 billion in the first nine months of fiscal 2014, positioning it well to meet demand for fiscal years 2014 and 2015.
California-based KB Home (KBH - Free Report) spent $1.14 billion in land investment in fiscal 2013 and around $860 million so far in 2014. In fact, aggressive land investments helped KB Home record better order trends in its first half of 2014 after a soft 2013.
High-End Homes Driving Prices
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 and D.R. Horton are also shifting focus from first-time buyers to higher-income, move-up buyers who demand larger, higher-priced and more upgraded homes and are more likely to qualify for home loans.
Pulte is shifting its focus towards its high-priced Pulte-branded, move-up and Del-Webb branded active-adult 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 Corp.
(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 luxury quotient of its homes, thus giving it a competitive advantage.
Healthy Margins Offset Weak Volumes
Though volumes were soft in the June quarter, home prices remained strong which along with a favorable mix, 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 improved housing demand to continue to boost profitability in the second half.
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 adequate to meet current demand leave alone pent-up demand. If supply fails to improve, home prices could shoot up further, causing many homebuyers to hold back their purchase decisions.
Slow Economic Recovery
Sustainable revival in housing and housing demand for the long term will require the overall economy to strengthen. This means further job growth, improving household income, rising consumer confidence and easing of credit availability. The economy though on the mend is far from a full-fledged recovery. The lending environment is still overly restricted for certain borrowers. Until there is a more robust economic recovery, new home sales would continue to lag historical levels.
Rising Labor, Land and Material Costs
Rising building materials and labor costs are an increasing margin headwind. As housing starts accelerate, both labor and construction material costs continue to drive prices higher. This could eat into the margins of the homebuilders in the forthcoming quarters. Most homebuilders expect higher land and construction costs in 2014.
How Did the Major Players Fare Last Earnings Season?
The June quarter was rather soft for the homebuilders, as demand for homes belied expectations in the spring selling season. Pulte missed the Zacks Consensus Estimate for both earnings and revenues due to a decline in net orders and the number of closings along with a higher tax rate.
Higher closings and pricing gains helped D.R. Horton beat the Zacks Consensus Estimate for revenues. However, earnings missed the consensus mark and declined year over year. Higher incentives, reduced gross margins, higher SG&A ratio and massive inventory/land impairment charges in the Chicago market hurt quarterly earnings. Management had increased incentives to quicken the sales pace in the quarter. Though the strategy worked well for order trends, it took a toll on gross margins.
Others like Lennar and KB Home beat the Zacks Consensus Estimate for both earnings and revenues in the second quarter helped mainly by strong pricing and solid margins. While Lennar’s order trends declined sequentially due to a softer-than-expected spring selling season, KB Home’s orders improved sequentially in the second quarter.
Among smaller homebuilders, New Jersey-based Hovnanian Enterprises Inc.
and California-based Ryland missed expectations on both the top and bottom line. While higher SG&A ratio and a decline in the sales pace per community hit Hovnanian’s results, Ryland suffered from a soft order trend.
Others like Beazer Homes USA Inc.
(BZH - Free Report) , Meritage Homes and NVR, Inc.
(NVR - Free Report) performed relatively better in the quarter – beating the Zacks Consensus Estimate for both earnings and revenues. Higher sales prices, improved gross margins and better overhead leverage helped these companies outperform expectations. Toll Brothers' profits more than doubled in the just-reported quarter, though shares dipped on the news.
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. https://www.zacks.com/stocks/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 #98. This is in the middle 1/3rd of all industries ranked, highlighting the group’s near-term neutral outlook – the neutral stance reflects an improving home-sales environment after it stalled for a while in the first half of the year.
If we look at the overall results of the Construction sector, earnings shot up 14.2% in the June quarter from a 7.9% rise in the March quarter. Total revenues declined at a slower pace of 0.2% in the quarter than the 1.2% decline in the sequentially preceding quarter. The sector racked up an earnings beat ratio (the percentage of companies coming out with positive surprises) of 75.0% and a revenue beat ratio of 66.7% in the June quarter.
In the third quarter, earnings and revenues are expected to grow 7.7% and 6.0%, respectively with better growth rates expected in the fourth quarter as the sector regains momentum.
For 2014, earnings are expected to show a 10.1% increase. Revenues are forecast to expand 3.6%.
For more details about earnings for this sector and others, please read our latest ‘Earnings Trends.’
While the housing market has improved dramatically overall compared to where it was a couple of years back, the recent recovery has been a little choppier. However, homebuilders are increasingly optimistic of a pick-up in sales in the second half.
Our proprietary Zacks Ranks indicate the movement of stocks over the short term (1 to 3 months). At present, 11% of the stocks sport a bullish outlook while 78% are neutral. The remaining 11% are bearish.
Stocks which will likely outperform the broader market and currently hold a favorable Zacks Rank #2 (Buy) include KB Home and Toll Brothers. Despite their Zacks Rank #3 (Hold), we are also positive on Lennar due to it consistently strong performance, and Beazer Homes following its impressive June quarter results.
We are currently not too enthusiastic on Zacks Ranked #4 (Sell) William Lyon Homes
(WLC) and Gafisa S.A.
(GFA - Free Report) . We would also recommend avoiding Pulte, even though it carries a Zacks Rank #3 (Hold), due to its weak order trends in the first half.