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D.R. Horton (DHI - Free Report) , one of the biggest and most well-known homebuilders in the nation, reported lackluster third-quarter 2014 results on July 24 before the bell. Though the housing company came up with mixed results with earnings missing the Zacks Consensus Estimate by a wide margin and revenues beating the same, the real pessimism was in its business policy and the nation’s homebuilding outlook.

Q2 Numbers in Detail

The company’s adjusted earnings of 32 cents per share fell shy of the Zacks Consensus Estimate of 49 cents by 34.7% and declined 23.8% year over year. Soft margins can be held responsible for this miss. The company also witnessed a double-digit increase in cancellation rate.
This was pretty disappointing as the company had shown a solid history of beats in the preceding quarters. However, homebuilding revenues of $2.10 billion grew 27.3% year over year and surpassed the Zacks Consensus Estimate of $2.04 billion by 2.9%. Home sales increased 28.2% year over year probably due to management boosted incentives to trigger sales absorption, which in turn ate up profits.
Biggest Concerns

The biggest worries for D.R. Horton might be the sluggish recovery of the housing market which is seeing lesser demand thanks to poor wage growth and potential rise in interest rates in the next year. This in turn results in lower appreciation of home prices (Read Time to Worry about Homebuilder ETFs?).

As a result, the margins have become a troubling issue for firms like D.R. Horton as evident by a 70 bps decline in home sales gross margin (on a year-over-year basis) and 180 bps sequentially. The joint effect of higher incentives and rising costs accounted for 90 bps of the sequential margin pressure.

Beyond the market’s expectation, gross margins of the company could not even meet the company’s expected range of 21.5–22.5%. One can also understand the soft demand scenario from net sales orders for DHI which rose 25% year over year but slipped 0.2% sequentially. Cancellation rate was 24%, higher than 19% in the previous quarter.

While there was no marked change in cost structure, promotions began to creep up on the companies as they tried to lure buyers. D.R. Horton commented that incentives were at rock-bottom levels in fiscal 2013 and early 2014 that played a key role in a housing recovery, but are now coming back to normal levels in several markets.

Market Impact

Given the poor results and the unfortunate trend on the margin front, investors are growing increasingly bearish over D.R. Horton’s near term future and punished the stock brutally. The stock had a bloodbath in the key trading session of July 24 as it plunged 11.53%, representing a multi-year low level on five times high volume (read: Has Spring Finally Sprung for Housing ETFs?).

Another company – Pulte Group (PHM - Free Report) – also missed the Zacks Consensus Estimate on both lines. Its second-quarter 2014 adjusted earnings of 25 cents per share lagged the estimate and as well as the year-ago figure by 3.8%.

As expected from the industry fundamental, factors like weak net orders and higher selling, general and administrative (SG&A) ratio hurt Pulte’s earnings. Pulte Group’s total revenue of $1.29 billion in the quarter fell shy of the Zacks Consensus Estimate of $1.34 billion by 3.7% and was just up 0.8% year over year.

ETF Impact

The bearishness also caused a fall in broad housing ETFs as more questions are starting to appear regarding some of the key names in the industry. Housing ETFs including SPDR S&P Homebuilders ETF (XHB), iShares U.S. Home Construction ETF (ITB) and PowerShares Dynamic Building & Construction Fund (PKB) lost about 1.65%, 3.43% and 1.15% respectively on July 24.

DHI and PHM take first and third positions in ITB, accounting for about 10% and 9.58% respectively. XHB invests about 3.29% in DHI while PKB puts about 4.85% of portfolio in Pulte Group. All three ETFs have a Zacks ETF Rank #3 (Hold) (read: A Comprehensive Guide to Housing ETFs).
Bottom Line

While the recent releases weren’t great for the space, it has seen some light at the end of the tunnel. U.S. home re-sales touched an eight month-high in June indicating that the gloom over the sector might disperse in the coming months if the economy picks up momentum.  Now that the U.S. economy is on the verge of leaving the cheap-dollar era, this sort of distortion in profitability appears warranted.

Given this, investors probably shouldn’t set aside the entire housing space just yet. In fact, they can buy the aforementioned ETFs on recent weakness.  However, to do so one needs to be hawk-eyed and closely monitor the every economic release minutely (read: 2 Hot Summer ETFs Surging to #1 Ranks).

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