The housing market has steadily made a comeback from the lows witnessed in mid-2006 from the severe and widespread downturn. The stability in the home buying market, combined with low interest rates and increased rentals, has increased the affordability of homes.
Moderate job growth and slowly increasing consumer confidence are also contributing to a rise in demand for new homes. Inventory of foreclosed homes and short-sale homes are declining, thus stabilizing prices of new homes. Home prices have started moving up with market demand gathering momentum.
As the housing market returns to its pre-downturn level, it will drive employment upward and build consumer confidence, thus providing stimulus to the overall economy. In fact, the health of the housing market is often an indicator of the health of an economy at large.
Homebuilders are thus witnessing increasing traffic levels due to heightened consumer demand. Most homebuilding companies are witnessing significant growth in both volumes and average selling prices (ASP). New home orders, backlogs (number of homes under sales contracts at the end of the year) and homes delivered are climbing year over year.
Moreover, improving homebuilding revenues combined with tight cost control and better overhead leverage (as volumes improve) are boosting margins for most homebuilders. The large discounts and incentives offered in response to declining demand during the housing downturn have mostly been called back.
Overall, the U.S. housing market has seen significant upside in new home sales volume for 2012 with industry-wide sales increasing roughly 25% from prior-year levels. New home construction activity improved 25% in 2012. Faced with the fiscal cliff at 2012 end, and the threat of sequestration and a mounting national debt, the recovery of the housing market was one bright spot on the U.S. economic horizon.
Increased Investments in Land Positions
With sales and profitability improving, most housing companies have strategically focused on acquiring new home sites in high demand areas, which will further improve revenues and profits. In addition to purchasing finished home sites, companies like Lennar Corporation (LEN), KB Home (KBH) and D.R. Horton, Inc. (DHI) also acquire early stage raw lands in A-plus locations, on which finished home sites can be built faster at a relatively lower cost.
D.R. Horton has indeed stepped up investments in homes under construction, land development and finished lots on the strength of its improved liquidity position from solid sales growth in 2012. The company’s land and lot position is now the strongest in its 35-year history.
PulteGroup, Inc. (PHM) spent $925 million on land and land development in 2012 and plans to spend another $1.2 billion on land and related development in fiscal 2013 and 2014. While the company is disciplined in adding land positions, it is also divesting lower-margin projects and exiting underperforming communities and lower-margin land lots which no longer fit into their operating strategy. This would free up cash to invest in other potential opportunities, generating higher returns.
KB Home has also exited underperforming markets like South Carolina, downsized operations in Arizona and Charlotte, disposed of unnecessary land and reduced exposure to risky joint ventures.
Focus on High-End Communities
Most homebuilders are shifting their focus on high-end communities. The average selling prices (ASPs) are improving for most large-cap homebuilders due to changes in the community/product mix. ASPs have gained from increased sales in high-end communities of California, Arizona, Colorado and Florida, where home prices are generally higher.
Given the scenario, large builders are eating into the share of other undercapitalized/small/medium-sized private builders on the back of overall housing demand, stronger capital and better land positions.
Lennar strategically focuses on acquiring new home sites that would boost margins and percolate down to the bottom line. The company focuses on high-margin, well-positioned communities and avoids fringe or tertiary markets where price is the only driver. The company’s focus on quality instead of quantity is benefiting margins and boosting new sales orders.
Pulte is also shifting its focus towards high-priced Pulte-branded move-up homes, which improve the overall ASP. A better mix of sales, particularly Pulte-branded move-up homes, as well as addition of new higher margin communities, is consistently boosting the company’s margins.
Small homebuilders like KB Home has started rolling out communities in highly desirable submarkets primarily in the Central and West Coast regions, which allow it to sell larger, higher-priced homes, driving up the ASP. KB Home in the fourth quarter 2012 has been able to drive up ASPs for 10 consecutive quarters. KB Home is also targeting higher income, first-time and move-up buyers — all of whom are more inclined toward buying a new home rather than buying a foreclosed one.
Another small homebuilder, Meritage Homes Corp. (MTH) 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 (TOL) is focused on raising the quality and the luxury quotient of its homes, thus giving it a competitive advantage.
Ancillary Companies also Stand to Gain
Construction material companies, Vulcan Materials Company (VMC) and Eagle Materials Inc. (EXP), and building product makers Masco Corporation (MAS) and Louisiana-Pacific Corporation (LPX) are also slowly gaining momentum from improving new home demand. These companies are also seeing a concomitant rise in demand and volume.
With both residential housing starts as well as non-residential contract awards showing a steady improvement, Vulcan is seeing some improvement in demand for its aggregates as well as non-aggregates businesses. Its aggregates business, which was sluggish in 2012, is expected to see solid demand growth in 2013 as private construction demand rises.
Masco is seeing improving North American sales on the back of increasing new home construction activity, which is driving demand for its home improvement products.
Strategic Restructuring & Cost Saving Initiatives
Most housing companies are striving to improve their operating and financial performance. The initiatives taken include steps to expand margins, improve overhead leverage, manage inventory tightly and implement new pricing strategies.
As part of its cost reduction program, Pulte has made significant workforce reductions and is also aggressively working to reduce overhead costs. In addition, the company had effectively managed its business during the downturn that led to positive cash flows, which in turn could be used to pay back outstanding debt. The company is also adjusting contents of its homes and building smaller floor plans to curtail construction costs.
Masco’s strategic initiatives include improvement of underperforming businesses like Installation and Cabinet, solidifying its market position and leveraging its brands, new product introductions and product innovation, reducing costs, paying off debt and strengthening its balance sheet. The company’s cost-saving initiatives included business consolidations, system implementations, plant closures, branch closures, improvement in the global supply chain and headcount reductions.
Over the last 4-5 years, Masco has reduced its gross fixed costs by approximately $600 million by closing around 33 facilities and reducing headcount by more than 30,000.
Construction aggregates maker Vulcan’s aggressive cost saving actions resulted in improved per-ton margins in 2012. In addition, the company re-organized its structure (consolidated eight divisions into four regions) in 2012, which lowered its selling, general & administration costs by 11% in 2012.
The company also has two other ongoing initiatives — a Profit Enhancement Plan and planned asset sales — in order to improve earnings and cash flows, pay off debts and thereby strengthen its overall credit profile.
The Profit Enhancement Plan is designed to reduce costs as well as enhance profitability by streamlining the management structure. Under the planned asset sale, Vulcan plans to divest its non-core assets in order to focus on the higher-growth Aggregates business. These sales will improve the company’s liquidity position and earnings.
KB Home is improving and refining its products, activating communities (which were held for future development) in stabilizing markets, increasing revenues per community with intense focus on sales performance, and strengthening management teams with additional resources to improve its operating performance while carefully managing costs.
Most homebuilders expect these cost reduction and operating efficiency improvement plans combined with reinvigorated housing demand to boost profitability in 2013.
How Will the Big Players Perform this Quarter?
A look at the Earnings ESP (Expected Surprise Prediction – Zacks’ proprietary methodology for determining which stocks have the best chance to surprise with their next earnings announcement) in the table below shows that Louisiana-Pacific could beat the Zacks Consensus Estimate in its first quarter 2013. The company is expected to outperform on the back of solid performance in its Oriental Strand Board (OSB) and Sliding segments driven by the housing market recovery. Masco is also expected to beat earnings this quarter driven by continued improving trends in the North American and the company’s turnaround efforts and profit improvement initiatives.
Among those which have already reported their results for this quarter, Lennar beat the Zacks Consensus Estimates for both revenue and earnings; KB Home beat on revenues and incurred a narrower loss; and Fastenal Company (FAST) delivered in line earnings and missed on revenues. While Lennar and KB Home gained from improving housing fundamentals, Fastenal continues to see sluggish sales of its fasteners product line (hurt by end-market slowdown and a broader economic uncertainty). Fastenal is a national distributor of industrial and construction supplies.
In terms of composite growth expectations (combining the reports that have come out with those still to come), total earnings for companies in the construction sector are expected to increase 80.5% (year over year) in the first quarter after the +90.3% gain in the fourth quarter of 2012, thus continuing its positive momentum. This reflects 10.9% increase in revenue and a modest margin contraction.
Note: DHI’s fiscal year ends in September while that of all other companies end in December.
Will the Housing Momentum Continue?
Notwithstanding the improving trend, the U.S. new home demand remains at historically low levels due to the currently weak U.S. economic conditions and tight mortgage lending standards. Sustainable increases in housing and housing demand for the long term will require the overall economy to strengthen, including further job growth.
Consumers will remain cautious until the employment scenario improves, home prices appreciate further and access to the credit markets ease. A sustainable housing recovery in the long term can be achieved only through a broad-based recovery in the overall economy, which we believe will take time.
Rising input costs are also 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 margins in the future.
The National Association of Home Builders/Wells Fargo Housing Market Index (HMI), known as the homebuilder sentiment index, dropped by 2 points to 45 in April due to rising building materials costs and shortage of developed lots and labor supply. Moreover, difficulty in obtaining construction loans and tightened lending standards are making it tough for homebuilders, especially the smaller ones to effectively respond to increasing demand.
That said, the earnings momentum for homebuilders has remained positive for the near term, resulting in a Zacks #1 Rank (Strong Buy) for D.R. Horton, Louisiana-Pacific and The Ryland Group, Inc. (RYL), and a Zacks #2 Rank (Buy) for Pulte, Masco, Lennar, KB Home and Hovnanian Enterprises, Inc. (HOV).
D.R. Horton has beaten Zacks earnings estimates in all the quarters of fiscal 2012 (ended Sep 2012) as well as in the first quarter of fiscal 2013 driven by growth in net sales orders, homes closed and sales order backlog. The company is expected to see continuous improvement in profitability on the back of geographic diversity, solid cost discipline, sound balance sheet, improved liquidity position, better pricing power, and rising home inventories and land position.
Lennar has witnessed solid year-over-year growth in new home orders, average selling prices and home closings in all quarters of 2012. Margins have also been above average, despite rising costs, driven by strong operating leverage. The company expects to continue to achieve further profitability in fiscal 2013 on the back of rising home prices, strong liquidity positions, solid backlog, strategic land acquisitions and new community openings.
Pulte has beaten Zacks earnings estimates in the last three quarters of 2012. Improving homebuilding revenues combined with the company’s cost control initiatives and solid operating leverage to boost margins. We believe that homebuilders like Pulte, who have significant land positions, broad geographic and product diversity, and better capital positions, are expected to benefit the most as market conditions recover.
Masco’s had a solid fourth quarter as both top and bottom line results surpassed the Zacks Consensus Estimate. The strong quarterly results were driven by strong performance in North America and Masco’s profit improvement initiatives. We are encouraged by Masco’s continued focus on product innovation and cost improvements. In general, management expects improved profitability in 2013 as both the new home construction and repair and remodel activities continue to recover.
With the housing market on a recovery path, we are not generally bearish on any housing company. However, we advise investors to avoid Fastenal. Fastenal’s daily sales growth rates in the last three quarters of 2012 were lower than the first quarter as well as the year-ago comparable periods. Daily sales growth rates to manufacturing customers have declined sharply due to lower sales of fasteners. We believe that the shift of resources to vending may also be hurting fastener sales. The stock carries a Zacks #3 Rank (Hold).
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