Why Homebuilder Stock Prices Lack Structural Support

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To understand why the public homebuilders have no business trading at their current prices, one needs to look no further than their price to earnings (( PE )) ratio. As most public homebuilders haven't reached profitability on a trailing twelve month basis for over two years, their current price to earnings ratio has been incalculable and useless.

However, as these builders slowly make their way back to positive earnings and exude excitement from unknowing investors that believe they are buying at the bottom, it is important to look at where we have been to help figure out where we might be going.

When profitable, most public homebuilders traded at similar PE ratios. During the period from 2000 through 2006, arguably the strongest period of growth in the housing industry, homebuilder PE multiples were generally just below 10x on a Trailing Twelve Month (( TTM )) basis and 8x on a Forward Twelve Month (( FTM )) basis.


Assuming those multiples are the norm for the industry, how long will it take these builders to get the earnings to catch up with the price?

This is not likely to happen anytime soon.

Methodology

Our approach started with the premise that homebuilders' stocks should eventually get back to trading at historical PE multiples of 8x (on a FTM basis). We developed a simple financial model to determine what improvements in home closings and average sales prices need to occur in order for homebuilder's earnings to make sense in light of current share prices.

We performed this analysis on the top publicly-traded homebuilders ([[BZH]], [[DHI]], [[HOV]], [[KBH]], [[LEN]], [[MDC]], [[MTH]], [[PHM]], [[RYL]], [[SPF]], [[TOL]]), but have chosen to highlight two builders for this article, DR Horton ( DHI ) and KB Homes ( KBH ). While there are many variables that could be adjusted, the fact is closings and the average sales prices are going to be the primary drivers for homebuilder earnings improvement going forward.

Most builders have already shaved their overhead as far as they can. Therefore, inherent in our analysis is that selling, general & administrative (SG&A) expenses will remain at current levels going forward, and staffing levels and advertising, will be adequate to handle the increase in volume (we know this is conservative and borderline funny, however we had to start somewhere).

The only portion of selling and marketing costs that we assumed to be variable are commissions since they are directly tied to the sale of a home. As a result, SG&A, which is currently running in the high teens as a percentage of revenues for most homebuilders today and actually higher for several others, with the exception of DR Horton, should decline to approximately 10% of revenues in the future. This is a pretty conservative level as only DR Horton would consistently achieve an SG&A level of 10% of revenues in the "good old days."

We also assumed that gross margins in the future will be in the 22-25% range, excluding the impact of impairments. Currently, when you exclude impairments, the homebuilders, as a group, are selling homes at approximately 16%.

Historically, builders that operated in the high growth areas of California and Florida would expect to see margins in the high 20% range, and those that operated in the lower growth regions would expect to see gross margins in the high teens. On a blended average, 20-25% has historically been a reasonable goal of most homebuilders.

Additionally, we assumed that financing would be available to fund any additional growth. Further, as these results are expected to happen a few years down the road, we assumed they would be tax payers at a rate of 35%.

Results

  • DR Horton

DR Horton would need to achieve a target EPS of $1.59, or $533 million of net income, assuming an 8x PE multiple based on their approximate 318 million shares outstanding to support their current stock price of $12.70. Given their current trailing 12 months of closings and average sales price in backlog, DR Horton would need to grow their revenues to $6.7 billion or approximately 70% from today's current pace.

In order to hit this level, we assumed that they would need to grow their unit closings by 50% and raise their average sales price 15%. If DR Horton could increase their average sales price 4% per year and grow closings 15% per year, they would achieve an EPS of $1.59 in just less than 4 years.

This also assumes that their SG&A which currently is at 14.4% of revenues would decline to 9.5% and their gross margin, which is currently at 18%, would improve to 23%. As a point of reference, DR Horton was running SG&A at 9-10% of revenues during their peak earnings years.

  • KB Homes

KB Homes, would need to achieve a target EPS of $1.98, or $153 million in net income, assuming an 8x multiple based on their approximate 77 million shares outstanding to support their current stock price of $15.85. Given their current pace of home closings and their average sales price in backlog contracts, KB Homes would need to grow their revenues to $2.9 billion or approximately 80% from today's pace.

In order to hit this level we assumed they would need to grow their unit closings by 50% and raise their average sales price by 20%. If KB Homes could increase their average sales price by 4% per year and grow closings 10% per year, they would achieve an EPS of $1.98 in just over 4 years.

This also assumes that their SG&A would decline to 12.5% from their current level of approximately 17% and their gross margin, which is currently at 18.8%, would improve to 23%. As a point of reference, KB Homes was running SG&A at 12-13% of revenues during their peak earnings years.

Conclusion

Our assumption for the annual growth rate of closings for most builders ranges from 10-15%. During the early 2000's, annual growth rates for housing starts and new home sales ranged from 7-12%. However, the economic climate was much more favorable during this earlier time period. Further, most homebuilders are still showing declines in unit closings, with only Beazer ( BZH ) and DR Horton producing YOY increases for their most recent quarters.

Our assumption for annual average sales price increases is 4%, while many economists are predicting less than 4% annual increases over the next four years. Actual growth in closings and sales price appreciation will be impacted by the overhang of foreclosures and shadow inventory which continues to depress the level of housing starts and mortgage applications. As a result, we believe that 4 years appears to be a reasonably conservative estimate for DR Horton, KB Homes and the other public builders to achieve a level of earnings that would warrant trading at their current stock prices.

The real issue isn't whether homebuilders will ever get back to these earnings levels, but rather when will they. If that 'when' is in 4 years, then why invest in these homebuilders at the current price levels today?

Disclosure: No positions

See also Timber! Lumber Prices Hitting the Ground on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , US Markets

Referenced Stocks: BZH , DHI , FTM , KBH , PE , TTM

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