After the tough years 2006-2007, the housing market is now recovering steadily. The stability in the home buying market, combined with low interest rates and increased rentals, have increased the affordability of homes. Improvement in employment and consumer confidence is also contributing to a rise in demand for new homes.
Inventory of foreclosed homes and short sale homes is declining, thus stabilizing prices of new homes. Additionally, buyers are selecting larger and upscale homes with energy-efficient features, which are increasing average sale prices.
Thus, homebuilders are 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. Home prices have started moving up lately with market demand gaining momentum.
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 and an oversupply situation are gradually being rolled back.
Overall, the U.S. housing market has seen significant upside in new home sales volume for the first nine months of 2012 with industry-wide sales increasing roughly 25% from prior-year levels. The improving housing outlook thus has been a solitary bright spot on the economic horizon.
The National Association of Home Builders/Wells Fargo Housing Market Index (HMI), known as the homebuilder sentiment index, rose for the eight consecutive month in December, improving by 2 points to 47. This is a significant improvement from the depths of the housing downturn and is the index's highest level since April 2006. The improvement in this index suggests an increased demand for housing and better sales prospects for the next few months.
Focus on High-End Communities
Most homebuilders are focusing on the 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 shares of other undercapitalized small/medium-sized private builders on the back of overall housing demand, stronger capital and better land positions.
Lennar Corporation ( LEN ) strategically focuses on acquiring new home sites that would boost margins and benefit 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.
PulteGroup, Inc. ( PHM ) is also shifting its focus toward 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 ( KBH ) has started rolling out communities in highly desirable submarkets, primarily in the Central and West Coast regions, which allows it to sell larger, higher-priced homes, driving up the ASP. The company is also reallocating resources to focus on core preferred markets with strong growth prospects like those of California and Texas. 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 foreclosure.
Another small homebuilder, Meritage Homes Corporation ( MTH ) is investing in well-positioned and high-priced land and new communities in the most desirable submarkets, which should ensure profits as the market gets stronger.
Increased Investments in Land Positions
In addition to purchasing finished home sites, companies like Lennar 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 and at a relatively lower cost.
The pace of D.R. Horton's investments in homes under construction, land development and finished lots has increased following the improved liquidity position from solid sales growth in the first nine months of 2012. In the first nine months of 2012, the company invested $938 million on land developments versus total investment of more than $800 million over the past couple of years.
Pulte is also investing in acquiring land positions and expects to spend $1 billion on land and land development in 2012. 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 its operating strategy, thus freeing up cash to invest in other potential opportunities, which could generate higher returns. Pulte is also using its existing land assets more efficiently and lowering unsold inventory levels more aggressively, which in turn are benefiting its working capital and margins.
Most housing companies resorted to cost reduction initiatives in order to cope with the housing downturn and raw material cost inflation.
Pulte has made significant workforce reductions and is also aggressively working to reduce overhead costs. In 2011, the company consolidated its field organization and certain corporate functions. It also consolidated its regional operations in Arizona, Florida, New York and New Jersey and merged its West and Central areas.
Home improvement products-maker Masco Corporation's ( MAS ) cost-saving initiatives included business consolidations, system implementations, plant closures, improvement in the global supply chain and headcount reductions. The restructuring initiatives are expected to result in about $175 million of gross cost reduction in 2012.
Construction aggregates maker Vulcan Materials Company ( VMC ) has invested in a new Oracle-based ERP and Shared Services platform, which allowed the consolidation of the company's eight divisions into four regions. The system also streamlined its support functions, thereby reducing related positions and overhead costs.
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, the company 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.
Other smaller homebuilders like KB Home significantly reduced its overhead, inventory and community count levels to better align operations with the reduced housing activity. Consequently, the company exited underperforming markets like South Carolina, downsized operations in Arizona and Charlotte, North Carolina, lowered production costs, disposed of unnecessary land and reduced exposure to risky joint ventures.
Most homebuilders are expecting these restructuring and cost savings initiatives to help them achieve profitability as the housing dynamics continue to improve.
Performance of Key Players in the Past Quarter
Gaining from the improving housing dynamics, key housing companies like Pulte, Lennar and D.R. Horton delivered stronger-than-expected results in the third quarter. However, other operators like Vulcan Materials and Fastenal Company ( FAST ) either missed or could only meet expectations. While Fastenal, a national distributor of industrial and construction supplies, faces uncertainty in the growth outlook for some of non-housing end markets, Vulcan Materials is facing volume headwinds in its largest segment, Aggregates.
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) shows that Pulte could beat the Zacks Consensus Estimate in the fourth quarter of 2012. Pulte management is also expecting better profitability in the future quarters.
Overall the earnings picture for the group as a whole remains very robust. Total fourth quarter 2012 earnings for the homebuilder sector are expected to be the highest of all 16 Zacks sectors at 33.3% from the same period last year, reflecting a combination of strong revenue growth and margin expansion. This follows the group's strong performance in the third quarter, when total earnings increased 56.6%.
With overall earnings growth in the broader S&P 500 essentially flat in the third quarter and expected to be no different in the fourth quarter, the housing group provides the few areas of earnings growth in the present environment. Importantly, the trend has only just started and still has plenty of room to grow.
Full Housing Recovery Will Take Time
The last few years have seen a very fragile housing market. The downturn in housing -- aggravated by an overall weak economy, high unemployment rates, low consumer confidence, rising interest rates and tightened mortgage-lending standards -- weighed on homebuilders.
Declining demand for new homes and an excess of supply in the market in 2011 drove homebuilders to make large concessions in prices, largely hurting profitability. Homebuilders' sales and profit margins had dropped dramatically from peak levels in 2006.
As discussed above, there have been signs of a gradual strengthening in the housing market in 2012. However, homebuilders have cautioned that the process of stabilization is erratic and not adequately broad-based.
The housing market improvement has been uneven across the country. Most of the gains have, by and large, been observed in high-end communities. In addition, some homebuilders are still facing impediments in raising prices in some markets. Tight credit standards and reduced credit availability for residential consumer mortgage loans still remains a constraint.
Moreover, consumers will remain cautious until job growth, continued home price appreciation and access to credit improve their confidence. A speedy housing recovery is thus unlikely and the timing of the markets to fully recover and return to a more historically typical operating environment is uncertain.
The improved business backdrop is showing up in positive earnings momentum for homebuilders, resulting in Zacks #1 Rank (Strong Buy) for Lennar and Zacks #2 Rank (Buy) Pulte ( PHM ), Hovnanian Enterprises, Inc. ( HOV ) and The Ryland Group, Inc. ( RYL ).
Lennar has witnessed solid year-over-year growth in new home orders, average selling prices and home closings in all the three quarters of 2012. Margins have also been above average, despite rising costs, driven by strong operating leverage. Lennar appears to be well positioned for growth in the future quarters as well.
We believe that the company is performing better than its peers by increasing sales prices, reducing incentives, improving volumes and by making opportunistic land acquisitions.
Pulte has beaten the Zacks Consensus Estimates in the second and third quarters of 2012. Improving homebuilding revenues combined with the company's cost control initiatives are boosting 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.
We are also optimistic that, despite a Zacks #3 Rank, these companies have bright prospects going forward:
Toll Brothers ( TOL ) enjoys the competitive advantage of being the largest luxury home builder in the country with little competition in this niche sector. Toll Brothers delivered solid results in the last three quarters of fiscal 2012 (ended October 2012). The company has delivered double-digit growth in net orders in every quarter of fiscal 2012 and expects the momentum to continue in fiscal 2013 as well.
D.R. Horton's ( DHI ) strong cash flows, its geographic diversity and its solid cost discipline encourage us. The company has beaten the Zacks Consensus Estimate of earnings in all the quarters of fiscal 2013 (ended September 2012) driven by growth in net sales orders, homes closed and sales order backlog as the housing market recovers.
Meritage Homes ( MTH ) delivered solid results in the second and third quarter of 2012, owing to robust new order growth and improved pricing. The company saw significant growth in closings, average sales prices, revenue, orders, backlog, gross margin and net earnings in both the quarters. The company has also started raising prices in most of its communities. It is expecting revenues to increase at an impressive growth rate of 20%-30% in fiscal 2013. We believe the company's focus on acquiring new communities in the most desirable submarkets will generate profits in the long run.
With the housing market showing a steady recovery, we are not generally bearish on any housing company. However, we advise investors to avoid names that have reported sluggish results in the past 2-3 quarters.
Fastenal's ( FAST ) daily sales growth rates in the second and third quarters of 2012 were lower than the first quarter as well as year-ago comparable periods. Daily sales growth rates to manufacturing customers have declined sharply due to lower sales of its fasteners product line, which are being hurt by end market slowdown and broader economic uncertainty. We believe that the shift of resources to vending may also hurt fastener sales. The stock carries a Zacks #4 Rank (Sell), reflecting its lack of earnings momentum.
Vulcan ( VMC ) reported lackluster earnings in the second and third quarters of 2012 due to a decline in revenue and volumes. Revenues declined from the prior-year quarter levels mainly due to a decline in shipments and an unfavorable geographic mix in its flagship Aggregates segment, which produces construction aggregates. The stock carries a Zacks #3 Rank (Hold). Despite being a Zacks #3 Rank stock, we cannot rule out a downgrade in the near future following back-to-back disappointing quarters.
Masco ( MAS ) can also be avoided currently as it faces headwinds from weak big ticket remodeling activity and slow European economies, offsetting the benefit from an improving new home construction environment in the U.S. The stock carries a Zacks #3 Rank.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.