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Ticker: PulteGroup, Inc. (NYSE:PHM)

Rating: Downgrade from Buy to Hold

Thesis:

The 2012 story for PHM was very positive. We had shares Buy-rated at the beginning of the year and benefited from the stock in our long-term portfolios. Housing stocks have been the brightest story of 2012, but are they setting up for a flat 2013? We believe so. The problem for most of these stocks is that they have more than priced in their growth potential for 2013 and beyond. Taking PHM as an example, the company is now operating with a 44 PE and 20 future PE for us. While we see the company as in a definite growth mode, a 20 future PE is still showing a lot of future potential is pricing into the stock. As our model below shows, we believe PHM should see another 175% growth in operating income through 2016. With that much growth being priced into the model, we still only come up with a $17 price target, which is under where shares are currently. Additionally, we believe housing has more potential growth risk than most industries due to its connection to mortgage rates.

The company's latest quarter was fantastic, and we will not deny this. We had a Buy-rating moving into it. The company saw new home orders rise 27% to 4,544 along with a 6% jump in price as buyers continue to be attracted to new homes with mortgage rates very low. That trend should continue for all homebuilders with the Fed continuing to buy up Treasury bonds and liquidate markets, keeping rates low on loans. The company saw profits of $177M vs. a loss of $129M one-year prior. Additionally, the company has started to increase margins again as gross margins jumped from under 19% to over 21% in the latest quarter. We do not deny the story is bullish for PHM. The problem is that some threats remain, and the market has priced in the best-case scenario for PHM at this point.

First off, CEO Richard Dugas has commented that the company is being asked to by back 150-200 bad loans per month from Fannie Mae and Freddie Mac, which is up from the 50-100 they were doing earlier. The increase is likely due to the company's increase of free cash flow to $580M in the trailing twelve months compared to negative FCF in 2011. At the same time, the company says they will have to raise loan loss reserves, which will hurt equity value, if they are forced to make this change. Most of the bad loans are from Centex. Further, the home buyers that the company is seeing right now are due mostly to such low mortgage levels that are being held down by the Federal Reserve's actions and lack of strong consumer base. If the Fed pulls the plug or the unemployment rate dips, it could cause mortgage rates to rise, which may hurt demand. While we believe the trend is up over the next couple years, we are not as bullish that it's going to be a straight line up for housing as many share prices reflect. Some cyclical movement down in a long-term trend up should be expected. Share prices reflect a zero-to-sixty approach currently.

We do like PHM's efforts to increase its spending on land. The company is expected to increase its investment in land development and acquisition by $1.0B. The number of available new homes is actually diminishing, and this move is smart by PHM. The company, additionally, has strong geographic and product diversity, which is crucial. Different regions are seeing better recovery than others as well as different income levels, but these trends change quickly. Further, we like the company's continued payment of debt levels, which have declined by 29% since the end of 2010. They do still have $3B in long-term debt. That level is holding share prices in check, and a payment off of that debt level would increase our share price expectations. Yet, cash levels are diminishing, and the company is being forced to pay back bad Centex loans, which muddies the picture.

When stocks grow 150% in a year, most have missed the move. That's the case with PHM if you were not already in it. Our Hold rating means investors that hold should continue to hold. They have a solid housing company, but we do not expect significant upside in 2013. We also do not expect significant downside to Sell. For those not involved, if you see PHM see a significant dip to around $14, that is a great place to get involved. For those looking for housing exposure, we have a Buy-rating on M/I Homes (NYSE:MHO) with a $40+ price target for 2013. Other companies that will be covered below are DR Horton (NYSE:DHI), Standard Pacific (SPF) and Beazer Homes (NYSE:BZH). We have a Hold rating and $20 price target on DHI. Hold rating on SPF with $7 price target, and we have a Sell rating on BZH with $12 price target.

Price Target:

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

PHM

$17

$13

Hold

Buy

$14/$19

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

410

550

650

850

1110

Taxes

41

55

65

85

111

Depreciation

22

40

50

65

68

Capital Expendit.

-17

-40

-60

-80

-97

Working Capital

130

130

130

130

130

Available Cash Flow

244

50

265

440

840

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for PHM: 10.29%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9067

0.8221

0.7454

0.6759

*

PV of Available Cash Flow

221

41

198

297

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out the residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for the industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you the cap rate.

Cap Rate for PHM: 8.3%

2016

Available Cash Flow

840

Divided by Cap Rate

8.29%

Residual Value

10133

Multiply by 2016 PV Factor

0.6759

PV of Residual Value

6848

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

757

PV of Residual Value

6848

Cash/Cash Equivalents

1564

Interest Bearing Debt

3000

Equity Value

6169

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

6169

Shares Outstanding

386.32

Price Target

$16

In the end, we have found that PHM is worth around $16, which we believe accurately reflects the company's five-year projections.

Profitability:

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

8.6%

-17.8%

Gross Margin

18.0%

15.7%

Return on Equity

6.9%

-11.6%

Profitability has drastically improved for PHM as they are seeing black for the first time in years, and they are seeing margins get back into positive territory. Right now, companies are seeing slight profitability across the board in housing, so these comparisons are not as strong for more established industries. Still comparing profitability can help us to see what companies are executing the best on current rebound trends.

DHI has a 5% operating margin, 18% gross margin, and 26% ROE. MHO has a 4% operating margin, 20% gross margin, and 3% ROE. SPF has a 7% operating margin, 20% gross margin, and 6% ROE. Finally, BZH has a -2% operating margin, 10% gross margin, and -55% ROE. As we can see, PHM sits with the best operating margin, third best gross margin, and second best ROE. They are one of the industry leaders and have been bought up for that reason. Still these margin levels are very weak compared to most industries and need a great deal of improvement before we can justify such strong valuations for PHM.

Value:

Current

Industry Average

P/E

40.9

13.1

Future P/E

19.1

N/A

The PE ratio on PHM is very high, but it reflects a lot of future PE growth. Our 19 future PE is higher than industry averages. We do not have as strong of hopes for 2013 with profitability for PHM as we see the payments for bad loans to Freddie and Fannie inhibiting profits. How do these levels compare to competition?

DHI has a 7 PE and 14 future PE. MHO has an 84 PE and 16 future PE. SPF has 41 PE and 23 future PE, and BZH has neither as its operating at a loss. Valuations for these companies really are not as crucial once again as when looking at other companies due to their rebound phase. Yet, 15 is usually the level for future PE we look at for value in companies. None of these companies are at these levels, and we do not consider stocks rebounding from losses as growth stocks. Therefore, they show overvaluation.

Source: Home Builders, Pulte Homes Will Slow Down In 2013