Ticker: D.R. Horton Inc. (DHI)
Rating: Downgrade from Buy to Hold
Thesis:
2012 was a great year for housing, but we are not seeing the same type of upside in 2013. One of the top performers of 2012 was DR Horton. The homebuilder is up close to 60% this year, but with such a strong performance, the stock's valuation has become unattractive. DHI is currently sitting with a 15 future PE. While not extreme, we look for sub-15 for value. The company's CEO confirmed our worry about the health of the housing industry in the company's latest quarter as he commented he is worried about further growth next year as employment remains depressed. With a lack of job growth in 2013, it would be hard to expect that the housing industry will see a drastic amount of growth year-over-year, and we believe that DHI is fairly limited due to this main reason. We are expecting a slight drop in 2013 with renewed growth in 2014.
Here are the CEO's comments from the latest quarterly report:
"I still don't see a lot of jobs being created…And I also see the fact that there are potential layoffs in a number of industries, especially the defense industry."
We believe growth for 2014 will ensue, but the market appears to be pricing in appropriately that growth already. The market is continuing to rebound as cheap home prices remain, and as confidence grows about the overall state of economy, people are dipping back into the housing market. Yet, we see that development as a plus for existing homes and less for new homes. Further, interest rates remain low, but while they do remain low, people need more jobs to want to buy homes. The most exciting thing for homebuilders is that they have cut costs to the bone, and that means that profitability is very strong. Profits should remain strong for all homebuilders, but we foresee some repressed demand that extends from lack of employment growth. Homebuilders are on their way, but 2013 may be the lull before another explosion in 2014-2016.
The problem with DR Horton, individually, is that we believe shares are fairly well priced at this time. We have expectations for the growth of operating income around 175% for the company through 2015. That level shows significant growth, yet even with that growth, our price target shows only around $20 for fair value for DHI as can be seen below. First off, we expect a strong increase in changes in working capital as the company continues to increase its current assets in a growth mode as well as capital expenditure increases. Additionally, what is hurting our price model from showing stronger prices is the fact that the company has $2.5B in debt right now. Those significant debt levels are holding the share price targets down for us, and we need to see those levels come down before we would increase our targets.
We realize that housing is the popular industry right now, but we believe that a lot of the excitement needs to be held in check until we see unemployment rates come back down. Further, the fiscal cliff that could potentially occur at the beginning of the year would drastically hurt the housing market. Right now, we need to see a decrease in debt, profits rising over 2012 levels, and unemployment decrease below 7% before we are ready to put our money into DHI. Right now, we also see most of the company's competition at similar levels with a Hold rating. Our recent article on Pulte Homes (PHM) showed the company at a Hold for similar reasons. We see most of the company' competition at similar fair valuations. We have Standard Pacific (SPF) Sell-rated with a $7 price target. We have Beazer Homes (BZH) Hold-rated with a $12 price target. Of the 12 companies we have coverage on, we only like M/I Homes (MHO) as a Buy in 2013 with at $40 price tag. You can see those price targets here.
Price Target:
Ticker | New Price Target | Old Price Target | New Rating | Old Rating | New Buy/Sell Range |
DHI | $20 | $21 | Hold | Buy | $16/$22 |
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 | 204 | 185 | 260 | 350 | 564 |
Taxes | 20 | 19 | 26 | 35 | 56 |
Depreciation | 19 | 25 | 40 | 50 | 59 |
Capital Expendit. | -34 | -35 | -35 | -55 | -71 |
Working Capital | 100 | 100 | 100 | 100 | 100 |
Available Cash Flow | 69 | 57 | 139 | 210 | 396 |
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 DHI: 8.76%
2012 | 2013 | 2014 | 2015 | 2016 | |
PV Factor of WACC | 0.9195 | 0.8454 | 0.7773 | 0.7170 | * |
PV of Available Cash Flow | 63 | 48 | 108 | 150 | * |
* 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 residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for 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 cap rate.
Cap Rate for DHI: 3.76%
2016 | |
Available Cash Flow | 396 |
Divided by Cap Rate | 3.76% |
Residual Value | 10521 |
Multiply by 2016 PV Factor | 0.7145 |
PV of Residual Value | 7520 |
Step 4.
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows | 369 |
PV of Residual Value | 7520 |
Cash/Cash Equivalents | 1030 |
Interest Bearing Debt | 2493 |
Equity Value | 6426 |
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 | 6426 |
Shares Outstanding | 320.97 |
Price Target | $20 |
In the end, we have found that DHI is worth around $20, which we believe accurately reflects the company's five-year projections.
Profitability:
Q1-Q4 2012 | Q1 - Q4 2011 | |
Operating Margin | 4.8% | -0.2% |
Gross Margin | 17.6% | 14.8% |
Return on Equity | 26.2% | 2.7% |
One of the benefits of DHI is that it has done very well to increase its profits year-over-year. The company has seen margins increase YoY as well as its return on equity. Its margins are still at fairly limited levels, but the ROE is looking very strong right now. How does this compare to competitors?
PHM has an operating margin of 9%, gross margin for 18%, and ROE of 7%. MHO has an operating margin of 4%, gross margin of 20%, and ROE of 3%. SPF has an operating margin of 7%, gross margin at 20%, and ROE at 6%. Finally, BZH holds a negative margin and ROE and gross margin at 10%.
As we can see, DHI sits in the middle of profitability for its industry, and this reason is definitely another reason to be cautious with DHI. They are not the best in the industry.
Value:
Current | Industry Average | |
P/E | 6.8 | 13.1 |
Future P/E | 14.1 | N/A |
As far as value goes, we see DHI as close to fairly valued. PHM has a 41 PE and 15 future PE. SPF has a 41 PE and 23 future PE. MHO has an 84 future PE and 16 PE, and BZH has no PE or future PE due to no profitability. The company sits pretty similar to the rest of the industry as far as value.
