Shares of homebuilding stocks and anything related to housing were the momentum trade of 2012. What started out as justifiable appreciation that appeared to track the steady improvement in housing during the first 9 months of the year, turned into a momentum trade in the last quarter of the year. As housing starts and home sales stayed relatively flat since October, home building stocks continued their upward ascent into year end. I believe the valuations of many stocks in the sector are now stretched as they are trading well above traditional forward PEs and price/book ratios, and apparently are already pricing in not only a strong 2013 but a strong 2014 as well. And in the case of Hovnanian, I would argue the market is pricing in a strong decade and a housing market that never has another downturn.
Hovnanian (HOV) and M/I Homes (MHO) are two stocks in the sector which ran wild in the 4th quarter even as housing starts' sequential growth stalled. I believe these two builders will be especially vulnerable in 2013 as I believe investors last year seeking to buy everything housing, have overlooked the fact that these two companies are prohibited from making payments of preferred stock dividends. It is remarkable that these companies have been bid up to nosebleed historic valuations, when they can't even make payments on large issues of preferred stock outstanding because of debt covenants. Usually such a situation would warrant a large discount in stock valuation to otherwise fair value. Because if a company can't make a payment on its preferred stock, the company is unlikely to pay a dividend on its common shares or to return money to shareholders via a share buyback. It would appear that investors are overlooking the lack of creditworthiness this implies as well as future increases in cost of capital. Shares of Hovnanian were up 102% in Q4 while shares of M/I Homes rallied 37%.
M/I Homes has $100 million in preferred stock outstanding
Note 19 of M/I Homes' 10-k reveals that the company has been skipping dividend payments on its preferred stock since mid 2008. By my calculations, had debt covenants of M/I Homes permitted the paying of dividends on its preferred stock, earnings in the most recent quarter would have been $.10/share lower or 38% lower. Furthermore, the forward PE of 18 that is already extremely high by historical standards, would increase to approximately 25 were preferred dividends to be paid.
Hovnanian has $140 million in preferred stock outstanding
Hovnanian has been restricted from making a payment on its preferred stock for the last five years and currently their preferred shares trades at around 52 cents on the dollar.
While earnings reports for these 2 companies are currently being benefited by them having a large chunk of their capital structure with a cost of capital of zero, eventually either they will have to start making dividend payments to preferred shareholders which will depress earnings, or they will have to replace that capital with either debt or equity at a much greater cost.
Hovnanian's balance sheet makes it one of the more absurdly overvalued stocks on the NYSE
As of October 31th, 2012, Hovnanian had negative shareholder equity of $485 million. This includes the $140 million preferred share class. So net of preferred stock, common shareholder equity equaled a NEGATIVE $620 million! While it is not entirely uncommon for publicly traded companies to have negative tangible equity, it is particularly noteworthy in an industry such as homebuilding, where companies are principally valued off of a price to equity ratio and for an industry where one is attempting to make a return on equity.
Investors appear to already be pricing in $1 billion in future Hovnanian profits
Consider that the typical homebuilder trades at approximately 2 times book value. For example, DR Horton (DHI) recently traded at a price/book of 1.72. Now that Hovnanian shares have risen to an astonishing market cap of over $900 million, they would need to earn $1 billion+ to improve the negative $620 million equity position to a positive level to be in line with the typical 2 times book ratio that other well capitalized builders trade at. And seeing how fiscal year 2014 estimates are for only around 47 cents a share in profit (about $65 million), it is safe to assume that it will probably take at least a decade for them to earn $1 billion and that is if they are lucky.
During housing busts homebuilder stocks trade toward book value
Since homebuilding is an extremely cyclical industry, it is important to consider future down cycles when attempting to arrive at a fair stock valuation. In past down cycles, homebuilder stocks have fallen toward or even well below tangible book value. My big concern for Hovnanian, is that they will be hard pressed to get their book value back positive before the next bust hits. And even if they manage to, the trough valuation implied by what will likely still be an extremely low amount of equity will not justify anything near the current share price. While the likelihood of Hovnanian getting their common equity back above zero before the next housing bust occurs through operating profits is close to zero, let's give them the benefit of the doubt and assume they will earn $1 billion between now and say 2022. Lets use a generous assumption that there won't be another housing bust prior to 2022. So for argument sake, let's assume everything goes perfectly and that in 10 years out Hovnanian will have rebuilt common shareholders' equity to around $400 million. That would equal about $3/share in tangible book value. Therefore, when the next housing bust materializes in 2022, I would expect HOV could be trading at about $3/share or lower at that time entering the next bust cycle.
Present Value Calculation for Hovnanian shares of $1.53
Working backward from the above future bust cycle valuation of $3/share, discounting a $3 share price back 10 years at a conservatively low 7% required rate of return yields a present fair value of only $1.53/share. Even a boom valuation of 3 times book value only yields a present value of $4.57.
So why is Hovnanian trading at $7/share when median analyst target prices are in the $3 range and my present value trough scenario calculation is only $1.53 even when I use wildly bullish earnings expectations?
I believe that there are many investors playing the homebuilder sector on a technical basis without looking at the fundamentals. Also I believe many traders have been drawn to the shares of Hovnanian because they are the lowest price of all the companies in the sector. Many view Hovnanian like an option on housing. And since housing was the hot sector for 2012, there just aren't enough shares to go around to meet the demand of people wanting to throw down some bucks on housing. Most people who own shares in the company probably don't realize they even have a class of preferred shares for which no dividend has been paid in 5 years and certainly the algos and high frequency traders which dominate the float have no interest in this fact! Statistically Hovnanian stock has traded with the housing sector and has a very high beta of 2.84. So people buy and sell the stock as a beta chase with little regard to intrinsic value.
M/I Homes isn't as crazily valued as Hovnanian as it actually has positive shareholder equity and trades at a close to average price/book of 2.3. I would however wait for a pullback closer to the mean analyst target price of $22 before initiating a longer term position.
I expect valuations for these two builders to return to the penalty box in 2013 when the buy everything housing trade subsides.